Rights of First Refusal (ROFR) are critical provisions that affect how employees can transfer or sell their equity. This comprehensive guide explains ROFR, its implications, and how to navigate these provisions effectively.
What is a Right of First Refusal?
A Right of First Refusal is a contractual right that gives the company (and sometimes other shareholders) the opportunity to purchase shares before they can be sold to a third party. This right typically applies to:
How ROFR Works: Step-by-Step Process
Notice Requirements: When an employee receives a third-party offer:
Written Notice Requirements:
- Proposed buyer's identity
- Purchase price
- Payment terms
- Other material conditions
Timing Requirements:
- Usually 30-45 days notice
- Can vary by company
- Clock starts upon proper notice
Example Notice Format: Notice of Proposed Transfer under ROFR
- Date: [Date]
- To: [Company Name]
- From: [Employee Name]
Details of Proposed Transfer:
- Number of Shares: 10,000
- Price per Share: $25
- Total Consideration: $250,000
- Proposed Buyer: XYZ Investment Fund
- Payment Terms: Cash at closing
- Proposed Closing Date: [Date]
Company Response Period
Typical Timeline:
- Day 1-15: Company evaluation period
- Day 15-30: Company decision
- Day 30-45: Closing period if company exercises
Company Options:
Exercise ROFR
- Match third-party terms
- Purchase all or portion
- Set closing timeline
Waive ROFR
- Allow third-party sale
- May have conditions
- Time limit for completion
Real-World Scenarios
Scenario 1: Simple Cash Offer
Situation:
- Employee has 20,000 vested shares
- Receives offer for $15/share
- All-cash transaction
Timeline:
- Day 0: Notice submitted
- Day 20: Company exercises ROFR
- Day 35: Transaction closes
Financial Impact:
- Same proceeds ($300,000)
- Different buyer (company vs. third party)
- Potentially faster closing
Scenario 2: Complex Terms
Situation:
- 50,000 shares
- Offer includes:
- $10/share cash
- $5/share earnout
- Strategic partnership terms
ROFR Complications:
- Company must match all material terms
- May need to provide equivalent value
- Could lead to negotiations
Scenario 3: Partial Exercise
Original Offer:
- 100,000 shares
- $20/share
- Single buyer
Company Response:
- Exercises ROFR on 60,000 shares
- Waives rights on 40,000 shares
- Same price terms
Result:
- Split transaction
- Multiple closings
- Additional complexity
Key ROFR Provisions to Understand
Scope of Rights
Common Coverage:
- Voluntary transfers
- Involuntary transfers
- Pledges and encumbrances
- Estate planning transfers
Exceptions Often Include:
- Family transfers
- Charitable donations
- Estate transfers
- Small percentage transfers
Exercise Mechanics
Price Matching Requirements:
- Exact same terms
- Equivalent value
- Payment timing
Example Price Match:
Original Offer:
- $1M total price
- $800K cash
- $200K note
Company Match Options:
- Identical terms
- All cash at present value
- Modified payment schedule
Time Periods
Critical Deadlines:
- Notice period
- Exercise period
- Closing period
- Waiver expiration
Example Timeline:
- Day 0: Notice delivered
- Day 30: ROFR exercise deadline
- Day 60: Closing deadline
- Day 90: Waiver expiration
Impact on Sale Strategies
Finding Buyers
Considerations:
- Buyer awareness of ROFR
- Price negotiation impact
- Timeline expectations
Strategy Example:
- Identify multiple buyers
- Obtain written offers
- Select best terms
- Factor in ROFR probability
Negotiating Terms
Key Points:
- Price structure
- Non-price terms
- Timing considerations
- Break-up provisions
Example Term Sheet:
Purchase Terms:
- Shares: 25,000
- Price: $30/share
- Deposit: 5%
- ROFR Period: 45 days
- Break-up Fee: $50,000
Transaction Planning
Timeline Management:
- ROFR notice preparation
- Response period
- Closing coordination
- Back-up plans
Tax Considerations
Timing Issues
Hold Period Impact:
- ROFR exercise timing
- Capital gains qualification
- Tax year planning
Example Calculation:
- Exercise date: January 1, 2023
- ROFR notice: December 1, 2023
- Closing: January 15, 2024
- Tax year implications
Structure Considerations
Tax Planning Opportunities:
- Payment timing
- Installment sale treatment
- State tax implications
Example Structure:
- Total value: $500,000
- Year 1 payment: $300,000
- Year 2 payment: $200,000
- Tax impact spread
Best Practices
Documentation
Essential Records:
- Equity agreements
- ROFR notices
- Company communications
- Transaction documents
Document Checklist:
- Original grant documents
- Vesting records
- Transfer notices
- Tax records
Common Mistakes to Avoid
Process Errors
Frequent Issues:
- Incomplete notices
- Missed deadlines
- Poor documentation
- Inadequate terms
Prevention Steps:
- Use notice templates
- Calendar all deadlines
- Maintain communication records
- Verify all terms
Strategic Errors
Planning Mistakes:
- Ignoring ROFR in negotiations
- Poor timing choices
- Inadequate preparation
- Missing market opportunities
Action Items
Preparation Phase
Documentation Review:
- Locate all agreements
- Understand terms
- Identify requirements
- Prepare templates
Transaction Phase
Execution Steps:
- Buyer identification
- Term negotiation
- Notice preparation
- Response management
- Closing coordination
Understanding and properly managing ROFR provisions is crucial for successful equity transactions. Careful planning, proper documentation, and professional guidance can help navigate these requirements effectively while maximizing transaction value and minimizing complications.