What Is Right of First Refusal Everything You Need to Know [FAQ]

What Is Right of First Refusal Everything You Need to Know [FAQ] If you’re brokering a business deal or starting a real estate business, you’re likely to encounter a RoFR at some point in the process.In simple terms, the clause is a contractual right (though, not obligatory) that gives someone the chance to buy an asset from a business or individual seller, before any other party has the opportunity to do so.Should the potential buyer choose to not exercise their RoFR, and turns down the offer to purchase, the business will then be free to open up bidding to other parties that are interested.It can be closely related to a RoFO (Right of First Offer), though it’s not the same.This indicates how substantial a difference can be made, by minor details in the language relating to the clause.That said, you must have a thorough understanding of both terms and their implications to make an informed decision about which clause to choose for your contract, or indeed, whether to accept either.WHAT’S THE DIFFERENCE BETWEEN RIGHT OF FIRST REFUSAL AND R IGHT OF FIRST OFFER?A straightforward way to differentiate between RoFR and RoFO, is that Right of First Refusal essentially gives the right to have a last look at a deal, whilst Right of First Offer gives the first look at a deal.When you have RoFR, you know the offers put in by other businesses, and decide whether you wish to match them or not. If you’re able to match the highest offer, it’s a relatively straightforward sale in that you would automatically win the bidding process.This is something often used by business partners, when one of them wants to exit the business. It’s a strategic way of controlling shareholders, and prohibiting outsiders from getting a stake in the business.RoFO means you can be the first to make a bid before anyone else. The seller isn’t obligated to take the offer, which means that they can either accept straight away, or opt to reject the proposal.However, if they’re unable to get higher offers elsewhere, they have the freedom to come back to the person with the RoFO, that originally placed the first bid.Choosing between the two clauses essentially comes down to the amount of knowledge the parties have in regards to the value of the investment.If a shareholder opts to give up their shares, they may not necessarily know how much they’re worth. This could be for any number of reasons.For example, if they only have a minority share, and therefore do not have the required information rights to find out.An RoFR means they can open up bidding to external buyers. Based on the offers that come in, they can get a good estimate of how much their shares would go for on the market.Right of First Refusal is the more useful tool for them in this instance, because it allows them to ensure they get the best value for their shares.Alternatively, if they’re already certain of the shares’ value, the RoFR process wouldn’t be necessary because it would not reveal any new information to the seller.Rather, they’d be better off mak ing an offer straight away to their fellow shareholders, for the value they know it’s worth.In this scenario, the Right of First Offer clause would serve them better, because they’d save on time and transaction fees.WHAT ARE THE BASICS OF RIGHT OF FIRST REFUSAL?Knowing that the RoRF allows the buyer to enter into a transaction before other parties, is just a small portion of the knowledge required to navigate this clause.Understanding the circumstances under which someone might prefer to have a RoFR, also helps to provide context.Typically, RoFR is requested by someone when they want to hold off on committing to any agreements, until they get a feel for how the opportunity may pan out.For instance, to find out if they can get better prices on the assets they intend to buy or sell.They therefore may wish to step in later on in the bidding process, rather than immediately pay or commit to anything.In cases where RoFR are used for real estate deals, a potential buyer of a property could use the clause to buy more time whilst they make their checks on the property, before going ahead with a purchase.This ideally gives them enough leeway to ensure the property is in a condition suitable enough for them to comfortably purchase it in.Whilst the RoFR allows this freedom to both the buyer and seller, it has certain parameters put in place typically being time periods.Therefore, the standard clause will usually have modifications made to it in order to suit both parties.These will reflect an agreement on the period of time that the buyer has, before having to decide whether to buy. In the instance that they choose not to, the seller would then be able to open up discussions with other potential buyers.WHAT TYPES OF CONTRACTS INCLUDE A RIGHT OF FIRST REFUSAL?A Right of First Refusal clause can be used in several different types of contracts.Shareholders agreementAs per the earlier example, one type of contract where a RoFR is typically used, would be a shareholder a greement.It’s not mandatory to include this clause in the contract.Though, once agreed upon and implemented in writing, it compels the shareholder leaving the business to extend their shares to their fellow shareholders in the first instance.The remaining shareholders would then decide whether or not to accept the offer. If the offer isn’t accepted, the shares are put on the market.The wording of the clause itself for a shareholders agreement can vary. It could be made simple and relatively straightforward in terms of how it works, or it may have several conditions attached to it.These conditions can denote the time period of the RoFR, the quantity and/or price of shares that will be made available.There are three key benefits to shareholders implementing the Right of First Refusal: They can control who becomes a shareholder, retain the largest percentage ownership of the company, and fend off bids from outside investors.Shareholder control:Whilst the clause can’t necessarily stop shares being sold to third parties, it does at least give the remaining owners a chance to lessen the likelihood of that happening.  Ownership:The remaining business shareholders can keep a majority of the shares, through wording the clause in such a way that they’ll have the right to buy the same measure of their current shareholding. Take the following example.Three founders own company shares 50%:25%:25%. One of the shareholders owning the 25% share decides to leave. The 50% shareholder now has the opportunity to purchase up to two thirds of the shares on offer.This would simultaneously help the shareholder with the minority of shares, who may not wish for the majority owner to get even more power; Whilst still allowing the majority shareholder to collect extra shares.Additionally, all the parties involved would have the power to achieve this, with the company still maintaining the same amount of control overall.Outside investors:Just the knowledge that a Right of First Re fusal clause exists can serve as enough of a deterrent to external investors.A lot of time and work is required to evaluate a business and how much value there would be in investing in it.Bearing that in mind, the prospect of doing all the necessary groundwork, with the knowledge they may not even have a chance of acquiring shares in the long-run, can lead to potential buyers simply walking away once they hear this clause is in effect.For that reason, because the Right of First Refusal can be so strong a deterrent to outsider buyers, it tends to be more of an appealing prospect for the founders to team up and sell altogether.To that end, the clause helps incentivize founders to become more aligned in their strategy and overall vision for the company. The goal being for them to sell at the highest possible price, when they are all eventually ready to sell.That said, whilst this can be a very positive thing for the founders, it could also be interpreted differently depending on the vi ewpoints of individual parties.Because it’s unlikely that outsiders would want to tackle the RoFR, it means that all the shareholders would tend to have to go along with others’ decisions.This will particularly affect those with smaller shares.Franchise AgreementFranchise agreements will normally give franchisors a non-obligatory option of exercising a Right of First refusal, when a franchisee wants to leave the system.The franchisee who is leaving, presents their franchise at the same price offered by other potential buyers. The franchisor will then have between 30-60 days to either accept the offer, or otherwise.Due to the fact that RoFR clauses have a tendency to put off external buyers, a Right of First Offer may be implemented into the agreement.If this happens, the franchisor would therefore have the right to place the first bid. If they refrain from making an offer, or if the offer made is not acceptable to the franchisee; The franchisee would then go out and obtain offer s from third parties.In this instance, the upside for the RoFR holder (the franchisor) is that they will either gain full operational control of the franchise, or a profitable sale from it.LeaseIf a tenant is renting a property and the property owner decides to sell, a lease in certain situations would give tenants a first look at buying the property before it goes on the market.The landlord will be legally required to serve formal notices to their tenants, in the event they want to sell. During this period, tenants would be granted a period of time to consider whether they wish to purchase the property themselves.The tenant’s RoFR will mean that during this period, the landlord cannot offer the property to anyone else at a lower price than that which was offered to the current tenants.A benefit of this arrangement is that It enables the landlord to save the money they would have otherwise spent on agency and advertising fees; whilst the tenant is given some security.There are a few important areas that need to be given extra consideration, when a RoFR clause is incorporated into a lease.Property to be coveredIt would need to be established exactly what property will be covered by the Right of First Refusal. In general, this detail tends to be relatively clear in the RoFR clause.However, there may be times when it causes confusion.Take for example, if the owner has more than one related property, and they intend to sell them all as part of a package.More specifically, the property may be part of a shopping center, or a cluster of commercial properties.What does that mean for the person holding the RoFR?Would they have to consider bidding on the whole group of properties, or will the right enable them to force the owner to sell each property separately instead?It could certainly make for tempestuous waters, if one the one hand, you have the RoFR holder trying to block the owner’s efforts to sell the property.Whilst on the other hand, the owner may be circ umventing this by teaming up with a third party buyer and making the terms of sale too undesirable for the property/ies to be bought individually. (The goal being to put RoFR holder off the property altogether.)One way they might do this is by limiting how much the right holder can use the property, whilst making it relatively easy for the third party buyer to continue their use of it, completely unaffected.There isn’t a definitive way to keep both parties 100% happy and ensure this type of situation doesn’t arise.However, acknowledging the issue at the outset gives both parties the opportunity to formulate an RoFR clause, that can on the whole, be fair and agreeable.Through doing this, they should be able to lessen the likelihood of having to navigate a particularly hostile transaction.Sale of the owner instead of the propertyAnother potential problem area is if the actual owner (when the owner is an entity) may be sold, rather than the property itself.If this is a possibility, it’s crucial to establish whether the RoFR can be triggered by any stock or membership interest sales.Assuming that the entity’s primary asset is the property, the RoFR should therefore indicate that the sale of stock is essentially the sale of the Property, which will consequently trigger the RoFR. (This would also apply to the transfer of membership interests.)If this isn’t clearly stipulated, the property owner may block the Right of First Refusal, by attempting to sell the company instead of the Property.DurationDefining the period of time that the Right of First Offer can be in effect once triggered, is a standard element of the clause that both parties usually agree on during negotiations. For that reason, duration isn’t typically a problem.Nevertheless, there can be uncertainties around a Right of First Refusal’s duration in a lease, if care isn’t taken to detect where this might occur.One example being a tenant that has a RoFR to buy a property, which is current ly being leased to them. The clause will typically have a sentence stating they have this right, which could go something like this:During the term of this Lease, the Tenant will have a ROFR on the Leased Premises.But what does that categorically mean?It could mean that during the lease, whenever the property goes on sale, the tenant can exercise their Right of First Refusal each time it’s on the market.Or, that they only have the right to the first sale but this can only be clarified through using unambiguous language to make it clear in the contract.The wording has to specify whether it’s a one-time, or ongoing right.General Commercial ContractsRoFR clauses are commonly found in general commercial contracts.Such as distribution agreements that give distributors exclusive rights to circulate newly released products from suppliers; As well as service agreements proffering permission to specific service providers to supply a service, before any other service provider is solicite d.WHAT ARE THE KEY TERMS IN A ROFR?There are four key areas to consider when deciding whether to accept the terms of a Right of First Refusal clause:Time Frame   The set period of time must strike a balance. It should be short enough for sellers to solicit third parties should they ultimately need to if it’s too drawn out to the extent of being open-ended, the seller may lose out on other potential buyers.That being said, it must be long enough for the buyers to take care of the specifics on their end. Such as a franchisor deciding whether to purchase a small franchise. They would require enough time to look into the business and do some risk analysis, in order to determine whether it would be a suitable and worthwhile investment for them.Commercial TermsThese stipulate which party decides the commercial terms, such as the price of a share will be sold at.If for example the franchisee determines the price on offer to the franchisor, the franchisor must decide if they agree on the price. But additionally, they would need to confirm the price the franchisee can put the business up on the market for external buyers.ValuationAn evaluation of the assets on offer would be undertaken. The valuation  will assist in clarifying whether the terms will fairly compensate the seller for their share, whilst weighing up the buyer’s potential investment against the return.In the case of a dispute between the two parties over the value of an asset, an independent third party can be useful in helping to reach a resolution.Other TermsThe Right of First Refusal clause works in conjunction with the rest of the contract, it is not separate from other stipulated terms.Take for instance, a shareholder agreement.Even if the remaining shareholders cannot purchase the shares on offer by the one that is leaving, there may be other clauses in the contract that deem it essential for the new buyer to be approved by them before the buyer can officially purchase the shares.WEIGHING UP THE PROS AND CONS OF ROFRIt’s important to have a firm grasp of the positives and negatives of the Right of First Refusal clause. There are considerably lucrative advantages, but it can also cause a degree of conflict.We saw an example of this play out in a very public way in 2013, when the Nestle group’s chairman Peter Brabeck broadcasted that he intended to open up bidding on his L’Oreal shares. As Nestle was the second largest shareholder of L’Oreal at the time, his decision to not extend the RoFR clause at the end of their 10 year agreement, was a very publicised one.The RoFR does generally have a tendency to benefit the person or entity holding the right, as opposed to the other party. It serves as a good insurance policy, in that the right holder probably won’t lose an asset that they definitely want (or need) to hold on to.Meanwhile, it may sometimes be an encumbrance to the seller because of the limitations it puts on how and when they can solicit buyers.What’s mo re, it can create a precarious situation for the seller in circumstances where there aren’t many external buyers to choose from. In those scenarios, there’s more pressure for the seller to obtain higher bids from the small amount of interest they do manage to attract.It’s not all doom and gloom for the sellers, though.Afterall, the clause does enable them to test the market and discover the best offer they can get.It’s also worth noting that on the whole, Right of First Refusal does in fact increase joint profits for both the seller and the right-holder, by reducing the profit of outside buyers.