It is common for shareholders of a closely held corporation to set out the rules that govern their relationship vis-à-vis one another in the form of a shareholder agreement. One key concern for shareholders when negotiating a shareholder agreement is controlling the transfer of shares to unknown or undesirable persons, while still maintaining liquidity in their shares. A common mechanism used to address this concern is a right of first refusal (ROFR).
Right of first refusal
A ROFR provides non-selling shareholders with the right to accept or refuse an offer by a selling shareholder after the selling shareholder has solicited an offer for their shares from a third-party buyer. The non-selling shareholders receive the selling shareholder’s offer on the same terms as presented by the third-party buyer. This right allows non-selling shareholders to control the process of adding a new shareholder, while preserving liquidity for the selling shareholder.
Right of first offer
A less known but similarly useful mechanism in the context of a shareholder agreement is a right of first offer (ROFO). A ROFO provides non-selling shareholders with the right to be offered the shares before any external solicitation takes place. If the offer is refused by the non-selling shareholders, only then may the selling shareholder solicit third-party offers on the same terms that were presented to the non-selling shareholders. Thus, a ROFO achieves the same aim as a ROFR: it allows non-selling shareholders to control the process of adding a new shareholder, while preserving liquidity. So the question then begs, how would one decide between using a ROFR and a ROFO?
ROFR versus ROFO
The answer often comes down to the degree of knowledge shareholders have in respect of the value of their investment. In the case of a ROFR, because the solicitation process occurs prior to any offer being made to non-selling shareholders, a selling shareholder is able to have more certainty that it is receiving the best value that exists on the market for its shares. Thus, where a selling shareholder lacks insight into the corporation’s value (possibly because it is a minority shareholder and/or lacks information rights), it may be advantageous to negotiate a ROFR to ensure it gets the best value for its investment upon exit.
On the other hand, where a selling shareholder has insight into the corporation’s value, it should be better positioned to value its investment. Therefore the solicitation process would not be useful to said selling shareholder in determining value. Instead, a selling shareholder may wish to effect a sale as quickly and with as little transaction costs as possible. A ROFO offers this possibility. A ROFO permits a selling shareholder to immediately make an offer to the non-selling shareholders instead of spending the time soliciting a third-party offer first. Moreover, where a third-party buyer is aware that the shares are subject to a ROFR, the third party buyer might ask to be reimbursed for the due diligence and related expenses if the transaction fails to close. Closing uncertainty in the case of a ROFR may also cause the third party to offer a lower price in the first place.
All this to say, whether a ROFR or ROFO is preferred will depend on the circumstances at hand and shareholders would be wise to carefully consider the pros and cons of each option before deciding.
The author would like to thank Shreya Tekriwal, Articling Student, for her assistance in preparing this legal update.
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