Term Sheet: Right of First Refusal

Today’s “term that doesn’t matter much” from our term sheet series is the Right of First Refusal. When we say “it doesn’t matter much”, we really mean “don’t bother trying to negotiate it away – the VCs will insist on it.” Following is the standard language:

Right of First Refusal: Investors who purchase at least (____) shares of Series A Preferred (a “Major Investor”) shall have the right in the event the Company proposes to offer equity securities to any person (other than the shares (i) reserved as employee shares described under “Employee Pool” below, (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their right of first refusal) to purchase [X times] their pro rata portion of such shares. Any securities not subscribed for by an eligible Investor may be reallocated among the other eligible Investors. Such right of first refusal will terminate upon a Qualified IPO. For purposes of this right of first refusal, an Investor’s pro rata right shall be equal to the ratio of (a) the number of shares of common stock (including all shares of common stock issuable or issued upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and options) held by such Investor immediately prior to the issuance of such equity securities to (b) the total number of share of common stock outstanding (including all shares of common stock issuable or issued upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and options) immediately prior to the issuance of such equity securities.”

There are two things to pay attention to in this term that can be negotiated. First, the share threshold that defines a “Major Investor” can be defined. It’s often convenient – especially if you have a large number of small investors – not to have to give this right to them. However, since in future rounds, you are typically interested in getting as much participation as you can, it’s not worth struggling with this too much.

A more important thing to look for is to see if there is a a multiple on the purchase rights (e.g. the “X times” listed above). This is an excessive ask – especially early in the financing life cycle of a company – and can almost always be negotiated to 1x.

As with “other terms that don’t matter much”, you shouldn’t let your lawyer over engineer these. If you feel the need to negotiate, focus on the share threshold and the multiple on the purchase rights.

  • Keith

    Share threshold? Why do VCs always think it is fine to screw over the small shareholders. Often these people were the first ones in. Is their money not good enough somehow?

    CEOs and companies should treat their shareholders equally to the greatest possible extent.

    It boils my ass—and I’ve been a successful VC at a top firm and a successful CEO–how VCs want EVERYTHING while crying about the risks they supposedly take. E.g.: multi-liquidation prefs; anti-dilution (amazing to me, that one); board control; negative control via covenants; first-refusals, etc.

    Either all shareholders get a first refusal…or NONE of them do. Simple, yes? And fair (not a word VCs like, that one).

  • Keith

    Protect against malicious comments?

    I have never seen that before, on any blog.

    What are you worried about, Mr. Feld?

  • Keith – I’m not sure what your comment concerning “malicious comments” is. Is this referring to the the “comments approval” notice you got? I have Movable Type approve comments on to help deal with all the comment spam I get.

    I don’t think the Right of First Refusal is about “screwing small shareholders.” In many financings, especially down round financings, VCs will insist the company do a rights offering to give EVERY shareholder an opportunity to participate on the same terms as the VCs in the new round. I’ve found that entrepreneurs often push for a share threshold so they don’t have to “include all the old investors” in the ROFR process. So – this one is a mixed bag – but the goal is not to screw the small / earlier shareholders.

  • Michael Chen

    I have a question of first right of refusal and would appreciate your opinion.

    Recently an invester gave notice to our company regarding the transfer of shares to 3rd party and our company, which is entitled first right of refusal, responded with intention to purchase all the shares that the investor intended to sell. After our comapny’s notice, the investor did not respond (I guess the investor was surprised that the company would buy all the shares back) although we have been pushing for action. Anyway, we followed all the procedures under shareholders agreement and we are expecting the investor do the same. Is there anyway we can push for the share transfer closing without going to Arbitration as stipulated per share holders agreement?

    Thanks for your opinion.

  • Michael – you are going to have to ask your lawyer on that one. The actual rights and process will vary based on how the language is written.

  • Brad –

    Thank you for this posting. Would you consider this paragraph suitable for a certificate of designation for Series A stock?


  • No – you should work with your lawyer to put this into the appropriate “legal language” in the final document.

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