What is a right of first offer clause and why include it within a shareholder agreement?

Such a clause confers a right to existing shareholders to subscribe for a new issue of shares before outsiders can do so.

Simply put, it allows an existing shareholder to maintain the proportion of the company that he or she owns and thus the amount of control he or she can exert over decision making.

New share issues and percentage dilution

New shares are usually issued in order to bring in outside investment into a company. Existing owners may agree to increase the number of shares in the company, which are then sold by the company to new shareholders at a premium to the value of the business. The sale proceeds collected by the company are used for further investment.

Dilution of ownership can occurs at any new share issue. If a company has 100 shares and issues a further 20, then a shareholder who held 40% of the shares previously would find that he held only 33% of them after the issue. The new issue has the effect of reducing how much say he has in the running of the expanded company.

Right of first offer allows him to buy some of the new shares (usually up to the proportion he held before) in preference to anyone else so that he can maintain his relative power compared to other shareholders.

The dilution referred to above is known as “percentage dilution”.

Shareholders can also suffer from “economic dilution”. This happens when new shares are issued that have a lower face value than old shares in the same class. For example, a company might have issued 100 £1 shares and have a share capital of £100. If it issues a further 100 shares at £0.50 and the new subscription is taken up, then the share capital of the company becomes £150 with 200 shares in circulation. The average price of a share for a shareholder who held shares before the new issue drops from £1 to £0.75.

Why a right of first refusal clause might be important to include in a shareholder agreement?

The issue of new share capital affects the value of the investment of every shareholder. Yet the decision to issue is not one that all shareholders might make, or be able to control. Sometimes, it may not be the shareholders who make the decision at all, but rather the directors.

A majority shareholder might be able to control shareholder decisions; but he might not be able to prevent the board of directors authorising the issue of new capital and reducing his voting power as a shareholder on matters important to him. (He might have limited power on the board because he might not be a director or he might only control one or few of many board seats).

A minority shareholder might be powerless to control whether a share issue happens. The effect might be to further reduce his relative holding below the limits at which the law gives him automatic rights to do certain things. He may find himself edged out of the company without being able to prevent it.

In either case, the inclusion of a right of first refusal would allow the shareholder to maintain his power.

Mechanics of the clause

Usually, a limit is put on the number of new shares that can be bought so that a shareholder can maintain his ownership percentage, but not strengthen his position unless another shareholder decides not to (or cannot) exercise his right.

The company could make it easier for shareholders to take up their right by allowing them to buy the shares at a discount to the price external buyers would pay.

Should you include this clause within your agreement?

A right of first offer clause is not common in shareholder agreements where the company is small (and/or new). That is usually because shareholders are also directors, and all owners have similar sized stakes.

You might consider the inclusion of the clause if you think that your company will be seeking external equity investment in the future, but it is likely that any new investor, particularly an institutional one, will insist on creating a new shareholder agreement.

A right of first refusal (abbreviated to ROFR and also known as a right of pre-emption) is an optional right that company owners can give to each other in a shareholders agreement.

The clause allows existing shareholders to buy the shares of an owner who is selling before any outsider can do so. The price paid is usually the price that the external buyer has agreed to pay.

There is no standard wording. The clause could be very simple in how it works, or have many conditions attached that vary the price or the amount of shares that any existing shareholder can buy. There might also be other clauses in the shareholder agreement that limit the effect of the ROFR clause (such as those that limit voting power on certain matters).

The offer price

The inclusion of the clause has an interesting implication on the price at which shares are sold.

If we assume that existing owners have better information about the true value of the company (and future prospects), to be allowed to buy, any outsider will have to offer more money than any insider would pay.

If the outsider offers a lower price than the existing owners value the company at, then the existing owners (provided they have the money to do so) are likely to buy the shares themselves.

In other words, with a ROFR clause, effectively, outsiders pay a premium price to come into the company.

And unlike a subscription for new shares, it is the outgoing shareholder who benefits, not the remaining owners or the company.

Why use a ROFR clause?

ROFR is not a right that shareholders have by default under the Companies Act. It must be agreed explicitly in the shareholders agreement. The reasons why they might want to do so are:

Controlling who can become a shareholder

ROFR gives existing owners the opportunity to prevent outsiders from buying shares and therefore exerting control over the company.

The clause can’t prevent sale to an external third party, but it does give the opportunity to the existing shareholders to block the entry of a new owner.

Maintain the proportional ownership of the company

Many right of first refusal clauses are worded so that all owners have the right to buy in proportion with their current shareholding. For example, if company shares are held 50% : 25% : 25% by three founders and one of the owners of 25% wishes to sell completely, then the owner of 50% of the shares has the right to buy up to two thirds (50/75) of the shares being sold.

This allows relative control of the company to remain the same, which may be important for a shareholder with a small majority or a minority who doesn’t want a majority (for example, one who already holds 74% of the shares) to gain additional power.

Discouraging external investors from bidding

A right of first refusal is a right to buy on the same terms. In order to do so, those terms must have already been agreed, and to arrive at that point, most external investors will have carried out a lot of due diligence on the company and spent time negotiating the terms.

If a potential external buyer knows in advance that he will have to carry out a lot of work assessing the value of the company but that there is a high chance he will never be allowed to buy, he might simply walk away as soon as he learns of the existence of the ROFR clause.

A right of first refusal clause can be such a sufficient disincentive to an external buyer, that the existence of one often makes it more attractive to founders to sell the company together in agreement rather than selling individually. Including a ROFR clause in the shareholders agreement can motivate founders to pursue the same strategic goals so as to maximise the price of the company when they do sell.

Because it is such a discouragement to incoming shareholders, including one in the shareholder agreement acts as a disincentive to founders who might want to sell. It will be hard to find anyone who is willing to buy the shares, and risk invest time and money in the due diligence process if the outcome is likely to be that he is blocked from buying by the existing owners. With a ROFR clause in place, all shareholders – particularly minority ones – are likely to be carried along with the decisions of the others.

Should you include a ROFR in your shareholders agreement?

Right of first refusal clauses are fairly unusual in shareholder agreements that founders would set up. Most solicitors drawing a document from scratch for you would not assume that you would need one, and the vast majority of shareholder agreement templates do not include them. They tend to be an instrument later on in the company lifecycle, rather than at the start.

The reason is that although a ROFR clause has advantages it can also disadvantage you by limiting your options when you sell. You might be selling because you want out, but in an early stage company, there might be other reasons you are selling – you might need to raise further equity finance or cash out of your investment for personal reasons.
If you are considering using one, our advice is to find sample wording within a shareholder agreement template and review whether what it does is really what you want. We wouldn’t advise simply ordering the inclusion of the clause from your solicitor straight out.

A shareholders agreement is a way of planning for the future. The document redistributes decision making power on matters that are important to certain owners, and sets out what happens in certain circumstances.

Unlike with articles of association, there is no legal requirement to use a shareholders agreement. However, you’ll find that your investment in your company is much better protected if you do put one in place.

You don’t need to use a solicitor to draw one up. Often the best way of creating one is to use one or more templates as the foundation of the mutual written agreement between all owners.

Your agreement does need to be written within the framework of company law. For example, you can’t override the statutory requirement under the Companies Act for shareholders holding at least 75% of the voting shares of the company to approve changes to the articles of association.

So what should your shareholders agreement cover?

Decision making by directors as opposed to shareholders

Directors run the company on a day to day basis on behalf of the shareholders. Directors usually have an equal say on matters at board meetings. So if you have three directors, if two directors vote for a motion, it will be passed.

However, when directors are also shareholders, the directors might have unbalanced power compared to the shares held. Going back to the example above, if all directors were also shareholders, and the shareholdings were in the ratio 55:25:20, then the shareholder with the majority ownership might find that the other two shareholders (in their position of power as directors) were able to force a motion.

Of course, in the example above the majority owner could sack the other two directors, but while that might be possible in law, in a real world working relationship, removing the directors is unlikely to be practical or desirable because (a) they remain owners and (b) their skills and knowledge is probably needed to make the business successful.

Grant of rights to lenders who are also shareholders

The situation becomes more complicated if one of the owners has lent the business money. A lender has no rights at all, but might have a significant interest in the business as a result of the amount of his lending. Buying shares in return for the investment might not be possible, so one way of protecting his additional investment is for all shareholders to agree in a shareholders agreement that the lender is to be able to have greater voting rights in certain matters related to his loan.

Transfer of shares

One of the advantages of incorporation – of creating shares in a business – is that those shares can be sold or given to someone else. The downside of being able to sell shares is that in doing so, an owner gives away control. He or she probably doesn’t mind too much. But the other shareholders might. Transfers of ownership may upset relative power. They might transfer power to other owners, or they might transfer power to newcomers.

You can’t ban a shareholder from selling or transferring his shares. But you can agree (together, in advance) to limit the transfer of power.

As examples:

You might agree that before any shareholder sells to an outsider, other shareholders might have the right to buy at the price the outsider will pay. This is known as a right of first refusal.

You might agree that if any shareholder sells to an outsider, the acquiring owner must also buy the shares of any other shareholder who also wants to sell at that price. This is known as a tag-along right.

You might agree that if any of the shareholders die, then the shares can pass to his or her family members, but those family members do not have any decision making power (other than that granted by law) until all the remaining original shareholders vote unanimously to give it to them, or unless that new shareholder has worked in the business for more than two years. That might prevent a rash, young beneficiary with little experience from upsetting the business. You can’t prevent who inherits someone else’s shares easily, but you can limit what the new shareholder can do.

Planning for exit

When you found a company, you don’t think of selling it. But your other shareholders might have different ideas. They might want to sell within four years, for example, so that they can set up the next big project.

One thing you can do is to set out a statement of intention. This is simply your intention at the current time about what you will do in the future. It is not set in stone, and is not legally binding on you. But it might give other shareholders confidence that there is a plan, and that they can expect their money back from the venture one day.

The next thing you can do in your agreement is to specify what happens in precise exit scenarios. For example, what would happen if the company was approached by a competitor?

Some shareholders will benefit more in certain circumstances than others, so your agreement needs to cover what happens to each (in broad or specific terms).

Working with other businesses and people

Your business will interact with many other people and businesses. Those relationships may be more beneficial to other shareholders than to you.

For example, one shareholder may insist that your business appoints another of his businesses (in which you have no interest) as a “preferred supplier”. That other business might give your business beneficial prices by passing along a bulk discount, but it might also charge above market rates. In either situation your fellow owner might profit. However, you only profit in one of them.

A fellow shareholder might insist that you hire his friends or family to work in the business. Again, this might be fine if they have the right qualifications and experience, but it might be disastrous if his family members are promoted to senior positions because of their relationship status rather than because of their suitability.

Lastly, you may find that your shareholders decide to compete with your business. Perhaps your company has grown from being a single service provider to being a multi-service provider. One of your fellow shareholders might see that one of the new services gives high profit margins, and poaches several key staff working in this service area to set up a new company with him. Your shareholder agreement should cover what happens if a shareholder does compete (perhaps the supply of operational information is limited if a shareholder is deemed to have conflicts of interest, or perhaps his voting rights on certain matters are reduced).