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What Is Right of First Refusal
A right of first refusal is a contractual provision where a party is granted the right to enter into a business transaction before anyone else can enter into the same transaction.
In other words, the party who is granted the right of first refusal has the right to entertain a business offer before anyone else.
Having the right of first refusal does not force you to enter into a business transaction when an offer is made, you have the “right” to do so.
If the offer is refused, then anyone else can potentially accept the offer.
For example, an investor may purchase 10% of a company’s shares immediately but obtain the right of first refusal for the purchase of another 5%.
If the company wants to issue additional shares, it must first make an offer to the investor who will have the right to purchase up to 5% of additional company shares.
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How Does Right of First Refusal Work
The right of first refusal can be given to any contracting party and in any type of commercial transaction.
The main reason why a right of first refusal is given to an individual or company is to give that party the “option” to enter into a transaction in the future.
For example, a real estate property owner may grant the right of first refusal to a commercial tenant to purchase the property in the event a third party makes an offer.
This means that the commercial tenant will have the “option” or “choice” to acquire the property if a third party makes a formal offer.
The contracting parties can define the terms of the right of first refusal to the specifics of their transaction.
However, in most cases, this right is granted for a specific period of time and gets triggered in very specific contractually defined events.
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Right of First Refusal Elements
The parties to a contract can negotiate a right of first refusal in an unlimited number of ways and have it customized to their needs.
In general, the right of first refusal includes the scope of the right, events that trigger the right, the exclusions, the duration of the right, how long the beneficiary of the right has to respond, and the transferability of the right.
The scope of the right provides details as to what business transaction is covered by the right of first refusal (is it to purchase land, real estate, shares, equipment, etc).
The events that trigger the right refer to in what circumstances will the beneficiary of the right can exercise its options (is it when the owner wishes to sell, the receipt of a third party bona fide offer, etc).
The exclusions are events that the parties specifically intend to exclude.
The duration of the right is the period of time the beneficiary of the right is given the option to enter into the underlying transaction.
The time period to respond refers to the time period the beneficiary has to accept or waive its right of first refusal when the right is triggered.
Transferability refers to the right of the parties are authorized to transfer the right of first refusal to someone else or not.
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Right of First Refusal Advantages
A right of first refusal can have several advantages.
The party benefiting from the right of first refusal will have an advantage in the business transaction over anyone else.
For example, if an investor has the right of first refusal on additional shares issued by the company, the investor has the assurance that it can always purchase additional shares to protect its share ownership percentage.
Another advantage of a right of first refusal is that it’s a “right” and not an “obligation”.
The beneficiary of the right can choose to exercise the right if it makes sense and waives the right if the conditions are not optimal.
Another benefit of the right is that it gives the beneficiary of the right time to consider entering into a commercial transaction in the future or not.
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Right of First Refusal Disadvantages
Although the right of first refusal can have many benefits, you should also consider its drawbacks.
The first drawback is that the right of first refusal may be triggered at a point in time when the beneficiary of the right is not in a good financial position to enter into the transaction.
Since the right can get triggered at any time, the beneficiary of the right must constantly preserve the financial and legal capability of entering into the underlying transaction.
The second drawback is that the right of first refusal may get triggered based on strict or onerous conditions resulting in the more likely waiver of the right.
Another drawback is that when the right of first refusal is timebound, the right may never get triggered during the effective period of the right.
Right of First Refusal Example
Let’s look at an example of how the right of first refusal works in practice.
Let’s say that Company ABC is a very successful startup but the founders need financing to scale the business.
An investor agrees to provide $2 million in financing in exchange for 10% of the company’s stocks.
However, the investor does not want to have its stock position of 10% diluted in the future and demands that the company provide it with a right of first refusal on the issuance of any additional shares.
The company accepts.
The company is doing well a year later and wants to raise additional funds by selling another 10% of its shares.
A new investor is willing to invest in the company.
However, before the company can sell any shares to the new investor, it must offer the original investor the right to purchase the shares at the then current market value.
In this case, the original investor has the right to purchase some or all of the additional shares or waive its right allowing the new investor to purchase the company stock.
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Right of First Refusal FAQ
What is a right of first refusal?
The right of first refusal is an agreement between two parties where one party agrees that the other party can enter into a business transaction on certain terms when certain trigger events occur.
For example, in real estate, a landlord can agree to provide a tenant with a right of first refusal in case he or she wants to sell the property or receives an offer.
When that happens, the tenant will have the right to purchase the property based on the terms and conditions specified in the contract.
Who can get a right of first refusal?
Essentially, anyone can be given the right of first refusal.
However, such agreements are more prevalent in real estate and mergers and acquisitions.
The right can be granted to an individual, private company, public company, government, partnership, or any other legal entity.
What happens if the right of first refusal is violated?
If the right of first refusal is violated, the non-breaching party can take legal action against the breaching party for injunctive relief, damages, or other remedies.
The right of first refusal is fundamentally a contractual right that will be exercised in court.
The courts will typically enforce the contractual penalties if the contract provides the consequences of a breach of the right.
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What is the difference between right of first refusal and right of first offer?
The right of first refusal gives the beneficiary the right to enter into a transaction on specific terms and conditions.
On the other hand, the right of first offer is more limited providing the holder of the right to make an “offer” when the trigger events occur.
However, the other party is not obligated to accept the offer and can still enter into a business transaction with a third party.
Takeaways
So there you have it folks!
What is the right of first refusal?
In a nutshell, the right of first refusal is a contractual right allowing a party to enter into a business transaction before anyone else.
Typically, the right of first refusal defines the scope of the right, triggering events, the procedure for exercising the right, time period for exercising the right, and how long the right of first refusal is granted.
Now that you know what a right of first refusal is all about and how it works, good luck with your research!
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