Right of First Refusal

The right of first refusal clause, also known as “ROFR”, or “ROFR” clause is an important provision in term sheets— it can make or break the deal. It gives the current investors of a startup the right to match or exceed competing offers that they receive from other investors. If you come across the right of first refusal in any of your term sheets, make sure that you understand the potential implications and the common pitfalls to avoid.

What is the right of first refusal clause?

The right of first refusal is a contractual provision that gives venture capitalists and other investors in a startup the right to match or exceed competing offers within a specified period. If the investor decides to invoke their rights and match or exceed the current offer, the startup must accept the terms of said offer. If the investor declines to invoke their rights, the startup is then free to accept the competing offer.

How does the right of first refusal clause work?

The right of first refusal is fairly straightforward. Startups looking to raise capital receive term sheets from potential investors outlining their offer. Upon receipt, the startup is obligated to notify current investors who have the right of first refusal (ROFR). Those with the ROFR must decide whether to decline or invoke their rights and match or beat the outstanding offer.

If the investor decides to match or exceed the outstanding offer, the startup must accept its terms. If they decline, the startup is free to accept the competing offer. This gives investors an advantage in the negotiation process, as they can set the initial terms of a deal and know that they will have the first opportunity to match or exceed any competing offers.

What are the associated terms with the right of first refusal clause?

When negotiating the right of first refusal clause, several terms need to be agreed upon by both parties. 

• Time period: this is the period in which the investor can invoke or decline their right to match/beat the competing offers
• Transaction types: this outlines the types of transactions that the clause applies to.
• Information: this outlines the specific pieces of information that the investors are privy to, including the strike price, valuation, and any other associated provisions.
• Exclusions: these outline the specific instances in which the right of first refusal does not apply to.

Why do venture capitalists ask for the right of first refusal clause?

Venture capitalists, like other investors, have two goals: first, protect their investment, and second, grow their investment—the right of first refusal clause enables them to do both. In situations where the startup is quickly growing and other investors want a piece, they can invoke their right and match the outstanding offer to maintain their equity in the company. In situations where the company isn’t performing as well, current investors can decline their rights and enable other parties to provide capital and therefore derisk the investment.

Why do startups agree to the right of first refusal clause?

Startups may agree to the right of first refusal clause for several reasons. First, it can help them attract more high-quality investors by making the opportunity more attractive. Second, it can help improve the outcome of the raise, by forcing investors to “one-up” each other. Lastly, it can be used as a bargaining tool to eliminate other more restrictive or costly contractual provisions, such as anti-dilution protection, pro-rata rights, or redemption rights.

Sample “right of first refusal” clause in a term sheet

If you’re negotiating a term sheet, here’s how the right of first refusal clause might be structured or written. “XYZ Firm shall have the right to match or exceed any competing offer that ABC startup receives from other investors within a period of 30 days. If XYZ Firm decides to match or exceed the offer, the startup must accept the terms of XYZ Firm. If XYZ Firm declines to match or exceed the offer, the startup is free to accept competing offers.”

Are venture capitalists obligated to invoke the right of first refusal clause?

No, venture capitalists, angel groups, angel syndicates, and other investors are not obligated to invoke the right of first refusal. The ROFR clause is simply an option that investors have and can choose to invoke or decline to do so.

When would an investor decline invoke their right of first refusal?

Investors may decline their right of first refusal for several reasons. 

• Round size: If the startup is raising hundreds of millions of dollars, but the firm only invests tens of millions of dollars the firm may partially invoke its rights. They would match the terms, but not the size, and only put in a portion of the total capital raised.
• Competitiveness: If the competing offer is significantly better than their offer, the investors may choose to decline to match or exceed the offer.
• Risk: If the startup is not performing to their expectations or underperforming, the investor may decide not to invoke their rights, thereby limiting their risk.

Best practices for negotiating the right of first refusal clause?

When negotiating the right of first refusal clause, several best practices should be followed. 

• Clarity: the clause should be unambiguous and all of the associated terms should be discussed and agreed upon. 
• Binding: the clause should be written in a manner that is legally binding and enforceable.
• Legal: the clause should not violate any existing laws or regulations.

Compared: the right of first refusal clause vs the right of first offer clause?

The right of first refusal clause and the right of first offer clause are similar, but there are some key differences between them. The right of first refusal clause gives investors the right, but not the obligation to match or exceed competing offers. The right of first offer clause, on the other hand, gives investors the right to make the first offer before any other offers can be made. If the startup declines the offer, the investor is free to make competing offers.

Reasons to agree to the right of first refusal clause?

There are several reasons why a startup may agree to the right of first refusal clause. First, it allows their current investors to match or exceed any competing offer. Second, it allows the startup to receive multiple similar offers from investors, resulting in a bidding war. Lastly, it can be used as a bargaining chip to improve the other terms of the deal.

Reasons for not agreeing to the right of first refusal clause?

There are several reasons why a startup may choose to avoid the right of first refusal clause. 

• It can limit the number of investors the startup can engage with, as their current investors can simply match competing offers and prevent the startup from taking on new investors.
• It can limit the startup’s ability to negotiate better terms, as the investor can set the terms of the deal and the startup may have to accept those terms if they decide to match or exceed any competing offers.
• It can limit competition for a startup funding round, as new investors know that they may miss out on the right because the current investors can simply match their offer.

Final thoughts on the right of first refusal clause

The right of first refusal clause can make or break a deal. It gives startups’ current investors the right to match or exceed competing offers that they receive which can limit the amount of interest in the round. But it can also increase competition for a round because new investors are forced to put forth more competitive terms to thwart the current investors from matching it, which can be beneficial for the startup. If you are considering agreeing to the right of first refusal, ensure that you leverage it to eliminate other, more restrictive terms, from the deal.