From Idea to Exit: Structure - Rights of First Refusal

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At Freeman Lovell, our business lawyers help entrepreneurs and small business owners structure and build businesses that can scale and be sold someday.

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First Protect Your Business

As a business law firm that focuses on helping small businesses succeed, one of the common mistakes we see businesses make is adopting operating agreements or corporate bylaws that don’t allow the company to control its cap table by protecting the company’s owners instead of protecting the company itself.

The decision between a right of first refusal and a right of first offer is a place where this mistake is commonly made. Many business owners mistake a right of first refusal and a right of first offer as the same thing. This article will clarify the differences.

What is a Right of First Refusal?

A right of first refusal gives the company the right to buy the equity that an owner is trying to sell to a known third party.

For example, let’s say that I own equity at XYZ Corp with others. Later on, I decide to sell my shares and, as part of this decision, I find a friend who wants to buy my shares in XYZ Corp. If XYZ Corp has a right of first refusal provision in its bylaws, then the company has the first right to buy the equity on the same terms that my friend wants to buy my shares.

After presenting the terms to the company, the company can elect to purchase my shares on those terms. If the company declines to purchase on those terms, then the other owners may have the right to buy my shares on those terms (depending on the terms of the operating agreement or bylaws). Only when neither the company nor the other owners choose to buy my shares can I return to my friend and sell the shares to him on those terms.

In sum, the right of first refusal works when an owner first finds the buyer, negotiates terms with the potential buyer, and then presents them to the company and its owners to decide whether they want to match those terms and buy the shares.

What is a Right of First Offer?

In a right of first refusal, the equity owner has to negotiate and set terms with the potential buyer first. In a right of first offer, the owner must negotiate first with the company before finding a third-party to buy that equity.

For example, say I am an owner of membership units in ABC, LLC, and its operating agreement contains a right of first offer clause instead of a right of first refusal. To sell my units before I find a third-party buyer, I need to go to the company first and make an offer to sell on the terms I set. Then the company can accept or deny my offer. If the company rejects my proposal, I can try to find and sell the shares to a third-party buyer.

Company > Owner: The Case Against the Right of First Offer

Here are the reasons why I advise my entrepreneur clients generally to avoid the right of first offer:

Any time an owner of the business wants to sell their equity, they will have to make an offer to the company’s managers or directors to approve or deny. Having to respond to these offers alone is inefficient.
The company will have to deal with unrealistic expectations as to the value of the owner’s equity.
The company cannot make its decision based on the potential buyer.
The company does not know whether a third party would buy the owner’s equity on the terms that the owner wants.
The company may have to entertain multiple offers from the same owner while the owner tests and fails in selling on unrealistic terms to both the company and third-party buyers.

In comparison with a right of first offer, here are the reasons why a right of first refusal is better for the company:

The right of first refusal puts the company in the driver’s seat.
The company’s management will not be interrupted by the owners wanting to sell their equity.
The unrealistic expectation problem is solved because the owner must find an actual third-party buyer willing to buy on set terms before presenting the offer to the company.
The efficiency and decision-making process is more straightforward and informed for the company in knowing that there is an actual buyer of the company equity and who the actual purchaser would be.
The process is streamlined and will not loop back on itself because an actual buyer will purchase if the Company decides not to.

These provisions can be complicated. Our job is to help our clients understand these options and put their business first.

Freeman Lovell’s business and corporate attorneys ensure that entrepreneurs and small-business owners have operating agreements and bylaws that work for their company’s success. To learn more about how to structure a business for success, watch our From Idea to Exit presentations .

Call or text us at (385) 217-5611 or send us a message through our Contact Form .

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Beneficial Ownership Rules

28 Dec, 2023

In a couple of months, a new rule will take effect, requiring all registered legal entities to report their beneficial owners to the Financial Crimes Enforcement Network (FinCEN). We wanted to give you a heads up about the rule and give you as much information about what it means to you. What is the rule? The rule, which is called the Beneficial Ownership Information Reporting Requirements (BOI Rule), comes from the Corporate Transparency Act, which was passed by Congress in 2021. This law created the BOI Rule with FinCEN as part of the U.S. government’s efforts to make it harder for bad actors to hide or benefit from their ill-gotten gains through shell companies or other deceitful ownership structures. Under this new law, FinCEN will permit Federal, State, and local officials to obtain ownership information for authorized activities related to national security, law enforcement, and intelligence. When does the rule take effect? And when do I have to submit a report? The BOI Rule takes effect on January 1, 2024 . If your company existed before January 1, 2024, you must file its initial beneficial ownership information report by January 1, 2025. If your company is formed or registered after January 1, 2024, you must file its initial beneficial ownership information report within 30 days after receiving actual or public notice that its creation or registration is effective. If any beneficial ownership information changes, you will have 30 days from the day of the change to file an updated or corrected report with FinCEN. What do I need to include in the report? The BOI Rule requires that all entities report information about the company, each individual with substantial control over the entity, and each beneficial owner. What information is required to report about the entity? Full legal name of your company and any DBAs names; Complete current street address for your company's principal place of business (P.O. boxes will not be accepted); The jurisdiction of formation or registration; and Tax identification: IRS tax identification number (TIN) and employer identification number (EIN). What information is required to report about the controlling individuals and beneficial owners? The individual's legal name; Individual's date of birth; Individual's residential address; and A unique identifying number from an acceptable identification document (such as an unexpired driver's license, passport, identification document issued by a State or local government or Indian tribe.) and the name of the issuing state or jurisdiction. Who is considered to have substantial control of the entity? Examples of an individual that exercises substantial control over the entity are: An individual is a senior officer (President, CEO, CFO, COO, Manager, or other office who performs a similar function); An individual has the authority to appoint or remove certain officers or a majority of directors of the reporting company; An individual is an important decision-maker for the company; or An individual has any other form of substantial control over the company. Who is considered a beneficial owner? A beneficial owner is an individual that owns or controls at least 25% of the entity’s ownership interests. This includes individuals that indirectly own or control 25% of the ownership interest. For example, if Joe is a 50% owner of Parent LLC, which in turn owns 50% of Subsidiary Corp, then Joe beneficially owns 25% of Subsidiary Corp (50% of 50% = 25%). What type of entities will be required to file a report with FinCEN? All domestically formed entities and foreign registered entities in the USA are required to file a report. Types of entities include corporations, limited liability companies, limited partnerships, general partnerships, and any other entity registered with a state Secretary of State or Division of Corporations or other similar office. There are some types of companies that are exempt from the reporting rule, and in general they are companies that already have to report beneficial ownership to another federal agency. The 23 exemptions listed by FinCEN are: Securities reporting issuer, Governmental authority, Bank, Credit union, Depository institution holding company, Money services business, Broker or dealer in securities, Securities exchange or clearing agency, Securities exchange or clearing agency, Other Exchange Act registered entity, Investment company or investment adviser, Venture capital fund adviser, Insurance company, State-licensed insurance producer, Commodity Exchange Act registered entity, Accounting firm, Public utility, Financial market utility, Pooled investment vehicle, Tax-exempt entity, Entity assisting a tax-exempt entity, Large operating company, Subsidiary of certain exempt entities, and Inactive entity. Now what do I do to comply with the BOI Rule? While you are not able to submit the beneficial ownership information report until January 1, 2024, you should use this time to gather information about your company, owners, and other entities now, so you can timely file your report. We added a small BOI Rule cheat sheet for you to keep and reference. Also, you can read FinCEN’s FAQ page about the BOI Rule https://www.fincen.gov/boi-faqs . Can you help me with my company’s report? Yes! We are happy to help prepare and file your company’s BOI Rule report with FinCEN. We can begin to gather and prepare the information for your filing right away and be ready once the BOI Rule takes effect January 1, 2024. To get started, please reach out to us. We also know that some situations can be complicated, so please feel free to ask us any questions regarding compliance with the beneficial ownership interest reporting requirements for your company.