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