Venture Capital Term Sheet Negotiation — Part 15: Rights of First Refusal and Co-Sale

This post is the fifteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior fourteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, and discussed valuation, cap tables, and the price per sharedividends on preferred stockliquidation preferencesthe conversion rights and features of preferred stockvoting rights and investor protection provisionsanti-dilution provisionsanti-dilution carve-outs and “pay to play” provisionsredemption rightsregistration rights,  management and information rightspreemptive rights, drag-along rights, and representations and warranties. In this post, we will discuss rights of first refusal and co-sale.

Rights of First Refusal

The NVCA model term sheet contains a right of first refusal in favor of the company and the venture capital investor. If the founders ever want to sell any of their shares to a third party, the right of first refusal requires them to give the company the first opportunity to purchase the shares on the terms offered by the third party. If the company doesn’t exercise its right of first refusal, the venture capital investor then has the opportunity to purchase the shares on the same terms. If both the company and venture capital investor forego their rights of first refusal, then the founders may proceed to sell their shares to the third party. A right of first refusal is designed to control which parties may own a significant number of shares in the company and give venture capital investors the first opportunity to purchase shares if they desire to do so. While the right of first refusal appears not to limit the founders’ ability to transfer their shares, it can have that impact (third parties may not spend the time to negotiate a deal with founders if they believe the company or venture capital investor can step in and take their offer via the right of first refusal).

If there is more than one venture capital investor, if the investors exercise their right of first refusal, each investor may participate in the purchase pro rata based on the number of shares held by each. If any investor declines to participate in the purchase, the others have a “right of oversubscription” to purchase the shares that the non-purchasing investor was entitled to purchase, again pro rata based on the number of shares held by each purchasing investor.

A right of first refusal applies to all “transfers” of shares, which encompass a variety of dispositions in addition to outright sales. Definitions of “transfer” typically include offers to sell, assignments, pledges (for example, to secure debt), mortgages, grants of options, and encumbrances, of the shares themselves or any interest in the shares. The definition can include involuntary transfers, such as those that happen upon death or divorce. The NVCA model term sheet points out that the parties will negotiate exceptions, for example, for estate planning purposes or in the case of transfers of very small amounts. If the consideration to be paid by the third party is property or services or other non-cash consideration, the board of directors of the company may have the right to determine the fair market value of the consideration, and those exercising the rights of first refusal can pay the cash equivalent of such value.

Rights of Co-Sale

The NVCA model term sheet also contains a right of co-sale (also called a “take-me-along” provision or a “tag-along” provision) for the venture capital investor. If the founders wish to sell their shares and the shares are not purchased pursuant to the rights of first refusal (discussed above), they must give the venture capital investor the opportunity to participate in the sale pro rata based on the number of shares held by the selling founders and by the participating investors. This gives the investor the opportunity to a partial exit from the company along with the founders if the latter are presented with the right opportunity. If the transaction with the third party constitutes a “Change of Control” (e.g., shares representing more than 50% of the voting power), the co-sale provisions may require that the aggregate proceeds be divided among the selling stockholders in accordance with the Certificate of Incorporation as if the transaction were a “deemed liquidation event”; this gives the investors their liquidation preference upon a sale to a third party. See the discussion of liquidation preferences here.

Negotiation Tips

While rights of first refusal and co-sale rights are common in venture capital deals, founders should pay attention to these provisions and make sure they are customary and not overreaching. For example, founders can (and should) negotiate a provision that provides those exercising the rights of first refusal must purchase all (and not less than all) of the stock subject to the rights, or they forfeit their right to do so. This prevents investors from disturbing the deal with the third party and not purchasing all of the subject stock. Also, founders should make sure the rights of first refusal do not apply to their preferred stock (if any) or any common stock issued upon conversion of preferred stock. The theory is that the founders have purchased this stock and so the rights of first refusal should not apply.

In the next post, we’ll discuss closing conditions and expenses.

This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Casey W. Riggs

Casey W. Riggs

Casey Riggs is a corporate and business attorney who represents companies of all sizes, from startups to large corporations, and in all stages of the business life cycle, from entity formation through an exit event. Casey also represents many of his clients in estate planning and administration.

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