Brad Feld

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Right of First Refusal

Apr 26, 2006
Category Management

Following is a question I got the other day.

We have some people who are currently interested in doing a Series A round with us.  They aren’t VC’s – they’re a company in our market who offer a pile of services complimentary to ours (they aren’t competitors, or substitutes.)  In our conversations with them, they’re asking for a Right of First Refusal – I know this is standard stuff, however, they’re asking for a ROFR for acquisition offers, as well.  Their reasoning (which is valid), is that they don’t want one of their competitors coming and buying us outright – they’d want to do it themselves. My question is, in an acquisition scenario, will this type of ROFR cause problems that make us a less appealing acquisition?  What type of issues might we run into in the future?  Any advice?

In our Term Sheet series, Jason and I talked about the Right of First Refusal (ROFR) in the context of a financing.  When a ROFR is requested for future financings, this is a standard term and one that isn’t usually worth negotiating much.  However, it’s an entirely different case if a ROFR is requested in a financing that will apply to acquisition.

While a rational request, it’s very dangerous to provide a ROFR on an acquisition to investors in a financing.  A VC will rarely request this (and – if he does – tilt your head sideways at him as say “huh – why?”)  However, corporate investors (also known as “strategic investors”) will often ask for this.  The theory is almost always the one posited in the question above – namely – we want to invest in you now but want first crack at acquiring you if one of our competitors starts sniffing around.

Good theory; bad implementation.  Giving an early investor a ROFR on an acquisition materially handicaps the company and disadvantages all shareholders, except the corporate investor that is getting the ROFR.  The corporate investor will already have visibility into your company and will likely have a variety of rights (including potentially a board seat) by virtue of their investment.  In some cases, they’ll be aware (by virtue of their board seat) of any potential acquisition activity.  If they aren’t, it’s likely that if you get into discussions with a potential acquirer, you’ll bring it up (carefully – of course) with your corporate investor and suggest that – if they are interested – that now would be the time to consider making an offer for the company.  So – the notion that they’d be left out in the cold completely – while possible – is unlikely.

If you have a ROFR in place, you are in a bad position with regard to a potential acquirer that is not the corporate investor.  Depending on how the ROFR is written, you’ll likely have a difficult time signing an LOI with a potential acquirer without first notifying the corporate investor and giving them a ROFR.  In the extreme case, you’ll need to disclose the terms to them so that they have an opportunity to match or exceed the offer.  In the mean time, you will lose major deal momentum with your new potential acquirer.  In addition, since your discussion with your potential acquirer is likely governed by a confidentiality agreement, you’ll have to tread carefully as to what you discuss or disclose.  This gets even more difficult when you are balancing multiple potential offers and buyers – the logistics of managing the ROFR can get very challenging.

In all scenarios, unless you have developed a negative relationship with your corporate investor, it’s all probably unnecessary anyway.  Since the corporate investor already owns a percentage of your company (typically less than 20%), they have a built in discount on the acquisition based on the ownership position they already have.  While they’d of course love to buy the company at the lowest price possible, the ROFR probably won’t help them accomplish this as any savvy seller will be able to manage the buying process to get the best offer on the table before exposing the ROFR.  All the ROFR does is jeopardize the deal, which doesn’t do anyone any good (e.g. your corporate investor decides not to proceed with acquiring the company but the intervening time has caused the buyer to get cold feet and back off.)

While it’s conceivable the ROFR will reduce the number of companies potentially interested in acquiring your company, this can be managed.  It’s often said that buyers won’t pursue a company that has a ROFR – in practice I’ve found it relatively easy to “trip” the ROFR early in the process and get that out of the way.  I have run into aggressively written ROFR’s that cause me to shake my head as it is possible for the ROFR to completely tie up the seller – but I attribute this to poor negotiation on the part of the attorney’s for the seller that negotiated the ROFR in the first place.

The bottom line is that a ROFR on an acquisition is never helpful to the investee and rarely accomplishes what the investor that insisted on it wants.  My simple recommendation is to negotiate hard on this term – it’s not worth having it hanging around.