ROFR & Co-Sale: Control Over Cap Table

The Right of First Refusal (ROFR) is a contractual provision that gives certain existing shareholders (often the company itself and/or its investors) the first opportunity to purchase shares from a selling shareholder before those shares can be offered to an outside party. Think of it as “first dibs” on shares. If a founder or another major shareholder wants to sell their shares, they must first offer them to the ROFR holders on the same terms as they would offer to a third-party buyer. Only if the ROFR holders decline can the shares then be sold to the external party.

Co-Sale Rights, often paired with ROFR, are also known as “Tag-Along Rights” or “Piggyback Rights.” This clause grants certain shareholders (typically investors) the opportunity to sell their shares alongside a major selling shareholder (like a founder). If a founder decides to sell a significant portion of their shares to a third party (and the ROFR hasn’t been exercised), co-sale rights allow investors to “tag along” and sell a proportional amount of their own shares under the same terms and conditions. This ensures they aren’t left behind and can participate in a liquidity event.

Why it Matters?

These clauses are crucial for both investors and the company:

  • For Investors:
    • Control over Ownership: ROFR allows investors to prevent unwanted new shareholders from acquiring a stake in the company, maintaining control over the shareholder base and strategic alignment.
    • Preventing Dilution: Investors can exercise their ROFR to buy additional shares, increasing or maintaining their ownership percentage in the company and preventing their stake from being diluted when others sell.
    • Equitable Exit Opportunities: Co-Sale rights ensure that if founders or other major shareholders find a buyer for their shares, investors also have the chance to sell some of their stake on the same favourable terms, providing an early liquidity path if desired.
  • For the Company:
    • Cap Table Management: The company can use ROFR to control who becomes a shareholder, ensuring that the cap table (capitalization table) remains aligned with its long-term vision.
    • Stability: By limiting who can acquire shares, ROFR and co-sale contribute to the stability of the company’s ownership structure.

Common Variations

While standard, the specifics of ROFR and Co-Sale clauses can vary:

  • Order of Priority (ROFR):
    • Some term sheets give the company the first right to purchase the shares, followed by the investors (often on a pro-rata basis, meaning in proportion to their existing ownership).
    • Others might grant the right solely to the investors.
    • Founder Watch Out: Understand whose right comes first. A company-first ROFR can be beneficial as it keeps control within the company.
  • Scope of “Transfers” (ROFR):
    • The definition of “transfer” that triggers the ROFR can be broad, covering not just outright sales but also gifts, pledges, or transfers to trusts.
    • Founder Watch Out: Negotiate carve-outs for “permitted transfers,” such as transfers for estate planning purposes (e.g., to a family trust) or to affiliates, without triggering the ROFR. These exceptions are common and important for founder flexibility.
  • Response Period (ROFR): The timeframe within which ROFR holders must decide whether to exercise their right can vary (e.g., 20-30 days).
    • Founder Watch Out: A lengthy response period can deter potential third-party buyers, as they may not want to wait. Aim for a reasonable and clear timeline.
  • Pro-Rata Allocation & Oversubscription (ROFR): If multiple investors exercise their ROFR, shares are typically allocated pro-rata. Some agreements include an “oversubscription right,” allowing participating investors to purchase shares that other investors declined.
  • Threshold for Co-Sale: Co-Sale rights typically apply when a “major shareholder” (often defined by a certain ownership percentage) sells shares.
    • Founder Watch Out: Ensure the threshold is reasonable and doesn’t hinder small, necessary share transfers.
  • Exclusions (Co-Sale): Similar to ROFR, co-sale clauses often have exceptions for permitted transfers like those for estate planning.
  • “Carve-Outs” for Small Sales: Sometimes, term sheets include de minimis exceptions, allowing founders to sell a very small percentage of their shares (e.g., 1-2% annually) without triggering ROFR or co-sale rights. This can provide founders with a small amount of liquidity.

Examples

ROFR Example: Imagine Sarah, a founder, holds 10% of her startup, “Innovate Co.” She receives a compelling offer from “Tech Giant Inc.” to buy her entire 10% stake for $1 million.

  1. According to her term sheet, Sarah must first formally notify Innovate Co and its investors of Tech Giant’s offer, including all terms (price, quantity, etc.).
  2. Innovate Co and/or its investors (as per the ROFR priority) then have a specified period (e.g., 20 days) to decide if they want to purchase Sarah’s shares on the exact same terms.
  3. If they exercise their ROFR, Sarah must sell her shares to them for $1 million.
  4. If they decline, Sarah is then free to sell her shares to Tech Giant Inc. under those terms. If Tech Giant Inc. later lowers their offer, Sarah would likely have to re-offer the shares to the ROFR holders at the new, lower price.

Co-Sale Example: Continuing with Sarah and Innovate Co, suppose Sarah decides to sell 5% of her shares to a third-party investor, “New Capital,” and the ROFR was either not exercised or didn’t apply to this specific transfer.

  1. The term sheet states that major investors have co-sale rights.
  2. If an investor, David, owns 2% of Innovate Co, and Sarah is selling half of her shares (5% out of 10%), David might have the right to sell half of his shares (1% out of 2%) to New Capital on the same terms as Sarah.
  3. New Capital, if they agree, would then buy 5% from Sarah and 1% from David, maintaining the proportional ownership as they enter.

Evolv’s Recommendations:

  • Negotiate Permitted Transfers: This is paramount. Ensure the ROFR and Co-Sale clauses have clear, reasonable exceptions for transfers to family members, trusts, or for estate planning. You don’t want to accidentally violate your agreement by simply reorganizing your personal holdings.
  • Understand the Priority and Scope: Know who holds the ROFR (company, investors, or both) and in what order. Also, be clear on what types of “transfers” trigger these rights.
  • Reasonable Timelines: Push for concise response periods for ROFR to avoid unnecessarily delaying potential sales. Protracted decision periods can make your shares less attractive to outside buyers.
  • Consider De Minimis Exceptions: If possible, negotiate a carve-out for small, periodic sales of shares that don’t trigger ROFR or co-sale. This can provide some personal liquidity without requiring investor approval for every minor transaction.
  • Impact on Future Investors: Be aware that overly restrictive ROFRs can deter future investors, as they may be wary of a clause that gives existing investors an automatic right to step into any deal they negotiate.
  • Legal Counsel is Key: Always have experienced legal counsel review your term sheet. They can help you identify subtle nuances and negotiate terms that are fair and protect your long-term interests as a founder.