What is a right of first offer (i.e., pro rata right)?

Takeaway: Pro rata rights allow investors to purchase their pro rata share of a new sale of shares by the company. This allows investors to maintain their proportionate ownership of the company.

The right of first offer (ROFO) (also called a pro rata right or preemptive right) is a crucial tool that helps protect the interests of investors and maintains stability in the investment landscape. This post will explore the concept of the right of first offer, its role in venture capital financings, and its implications for both investors and startups.

What is a Right of First Offer?

The right of first offer is a contractual provision that gives existing investors the opportunity to purchase additional shares in a company before those shares are offered to new investors. When a company decides to issue new shares, the right of first offer requires the company to first approach its current investors and offer them the opportunity to buy the new shares at the same price and under the same terms that would be offered to new investors.

Role in Venture Capital Financings

The right of first offer plays a vital role in venture capital financings for several reasons:

  • Maintaining Proportionate Ownership: By giving existing investors the first opportunity to purchase new shares, the right of first offer helps them maintain their proportionate ownership in the company. This can be particularly important for venture capital firms that want to preserve their ownership percentage and influence over the company's strategic direction.

  • Preempting Dilution: The right of first offer helps protect existing investors from dilution that can occur when new shares are issued. By participating in the new issuance, investors can maintain their relative ownership stake in the company and avoid having their investment diluted by the entry of new investors.

  • Strengthening Investor-Company Relationships: The right of first offer also serves to strengthen the relationship between investors and the company. By giving existing investors the first opportunity to invest in new shares, the company demonstrates its commitment to its current investors and acknowledges the value of their continued support.

Implications for Investors and Startups

For investors, the right of first offer has several benefits:

  • Protection from Dilution: As mentioned earlier, the right of first offer helps protect investors from the dilution of their ownership stake when new shares are issued.

  • Opportunity for Increased Investment: The right of first offer provides investors with the opportunity to increase their investment in the company, potentially leading to greater returns if the company is successful.

For startups, the right of first offer can have both positive and negative implications:

  • Positive: The right of first offer can help strengthen the relationship between the company and its existing investors, fostering long-term support and collaboration.

  • Negative: On the other hand, the right of first offer can potentially limit the company’s ability to raise funds from new investors. The more of its existing investors that take their pro rata, the less allocation there is to sell to new investors. Companies should be cognizant of who they give pro rata rights to.

Conclusion

The right of first offer is an essential tool in the venture capital financing landscape, helping to maintain stability and protect the interests of both investors and startups. By providing existing investors with the first opportunity to purchase new shares, the right of first offer helps maintain proportionate ownership, preempt dilution, and strengthen investor-company relationships. While there may be some drawbacks for startups, the right of first offer ultimately serves to create a more balanced and stable investment environment that benefits all parties involved.