What is a right of first refusal and co-sale agreement?

Takeaway: A right of first refusal and co-sale agreement provides two related rights to investors: the right of first refusal and the co-sale right. The right of first refusal permits investors to purchase shares from the founders in the event a founder tries to sell shares. The co-sale right allows investors to sell shares in lieu of a founder if the founder tries to sell shares. These rights are designed to make it more difficult for founders to sell stock before an acquisition or IPO.

In the world of venture capital financings, the right of first refusal and co-sale agreement plays a significant role in protecting investor interests and ensuring a fair distribution of exit opportunities. This post will delve into the concept of the right of first refusal and co-sale agreement, its purpose in venture capital financings, and its implications for both investors and startups.

What is a Right of First Refusal and Co-Sale Agreement?

A right of first refusal and co-sale agreement is a contractual provision commonly found in venture capital financing agreements that governs the sale of shares by a company's founders or other major shareholders. This agreement consists of two key components:

  • Right of First Refusal (ROFR): This provision grants existing investors the right to purchase shares that a founder or major shareholder wishes to sell before those shares can be sold to a third party. The existing investors must be given the opportunity to buy the shares at the same price and under the same terms offered by the third party.

  • Co-Sale Agreement (Tag-Along): The co-sale agreement allows existing investors to "tag along" when a founder or major shareholder sells their shares to a third party. In other words, the investor has the right to sell a portion of their shares in the company alongside the founder or major shareholder, often at the same price and under the same terms.

Role in Venture Capital Financings

The right of first refusal and co-sale agreement serves several important functions in venture capital financings:

  • Maintaining Control: The ROFR provision helps ensure that a company's existing investors maintain some control over the company's ownership structure by giving them the first opportunity to purchase shares before they are sold to a third party. This can help prevent unwanted changes in the company's ownership or governance.

  • Fair Distribution of Exit Opportunities: The co-sale agreement helps ensure that all investors have a fair opportunity to participate in a potential exit event, such as the sale of the company or a founder's shares. By allowing investors to "tag along" in a sale, the co-sale agreement helps to create a more equitable distribution of exit opportunities.

  • Alignment of Interests: The right of first refusal and co-sale agreement aligns the interests of founders, major shareholders, and investors by creating a framework that ensures fair treatment and shared exit opportunities.

Implications for Investors and Startups

For investors, the right of first refusal and co-sale agreement offers several benefits:

  • Control Over Ownership: The ROFR provision helps protect investors' interests by allowing them to maintain some control over the company's ownership structure.

  • Participation in Exit Events: The co-sale agreement ensures that investors have the opportunity to participate in exit events, potentially leading to greater returns on their investment.

For startups, the right of first refusal and co-sale agreement can have both positive and negative implications:

  • Positive: The agreement can help foster a more collaborative relationship between the company and its investors by aligning their interests and ensuring fair treatment.

  • Negative: On the other hand, the right of first refusal and co-sale agreement can slow down the sale process or make it more challenging for founders and major shareholders to sell their shares when they desire. It is often more difficult to find a buyer for your shares when the buyer knows existing investors can step in and buy them instead.

Conclusion

The right of first refusal and co-sale agreement is a critical component of venture capital financings, offering protection and benefits for both investors and startups. By ensuring that existing investors maintain control over the company's ownership structure and have fair access to exit opportunities, this agreement helps align the interests of all parties involved. While there may be some drawbacks for startups, the right of first refusal and co-sale agreement ultimately serves to create a more equitable and stable investment landscape.