What is a right of first refusal and co-sale agreement?
Takeaway: The ROFR and Co-Sale Agreement is a critical governance document that gives the company and its investors control over who can become a stockholder, preventing founders from selling their shares to an undesirable party without offering them to the existing stakeholders first.
In a private startup, the identity of your stockholders matters. You want to maintain a "closed" system, where ownership is limited to a small group of founders, employees, and sophisticated, value-add investors. The last thing you want is for a founder or an early employee to sell their stock to a competitor, a difficult individual, or an unsophisticated buyer who could create legal problems.
To prevent this, every venture-backed company has a Right of First Refusal and Co-Sale Agreement (often called a "ROFR/Co-Sale Agreement"). This is a formal contract, signed by the founders and all major investors, that strictly governs the process for any founder or major stockholder who wants to sell their shares to a third party.
This agreement provides two distinct layers of protection for the company and its investors.
Layer 1: The Right of First Refusal (ROFR)
The ROFR gives the company a chance to keep the stock "in the family."
How it Works: If a founder receives a bona fide offer from an outside party to buy their shares, they cannot simply accept it. They must first offer to sell those same shares to the company on the exact same terms.
The Second Right: If the company declines to purchase the shares, the major investors are then typically given a secondary right of first refusal to purchase the shares themselves, pro-rata.
The Outcome: Only if both the company and the major investors decline to exercise their ROFR is the founder then free to sell their shares to the original outside party. This gives the company and its investors total control over who is allowed to enter the cap table.
Layer 2: The Right of Co-Sale (or "Tag-Along" Right)
The co-sale right protects the minority investors. It ensures that if a founder gets an opportunity to sell some of their shares, the investors can "tag along" and participate in that sale.
How it Works: If a founder is selling a portion of their stock, the major investors have the right to sell a proportional amount of their own stock to the same buyer, on the same terms.
The Rationale: This prevents a situation where the founders can get early liquidity for themselves while the investors' capital remains locked up in the company. It ensures that any opportunity for a partial, early sale is shared with the company's financial partners.
The ROFR/Co-Sale Agreement is a fundamental governance document. In most cases, it is a standard and non-negotiable part of any venture financing. It provides the essential controls needed to maintain the integrity of your cap table and to ensure that the relationship between the founders and the investors remains aligned when it comes to any future sale of stock.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.