3. Participation Rights

3.1. Right of First Refusal

The right of first refusal gives the investors (and usually also the company) the right to purchase shares proposed to be sold (or transferred) by the founders.

With such a right in place, the founders cannot directly sell (or transfer) shares to a third party. Suppose, for example, that one of the founders would like to sell 100'000 shares of common stock to an outside investor to generate some liquidity. Let us also assume that the outside investor is willing to pay $20 per share. 

With a right of first refusal, the founder has to offer this deal to the company (usually first) and the investors (usually second). The founder can sell to the outside shareholder only if the company and the current investors refuse to take the deal proposed by the outside shareholder.

One of the main benefits of the right of first refusal is that it gives the company (and the other investors) control over who owns a significant part of the company. However, it also makes it unattractive for third parties to do all the research associated with an investment in a privately held new venture: These outside investors know that if they strike a good deal, the most likely outcome is that the company or the other shareholders will take it. Put differently, with a right of first refusal in place, outside shareholders will generally only be able to buy shares at a price that is unattractive to the company or the other investors. 

 

A typical term-sheet formulation for a right of first refusal could be:

 

Right of First Refusal

Company first and Investors second (to the extent assigned by the Board of Directors,) will have a right of first refusal with respect to any shares of capital stock of the Company proposed to be transferred by Founders [and future employees holding greater than 1% of Company Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options)], with a right of oversubscription for Investors of shares unsubscribed by the other Investors. 

 

In firms with many smaller investors, the right of first refusal is often limited to major investors (e.g., investors who have bought more than X shares).

Note that the right of first refusal applies to all "transfers" of shares, not only sales to outside parties. Therefore, it is important to clearly define what constitutes a "transfer" and what possible exceptions are. This definition of "transfer" can take place in a separate document outside the term sheet. 

In addition to offers to sell, the definition of "transfer" usually includes events such as:

  • Assignments (i.e., the transfer of some or all of the rights and obligations associated with the shares to a third party)
  • Pledges (e.g., to secure a debt)
  • Grants of options on the shares
  • Etc.

The definition can also include involuntary transfers that could happen upon:

  • Death 
  • Divorce.

  

With the right of first refusal, the investors (and the company) make sure that they can purchase shares from the founders if the purchase price is attractive. This right of first refusal is usually combined with the so-called "Co-Sale Right," which gives the investors the right to participate in the sale of shares held by the founder. This co-sale right is the topic of the next section.