Right of First Refusal and Co-Sale Terms and Agreements Explained

Early reports are revealing that capital raises in 2025 are set to reach over $200 billion. While the American funding market is most certainly buoyant, founders and senior executives preparing for a raise would be wise to pay close attention to the many legal agreements that make up the integrity of their deal.

Two key terms often encountered in this journey are the right of first refusal and co-sale (also called pre-emptive rights and tag-along rights, respectively). These terms can play a key role in negotiations with investors and stakeholders. In this article, we're diving into the details of these agreements, from how they can impact your business during fundraising to what you need to be aware of. 

We discuss:

• What is a right of first refusal(ROFR)?
• What is a co-sale right?
• How does a right of first refusal relate to a co-sale right?
• How does the right of first refusal impact American businesses seeking capital?
• How does the right of first refusal and co-sale work?

Let's start with the basics.

What is a Right of First Refusal?

A right of first refusal (ROFR) is a strategic tool used in a variety of transactions, most commonly within corporate deals, capital raises and venture capital. In simple terms, a ROFR gives a shareholder the first opportunity to buy new shares before a selling shareholder can offer it to someone else. This provision is particularly popular in agreements involving potential share sales amongst startup companies.

Why does this matter? The specifics of the ROFR you grant can greatly impact the company’s cap table and your ownership and control. It serves as a safety net to prevent or reduce dilution for existing shareholders when the company is bringing in investments from new investors. 

In the context of a share sale, the ROFR is also used to give existing shareholders the opportunity to purchase those shares and grow their stake in the company before a new investor is given the offer. If they choose not to purchase, the shares can then be sold to external parties. You can think of it a bit like having the first look at a precious painting before it goes to an auction.  By providing this security, a business can assure its existing backers while looking into growth and new funding options.  

A ROFR is normally embedded in a shareholder agreement or stock purchase agreement, but can also be a standalone agreement.

Understanding and effectively employing an ROFR agreement or clause requires an expert touch, which is why enlisting the guidance of expert lawyers can be invaluable.

What is a Co-Sale Agreement?

A co-sale agreement is typically crafted in tandem with the right of first refusal (ROFR) to further protect the interests of shareholders, particularly minority shareholders. This right grants these shareholders the opportunity to sell their shares alongside a major selling shareholder (or group of shareholders). When a majority shareholder decides to sell their shares, a co-sale right allows minority shareholders to "tag along" or “piggyback” in the sale and sell their shares under the same conditions, ensuring they aren't left behind. 

Let's say a major shareholder has found a buyer willing to purchase their shares. Without a co-sale right, minority shareholders might be left in a company with a changed ownership dynamic that no longer aligns with their interests. By invoking co-sale rights, these minority shareholders can require the acquirer to also purchase their shares on the same terms as the major shareholder. This arrangement is particularly beneficial in circumstances where the selling shareholder receives favorable terms or where the overall business landscape may change post-sale. 

Incorporating co-sale rights, therefore, offers an added layer of financial protection to shareholders. It's a strategic tool for managing the shifts in control or ownership that can occur in a share sale. For American businesses, especially those looking to attract venture capital, crafting well-defined co-sale rights can be a crucial step in maintaining an equitable balance when key shareholders diverge on their investment journeys.

How does a right of first refusal relate to co-sale rights?

While right of first refusal (ROFR) gives existing stakeholders priority in acquiring shares before they're offered to outside parties, a co-sale agreement allows shareholders to tag along and also sell their shares when a major shareholder (or a group of shareholders holding the majority of shares) decides to sell theirs. This creates a safety net, ensuring shareholders can capitalize on an exit. 

For companies in the US, this relationship between ROFR and co-sale rights facilitates a balanced protection mechanism. ROFR ensures that the existing shareholders are not diluted and have priority over shares being sold to third parties. Meanwhile, a co-sale agreement provides minority stakeholders with an opportunity to exit under the same favorable conditions as majority shareholders. When done right, this combination enhances your company's attractiveness to potential investors, providing both security and flexibility, key ingredients in securing and maintaining capital investment.

How does the right of first refusal and co-sale rights work?

A right of first refusal (ROFR) and co-sale rights, often found hand-in-hand, offer a layer of control over share transactions, beneficial for both companies and investors. Together, they operate as a shield and a means of ensuring equitable opportunities in share sales and share issues 

The process for Right of First Refusal 

Here's how it unfolds: 

• Trigger: When a shareholder desires to sell their shares, they must first approach the company, which will then notify the other shareholders of the opportunity to buy the shares.
• Evaluation: The other shareholders have a limited timeframe to evaluate and either accept or decline the offer.
• Decision: If a shareholder chooses to purchase, the selling shareholder sells to that shareholder at the preset terms. If declined, the shareholder is free to sell to a third party.

Another trigger can be in the event of a capital raise.

• Trigger: The company desires to raise capital and issue new shares. When it finds an investor willing to purchase new shares, it must notify existing shareholders and offer those shareholders the opportunity to participate in the round and purchase shares on the same terms as the incoming investor.
• Evaluation: Similarly, existing shareholders will have a limited timeframe to either accept or decline to participate in the round.
• Decision: If an existing shareholder wishes to participate in the round, then they will purchase new shares on the same terms as the incoming investor. Otherwise, they will waive their right of first refusal, and the capital raise will proceed without them.

The process for Co-Sale Agreement

This kicks in when: 

• Trigger: If a majority shareholder finds a buyer for their shares, they must notify the company of the proposed terms of sale. The company must then notify the other shareholders of the terms of the sale and give them the opportunity to “tag along” and sell their shares too.
• Evaluation: Other shareholders granted co-sale rights can issue a tag-along notice or otherwise enforce their co-sale rights to join the transaction and sell their shares.
• Decision: The selling shareholder must then make it a condition of the sale that the buyer also acquires the shares of the minority shareholder exercising their co-sale rights on the same terms

In tandem, these agreements offer a safety net, preventing undesirable ownership changes while facilitating a balanced and fair exit strategy for investors. For American companies strategizing their approach to capital and shares, understanding and utilizing these mechanisms can be crucial.

Conclusion

ROFR and co-sale rights not only provide protection against unwanted shifts in ownership but also ensure that existing owners maintain control over the business. When strategically combined, they serve as a robust mechanism to manage equity transactions smoothly, aligning the interests of all parties involved. 

For US entrepreneurs and investors alike, the benefits of these agreements can be substantial, providing peace of mind and clarity in potential future transactions. However, it's essential to draft these agreements carefully, ensuring they are both comprehensive and legally binding. 

Want to integrate the right of first refusal and co-sale rights into your company's capital raise strategy? We're an experienced team of financing lawyers, with expertise on the global stage. Get in touch today to see how we can help you.