NOTE: This is the fourteenth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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While the Investor Rights Agreement deals with the rights of the investors vis-à-vis the company, the Right of First Refusal and Co-Sale Agreement gives the company and the investors certain rights vis-à-vis the company’s common stockholders. The principal rights conferred are the eponymous Right of First Refusal (“ROFR” – rhymes with gopher) and Right of Co-Sale (a/k/a “Tag Along”), both of which apply to any proposed sale of stock by common stockholders prior to the company’s initial public offering. The Lock-up applies to sales by the common stockholders following the company’s initial public offering.
Right of First Refusal
The NVCA term sheet includes a standard ROFR provision where the company has the first right to purchase shares offered for sale by common stockholders and the investors have the right to purchase any shares the company does not elect to purchase. The ROFR order of priority may be reversed so that the investors’ right precedes that of the company. The impact of reversing the order is essentially economic: if an investor purchases shares she pays the purchase price out-of-pocket, so the money doesn’t drain the company’s coffers, but she also increases her ownership interest relative to all other stockholders, whereas a repurchase by the company would result in a proportionate increase in the value of shares held by all stockholders.
The NVCA term sheet also gives investors an oversubscription right to purchase a pro rata portion of any shares subject to the ROFR that are not purchased by other investors (this is akin to the Over-Allotment Right that arises in the context of the investors’ Preemptive Rights). The oversubscription right is particularly important to investors if, as is often the case, the ROFR must be exercised, collectively by the company and the investors, with respect to all shares proposed to be transferred in order to be given effect. This “all-or-none” restriction on the ROFR is beneficial to selling stockholders, especially those with a large equity stake in the company, because it prevents the company or the investors from dissuading a potential buyer (who may wish to obtain the selling stockholders entire equity stake in the company) by exercising the ROFR with respect to a portion of the shares offered for sale.
Note that in some cases, particularly where there are a number of smaller investors, the ROFR may be applied to the investors as well as the common stockholders. This is generally an inter-investor matter that has little practical significance to the company and the founders.
Right of Co-Sale
Where the ROFR gives investors the opportunity to purchase shares offered for sale, the Tag Along gives them the right to sell their shares (on an as-converted-to-common-stock basis, if necessary) to a purchaser alongside the prospective seller. The Tag Along comes into play to the extent shares offered for sale are not purchased through the ROFR, and it applies pro rata based on the relative ownership interest of the investors and the selling stockholder. As with the ROFR, the Tag Along may be applied to the sale of shares by investors as well as common stockholders, but unlike the ROFR there is never an oversubscription right if certain investors elect not to exercise the Tag Along.
Lock-Up
The Lock-Up requires the founders (and often other significant common stockholders) to agree that they will not sell their shares for a given period of time after the company’s initial public offering. The common stockholders’ lock-up may be somewhat more stringent than the investors’ lock-up (mentioned in our discussion of the investors’ Registration Rights) to give the investors a head-start on the founders in selling shares after the company goes public.
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None of the ROFR, Tag Along or Lock-Up is typically the subject of discussion at the term sheet stage, and there is rarely much negotiation when the transaction documents are drafted. There are, however, a few issues to consider. First, the common stockholders who must become party to the Right of First Refusal and Co-Sale Agreement (and therefore subject to its restrictions) may be limited to a specific group of stockholders (ex. the founders and executive officers) or to stockholders holding at least a minimum percentage of the company’s fully-diluted equity ownership (sometimes as low as 1%). The smaller the number of stockholders subject to the agreement, the easier it is to administer; both because the company does not need to require every stockholder to sign the agreement and because not every little transfer will trigger the ROFR and Tag Along. Likewise, where there are a number of small investors it may be beneficial – to the company and to the lead investors – to only give ROFR and Tag Along rights to the larger investors. Again, this eases the administrative burden on the company when the rights are triggered. Finally, both the ROFR and the Tag Along are usually subject to standard exceptions to permit stockholders to transfer shares for limited purposes, such as estate planning.