Drafting a Shareholders Agreement: What Is ‘First Right of Refusal’?

A well-drafted Shareholders Agreement sets out how you will manage the business and the procedure if one of the shareholders wants to sell its shares. Amongst other clauses, you can find the “right of first refusal” clause in a Shareholders Agreement. There may be situations where one shareholder wishes to sell some or all its shares. Likewise, the first right of refusal clause gives other company shareholders the right to first purchase those shares before being sold to a third-party. This article will explain the right of first refusal clause, essential elements the clause should include, and what to do if a shareholder decides to sell their shares.

How Does the “Right of First Refusal” Clause Work?

A well-drafted Shareholders Agreement will outline the process for the sale and transfer of shares. This will usually include a first right of refusal clause. The clause essentially gives other shareholders the right to have “first dibs” when purchasing another shareholder’s shares; or the first chance to “refuse” to buy shares. 

A standard first right of refusal clause will require the selling shareholder to provide notice of an offer from a third party to who wishes to buy their shares. This notice must be in writing to all other shareholders in the company. Consequently, other shareholders then have the first opportunity to purchase the shares on the same terms as that offer.

Further, shareholders can decide to purchase the shares from the selling shareholder, or the company can buy-back the shares. If the other shareholders choose not to buy the exiting shareholder’s shares, the exiting shareholder will then proceed with the third party’s sale.  

Why Is a “Right of First Refusal” Clause Important?

It is crucial to include the first right of refusal clause in your Shareholders Agreement. This clause prevents a shareholder from selling its shares without first reverting to the existing shareholders. This could be particularly problematic if a majority shareholder wishes to sell their shares. Without giving notice to the other shareholders to provide them with an opportunity to purchase the shares, any third party could obtain an interest in the company.

The first right of refusal clause is often essential in a Shareholders Agreement. It ensures that existing shareholders can control the company’s structure and composition. Most small businesses do not have many shareholders, so the Shareholders Agreements should contain a first right of refusal clause. The clause can protect your business by ensuring that the business’s interests will not go to third parties who may have no interest in running the business or values that do not fit with your vision.

Having a well-drafted right of first refusal clause in your Shareholders Agreement is very important for startups. It allows co-founders more control over the company composition. This clause is particularly crucial for shares with substantial voting rights attached to them. Giving other shareholders rights to first purchase shares when selling can allow them to retain control of their company and the startup’s vision.

What Should a “Right of First Refusal” Clause Include?

There are a few essential terms which your first right of refusal clause should contain.  

Time Frame

The clause should specify the time frame that other shareholders have to exercise the first right of refusal. Without a time frame, the clause will be open-ended. If there is ambiguity around time periods, it can cause problems when dealing with third party interested buyers. A time period for other shareholders to respond to a notice of intention to sell should not be overly short. It is usually a 30-day period.

Notice Period

The clause should also set out how the selling shareholder must provide the notice of intention to sell shares to other shareholders. 

Commercial Terms of Sale

Moreover, the first right of refusal clause needs to address the different circumstances of the sale. For example, what happens if only some shareholders are interested in the shares?  What happens if every shareholder wants to purchase a portion of the shares? 

The answer to this is to require the selling shareholder to sell its shares on a pro-rata basis, based on each shareholder’s proportionate shareholdings. Other shareholders may refuse or cannot buy the exiting shareholders shares. In that case, you can draft other clauses to still require the shareholders to approve a third party purchaser.

Procedure for Sale and Transfer of Shares

Further, the first right of refusal clause needs to include the procedure for the transfer of shares. Once the remaining shareholders have agreed to purchase the shares, you must transfer them. Issues can arise if the selling shareholder, for whatever reason, refuses to sell or does not transfer the shares when required. The Shareholders Agreement can set out that, in such circumstances, the company can act as the attorney of the selling shareholder and undertake the transfer on the agreed terms.

Key Takeaways

A right to first refusal clause is an essential clause to include in your Shareholders Agreement. It can protect remaining shareholders’ interests by retaining control over the company structure and composition. A Shareholders Agreement is a critical legal document. If you have any questions regarding a Shareholders Agreement or the first right of refusal clause, contact LegalVision’s contract lawyers on 1300 544 755 or fill out the form on this page.