A right of first refusal grants one party certain rights before these become available to anyone else. Overall, this is a contractual right that benefits businesses by ensuring they will not miss commercial opportunities which arise. This article sets out how the right of first refusal operates and how this clause may impact your business.
What is the Right of First Refusal?
A person holding a right of first refusal has the option to accept a business offer before anyone else. This right covers most assets, including business transactions and real estate. For example, a business owner may have the first right to consider buying or selling a supplier’s goods. If the business owner chooses not to exercise their right, the other party will usually be entitled to offer the right to another business or deal to external third parties.
What Types of Contracts Include a Right of First Refusal?
There are a variety of types of contracts which may include a right of first refusal clause, including:
Shareholders leaving a company may be obligated to first offer their shares to the existing shareholders of the company first, under a shareholders agreement. If this offer is not taken, the leaving shareholder may then offer the shares for sale on the market.
This benefits the remaining shareholders by ensuring that existing shareholders will continue to control the composition of their company. This is particularly crucial if there are substantial voting rights attached to the shares.
Franchise agreements sometimes require franchisees exiting the system to first offer to sell their business to the franchisor.
This benefits the franchisee as they may save costs that would have otherwise been spent on a business broker or advertising the business. Additionally, the franchisor will benefit from either the opportunity to operate the business or sell it at a profit.
Leases may grant tenants the first right to purchase a property when the lease comes to an end or prior to the landlord selling the property.
This may provide a sense of security to the tenant while saving the landlord agency and advertising fees.
|General commercial contracts||General commercial contracts also include rights of first refusal. For example:
What Are Key Terms in a Right of First Refusal?
When reviewing a right of first refusal clause, key terms to pay attention to include:
|Time frame||The clause should specify a time frame in which a party can exercise their right of first refusal. Without a time frame, the right may be open-ended and restrict the other party’s ability to deal with third parties. However, the specified time frame should not be overly short. For example, a franchisor should have sufficient opportunity to conduct research and risk analysis before purchasing a franchise business.|
The clause should indicate which party will decide on the commercial terms of the offer.
For example, whether the franchisee or franchisor should decide on the sale price of the franchisee’s business.
If the franchisor accepts the price, the clause should also answer whether the franchisee may still sell the business in the market for an equal or lesser price.
|Valuation||The clause may include provisions as to the valuation of commercial terms. For example, an independent third party may be appointed if there is a dispute as to an asset’s value.|
Crucially, the right of first refusal clause does not operate in isolation from other terms in a contract.
For example, if existing shareholders are unable to purchase the shares of an exiting shareholder, other clauses of the contract may still require the purchaser to be approved by the existing shareholders.
What is the Right of Last Refusal?
The right of last refusal operates differently from the right of first refusal. Instead, in the period between negotiating and finalising a contract, the party with a right of last refusal should have the opportunity to make an offer. Using the example of a distribution agreement, a right of last refusal would operate as follows:
- a supplier searches the market for a new distributor to distribute their new products;
- the supplier receives an offer from a third party to distribute the new products; and
- prior to finalising the distribution agreement with the third party, the supplier must offer their original distributor the right to enter into a distribution agreement. Only after the original distributor refuses may the supplier complete the new distribution agreement with the third party.
In this example, the right of last refusal provides the distributor with commercial insight by allowing them to observe the market rate of distribution agreements.
However, third parties may become deterred from negotiating after learning the original distributor may accept the supplier’s offer. Consequently, a right of last refusal clause in this context is to the supplier’s detriment.
A right of first refusal is commonly used in commercial contracts to the benefit of both parties. However, both parties should analyse the operation of the clause to determine whether it operates to their advantage. As such, before including a right of first refusal clause you should consider whether:
- you are granting or receiving the right of refusal;
- the contract provides specific and sufficient time frames and defines commercial terms;
- you require a valuation clause; and
- you or the other party require additional rights such as a right of last refusal.
If you require assistance drafting or reviewing a right of last refusal clause, get in touch with LegalVision’s contract lawyers on 1300 544 755 or fill out the form on this page.
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