What is a Right of First Refusal (ROFR)?

You are reading through a shareholder agreement or a term sheet. You encounter a clause labeled Right of First Refusal or ROFR. It sounds like standard legal jargon.

It is actually one of the most powerful control mechanisms in a startup.

A Right of First Refusal is a contractual right. It gives a specific party the option to enter into a business transaction with you before you are allowed to do so with anyone else. In the context of a startup, this usually relates to the sale of shares.

This clause dictates who is allowed to own a piece of your company and under what conditions.

The process follows a specific order of operations. You cannot simply decide to sell your shares to a friend or a new venture capital firm if a ROFR is in place.

First, you must go out and find a willing buyer. That buyer must provide a bona fide offer. This means they put a price and terms on the table in good faith.

Once you have that offer, the ROFR triggers. You must take that exact offer to the rights holder. This is usually the company itself or existing major investors.

The rights holder then has a choice to make:

• They can accept the offer, meaning they buy your shares at the same price and terms proposed by the third party.
• They can refuse the offer, allowing you to proceed with the sale to the outsider.

This ensures that existing stakeholders can prevent new, unknown parties from joining the capitalization table if they have the capital to step in.

It is easy to confuse Right of First Refusal with Right of First Offer (ROFO). They sound similar but create very different dynamics for a founder.

ROFR is reactive. You have to do the hard work of finding a buyer and negotiating a price first. Only then does the existing investor decide if they want the deal. They get to watch from the sidelines until the market sets the price.

ROFO is proactive. Before you ever speak to an outside buyer, you must notify the rights holder that you want to sell. They make an offer first. If you reject their offer, you can then go look for a better deal elsewhere.

Founders often prefer ROFO because it does not require them to use an outside buyer as a pricing tool before knowing if existing investors are interested.

There are valid reasons to include a ROFR in your agreements. It keeps competitors off your cap table. It allows founders and early investors to maintain their percentage of ownership as the company grows.

However, there is a significant downside known as the stalking horse problem.

Imagine you are an outside investor. You spend weeks doing due diligence on a startup. You negotiate a price. You issue a term sheet.

Then, at the last minute, an existing investor exercises their ROFR and takes the deal you negotiated.

You did all the work, but you got none of the equity.

Because of this risk, some investors are hesitant to bid on shares that are subject to a ROFR. It creates friction. It can reduce the pool of potential buyers because they know their offer might just be used to set a price for someone else.

When you are reviewing these terms, ask yourself how much friction you are willing to accept in future transactions.