Equity Investment Term Sheets: Right of First Refusal and Co-Sale Right

Two common equity investment term sheet phrases are “right of first refusal” and “co-sale right” – but what do they mean?

Right of First Refusal

The right of first refusal is a right given to investors that allows them to purchase shares of stock that a stockholder is attempting to transfer. 

For example, a co-founder wants to transfer a portion of her shares to an advisor. This proposed transfer would trigger the right of first refusal. If the investor has the only right of first refusal, they will have the ability to buy those shares from the co-founder and essentially prevent the transfer to the adviser.

There are a few things that can limit the right of first refusal. One of the most common limits is granting the Company a primary right of first refusal so that the Company can repurchase the shares first, before the investor. If the Company chooses not to, then the investor can purchase the shares. If neither exercises their right, the shares can be transferred.

Investors almost always want to see the Company grow so they can recoup their money and potentially get a good return on investment. It’s unlikely that an investor would block a transfer that would be beneficial to the Company. However, they do often have the right to do so.

Finally, the right of first refusal sometimes has exceptions. For example, it may only apply to stockholders who own 1% or more of the Company or may only apply to key stockholders (such as founders). There can also be specific exceptions such as transfers to immediate family members or transfers for estate planning purposes.

Co-Sale Right

A co-sale right is the right to force a transferring stockholder to include the investor’s shares in any potential transfer. These are also known as tag-along rights which I’ve addressed in a previous post.

They are particularly important in this context because both rights combined grant investors (1) the ability to buy up any stock that a stockholder is attempting to transfer and (2) if the right of first refusal isn’t exercised, the investor can force the transferring stockholder to include their stock in the proposed transfer. This ensures that stock isn’t being sold to someone an investor doesn’t like (such as a competitor) and it prevents them from being left behind if a founder jumps ship.

It is important to understand how these rights work together and how board versus stockholder approvals can contribute to these rights.

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