Keeping Ownership in the Family: Part I, Rights of First Refusal

Many closely-held businesses have adopted agreements among their equity owners that restrict the owners in what they can do to sell or transfer their equity.  In corporations, such agreements are frequently referred to as shareholders’ agreements.  In limited liability companies, the key terms of such agreements are included in LLC operating agreements.  And in certain start-up contexts, such restrictions can be broken out into several different agreements, such as investor rights agreements, voting agreements and right of first refusal agreements.

Under any of these names, a primary goal of the agreement is to set the terms for transfer of any of the company’s equity.  The agreement is signed by all the shareholders (or members) and each of them agrees to transfer or sell his or her interest in the Company only under certain circumstances and after certain approvals.  Not surprisingly, in a family-owned business, this can be the single most important precept of the company’s governance structure.  Such an agreement may be essential to keeping the family-owned business ownership within the family.

An outright prohibition on all transfers of stock is usually considered to be unfair and unreasonably burdensome on the shareholders (even shareholders in a family business).  Therefore, most buy/sell agreements set out various procedural mechanisms to make sure the company retains control of any transfer process.  The three most commonly relied upon methods are: (i) a right of first refusal, (ii) a “tag-along” right and a “drag along” obligation, and (iii) a concept of “permitted transfers”.  Here we will discuss a right of first refusal.  In subsequent posts, we will discuss the other two.

In a typical right of first refusal, a shareholder wishing to sell his or her shares must first strike a deal with a third party to sell his or her shares.  That third party has to commit to the basic terms of a purchase of some or all of the shareholder’s shares.  Once the shareholder has an offer in hand, though, he or she must go back to the company and offer the company the right to buy those same shares on the same terms offered by the third party.  This way, if the management of the company wants to restrict transfers to outsiders, it can purchase the shares from the shareholder and keep ownership of the company restricted.  If the company declines the offer, the shareholder is free to sell to the third party.

Buy/sell agreements can include countless variations on this basic structure to make them more or less favorable for the shareholder or the company.  For example:

• The company may be permitted to purchase the shares through offering of a promissory note, rather than paying cash.  This permits the company to exercise its right of first refusal even if it does not have the cash to do so.  It also forces the shareholder into a sale where he or she might not get any immediately liquidity – which was probably the reason for the sale in the first place.
• The right of first refusal may be offered to the other shareholders, rather than the company.  In other words, the selling shareholder may have to offer the deal to all his or her fellow shareholders before selling to the third party.
• The right could be one of first offer instead of first refusal.  Instead of forcing the shareholder to get a bona fide offer before coming to the company, the shareholder might be required to come to the company first.  This means that a shareholder would be obligated to try to negotiate a sale with the company, but if that does not work, he or she would be free to find a third party to sell to at the same or higher price.  This can be a substantial benefit to the shareholder trying to negotiate sales out in the market.

In practical reality, a right of first refusal is not just a procedural hurdle to overcome.  In most instances, it effectively precludes shareholders from selling to a third party without the consent of all the other major shareholders.  In a family-owned business, this kind of centralized control over ownership can be as important as anything else about the way the business is run.

Drew Steen is an Attorney in Davis Wright Tremaine’s Seattle office.  He represents both buy-side and sell-side clients in mergers and acquisitions and other equity-based transactions, including venture capital investments, joint ventures, equity co-investments, and restructurings. Drew can be reached via email at andrewsteen@dwt.com or directly at 206.757.8081.