Right of first refusal (ROFR or RFR) is a contractual right that gives its holder the option to enter a business transaction with the owner of something, according to specified terms, before the owner is entitled to enter into that transaction with a third party. In brief, the right of first refusal is similar in concept to a call option.
An ROFR can cover almost any sort of asset, including real estate, personal property, a patent license, a screenplay, or an interest in a business. It might also cover business transactions that are not strictly assets, such as the right to enter a joint venture or distribution arrangement. In entertainment, a right of first refusal on a concept or a screenplay would give the holder the right to make that movie first. Only if the holder turns it down may the owner then shop it around to other parties.
Because an ROFR is a contract right, the holder's remedies for breach are typically limited to recovery of damages. In other words, if the owner sells the asset to a third party without offering the holder the opportunity to purchase it first, the holder can then sue the owner for damages but may have a difficult time obtaining a court order to stop or reverse the sale. However, in some cases the option becomes a property right that may be used to invalidate an improper sale.
ROFR also arises in visitation agreements/orders in divorce cases. In such cases, an ROFR may require a custodial parent to offer parenting time to the non-custodial parent (rather than having a child supervised by a third party) any time that the custodial parent is unable to exercise his/her right to parenting time (e.g., the custodial parent needs to travel out of town). Under these circumstances a breach may result in a finding of contempt and any remedies for contempt.
An ROFR differs from a Right of First Offer (ROFO, also known as a Right of First Negotiation) in that the ROFO merely obliges the owner to undergo exclusive good faith negotiations with the rights holder before negotiating with other parties. A ROFR is an option to enter a transaction on exact or approximate transaction terms. A ROFO is merely an agreement to negotiate.
ROFR: Abe owns a house that he plans to sell to Bo for $1 million. However, Carl holds a right of first refusal to purchase the house. Therefore, before Abe can sell the house to Bo, he must first offer it to Carl for $1 million. If Carl accepts, he buys the house instead of Bo. If Carl declines, Bo may now buy the house at the proposed $1 million price.
ROFO: Carl holds a ROFO instead of an ROFR. Before Abe can negotiate a deal with Bo, he must first try to sell the house to Carl. Abe and Carl attempt to reach a deal. If they reach an agreement, Abe sells the house to Carl. However, if they fail, then Abe is free to start fresh negotiations with Bo without any restriction as to price or terms.
The following are all variations on the basic ROFR.
Duration. The ROFR is limited in time. E.g. Abe must only make the offer to Carl for any proposed sale in the first five years. After that the right expires and Abe has no further obligation to Carl.
Exceptions. Certain transactions are exempt. E.g. Abe may sell or transfer the property to a holding company, a trust, family members, etc., without first offering it to Carl. However, the new owners remain subject to the right.
Transferability. Carl may assign his ROFR to Bo. Abe must now offer Bo an option to purchase the property instead of Carl. Not every ROFR is transferable; some are personal to the original holder.
Extinguished on first sale. If Abe sells the property to Bo because Carl declines the right, the property is no longer subject to the right. Bo may re-sell it free of the ROFR.
Extinguished on declined / failed exercise. If Abe proposes to sell the property to Bo and Carl declines, or if Carl accepts but is unable to complete the transaction, the right is extinguished whether or not Abe ultimately sells the property.
Persistent. In contrast to the above two, in this case the right runs with the property and binds the new purchaser. E.g. Abe sells the property to Bo. Now Bo must offer the property to Carl first, just as Abe did, if Bo wishes to re-sell it.
Offer and acceptance terms. Specific deadlines, procedures, and forms may be required. For example, Abe must give Carl a "notice of sale." Carl has thirty days to accept or reject, with failure to respond counting as rejection. Carl must then close the transaction within thirty days or else that counts as a failed attempt to exercise.
Limited time period to close transaction. Abe offers the property to Carl under the ROFR and Carl declines. Abe now has 60 days to close the transaction with Bo. If it cannot close within 60 days Abe must offer it again to Carl before proceeding further with Bo.
Substitute purchaser allowed. Abe offers the property to Carl, who declines. Abe is then free to sell it to Bo but that transaction fails. Abe may sell the property under the same terms to Erin instead without re-offering it to Carl.
No pending transaction required. Abe wishes to sell the house for $1 million but has not yet identified a purchaser. He prepares proposed sales terms and offers it to Carl on those terms. If Carl declines, he may then shop around for a purchaser.
Slight variations allowed in exercise. Abe enters an agreement with Bo calling for Bo to put down a 30% down payment, conduct certain inspections, and close the transaction in 20 days. He offers it to Carl at those terms. Carl accepts but is entitled to insist on a 20% down payment and a 30 day closing period.
Slight variations allowed in sale. Abe offers the house for $1 million to Carl. Carl declines. Abe then enters a transaction with Bo but during the escrow Bo discovers a flaw in title and several defects. Abe is entitled to discount the price by $20,000 to close the sale with Bo without having to re-offer the house to Carl at $980,000.
Many other variations are possible. A fully drafted ROFR addresses all of these types of issues and more, and in the case of valuable or complex transactions is subject to negotiation and review by business transaction attorneys. However, many ROFR are not completely specified. Even the best drafted ROFR agreements suffer a high risk of dispute and litigation because they are anticipating future transactions and contingencies that are unknowable at the time the ROFR originates.
In venture capital
In venture capital deals, the right of first refusal is a term sheet provision permitting existing investors in a company to accept or refuse the purchase of equity shares offered by the company, before third parties have access to the deal. The main goal of the provision is to allow investors to prevent ownership dilution as the company raises additional capital. Typically, the provision will exempt certain types of shares, such as those in an employee pool, or shares issued to equipment loaners or lessors.Startup companies are advised to attempt negotiating out this right, because it enables existing investors to send stronger (potentially negative) signals to new investors, and consequently drive down the company's valuation.