Continuing our series on NVCA term sheets, this seventh article focuses on essential strategic provisions—Right of First Refusal (ROFR), Co-Sale Agreements, and Drag-Along Rights. These provisions influence shareholder liquidity, equity transactions, and exit strategy effectiveness. If you missed our previous exploration on board composition and governance, read it here.
Understanding Strategic Provisions
Strategic provisions such as ROFR, co-sale agreements, and drag-along rights are integral to aligning stakeholder interests and ensuring orderly equity transfers. They provide a framework for managing equity sales and protecting investor and founder interests.
Right of First Refusal (ROFR)
The Right of First Refusal (ROFR) grants the company and often its existing investors the first opportunity to buy shares from selling shareholders before those shares are offered to outside parties.
- Benefits:
- Protects current shareholders from undesirable or conflicting external parties.
- Maintains control within a familiar shareholder group.
- Challenges:
- Can limit liquidity options for founders or employees looking to sell shares.
- Potentially delays or complicates transactions due to procedural requirements.
Co-Sale Agreement (Tag-Along Rights)
A co-sale agreement allows minority shareholders to sell their shares alongside majority shareholders during significant sales events, such as when a founder or major investor exits.
- Benefits:
- Ensures minority shareholders have equitable exit opportunities.
- Aligns interests among all shareholders during major equity transactions.
- Challenges:
- Can make negotiations with prospective buyers more complex.
- Potentially reduces flexibility in structuring transactions.
Drag-Along Rights
Drag-Along Rights enable majority shareholders or a specified group of shareholders to compel minority shareholders to sell their shares in the event of an acquisition or sale, ensuring transaction smoothness and efficiency.
- Benefits:
- Facilitates streamlined decision-making and deal completion during exits.
- Ensures minority shareholder resistance does not derail major corporate transactions.
- Challenges:
- Minority shareholders might feel disenfranchised if terms are not carefully negotiated.
- Potential for conflict if minority shareholders perceive unfair treatment or undervaluation.
Founder Negotiation Tips
- Balance Control and Flexibility: Negotiate to retain reasonable flexibility in equity transactions, ensuring ROFR provisions don’t overly restrict your liquidity options.
- Clear Exit Paths: Ensure co-sale rights are structured clearly, providing equitable and transparent participation for all shareholders.
- Fair Drag-Along Terms: Advocate for fair and clearly defined drag-along terms that protect minority shareholders’ interests to prevent disputes and foster cooperation.
Common Pitfalls to Avoid
- Ignoring Terms Early: Neglecting to negotiate these rights early can result in limited flexibility during pivotal moments, like future fundraising or exit transactions.
- Ambiguous Language: Vague language in agreements can lead to disputes and hinder transaction effectiveness.
- Misalignment of Interests: Failure to consider long-term alignment of interests between founders, investors, and minority shareholders can cause friction during critical events.
Best Practices for Structuring Strategic Provisions
- Clear Terms: Clearly define rights and obligations under each provision to avoid ambiguity.
- Balanced Approach: Ensure terms fairly balance the interests of founders, majority investors, and minority shareholders.
- Forward-Looking: Anticipate future financing rounds and exit scenarios, structuring provisions that accommodate growth and transaction complexity.
Looking Ahead
In our next article, we will dive into the final aspects of closing your financing round, discussing confidentiality agreements and no-shop clauses in greater detail.
At Veritas Global, we provide comprehensive guidance to startups and investors, ensuring robust shareholder structures and effective transaction processes. To discuss strategic considerations specific to your company, schedule a consultation with our expert team today.
Explore additional insights and resources on startup financing and governance in our Insights section.
