All investment documents include some restrictions on share transfers. This should be a simple concept – investors don’t want founders (or other investors) freely transferring shares to third parties. But term sheets and shareholders’ agreements vary a lot when it comes to the detail.
We’ve captured three key restrictions that you commonly see: founder lock-in, right of first refusal (ROFR), and tag along rights. Note we’ve not included any detail in here about vesting – see our separate blog on vesting here.
what is founder lock-in?
On series A deals we often see founders being restricted from selling shares for a specified period after closing of the transaction – often 2 or 3 years. This is in addition to any vesting arrangements in place which might enable the company to claw back unvested shares in certain circumstances.
why is founder lock-in important?
Investors want the certainty that founders will not seek to sell shares in the next key period of growth. Whilst this certainly makes sense, founders may still want some carve-outs from the absolute prohibition on selling. For example, we sometimes see exceptions for a small percentage of a founder’s total shareholding, or separately permitted transfers for the purposes of tax or estate planning.
Overall, we don’t see this point negotiated too hard by founders if investors seek a lock in. If founders are committed to the business, they are likely to stick around for the next 2 or 3 years anyway and won’t be looking to sell shares.
right of first refusal (ROFR)
what is a right of first refusal?
A ROFR gives certain shareholders the right to take up any shares that a shareholder is looking to sell to a third party. This is a standard right and all shareholder’ agreements will have some form of ROFR.
right of first refusal tips
As a founder, consider the following questions when the ROFR is put in place as part of a financing round:
- Who has the benefit of the ROFR. Is it all shareholders or a smaller group, which might just be investors, or perhaps major shareholders holding over a certain percentage of the share capital. In general, we don’t see this point argued over too much as founders are unlikely to buy shares being offered up by investor shareholders anyway.
- Do the holders of the ROFR have over allocation rights, i.e. once investors have taken up their pro rata entitlement, can they also elect to buy shares of the selling shareholder that another ROFR holder has declined?
- Perhaps more importantly, who is bound by the ROFR. Is it is all shareholders or are investors excluded. Increasingly, VCs require their shares to be freely transferable. This means that ROFR cannot apply to them. Even if that is agreed, you may want investor to be prohibited from selling shares to competitors of the business.
tag-along rights / co-sale rights
what is a tag-along right and why is it important?
Tag-along rights give holders of those rights the ability to require a buyer to also purchase some of their shares if shareholders are looking to sell. If the buyer refuses, the proposed sale cannot proceed. This operates as a further restriction on founders (and potentially any shareholder) selling shares in the company unless investors can also sell down at the same time.
tag-along rights tips
Founders rarely push back on the principle of tag-along rights, but there are a few things to think about:
- Who has the benefit of the tag-along rights (i.e. who are the Tag-Right Holders?). Is it all shareholders or more likely just the investors?
- When are the tag along rights triggered? For example, it is only if founders wish to sell some of their ordinary shares? Or does it capture a proposed sale by any shareholder (including investors). Alternatively, is the tag along right only triggered if there is a major sale (for example representing a change of control)? Sometimes we see a combination of some or all of these things.
- How is the number of tag-along shares calculated? In most shareholders’ agreements, the tag-along right works on a simple pro rata basis, eg. if a founder wants to sell 20% of his or her holding, the Tag Rights Holders can also sell 20%. This means that the proposed buyer of the shares has to increase the total number of shares that it wishes to buy if the sale is to go ahead.
calculating tag-along shares
When it comes to calculating tag-along shares, the Singapore VIMA model investment documents has an alternative formulation. This calculates each Tag Right Holder’s tag-along entitlement based on its holding as a ratio of the total number of preference shares in issue. They are then able to sell that percentage of the number of shares that the selling founder wants to sell. The number of shares the founder may sell is then reduced (scaled back) by the number of shares the Tag Rights Holders elect to sell.
The result is that the total number of shares offered to the proposed buyer never exceeds the amount stated in the original tag-along notice. Whilst this mechanism is arguably better for founders as it is more likely to result in a sale actually going ahead (as the buyer doesn’t have increase the number of shares it is looking to buy), in practice, on nearly all deals we see, this is amended in the VIMA documents, and the more conventional pro-rata mechanism described at paragraph 3 above is used.
Conventional wisdom is that you don’t need to spend too much time negotiating ROFR and tag-along rights in investment documents. And that is true to some extent – investors will always need to see them. That said, there are lots of variations and these are often not apparent at the term sheet stage.
If this has sparked questions for you about your upcoming financing transaction, get in touch with our team. Otherwise, browse our other resources.