are rights, sometimes referred to as preemptive rights, that give an investor the opportunity but not the obligation to participate in future company financings. Except when they are granted to avoid giving an investor another, more onerous right, first refusal rights should generally be avoided. They do not guarantee a company any funding and can make it more difficult to find new investors.
As a practical matter, however, many venture investors insist on some sort of first refusal right as a condition to their investing. Some use first refusal rights like options to secure the opportunity to purchase more shares in the future. Some use them for antidilution protection. The first refusal rights enable them to maintain and, sometimes, increase their ownership in a company by purchasing shares at then current rates. Others use them to exercise control over who the company’s other investors will be.
First refusal rights are usually structured in one of two ways. One variation allows the company to negotiate with others for needed capital, but only if it gives the first investor a right of "first refusal" to provide the desired financing on the same terms management negotiates with its other investor. Under this variation, management can discuss but cannot close a funding with another investor until the first investor declines to take the deal. The other type of first refusal right requires the company to present the first investor with the opportunity to invest on terms suggested by the company. If the first investor does not make the investment, the company is then free to negotiate with others to provide the funding on terms no more favorable to the new investor than those presented to the first investor.
Both variations impair a company’s ability to raise money to some degree. The first form can make it very difficult because most potential investors are reluctant to negotiate with managements when they know the deal they make can be taken away from them by another investor. In fact, many investors will not even talk with a company’s management unless it has the ability to close the deal it is offering.
The second variation also chills a company’s ability to obtain financing because it requires the company to construct an investment proposal for the first investor before it has had an opportunity to shop around to see what the best available deal is. It requires the company to begin looking for money earlier because the first investor must be given time to evaluate the investment proposal. If the first investor declines to make the requested investment, the company is still restricted in how much equity it can sell to obtain the money needed.
In general, managements prefer to avoid rights of first refusal when possible asking, instead, that investors be comforted with company exhortations of loyalty and the reality that money is hard to find. If the right of first refusal is insisted upon, the second form of right of first refusal is generally preferable. Under that scenario, once the company has presented its investment proposal to the first investor, it is free to go and negotiate with others. Unlike the first variation, the company will be able to tell those other investors that it can close the deal it is negotiating.
Sometimes an investor will accept the addition of a twist to the second type of first refusal right that makes it more palatable to management. This requires the first investor who rejects the company’s offer to either make a binding offer of his own to fund the company or release it completely from the right of first refusal. If the investor waives the first refusal right, the company is free to negotiate with others. Even if the investor does not waive his refusal rights, the company can proceed to try to negotiate a better deal with outside investors. If it cannot make a better deal, it can still accept the first investor’s offer. See: Antidilution Provisions, First Refusal Rights (Shareholder), Options, Preemptive Rights, Warrants.