Rights of First Refusal, Pre-Emptive Rights and Piggyback Rights: Restrictions on the Ability to Transfer Shares and What You Should Consider

Rights of First Refusal, Pre-Emptive Rights and Piggyback Rights: Restrictions on the Ability to Transfer Shares and What You Should Consider

You have started a business and have decided to raise capital by issuing equity. You want to incentivize early investment so you offer to protect potential shareholders’ shares by creating A Shareholders’ Agreement that would ensure their ownership stake is protected. A Right of First Refusal (“ROFR”), Pre-emptive Rights, or Piggyback Rights seem like the perfect forms of protection and incentive. However, if you are not careful, they can create overly restrictive share transfer abilities and discourage future investment. If you want to impose restrictions on the ability to transfer shares, then it is important that you understand the purpose of those restrictions and how you can draft them so they are not overly restrictive.
 
Rights of First Refusal
A ROFR requires any shareholder intending to sell their shares (“Intending Shareholder”) to first offer them to their fellow shareholders or the company[1]. ROFRs also grant shareholders the ability to control who their fellow shareholders are. It is a reasonable device to prohibit the sale of shares to competitors as long as it is not too onerous or time-consuming.
 
There are two kinds of ROFRs. The first kind, a Hard ROFR requires the Intending Shareholder to acquire a bona fide offer from a third party to acquire their shares before shares are offered to fellow shareholders.[2] The second kind of ROFR is a soft ROFR, which permits the Intending Shareholder to first offer the shares to the other shareholders, and then, if not taken up, offer them to third parties at the price offered to the other shareholders or higher.[3]
           
Hard ROFRs can make it difficult for shareholders to sell their shares because a potential third-party investor can easily lose a deal. Soft ROFRs are less restrictive because they must be exercised before any potential third-party purchaser is identified. If a ROFR is going to be included in a Shareholders’ Agreement, a Soft ROFR would provide more flexibility for shareholders to sell their shares.[4] Further, regardless of what sort of ROFR is implemented, the ability for shareholders to sell a certain percentage of their shares before the ROFR is triggered is a reasonable and effective addition to a ROFR.
 
Pre-emptive Rights
Pre-emptive Rights provide current shareholders with the right to participate in future financing and are frequently included in early-stage Shareholders’ Agreements. This right to buy future shares can be used to protect early investors’ shares from being diluted when a company decides to issue more shares.[5]
 
While the use of Pre-emptive Rights can be beneficial to shareholders, it can also serve as an obstacle to a company looking to attract investment from outside investors. The injection of non-professional investors into financing can result in an inability to provide a workable structure that includes Venture Capitalists, and as a result, stunt the growth rate or ability of a company.
 
If Pre-emptive Rights are to be used, they should be accompanied by either or both a Sunset Provision and a Pay to Play Provision. A Sunset Provision would provide the Pre-emptive Rights only for the period the shares are cheap and early stage capital is being raised.[6] In other words, the Pre-emptive Rights Provision would terminate after a certain period of time (For example: two years after the execution of the Shareholders’ Agreement). A Pay to Play Provision requires existing investors to invest on a pro rata basis in subsequent financing rounds or they will forfeit certain or all preferential rights.[7] This discourages the strategic use of Pre-emptive Rights in future financing rounds.
 
Piggyback Rights[8]
A Piggyback Right requires that an Intending Shareholder permit other shareholders to sell their shares along with it on a pro rata basis. The rational for this device is to ensure that shareholders with this benefit can exit a company at the same time and rate as the shareholder subject to the right. The issue with a Piggyback Right is that it can delay and drag out potential sales of shares because they require a notice period (to the other shareholders), and a buyer for more than one shareholder’s shares must be found. This can discourage not only potential buyers, but also shareholders, due to the difficult tasks of finding purchaser(s).

​Piggyback Rights should be used with caution, and potentially limited to irreplaceable executives and majority shareholders.[9] It shouldn’t matter if an indifferent shareholder decides to sell their shares, however, if an executive shareholder decides to sell all their shares, then other shareholders should have to opportunity to sell their shares as well as this could be an indication that the company’s value is going to decline.
 
Conclusion
Many forms of restrictions on the ability to transfer shares exist. ROFRs, Pre-emptive Rights and Piggyback Rights are but a few such restrictions that can be used to protect shareholders. However, if these provisions are included in Shareholders’ Agreements without understanding how they may implicate the ability to transfer shares, it can halt a company’s ability to attract investment in the future. If restrictions are to be imposed on the ability to transfer shares, they should be included in a manner that does not make their application absolute and avoids barriers that make the ability to transfer shares too onerous or impossible.
 
For more information contact the BLG Venture Clinic.
 
Suleiman Semalulu is member of the BLG Venture Clinic and is a third-year law student at the Faculty of Law, University of Calgary.

References
[1] Bryce Cyril Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, (Canada: LexisNexis, 2018) [Tingle].
[2] Sara C. Pender, “Canada: Five Beneficial Clauses To Consider When Drafting A Shareholders’ Agreement” (July 19, 2013), online (blog): Mondaq < http://www.mondaq.com/canada/x/252080/Shareholders/Five+Beneficial+Clauses+To+Consider+When+Drafting+A+Shareholders+Agreement>.
[3] Ibid.
[4] Tingle, supra note 1.
[5] Joshua Kennon,” Understanding Shareholders Pre-emptive Rights” (February 8, 2019), online (blog): Investing for Beginners < https://www.thebalance.com/what-is-the-preemptive-right-358100>
[6] Tingle, supra note 1.
[7] Ibid.
[8] Ibid; Shanlee von Vegasack, “A Brief Introduction to Unanimous Shareholder Agreements” online (blog): BD&P < https://www.bdplaw.com/content/uploads/2016/06/Shareholders-Agreements.pdf>.
[9]  Tingle, supra note 1.