Right of First Offer

Both a right of first refusal and a right of first offer exist to give the existing shareholders a chance to increase their stake before an outsider is let in. They differ in who names the price first.

Under a right of first refusal, the seller goes to the market first, comes back with the best quote obtained, and the ROFR-holder may match it or refuse.

Under a right of first offer, the order is reversed. The seller must go to the ROFO-holder first and ask for that holder's best offer. Only then can the seller shop the shares around. If the market beats the ROFO-holder's price, the seller is free to take it. If the market cannot, the seller is compulsorily obliged to sell to the ROFO-holder at the price the holder named.

These are arrangements between shareholders. They sit in the shareholders' agreement and do not affect the company itself.

The sequence matters, because the exam tests it as a sequence:

Chapter 10 groups these with the other exit rights, each solving a different problem:

• Co-sale / tag along — if a shareholder sells, the others can insist the potential purchaser agrees to buy an equivalent percentage of their shares, at the same price and on the same terms. The stated rationale is to make the shares harder to sell, because AIF investors are backing the founders' technical and management experience and do not want those individuals reducing their stake or leaving while the fund is still invested.
• Drag along (or bring along) — the holder can force the other shareholders to sell to the same buyer on the same terms. Usually insisted on where the AIF is a minority investor, so the block offered to a buyer is large enough to attract a control or strategic premium, instead of suffering a minority or non-marketability discount.

ROFR and tag along are usually provided for simultaneously over the promoters' and key managers' shares, and are often reinforced by a lock-in for a specified period.

A Category II AIF holds 22 per cent of an unlisted speciality retailer. The shareholders' agreement gives the fund a ROFO over the promoter's shares. The promoter now wants to sell 15 lakh shares.

Step 1 — the promoter must come to the fund first. The fund names Rs 620 a share, or Rs 93 crore.

Step 2 — the promoter tests the market.

Now run the same facts as a ROFR. The promoter goes to the market first, comes back with Rs 675, and offers the fund the chance to match. The fund pays Rs 675 or walks away.

Same shares, same buyer pool, same day — and the fund pays Rs 8.25 crore more under a ROFR than the price it would have named itself under a ROFO. A ROFO lets you set your price and risk being outbid; a ROFR lets you see the price and risk paying somebody else's.

Chapter 10 (Investment Process and Governance of Funds), section 10.4.6 on exit rights. This is a reliable question: you are given the mechanics of one right and asked to name it, or given a scenario with a higher or lower market offer and asked what the seller must do. The discriminator is always who quotes first.

• ROFO: the holder quotes first. ROFR: the market quotes first. Everything else follows from that.
• Under a ROFO with a lower market offer the sale to the holder is compulsory, not optional, at the holder's own stated price.
• Under a ROFR the holder must match the best market quote — it does not get to name its own number.
• These are inter-se rights between shareholders. They do not affect the company, and the workbook says so explicitly.
• Tag along protects the other shareholders; drag along serves the seller. Tag along makes shares harder to sell; drag along is insisted on by a minority AIF so it can deliver a control block and capture a strategic premium.
• Do not confuse the pre-emptive right in section 10.4.3, which is about new issues by the company, with ROFR and ROFO, which are about existing shares changing hands.