Right of First Refusal
Also written ROFR · Right of First Refusal (ROFR) · First right of refusal
A shareholder right to match the best outside quote a selling shareholder has obtained — the holder sees the price first and may buy at it, or refuse and let the sale proceed.
In plain language
An AIF that owns a minority stake in an unlisted company has a problem it cannot solve with money: it does not choose who its fellow shareholders are. If the promoter sells to a competitor, the fund wakes up in business with a competitor.
A right of first refusal is the contractual answer. Before the promoter can sell to anyone, it must bring the deal to the fund. Specifically, it must bring the best quote it has obtained from the market, and the fund may match that price and buy, or refuse and let the sale go ahead.
The rationale, in the workbook's words, is that existing shareholders should get the chance to increase their stake before the shares are offered to a third party.
How it works
ROFR sits in the shareholders' agreement alongside its near-twin, the Right of First Offer. Both are arrangements inter-se between shareholders; neither affects the company itself.
ROFR — the holder goes last. The selling shareholder must approach the ROFR-holder with the best quote from market participants. The holder may buy by matching that quote, or refuse.
ROFO — the holder goes first. The selling shareholder must approach the ROFO-holder and seek its best offer. Armed with that, the seller then goes to the market. If the market offer is lower, the seller must offer the shares to the ROFO-holder at the ROFO-holder's price. If the market offer is higher, the seller may sell at the market price.
The practical difference is information. Under ROFR the holder knows exactly what it has to beat. Under ROFO it bids blind and can be outbid.
Two neighbouring rights complete the exit-rights clause:
- Co-sale / tag-along — if a shareholder sells, the others may insist the buyer takes an equivalent percentage of their shares on the same price and terms. Its purpose is to make the seller's shares harder to sell, because AIF investors back the founders' technical and management experience and do not want them exiting while the fund remains invested.
- Drag-along — the opposite obligation: the holder, when it sells, can force the other shareholders to sell to the same buyer on the same terms. It is insisted on when the AIF is a minority investor, so the stake offered 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 granted together over promoter and key-manager shares, often with a lock-in for a specified period.
A worked example
A Category II private equity AIF holds 22% of an unlisted specialty chemicals company valued at Rs 2,200 crore at the last round. The promoter holds 55% and wants to sell 15% — about Rs 330 crore at that valuation. The shareholders' agreement gives the AIF a ROFR.
Under the ROFR. The promoter runs a process and obtains a best bid of Rs 360 crore from a strategic buyer. It must bring that quote to the AIF. The AIF now has one decision:
| Choice | Outcome |
|---|---|
| Match at Rs 360 crore | AIF pays Rs 360 crore; its stake rises from 22% to 37% |
| Refuse | The strategic buyer completes at Rs 360 crore and joins the register |
Under a ROFO instead. The AIF must quote first, with no sight of the market. Say it offers Rs 340 crore:
| Market offer | What must happen |
|---|---|
| Rs 320 crore — lower | The promoter must offer the shares back to the AIF at the AIF's own Rs 340 crore |
| Rs 360 crore — higher | The promoter sells outside at Rs 360 crore; the AIF gets nothing |
The AIF is Rs 20 crore better off and holds the deciding vote under the ROFR, and can be shut out entirely under the ROFO. Same stake, same company, same seller — the difference is one letter in the middle of the acronym, and it is worth fighting over at term-sheet stage.
Why NISM asks about it
Chapter 10 (Investment Process and Governance of Funds), section 10.4.6 "Exit Rights", which sets ROFR and ROFO out in consecutive paragraphs and then adds co-sale/tag-along and drag-along.
The classic question describes one mechanic — "the selling shareholder must approach the holder with the best quote received from the market" — and offers ROFR and ROFO as two of four options. Because the workbook presents them as a pair, the exam treats them as a pair.
Common exam traps
- ROFR: match a price the market has already set. ROFO: set a price before the market is asked. If you remember nothing else, remember which party moves first.
- Under ROFR the holder sees the best market quote. Under ROFO it does not. The ROFO-holder bids blind and can be beaten.
- Under ROFO, a higher market offer frees the seller; a lower one forces the sale back to the holder at the holder's own price. Candidates routinely invert this.
- Both are inter-se between shareholders and do not affect the company. They are not charter provisions and they do not bind the board.
- ROFR is not tag-along and not drag-along. Tag-along lets you sell alongside the seller; drag-along forces you to sell. ROFR governs who may buy.
- Drag-along is a minority investor's right, not a majority investor's. The point is to assemble a big enough block to earn a control premium.
- ROFR, tag-along and a lock-in over promoter and key-manager shares are usually drafted together — three separate protections that get compressed into one clause and then examined separately.
Check yourself
1.Under a Right of First Offer (ROFO), a shareholder wishing to sell must:
- a)Obtain the best quote from market participants and then offer the shares to the ROFO-holder to match
- b)Approach the ROFO-holder for his best offer first, then approach the market - and must sell to the holder at the holder's price if the market offer is lower
- c)Sell only to the ROFO-holder, at a price determined by an independent valuer
- d)Obtain the written consent of the company before approaching any buyer
Show the answer
Answer: (b) Approach the ROFO-holder for his best offer first, then approach the market - and must sell to the holder at the holder's price if the market offer is lower
The two rights differ only in sequence, and that is exactly what is tested.
ROFO - holder first, then market. The selling shareholder must approach the ROFO-holder and seek his best offer for such shares. After receiving the best quote from the ROFO-holder, the selling shareholder can approach other investors in the market. Then:
- a LOWER market offer means he must compulsorily offer the shares to the ROFO-holder at the ROFO-holder's offered price
- a HIGHER market offer means he can sell at the best offer price in the market
ROFR - market first, then holder. Option 1 describes this: the seller must approach the ROFR-holder with the best quote from market participants, and the holder may buy by matching the best quote, or refuse.
The rationale behind both: existing shareholders must be provided with the benefit of increasing their stake in the company before offering such shares to a third party.
Both are contractual terms between shareholders in the Shareholders' Agreement - inter-se arrangements that do not affect the company as such, which disposes of option 4.
2.An AIF holding a 22 per cent minority stake insists on a drag along right over the promoters. The objective is to:
- a)Prevent the promoters from selling their shares while the fund remains invested
- b)Oblige the promoters to sell to the same buyer on the same terms, so the combined stake attracts a control or strategic premium
- c)Allow the promoters to join any sale the fund negotiates, at the same price
- d)Give the fund the first opportunity to buy the promoters' shares before a third party
Show the answer
Answer: (b) Oblige the promoters to sell to the same buyer on the same terms, so the combined stake attracts a control or strategic premium
A drag along right (sometimes called "bring along") creates an obligation on the other shareholders of the company to sell their shares to a potential purchaser if the shareholder with such right chooses to sell to that buyer. So if the AIF wishes to exit, the promoters will be obliged to sell to the same buyer on the same terms.
When it is used and why: a drag along is usually insisted when the AIF is a minority investor in the investee company. The objective is to drag the promoters along so that the stake that can be offered to the buyer would be large enough to attract a control or strategic premium, thereby optimising the exit for the investor. In the absence of this right, sale of a minority stake could be difficult and sub-optimal due to minority or non-marketability discount.
The other options describe the neighbouring rights:
- Option 1 is the effect of a tag along plus lock-in - keeping founders in
- Option 3 is a co-sale / tag along, letting others join a sale
- Option 4 is a ROFR
Remember it as: tag along protects the small shareholder who is left behind; drag along protects the one who wants out.
Where this is taught
Free preparation for NISM Series XIX-DRelated terms
- PromoterA person named as such in the offer document or annual return, or who controls the issuer's affairs directly or indirectly, or on whose advice, directions or instructions the board is accustomed to act — excluding a…
- Due diligenceProcesses ensuring enough safeguards are taken and reasonable care exercised in protecting the interests of the investigating party.
- Category II AIFThe residual AIF category: anything that is neither Category I nor Category III and takes no fund-level leverage beyond a narrow temporary carve-out — private equity, private debt and fund-of-funds.
- Private Equity FundAn AIF investing primarily in equity or equity linked instruments or partnership interests of investee companies — typically later-stage businesses with an established model needing to be scaled up.
- Liquidation PreferenceA right in recognition of the risk the investor bears, under which preferred shareholders receive a certain amount of proceeds in priority to all other shareholders including founders.
- Shareholders' AgreementAn inter-se agreement among shareholders, necessary because the conditions in the share subscription agreement bind only the company and not its shareholders, who are not party to it.
- Term SheetThe non-binding Letter of Intent, also called the Summary of Principal Terms, entered into by the manager with a potential investee company.
- Right of First OfferA selling shareholder must first seek the ROFO-holder's best offer, then may approach the market.