ROFRs/ROFOs in sale processes 8 min read
Too often, pre-emptive rights on transfers in shareholders agreements obstruct an investor's ability to exit efficiently and realise liquidity. These rights are often agreed as 'checklist' terms at the time of acquisition, without sufficient consideration given to how they will work in practice when it comes time to sell. They are meant to facilitate orderly liquidity, but if not carefully crafted they can disproportionately favour non-selling investors and curtail an effective auction.
In this Insight, we consider an alternative approach that may better balance the rights of selling and non-selling investors in some cases; and otherwise, where a pre-emptive right remains appropriate (eg in the context of certain long-term, high-capex joint ventures and resources joint ventures), how to navigate the pitfalls they can present.
Effective last rights
It is customary for investors in a consortium, joint venture or majority-plus-minorities scenario to include pre-emptive rights on transfers in the agreement that governs their relationship. The pre-emptive right is often framed as a first right—either a first right of refusal (ROFR) or, less commonly, first right of offer (ROFO)—to provide non-selling investors the first opportunity to buy the selling investor's stake before a third party does.
The problem is that often they do not truly operate as a first right; rather, in practice, they operate as an effective last right. This usually comes down to insufficient focus on how a typical sale process can be run within the four walls of the shareholders agreement. More on this below.
An effective last right makes it difficult to run a proper sale process that attracts a full cast of third party bidders to participate and spend real money on due diligence and advisers. They might be prepared to look at an information memorandum, vendor financial model and submit an indicative bid (ie participate in the first stage of a typical two-stage process). However, once they are shortlisted to proceed to stage two, bidders want to know that the pre-emptive rights have been cleared and there is a stake for sale before proceeding with detailed due diligence and incurring substantial bid costs—they are rightly reluctant to be used as proverbial 'stalking horses' for the non-selling investors who hold the pre-emptive rights. Of course, there are ways through this dilemma—eg by offering shortlisted bidders capped cost underwrites (similar to break fees) if the stake is subsequently acquired via the pre-empt—but a selling investor shouldn't have to search for such solutions and give away value simply to realise their investment.
An alternative approach: a right to participate
Private equity sponsors are on top of this issue. They generally look to exit their investments over a shorter-term horizon, which means that when buying in, they are already considering their pathways to exit. PE shareholders agreements with managers and founders (together holding the minority interests) often do not include pre-emptive rights on transfers; or, if they do, they don't apply to the PE sponsor's stake, and the PE sponsor will generally have full control over the exit of all shareholders regardless. The PE approach is, of course, tailored to the relative shareholder dynamics that come with that sector, but similar considerations should apply in other majority and minority investor scenarios (particularly where the minorities have tag-along rights).
Even in a scenario involving a consortium of broadly 'equal' investors, standard pre-emptive rights shouldn't necessarily be the base case. Instead, consideration should be given to whether it is more appropriate for non-selling investors to instead be granted a right to participate in a sale process with guardrails that prevent sales and information access to 'bad actors' and competitors of the portfolio company. This is particularly relevant to scenarios where the investors might be a group of private capital investors—think superannuation, pension and sovereign wealth funds or fund managers. Subject to ESG type considerations, a selling investor is generally indifferent to whom they sell their stake. They want the best price and terms for that sale and certainty that the sale will complete, and a pre-emptive right should not diminish a selling investor's ability to ultimately realise that objective.
A right to participate in a sale process, in contrast, sees the non-selling investors stand alongside third-party bidders, such that the selling investor has visibility over the price and terms offered by the entire 'market' at the same time. All other things being equal, a selling investor would select the best price and terms on offer, and there is no reason why a selling investor (particularly a financial investor looking to maximise return) would sell their stake to a third party on terms worse than what a non-selling investor offers.
Some might say that a first right heads off the need to run a process and divulge confidential information about the investment to the broader market. In practice, some form of sale process is often inevitable, including because most private capital investors need to run a process to demonstrate to their investment committees and underlying investors/members that they are selling at a market price and on market terms. In any event, there is always the opportunity for a non-selling investor to move in advance of a process and make a compelling offer to the selling investor. There would also be the guardrails regarding with whom and when confidential information can be shared.
Equally, a right to participate may not always be appropriate—eg where the identity of the other investor(s) is critical, such as with an operating partner in a resources joint venture. Ultimately, parties need to critically consider whether a form of pre-emptive rights regime is appropriate and, if it is, to take care to ensure that the agreed regime and broader shareholder agreement strike the right balance (eg whether to adopt an ROFO or ROFR) and are drafted to work with, and not against, a sale process.
The pitfalls to navigate: key issues to consider when negotiating rights
With this in mind, set out below are some key issues to consider when negotiating a pre-emptive right on transfers.
What is needed from the company to assist with the sale process?
- Think well beyond the pre-emptive rights clause: consider everything a selling investor might need to undertake a sale process and ensure the shareholders agreement facilitates this.
- This will likely need to include: preparation of an information memorandum, vendor due diligence reports and virtual data room, management assistance with these matters, management presentations to bidders, site visits, management input into bidder Q&A (including as part of a warranty and indemnity insurance underwriting), management review of business warranties in the sale agreement (both auction draft and final draft), management assistance with change of control consents post signing, management not breaching pre-completion business conduct obligations in a sale agreement, and management assistance with completion deliverables.
- Importantly, pay close attention to the confidentiality clause and the ability to disclose confidential information to the desired universe of bidders and their usual representatives, including debt and equity financiers. Further, in circumstances where confidentiality agreements with bidders need to be in favour of the consortium/joint venture company, consider when it is appropriate to provide them to the company as well.
The duration
- Consider the preferred timing for the pre-emptive process to operate in the context of a broader sale process timetable. As mentioned, in the context of an ROFR, this will likely be after indicative bids have been received from third-party bidders (to give an indication of market value and key terms to include in the ROFR notice) but before binding bids are sought from shortlisted bidders. In this case, the time periods in the pre-empt process should not impede keeping shortlisted bidders warm ahead of entry into the binding bid phase, should a stake remain available.
- To that end, a single round process under the pre-empt, where non-selling investors need to indicate the extent to which they're willing to acquire in excess of their pro-rata entitlement up to the entire stake available, is preferable.
- If there is a shortfall of acceptances under the pre-empt process, ensure the sale notice can be withdrawn or the entire stake can be made available to third party bidders (ie disregarding acceptances by non-selling investors). This can be ensured by providing that any pre-emptive right exercise must be with respect to the entirety of the interest being sold (and it is pro-rated down if more than one non-selling investor exercises their pre-emptive right).
- The tag-along right can also operate in parallel to the ROFR right, so that there is earlier clarity on the total stake available to market to third-party bidders and fewer delays in completing the pre-empt process.
Avoid further bites
- Carefully check that the first right does not inadvertently operate as a last right. ROFR sale notices typically require a price and other material terms to be included, such that any third-party sale cannot be on terms more favourable overall to the third party. Sometimes, the ROFR sale notice may require all terms to be included (this effectively requires a full form sale agreement to be attached) or provide that a third-party sale must not be on more favourable terms without reference to terms overall (this effectively means that any more favourable terms are not allowed). A third-party purchaser will invariably receive more favourable terms (outside of price), even overall, compared with non-selling investors. For example, they would receive business warranties, and likely a tax indemnity, that existing owners of the investment would not be expected to receive. If the pre-emptive right does not confine any 'no more favourable terms' limitation to price only or disregard such other material terms, the ability to offer them in a sale agreement to third parties could come undone (absent capturing them in the ROFR sale notice and therefore also offering them to non-selling investors).
Remember regulatory approvals and consents
- Provide for automatic extensions to the relevant time periods in the pre-empt process for receipt of required regulatory approvals (such as Australian foreign investment (FIRB) and Australian competition (ACCC) approvals) and material change of control consents (in a control stake sale). This applies to both the deadline by which a sale to existing investors must complete (assuming they have agreed to acquire the entire stake) and, otherwise, by which a sale to a third-party purchaser must complete (before the pre-emptive process must be re-run again to sell to a third party).
A failure to complete—release the shackles
- Ensure that if a sale to an existing investor fails to complete, a selling investor is free to proceed to a third-party sale. This is often overlooked (such that the only available potential remedies are to sue for damages and/or enliven the event of default provision to compulsorily acquire the defaulting investor's stake, potentially at a discount—neither necessarily provides a satisfactory solution to the immediate desire to sell).
The final thought
The liquidity of an investment goes to its value. When pre-emptive rights on transfers are involved, they can serve to diminish that liquidity if the shareholders agreement is not negotiated with a sale process in mind. As such, careful consideration should be given to whether a right to participate in a sale process might be more appropriate for a particular investment or investor dynamic. Where that might not be appropriate, the premise remains that investors should consider whether a pre-emptive right is a suitable starting point and, if it is, take care to navigate the pitfalls they can present. Ultimately, most investments are only worth what you can realise for them.