Don't Forget to Factor in Rights of First Refusal
When considering an exit strategy for leaving the ownership of a business, don't forget to factor in the rights and input on the subject to which your fellow owners may be entitled. In many cases, finding a buyer for your equity stake is only part of the process.
Whether it's a closely held corporation or LLC whose equity holders are owner-operators or an investment vehicle LLC with sophisticated equity holders, the Operating Agreement or Close Corporation Agreement is quite likely to contain some restrictions on the manner in which ownership interests can be transferred to nonowners. Often one such restriction will be a "right of first refusal" which requires that one's fellow owners, and/or the company itself, be given an opportunity to purchase the ownership interest before any sale or transfer to a third party is permitted.
The typical "right of first refusal" generally follows the following sort of sequence:
1. Getting the Purchase Offer in Writing. The equity holder wishing to sell to someone outside the existing ownernship must obtain a WRITTEN bona fide offer from the propsective purchaser setting forth the material terms and conditions of the offer and the amount of consideration offered.
- YES, it really does need to be written. It doesn't necessarily have to be in the form of a formal purchase agreement, but a few notes on the back of an envelope or business card will probably not be adequate.
- Bona fide just means it needs to be something that the prospective purchaser really will follow through on and there are not any questionable side transactions (e.g., part of the purchase price is immediately refunded to the purchaser) required to support the proposed transaction.
- Yes, it does need to be specific. If, for example, payment is going to be made over time, that needs to be explicitly stated.
2. Notifying the Remaining Owners. A copy of the written bona fide offer, together with some sort of written notice setting forth the desire to sell, must be provided to all of the remaining equity holders.
- NO, an e-mail to the remaining equity holders from the owner wishing to sell out which summarizes the terms of a verbal offer is probably not good enough.
- The precise form of the notice required is generally not spelled out in the Operating Agreement. However, nothing more complicated than indicating it is a notice of the desire/intent to sell is necessary. Some Operating Agreements do require the notice to contain a summary of the terms and conditions of the offer.
3. Waiting for a Response. The company and the remaining equity holders are given a period of time to consider whether they wish to "meet" the offer made and buy back the equity interest. Usually, but not always, the company is given the first "right of refusal" with the remaining equity holders being given a chance to purchase if and only if the company decides not to exercise its right of refusal.
- The amount of time given for consideration of the offer varies, although 15, 30, or 60 days are common choices. Generally the length of consideration time is the same for all parties having a rights of first refusal, i.e. both the company and the remaining owners will each be given 30 days.
- The consideration time is usually cumulative, i.e. the company has 30 days to decide and then the remaining owners get 30 more days after that to make their decision.
o Occasionally, Operating Agreements provide that the presentation of a bona fide offer permits the remaing equity holders to purchase the subject equity interest at predetermined price, perhaps "fair market value", as determined by an agreed upon formula or method. - The purchase by the company or remaining equity holders in the aggregate must be for the entire portion of ownership interest being offered for sale - no partial purchases are permitted, although it is often possible for the equity interest to be divided among the remaining owners.
4. Exercising the Right of First Refusal. If the parties holding "rights of refusal" wish to exercise them, they must provide the party wishing to sell with written notice of that intent within the time required. The transaction must then be closed within the time specified by the Operating Agreement which can vary considerably from one Operating Agreement to another. Some Operating Agreements may even prevent a closing prior to the expiration of at least some period of time, i.e. 30 or 60 days.
5. Right of First Refusal NOT Exercised. If the parties holding the rights of refusal choose not to exercise them, the party wishing to sell may proceed to consummate the offer under the terms and conditions disclosed. Generally, if the transaction is not consummated within a certain period of time, perhaps as short as 30 or 60 days, the party wishing to sell will have to go through the entire right of first refusal process again.
Make sure you understand the "big picture" once you've decided it's time to move on and want to transfer your ownership interest in a business to ensure you don't lose valuable time.
Teri, I offer one gloss to your excellent summary of rights of first refusal. Depending on the terms of the governing agreement, notice by e-mail may very well be good enough if a copy of the actual offer is attached. The Uniform Electronic Transactions Act (Ohio Revised Code Chapter 1306) lets the parties use e-mail for many things that used to require a signed piece of paper. That's one reason the operating agreement, shareholder agreement or partnership agreement should specify when electronic notice is and is not acceptable.If the agreement is silent, a court may decide that sending a notice and copy by e-mail is good enough.
Jack Levey, Plunkett Cooney