Right of First Refusal and Co-Sale Agreement is one of the standard transaction agreements executed in the framework of a US based startup’s financing round, based on the NVCA templates.
This agreement envisages different rights, the two key being a right of first refusal, and a co-sale right. We discussed the right of first refusal (ROFR) in detail, and if you are interested to learn more, you can access the article using this link.
This article will delve into the concept of the right of co-sale and its nuances.
The NVCA’s Right of First Refusal and Co-Sale Agreement is not the only document to discuss the two rights together, the ROFR and the Co-Sale right, are often paired or discussed together, under a single document, in other standard financing documents used in both Israel and the US (mostly under the articles of association). Because both address the rights and obligations of stockholders desirous to transfer their shares to a third party, and provide protections, both legal and of interest, in such events.
ROFR obligates the stockholders subject to this arrangement and desirous of selling their stock to offer the same to the company and then to the other investors, before the seller is free to be selling to a third party (Note: It is worth noting that outside of the US, the company does not always receive a primary right). On the other hand, co-sale (also known as tag-alone rights) grants investors who are part of the co-sale agreement the right to join in the transaction when the founders, or in some cases other stockholders, sell their stock to any third party. It provides an opportunity for the holders of the co-sale right to sell their stock on the same terms as founders or the selling stockholders. The right of co-sale is exercisable after the stockholders, and sometimes the company, have not exercised their right of first refusal, and now the shares are being sold to a third party. The participating investors can be part of the transaction in proportion to the number of shares held by them (pro-rata basis).
According to the agreement, any participating stockholder who is desirous of exercising this right, needs to give the selling founder/stockholders a written notice to that effect, within the agreed-upon deadline. Providing such written notice implies that the co-selling stockholder has exercised his co-sale right, and is demanding to participate in the sale and to transfer a portion of such stockholder’s stock to the acquirer. In the given scenarios, if the founder or a stockholder subject to a co-sale right sells his shares in non-compliance with this agreement, then the transaction would be null and void, ab initio.
This right mostly benefits the minority stockholders and allows them to join in the profitable deals and sell stock along with the selling stockholders or founders of the company. The joining stockholders are subject to the same pricing and terms and conditions as that of original sellers. Key shareholders, like venture capital firms, have the ability to negotiate prices and procure buyers and this right allows other investors who do not have a similar capacity to capitalize on such deals.
For example, if the startup has provided co-sale rights to all of its stockholders (worth noting this rarely happens, and usually, only the founders are subject to a co-sale obligation) and if a venture capital subject to a co-sale obligation decides to sell its stake in the company and offers the share for $50 each, those stockholders who have not exercised their ROFR can exercise co-sale rights and sell their shares on a pro-rata basis to the third party at the same price.
Like ROFR, co-sale rights are also subject to predefined exceptions like transfer to family members, transfers for estate planning purposes, in between mutually controlled entities, etc. This exemption is generally referred to as the “Permitted Transferee” exemption, and it should be noted that many venture financing documents exclude transfers to a list of “Permitted Transferee” and consequently these transfers are exempt from the ROFR or Co-Sale obligations.
From the above discussion, the importance of the right of co-sale is evident and why it co-exists with the ROFR.
Investors can request this right because it provides them privilege and allows them to sell their shares and be a part of profitable transactions, but also because it “aligns” their interest with the interest of the founder, who they usually feel must keep a relatability substantial holding percentage, to keep its interest and “skin-in-the-game” in relation to the venture.
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