What Does First Right of Refusal Mean?

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What Does First Right of Refusal Mean?

August 4, 2021         Ishani Gangopadhyay

The first right of refusal is a contractual right that ensures businesses have access to certain commercial opportunities before others. It is similar to an options clause because the holder has the right, but not the obligation, to enter into a transaction. The right is used in a variety of commercial arrangements such as franchise agreements, leases and shareholders agreements.

How Does the First Right of Refusal operate?

A person or entity holding this right has the option to accept a business offer before anyone else. The right is included as a clause in a contract and can cover most assets, including business transactions and real estate. When included in a lease, it allows a tenant to have the option to buy the property before others get the opportunity. If the tenant chooses not to exercise the right, the landlord may deal with other prospective buyers.

The right is often sought by individuals or companies who wish to see how a business or opportunity will turn out before making a serious commitment.

Common Uses of the Right

Shareholders agreement

A shareholders agreement may include a clause that obliges those exiting from a shareholding in a company to first offer their shares to the existing shareholders. If this offer isn’t taken, the leaving shareholder may then offer the shares for sale to the public. This is important for shareholders because it allows the remaining shareholders to continue to control ownership of their company. It also lets remaining shareholders obtain the voting rights attached to shares.

Lease

A lease may grant tenants first right to purchase a property when the lease comes to an end or before the landlord sells. The right benefits a commercial tenant that may prefer to lease but opt to buy the premises to prevent their eviction if the property is sold to a new owner. Thus, it provides security to the tenant as they have the option to buy if leasing becomes impossible.

The right also benefits landlords as it means there are no agency or advertising costs. However, it can be a disadvantage for a landlord as it limits their ability to negotiate with multiple buyers who could drive up the price of the property.

Franchise Agreement

Right of first refusal clauses are sometimes included in Franchise Agreements. It may apply where franchisees are exiting a franchise arrangement. The clause would require leaving franchisees to first offer their business to the franchisor. This saves costs associated with advertising and dealing with prospective buyers while benefiting the franchisor who can operate the business or sell it at a profit.

Key Considerations

When including a right of refusal clause in a contract, it is crucial to consider these key aspects:

–   The time frame in which a party can exercise the right. Since it restricts a party’s ability to deal with third parties, it should not be too long. However, sufficient time should be provided for a party to consider the transaction. For instance, a commercial tenant requires time to consider the property’s value and compare it to others in the market.

–   Commercial terms indicating the price of sale or fees that relate to payment structures.

–   Terms on the valuation of an asset (e.g., whether an asset’s value is to be determined by an independent third-party)

–   Other relevant terms as the clause does not operate in isolation and may be affected by other parts of the overall agreement.

In Summary

Rights of first refusal are common in contracts for joint venture arrangements, shareholder agreements, commercial real estate, sports, entertainment and more. The clause assures the holder that they will not lose their rights to an asset if others express interest. Although, it can limit the owner’s potential profits because they cannot deal with third-party offers without first offering the asset to the rights holder.

If you need help with drafting a right of first refusal clause or require other assistance with a contract, contact OpenLegal’s team of commercial lawyers on 1300 337 997 or fill out the form on this page.

About Ishani Gangopadhyay

Ishani works with OpenLegal as a paralegal whilst completing her law degree at the University of NSW. She is also Director of Content at the non-profit organisation Echo, and has worked within the business and marketing teams of The Meridian Magazine.