Fundraising Agreements: Part 8 - ROFR, Tag/Drag Along Rights, Lock-Up Period.

Fundraising agreements are crucial in the context of startups and investments, ensuring that the interests of both founders and investors are protected while facilitating the smooth transfer and sale of company shares. Four key types of agreements/clauses often discussed in this context are the Right of First Refusal (ROFR) Co-Sale Agreement (also known as Tag-Along Rights), Drag-Along Rights and Lock-Up Period. Here's a detailed overview of each:

?? Right of First Refusal (ROFR)

Imagine a scenario where three founders, A, B, and C, start a tech company and agree that any founder wishing to sell their shares must give the others the first chance to buy them. Founder A decides to sell 10,000 shares at $10 per share to an external investor. According to the ROFR agreement, Founder A must first offer these shares to Founders B and C at the same price.

Upon receiving the offer notice, Founders B and C have 30 days to decide whether to buy any or all of Founder A's shares at $10 per share. Suppose Founder B decides to purchase 5,000 shares, and Founder C declines the offer. Founder A can then sell the remaining 5,000 shares to the external investor at the agreed price, provided the sale is completed within a specified time frame (e.g., 60 days) and under the same conditions offered to Founders B and C.

A well-drafted ROFR clause should include:

• Definition of Shares: Clear identification of the shares subject to the ROFR, which can include common stock, preferred stock, or any other equity interest.
• Procedure for Offering the Shares: Detailed steps the selling shareholder must follow to offer the shares to the ROFR holder, including how the offer notice is delivered.
• Pricing Mechanism: The method for determining the price of the shares, whether it’s the same price offered by a third party or a formula defined within the agreement.
• Decision Period: A clearly defined period within which the ROFR holder must exercise their right to purchase the shares.
• Consequences of Non-Exercise: What happens if the ROFR holder chooses not to purchase the shares, including any conditions under which the shares can be sold to a third party.

Legal Considerations

• Specific Performance: In the event of a dispute, courts may enforce specific performance, requiring the selling shareholder to offer the shares to the ROFR holder under the agreed terms, especially if monetary damages are deemed insufficient.
• Fair Market Value Determination: Disputes may arise over how the share price is determined. The ROFR agreement should clearly define the mechanism for determining the price to minimize conflicts.
• Transfer Restrictions: The ROFR is often accompanied by other transfer restrictions, such as drag-along rights, tag-along rights, and lock-up periods, which can affect shareholders’ rights to sell their shares.
• Compliance with Securities Laws: The sale of shares, even within private transactions, must comply with federal and state securities laws, including exemptions from registration requirements.

The implementation of a ROFR must be carefully considered and tailored to the company's specific needs and shareholder dynamics. Legal counsel plays an essential role in drafting and reviewing these agreements to ensure they are enforceable and aligned with the company’s governance strategy.

CONSIDER IT AS AN EDUCATIONAL MATERIAL, ?NOT A LEGAL ADVICE??♂?. Here are the possible clauses about ROFR you can include in your contract:

1. Definition of Shares Subject to Right of First Refusal (ROFR): All shares of the Company, whether common stock, preferred stock, or any other equity interest held by the Shareholders (hereinafter referred to as "Shares"), shall be subject to this Right of First Refusal (ROFR) clause.

2. Notice of Intended Sale: Should any Founder (the "Selling Founder") wish to sell any of their Shares, they must first provide written notice to the other Founders (the "Non-Selling Founders") detailing the number of Shares intended to be sold, the proposed sale price per Share, and the identity of the prospective external buyer (if applicable).

3. Exercise of ROFR: Upon receipt of the Notice of Intended Sale, the Non-Selling Founders shall have a period of thirty (30) days to elect to purchase any or all of the Shares proposed to be sold on the terms specified in the notice. This election must be made in writing.

4. Pricing Mechanism: The purchase price for the Shares shall be as specified in the Notice of Intended Sale. If the intended sale is to a third party and involves consideration other than cash or on terms that are not equivalent to cash terms, the price shall be the fair market value of such consideration, as agreed upon by the Selling Founder and the Non-Selling Founders, or in the absence of agreement, as determined by an independent appraiser selected by the Company.

5. Transfer of Shares: If any or all of the Non-Selling Founders elect to purchase the Shares, the sale and transfer of such Shares shall be completed within sixty (60) days from the date of the Notice of Intended Sale, under the same conditions as originally proposed.

6. Consequences of Non-Exercise: Should the Non-Selling Founders decline to purchase the Shares or fail to notify their intent within the thirty (30) day period, the Selling Founder shall be free to sell the Shares to the identified third-party buyer under the terms and conditions no more favorable to the third-party buyer than those offered to the Non-Selling Founders. Such sale must be completed within sixty (60) days following the expiration of the ROFR exercise period, failing which the ROFR provisions shall apply anew.

7. Legal and Regulatory Compliance: All sales of Shares under this ROFR clause shall comply with applicable federal and state securities laws and regulations.

8. Specific Performance: In the event of a breach of this ROFR clause, the Non-Selling Founders shall be entitled to specific performance or injunctive relief as a remedy for any such breach, in addition to any other remedies available at law or in equity.

9. Miscellaneous: This ROFR clause shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns. This clause cannot be amended, altered, or waived except in writing signed by all Founders.

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?? Co-Sale Agreement (Tag-Along Rights)

Suppose a majority shareholder (60% ownership) of a startup receives an offer from an external investor to buy their shares. According to the Co-Sale Agreement, this majority shareholder must notify the minority shareholders (holding the remaining 40%) about the offer. If a minority shareholder holding 10% decides to tag along, they can sell their shares on the same terms and conditions as the majority shareholder, ensuring they can exit the investment alongside the majority shareholder.

The Co-Sale Agreement, also known as Tag-Along Rights, is a fundamental provision in the context of shareholder agreements, particularly designed to protect minority shareholders in private companies within the United States. This agreement ensures that if a majority shareholder decides to sell their stake, the minority shareholders have the right to join the sale and exit the company under similar terms. This provision is crucial for aligning the interests of minority and majority shareholders.

CONSIDER IT AS AN EDUCATIONAL MATERIAL,?NOT A LEGAL ADVICE??♂?. Here are the possible clauses about Tag-Along Rights you can include in your contract:

1. Triggering Event: In the event that any majority shareholder(s) (holding 50% or more of the Company's total issued and outstanding equity) (the "Selling Shareholder") receives a bona fide offer from an external party (the "Buyer") to purchase any of their shares of the Company (the "Offered Shares"), such Selling Shareholder must promptly notify all minority shareholders (holding less than 50% of the Company's total issued and outstanding equity) (the "Tag-Along Shareholders") of the offer.

2. Notification: The notification to Tag-Along Shareholders shall include (a) the number of Offered Shares to be sold, (b) the price per share and total consideration offered by the Buyer, and (c) all other material terms and conditions of the offer.

3. Exercise of Tag-Along Rights: Upon receiving the notification, Tag-Along Shareholders shall have the right, but not the obligation, to elect to participate in the sale and sell a proportionate part of their shares to the Buyer under the same terms and conditions as the Selling Shareholder. The election to participate must be made in writing within fifteen (15) days from the date of receiving the notification.

4. Proportionate Participation: The number of shares that each Tag-Along Shareholder may sell to the Buyer shall be determined based on the proportion that the Tag-Along Shareholder's equity interest in the Company bears to the total equity interest being sold by the Selling Shareholder to the Buyer.

5. Sale Execution: Should any Tag-Along Shareholder(s) elect to exercise their Tag-Along Rights, the sale of their shares shall be executed concurrently with the sale of the Offered Shares by the Selling Shareholder, and all parties shall cooperate in good faith to complete the sale, including executing any necessary documents.

6. Conditions and Limitations: The exercise of Tag-Along Rights by Tag-Along Shareholders is subject to (a) compliance with all applicable securities laws and regulations, and (b) the Buyer's agreement to purchase the shares from Tag-Along Shareholders under the same terms and conditions as those offered to the Selling Shareholder.

7. Waiver of Tag-Along Rights: The Tag-Along Rights provided herein may be waived by any Tag-Along Shareholder with respect to any particular sale of Offered Shares by written notice to the Company and the Selling Shareholder prior to the closing of such sale.

8. Legal and Regulatory Compliance: All parties agree to comply with all applicable federal and state securities laws and regulations in connection with any sale of shares under this Co-Sale Agreement.

9. Amendment and Modification: This Co-Sale Agreement clause may only be amended, modified, or waived by a written agreement signed by the Company and holders of a majority of the shares then subject to these Tag-Along Rights.

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?? Drag-Along Rights

Drag-Along Rights are somewhat the inverse of Tag-Along Rights. They allow a majority shareholder to force minority shareholders to join in the sale of a company. This is particularly useful in facilitating the sale of the entire company, as it ensures that a potential buyer can acquire 100% of the company's shares without opposition from minority shareholders. If the same majority shareholder decides to sell their stake and the buyer wants to acquire the entire company, the majority shareholder can use drag-along rights to compel the minority shareholders to sell their shares at the same terms.

CONSIDER IT AS AN EDUCATIONAL MATERIAL,?NOT A LEGAL ADVICE??♂?. Here are the possible clauses about Drag-Along Rights you can include in your contract:

1. Introduction and Purpose

This Drag-Along Rights Clause is intended to ensure that, in the event of a proposed sale of the company (the "Company"), where the selling shareholder(s) ("Selling Shareholder(s)") holding a majority interest in the Company wish to sell their shares, all minority shareholders ("Minority Shareholder(s)") are obligated to participate in the sale, thereby allowing for the orderly and unified sale of the Company.

2. Triggering Event

A Drag-Along event (the "Drag-Along Event") shall be deemed to occur when Selling Shareholder(s) holding at least sixty percent (60%) of the Company's outstanding voting shares agree to sell their shares to a third-party buyer (the "Buyer"), under terms that require the sale of one hundred percent (100%) of the Company's shares.

3. Notice of Drag-Along Event

Upon a decision to initiate a Drag-Along Event, the Selling Shareholder(s) shall provide written notice to all Minority Shareholder(s) (the "Drag-Along Notice") at least forty-five (45) days prior to the proposed sale. The Drag-Along Notice shall include:

• The name and details of the Buyer.
• The proposed sale price per share and the aggregate sale price.
• All material terms and conditions of the sale, including payment terms.
• The expected date of the sale.

4. Obligations of Minority Shareholder(s)

Upon receipt of the Drag-Along Notice, Minority Shareholder(s) are required to sell their shares to the Buyer under the same terms and conditions as the Selling Shareholder(s). Minority Shareholder(s) shall take all necessary actions as may be reasonably required to consummate the sale, including, but not limited to, executing agreements and delivering share certificates as necessary.

5. Representations, Warranties, and Indemnities

All shareholders shall make customary representations and warranties to the Buyer. Each shareholder shall be responsible for their own breach of representations and warranties on a several, not joint, basis, proportional to the proceeds received by each shareholder from the sale.

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?? Lock-Up Period

A Lock-Up Period is a predefined duration during which shareholders are prohibited from selling their shares, typically following an initial public offering (IPO) but can also be applied in private agreements to stabilize share ownership post-investment or other significant transactions.

• Purpose: The primary goal is to prevent large sell-offs that could negatively impact the share price. In private companies, it ensures stability in ownership during critical growth phases or following major investment rounds.
• Legal Consideration: The terms of the lock-up period, including its duration and any exceptions, must be clearly defined in the investment agreement or the shareholders' agreement to ensure enforceability.

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CONSIDER IT AS AN EDUCATIONAL MATERIAL,?NOT A LEGAL ADVICE??♂?. Here are the possible clauses about Lock-Up Period you can include in your contract:

1. Purpose

This Lock-Up Period Clause is established to ensure the stability of the Company's share price and to prevent the potential negative impact on the share price that could result from the premature sale of shares by the Company's shareholders. This clause is particularly crucial following the Company's Initial Public Offering (IPO), private placement, or any significant transaction that might affect the Company's ownership structure.

2. Definition of Lock-Up Period

The "Lock-Up Period" shall refer to a predefined duration post-IPO or any specified significant transaction during which specified shareholders of the Company (the "Restricted Shareholders") are prohibited from, directly or indirectly, selling, offering, contracting to sell, pledging, or otherwise disposing of any shares of the Company or any securities convertible into or exchangeable for shares of the Company.

3. Duration of the Lock-Up Period

Unless otherwise agreed to in writing by the Company and the Underwriter(s) (in the case of an IPO) or the Company and the Restricted Shareholders (in the case of a private agreement), the Lock-Up Period shall be set at one hundred eighty (180) days from the effective date of the IPO or the closing date of the specified significant transaction.

4. Restricted Shareholders

The Restricted Shareholders shall include all current shareholders of the Company at the time of the IPO or the specified significant transaction, including but not limited to, officers, directors, and significant shareholders (holding more than 1% of the Company's outstanding shares).

5. Permitted Exceptions

Notwithstanding the restrictions set forth herein, the following transactions shall not be considered a violation of this Lock-Up Period Clause, provided that the Company is given prior written notice and the transactions are conducted in a manner that does not negatively impact the Company's share price:

• Transfers of shares as a bona fide gift.
• Transfers of shares to any trust for the direct or indirect benefit of the Restricted Shareholder or the immediate family of the Restricted Shareholder.
• Any sale or disposition of shares pursuant to any order of a court or regulatory agency.

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??Differences and Complementarities

Right of First Refusal (ROFR) serves as a control mechanism, ensuring existing shareholders or the company itself has the opportunity to buy shares before they are sold to an external party. This right is triggered when a shareholder wishes to sell their shares, aiming to maintain a stable and controlled shareholder base.

Tag-Along Rights protect minority shareholders by allowing them to join in the sale of shares by a majority shareholder under the same terms. This right is crucial when a majority shareholder decides to sell their stake, ensuring that minority shareholders have an equitable exit opportunity.

Drag-Along Rights are somewhat the inverse of Tag-Along Rights, allowing majority shareholders to compel minority shareholders to participate in the sale of the company. This mechanism facilitates the sale of the entire company by ensuring that a potential buyer can acquire 100% of the company's shares without opposition, aligning the interests of all shareholders towards a common sale goal.

Lock-Up Periods impose a temporary restriction on shareholders, preventing them from selling their shares for a certain period typically following an IPO or significant transaction. The primary goal here is to prevent large sell-offs that could negatively impact the share price, ensuring stability in ownership and share price during critical growth phases.

While each of these mechanisms serves a distinct purpose:

• ROFR focuses on controlling who can become a shareholder.
• Tag-Along Rights ensure minority shareholders can exit on similar terms as majority shareholders.
• Drag-Along Rights enable a cohesive sale process by aligning shareholder interests.
• Lock-Up Periods aim to stabilize the company's share price and ownership post-major transactions.

Together, these rights and restrictions form a comprehensive framework for managing share transfers and sales within a company. They balance the interests of majority and minority shareholders, protect the company's valuation, and ensure equitable treatment of all parties involved. Incorporating a combination of these mechanisms can significantly contribute to the smooth operation and governance of a company, especially during periods of transition and growth.