Closely Held Corporations: Right of First Refusal

Mar 5, 2019 | Business

Getting out of a closely held corporation is difficult. Unless there is an agreement on how to get out, the corporation must be dissolved. When a corporation is dissolved, all its assets are sold, all the debts are paid, and the shareholders are paid whatever is left. In many cases, the amount of money shareholders get in dissolution is less than if the business sold.

One way to avoid dissolution is to let a shareholder try to find a buyer for her shares. The issue for the shareholders is they may not want the new shareholder in the company.

A right of first refusal gives the company and the other shareholders the opportunity to buy the shares before they are sold. This is how it works.

First, the selling shareholder must go find a buyer who is willing to buy the shares. In many cases, this is very difficult. Investors typically do not want to buy shares in a closely held corporation. There is simply too much baggage and risk. Where it does happen is if the shareholder who is selling has control.

When a selling shareholder finds a willing buyer, she must go back to the company and offer to sell her shares to the company at the same price, terms, and conditions. The company is given 30-90 days to decide whether it wants to buy the shares. If the majority shareholder is making the offer to sell, the offer will rarely accepted by the company. The reason is the majority shareholder would be using the company resources to buy her own stock. The money she receives she would have been entitled to anyway. If the company tries to borrow the money, it is likely the majority shareholder will be asked to personally guaranty the debt. In short, she will guaranteeing to pay the bank on her own buyout.

If the company does not buy the stock, the other shareholders are often given 30-90 days to buy the shares. The remaining shareholders are given the ability only to buy their prorated share of the shares that are offered for sale. This prevents one shareholder from acquiring a larger ownership stake in the company. However, if the other shareholders refuse to buy the shares then one shareholder can buy them all. This increases his ownership in the company but the other shareholders had a chance.

If some of the shareholders buy some stock but not all of it, the selling shareholder may still sell the remaining shares to the third party. However, the fact that less shares are being sold may kill the deal. The right of first refusal should state that if the third party doesn’t buy the remaining shares, then of any shares may be terminated by the selling shareholder.

This is a form clause we have used in the past to add a right of first refusal to a shareholder agreement.

X.XX Right of First Refusal. No Shareholder shall have the right, at any time, to sell or transfer any portion of his or her shares purchased hereunder unless:

(a) Offer to Company. The selling Shareholder shall deliver a written notice to the Company, stating the price, terms, and conditions of the proposed sale or transfer, the shares to be sold or transferred, and the identity of the proposed transferee (”Seller’s Notice”). Within 30 days after receipt of the Seller’s Notice, the Company shall have the right to purchase all or any portion of the shares so offered at the price and on the terms and conditions stated in the Seller’s Notice.

(b) Offer to Other Shareholders. If the Company fails to purchase all of the Shares specified in the Seller’s Notice, and if the Company has not then made an initial public offering of its Common Stock, the following procedure shall be followed with regard to any sale or transfer of Shares. The Company shall, at the expiration of 30 days after receipt of the Seller’s Notice, notify each of the Shareholders of the total number of Shares not purchased by the Company, enclosing a copy of the Seller’s Notice (the “Company’s Notice”). Each of the Shareholders shall have 30 days after the mailing of the Company’s Notice to notify the selling Shareholder in writing of his or her intention to purchase all or any specified portion of the available Shares described in the Company’s Notice on the terms and conditions set forth in the Seller’s Notice. Each Shareholder shall deliver to the selling Shareholder by mail or otherwise a written offer or offers to purchase all or any specified portion of the selling Shareholder’s Shares remaining for sale (”Shares for Sale”) on the terms described in the Seller’s Notice. Each Shareholder shall be entitled to purchase the proportion of the Shares for Sale at the ratio that his or her Shares bear to the total Shares held by all Shareholders desiring to purchase Shares for Sale.

If the total Shares specified in the offers received within such period by the selling Shareholder exceed the Shares for Sale, each Shareholder desiring to purchase a percentage of the Shares for Sale in excess of his or her proportionate share shall be entitled to purchase the proportion of the Shares for Sale that remains thus undisposed of, at the ratio that his or her Shares bear to the total Shares held by all of the Shareholders desiring to purchase shares in excess of those to which they are entitled under such prior apportionment. Such apportionment shall be made successively until all of the Shares for Sale shall have been allocated to purchasing Shareholders.

(c) Transfer to Third Parties. If none or only a part of the Shares for Sale is bid for purchase by the other Shareholders, then the selling Shareholder may dispose of the remaining Shares for Sale to any person or persons but only within a period of 90 days from the date of the Seller’s Notice. However, the selling Shareholder shall not sell or transfer any of the Shares for Sale at a lower price or on terms more favorable to the purchaser or transferee than those specified in the Seller’s Notice. After the 90 day period, the procedure for first offering to the Company and other Shareholders shall again apply. If only part of the Shares for Sale are purchased by the other Shareholders and the other purchaser or transferee elects not to purchase the remaining shares, the selling Shareholder may elect not to sell any shares.

(d) Transfer by Gift or at Death. The requirement that no transfer of the Shareholder’s Shares shall be valid until it is first offered to the Company and other Shareholders shall not apply to transfers by inter vivos gift or by intestate succession or testamentary disposition on the Shareholder’s death. However, any such transfer by the donee, estate, representative or beneficiary must be made in accordance with the provisions of this paragraph X.XX