Right of First Refusal

The Right of First Refusal is a mechanism frequently used in investment agreements to govern the rights and obligations of shareholders in capital companies regarding their freedom to dispose of shares. This right reserved in the investment agreement and the company’s articles of association can play a crucial role in safeguarding the interests of existing shareholders and maintaining the stability of the company’s ownership structure.

Legal basis

Pursuant to the Code of Commercial Companies (KSH), specifically Article 182 § 1 KSH, the shareholders of a limited liability company may restrict the transfer of shares in the company’s articles of association, for example, by establishing a right of first refusal for the remaining shareholders. A similar restriction can be introduced in the statutes of joint-stock companies based on Article 337 § 2 KSH.

Mechanism of the Right of First Refusal

The right of first refusal is typically specified both in the company’s articles of association (or statutes, in the case of a joint-stock company) and in the investment agreement. The inclusion of the right of first refusal in the company’s articles of association is particularly important in light of Articles 182 § 1 and 337 § 2 KSH, which provide that it is in the company’s AOA that restrictions on the transferability of shares may be imposed. The clause introducing the right of first refusal should specify the conditions under which a shareholder can exercise the same. Such conditions ought to outline the notification procedure, the timeframe for making a decision, and the form of the statement to be issued by the shareholder intending to transfer their shares, containing information on the key elements of the proposed transaction.

A deadline is introduced (usually between 15 and 30 days) for the remaining shareholders to decide whether they wish to exercise their right of first refusal. If the shareholders choose to purchase the shares, the transaction is executed in accordance with the agreed terms. If they do not, the selling shareholder may offer the shares to a third party, and the right of first refusal for the existing shareholders expires.

Benefits of including the Right of First Refusal in the agreement

The right of first refusal protects shareholders from the sudden introduction of new individuals into the company who could influence its operational and strategic activities. It ensures stability in the company’s ownership structure, which is crucial for long-term planning and execution of the business strategy. It also provides shareholders with the opportunity to increase their shareholding in the company, which can be advantageous for consolidating control.

Ensuring the effectiveness of the Right of First Refusal

The clause should comprehensively regulate the process of exercising the right it grants, as well as the consequences of its breach. To this end, instruments such as  contractual penalties can be utilized. Additionally, the clause may enable demands for compulsory or automatic redemption of shares transferred in violation of the right of first refusal.

Right of First Refusal vs. Right of Pre-emption

The right of first refusal is often confused with the right of pre-emption. The purpose and effect of these rights are the same, namely to provide the entitled shareholder with the opportunity to acquire the shares being sold before other potential buyers. However, the difference lies in the method of exercising this right. The right of pre-emption is limited exclusively to the acquisition of shares under a contract of sale. Exercising the right of pre-emption automatically results in the acquisition of the shares to which the same pertains. In contrast, the right of first refusal is exercised at an earlier stage of the disposal process and can apply to any act resulting in the transfer of shares.

Summary

The right of first refusal is a crucial mechanism in investment agreements, designed to safeguard the interests of shareholders by allowing them to maintain control over the company’s ownership structure. If properly formulated in an agreement, the right of first refusal benefits both the shareholders and the company itself.

We understand that drafting an investment agreement is a demanding process. If you need legal support in this area, the Hoogells team is ready to provide any support you may require.