What is a Right Of First Refusal

Right of first refusal is a contractual right, but not obligation, to enter into a business transaction with a person or company before anyone else can. If the entity with the right of first refusal declines to enter into a transaction, the owner of the asset who offered the right is free to open the bidding up to other interested parties.

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Right of First Refusal

Basics of Right Of First Refusal

Rights of first refusal are similar to an options contract, since the holder has the right, but not the obligation, to enter into a transaction that generally involves an asset. The person with this right has the opportunity to make an agreement on an asset or contract before others can. 

A right of first refusal is usually requested by an individual or company when it wants to see how a business or opportunity will turn out. The right holder may prefer the option to get involved at a later point, rather than make the outlay and commitment up front. Right of first refusal allows them to do this. They don't need to commit now, but will have the first chance to commit (before others) if they decide to.

Right of first refusal clauses can be customized to create variations of the standard agreement. In such customizations, the two parties can incorporate changes, such as specifying a time period for the right or allowing another third party nominated by the buyer to make the purchase. Typically, right of first refusal agreements are bound by time periods. After the time period's expiry, the seller is free to pursue other buyers for their asset.

Advantages and Inconveniences of Rights of First Refusal

For the entity holding it, a right of first refusal is an insurance policy that they will not lose an asset that they want or need. For example, a commercial tenant may prefer to lease a location, but would buy the premises if not doing so meant that he would be evicted by a new owner. In such a case, the tenant would negotiate to have a right of first refusal incorporated into their lease. This way, if leasing becomes impossible, they would have the option to buy the location before others have the chance. 

Conversely, the right of first refusal is a hindrance for the property owner since it limits the ability to sell and seek buyers. In the example above, the landlord may have a difficult time attracting buyers if they know that the current tenant is always first in line to buy. However, if attracting the right tenant necessitates a right of first refusal, the property owner might still do it.

Common Uses of Rights of First Refusal

In the business world, rights of first refusal are commonly seen in joint venture situations. The partners in a joint venture generally possess the right of first refusal on buying out the stakes held by other partners, should the latter wish to leave the joint venture. Similarly, in private companies, shareholder agreements commonly allow existing shareholders to purchase those who wish to leave before any new shareholders are brought in.

Rights of first refusal are a common feature in many other areas, from real estate to sports and entertainment. For example, a publishing house may ask for the right of first refusal on future books by a new author.

Key Takeaways

  • Right of first refusal is a contractual right, not an obligation, for a buyer to enter into a transaction with the seller of an asset. It is similar to a call options contract, where the option's buyer has the right, but not the obligation, to purchase the security at a pre-determined strike price.
  • The right of first refusal clause can be used in a wide variety of situations. For example, it can be used during commercial real estate transactions to ensure that a leasing party is not forcibly evicted from a property when a buyer decides to sell.
  • The clause can also be customized to include time periods after which it becomes ineffective, allowing sellers to conduct transactions with their asset.