A Right of First Refusal provision provides a startup with the right to step in place of a prospective 3rd party purchaser when a current stockholder desires to sell their stock. That is, the startup has the right to purchase and redeem any of its stock prior to such stock being sold to another prospective stockholder. This is helpful for a startup to maintain its shareholder base, although there are usually exemptions for things like estate planning.
The Right of First Refusal provision can either be located in each individual stock purchase or grant agreement or it can be in a startup’s Bylaws. Though, some startups choose to use both methods (the belt and suspenders approach). Most of the time a startup will have a Right of First Refusal provision in each stock agreement, but having a Right of First Refusal in the Bylaws isn’t necessarily a wrong approach. Further, it is potentially more convenient having the provision in the Bylaws because then you may not have to worry about making sure a Right of First Refusal is in each stock agreement. (Note that if your startup goes through a seed or venture capital round, it may have a Right of First Refusal document which allows investors similar rights to the company to step in place of a prospective 3rd party purchaser and purchase the securities being transferred by a current stockholder.)
Sometimes a Right of First Refusal provision in the Bylaws can cause issues. We’ve seen this a few times when the shares subject to the Right of First Refusal include all securities, as opposed to just common stock. Such a blanket provision includes preferred stock and thus, the investors’ securities. Investors typically do not want their shares so restricted, although this provision can fall through the cracks on diligence. Thus, the Bylaws of a startup should always be examined prior to investment, even if the investment structure is a convertible security like a convertible note or convertible equity.
Solution — Carving Out Preferred Stock
A solution to this potential issue is that you can include the Right of First Refusal in your Bylaws but preempt any investor issues by including a carve out for preferred stock. In other words, just restrict the provision in your Bylaws to apply only to common stock. This would prevent you from having to amend and restate your Bylaws as well as protect the company as originally intended with the Right of First Refusal.