The VC Series – Share Transfers: Right of First Refusal, Co-Sale and Tag Along

‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from VCs. Further information about The VC Series can be found here.

This article looks at some of the key terms that VCs would expect to see included regarding the transfer of shares – specifically, the right of first refusal, co-sale and tag along rights. The next article will then explore drag along rights.

Share Transfers v Issue of New Shares

This article focuses on the different provisions that relate to the transfer of existing shares by a shareholder or a group of shareholders.

This is distinct to the issue of new shares by the company. This article will not cover the issue of new shares in any detail, other than to say that typically (i) some form of shareholder authority will typically be required before the directors are authorised to issue shares, (ii) in addition, it is likely to require the consent of the VC, and (iii) unless waived by the shareholders (normally be a special resolution), any issue of new shares must be offered to all shareholders in proportion to their existing shareholdings.

Right of First Refusal (RoFR)

The investment documentation (typically the articles of association) will provide that, as with an issue of new shares, if a shareholder wishes to transfer some or all of their shares, they must first offer them to the other shareholders (or sometimes a particular group of shareholders) in proportion to their shareholdings.

Are there any exceptions to the RoFR?

The exceptions that you might expect to find are:

• Lock-in Periods: it is common for VCs to require that a founder is not permitted to sell his or her shares for a period of time following completion, as they will not want important members of the team to sell their shares whilst they remain an investor – this is referred to as a ‘lock-in period’. The period of time is often a matter for negotiation, but 3 years is not unusual;
• Permitted Transfers: VCs will require that they are able to transfer shares freely within their group, and often more widely. Otherwise, individuals may be permitted to transfer their shares to close relatives or within an investor’s group – VCs will though argue that this should be subject to their prior consent.
• Board and Investor Consent: it is not unusual for the investment documentation to allow the board and the investor to between them agree to waive the Right of First Refusal – this will though be at their discretion on a case by case basis.
• Founder Transfers: it is sometimes agreed that a founder is permitted to sell a certain number of shares, to reflect the fact that he or she might have been taking a very small salary in previous years and may require funds to, for example, purchase a house.

Practical Challenges

Whilst these are provisions that need to be negotiated and agreed in a proper way, it is also important that they are put in context.

The reality is that there isn’t often a market for shares in scale-up companies, particularly given that S/EIS relief is only available on the issue of new shares, not the acquisition of existing shares. The likelihood therefore is that, even if the documents provide for a certain amount of flexibility, a founder might not be in a position to sell any shares until an exit (or to an investor on a future funding round if that can be negotiated).

Co-Sale and Tag Along Rights

Co-sale and tag along rights impose further restrictions on the ability of shareholders to sell their shares. There is a subtle difference between the two terms, explained as follows:

• Co-Sale: before the founder or a group of shareholders sell any shares to a third party, the VC (or investor group) must be given the opportunity to sell the same proportion of their shares to the buyer on the same terms.
• Tag-Along: should shareholders holding a majority of the shares decide to sell all of their shares to a third party, the tag along right allows the minority shareholders to require that the third party also offers them the opportunity to sell their shares on the same terms – i.e. to ‘tag-along’ to the transaction. This is an important protection for minority shareholders, as it prevents them from being left behind with a new majority shareholder. The right can also sometimes apply on a proportionate basis – i.e., where the majority are selling some only of their shares.

In each case, the right typically only kicks in after the RoFR process has been completed.

The VC Series – Next Article

The next article in The VC Series explores drag along provisions.

Full details of the VC Series can be found here.

If there is anything that we have not covered which you would find useful, then please let us know.