We agree for a Rofo but not a Rofr.”
“Calculate the percentage of equity on a fully diluted basis.”
These are examples of statements often used in negotiating equity deals and later translated into agreements. Typical documents used for capturing terms of equity investments, that is, share-purchase agreements or shareholders’ agreements, are now complex and ridden with industry terminology such as these. This may be explained as a consequence of increased foreign equity participation in Indian companies, which has resulted in the import of internationally identified terms of negotiation. While parties represented by industry specialists are quite familiar with such concepts, and therefore adept at using such terminology to their advantage, these terms can nevertheless sometimes be misunderstood.
A simple explanation of these terms and their contextual usage is provided here.
First, the difference between the right of first offer (Rofo) and the right of first refusal (Rofr). These terms are used in the context of an exit by a party, that is, sale of shares by a shareholder in the company. A Rofo essentially means that if a shareholder entity decides to sell its share in the company, the selling shareholder must first offer its shares to the other shareholder (to whom a Rofo is granted), who in turn may offer a price for the shares to the selling shareholder. If satisfied by the price offered by the other shareholder or if the selling shareholder is unable to obtain a higher price from a third party, then the selling shareholder entity only has the option to sell its shares to the shareholder who has the Rofo right. However, if the selling shareholder receives a price higher than that offered by the other shareholder from a third party, the selling shareholder is free to sell shares to the third party at the higher price.
Illustration: Jayachandran / Mint
For instance, if there are two shareholders in a private company, say, A and B, with a Rofo in favour of B granted by A, and A decides to sell his shares, then A must first offer his shares to B. Only if B refuses to purchase A’s shares, or if A can obtain a higher price for his shares from a third party than that offered by B, can A sell his share to a third party. On the other hand, if there is a Rofr in favour of B, then A is first required to offer his share to third parties and obtain a price from them for this. A is then required to approach B with the price offered by third parties. If B can match or better the price offered by third parties, A must sell his share to B.
For an investor seeking to exit a company, a Rofo in favour of the promoters will be the preferred option. This is because a Rofo provides the investor a price with which to begin negotiations with third parties and the process of price discovery remains in the investor’s hands.
However, if there is a Rofr in favour of the promoters, no third party would be interested in the investor’s shares as even after an extensive and expensive diligence process by the third party to discover the price for the investor’s shares, there remains a possibility that no sale will occur if the promoter trumps the price offered by the third party. Promoters would also vie for a Rofr as it will give them an opportunity to buy the investor shares by only matching or slightly bettering the price.
Of course, depending on negotiations, there can be a number of add-ons to the basic concept; for example, the straitjacket Rofr concept may be softened by adding a requirement on the promoters to better the third party price by at least an agreed percentage/amount. This will ensure some incentive to third parties to be interested in the shares subject to a Rofr, and may also appease the promoters by letting them have some control over the sale.
The other oft-used terms are “drag” and “tag”. Simply stated, “drag” means “if I sell, you will be required to sell with me” and “tag” means “if you sell, I will have the right to sell along with you”.
Private equity investments usually have a horizon where the promoters agree to provide an exit for the investors on predetermined terms. Where the promoters have failed to provide the investor with the agreed exit from the company, “drag” provisions in favour of the investor are useful. In such cases, the investor will have the right to force the promoters to sell their shares along with it on the same terms and to the same person to whom the investor is selling for its exit from the company. A drag right becomes meaningful on the principle that there is greater marketability for a larger shareholding in the company (as the drag enables sale of the investor’s and the promoters’ shares together) than only of the investor’s shares. Tag rights may be used by an investor if the promoters decide to sell their shares in a good deal, in which case the investor entity can sell its share on terms similar to those offered to the promoters. Moreover, sometimes investments may be made in a company on the basis of the capabilities of its existing shareholders/promoters. Here again, a tag right is useful as it will provide the investor with the opportunity to exit if the very reason for investment—the existing shareholders/promoters—are exiting the company.
Then there is the phrase “on a fully diluted basis”. This phrase essentially conveys that the equity base of the company is to be calculated assuming that all convertible instruments have been converted into equity. This gives a party an accurate picture of how much equity percentage it will eventually hold in the company.
In conclusion, while the terms above are commonly used in documentation, these nevertheless remain subject to law. So a “drag” of Indian promoters by a foreign investor to another foreign party may not be possible in a foreign investment-regulated sector where there are requirements that majority control of a company remain with Indian promoters. Similarly, price discovery in a Rofo or Rofr process may be restricted by prescribed pricing guidelines for transfer of shares from non-resident entities to resident Indian entities.
This column is contributed by Daksh Trivedi of AZB & Partners, Advocates & Solicitors.
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