How To Get Out Of A Right Of First Refusal

Right of First Refusal: A Potentially Win-Win Negotiation Tool

Including a right of first refusal in your sale can be a value-creating move. To get the most out of one, you will need to carefully negotiate the details.

By — on September 29th, 2020 / Business Negotiations

Looking for ways to get more value out of your sales negotiations? You may be able to do so by negotiating a right of first refusal.

A right of first refusal, also known as a matching right or right of first offer, is a contractual guarantee that one party to a business deal can match any offer that the other side later receives for the item or issue being negotiated, explains Harvard Business School and Harvard Law School professor Guhan Subramanian.

Here's how a right of first refusal might work. Suppose you're a landlord negotiating an apartment lease with a prospective tenant. You want to maintain the ability to sell the apartment in the future. Your prospective tenant, meanwhile, wants a commitment to rent the apartment for as long as she wants. The solution might be to offer the tenant a right of first refusal—the right to match any legitimate third-party offer for the apartment. In this manner, the tenant gains the opportunity to avoid the disruption of a move, and you preserve your flexibility to sell to the highest bidder.

The rights of first refusal can be a win-win tool that can enhance your business negotiation skills, but to ensure that they are mutually beneficial, they need to be negotiated with care.

Don't Forget the Details

Too often, deals that seem to guarantee a right of first refusal are overly vague about what will happen when a right holder exercises that right, cautions Subramanian. For example, potential right holders often fail to negotiate what will happen if they choose to match a competing bid. When you match a competitor's bid, will this end the competition or launch a bidding war?

It's also important to specify how long you have to decide whether to match an offer. "If the duration of the right of first refusal is ambiguous," warns Subramanian, "a third party could short-circuit your right by making an exploding offer with a short fuse." Time pressure could keep you from successfully matching an offer. So, be sure you negotiate ample time to respond to a competing offer.

Negotiate the Type of First Refusal

As we've explained, typically, the holder of the right of first refusal only has to match the high bid that that seller receives without engaging in the auction.

But in another type of right of first refusal that's common in certain real-estate and entertainment markets, the right holder must accept or reject the seller's specified price before other potential buyers are offered the same deal. If the right holder refuses the price, she forfeits the chance to match other offers.

In their research, Brit Grosskopf of Texas A&M University and Alvin Roth of Harvard University warn that this language can turn the apparent blessing of a right of first refusal into a curse.

For example, imagine you hold a right of first refusal for a piece of property that you value at $500,000. If you only have to match the high bids, you may get a bargain if the market is weak, perhaps buying back the parcel for $400,000. But suppose you have to respond before the market has been tested. If the owner demands $475,000, you'll be pushed close to your limit yet reluctant to risk losing the property to a higher bidder. In essence, this second type of right of first refusal leaves you bidding against yourself.

As this example suggests, not every right of first refusal is created equal. When negotiating one, make sure the specific terms won't backfire on you later.

Advice for Third Parties

What if you're thinking about making an offer that would trigger a right of first refusal? You face a dilemma, according to Subramanian: If your would-be competitor exercises its right of first refusal, you might waste time conducting due diligence and negotiating. But if the company doesn't exercise its right of first refusal, you likely have overpaid. Why? Because the company probably has better information about the true value of the purchase than you do. For this reason, many negotiators avoid deals that trigger a right of first refusal.

Yet when negotiating business deals, some circumstances eliminate those concerns. First, the right holder might not be able to match your offer due to a liquidity crunch. Second, you may have just as much or better information about the value of the asset as the right holder. Third, you might bring some special value to the table that the right holder lacks. If any of these justifications apply, you should feel comfortable making a bid.

Have you ever negotiated a right of first refusal, and if so, how did it turn out?