I’m asked for a lot of advice from early stage founders. The trouble with generic advice is that it’s rarely the right advice for everyone. But when I’m forced to give just one golden tip for early stage startup founders, there’s one point, slightly exotic but hugely important, which I think is universally sound advice:
Don’t give your early stage investors a Right of First Refusal (ROFR) on later investments.
A ROFR means that your early investors get the right to do the future investments in the company, if you decide to ever raise another round. It’s usually packaged as a very benign, even positive!, term – “We’ll know the company better than anyone at that point, and it’ll make your life easier to get an investment offer from us rather than be forced to figure out new investors!”
In the words of Admiral Ackbar: “It’s a Trap!”. There is *nothing* benign about this, and founders should avoid the ROFR like the plague. I’d even say – if an investor included a ROFR in their agreement, re-consider whether that’s even a trustworthy investor you wish to engage with at all.
The reason this is so poisonous: Giving someone a ROFR basically means that they are de-facto the *only* potential investor you’ll have in the next rounds. You won’t have any other options, and the ROFR-holding investor will be able to set whatever terms s/he wants for the next investment. If they’re asking for a ROFR in their investment, they’re not really investing in you. Rather – they are buying a very cheap and well-hidden PUT option on your next investments.
The reason for this is that any future potential investor will ask you a very simple question when they start the process: “Does anyone have a ROFR?”. The last thing any investor wants to do is waste time and effort figuring out a company, doing due-diligence, engaging lawyers, etc, etc, to only learn at the last minute that someone with a ROFR is exercising it and taking the round from them. The early investor knows this – No serious investor will even engage a company that has given someone a ROFR. Which means that the early investor got de-facto exclusive rights to do future rounds, without even having to work hard for that or pay for that option.
The only compromise which makes sense, is giving early investors pro-rata rights to invest in the next rounds. So if they own 10% of the company, they have the right to invest 10% of the next round. Even that has some hidden downsides, but it’s a fair compromise to those who took the risk and invested early. For a full round, your existing investors should need to compete on equal footing with any new investors.
If there’s a ROFR in the term sheet – run away!
