Drag along, ROFR, MFN: Most-used legal terms in VC explained

By Denys Krasnikov, head of PR at F1V

Venture capital deals come with a lot of unfamiliar terms. Although it's important for founders to hire a good lawyer, it's also helpful to understand the key terms yourself.

To help you out, we have gathered and explained the 9 terms that you are likely to encounter during your meetings with investors.

If you own a majority stake in a startup, drag-along rights allow you to compel minority shareholders to sell their shares when you sell yours. It ensures unanimous agreement and prevents obstruction.

Drag-along rights grant majority shareholders greater control over the company and make it easier to sell the entire company.

Drag-along rights may be perceived as unfair to minority shareholders and can lead to disputes if not properly negotiated. When negotiating drag-along rights, consider the required percentage of shares to activate the provision, and any exceptions or limitations. Protect your interests while maintaining decision-making flexibility.

For successful companies, drag-along rights are rarely used. For less successful ones, drag-along can be useful when there’s a less-than-great purchase offer that investors wish to accept, but certain shareholders oppose it.

Founders can try to safeguard themselves from a situation where their company is sold without their agreement by requesting specific safeguards, such as setting a minimum price for the sale.

Tag-along rights protect minority shareholders by allowing them to sell their shares alongside the majority shareholder during a sale. This prevents them from being left behind or forced into an unfavorable situation.

These rights ensure fairness for minority shareholders who have less influence over company decisions. They ensure that everyone is treated fairly during a sale.

Tag-along rights may limit decision-making flexibility and potentially complicate or delay a sale. When negotiating tag-along rights, apply them equally to all shareholders without exceptions and consider setting a minimum price for the sale of shares.

In companies with limited liquidity, tag-along rights enable shareholders to sell their proportional share when a significant shareholder sells their shares to a buyer. If she's selling $500,000 worth of shares, other shareholders can tag along and sell their pro-rata portion of that.

ROFR allows shareholders to accept or refuse an offer to purchase shares after the selling shareholder received a third-party offer. This right applies to both new and existing shares.

ROFR rights are typically pro-rata, enabling shareholders to buy shares proportionate to their current ownership percentage. If a company issues 1,000 new shares, a ROFR shareholder with a 10% stake can buy 100 shares to maintain their percentage of ownership.

ROFR preserves ownership control and can potentially limit dilution, promoting stability. However, it can hinder fundraising and deter new investors due to limited share availability.

ROFO is similar to ROFR (right of first refusal), it grants existing shareholders the option to purchase a selling shareholder’s shares. However, contrary to ROFR, it needs to be before the shares are offered to third parties.

For example, if a shareholder intends to sell 1,000 shares, a 10% shareholder with ROFO can buy 100 shares before they are offered to other potential buyers.

ROFR can lead to lower-priced offers for sellers, as existing holders have the right to purchase the shares. On the other hand, ROFO is more favorable to sellers, as ROFO holders must initiate an offer first, and if the time expires, sellers are free to sell to other parties.

Pro-rata rights enable existing shareholders to maintain their proportional ownership stake when new shares are issued.

These rights are similar to ROFR/pre-emption rights but apply only to new shares, rather than existing ones. If you own 10% of a company and it issues additional shares, your pro-rata rights let you purchase enough new shares to keep your 10% ownership.

Pro-rata rights prevent dilution, ensuring fair opportunities for existing shareholders to participate in future financing rounds and maintain their influence and control.

Certain investors might ask for super pro-rata rights, which means they automatically get the option to buy shares above and beyond the amount that accounts for dilution. Founders should refuse this request because it can discourage other investors from participating in future funding rounds.

Similar to pro-rata rights, pre-emption rights give existing shareholders the first chance to buy new shares in a company before they are offered to others.

Pre-emption rights are a specific subset of pro-rata rights that focus on the initial opportunity to purchase new shares, whereas pro-rata rights encompass a wider range of situations where shareholders can maintain their proportional ownership.

The distinction lies in the scope and timing of the rights, but the underlying purpose of both is to protect existing shareholders from dilution and maintain their relative ownership.

Liquidation preference grants priority to preferred shareholders in a company’s liquidation or sale, protecting them from significant losses. Preferred shareholders are typically repaid before common shareholders.

Liquidation preferences are relevant when a company’s success is limited and the investor’s exit value is lower than their initial investment.

A 1x liquidation preference means that, in the event of an exit, an investor will receive the original sum they invested before other shareholders receive anything. 1x is the standard multiple, and founders should be wary of agreeing to anything above.

There are participating and non-participating preferences. Participating preferences entitle shareholders to their liquidation preference amount and a share of the remaining proceeds. Non-participating preferences offer a choice between the two.

Pari passu preferences mean equal priority for all preferred shareholders; stacked preferences mean that certain shareholders have priority.

Liquidation preferences pose risks for founders and common shareholders if the sale price is lower than the total preference amount — they may receive nothing at all.

Vesting is crucial for retaining talent in startups, including founders and employees; it gradually grants them ownership rights over shares or stock options for staying loyal to the company.

After founders enter into a vesting agreement, they will be earning their equity stake over a few years. There’s typically a one-year cliff, which means shares don’t vest during the first 12 months. It’s designed to make sure the founders remain in the company for at least this period. The shares are accumulated and vested at the conclusion of this first year; after that, the shares typically vest each month.

Vesting terms are negotiable and outlined in agreements or stock option plans. If founders leave the company, they will surrender all unvested shares, which will be returned to the company’s option pool.

Similarly, employees, especially key team members, have vesting tied to their continued employment, which promotes loyalty.

The MFN clause is a way to protect an early investor. The idea is simple: if a future investor negotiates better terms, an early one gets them too.

When raising capital, startups often use simple agreements for future equity (SAFE) that include a most favored nation (MFN) clause.

SAFEs are common financing tools for early-stage startups, providing investors with the option to purchase shares at a discounted price in future rounds. They are not debt and do not accrue interest.

With an MFN clause, investors can ensure they receive the same terms as new investors in subsequent funding rounds. Example: A startup raises $100,000 from Investor 1 via a SAFE with no discount rate at a $1 million valuation cap. Later, the startup raises another $100,000 from Investor 2 via a SAFE. This time, there’s a 5% discount rate and a valuation cap of $900,000. Investor 1 uses the MFN clause to receive the same terms.

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