The Right of First Offer Xinyu Hua Hong Kong University of Science and Technology

Motivation The right of first offer is adopted in many pre-sales agreements, before contracting parties negotiate for sales price and before new buyers enter. It prevents a seller from selling his asset to subsequent buyers at a price below the price he offers to the contracted buyer. Example: The partners of Equistar Chemicals L.P. have signed the right of first offer. In January 2000, one of the partners, Millennium Chemicals Inc., decided to sell its shares and made a price offer to other partners. The other partners declined the offer. Millennium then tried to sell its shares to outside buyers. However, Millennium did not receive any offer which was above the price it offered to its partners, and consequently, no trade took place. The right of first offer is often adopted in partnership contracts, property sales contracts, and pre-acquisition contracts. 2/22/2019

The Right of First Offer vs. the Right of First Refusal The right of first offer is different from the right of first refusal. -- The right of first refusal allows the right holder (contracted buyer) to win the asset by matching other buyers’ price offers. That is, the seller should have received a price offer before the right holder exercises the right (Choi, 2007). -- In contrast, the right of first offer asks the seller to make a price offer to the contracted buyer before the seller’s bargaining with subsequent buyers. 2/22/2019

Overview of This Paper The right of first offer may have two effects. -- First, it may reduce the seller’s subsequent trading opportunities and therefore mitigate the seller’s rent-seeking vis-à-vis the first buyer who privately learns his valuation. -- Second, when the subsequent buyer has bargaining power, this contract can be used strategically to extract more rent from the subsequent buyer. This paper explores: -- The scenario with a competitive subsequent market -- The scenario with a non-competitive subsequent market where the subsequent buyer has some bargaining power 2/22/2019

Overview of This Paper (Cont’d) The right of first offer may increase the joint surplus for the contracting parties when -- the subsequent market valuation is sufficiently high, -- the seller is very likely learn about the subsequent market valuation, --and/or when the subsequent buyer has large bargaining power. The right of first offer reduces the probability of trade, but may also lead to more efficient allocation of the asset between the buyers. Accordingly, it may increase social welfare under certain conditions. 2/22/2019

Related Literature Strategic contracts -- Strategic rent extraction and/or relationship-specific investments: Aghion and Bolton (1987), Rogerson (1984, 1992), Chung (1992), Spier and Whinston (1995), Che and Chung (1999), Che and Hausch (1999), Segal and Whinston (2000), Che and Lewis (2007), Choi (2007), Hua (2007) -- Trading opportunities: Segal and Whinston (2000), Matouschek and Ramezzana(2007) -- Optimal strategic ex-ante contracts: Hua (2007) Most-favored-customer clause -- Butz (1990), Spier (2003), Daughety and Reinganum (2004) 2/22/2019

The Model with A Competitive Subsequent Market Risk-neutral players: seller S, buyer B1, and many subsequent buyers S has one unique and indivisible asset for sale (without costs). B1’s valuation and the subsequent buyers’ valuation are independently drawn from distributions on . --Monotone hazard rate: decreases in . Trading opportunities are not durable. 2/22/2019

1. (Ex-ante) Contracting stage 3. S goes to the subsequent market The Timing Date 1: S and B1 have symmetric information and decide whether to sign the right of first offer. The contract may also include an upfront transfer. Date 2: S offers a take-it-or-leave-it price to B1. -- B1 privately learns his valuation . -- S may learn the subsequent market valuation with a probability . Date 3: If B1 rejects S’s offer, S goes to the subsequent market. -- The competition in the subsequent market leads to a price equal to the subsequent market valuation ; however, -- If S and B1 have signed the right of first offer, then . 1. (Ex-ante) Contracting stage 2. S offers a price to B1 3. S goes to the subsequent market 2/22/2019

1. Equilibrium when S learns the subsequent market valuation The equilibrium without the right of first offer: S offers B1 a price higher than the subsequent market valuation: The equilibrium with the right of first offer: if the subsequent market valuation is small, S ignores it and offers B1 a monopoly price; if the subsequent market valuation is large, S offers B1 a price equal to the subsequent market valuation: There exists a unique such that, If , If , 2/22/2019

Furthermore, assume that follows the distribution such that Private Incentives to use the contract when S learns the subsequent market valuation The right of first offer makes S less aggressive in bargaining with B1 but also reduces the probability of trade. Furthermore, assume that follows the distribution such that first order stochastically dominates for any , and for any , can be arbitrarily small when goes to infinity. Then there exists such that the right of first offer increases the joint surplus for S and B1 if . In particular, assume that follows the uniform distribution on and follows the uniform distribution on . Then there exists a unique cut-off such that the right of first offer increases the joint surplus for S and B1 if and only if . 2/22/2019

2. Equilibrium when S does not learn of the subsequent market valuation The equilibrium without the right of first offer: S offers B1 a price higher than the expected subsequent market valuation: The equilibrium with the right of first offer: S becomes less aggressive and offers B1 a relatively lower price: 2/22/2019

Private incentives to use the contract when S does not learn of the subsequent market valuation The right of first offer makes S less aggressive in bargaining with B1 but also reduces the probability of trade. Example 1: Assume that both and follow the same uniform distribution. Then the right of first offer reduces the joint surplus of S and B1. Example 2: Assume that follows the uniform distribution on [1/2, 3/4] and follows the uniform distribution on [0,1]. Then the right of first offer increases the joint surplus of S and B1. 2/22/2019

3. Private incentives to use the contract when S learns the subsequent market valuation with a probability The right of first offer increases the joint surplus for S and B1 if the subsequent market valuation is likely to be high and/or if S is very likely to learn the subsequent market valuation. There is no divergence between the private incentives and the social desirability for the right of first offer, since the subsequent market is competitive. 2/22/2019

The Model with a Non-competitive Subsequent Market Risk-neutral players: seller S, buyer B1, and one subsequent buyer S has one unique and indivisible asset for sale (without costs). B1’s valuation and the subsequent buyer’s valuation are independently drawn from distributions on . --Monotone hazard rate: decreases in . The subsequent buyer has bargaining power: With probability , S offers a take-it-or-leave-it price to the subsequent buyer; with probability , the subsequent buyer makes a take-it-or-leave-it price offer. 2/22/2019

1. Equilibrium when the subsequent buyer has all the bargaining power and S learns of the subsequent buyer’s valuation The equilibrium without the right of first offer: S derives no revenue from the subsequent market and offers B1 a monopoly price: The equilibrium with the right of first offer: if the subsequent market valuation is small, S ignores it and offers B1 a monopoly price; if the subsequent market valuation is large, S offers B1 a price equal to the subsequent market valuation: There exists a unique such that, If , If , 2/22/2019

It also strategically extracts more rent from the subsequent buyer. Private incentives to use the contract when S learns of the subsequent buyer’s valuation If the subsequent buyer’s valuation is small, the right of first offer makes S (weakly) less aggressive in bargaining with B1; If the subsequent buyer’s valuation is large, the right of first offer makes S more aggressive in bargaining with B1. It also strategically extracts more rent from the subsequent buyer. If S learns the subsequent buyer’s value with certainty, there exists such that, if , i.e., the subsequent buyer has all or large bargaining power, then the right of first offer always increases the joint surplus for S and B1. 2/22/2019

Social welfare effects when S learns the subsequent buyer’s valuation If the subsequent buyer’s valuation is small, the right of first offer reduces the probability of trade, which decreases social welfare. However, if the subsequent buyer’s valuation is large, the right of first offer achieves socially efficient asset allocation between the buyers. 2/22/2019

Furthermore, assume that follows the distribution such that Social welfare effects when S learns the subsequent buyer’s valuation (Cont’d) If the subsequent buyer has sufficiently large bargaining power, S and B1 may adopt the right of first offer though it may reduce social welfare. Furthermore, assume that follows the distribution such that first order stochastically dominates for any , and for any , can be arbitrarily small when goes to infinity. Then there exists such that the right of first offer increases social welfare if . In particular, assume that follows the uniform distribution on and follows the uniform distribution on . Then there exists a unique cut-off such that the right of first offer increases social welfare if and only if . 2/22/2019

2. Equilibrium when S does not learn of the subsequent buyer’s valuation If the subsequent buyer has sufficiently large bargaining power, the right of first offer strategically extracts more rent from the subsequent buyer and therefore makes S more aggressive in bargaining with B1. If the subsequent buyer has no bargaining power at all, the right of first offer makes S less aggressive in bargaining with B1 and more aggressive in bargaining with B2. In particular, S would offer the same price to B1 and the subsequent buyer, . 2/22/2019

Suppose that the subsequent buyer has no bargaining power. Private Incentives to use contract when S does not learn of the subsequent buyer’s valuation Suppose that the subsequent buyer has all the bargaining power. Assume that both buyers’ valuations follow the same distribution on . Then there exists such that the right of first offer decreases the joint surplus for S and B if . In particular, assume that both buyers’ valuations follow the uniform distribution on . Then there exists one unique such that the right of first offer decreases the joint surplus for S and B1 if and only if . Suppose that the subsequent buyer has no bargaining power. -- If the buyers’ valuations follow the same uniform distribution, the right of first offer increases the joint surplus for S and B1. -- If the buyers’ valuations follow the same binary distribution, the right of first offer (weakly) decreases the joint surplus for S and B1. 2/22/2019

3. Private incentives to use the contract when S learns of the subsequent market valuation with a probability Suppose that the subsequent buyer has all the bargaining power. Then there exists such that the right of first offer increases the joint surplus for S and B1 if and only if , i.e. if S is very likely to learn the subsequent market valuation. 2/22/2019

first order stochastically dominates for any , Social welfare effects when S learns of the subsequent buyer’s valuation with a probability Suppose that the subsequent buyer has all the bargaining power. Furthermore, assume that follows the distribution such that first order stochastically dominates for any , and for any , can be arbitrarily small when goes to infinity. Then there exists and such that the right of first offer increases social welfare if and . 2/22/2019

Conclusions The right of first offer may reduce the seller’s trading opportunities in the subsequent market and therefore mitigate the seller’s rent-seeking vis-à-vis the first buyer. This may achieve more efficient asset allocation between the buyers. The right of first offer may also strategically extract more rent from the subsequent buyer. Firms have incentives to adopt the right of first offer when the subsequent market valuation is sufficiently high, the seller is very likely to learn of the subsequent market valuation, and/or the subsequent buyer has sufficiently large bargaining power. 2/22/2019

Conclusions (cont’d) When the subsequent market is very competitive, courts should allow firms to adopt the right of first offer. When the subsequent market is not competitive, courts may or may not support the use of right of first offer. Extensions: -- Renegotiation between contracting parties over the right of first offer -- The seller’s costs of learning the subsequent market valuation -- Optimal ex-ante contracts with sequential buyers 2/22/2019