How can rights of first refusal protect prime agricultural land? This paper develops a theory for valuing rights of first refusal based on compensation for foreclosing future demand, information asymmetry, and advance purchase of market share. A procedure is developed for governments to use these rights to prevent conversion.Land Economics/Use,

Duke, Joshua M.

MacKenzie, John

Malcolm, Scott A.

English

Research Papers in Economics

Using Rights of First Refusal for Farmland Retention
Scott Malcolm, Joshua M. Duke, and John Mackenzie
1
Food and Resource Economics
University of Delaware
205 Townsend Hall
Newark, Delaware 19717-1303
Phone: 302-831-1309
Fax: 302-831-6243
Email: duke@udel.edu
Presented at AAEA Conference, August 2001, Chicago, IL
Abstract
How can rights of first refusal protect prime agricultural land?  This paper develops a
model for ex ante valuation of rights of first refusal based on differences in the value of a
particular property, and likelihood of time of sale  A procedure is outlined for
governments to use these rights to prevent conversion.
Copyright 2001 by Scott Malcolm, Joshua M. Duke, and John Mackenzie.  All
rights reserved.  Readers may make verbatim copies of this document for noncommercial
purposes by any means, provided that this copyright notice appears on all such copies.
                                                
1 Contact information is supplied for Duke.This paper establishes a set of conditions under which rights of first refusal (ROFR) have
ex ante value and then applies the conceptual model to situations in which the
government may use ROFR to achieve farmland preservation goals.  Black’s Law
Dictionary defines ROFR as the “right to meet terms of proposed contract before it is
executed” (Nolan 1990).  Unlike options in which the right holder (buyer) triggers the
transaction, ROFR are conditional only on the seller’s decision to market the good.
ROFR also differ from options in that they do not require a specified time period in
which they can be exercised (Wheat 1987).  ROFR take many different contractual forms
and may merely be one of many terms of agreement.  Importantly, ROFR do not have to
be officially recorded, and so potential buyers of a good may not know there is an
encumbrance until after an offer is made.
The Evidence on the Value of Rights of First Refusal
The simple fact that a market for these rights exists in the real world suggests that
they have ex ante value.  For instance, a survey of case law in Delaware suggests that
numerous real estate litigations involve ROFR.  State courts, however, have faced
difficulties in distinguishing ROFR from options (Wheat 1987).  Nevertheless, courts
often find that ROFR have value, legally, in that ROFR with unspecified length of terms
are ruled invalid, violating the “law against perpetuities” by permanently encumbering
fee-simple land, see Stuart Kingston, Inc. v. Robinson, 596 A.2d 1378 (1991).  Other
real-world applications suggest ROFR have ex ante value.  ROFR have been
recommended as a tool for land conservation (Information Center for the Environment2001, for example).  In addition, real estate scholars accept as fact that ROFR have value
(see Blumenfeld and Rowe 2000).
Given that existing markets and noneconomists treat ROFR as though they have
value, it is rather surprising that economists have yet to develop a theory explaining the
ex ante value of ROFR.  The only two economic approaches to date have assumed that
ROFR have ex ante  value, and then derived implications based on this assumption
(Walker 1999, Kahan 1999).  Kahan (1999) develops a game-theoretic model to show
that ex post value derives from reducing the incentives for costly strategic bargaining.
Kahan (1999) also shows that this value varies directly with transaction costs, is not
affected by imperfect information by a right holder, and is affected by imperfect
information by a third party.  Using a different approach, Walker (1999) finds the main
source of ex post value to arise from the way that ROFR discourage third-party buyers
from making offers, which in turn decreases demand.  Because this tends to reduce the
price the right holder will eventually be asked to match, sellers require compensation.
Walker (1999) also criticizes traditional legal explanations for ROFR value: (1) a way to
avoid costly breakdown in bargaining and (2) a way to prevent sale to an undesirable
party.  The economic conditions that would inspire a potential buyer to purchase an
ROFR at an indefinite time before a property is to be sold (if the property is ever sold)
have not yet been examined in the literature.  This paper investigates the emergence of
ROFR by explaining ex ante value.  The second section builds the theory and the final
section interprets the results in terms of public policy for farmland preservation.
An Economic Model of ROFR ValueTo begin we establish the ex post valuation of ROFR.
2  We introduce the case
where there is no ROFR on the property sold.  A certain piece of property comes on the
market at some time T, which the owner must sell; that is, he must accept the highest bid.
Consider a large number of bidders, represented by two buyers, R, whose value for the
property at the time of sale is VR(T), and B, whose value V B(T) is the maximum of the
values of all other bidders except for R.  If V R(T) ‡ V B(T), bidder R purchases the
property at price VR(T). if VR(T) < VB(T), then bidder B buys the property at price VB(T).
Now assume that bidder R holds an ROFR on the property.  Bidder R does not make a
bid, but rather will purchase the property at price V B(T) if V R(T) ‡ V B(T), with bidder B
purchasing the property if V R(T) < V B(T).  Thus, the ROFR has value to bidder R if
VR(T) is greater than VB(T) plus the present value (at the time of sale) of the cost of the
ROFR.  Thus, for the ROFR to hold economic value, VR(T) ‡ VB(T) + pRe
dT, where pR is
the price paid for the ROFR and d is the rightholder’s discount rate.  So, at the time of
sale, the value of the ROFR is:
pR <  [VR(T) -VB(T)] e
-dT.                                              (1)
We now turn our attention the ex ante valuation of ROFR.  Rather than consider
the price already paid for the ROFR, we measure the value of the ROFR at time T = 0 on
a property that is to be sold at some time T > 0 as an upper bound on a price an interested
party would be willing to pay. We denote this value as wR.  Bidder R will not accept any
price greater than wR for the ROFR.  Since at the time the ROFR is purchased it is not
known with certainty when the time of sale will occur, T is a random variable with
                                                
2 In our model of ROFR valuation, we do not suggest any specific market clearing mechanism, nor do we
assume that other potential bidder’s valuations for the property will be influenced by the existence of the
ROFR.probability density function f(t), and thus the quantity on the right-hand side of Equation
1 is also a random variable.  The present value of the ROFR to the purchaser is the
expected discounted present value of the difference between the purchaser’s value and
the value of the highest bidder besides the purchaser, that is
dt ￿
¥
=
0
t -
B R R e   (t)]f(t) V -   (t) [V   w
d .                                              (2)
To show how the value of the ROFR is influenced by the knowledge bidder R has
about the different factors, we consider some illustrative cases.
Case 1: Bidder R value constant, bidder B value uncertain and time-invariant, time of
sale distribution uniform.
The value bidder B has for the property is an important, yet unknown factor in
bidder R’s valuation of the ROFR.  This case where the potential buyer of ROFR has
perfect information regarding her own value, but limited information about competitors
likely values or the sales time of the property. Describe bidder R’s knowledge of bidder
B’s value for the property as uniformly distributed on the interval [V0, (1+a)VR], where
V0 can be thought of as an estimate of the seller’s reservation price, or some other value
that places a lower bound on the estimate of bidder B’s likely value.  Parameter a defines
the likely upper bound of bidder B’s bid relative to the value of bidder R.  Assuming that
the time of sale is uniformly distributed on [T0, T 0+T*], substituting into Equation 2
yields:
dt
T T
R ￿
+
=
*
0
0 T
t -
B R * e   ] V -   [V
T
1
  w
d                                              (3)where  B V , the expected value of VB, is  2 / ) ) 1 (( 0 V VR + +a .  Simplifying this expression
gives the value of the ROFR to bidder R
( )
œ ß
ø
Œ º
Ø -
-
=
-
2
)
2
1
(
*
e - 1
  w
0
T* - 0 V
V
T
e
R
T
R
a
d
d d
                                          (4)
As expected, ROFR has greater value when T0 is small (sale of the property will
occur sooner, rather than later) and when T* is of short duration (less uncertainty about
when the sale of the property will occur). Also, ROFR has positive value only when the
term in brackets is greater than zero, or when the following inequality holds
0 1
1
V VR a -
‡                                                          (5)
Bidder R has absolute certainty that her value for the property will be greater than
that of bidder B if a is equal to (or less than) zero. Since V R > V 0, levels of a slightly
greater than zero will lead to satisfaction of the inequality.  For a between zero and one,
bidder R’s confidence declines in the degree to which her value will be higher than that
of bidder B.  There is a critical level of a where the expected value for bidder B will be
equal to that of bidder R. This critical level is 1 - V0/VR. When a exceeds this level, the
expected bid of bidder B will be greater than that of bidder R, and the ROFR will have no
value to bidder R. Thus we find that ROFR has less value to bidder R the greater the
uncertainty in knowledge of competitor’s likely bid.
Case 2: Bidder R value constant, bidder B value increasing and certain
In this situation, it is assumed that V R(0) > VB(0), and V B(T) = (1+bt)VB(0), with
b > 0. The only unknown factor is the time of sale.  At some time TR, the values of R andB will be equal, with the B’s value for the property exceeding that of R at times later than
TR.  This relationship between the values of the bidders is represented in Figure 1.
Clearly, ROFR only has value to bidder R if the sale takes place before T R, whereas it
will have value to bidder B if it takes place after TR.
3  The time TR is defined by
) 0 (
) 0 (
B
B R
R V
V V
T
b
-
=                                                        (6)
If the initial value of bidder R is sufficiently close to that of bidder B or the rate of
increase in bidder B’s valuation is large enough, then T R will be in the not-too-distant
future.  Consequently, in addition to the relative valuations of the two bidders, prior
knowledge about the likely sale of the property is of paramount importance.  Since it is
assumed that bidder R knows TR a priori, the valuation must take this into account. After
time T R bidder R will not exercise the ROFR or, if the ROFR is transferable, sell the
ROFR to bidder B (who would subsequently base his own valuation for the ROFR on his
own value for the property and that of another bidder).  The shaded area in Figure 1
represents the expected gain to bidder R if the property is sold before time TR.  Therefore,
it is necessary to apply Equation 2 conditioned on the likelihood that T will occur before
TR, which gives
dt
R T
￿ £ =
0
t -
B R R R e   (t)]f(t) V -   [V ) T P(T   w
d                            (7)
For a uniform distribution for sales time, the value of ROFR is
( ) ￿ ￿
ł
￿
￿ ￿
Ł
￿ -
- - =
-
*
1
) 0 (
*
1
) 0 ( 2T
e
V
T
V V w
R T
B B R R d
b
d
d
                      (8)
                                                
3 This feature implies that ROFR has ex ante value to bidder B if he believes that sales time is likely to
occur later than TR.The first term on the right hand side of Equation 8 reflects the importance of the
initial difference in bidder’s values, with the second term adjusting for the rate at which
bidder B’s value changes over time.  The more rapidly the value of bidder B is expected
to increase over time, the lower the value of the ROFR to bidder R.  Large initial spreads
in the property value contribute to a higher valuation.
Uniform likelihood implies maximum uncertainty of the sales time.  Information
regarding the distribution of sales time would affect bidders R’s  ex ante value of the
ROFR.  An expectation that the property is likely to be sold before TR is likely to increase
bidder R’s valuation, whereas the opposite expectation is likely to lead to a reduction in
valuation.  Note that any non-zero probability of sale before T R will lead to a positive
value for ROFR under the property value assumptions outlined in case 2.
To demonstrate how the distributional assumption on sales time affects the value
of an ROFR, sales time is modeled using uniform, exponential and lognormal
distributions.  The parameters for each distribution were chosen so that the value of P(T£
TR) are equal for each case so that this does not affect the valuation.  Exact solutions are
obtained for the uniform and exponential distributions.  Under the lognormal distribution,
the value is solved for using Monte Carlo simulation. Table 1 shows how the valuations
change under the different distributions. The more likely the sale of the property is to
occur closely to the sale of the ROFR, the greater the value. The more likely the sale is to
occur in the future decreases the willingness to pay for ROFR by bidder R.
TR P(T£ TR) f(t) wRU(0,20) 21.3
Exponential(17.4) 22.5 5 0.25
Lognormal(7.7, 3.85) 8.1
U(0,20) 36.8
Exponential(14.5) 42.2 10 0.5
Lognormal(11.2, 5.6) 16.0
Table 1: ROFR values under different sales time distributions. (VR = 1000,
VR/ VB(0) = 1.25, d d=0.1)
In summary, the value a potential buyer of a property places on an ROFR on that
property is a function of not only the her own assessment of the value of the property, but
of judgments relating to the additional buyer’s valuations and the time at which the
property will come on the market.  Improved information in the form of reduced
uncertainty on these factors will help the buyer to make a better valuation.  The model we
have presented for valuing ROFR has few institutional or behavioral constraints.  It is
likely that modifications to the model that explicitly consider such issues will affect the
value placed on an ROFR.
ApplicationWe are interested in how ROFR can be used to protect prime agricultural land.  It
has been shown that there is value to holding ROFR if the holder has a higher value for a
property than any likely competing purchaser.
Governments (and private organizations dedicated to preserving natural areas)
may use the ROFR market to achieve farmland retention goals.  ROFRs could be
obtained through eminent domain or as a condition for receiving a governmental benefit,
like use-value assessment. Governments that buy parcels in this way can resell to farmers
with a severed development right, i.e., a “salvage value”.  Such a mechanism ought to be
the most cost-effective land-preservation tool if the desired policy goal is defined as
prevented conversions. This is because government intervention occurs only when the
conversion decision is made.
Conclusion
This paper develops a model which explains the ex ante value of ROFR and
which corresponds to actual behavior arising in law and markets.  The model shows the
way in which a right holders' value is affected by the uncertainty associated with other
buyers' values and the time of sale.  Results also suggest how buyers make ex ante
decisions about purchasing ROFR and the effects of ROFR on the behavior of buyers at
the time of sale.  The policy application discussed how governments might use the power
of eminent domain to secure ROFR on agricultural and environmentally sensitive land.
The model helps value these rights for compensation under the eminent domain clauses
of state and federal constitutions.  Public securing of ROFR may be a less expensive way
to protect these lands, which generates positive externalities, since large expenditures areonly required at the time the land is actually threatened with conversion  - not in
anticipation of such harms.
An implication of this work arises from the social efficiency effects of ROFR for
land.  Without formal empirical work, we can only speculate that there are social
inefficiencies associated with ROFRs and the market for developable land.  For instance,
in many locations experiencing development pressure, developable-land markets are
dominated by a few developers and characterized by oligopsony and speculation.  ROFR
also may introduce an unnecessary information asymmetry into the land market, which
may promote rent-seeking in the form of the advance purchase of market share.
Moreover, ROFR may even be a negative-sum game among developers because they are
forced to purchase market share in a advance or exit.  Exit, in turn, intensifies the effect
of oligopsony.  Although ROFR may be privately optimal contracts between right holder
and seller, ROFR may sustain and exacerbate the aforementioned market imperfections.
Undoubtedly, ROFR allow for the exploitation of naive landowners by savvy developers.
Taken as a whole, the social efficiency outcomes within the developable-land market
may be improved with more formal public participation.  As discussed in the policy
application section, a first step is to introduce the government as a buyer of ROFR for
land conservation purposes.  A second step may be to disseminate more widely
information about the existence of ROFR.  An easy way to implement this is to require
ROFR to be recorded and made available to the public if they are to be enforced.Works Cited
Blumenfeld, Glenn D. and James F. Rowe, II.  2000.  Consider a counteroffer they can’t
refuse—an alternative to options, rights of first refusal, and rights of first offer.
Real Estate Review summer:40-5.
Harris, R. Scott.  1985.  Planning, flexibility, and joint specificity of inputs: The use of
first-refusal rights.  Journal of Institutional and Theoretical Economics
141(4):576-85.
Information Center for the Environment, University of California, Davis.  2001.  Guide to
California programs for biodiversity conservation, accessed April 28:
http://ice.ucdavis.edu/guide_to_california_programs_for_biodiversity_conservatio
n/methods.htm
Kahan, Marcel.  1999.  An economic analysis of rights of first refusal.  New York
University, Center for Law and Business, Working Paper #CLB-99-009.
Nolan, Joseph R. and Jacqueline M. Nolan-Haley.  1990.  Black’s Law Dictionary, 6
th St.
Paul, Minnesota: West Publishing Company.
Walker, David I.  1999.  Rethinking rights of first refusal.  Stanford Journal of Law,
Business & Finance 5(1):1-58.
Wheat, R. David.  1987.  Comment: Clarifying the nature of Louisiana’s right of first
refusal in the transfer of immovables.  Louisiana Law Review 47:899+.VB(0)
t TR
VR
T* T
Figure 1: Increasing values for bidder B

USING RIGHTS OF FIRST REFUSAL FOR FARMLAND RETENTION

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