3. Registration Rights

The purpose of the registration rights is to make sure that the investors can require the company to list their shares publicly.

Shares cannot be freely sold to "public" shareholders without filing a registration statement with the United State's Securities and Exchange Commission (SEC) (or similar agencies in other countries). Now the problem is that only the company can file such a registration statement - individual investors cannot do that on their own. Therefore, investors negotiate for certain registration rights to insure their contractual ability to exit into public markets should the company develop into an IPO case. The two most common registration rights are:

  • Demand rights
  • Piggy-back rights.

 

Demand Rights

The demand rights allow investors to demand that the company registers shares so that the investor can sell them to the public. Therefore, demand rights essentially force the company to do an IPO (or expand the free float of the already listed shares), even if the management is against it. Some key elements of the demand rights include:

  • Demand rights usually kick in 3 to 5 years after the investment (or 6 months after the IPO).
  • Depending on the firm's listing status, there are two types of demand rights available to the investors:
    • Registration on Form S-1: This is the registration statement that is required for the initial public offering of shares. If the firm has no publicly traded shares, investors have to demand a Form S-1 registration for the first listing.
    • Registration on Form S-3: If the firm already has been public for at least 1 year, it may be able to list additional shares using the less complex S-3 registration form.
  • When negotiating registration rights, three issues are often important:
    • The number of registrations: Because registering shares is a time consuming and expensive process (for example, it entails significant legal and accounting expenses), the company will want to limit the number of registrations to 1 or 2 per year.
    • The minimum size of the registration: Similarly, the company will want the value of the securities to be registered larger than a certain dollar amount, to avoid trivial registration requests. In the context of S-1 registration, the minimum threshold could be 5 to 15 million whereas in an S-3 registration, it could be around 1 to 5 million.
    • Who bears the registration expenses. Usually, the company will have to pay for registration.

Typical formulations for registration rights could be:

Registration Rights:

Registrable Securities:

All shares of Common Stock issuable upon conversion of the Series A Preferred [and [any other Common Stock held by the Investors] will be deemed “Registrable Securities.”

 

Demand Registration:

Upon earliest of (i) [three-five] years after the Closing; or (ii) [six] months following an initial public offering (“IPO”), persons holding [__]% of the Registrable Securities may request [one][two] (consummated) registrations by the Company of their shares. The aggregate offering price for such registration may not be less than $[5-15] million. A registration will count for this purpose only if (i) all Registrable Securities requested to be registered are registered and (ii) it is closed, or withdrawn at the request of the Investors (other than as a result of a material adverse change to the Company).

 

Registration on Form S-3:

The holders of [10-30]% of the Registrable Securities will have the right to require the Company to register on Form S-3, if available for use by the Company, Registrable Securities for an aggregate offering price of at least $[1-5 million]. There will be no limit on the aggregate number of such Form S-3 registrations, provided that there are no more than [two] per year.

 

Expenses:

The registration expenses (exclusive of stock transfer taxes, underwriting discounts and commissions will be borne by the Company. The Company will also pay the reasonable fees and expenses[, not to exceed $______,] of one special counsel to represent all the participating stockholders.

 

Piggy-back Registration

The demand rights discussed above give the investor the right to initiate the registration of the company's securities for public trading. In addition to these registration rights, the investors will generally also ask for so-called piggy-back rights. These rights allow investors to include their shares in a "regular" IPO (that is, an IPO that is not triggered by demand rights) along side with those of the company. 

A typical term sheet formulation for piggy-back rights could be:

 

Piggy-back Registration:

The holders of Registrable Securities will be entitled to “piggy-back” registration rights on all registration statements of the Company, subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered to a minimum of [20-30]% on a pro rata basis and to complete reduction on an IPO at the underwriter’s discretion. In all events, the shares to be registered by holders of Registrable Securities will be reduced only after all other stockholders’ shares are reduced.

 

What the company (and the investment banks who assist it in the IPO) generally wants to avoid is that too many shares are listed for trading on the stock exchange and that such an excess supply of shares then depresses the stock price of the company. To avoid this, the piggy-back rights generally contain a clause that allows the investment banks (the so-called "underwriters") to reduce the investors' number of offered shares to a certain minimum amount, at their own discretion.

The reduction of offered shares follows the seniority of the shares outstanding. For example, with standard seniority, the piggy-back rights of Series B Preferred holders will only be reduced after all the common stock holders and all the Series A Preferred holders are reduced to zero.

 

Lock-up Provisions

To further address the concern that too many of the existing shareholders will try to sell their shares right after the IPO and therefore send the stock price south, term sheets typically stipulate so-called lock-up provisions.

Lock-up provisions imply that the existing shareholders are not allowed to sell (or transfer) any shares for a period of usually 180 days after the IPO. In addition to preventing excess supply of shares in the early days of trading, such lock-up provisions also sends a potentially valuable signal to the new investors: Because the original shareholders (including the management) are still on board, they have an incentive to take actions that are beneficial to all shareholders (at least for the medium term). Thereby, lock-up provisions might help to align the incentives of the original and the new shareholders.

A typical lock-up provision in the term sheet could be:

 

Lock-up:

Investors shall agree in connection with the IPO, if requested by the managing underwriter, not to sell or transfer any shares of Common Stock of the Company [(including/excluding shares acquired in or following the IPO)] for a period of up to 180 days [plus up to an additional 18 days to the extent necessary to comply with applicable regulatory requirements]  following the IPO (provided all directors and officers of the Company [and [1 – 5]% stockholders] agree to the same lock-up). [Such lock-up agreement shall provide that any discretionary waiver or termination of the restrictions of such agreements by the Company or representatives of the underwriters shall apply to Investors, pro rata, based on the number of shares held.