Registration rights are control provisions that allow an investor to force the business to file a registration statement with the Securities and Exchange Commission (SEC) and state regulators. The Securities Act of 1933 regulates the transfer or sale of securities. Specifically, it requires that securities be registered prior to sale or exchange. The registration process can be costly and burdensome. As such, startups rely heavily on exemptions for the securities registration requirements. Many of these exemptions restrict the sale of securities to certain third parties, thereby reducing the liquidity of the securities. Specifically, Rule 144 restricts the sale or exchange of certain securities for one year following their issuance. Forcing registration of shares makes the shares liquid and allows investors to easily sell the shares and exit the venture.
Registration rights are often defined to s specific class of shares (generally common stock). And these rights are generally grouped into “piggyback” and “demand” registration rights.
Demand & Piggyback Registration Rights
Demand rights provide the investor with the ability to force the business to register a class of shares with the SEC. Demand rights are often contingent on the occurrence or non-occurrence of certain events or conditions, such as a certain period of time. Piggyback rights allow an investor or class of investors to be a part of any registration of the business’s securities. That is, if another class of security holder registers a class of security, the investor with registration rights can also participate in that registration.
Demand registration rights will generally have any of the following attributes:
- S-3 Registration – Holders of a certain class and percentage of securities may require registration via form S-3. Registration is generally completed on form S-1. S-3 is less burdensome, as it allows for the reference of disclosures made in other filings. The S-3 may only be used 1 year following an IPO. The number of shares and dollar value of a S-3 registration will be limited.
- Number of Registrations – The articles may restrict the number of registrations a holder of preferred shares may demand. This may not be an issue as preferred shares have conversion rights to common shares, which is generally the target of registration demands.
- Timing of Registration – The time period is generally linked to a major funding event, such as 3 years after the original investor or 180 days following an IPO of the common shares.
- Value of Registration – Registration rights are generally limited to periods when the price of the preferred shares is 3-5x the purchase price of the preferred shares and a total aggregate value of the issuance (e.g., $10 million).
- Expenses – Shareholder may allocate the cost of registration (or any portion thereof) to the company. The costs associated with registration (i.e., legal fees) can be incredibly expensive. The cause of the expense is the extensive due diligence involved with making the mandatory disclosures. Failure to make accurate disclosures can lead to extensive civil and potentially criminal liability. In some cases, the expenses born by the company will be capped at a certain dollar value based upon the size of the registration.
- Lock-up Period – Shareholders agree that shares registered as part of an IPO will not be traded or exchanged for a period sufficient to comply withe regulatory requirements (180 days following the completion of the underwriting process). This reduces the likelihood of challenges to insider trading or market manipulation claims.
- Termination of Registration Rights – Generally upon an event where the corporation is liquidated, shares become unrestricted, or on a date related to an IPO.
- “Best-Efforts Requirement” – The investors may include a clause requiring the best efforts of the company in effectively carrying out the registration.
Piggy-back Registration Rights will generally have any of the following attributes:
- Share Reduction – Underwriters in an IPO may generally cut back the ability of investors to participate in the offering. As such, piggyback registration rights will generally allow investors to limit the ability of underwriters to cut back their participation in any follow-on issuances. The rights may assure the shareholders the ability to participate up to a given % in any subsequent financings.
- Priority – The investors may negotiate for their shares to have priority in any registration of shares above any other holders of non-company shares. This would allow those shareholders to participate in the registration while others cannot.
- Eligible Participants – The parties will negotiate whether common shareholders have the ability to participate in the registration. Otherwise, they are limited in their ability to liquidate their holdings.
Allowing investors to control the decision to make a public offering of the business shares protects the investor when the entrepreneur has majority control and complete decision-making authority over the business. The shareholder can either sell her shares in any public offering or force a public offering as a method of exiting the venture. While piggyback registration rights mitigate the investor’s perceived risk, demand rights shift control to the investor and risk to the entrepreneur. Specifically, an investor may demand registration to pursue an exit that does not benefit the entrepreneur or the business. This particular situation is known as “grandstanding”, when the investor seeks an exit to promote personal interests rather than those of the business. In practice, parties negotiate to limit the ability of the investor to unilaterally initiate a public offering. As such, registration rights are more of a tool that offers the investor leverage or control in the relationship.