“Registration rights” are the rights that preferred stock investors obtain to allow them to sell their stock in a registered offering.
There’s a lot to discuss here, so buckle up and let’s get going.
To understand registration, we must first understand the fundamental securities law in the US:
The offer or sale of any stock must be registered with the US Securities and Exchange
Commission (the “SEC”), unless an exemption from registration is available.
The SEC is the US government agency that oversees all securities transactions and the stock markets. The website is www.sec.gov.
When a startup company issues shares, it does so via an exemption to the registration requirements. The company is called a “private” company because none of its shares are registered – the stock is unregistered. Unregistered stock has lots of legal and contractual restrictions. This means that it isn’t that easy to sell unregistered stock in a private company. The stock is both unregistered and illiquid.
By contrast, when a company registers shares of its stock with the SEC, those registered shares can be freely traded on a stock exchange, such as the New York Stock Exchange (“NYSE”) or NASDAQ. The company becomes a “public” company through the process of registering the stock. The first registration by a company of its stock is known as an “Initial Public Offering” or “IPO.” The registered stock is liquid, because it is freely tradeable on a stock exchange (with some exceptions, discussed below).
I have written several posts on IPOs, and a listing of these posts is here: http://www.allenlatta.com/blog-post-categories.html#Initial%20Public%20Offerings%20(IPOs).
Why don’t startup companies just register their stock?
Startups don’t register their stock because registration (especially an initial public offering) is very expensive (millions of dollars in investment banking, attorney and accounting fees) and time-consuming (the process takes months), and only companies of sufficient size can generate interest from the public markets. Also, the process of registration requires a company to disclose all sorts of information about its business and finances, and once a company becomes a public company it must publish its financial statements on a quarterly and annual basis, as well make other disclosures. This is why most companies don’t go public.
As a recap:
- Fundamental Securities Law. The sale of any share of stock must be registered or exempt from registration.
- Registered Shares; Public Company. Registered shares are shares that have been registered with the SEC and can be freely traded on a stock exchange, such as the NYSE or NASDAQ. The company that has registered these shares is a public company.
- Unregistered Shares; Private Company. Unregistered shares are shares that have been issued under an exemption from registration. These shares are not freely tradeable, are illiquid and have restrictions on them. Companies that have no registered shares are private companies.
Now that we understand the basics of registered vs unregistered shares and public vs private companies, let’s turn to registration.
What is Registration?
Registration is the process a company goes through to register shares of its stock with the SEC. Once these shares are registered, they are freely tradeable on a public stock market.
The company can register new shares of its stock for sale, or register the unregistered shares held by existing stockholders, or both.
Terminology: Primary Offering; Secondary Offering; Follow-On Offering
You can skip this section if you know these terms.
A “primary offering” is one where a company sells new shares of its stock. In an IPO, the company undertakes a primary offering by registering new shares of its stock for sale on the public market.
A “secondary offering” is one where existing stockholders of a public company sell their stock in a public offering. The company files a registration statement on behalf of the existing stockholders so they can sell their stock in the public markets.
Often in an IPO, the company will allow existing stockholders to sell some of their shares as part of the company’s IPO. In this case, the IPO has both a primary offering component (sale of company shares) and a secondary offering component (sale of existing stockholder shares).
Also, after a company is public, if some of the stockholders holding unregistered shares want to sell their shares in the public market, the company can file a registration statement for these shares. This offering is also called a “secondary offering” because the existing stockholders are selling their shares.
A “follow-on offering” occurs when a public company wants to sell new shares in the public market. It’s called a “follow-on offering” because it follows the company’s IPO. A follow-on offering is also a primary offering because the company is issuing new shares. In some instances, a follow-on offering will include shares held by existing stockholders. In this case, the follow-on offering will have a primary component and a secondary component.
When a company registers shares of its stock in its IPO, it registers only small number of shares compared to the total number of shares that are currently outstanding. A company will usually register shares that amount to about 15% to 25% (sometimes more or less) of its outstanding stock. So, for example, if the company has 10 million shares of stock outstanding, the company may register 2 million (20%) shares in its IPO. The reason for this is that if too many shares were registered, the public market would be flooded with the company’s stock which would drive the stock price down (basic supply and demand – too much supply drives prices down).
Terminology: Public Float
“Public float” is the number of shares of a company’s stock that are freely tradeable on the public markets. This metric is used to understand how many shares aren’t freely tradeable (are unregistered) and can become freely tradeable, potentially driving down the company’s stock price. These unregistered shares are also known as “overhang.” Put another way, if a company has a small public float, this means lots of its stock can hit the public market at some time, and by the law of supply and demand, increasing the supply of a stock on the public markets can lower the price.
Let’s now look at the IPO registration process. For a more detailed explanation, see the post “IPO 101: An Overview of the Initial Public Offering Process.”
The IPO Process: S-1 Registration Statement
The document filed with the SEC for a company’s IPO is called a “Form S-1 registration statement,” or “S-1 registration statement,” or simply an “S-1.”. If you hear a venture capitalist say a portfolio company has filed their S-1, that means the portfolio company has filed a registration statement with the SEC for its IPO.
There are different types of registration statements, and the S-1 registration statement is for the company’s IPO (we will discuss a different registration statement, the Form S-3 registration statement, below). The S-1 is both a marketing document and a legal document, and contains detailed information on the company, its business, strategy, products and services, the market, competition, customers, and financials, as well as a discussion of the risks involved with investing in the company’s stock. Most companies are allowed to file these S-1 registration statements with the SEC on a confidential basis at first to “test the waters” to determine if there will be sufficient demand for the company’s IPO, but once the company decides to move forward, the S-1 registration statement becomes available to the public.
Where to Find the S-1
S-1 Registration Statements (and a host of other filings and information) can be found on the SEC’s company document depository called EDGAR. In case you want to search companies, the link to EDGAR is: https://www.sec.gov/edgar/searchedgar/companysearch.html
Uber’s S-1 Registration Statement. Here’s a link to Uber’s S-1 Registration Statement filed with the SEC on April 11, 2019:
Take a look at the table of contents – Uber’s S-1 contains a lot of information. And note that this registration statement is over 350 pages with exhibits.
The company addresses the SEC’s comments in amendments to the S-1 registration statements, which are shown on EDGAR as S-1/A filings. When the process is complete, the SEC will send the company a notice of effectiveness, and once that happens, the newly registered shares can start trading on a stock exchange and the IPO is complete.
Once the IPO has occurred, one more document is filed with the SEC, which is called the “Prospectus,” which is also known as a “424B4 filing.” The prospectus shows how many shares of stock were sold in the IPO and at what price.
Let’s look at the Uber prospectus, which can be found here:
The prospectus shows that the company sold 180 million shares of stock and selling stockholders sold 27 million shares of stock at $45.00 per share. That’s a lot of stock! However, the 180 million shares of stock sold by the company in the IPO represented only 11.4% of the total shares outstanding after the IPO. There were almost 1.5 billion shares of stock that weren’t registered as part of the offering.
A couple of notes about IPO registrations:
- Conversion of Preferred Stock. When a company goes public, all outstanding preferred stock converts to common stock. The reason for this is that public markets don’t like complex preferred share structures for newly public companies. The public market simply won’t understand or accept a newly public company having several series of preferred stock outstanding, each with different rights, and so all outstanding preferred stock converts to common stock at the IPO. Public market investors will accept separate classes of common stock when they are identical in all respects except for voting rights.
- IPO Lockup. The investment banks running the company’s IPO (called “underwriters”) are very concerned about how the stock price performs after the company goes public. One problem could be if all of the holders of the unregistered shares discussed above could rely on an exemption and sell their stock into the public market in a broker transaction. To protect against shares flooding the public market and depressing the stock price, the IPO underwriters require all holders of unregistered stock to agree to not sell their stock for a period of time, usually 180 days, after the IPO. This is known as an “IPO lock-up” because it locks up stockholders from selling their shares. For more on IPO Lockups, see the post “IPO 101: IPO Lockup Periods.”
What happens to the stock that wasn’t registered during the IPO? In Uber’s case almost 1.5 billion shares of stock weren’t registered in its IPO.
The answer is that the stock continues to be “unregistered,” and is still subject to the fundamental rule of securities: if an investor wants to sell unregistered shares of stock, these shares must either be registered or an exemption from registration must be available. While there are exemptions available that enable an investor to sell its unregistered shares in the public market (one such exemption is known as Rule 144), these exemptions are pretty restrictive, and so many stockholders can’t easily take advantage of these exemptions.
Follow-On Offerings and Secondary Offerings
After a company goes public, if its stock trades up after the IPO and for several months after the IPO, the company may decide, in consultation with its investment bankers, to issue and sell more new shares to the public. When a public company registers new shares for sale in the public markets, it is known as a “follow-on offering,” because it follows the company’s IPO. Follow-on offerings can be exclusively for the sale of new shares of stock by a company, but a follow-on offering can also include unregistered shares held by existing stockholders.
In some cases, a company will file a registrations statement to register shares held by investors, without registering any new shares of its own. These types of offerings are called “secondary offerings.”
Follow-on offerings and secondary offerings must be registered with the SEC, and the registration statement used for these offerings is known as a Form S-3 registration statement.
S-3 Registration Statement
An S-3 registration statement is a simpler, shorter form of registration statement than the S-1 registration statement, and is often called a “short-form” registration statement. The S-3 registration statement is available to public companies after they have been public for over a year, have at least $75 million in public float, and meet several other conditions. Registering shares using an S-3 registration is much easier, faster and less expensive than registering shares on an S-1 registration statement. If a company doesn’t meet all of the conditions to use an S-3 registration statement, then the company will have to use the much more onerous S-1 registration statement.
Now that we’ve covered the basics of S-1 and S-3 registration statements, in Part 2 of post we will discuss the registration rights found in preferred stock financings.
Here’s a preview of these registration rights.
Registration Rights Preview
So how does a holder of unregistered stock sell its shares in the public market? That’s where registration rights come in. Registration rights come in two flavors:
- Demand Registration Rights. Demand registration rights provide the investor with the right to force the company to file a registration statement so that the investor can sell some (or all) of its unregistered shares.
- Piggyback Registration Rights. Piggyback registration rights provide the investor with the right to participate in a registration that the company initiates after its IPO.
We will discuss demand and piggyback registration rights in more detail in Part 2 of this blog post.
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