Venture Capital Financings: Registration Rights Part 2

​This post is a continuation of the post “Preferred Stock Financings: Registration Rights Part 1.”
 
In the prior post, we discussed the registration process, which enables the company and/or existing stockholders to sell shares to the public on a stock exchange, such as the New York Stock Exchange (“NYSE”) or NASDAQ.  We discussed S-1 registration statements and S-3 registration statements, which are the primary ways for the company to sell stock to the public.
 
In this post, we explore “demand” registration rights and “piggyback” registration rights, which are rights held by the preferred stockholders in order to be able to register their shares so they can be sold in the public markets.

Before we dive in to demand and piggyback rights, let’s first recap the prior post.  Then we must introduce a concept known as “Registrable Securities.”  Once we’ve done that, we’ll be ready to discuss demand and piggyback registrations.
 
Recap
In the last post, we discussed the fundamental rule of US securities laws:
 
“The offer or sale of any stock must be registered unless an exemption from registration is available.”
 
When a private company issues preferred stock to investors, it does so under an exemption from registration (for those curious, the exemption is known as “Regulation D”).  The preferred stock owned by investors in the company is unregistered, which means that when the investor wants to sell their stock, the stock must either be registered or the sale must be exempt from registration.
 
Why the legal mumbo jumbo?  Because it is hard to sell unregistered stock.  Unregistered stock is subject to both legal and contractual restrictions on resale.
 
The easiest way for an investor to sell their stock is to sell it into the public market.  But this can’t happen until the company’s stock is publicly traded.  The company accomplishes this through its “Initial Public Offering” or “IPO.”  An IPO occurs when the company register shares for sale to the public for the first time.  The company registers the shares by filing an S-1 registration statement with the Securities and Exchange Commission (“SEC”) and going through the IPO process.  The company is then a “public company.”
 
Something very important occurs in the IPO:  In an IPO, all shares of preferred stock are converted to common stock.
 
What this means is that immediately prior to the IPO, all shares of preferred stock are automatically converted to common stock and the preferred stockholders become common stockholders.
 
Why does this automatic conversion occur?
This automatic conversion occurs because the public markets don’t like complex capital structures for newly public companies.  The most the public markets will accept are different classes of common stock that are identical in all respects except for voting rights.  Because of this, all shares of preferred stock automatically convert into commons stock at the IPO.  You can read more about this in the post “Convertible Preferred Stock: Understanding the Conversion Feature.”
 
And this is where we introduce the concept of “Registrable Securities.”
 
Registrable Securities
We use the term “Registrable Securities” to describe the shares of common stock that the preferred stockholder would have upon conversion of its preferred stock into common stock and for which the preferred stockholder has registration rights.  We use the term because it would be confusing to talk about registering preferred stock, because that isn’t what happens – only common stock is registered.  Term sheets for venture capital financings almost always use the term “Registrable Securities.”
 
Example: Startup company Lattaco raises $10 million in a Series A convertible preferred stock financing, issuing 1 million shares of Series A stock at $10.00 each.  As part of this financing, Lattaco grants registration rights to the preferred stockholders.  The Series A preferred stock converts to common stock on a 1:1 basis.  This means that if the Series A stock was converted into common stock, the holders of the Series A stock would receive 1 million shares of common stock.  These 1 million common shares are “Registrable Securities.”
 
Now let’s take a look at the registration rights.  There are two types of registration rights:

• 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 Registrable Securities in the public market.  Demand registration rights exist for both S-1 registrations and for S-3 registrations.
• Piggyback Registration Rights.  Piggyback registration rights provide the investor with the right to participate in a registration that the company initiates after its IPO.  Piggyback registration rights also exist for both S-1 registrations and S-3 registrations.

 
S-1 Demand Registration Rights
S-1 Demand registration rights enable the preferred stockholders to force the company to register the unregistered shares held by the preferred stockholders.  These S-1 demand registration rights take two forms:

• IPO Registration.  If the company hasn’t gone public after some period of time (usually 3-7 years), then preferred stockholders owning a majority (or some super-majority) of the Registrable Securities can force the company to hold its initial public offering (“IPO”) by filing an S-1 registration statement.  This demand registration is usually available only if the sale of the stock would have aggregate IPO proceeds of some negotiated amount, usually $10 million to $20 million.  The holders of Registrable Securities can only exercise this demand registration right once or twice, but it will only count if the IPO actually occurs.  The number of years, majority vs super-majority, the minimum IPO proceeds, and the number of demand registrations are all negotiated by the company and the preferred stockholders.
  • Never Seen it Happen.  I have never seen or heard of preferred stockholders exercising their demand registration rights to force a company to hold an IPO.  Many management teams don’t want the bright lights of the public markets shining on their every move.  Also, the IPO process is time-consuming, expensive and distracting for management and so they will only want to do it when they are ready and willing to do so.  Further, a company must be “ready” to go public – the expected market capitalization must be high enough for the company to generate interest from institutional investors and equity research analysts.  Finally, the IPO is managed by a group of investment banks, known as underwriters, which only get paid if the IPO is successful, and so they will only take a company public if they feel the offering will be successful.  If a company isn’t ready to go public, or management is against it, there’s no way an IPO demand registration will occur.  However, having the right to do this is valuable for investors, as it can be used as a bargaining chip in negotiations with the company on the topic.
• Secondary Registration.  After a company is public, the holders of Registrable Securities can demand that the company file an S-1 registration statement to allow the stockholders holding unregistered to sell their stock into the public market.  A public company would normally file a form S-3 registration statement to do this, but the company must meet several conditions to be able to use the shorter S-3 registration statement.  If the company doesn’t qualify for the S-3 registration statement, then it must use the S-1 registration statements.
• Expenses.  The company will pay for all of the expenses of the registration and public offering, and will also pay the expenses of one law firm who represents the selling stockholders.
• Bottom Line.  In my view, if the company doesn’t want to do a public offering, forcing them to do this will not yield good results for the investors.  While rarely used, preferred stockholders negotiate for these “demand” registration rights because it gives them some bargaining power to push the company to hold a public offering.

 
S-3 Demand Registration Rights
Once a company has been public for over a year, and meets certain other criteria, it can offer shares to the public through an S-3 registration statement.  Registrations on Form S-3 are much less burdensome to the company, but the company still wants to make sure that the amount of stock that is being registered is meaningful, and also that these S-3 demand registration rights aren’t abused.

• Mechanics of S-3 Demand Registration Rights.  If stockholders holding 10-30% of Registrable Securities (the exact amount is negotiated – the investors want a lower number, while the company wants a higher number) notifies the company that they want to sell shares in an S-3 offering, then the company must accommodate this request.
  • Has Happened, But with Poor Results.  Demand registration rights are rarely exercised by investors.  But they do happen.  I know – I was involved in one.  In that case, a venture capital fund held a large amount of unregistered stock of a company whose shares traded on the New York Stock Exchange.  This venture capital fund exercised its demand registration rights.  The company’s management was unhappy about this, and did the minimum amount of work possible on the offering.  During the process, the company’s stock fell in value by almost 30%, and even with this price drop, my clients decided to continue with the offering and sell their shares.  After the offering, the stock price rebounded to the pre-offering price in a few weeks after the closing of the offering.

• Expenses.  Similar to S-1 demand registrations, the company pays all of the expenses relating to the registration and offering, including the expenses of one law firm representing the selling stockholders.
  • Bottom Line.  As with S-1 demand registration rights, forcing the company to go through a public offering will likely not yield good results for investors.

  
Piggyback Registration Rights
Piggyback registration rights enable the preferred stockholders to participate in a public offering initiated by the company.  Piggyback registration rights are valuable rights for the preferred stockholders.
Let’s explore the IPO and follow-on piggyback rights.

• IPO Piggyback Rights.  If the company is initiating the registration process to hold its IPO, piggyback registration rights enable the preferred stockholders to participate in the IPO, with limitations.
  • Exercised by Holders of a Minimum Amount of Registrable Securities.  Holders of at least 10% to 30% (this is negotiated) of Registrable Securities must exercise the piggyback right.  This is to ensure that a meaningful number of holders exercise the right.
  • Minimum Offering.  The expected offering proceeds must be a minimum of $3 million to $5 million (this is negotiated among the company and investors at the time of the original preferred stock financing).  This is to ensure that the offering is of a meaningful size.
  • Mechanics.  When the company plans to hold its IPO, it sends a notice about the IPO to the holders of Registrable Securities and the holders then send a notice back to the company telling the company how many Registrable Securities they want to have included in the IPO.  If there’s enough demand, then all of the Registrable Securities will be included in the IPO.  If not, the number of Registrable securities is cut back.
  • Expenses.  The company pays for all expenses of the registration and offering, as well as the fees of one law firm representing the selling stockholders.
  • Cutback.  The group of investment banks managing the IPO (called the “underwriters” or “underwriting syndicate”) require the ability to reduce, or “cut back” the number of Registrable Securities in the IPO.  This is because the underwriters gauge the demand for the IPO.  If there’s lots of demand for the IPO, then the preferred stockholders won’t be cut back.
• Follow-On Offering Piggyback Rights.  If the company is holding a follow-on offering where it registers shares of its stock for sale on an S-3 registration statement, then holders of Registrable Securities have the right to participate in this offering.
  • No Limit.  There is usually no limit to the number of S-3 piggyback rights, except that there can be no more than one or two piggyback registrations in any 12-month period.  The reason for this is because of the time the company management has to spend on these offerings.
  • Mechanics.  The mechanics for a follow-on offering are the same as for an IPO.  The company gives the holders of the Registrable Securities notice of the follow-on offering and the holders of Registrable Securities send notice back indicating how many shares Registrable Securities they want to include in the offering.
  • Expenses.  The company pays for all expenses of the registration and offering, as well as the fees of one law firm representing the selling stockholders.
  • Cutback.  In follow-on piggyback registrations, the underwriters have the right to cut back the number of Registrable Securities to be included in the offering, but in contrast to the IPO piggyback cutback, the holders of Registrable Securities can’t be cut back completely.  Usually the cut back provision will require that some minimum number of the Registrable Securities be included in the offering, usually 20% to 30% of the total number of Registrable Securities that

 
Termination of Registration Rights
Registration rights don’t last forever.  They typically will terminate 3 to 5 years after the company’s IPO.  They also will terminate if an exemption from registration is available to the holders of Registrable Securities without restrictions.  Recall that the sale of any share of stock must be registered or exempt from registration.  There’s an exemption called Rule 144 that will allow non-insider stockholders (meaning stockholders who aren’t on the board, aren’t officers of the company and who don’t own 10% or more of the company’s stock) if certain conditions are met. 
 
I hope you find this overview of registration rights informative and useful.
 
 
 
Copyright © Allen J. Latta