In any venture term sheet, an entire page (typically page 3 or 4, after the key terms we have discussed previously) will often be devoted to the concept of registration rights, which ultimately are addressed in an Investors’ Rights Agreement or similar document. The sheer length of this section and the abundance of technical terms (“demand rights,” “registrable securities,” “aggregate offering price,” and the always popular “piggyback,” just to name a few) can often cause an entrepreneur’s eyes to glaze over, but would seem to denote that the section is of the utmost importance. At the end of the day, registration rights (or “reg rights” in common usage) are simply rights in the hands of investors to have their equity registered for sale to the public markets if the company goes public.
Practically speaking, while registration rights are present in the vast majority of venture financings in some form, the specific details of the rights are rarely items that need to be negotiated heavily because forces beyond the control of the company or the investors will largely dictate whether, when and how the company goes public. A lot of grief and cost can be saved by being practical about reg rights. However, it is always prudent for entrepreneurs to be familiar with all of the concepts contained in a typical term sheet, so this post will outline the typical registration rights language commonly seen in a venture term sheet, and explain the practical realities of these provisions in the event of an initial public offering.
“Upon earlier of (i) three years after the Closing; or (ii) six months following an initial public offering (“IPO”), persons holding 50% of the Registrable Securities may request two (consummated) registrations by the Company of their shares. The aggregate offering price for such registration may not be less than $10 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purpose only if (i) all Registrable Securities requested to be registered are registered, and (ii) it is closed, or withdrawn at the request of the Investors (other than as a result of a material adverse change to the Company).”
This basic demand registration provision allows the holders of a certain percentage of “Registrable Securities” (which is typically defined as the common stock into which the preferred stock being sold in the round converts, or something similar) to require that the company register its shares of common stock after a stated period of time (the earlier of six months following an IPO or three years following the closing of the round in the above provision is fairly standard). The provision above specifies that the investors can make this demand twice, which is fairly common, but can be negotiated. There is also usually a minimum value of the shares that can be registered to make the expense of registration more rational.
“The holders of Registrable Securities will be entitled to “piggyback” 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 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.”
Piggyback registration rights allow holders of Registrable Securities to participate in the registration or public offering of another class of shares by the company. This provides another potential avenue by which venture investors can force a company to register their shares, and provide potential liquidity for the investors.
“At any time after the Company becomes eligible to file a registration statement on Form S-3 (or any successor form relating to secondary offerings), the holders of 20% 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 $5 million (based upon then-current market price or fair value). There will be no limit on the aggregate number of such Form S-3 registrations, provided that the Company will not be required to effect more than one such registration in any six-month period.”
The S-3 registration right is similar to a demand registration, but underlying it is the idea that the company has already gone public and is eligible under SEC rules to use the Form S-3 to register shares, which is a simpler form than the form required for an IPO (this is the reasoning behind the smaller threshold percentage and aggregate offering price compared to the basic demand registration language). However, in order for a company to be eligible to file a registration statement on Form S-3, it must meet certain criteria, including having a class of common equity securities that is already listed and registered on a national exchange. So while this provision can provide greater flexibility for registration, the company must first meet certain criteria in order to be eligible.
The ability to force registration of shares pursuant to these types of provisions can be a valuable asset to venture investors, as prior to registration stock cannot be freely transferred or resold, and therefore is a fairly illiquid investment absent a potential acquisition or other means of sale. As a result, these types of provisions are included in almost every term sheet signed be venture investors, so it is important for entrepreneurs to be familiar with them in concept. Practically speaking, however, if a company ever reaches a point where these provisions become relevant (e.g. an IPO), the underwriters (bankers) involved in the offering generally dictate how the offering will be structured. The company’s shareholders will generally be expected to play along with the underwriters in order to participate in the offering, so it normally isn’t worth spending much time or energy negotiating these provisions in a term sheet.