This post is the tenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior nine posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, looked at anti-dilution carve-outs and “pay to play” provisions, and described redemption rights. In this post, we will discuss registration rights.
For a sample set of registration rights provisions, see the National Venture Capital Association’s (NVCA) term sheet here. These typical registration rights provisions pertain to a defined class of registrable shares, in this case, the common stock issuable upon conversion of the preferred stock. It can also include other common stock held by the venture capital investors. (Note that stockholders other than the preferred stockholders, such as founders, may also negotiate for registration rights.)
Before diving into a discussion of registration rights, it is important to remember the significance of registering stock. Stock that has not been registered with the Securities and Exchange Commission and applicable state authorities cannot be freely resold, and so represents a relatively illiquid investment for the stockholders. Federal securities regulations do permit the resale of unregistered stock to the public upon certain conditions, including a holding period of a certain length (at least six months depending on the circumstances) and other factors depending on whether the company is a public company and whether the stockholder is a company affiliate. A stockholder who wishes to sell or transfer shares at a particular time, however, may find that these conditions are not met and it is stuck holding the stock until the conditions are met or until the stock is registered. In addition, even if the regulatory conditions for a resale are met, venture capital investors often want the public, underwritten offering that accompanies a registration. Thus, venture capital investors will expect the term sheet to contain rights enabling them to require or participate in the registration of the company’s stock, transforming their investment into a liquid (and perhaps more valuable) one. Registration, however, is not a simple or cheap process; it demands considerable resources from the company, and results in extensive ongoing compliance and reporting requirements.
There are two types of registration rights, demand registration and “piggyback” registration. Demand registration rights allow the holders of a certain percentage of registrable securities to require that the company register its shares after a certain period of time, typically three to five years after the investment or six months after an IPO. The number of times the investors can make this demand can be negotiated; one or two is usual. Piggyback registration rights, as the name implies, enable holders of registrable shares to participate in the registration of any other class of shares by the company.
A set of registration rights provisions typically also contains a few other elements, including —
- The right of holders of a certain percentage of registrable securities to require the company to register shares using Form S-3 (a simpler form than that required for an initial registration) for a certain total offering price from time to time;
- A provision allocating the payment registration expenses (often to the company);
- A “lock-up” agreement of investors and other stockholders to hold their shares after an IPO for a period of typically 180 days plus any number of days required to meet regulatory requirements (this postpones the date the investment becomes liquid, but is required by underwriters); and
- Termination of registration rights upon a liquidation event, when all of an investor’s shares may be sold without restriction on resale, or on an anniversary of the IPO.
Founders should be aware that although having registration rights is important to venture capital investors, negotiating the details of the provisions in the term sheet is generally not something worth devoting a great deal of time to. When the time comes for an actual registration, the company’s investment bank and the underwriter will decide upon the terms they believe will maximize the success of the offering, which may or may not match the provisions agreed to in an earlier venture capital financing. Terms that are worth paying attention to are how many times the investors are entitled to demand registration, because of the expense and employee time required to pull off a registered offering, and the size of registration the investors may demand.
In the next post, we’ll discuss management and information rights.
© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.