What are Registration Rights?

To many investors, registration rights are one of the most important issues in a financing. If an investor is in a minority position in a nonpublic company, his exit possibilities depend on decisions made by others. Thus, some founders are proud that they have turned down entreaties from investment bankers to take their companies public. They claim that public shareholders might cramp their style and interfere with their ability to run the company according to their own tastes. Well and good for the founder, but not so comforting to a minority investor locked into the founder’s company. Even if the investors as a group are in control of the company, there may be differences of opinion as to when an exit strategy should be implemented; indeed, each investor may have a different sense of timing on the issue, based on facts peculiar to that investor.

The decision to sell the company as a whole is almost always dependent on at least a majority of the shareholders approving the sale. To be sure, the shareholders could by contract agree to sell out at the election of the minority, but such contracts, while common in Shareholders Agreements styled on drag-along rights, are seldom enforced in practice, in accordance with their terms. [1] The shareholders, however, can implement one primary exit strategy, in theory at least, singly and seriatim. The company can only sell its assets once, but it can have as many public offerings of its securities as the market will bear, and a public offering will eventually make the investors liquid.

However, the decision to go public in the first instance is often difficult; there are considerations on both sides. Moreover, even if a company is already public, the election to float another offering requires thought and discussion; any offering “dilutes” existing shareholders. Some shareholders may feel the currently obtainable price accurately reflects value and some may violently disagree.

As a technically legal matter, the decision to affect an IPO is a majority decision. Even if the company is not planning to sell any stock, only the company can file a registration statement; [2] a minority shareholder cannot register his stock for sale without the company’s consent. As the registrant, [3] the company sets the terms of the offering, including the question of how many insider shares to include. Accordingly, investors seek to bolster their position by securing that consent in advance, by insisting that there exist, as part of or allied to the Stock Purchase Agreement, an agreement called the Registration Rights Agreement. It is important to recall that a company “going public” does not undergo an instant transformation, with all its stock ipso facto turned into liquid instruments; the only shares which become truly public-that is, are released from resale restrictions [4] -are those registered for sale [5] and sold at the time. And the company ordinarily issues those shares; the investors’ share of the “action” in an IPO is severely limited because the market’s appetite for stock in an IPO is generally confined to those transactions in which most of the money raised is going to work inside the company. Nonetheless, an IPO is the most significant step on the road to liquidity, even for those investors not selling in the offering.

[2]-Categories of Registration Rights

Registration rights fall into two categories: “demand” and “piggyback.” Piggyback rights, as the name implies, give the shareholders a right to have their shares included in a registration the company is currently planning on behalf of itself (a “primary” offering) or other shareholders (a “secondary” offering). [6] Demand rights, as the name implies, contemplate that the company must initiate and pursue the registration of an offering including, although not necessarily limited to, the shares proffered by the requesting shareholder(s). Since demand rights are more controversial, the following discussion focuses principally (but not exclusively) on that variety.

It should be noted that there are various types of stock issuances, albeit registered, which should not be subject to piggyback rights by their nature-that is, issuance of shares in the course of acquiring another company or the registration of shares pursuant to an employee stock benefit plan. Moreover, the practical difference between demand and piggyback rights can be slight; the investors make a noise about demanding an IPO, the issuer (thus prodded) elects to go forward on its own and then the investors seek to piggyback on what has been, in effect, an offering they “demanded.” Thus, the discussion of “haircuts,” stand asides,” and “lock-ups” applies to all types of registration rights, not just demand rights.

[3]-The Principles Underlying Registration Rights

To comprehend adequately the various issues involved, a discussion of basic principles is in order. The first is that registration rights are seldom used in accordance with their terms, and yet some investors and their counsel view them as a central element of the deal. The actual use of the demand rights, for example, could prove very awkward: a group of minority shareholders insisting on registration, the CEO agreeing only because he has to, but saying, in effect, to the minority, “Find your own underwriter; conduct your own road shows; [7] do not bother me with questions from large institutional purchasers; in a word, sell the stock yourself.” Such would make for a disorderly marketing effort, and the price per share would suffer.

On the other hand, as stated, registration rights are often the only exit vehicle, which, as a practical matter, the minority shareholders can compel. A start-up may issue shares redeemable at the option of the holder, but the instances in which that privilege has been successfully exercised are few. A company still in the development stage may not have the legal power, let alone the cash and/or the agreement of its creditors, to redeem stock. If a controlling founder is content to sit in his office, play with his high-tech toys and does not need more money from his investors, the investors need leverage. Other than through the threat of enforcing the registration rights agreement, there is no legal way to compel the company to go public. Therefore, it is important to keep in mind that liquidating the investors’ shares through a public offering can be not only a promise but also a benchmark, meaning that the remedy, if the founder refuses to cooperate, need not be a lawsuit. Reallocation of stock interests can be triggered if an IPO fails to materialize on time.

The second interesting feature of the registration rights agreement is that it is a three-way agreement, but only two of the three parties negotiate and sign it. With a minor exception for “self-underwritten offerings,” a primary or secondary offering of securities requires an issuer, selling shareholders and an underwriter, either on a “firm” or “best-efforts” basis. However, the underwriter is usually not present when the registration rights agreement is signed, and the parties themselves have to anticipate what the underwriter will require. Following that point, underwriters as a rule do not favor secondary offerings for early-stage companies.

Given a choice, the market likes to see the proceeds of the sale go into the company’s treasury to be used for productive purposes, rather than released to outsiders. Moreover, whenever stock is being sold, the underwriter wants the number of shares issued to be slightly less than its calculation of the market’s appetite. An underwriting is deemed successful if the stock price moves up a bit in the after-market. If the price goes down, the buyers brought in by the underwriter are unhappy; if it moves up smartly, the company is upset because the underwriter underpriced the deal. Consequently, the underwriter does not want to see new shares coming into the market shortly after the underwritten offering is sold, creating more supply than demand. These imperatives account for terms in the registration rights agreement known as the “haircut” and the “hold back.”

Finally, including one’s shares in a publicly underwritten offering is not the only way shares can be sold. A holder of restricted securities can sell his shares, albeit at a discount attributable to illiquidity, in a private transaction; more importantly, he can “dribble” out the shares into the market once the company has become public, under Rule 144. Registration rights for the holder of restricted shares in an already public company are, therefore, redundant unless the holder wants to sell before the required holding period in Rule 144 has expired or the block is so large that it cannot be “dribbled” out under the “volume” or “manner of sale” restrictions set out in that Rule.

The “points” in a registration rights negotiation (points being a slang term for contested issues) [8] are of varying degrees of intensity. Some are standard. Thus, the issuer rarely agrees to register convertible preferred stock, convertible debt or other rights to purchase common stock. The market in the hybrid securities themselves can be messy and confusing to analysts of an emerging-stage issuer‘s IPO; indeed, the mere existence of a class of senior security may cloud the outlook for the common stock‘s participation in future earnings. [9] Hence, the holders of convertible securities must convert before they can include their stock in the offering and/or must convert in any event so as to “clean up” the balance sheet. Some “points” on the other hand, are potential battlefields. For example, a minority shareholder will want the right to threaten exercise of his rights (and thus bully the company into registration) at any time of his choosing. The company will fight to limit the permissible timing of the shareholder’s election-no less than, say, five nor more than seven years after he makes his investment. The shareholder will want to be able to transfer his registration rights if he transfers his shares-they are part of the bundle of rights for which he bargained. The company will fight to keep the rights personal to the holder-a right to force registration is a formidable weapon if the timing is totally inappropriate. A disgruntled shareholder-for example, a founder recently terminated as president-may wave the rights around like a club to win some unrelated concession.

Following that thought, the company needs to limit the number of fingers on the trigger, so to speak. Assume, for example, 10 investors who each hold 10 percent of the class of convertible preferred stock. If each investor enjoyed his personal trigger-that is, could demand registration-the company might find itself in the path of a stampede, helping neither itself nor the investors generally. Moreover, if the company agrees to pay all or a part of the cost of the registration, multiple demands could be expensive. It is, therefore, in the interest of the company and the major investors to vest control of the trigger in the shareholders acting in concert, at least to insist that most of them agree internally before the issue is brought before the company. In addition, the amount of stock they are willing to sell should also be substantial, both because of expense (a small registration is almost as expensive as a large one) and because a buoyant public market depends on “float,” enough shares in circulation to interest institutional investors. From the investor’s standpoint, of course, the situation is reversed. He wants the trigger to be one share less than the shares he holds. This issue becomes more difficult when an issuer goes through multiple rounds of financing, selling off registration rights in each round. If all the shares are of the same class and series, what does one do with a 51 percent shareholder in round one who becomes a 35 percent shareholder when round two is completed? Does he “lose” his solo finger on the trigger because he did not elect to participate in the second round or because the second round involved the acquisition of another company for stock in a transaction in which he was not eligible to participate?

Indeed, the question of inconsistent registration rights provisions occasioned by separate agreements for each round is a thorny one. If the company’s norm is that the rights are not meant to mature for three years from the date of investment, what is to be done with investors in earlier rounds who have held shares for almost three years? Will they have first and exclusive chance at the gateway to public securities? If series A preferred was sold last year (with a 51 percent trigger) and series B preferred is being sold currently, is there any way to compel the series A holders to join in with the series B (assuming the number of shares in each series is the same) to avoid a situation in which the trigger is suddenly held by 25.1 percent (versus 51 percent) of the outstanding preferred stock? Is the language of the agreement such that investors in the earlier rounds can claim to have a first priority for including their shares in a piggyback registration?

The fact is, when the later round occurs, most practitioners attempt to induce the prior holders (who often overlap with the investors in the later round) [10] to cancel the earlier agreement and accept a new provision that affects all the existing holders, old and new, equally. Alternatively, counsel for the early-round investors may bargain for provisions that constrain the issuer in agreeing to register shares of subsequent purchasers-either an absolute prohibition without the consent of the earlier investors or a priority in their favor.


[1] There is nothing conceptually impossible in the notion of “drag along” rights. If all the stockholders agree in advance, the board could be bound, at the instigation of the minority, to retain an agent and authorize it to negotiate the best terms possible for a sale or merger of the entire company. There could be problems in binding the board in advance to vote for a transaction to occur well in the future-one which passes a given hurdle, for example-but, if the majority refuses the agent’s recommendations, there could be other remedies: a control “flip,” for example, or more stock for the minority.

[2] Section 6(a) of the ’33 Act provides that the issuer, the CEO, the CFO, the comptroller or principal accounting officer, and a majority of the board must sign the registration statement.

[3] The term ‘Registrant’ means the issuer of the securities for which the registration statement is filed. ’33 Act, Rule 405.

[4] Even publicly registered shares may not be freely resold; the privilege of investors holding nonregistered shares in a public company to “dribble” out shares pursuant to Rule 144 is limited by the provisions of that Rule and may be further limited by a “hold back” imposed by underwriters, the NASD, and/or state securities administrators.

[5] ’33 Act, Rule 415, adopted in November 1983, permits underwritten shelf registrations, i.e., the registration of shares for later sale at the option of the holder for (1) mature public companies and (2) for secondary issues. See, e.g., Palm, “Registration Statement Preparation and Related Matters,” in Mechanics of Underwriting (PLI Course Handbook Series No. 547, 1987). The problem is that underwriters are reluctant to allow investors to include their shares in the registration statement for delayed sale under Rule 415 since that creates an “overhang” over the market. If the investor’s stock is registered “on the shelf” under Rule 415, it must be “reasonably expected” it will be sold within two years. Rule 415(a)(2).

[6] A “reverse piggyback” right occurs when the investors exercise a demand right, compel a registration that (under the agreement) is at their expense, and the company seeks the right to “piggyback” some newly issued shares on the investors’ registration. See Frome & Max, Raising Capital: Private Placement Forms and Techniques, 673 (1981).

[7] Road shows are meetings between the company, the underwriters, and potential buyers of the company’s stock held around the country after the registration statement has been filed and before it becomes effective. If a CEO wants to be obstreperous, not agreeing with the concept of an IPO, he can be less than enthusiastic about the company’s near-term prospects at the road show, thereby effectively chilling the offering.

[8] When negotiators want to show an increase in the fervor that they or their clients feel about a given issue, they label it a “deal point” or a “deal breaker.” The way experienced negotiators respond to a litany of “deal points” is to create an “escrow file,” meaning that the issue is left for later consideration. After a deal point sits in the escrow file for a bit, it often defuses itself. See generally, Fisher & Ury, Getting to Yes: Negotiating Agreements Without Giving In (1981).

[9] Since the existence of a convertible senior security can muddy the investing public’s perception of the common stock, conversion is usually mandated no later than the evening of an IPO.

[10] Investors in the early rounds are expected to follow on with fresh capital in late rounds to show their faith in the company; however, the existing investors often insist that the founder find at least one new investor, “new blood,” to join in late rounds, if only to avoid a situation in which the investors are negotiating on price and other issues with themselves.

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