Under federal law, securities can only be offered or sold pursuant with a registration statement filed with the Securities and Exchange Commission, or in accordance with an applicable exemption from the registration requirements. Stock held by venture capital funds and other investors in portfolio companies is not typically registered initially. This is where registration rights come into play. Registration rights give the investor the ability to require the company to facilitate the resale of the shares, ensuring they can sell previously unregistered securities into the public market. As such, these rights are considered by many investors to be among the most important issues in financing in later rounds.
Demand vs Piggyback
There are two principal types of registration rights: demand and piggyback.
With demand rights, investors are given the right to force a company to register shares of common stock so that the investor can sell them in the public market without restriction. This effectively causes the company to undertake an IPO if the company isn’t already public. Piggyback rights give the investor the right to include their shares in a registration that is carried out by the company.
While both types of registration rights allow investors to sell their securities to the public, piggyback rights are often seen as inferior to demand rights because the holders cannot initiate the registration process. Typically, only larger shareholders receive demand registration rights, while piggyback rights are granted to a broader group of investors. In practice, the difference between the two can sometimes be minimal. Minority shareholders could, for instance, pressure the company to go forward with an IPO and then piggyback on the offering – an offering that they, in effect, have “demanded.”
Negotiations and Other Considerations
Investors rarely use registration rights in accordance with the terms. For instance, exercising a demand right and pushing forward with an offering without cooperation from the company would create a messy situation and could depress the market price of the company’s stock. Nonetheless, investors often view registration rights as critical to a financing deal. They are often the only exit vehicle that minority shareholders can compel (other than redemption rights, if those have been negotiated) and provide investors with some degree of leverage to push a company to go public or otherwise cash out the investors.
When negotiating registration rights, there are some points that are relatively standard. For instance, the company typically does not agree to register convertible preferred stock, convertible debt or other rights to purchase common stock. Only common stock is registered, so any other rights would need to be converted into, or exercised for, common stock in a registration. Other issues might be more contested, such as the number of demand registrations that an investor can initiate and when shareholders can exercise their rights. Investors are often inclined to seek unlimited and frequent registrations of as many securities as desired, while companies will fight to impose some limitations. Typically, there are 2 demand registrations and those are usually only exercisable 5 years after an early investment round. Additional points of negotiation might include the minimum dollar size of a demand registration and whether the company needs to use “best” efforts or “commercially reasonable” efforts to effect a registration (investors often seek the former).
Absent SEC Registration, the holder of restricted securities can also sell their shares pursuant to Rule 144 of the Securities Act of 1933, which provides an exemption from registration requirements. While it can be useful, Rule 144 comes with several conditions, including how long the securities are held, the way in which they are sold, and the amount that can be sold at any one time.