Venture Capital Deals in IT: Registration Rights

We continue the series of articles on the instruments of venture capital deals in IT. We will now delve into the registration rights. 

Why is it necessary to register shares?

The concept of registration rights takes its origin in the US securities laws. The underlying rule states that any securities offering or sale requires the registration of such securities in the SEC (Securities and Exchange Commission) unless the securities are exempt from registration.

When a company issues shares (e.g., to the founders, venture capital funds, employees), it more likely does so under an exemption from the registration requirements. The company remains private until any of its shares is registered in the SEC – the shares are considered unregistered. Unregistered shares are relatively illiquid and cannot be easily bought or sold due to the legal restrictions. 

Once the company registers its shares, it is free to sell them on the stock exchanges (NASDAQ, NYSE, etc.). When the shares are registered, the company becomes public. Registered shares are liquid as, with certain exemptions, they are freely listed on the stock exchanges. 

 What are the registration rights and who needs to have their stock registered?

Registration rights are the rights of a stockholder to demand that the company register its previously unregistered shares on the stock exchange. In venture capital deals, registration rights are one of the investor’s exit options (options of the return of their investment). The investors consider these rights among the most important in financing (especially in later rounds of financing) to be able to demand a company to facilitate the resale of previously unregistered shares on the public market. The illiquidity of the unregistered shares, on the contrary, can make it difficult for the investors to exit their positions and realize their investments.

Registration rights are standard for the deals in some way relating to the US. However, even in the non-US related deals, the investors often seek to secure registration rights in expectation of a future listing in the US or considering restructuring (e.g., with establishing a US-based holding company).

What are the types of registration rights?

There are two main types: demand rights and piggyback rights.

1. Demand rights entitle the investor to demand the company to register its shares on the stock exchange (in effect, they entitle the investor to force the company to the IPO). Piggyback rights entitle the investor to include its shares in a registration process that has already been initiated by the company or another stockholder.
2. Piggyback rights do not allow initiation of the registration process, and the demand rights do, that is why the latter are considered superior. As a rule, only majority investors acquire demand rights, while piggyback rights are granted to a broader group of investors. 

What do you need to take into account in negotiating registration rights?

The following provisions are negotiated the most: 

• the number of times the investor can exercise demand rights: a standard practice – 1 time, less often – 2 times;
• the period after which demand rights can be exercised: most often is (a) 3-5 years after the investor’s entry into the company (in the early rounds of financing, a longer period is negotiated, in the later stages – on the contrary, a shorter one) and (b) at least 180 days after the IPO;
• the minimum shares number: the stockholders, who collectively own a certain percentage of the company’s shares, can exercise registration rights.  It is favorable for the companies to set a higher percentage to prevent minority stockholders from exercising registration rights;
• the minimum shares price: the minimum price for offering shares for registration is usually established at 3x-5x of the initial investor’s shares purchase price. For the companies, such a minimum threshold is necessary so that the investors do not abuse their registration rights and do not bring startups to the IPO before startups are ready for this;
• the right of a company to reduce the number of shares that investors with piggyback rights propose to include in a registration;
• the expenses allocation: registration is a time-consuming and expensive process. The expenses are commonly borne by the company and include capped investors’ legal and financial advisors’ costs.

In practice, once a company reaches a “ready to go public” moment when registration rights provisions become relevant (e.g., prepares for the IPO), the underwriters (investment companies or banks that are engaged in the IPO shares sale) determine how to do equity offering in the most efficient and profitable way. As a rule, the stockholders accept the terms offered by the underwriters. Nevertheless, it is important for the companies to make aware of registration rights at least in broad terms to avoid unfavorable conditions and mitigate the risk that the company will be forced to initiate the IPO at the wrong time.