NOTE: This is the tenth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
* * * * * * * * * *
The next several posts in this series concern the provisions located in the “Investor Rights Agreement,” “Right of First Refusal and Co-Sale Agreement” and “Voting Agreement,” which together give the investors a variety of contractual rights vis-à-vis the company and the company’s other stockholders. While the provisions contained in these three agreements are common to most VC financings, it is important to note that the titles of the agreements and the mix of provisions in each agreement can vary. We begin with the Investor Rights Agreement.
Registration Rights
The Registration Rights provisions in the NVCA term sheet give the investors the right to have the company register their shares with the Securities and Exchange Commission, which is a prerequisite to selling shares in the public markets (i.e. NYSE, Nasdaq, etc.). There are three types of registration rights typically granted to investors: (1) Demand Registration allows the investors to compel registration of their shares after some period of time following the offering, subject to certain conditions; (2) S-3 Registration allows the investors to compel registration at any time if the company meets the eligibility requirements for an “S-3” registration statement (which usually means that the company is already publicly traded); and (3) Piggyback Registration allows the investors to include their shares in any other registration of securities the company undertakes, subject to limitations on the number of shares that can be registered in some circumstances. The remaining Registration Rights provisions in the NVCA term sheet, neither of which is generally the subject of negotiation, are “Expenses,” which compels the company to pay the cost of a registration (which can be significant), and “Lock-up,” whereby the investors agree that they will not sell their shares for a given period of time after the company’s initial public offering.
Of the three types of registration rights, Demand Registration rights are by far the most important because the investors can compel the company to undertake the costly and time-consuming process of an initial public offering. From a strategic standpoint, however, Demand Registration rights are very similar to Redemption Rights: while they give the investors an exit opportunity, in practice they are almost never exercised because if the company has not gone public it is likely because either the company is not ready or the market conditions are not favorable. As with Redemption Rights, Demand Registration rights give the investors leverage against the company that they can use to extract concessions at a later date.
Registration rights are standard in a Series A financing and, as noted above, of limited consequence to the company, so any negotiation is usually best left to after the term sheet is signed. If investors in a pre-Series A financing require registration rights, the company should insist that they agree up-front to subordinate those rights to the registration rights of future venture capital investors. The points that are sometimes negotiated at the term sheet stage are: (1) the threshold percentage of investors required to trigger Demand Registration (see the discussion of voting thresholds in our post on Voting Rights and Protective Provisions); (2) the earliest date the investors may exercise Demand Registration rights (5 years from the date of the financing is typical for a Series A financing, which may be reduced as low as 3 years for later-stage venture rounds); (3) the number of times the investors may exercise Demand Registration rights (typically 1-2 total) and the frequency with which the investors may exercise S-3 Registration rights (typically 1-2 per year); and (4) the minimum aggregate offering price for any Demand Registration (typically the same threshold as would trigger a Mandatory Conversion) or S-3 Registration (should be no less than $1M). Note that the threshold percentage of investors required to trigger S-3 Registration is less important (and typically much lower) than for Demand Registration because the burden on the company is much less.
Finally, it is worth noting that companies are sometimes able to negotiate for S-3 and Piggyback Registration rights for founders and even for other common stockholders, provided that these rights are subordinated to the investors’ registration rights. Without registration rights, common stockholders must wait to sell their shares to the public until either they qualify for an exemption from registration, which usually comes with inconvenient conditions and restrictions, or the Board of Directors decides to register their shares, so obtaining registration rights for some or all of the company’s common stockholders is arguably more important that attempting to restrict the registration rights of the investors.