Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process.
In this series we’ll look to shed some light on the legal language contained in that term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both Company and Investor. Check out an overview here.
Last week when discussing redemption rights, I equated them to a sword hanging over the Company’s head. That’s because the right of an Investor to redeem his or her investment is not usually actionable. The Company simply isn’t likely to have the funds to pay back. The key to the term is the “leverage” given to the Investors, not the right itself.
Today we discuss another Investor “leverage” term: Registration Rights.
Without going too deeply into a discussion of U.S. securities laws, it is sufficient to know that all “securities” (interests in a Company held by a “passive” investor) sold in the United States must either be (i) registered with the federal government or (ii) exempt from such registration.
All stock (or convertible debt) sold by the companies we’re talking about in this series will initially be exempt from registration, usually through application of a “safe harbor” regulation, most often Rule 506 of Regulation D (a topic for another post). Because of that exemption, the stock sold to Investors will initially be deemed “restricted”; i.e, not generally available for resale to another party. That is, unless the Company undertakes certain significant (and costly) acts to register its securities with the federal government (allowing for “public” resale of the Investors’ holdings).
The ability to force the Company to take such acts are the Investors’ “Registration Rights”.
Let’s take a look at (some of) the model terms.
Upon earliest of (i) [three-five] years after the Closing; or (ii) [six] months following an initial public offering (“IPO”), persons holding [__]% of the Registrable Securities may request [one][two] (consummated) registrations by the Company of their shares. The aggregate offering price for such registration may not be less than $[5-15] million.
Here we have the Investors’ primary right as described above; the right to demand that the Company incur the time and expense necessary to allow the Investors to sell their interests on the open market through registration. Effectively the right to force the Company to go “public”.
Because the efforts required can be so expensive (depending on the offering, cost can rise into the millions), the same types of limitations as we saw in respect of redemption are put in place: the investment must be X number of years old, the right can only be exercised by a sufficient number of Investors acting together, and the value of the registration must be high enough to make the whole process actually worth it.
Because the Company doesn’t actually “want” to undertake these efforts (if it did, it wouldn’t need to be “forced”), discussions regarding exercise of the right are generally symptomatic of a certain amount of Investor acrimony in the first place.
That is why, I believe, that in my many years of representing Companies and Investors in the shadow of these rights, I have never once seen them exercised, only threatened. Now those threats can be very real, especially for a Company operating on the razor’s edge in terms of budget, so registration is a legitimate sword for the Investors to wield. Just not one I have ever seen actually pulled from its sheath.
S-3 (Reporting Issuer) Registration
The holders of [10-30]% of the Registrable Securities will have the right to require the Company to register on Form S-3, if available for use by the Company, Registrable Securities for an aggregate offering price of at least $[1-5 million]. There will be no limit on the aggregate number of such Form S-3 registrations, provided that there are no more than [two] per year.
S-3 registration is roughly analogous to the more straight-forward “demand” category, but is only applicable to a Company that has already been reporting to the federal government for some time. These rights would be used to register restricted securities after a Company’s public offering, for instance, and would not generally impose a large additional burden on the Company.
The holders of Registrable Securities will be entitled to “piggyback” registration rights on all registration statements of the Company, subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered to a minimum of [20-30]% on a pro rata basis and to complete reduction on an IPO at the underwriter’s discretion. In all events, the shares to be registered by holders of Registrable Securities will be reduced only after all other stockholders’ shares are reduced.
In this scenario, the Company has decided to register some of its securities on its own (not through the exercise of the Investors’ “demand” right).
This term says that in that case, the Investors holding restricted securities reserve the right to have their holdings “take up” up to 30% of the total number to be registered by the Company (that is the bracketed number you see above). The Company accedes to this request because it doesn’t so much care which stock is registered once it has agreed to undertake the cost of registration. The sole exception is with respect to a full-blown public offering, in which case the underwriters in such offering can (and often will) ignore the Company’s existing investors (or at least their negotiated “rights”) in favor of making a “clean” offering of the Company’s interests into the market place.
(In fact, once underwriters are involved, much of the language regarding Investor-held securities should be considered “advisory” rather than binding. In most instances, the Company will, at bare minimum, need to request waivers or amendments to Investor rights adjacent to such an underwritten offering.)
The registration expenses (exclusive of stock transfer taxes, underwriting discounts and commissions will be borne by the Company. The Company will also pay the reasonable fees and expenses[, not to exceed $______,] of one special counsel to represent all the participating stockholders.
Where the rubber meets the road. Registration rights wouldn’t do very much good if the Investors had to pay for their exercise. Here the Company agrees to pay for all the time and personnel required to get Investor stock registered. In addition, the Company also agrees to pay for Investor counsel to oversee the Company’s work. In most of my deals the above-bracketed number is set at about $35,000 (solely for payment to Investor counsel to review the Company’s materials and processes), which should give a good indication of the kinds of numbers we are dealing with here.
(It’s worth noting that the above is a heavily redacted version of the language used in the NVCA’s model term sheet (which itself is shorter than most). Registration right terms as they appear “in the wild” often contain a great deal of language that is mostly technical and/or logistical in nature with little variability from deal to deal. All of which results in a great number of pages in the definitive documents; pages used to describe a set of rights which are rarely, if ever, used.)
Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.
As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at firstname.lastname@example.org.