To comprehend adequately 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, 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, to put it mildly, and the price per share would suffer.
On the other hand, registration rights are often the only exit vehicle that, 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. There is no legal way, other than through the threat of enforcing the registration-rights agreement, to compel the company to go public. The second interesting feature of the registration-rights agreement is that it is, in point of fact, a three-way agreement, but with only two of the three parties negotiating and signing 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 in sight 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 "lock-up" and the "hold back," meaning that the underwriter has authority to reduce the number of shares sellers other than the company are selling and to require that insiders eligible to sell restricted shares immediately under Rule 144agree to refrain from selling for, usually, one hundred and eighty days.
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, a redundancy 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.
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
McCarter & English, LLP
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