The Importance of Registration Rights In Financing
Joseph W. Bartlett, Special Counsel, McCarter & English, LLP
To many investors, registration rights are one of the most important issues in a financing. If an investor is in a minority position in a nonpublic company, his exit possibilities depend on decisions made by others. Thus, some founders are proud that they have turned down entreaties from investment bankers to take their companies public. They claim that public shareholders might cramp their style and interfere with their ability to run the company according to their own tastes. Well and good for the founder, but not so comforting to a minority investor locked into the founder’s company. Even if the investors as a group are in control of the company, there may be differences of opinion as to when an exit strategy should be implemented; indeed, each investor may have a different sense of timing on the issue, based on facts peculiar to that investor.
The decision to sell the company as a whole is almost always dependent on at least a majority of the shareholders coming together in favor of the sale. To be sure, the shareholders could by contract agree to sell out at the election of the minority, but such contracts, the tail wagging the dog so to speak, are seldom encountered in practice. [1] One primary exit strategy, however, can be implemented–in theory at least–by the shareholders singly and seriatim. The company can only sell its assets once, but it can have as many public offerings of its securities as the market will bear, and a public offering will, at least eventually, make the investors liquid.
As has been suggested, however, the decision to go public in the first instance is often difficult; there are considerations on both sides. Moreover, even if a company is already public, the election to float another offering requires thought and discussion; any offering "dilutes" existing shareholders. Some shareholders may feel the currently obtainable price accurately reflects value and some may violently disagree.
As a technical legal matter, the decision to effect an IPO is a majority decision. Even if the company is not planning itself to sell any stock, only the company can file a registration statement; [2] a minority shareholder cannot register his stock for sale without the company's consent. As the registrant, [3] the company sets the terms of the offering, including the question of how many insider shares to include. Accordingly, investors seek to bolster their position by securing that consent in advance, by insisting that there exist, as part of or allied to the Stock Purchase Agreement, an agreement called the Registration Rights Agreement. It is important to recall that a company "going public" does not undergo an instant transformation, with all its stock ipso facto turned into liquid instruments; the only shares which become truly public–that is, are released from resale restrictions [4]–are those registered for sale [5] and sold at the time. And those shares are ordinarily issued by the company; the investors' share of the "action" in an IPO is severely limited because the market's appetite for stock in an IPO is generally confined to those transactions in which most of the money raised is going to work inside the company. Nonetheless, an TO is the most significant step on the road to liquidity, even for those investors not selling in the offering.
Registration rights fall into two categories: "demand" and "piggyback." Piggyback rights, as the name implies, give the shareholders a right to have their shares included in a registration the company is currently planning on behalf of itself (a "primary" offering) or other shareholders (a "secondary" offering). [6] Demand rights, as the name implies, contemplate that the company must initiate and pursue the registration of an offering including, although not necessarily limited to, the shares proffered by the requesting shareholder(s). Since demand rights are more controversial, the following discussion focuses principally (but not exclusively) on that variety. One point before leaving piggyback rights: There are various types of stock issuances, albeit registered, which should not be subject to piggyback rights by their nature–that is, issuance of shares in the course of acquiring another company or the registration of shares pursuant to an employee stock benefit plan. Moreover, the practical difference between demand and piggyback rights can be slight; the investors make a noise about demanding an IPO, the issuer (thus prodded) elects to go forward on its own and then the investors seek to piggyback on what has been, in effect, an offering they "demanded." Thus, the discussion of “haircuts,” “stand asides” and “lock-up” applies to all types of registration rights, not just demand rights.
[1] There is nothing conceptually impossible in the notion of a "drag along" clause. See Ch. 10. If all the stockholders agree in advance, the board could be bound, at the instigation of the minority, to retain an agent and authorize it to negotiate the best terms possible for a sale or merger of the entire company. There could be problems in binding the board in advance to vote for a transaction to occur well in the future–one which passes a given hurdle, for example–but, if the majority refuses the agent's recommendations, there could be other remedies: a control "flip," for example, or more stock for the minority.
[2] Section 6(a) of the '33 Act provides that the registration statement must be signed by the issuer, the CEO, the CFO, the comptroller or principal accounting officer, and a majority of the board.
[3] The term 'Registrant' means the issuer of the securities for which the registration statement is filed." '33 Act, Rule 405.
[4] Even publicly registered shares may not be freely resold; the privilege of investors holding nonregistered shares in a public company to "dribble" out shares pursuant to Rule 144 is limited by the provisions of that Rule and may be further limited by a "hold back" imposed by underwriters, the NASD, and/or state securities administrators.
[5] 33 Act, Rule 415, adopted in November 1983, permits underwritten shelf registrations, i.e., the registration of shares for later sale at the option of the holder for (1) mature public companies and (2) for secondary issues. See, e.g., Palm, Registration Statement Preparation and Related Matters, in Mechanics of Underwriting (PLI Course Handbook Series No. 547, 1987). The problem is that underwriters are reluctant to allow investors to include their shares in the registration statement for delayed sale under Rule 415 since that creates an "overhang" over the market. If the investor's stock is registered "on the shelf" under Rule 415, it must be "reasonably expected" it will be sold within two years. Rule 415(a)(2).
[6] A "reverse piggyback" right occurs when the investors exercise a demand right, compel a registration that (under the agreement) is at their expense, and the company seeks the right to "piggyback" some newly issued shares on the investors' registration. See Frome & Max, Raising Capital: Private Placement Forms and Techniques 673 (1981).
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
McCarter & English, LLP
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