"Haircuts," Stand-Asides," and "Lockups"

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

Underwriters are not parties to the registration rights agreement, but counsel who have been through the mill understand what the underwriters want and, indeed, demand. Piggyback (and sometimes demand) provisions, accordingly, routinely provide that the underwriters can cut down–"haircut"–the amount of stock included by secondary sellers. Moreover, demand rights are not exercisable for some period (usually three to six months) before a planned primary offering or for, say, a year thereafter in order to avoid multiple offerings at the same point in time; this is often called the "stand-aside" or "stand-off' provision. [1] Finally, at the request of the underwriters, all investors who are party to the registration rights agreement, or at least all significant investors, may be asked to agree to "lock up," that is, not to sell shares under Rule 144, for a period from three to six months after a primary registration becomes public.

These provisions are interesting in several respects. While the parties are often inclined to argue about the exact terms ad nauseam, the fact is that the underwriters are in charge of most offerings. Since they (allegedly) know what will sell and what will not, what they say goes, regardless of the language in any registration rights agreement. For an early-round investor to object long and hard to the underwriter's haircut makes minimal sense because he should realize that the underwriters will, in the final analysis, tell him what to do.

Moreover, a lockup may be very significant. There are theorists, including this author, who believe that, as a general rule in emerging company finance, a high percentage of final value is created while the company is privately held; perhaps because of lack of training, such investors do not attempt to understand or anticipate the vagaries of the public market. Once the stock is liquid, they want to sell, particularly since the market for the stock of high-multiple, relatively unseasoned issuers is extremely volatile. Having worked hard to achieve the exit strategy, they want to exit before the $10 price goes to $5. The fact that the stock may go to $15 is not as significant. The pleasure-pain index records significantly less pleasure at another $5 gain than pain at a $5 loss of what the investor already "had." Since a lockup can cost the investor significant dollars, [2] there is an argument that a shrewd investor should consider staying out, if he can, of any registration rights agreement entirely if it requires agreeing in advance to a lockup. The company is likely to go public at the first available opportunity regardless of the existence or nonexistence of a contractual compulsion to do so; the registration rights agreement does not involve a zero-sum game-everyone's interests are, ordinarily, focused in the same direction. And, if the underwriters are going to insist on a lockup, which they will, it is easier for them to pick out those investors who have already signed away their consent. The underwriters may not need to lock up every shareholder to achieve their results.

As indicated above, there is an alternative for investors. They may forgo a registration rights covenant as such and bargain for a promise from the issuer that, if the issuer has not publicly registered its stock and made the investors' stock liquid by a given date, the investors reap some sort of benefit, that is, more stock at the expense of the founder. Such provisions can have more substantive impact than a promise to do something the issuer wants to do anyway and which cannot be performed effectively any earlier than objective circumstances dictate; moreover, it can be phrased so as to require the issuer to get the investors all the way to their goal-that is, stock they can actually sell-by the date in question.

To be sure, the underwriter's lockup can be redundant. State securities administrators routinely insist on lockups of insider shares if they feel the price is at variance with the issuer's less-than-robust earnings, the theory being that, if much of the value anticipated by the market is "on the come," insiders should wait for the anticipated good things to happen like everyone else. However, the "blue sky" lockup usually extends only to recent purchasers of shares. [3]

Finally, if a particular offering is hot, there may be a reverse lock up, meaning that the underwriter will want the right to compel the issuer or major investors to sell into the offering if it is oversubscribed.

[1] The "stand-off" is, or should be, noncontroversial. If the company is planning an IPO, it is hard to envision circumstances in which investors, exercising their demand rights, would want to compete.

[2] Needless to say, if three separate financings have occurred and the investors in only one are subject to a potential lockup, the weight of the lockup will fall disproportionately on the burdened investors since, at least technically, the issuer and the underwriter cannot get at investors in the other financings to slow them down. The remedy is a provision in the first financing that requires a lockup (and a "haircut"–the same principal applies) for all investors in all future financings.

[3] A well-drafted lockup prohibits short sales and other trading strategies which amount to a sale without the shares actually being transferred.

Joseph W. Bartlett, Special Counsel,

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