Part three in a series of seven articles overviewing founders’ rights on a term sheet.
Registration rights are complicated. That’s why startups hire attorneys to help negotiate deals. That said, the founding team should take care to get educated on these very important rights that they will negotiate on behalf of the company, and sometimes themselves, as part of the deal.
This article will follow the hypothetical XYZ Corporation through negotiating its Investors’ Rights Agreement (IRA), one of the densest transaction documents in equity financings (Series Seed, Series A, Series B, and onward).
4 Things You’ll Learn about Investors’ Rights Agreements
- Steps required to understand the registration rights included in an NVCA style investors’ rights agreement
- What is entailed in negotiating registration rights in an NVCA style investors’ rights agreement
- Time frames for various aspects of registration rights
- Explanations of the common registration rights
The IRA covers multiple subjects, which may feel intimidating for founders as they review the various transaction documents, including the Stock Purchase Agreement, Certificate of Incorporation, Right of First Refusal Agreement, Voting Agreement and Investors’ Rights Agreement. As the title of the agreement suggests, the IRA includes various contractual rights that the company provides to its investors after the closing, commonly including registration rights, information rights, rights of first offer (also known as participation rights) and post-closing covenants.
After the transaction closing, this agreement becomes a staple resource for the founding team, board of directors and company counsel to review and ensure the company complies with its investor rights.
The goal of this article is to provide a helpful resource for founders to reference as they prepare for the equity financing and negotiate the registration rights with help of the company counsel.
I mentioned that this agreement is dense, and we are touching on one of the main sections of the IRA. The below set of quick reference definitions will be helpful as you make your way through this article.
Quick Reference Definitions
Here’s a glossary of common terms used in the IRA.
A contractual right that provides an investor who owns restricted stock in a corporation to require that the corporation list the shares for sale to the public, which provides the investor with the opportunity to sell its stock (and ideally receive a return on its investment). There are two common types of registration rights —a demand registration right and a piggyback registration right.
A demand registration right allows a group of investors to force a corporation to file a registration statement with the SEC to register a portion of each of the demanding investor’s securities so that the demanding investors can sell shares on a public market.
A piggyback right allows the investors to register their securities for sale on a public market when either the corporation or another investor initiates the registration. In practice, the investors are “piggybacking” on the already pending registration so a demand registration is not necessary in these cases.
A statutory and/or contractual privilege of a stockholder of a corporation that requires the corporation to provide the stockholder with certain financial and company related information. The information rights in the IRA are contractual rights.
Rights of First Offer (aka Participation Rights)
An economic right provided to certain stockholders through a contractual obligation that requires the corporation to provide certain investors with the right to purchase a percentage (typically pro rata) of new securities before attempting to sell the new securities to other third parties. These rights are colloquially referred to as “pro rata rights.”
A contractual obligation where the corporation is obligated to perform certain actions after the transaction closing. An example of a post-closing covenant is that the company is required to obtain directors and officers insurance within 90 days of closing.
With some variation in a fully negotiated IRA, the term “registrable securities” typically means the following: (i) common stock issuable or issued upon conversion of the preferred stock; (ii) common stock; (iii) common stock issued or issuable upon conversion and/or exercise of any other securities of the Company held by the investors (such as warrants, options, convertible notes, SAFEs, or otherwise); and, (iv) any common stock issued as or issuable upon the conversion or exercise of any security that is issued as a dividend or other distribution.
If included in the IRA, the key holders are typically the founders of the company.
What Are Registration Rights?
XYZ Corporation receives a term sheet from its lead investor. The term sheet calls for “customary registration rights.” Investors use this common tactic to push this somewhat complex discussion until the company counsel and investor counsel are negotiating the definitive agreement.
What Is an Investors’ Rights Agreement?
XYZ founders agree to this vague term and are surprised to see that registration rights take up a bulk of the IRA! So, what are registration rights, and how could XYZ corporation have negotiated for more company- and founder-friendly terms as part of the term sheet phase?
The Investors’ Rights Agreement provides the investors with the contractual right to either demand or piggyback in the company’s public offerings of stock (or other securities) being sold to the public market.
Demand rights, if exercised by the written request of the investors holding a majority of the “registrable securities” (the requisite investors), will either force the company to evolve from a private company to a public company (to “go public”) or sell the securities to the public market in a qualified public offering. Demand registrations are typically negotiated in the IRA as either part of the company’s (i) initial public offering (IPO) pursuant to the Form S-1 or (ii) a qualified public offering (QPO) pursuant to the Form S-3.
The Form S-1 demand rights require that upon the written request (a formal document) of the requisite investors, the company must file a Form S-1 with the SEC for the portion of registrable securities held by the requisite investors (typically around 40 percent) or a minimum offering size (in an early stage financing typically between $5,000,000 and $15,000,000). The minimum offering size increases as the company raises more money on a higher valuation.
The company and company counsel should closely review the voting analysis for the requisite investors to determine whether a single investor will have the right to control or block a demand registration vote. This analysis could be completed as part of the term sheet phase so the company could negotiate a higher voting percentage if any given investor would have all of the control.
The requisite investors have the right to request a demand registration either upon the date that is between three to five years after the date of the closing or 180 days after the effective date of the company’s registration statement for the IPO, whichever is earlier. The time-based trigger is provided so that the investors could force the company to go public, which is rarely exercised.
The alternate trigger is provided to allow the investors to exercise their demand rights in alignment with the underwriter lockup (see market standoff (aka lock-up) below) after an IPO, which is typically 180 days.
The Form S-3 demand rights provide the requisite investors (typically between 10 percent and 30 percent of the investors holding registrable securities) with the ability to require the company to complete a qualified public offering for the sale of the investors’ registrable securities of a minimum offering size. The purpose of the Form S-3 demand rights are to provide the investors with additional liquidity after the IPO.
The IRA includes limitations on the investors’ demand rights subject to the company’s good faith determination to defer a registration as well as the number of times that the company is required to comply with the investors’ requests.
Typically, the time-based limitations are one Form S-1 registration statement during the term of the agreement and one to two Form S-3 registration statements during any given 12-month period. These time limitations could be negotiated as part of the term sheet phase.
Company Registration (AKA Piggyback Rights)
Company registrations, also known as piggyback rights, allow the investors to participate in a planned public offering separate from a demand registration. If the company plans to register any of its securities in connection with a public offering, the company must provide the investors with notice of the registration and allow the investors a notice period to elect to participate in the offering. As discussed below, founders can sometimes negotiate to also have piggyback registration rights!
Market Standoff (AKA Lock-Up)
The market standoff (also known as a lock-up) section of the IRA sets a procedure for the company and investors during the IPO (and sometimes other registrations) that restricts the investors from selling their securities following the public offering for a set period. Typically, the market standoff period is 180 days from the IPO, which aligns with the market standard for underwriter requirements. Standard stock purchase agreements for the founding team will typically include a lock-up provision.
The underwriter is an intermediary between the company and the stockholders in connection with a public offering. The underwriter is essential to the public offering process because it assists the company in preparing for the offering, helping the company determine the valuation and target amount to be raised, and the securities that will be issued.
As a practical matter, the company’s underwriter will influence the effectiveness of the registration rights during their determination of the size of the offering, and some of the registration terms in the IRA will be superseded by the underwriting agreement, which is the services agreement between the underwriter and company. The underwriter may cut back the registration rights, which will require the company and investors to set a priority lineup of who participates in the public offering.
Later-stage investors may negotiate to have priority over the early stage investors, or the cutback may be determined on a pro rata basis. If key holder registration rights are negotiated in the IRA, these rights should be considered in the priority lineup to try and maintain the integrity of the founders’ rights.
Founder-Friendly Registration Rights
Often, the fact that founders can even negotiate for any registration rights for their own personal holdings of common stock is overlooked and excluded at the term sheet phase. If key holder registration rights are important to the founding team, these terms should be negotiated at the term sheet phase. Although rare, founders who have substantial negotiating power may find themselves in a position to negotiate registration rights for their common stock holdings.
That said, if this concept is not negotiated in the term sheet, it is unlikely that the lead investor will entertain “key holder registration rights” after the fact. If key holder registration rights are not negotiated in the first preferred stock financing, it is also unlikely that a lead investor in a subsequent financing will allow the founders to add key holder registration rights to the IRA in connection with the subsequent financing.
The founders of XYZ Corporation were not aware that they could negotiate these types of rights, so agreeing to the “customary registration rights” in the term sheet made it practically impossible for the founders to add founder-friendly terms during the substantive negotiations.
Termination of Registration Rights
The registration rights will terminate upon specific triggering events. The most common termination events are set out as the earlier of: (1) the closing of a Deemed Liquidation Event (as defined in the Certificate of Incorporation), (2) after the IPO lock-up, once the investor has the right to sell all of its shares (subject to some limitations for larger stockholders who may face constraints from lock-up periods and transferability issues); or (3) between the third and fifth anniversary of the IPO.
Early-stage companies and early-stage venture funds may negotiate to “kick the can down the road” when it comes to registration rights by removing all of the registration rights from the financing terms. Instead, the IRA will include a requirement that the company provides the early stage investors with the same registration rights that it will provide to future investors, once it is required to provide such rights in a subsequent financing.
This approach simplifies the IRA and helps the company and investors focus on the short-term control rights that will come into play after the closing, including the information rights, participation rights and post-closing covenants, which is beneficial to the company because these complex terms are removed from the negotiation process.
Although the NVCA template of the Investors’ Rights Agreement creates a shared language between investors and companies (and their respective legal counsels) to negotiate registration rights, complex issues around registration rights can arise during the course of the deal, especially as the company raises capital at an advanced stage of the business. It is important for founders to understand the long-term implications of registration rights and the dynamics that will be at play if the company conducts a public offering.
This article focuses on the most prevalent components of the registration rights; however, founders should pay close attention to all aspects of the registration rights in the IRA and work with their legal counsel to ensure that the founding team understands the opportunities and pitfalls of the negotiated rights.
Disclaimer: This material is intended for general information purposes only and does not constitute legal advice. For legal issues that arise, the reader should consult legal counsel. The NVCA model documents referenced in this article are the current documents as of the date of publication and do not include any updates that may occur thereafter.