Registration rights

Author: | Published: 4 Jan 2001
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Exit strategy is perhaps the most important item on any private equity investor's checklist. Many investors, particularly in new economy investments, look to a US listing (often on Nasdaq) for this exit.

But simply getting the initial listing of the target company in the US is only half the battle. The investor must also be able to register its shares for sale to the public after the initial public offering (IPO), and this registration cannot occur without the cooperation of the company. Rights to force the company to cooperate in the registration process – commonly known as registration rights – are integral to an investor's exit strategy in the US public markets. These rights are also called demand registration rights, to distinguish them from piggyback registration rights described later.

To understand the importance of registration rights to investors in a US public company, a bit of background on US securities laws is necessary. The United States is one of the few jurisdictions in the world where shares must be registered (or where an exemption from registration must be available) before the shares are sold to the public. The shares are registered under a registration statement, which includes a prospectus, which is filed with the US Securities and Exchange Commission. The company prepares, and must stand behind, the registration statement, and accordingly it is impossible to register shares without the cooperation of the company. Investors should also note that shares cannot be registered and held; only shares to be sold can be registered.

Registration rights are not provided by statute. They can only be granted in a registration rights agreement between the company or the controlling shareholders, on the one hand, and the investors to be granted these rights on the other. (These agreements may also be called investor rights agreements or similar names. The relevant provisions from the registration rights agreement may also be part of a larger shareholders' agreement.)

Registration rights agreements should address at least the following issues:

  • Who will be granted the rights?
  • When may the rights be exercised?
  • How often may the rights be exercised?
  • When may the company refuse to honour the rights?
  • Will piggyback rights be granted?
  • When are cutbacks appropriate?
  • Who pays for the registration?
  • Should the company indemnify the shareholders, and vice versa?
  • When do registration rights terminate?

This article will discuss each of these questions, with a view to providing practical guidance to investors in negotiating these agreements.

Who will be granted these rights?

This is the most basic question facing investors and the company, and in some respects the most difficult. There is no standard or correct approach to determine what investors will get registration rights.

As a practical matter, controlling shareholders seldom need registration rights, because they can force a company to register their shares at any time because of their influence over the board of directors.

The question becomes more difficult when deciding whether some or all outside investors should be granted registration rights. If registration rights are granted, it is not unusual for them to be granted to all minority outside (i.e. non-management) investors. It is also not unknown for distinctions to be drawn among groups of minority investors in terms of who is granted registration rights. Later-round investors, who may be paying much more for their shares than earlier-round investors, may argue that their greater investment justifies that they alone should be granted registration rights, or that at least their rights should be superior in certain ways, such as a right to take precedence in registering their shares in any oversubscribed offering.

At the same time, if earlier-round investors have veto rights over the issuance of additional equity, they may use the threat of vetoing the later round of financing as leverage to get registration rights equivalent to those of later-round investors.

Two factors often drive who will or will not be granted registration rights: the price the investor pays for its shares, and the amount it is purchasing. The greater the price for the shares, and the greater the amount purchased, the more likely the investor will be granted registration rights.

A related issue is whether the registration rights are personal to the investor to whom they have been granted (and, if so, whether the registration rights may be transferred to any subsequent purchaser of these shares), or whether they run with the shares (meaning that any holder of the class or series of shares to which registration rights have been granted has the benefit of these rights). If personal registration rights are transferable to subsequent purchasers, the company will sometimes require that the purchaser acquire a minimum amount of shares before the registration rights may actually be transferred.

When may the rights be exercised?

Investors usually demand, and companies often agree, that registration rights become effective immediately following the expiration of any lock-up (typically six months) following the initial public offering of the company's shares in the US.

Investors and the company often spend more time debating whether the registration rights can be used to force a company to go public in the US, even before management and the controlling shareholders think it is ready. If the registration rights become effective on a certain date (regardless of whether the IPO has taken place), they can be used to take the company public starting on this date.

Companies typically resist granting investors these rights to take them public. US public companies are subject to a host of regulatory burdens and constraints that will significantly affect the operation of the company. Moreover, bringing a company to market before it is ready may harm its reputation or its ability to raise financing in the future. Controlling shareholders may be concerned about putting such a decision in the hands of minority investors, whose interests may be focused more on short-term financial gain and less on long-term growth and management of the company.

Nonetheless, companies do from time to time grant such rights, particularly where the investors have great economic leverage, or where necessary to quell investor concerns about future exit opportunities. If such a right is granted, however, it is not unusual for the effective date to be a number of years after the investment, to give management and the controlling shareholder an opportunity to bring the company to the public markets at the time and under the circumstances they think best.

On a related issue, the company will often require that a certain minimum threshold of registrable securities be registered in connection with any single registration request, so that the company is not required to go through the time and expense of a registration (which can be considerable) unless a substantial number of shares are involved. This threshold is often expressed in terms of a percentage of all outstanding registrable securities or an aggregate dollar amount based on the market price of the registrable securities at the time the request is delivered. Large investors will often request that this number be set so as to allow them (in light of the size of their holdings) to deliver one or more registration requests without needing the participation of other investors.

How often may the rights be exercised?

Registration rights agreements often contain two types of limits on the number of times registration rights may be exercised. The first type caps the number of requests that any one investor or group of investors may make during the life of the registration rights agreement. The second type caps the number of times a request may be made during any given period of time, for example that no more than one registration request may be delivered to the company during any nine-month period.

There are no standard numbers, but it is fair to say that these caps, particularly of the first type, are often set in relation to both the number of registrable securities (and the percentage of the company's total share capital they represent) and the expected liquidity of the market for the company's shares. A good rule of thumb is that the greater the number of registrable securities, or the more illiquid the market, the higher the cap, under the theory that it is beneficial both for the company and the investor if a relatively large block of shares may be dribbled out over time (particularly in an illiquid market), rather than dumped all at once.

When may the company refuse to honour the rights?

Many registration rights agreements allow the company to decline to honour a registration request if the disclosure of a pending corporate transaction in connection with the registration would negatively impact the company. For example, if the company is in secret negotiations to sell a major business, these negotiations might potentially need to be disclosed in the registration statement. This disclosure might scupper the deal. In these circumstances, the company could decline to honour the registration request.

At the same time, registration rights agreements often limit the number of times during a given period (for example, once in any 12-month period) that a company can rely on such a provision, so that a company cannot perpetually point to pending transactions as an excuse not to honour registration requests.

What are piggyback rights?

In addition to, or instead of, demand registration rights, registration rights agreements often provide piggyback registration rights, that is the right to include shares in (or piggyback on) a registration initiated by the company or another shareholder. The piggybacking selling shareholder is not in the driver's seat in the registration process, but is essentially along for the ride initiated and controlled by the company or another shareholder.

Piggybacking on a registration is possible because there is no limit on the number of shares, or on the number of sellers of shares, that may be included in any one registration statement. Since the marginal cost to the company of including additional sellers under one registration statement may be relatively small, companies are quite often willing to grant them. Piggyback registration rights, however, are inferior to demand registration rights, in at least two respects.

First, the holders of piggyback rights have no ability to initiate a registration process. They may only participate in one initiated by the company or by another shareholder. Accordingly, having piggyback registration rights alone may not be appropriate for an investor that needs to control the timing of its sale into the market.

Second, shares to be sold under piggyback registration rights are typically excluded from an offering in favour of shares sold under demand registration rights if the underwriters determine that the market cannot absorb all of the shares to be registered.

On the positive side, registration rights agreements often allow the holder of piggyback registration rights to participate in an unlimited number of registrations (subject to the cutbacks described below), but not subject to any of the caps described above.

When are cutbacks appropriate?

Most registration rights agreements provide that the shares to be registered will be sold to the public in a firmly underwritten offering. Accordingly, there may be situations where the underwriter will advise that the market cannot absorb all of the shares requested to be registered at the prices sought. For these situations, registration rights agreements typically provide for some mechanism to cutback the number of shares that the investors and the company may register.

There is no standard way in which these cutbacks are allocated, but a few principles typically apply:

  • if the company wishes to participate in a registration, the holders exercising demand registration rights will often either be fully cutback before the company is cutback at all (under the theory that the company should have unimpeded access to the markets when it needs it), or the cutbacks will be made on some type of pro-rata basis between the company and the holders exercising demand registration rights;
  • investors exercising demand registration rights (as opposed to piggyback rights) are typically cutback among themselves in some pro-rata manner (assuming they have otherwise identical demand registration rights); and
  • investors exercising piggyback rights are typically fully cutback before either the company or the investors exercising demand registration rights are cutback.

Who pays for the registration?

The company may often pay for the incidental expenses of registration, including filing fees, printer's fees, company accountant's fees and similar expenses (even if the company is not itself registering any shares for sale to the public). Whether the company will pick up fees for counsel to the investors is less certain. Even if the counsel fees are paid for by the company, limits may be placed on the number of counsel whose fees will be reimbursed (for example, one counsel to all investors), or on the amount of counsel fees that will be reimbursed for any one registration.

Selling shareholders will, almost universally, pay the underwriting commissions and discounts associated with selling their shares.

Should the company indemnify the shareholders, and vice versa?

Under US securities laws, the company has strict liability for any material mis-statements or omissions in a registration statement. Selling shareholders also have some liability for mis-statements or omissions. Accordingly, selling shareholders typically request that the registration rights agreement contain an indemnification from the company to each selling shareholder for any liability arising from such material mis-statements or omissions, other than with respect to information provided by the shareholder in writing for inclusion in the registration statement.

In turn, the company often asks for a similar indemnity from each selling shareholder for any liability of the company arising from material mis-statements or omissions in any information provided in writing by the shareholder for inclusion in the registration statement. In this respect, investors should note that any shareholder selling shares under a registration statement will have to provide some basic information about itself, including its name and number of shares held. An anonymous sale is not possible.

When do registration rights terminate?

It is not unusual for registration rights agreements never to terminate. So long as the investors have not made all of the demand registrations to which they are entitled, and so long as there are other registrations on which they may piggyback, their rights may survive.

At the same time, some registration rights agreements do provide for termination, at least of demand registration rights, if all of the registrable securities held by an investor may be sold (either all at once or during a short period of time) under Rule 144 of the US Securities Act. Rule 144, sometimes called the dribble-out rule, generally allows a holder of unregistered shares to dribble out these shares to the public market after the investor has held them for at least a year, but there may be limits on the amount of shares that can be dribbled out during a given period of time, as well as restrictions on how these shares may be sold to the public.

It is not common to see registration rights agreements terminate simply after a period of time following the initial public offering in the US.

Many issues arising under registration rights agreements are the subject of negotiation, taking into account the investment climate at the time and the economic leverage of the investors. An experienced US lawyer can be helpful to an investor attempting to navigate these issues and maximize the value of this important exit strategy.

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