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Welcome back to Anatomy of a Term Sheet, a multi-part series in which we take the model Series A term sheet from the NVCA, and analyzing the various terms in depth.
We have finished with the charter terms and the Stock Purchase Agreement section of the model Term Sheet. Today we start working on the Investor Rights Agreement section, and we will begin with registration rights.
The ultimate goal of any venture capital investment is to make money. Most VC investments either fail, or just barely return the investors’ money. Consequently, VC’s have to hit a grand slam now and then, to pay for all the mediocre and poor investments, and allow the VC’s to cash out with a good return on their investment.
Cashing out is not an easy or simple process for the VC. Until the company goes public, all the investments in the startup, whether it is the seed investment or the Series A (and B, and C, etc.), have been private transactions. The company’s securities – common stock, convertible notes, and preferred stock – have all been sold without registering them with the SEC, and therefore the securities are “restricted.” Rule 144 of the Securities Act of 1933 imposes certain restrictions on the sale of unregistered securities, including that you must hold them for at least one year before you can sell. Also, certain public information about the company must be available, and there are limits on the volume of shares that can be sold, unless the seller holds the securities for at least two years and is not an affiliate of the company. Registration of the stock allows the VC investor to sell the stock without complying with Rule 144, but it is an expensive, time-consuming process involving lawyers, accountants, and investment bankers.
There are two kinds of registration rights: demand rights and piggyback rights. Here’s an example of the demand rights term from our model term sheet:
Upon earliest of (i) [three-five] years after the Closing; or (ii) [six] months following an initial public offering (“IPO”), persons holding [__]% of the Registrable Securities may request [one][two] (consummated) registrations by the Company of their shares. The aggregate offering price for such registration may not be less than $[5-15] million. A registration will count for this purpose only if (i) all Registrable Securities requested to be registered are registered, and (ii) it is closed, or withdrawn at the request of the Investors (other than as a result of a material adverse change to the Company).
“Registrable securities” are defined as all shares of common stock that will be issued upon conversion of the Series A preferred stock. The idea behind demand registration rights is that at some point in time, the VC investors want to be able to compel the company to register their shares with the SEC, so that they can cash out. The registration process takes up an enormous amount of management time and attention, and as a practical matter, it is extremely unlikely that investors are going to invoke demand registration, forcing a company to go through registration of their securities without management’s full buy-in. Nevertheless, there are points to negotiate. For example, the company will want to limit the number of demand registrations to one, while the investors will want the right to demand two or more. Another negotiable point is the minimum dollar size needed to trigger the demand rights. The company will want to set a reasonably high minimum dollar size for the offering, given the expense of a registration. The company also will want to ensure that a significant percentage of the investors support the registration demand, and that a single investor cannot cause a registration.
In the next installment, we will look at piggyback rights. Thanks for reading!
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