Anatomy of a Term Sheet – Piggyback and S-3 Registration

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth.

Last time we began a discussion of registration rights, and focused on demand registration rights. Today we are going to focus on two other kinds of registration rights — piggyback rights and S-3 registration rights — as well as expenses and lockup terms.

Piggyback Registration Rights

Here is the piggyback registration rights term from our Model Term Sheet:

The holders of Registrable Securities will be entitled to “piggyback” registration rights on all registration statements of the Company, subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered to a minimum of [2030]% on a pro rata basis and to complete reduction on an IPO at the underwriter’s discretion.  In all events, the shares to be registered by holders of Registrable Securities will be reduced only after all other stockholders’ shares are reduced. 

This is a fairly straightforward and noncontroversial term. Basically, if the company is going to be registering its securities with the SEC for a public offering, the investors want to be able to register the securities they hold at the same time. This will enable the investors to cash out without complying with Rule 144’s requirements.

There are a couple of interesting aspects to note. In the case of an IPO, the underwriter has the discretion to override the piggyback rights of the investor. In the case of subsequent public offerings, the underwriter can cut back the percentage of the investors’ shares that will be permitted to piggyback on the registration.

Founders and management should also negotiate to have piggyback registration rights, for the same reason the investors want them. The founders will want to participate in an IPO or other public offering, so they can cash out shares without complying with the requirements of Rule 144.

S-3 Registration Rights

The S-3 registration rights term is as follows:

The holders of [10-30]% of the Registrable Securities will have the right to require the Company to register on Form S-3, if available for use by the Company, Registrable Securities for an aggregate offering price of at least $[1-5 million].  There will be no limit on the aggregate number of such Form S-3 registrations, provided that there are no more than [two] per year.

A Form S-3 registration is shorter and less burdensome than the Form S-1 registration used in an IPO. It can be used by the company one year after an IPO, and allows the company to reference certain items contained in other SEC filings. Consequently, while the S-3 registration rights are demand rights, they aren’t as burdensome as the primary demand registration rights.

The company will want to limit the number of S-3 registrations to 1 or 2 a year, because of the costs and time involved. The company also will want to set a minimum dollar amount for S-3 registrations (somewhere between $1 million and $5 million), again because of the cost and time involved.

Expenses and IPO Lockup

There are two other items related to registration rights worth covering while we are on the subject. The first is expenses. Typically the company will pay the expenses of an SEC registration. Our model term sheet also contains a provision for the company to pay for one special counsel to represent all participating stockholders, subject to a negotiable cap on fees.

The second item is the IPO lockup. The lockup term prevents investors, directors, officers, and major shareholders (1-5%) of the company from selling their shares until 180 days after an IPO, if the underwriter requests. This allows the market to adjust and absorb the additional sales.

Thank you for reading. You can follow me on Twitter @PaulHSpitz

Anatomy of a Term Sheet – Registration Rights

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!

Follow me on Twitter @PaulHSpitz