The offer and sale of securities is regulated by both federal and state law. At the federal level, securities can only be offered or sold pursuant with a registration statement filed with the Securities and Exchange Commission (“SEC”), or in accordance with an applicable exemption from the registration requirements. When small business startups raise capital from outside investors—especially sophisticated angel investors or institutional investors—the company will typically rely on an exemption rather than spend the significant time and expense to file a registration statement with the SEC.
This is where registration rights come into play. Registration rights give an investor the ability to require the company to facilitate the resale of the shares, ensuring they can sell previously unregistered securities into the public market. As such, these rights are considered by many investors to be among the most important issues in financing in later offerings.
There are two primary types of registration rights: demand rights and piggyback rights.
Demand rights provide investors the right to force a company to register shares of common stock so that the investor can sell them in the public market without restriction. This effectively causes the company to undertake an initial public offering (“IPO”) if the company isn’t already public. Piggyback rights give the investor the right to include their shares in a registered offering of securities by the Company.
Demand rights are generally considered superior to piggyback rights because the holders of demand rights can unilaterally compel the company to register their shares. Piggyback rights are more passive. Relatively speaking, only larger shareholders receive demand registration rights, while piggyback rights are granted to a wider variety of investors.
In reality, investors rarely use registration rights in accordance with their specific terms. For example, exercising a demand right without a reasonable level of communication and cooperation from the company could create a cash flow crisis for the company and depress the value of the company’s stock. Nonetheless, many investors view registration rights as critical to a financing deal. They are often the only exit vehicle that minority shareholders can compel to monetize their investment.
Registration rights are typically limited to common stock as opposed to other classes of stock or convertible securities. Negotiated issues include: (i) the number of demand registrations that an investor can initiate, (ii) when shareholders can exercise their rights; (iii) the minimum dollar size of a demand registration, and (iv) whether the company needs to use “best” efforts or “commercially reasonable” efforts to effect a registration.
Without an SEC registration, holders of restricted securities can sell their shares pursuant to Rule 144 of the Securities Act of 1933, which provides an exemption from registration requirements. While it can be useful, Rule 144 comes with several conditions, including how long the securities are held, the way in which they are sold, and the amount that can be sold at any one time.
Contact Perkins Law to discuss your legal and compliance questions about raising capital for your small business.