Successful exits are critical for private equity sponsors. A sale at an attractive valuation providing immediate liquidity is typically the cleanest and simplest path, but for some portfolio companies and in some markets an initial public offering ("IPO") will yield a better valuation – or may even be the only plausible path to exit. It can be a long road from the initial investment to an IPO. Smart financial sponsors nonetheless seek to lock in generous registration rights provisions at the time of the initial investment, when sponsor leverage is at its maximum and other shareholder constituencies with differing interests may not yet have developed, in order to maximize returns should an IPO turn out to be the best path to exit. Effective registration rights are even more important for sponsors that elect to take public company stock as consideration for sale of a portfolio company, a situation in which the selling sponsor often will not have control over the listed company but can find itself holding a block of stock large enough that registration rights are necessary to obtain an efficient exit from the position. In this article, we explain what registration rights are, why they matter, and the key issues on which private equity firms should focus as they structure these arrangements.
What Are Registration Rights and Why Do They Matter?
Under the U.S. federal securities laws, a security may be offered and sold only pursuant to a registration statement filed with the U.S. Securities and Exchange Commission (the "SEC") under the U.S. Securities Act of 1933 or pursuant to an applicable exemption from such registration. Securities sold in transactions registered under the Securities Act may be freely sold into the public capital markets. Stock held by sponsors in portfolio companies, even after an IPO, is typically not registered and may not be freely sold. And public company stock received by financial sponsors in consideration for the sale of a portfolio company is also often not registered, or is otherwise subject to limitations on transfer as a “control security.”
Registration rights ensure that an investor can sell previously unregistered securities freely into the public capital markets. They consist of contractual rights obligating a company to facilitate the public resale of previously unregistered securities through one or more transactions registered with the SEC. Registration rights are typically granted at the time of an investment in unregistered equity securities and may be housed in a dedicated registration rights agreement or another transaction document, such as a stockholder’s agreement. They come in two flavors: “demand” rights, which permit an investor to require a company to effectuate the registration of the investor’s securities on an appropriate registration statement form under the Securities Act, and “piggy-back” rights, which permit an investor to require a company to include the investor’s securities in a registration statement under which securities are registered for sale by the company or another investor. Demand rights may specifically permit an investor to require a company, if it is not already public, to effectuate an initial public offering or other public listing of its securities in order to facilitate the exercise of its registration rights in conjunction with or following the IPO.
In the absence of Securities Act registration, unregistered or otherwise restricted securities are most commonly sold pursuant to Rule 144 of the Securities Act. While useful, Rule 144 precludes the sale of restricted securities during an applicable holding period (which is either six months or one year, depending on the relevant facts) and subjects the sale of “control” securities (generally, securities held by a sponsor that also has a seat on the board or owns 10% or more of the company’s stock) to volume and manner of sale limitations. Other exemptions from registration may be available. However, reliance on another exemption would limit the pool of potential investors to institutional and certain other sophisticated investors and typically causes purchasers to demand a “liquidity discount” on the purchase price since the securities will be “restricted” in the hands of the purchaser.
Getting Registration Rights Right
Customary registration rights contain a broad range of provisions that govern the frequency, timing and nature of an investor’s ability to require a company to help facilitate its public sale of securities. Negotiation dynamics around key registration rights provisions are informed by the investor’s desire to preserve the right to effectuate numerous (and potentially rapid) sales, and the company’s desire for orderly public dispositions of securities that minimize interference with ordinary course business and capital-raising activities.
Is Your Security a “Registrable Security”? A threshold question is whether the security held by an investor falls within the scope of the registration rights. Registration rights are typically limited to securities that are thought to “need” them in order to achieve liquidity. An investor will want to ensure that registrable securities remain so at least until the investor is able to resell the securities under Rule 144 without limitation (e.g., until any applicable holding period has fallen away and until the securities it holds cease to be “control” securities).
General Limitations—Size, Frequency and Scope. An investor’s natural inclination is to negotiate for open-ended registration rights that permit unlimited and frequent registrations of as many or as few securities as desired. From the company’s perspective, limiting the number or frequency of registrations (or “take-downs” under a shelf-registration statement) during a given period (or in the absolute) and setting a minimum number of securities with respect to which registration rights may be exercised helps to limit management distraction (especially management’s participation in “roadshows” and other marketing efforts) and the investment of company resources. These types of limitations could have a significant restrictive effect on an investor’s ability to effectively and timely monetize its investment. Sponsors should consider whether the proposed restrictions unreasonably impair their ability to achievinvestment goals and are appropriately tailored relative to the number and value of the securities held. Specifically, sponsors should review whether registration rights fall away after a date certain or following the occurrence of certain events (e.g., the registrable securities outstanding fall below a certain numerical or fair market value threshold) and whether the fall away trigger aligns with the sponsor’s investment horizon.
Suspension Periods—How Often and for What? Registration rights will customarily provide a company with the right to suspend or postpone a requested registration (or shelf takedown request) under certain circumstances, most commonly when the company would be required to publicly disclose material non-public information prematurely. Understandably, the company will want to reserve the authority to suspend the registration and prevent premature disclosure of that information. However, a company’s ability to suspend a registration is typically cabined by frequency and duration limitations on the suspension period. Sponsors should focus on these provisions to be certain the company is not able to effectively block its ability to sell during favorable market windows.
Cutting Back the Piggies. As noted above, piggy-back rights allow an investor to have its securities included in a registration statement for the offer and sale of securities initiated by the company or another investor. Typically, only larger holders receive demand registration rights, while piggyback rights are granted to a broader group. However, market demand may not be sufficient to absorb all shares proposed to be offered and sold. Further, while market demand may be sufficient to absorb the offered shares, the market clearing price may be depressed and the subsequent trading price of the securities may be negatively affected if the size of the offering is not calibrated appropriately. Registration rights typically contain a mechanism intended to address this situation in marketed offerings whereby some number of shares may be eliminated from an offering. This mechanism, by which shares are “cutback” according to a stipulated priority, is typically initiated at the direction of the underwriter for the offering with the type of offering and identity of the party initiating the registration or offering usually dictating the level of priority into which an investor’s shares fall. If a registration statement is filed by the company for a primary offering of its shares, it would be typical for the company’s shares to have first priority over piggy-backing investors. Similarly, in the case of a demand registration, the demanding holder would typically receive top priority. If several large investors hold relatively equivalent numbers of registrable securities, it would also be common for the securities owned by those investors to be grouped together for purposes of a cutback to facilitate a more orderly approach to marketed secondary transactions.
Lock-Ups—How Long and For Which Transactions? Parties to registration rights agreements are generally required to execute a lock-up agreement (especially investors with significant holdings). These agreements will block sales of securities around the time of underwritten sales of the company’s equity securities, including sales made in connection with an IPO and secondary sales. Sponsors need to be careful that lock-ups do not impede the ability to opportunistically sell into open-market windows, especially given the potential interaction with suspension periods as described above.
Facilitating Block Sales. Once a company has achieved a certain “seasoned” status, it may no longer be necessary to conduct extensive (or any) marketing efforts in connection with an SEC-registered distribution of shares. Without the drag of a marketing process, an investor may be able to efficiently and quickly sell a large number of shares by arranging for the acquisition of a block of shares through a registered “bought deal” or “block sale.” These transactions are common among investors focused on hitting short market windows (e.g., an investor could require a company to file an automatically effective shelf registration statement on Form S-3 and immediately thereafter execute a block sale under that shelf). Many registration rights agreements do not adequately or explicitly contemplate these types of transactions as market practice has generally outpaced registration rights technology. In order to retain the flexibility to facilitate effective and timely execution, these provisions should be drafted with consideration given to the nature and timing (if any) of piggyback notices that a demanding investor must deliver to nondemanding holders when contemplating a block sale of securities. Similarly, with speed integral to the success of block sales, investors should also consider how soon following a demand in respect of a block sale the company must file the registration statement and make other SEC filings necessary to effectuate the transaction.
Summing It Up
Getting registration rights right can mean the difference between a highly successful investment and a frustrating hit to internal rates of return caused by a delayed exit. Buried beneath the legal detail are key business judgments, and the time to make them is early when the sponsor is able to shape the playing field most effectively with an eye to a successful exit.