In connection with the initial public offering of a company, the underwriters will generally require the company to prevent their existing stockholders from selling their shares for a certain period after the offering (with 180 days being standard). The purpose of this “market standoff” or “lock up” is to delay the trading of these existing securities until the market can absorb the additional sales after the IPO. To avoid potential disagreements with shareholders immediately prior to the offering, the lock-up provision is typically contained in agreements in connection with every issuance of company stock.

Below is a typical form of lockup provision from an Investor Rights Agreement.

[If requested by the Company and an underwriter of Common Stock (or other securities) of the Company, each Holder shall not] [Each Holder hereby agrees that such Holder shall not] sell or otherwise transfer, make any short sale of, grant any option for the purchase of, or enter into any hedging or similar transaction with the same economic effect as a sale, of any Common Stock (or other securities) of the Company held by such Holder (other than those included in the registration) during the one hundred eighty (180) day period following the effective date [of a registration statement of the Company] [of the registration statement for the Company’s Initial Public Offering] filed under the Securities Act [(or such other period as may be requested by the Company or an underwriter to accommodate regulatory restrictions on (i) the publication or other distribution of research reports and (ii) analyst recommendations and opinions, including, but not limited to, the restrictions contained in NASD Rule 2711(f)(4) or NYSE Rule 472(f)(4), or any successor provisions or amendments thereto)] [, provided that: all officers and directors of the Company and holders of at least one percent (1%) of the Company’s voting securities are bound by and have entered into similar agreements]. The obligations described in this Section 2.10 shall not apply to a registration relating solely to employee benefit plans on Form S-l or Form S-8 or similar forms that may be promulgated in the future, or a registration relating solely to a transaction on Form S-4 or similar forms that may be promulgated in the future. The Company may impose stop-transfer instructions and may stamp each such certificate with the second legend set forth in Section 2.8(c) hereof with respect to the shares of Common Stock (or other securities) subject to the foregoing restriction until the end of such one hundred eighty (180) day (or other) period. [Each Holder agrees to execute a market standoff agreement with said underwriters in customary form consistent with the provisions of this Section 2.10.]

In more recent forms of lockup provisions, the lockup period may be extended due to rules that prevent underwriters in an IPO from issuing a research report or recommendation on the company within 15 days prior to or after the expiration of a lockup agreement. If the company experts to issue an earnings release within 15 days of the expected release of the lock-up, then extending the lockup period to allow the investment bank to issue an analyst report may be beneficial.

An S-3 registration entitles investors to demand that a company register their shares on a Form S-3 registration statement. Form S-3 is a shorter form of registration statement than a Form S-1 (used in an IPO) and may be used by a company one year after an IPO. Form S-3 requires less effort by a company than a Form S-1 because the company is allowed to refer to certain items contained in its other SEC filings.

The items typically negotiated in the S-3 registration rights provision include:

• The number of S-3 registrations. Typically, the company may want to limit the number to a one or two in any twelve month period and the investors will want unlimited S-3 registrations. There are legal and accounting expenses associated with an S-3 registration, which the company will want to limit.

• The minimum size of an S-3 registration. The company will want the amount of securities to be registered to be greater than a certain dollar amount, such as $1 million, in order to avoid frivolous registration requests.

Piggyback registration rights entitle investors to register their shares of common stock whenever the company conducts a public offering, subject to certain exceptions. Unlike demand rights, piggyback rights do not entitle investors to require a company to conduct a public offering but simply allow them to include shares in a registration that is initiated by the company. Piggyback registration rights typically are not particularly disruptive (other than the effort involved in contact investors with piggyback right to solicit their participation in a registration) and do not require the special effort of demand registrations. Companies usually bear the cost of investors exercising piggyback rights.

The items typically negotiated in the piggyback registration rights provision include:

• The ability of underwriters to cutback investor shares in an offering. Typically, the piggyback registration rights provisions allows underwriters to completely eliminate investors as selling shareholders in an IPO. In subsequent offerings, the investors will typically negotiate that they cannot be cutback to less than 25% or 30% of the offering.

• The priority of investor shares to be included in an offering. Some venture funds aggressively negotiate the priority of any shares that the underwriters allow to be registered in a company-initiated registration. An aggressive later investor may request that their shares be included in a registration before any other non-company shares are included in the registration.

• Whether founders and management can also have piggyback registration rights. Savvy founders will argue to obtain piggyback registration rights for the same reason that venture funds want the rights.  Absent registration, founders that are affiliates will need to comply with volume restrictions under Rule 144. A registered public offering may be one of the few orderly ways that a founder can sell a large number of shares.

Demand registration rights entitle an investor to force a company to register shares of common stock so that the investor can sell them to the public. This effectively causes the company to undertake an IPO if the company is not yet public. Registrations are time-consuming and expensive, particularly if they involve underwritten public offerings of securities. These offerings require significant efforts from management, diverting them from the business of running the company. These offerings can even depress the market price of the company’s stock if the offering is poorly timed.

As a practical matter, I have never heard of a demand registration right being exercised by an investor. Completing an offering without company and management cooperation is impossible.

The items typically negotiated in the demand registration rights provision include:

• The number of demand registrations the investor can require. Because registrations are expensive, the company typically tries to limit it to one, while the investors typically want two.

• When the investor can make a demand. In an early state financing, a demand registration cannot be exercised until five years from the closing of the financing. In a later stage financing, the time period may be much shorter, depending on the expected potential IPO-readiness date. In addition, a demand registration right typically cannot be exercised for a certain time period after an IPO, such as 180 days.

• Who pays for the demand registration and up to what amount. Typically, the company pays for registration expenses and the expenses on a single counsel to the investors (which is subject to a cap).

• The minimum dollar size of a demand registration. Given the expense involved in a registration, companies want to set some minimum requirements on a demand registration so that it is a legitimate offering. The minimum price per share to exercise a demand registration and the minimum dollar amount of the offering are typically similar to the definition of a Qualified Public Offering that causes the preferred stock to convert to common stock. This is typically set at around 3x to 5x the purchase price of the preferred stock (5x in earlier stage financings and 3x or lower in later stage financings) and an aggregate of $20M or higher to be raised in the offering.

• Rights to delay a demand registration. Companies routinely request the right to delay a demand offering for a fixed maximum period of time if the company has commenced preparations for a public offering or believe a delay would beneficial because of market or other conditions or to avoid disclosing material company developments, such as pending merger negotiations.

• Whether the company needs to use “best” efforts or “commercially reasonable” efforts to effect a registration. Investors ask for “best” efforts, which may require registration irrespective of costs or effort disproportionate to benefit. However, some commentators suggest that there is no real difference between any of these standards.

Registration rights entitle investors to force a company to register shares of common stock issuable upon conversion of preferred stock with the Securities and Exchange Commission.

Federal and state securities laws place certain limitations on the transfer of shares that have not been registered. Rule 144 of the Securities Act of 1933 requires that securities be held for at least one year before being sold.  Among other things, Rule 144 also requires that certain current public information about the company be available and limits the volume of shares that can be sold, unless the seller has held the securities for at least two years and is not an affiliate of the company.  Registration allows venture funds to freely sell the shares without complying with these restrictions even if they are deemed affiliates due to significant shareholdings or a director on the board.

Registration involves filing a registration statement with the SEC, which is a expensive and time consuming process. Please see the initial filing of Google’s registration statement for its IPO as an example of the complexity of the document. Legal, accounting and other fees in connection with an IPO can easily exceed $2M.

As a practical matter, registration rights are rarely used and have little practical effect on a company until after an IPO. However, some venture funds and attorneys seem to spend a long time negotiating these provisions, when they have little practical impact.  Registration rights are negotiated between the company and the investors, well before underwriters are involved.  At the time of an IPO and subsequent underwritten public offerings, underwriters will have the ability to dictate whether investors are allowed to sell, which makes the registration rights negotiated at the time of the venture financing a mere starting point for discussions with the company and the underwriters.

Information rights force a company to provide investors with financial statements and other company information.  These rights are typically contained in an Investor Rights Agreement.

A typical information rights provision from a term sheet provides:

The Company will deliver to each holder of at least [500,000] shares of Preferred, (i) [un]audited annual financial statements within [90] days following year-end, (ii) unaudited quarterly financial statements within [45] days following quarter-end, (iii) unaudited monthly financial statements within [30] days of month-end, and (iv) annual business plans. The information rights will terminate upon an initial public offering.

Most information rights also include the opportunity to visit the company’s facilities, inspect the company’s books and records and discuss matters with company officers.  As a practical matter, I don’t think that most venture backed companies are in 100% compliance with information rights provisions, especially the time periods for delivery of the information.  For example, audited financial statements for private companies never seem to be completed within the specified time period.

One issue that gets negotiated in the information rights provision are the number of shares that an investor needs to hold to receive information rights.  This concept of “major investor” is often used to limit the investors that receive preemptive rights and rights of first refusal and co-sale (to be covered in future posts).  The number of shares is typically set low enough to ensure that the smallest venture fund (or significant angel) in a syndicate receives information rights and high enough to avoid giving rights to numerous small investors.  In addition, companies may wish to avoid commiting to delivering annual business plans or monthly financial statements

Information rights provisions also contain provisions that ensure that investors keep the information confidential. This is important because directors have a fiduciary duty to keep company information confidential, but investors do not have a similar obligation absent a contractual confidentiality provision.

Most venture financings require the creation and issuance of a new series of preferred stock.  This typically requires an amendment of a company’s Certificate of Incorporation in Delaware (or Articles of Incorporation in California).  The stockholder vote requirements for these actions are governed by state law and the Company’s charter (COI or AOI) and bylaws.  The stockholder vote requirements under Delaware law and California law are outlined below.

Delaware

General.  Delaware corporate law provides that an amendment to the Certificate of Incorporation requires the approval of a majority of the outstanding stock entitled to vote and at least a majority of the outstanding stock of each class entitled to vote as a class.  (For example, common stock is a class, and preferred stock is a class.)  The shares and classes entitled to vote are determined by the Certificate of Incorporation.

Class Vote Requirements.  Delaware corporate law provides that a “class vote” is required if the amendment to the Certificate of Incorporation does any of the following:

• Increases or decreases the par value of the shares of the affected class(es) (subject to certain limited exceptions);
• Increases or decreases the aggregate number of authorized shares of the affected class(es); or
• Adversely affects the powers, preferences, or special rights of the shares of such class.

For the purposes of the class vote, different series of the same class are not treated as a separate class unless the amendment to the Certificate of Incorporation adversely affects the powers, preferences or special rights of such series.  The position of a class or series of shares relative to other classes or series is not a power, preference, or special right of the shares, so that the provisions granting a class vote where the powers, preferences, or special rights are affected adversely do not apply to an amendment that creates a class or series with rights, powers and preferences prior to those of one or more existing classes or series of stock.

Though not expressly required under Delaware law, the holders of common stock often have a vote when new senior preferred stock is issued.  This is because the corporation typically needs to increase the authorized number of common shares to allow for the future conversion of the newly issued preferred stock into common stock.  If the corporation already has sufficient authorized common stock to allow for the conversion of the new preferred stock, a new class of preferred stock could be created without common stockholder approval.  In addition, the number of authorized shares of common stock may be increased by a vote of the majority of the outstanding stock of the corporation if the Certificate of Incorporation allows.  Most typical Certificates of Incorporation for venture-backed companies provide for this flexibility to avoid a separate common stockholder vote in a future venture financing.

Practical answer.  Generally, the necessary stockholder approval for a venture financing for a Delaware corporation (assuming properly drafted articles avoiding a separate common vote) will be (i) a majority of all shares on an as converted to common basis (due to the general stockholder approval requirement to amend the Certificate of Incorporation under Delaware law), (ii) a majority of all preferred stock on an as converted to common basis (due to the need to authorize additional preferred stock triggering a class vote), and (iii) any other approval required by the protective provisions in the Certificate of Incorporation, such as a separate series approval or super-majority approval.

California

General.  California corporate law provides that amendments to the Articles of Incorporation require the approval of a majority of the outstanding shares.

Class Vote Requirements.  California corporate law provides that a class vote (in addition to the affirmative vote of a majority of the outstanding voting shares) is required if an amendment to the Articles of Incorporation does any of the following: 

• An increase or decrease in the aggregate number of authorized shares of such class (subject to certain limited exceptions);
• An exchange, reclassification or cancellation of any part of such class (including a reverse stock split, but excluding a forward stock split);
• An exchange, or creation of a right of exchange, of any part of such class into another class;
• A change in the rights, preferences, privileges or restrictions of the shares of such class;
• The creation of a new class of shares with rights, preferences or privileges prior to the shares of such class or an increase in the rights, preferences or privileges or the number of authorized shares of any class with rights, preferences or privileges prior to the shares of such class;
• Dividing any class of preferred shares into series having different rights, preferences, privileges or restrictions or authorizing the Board of Directors to do so; or
• The cancellation of or otherwise affecting accrued, unpaid dividends.

For the purposes of the class vote, different series of the same class are not treated as different classes unless such series are affected by an amendment to the Articles of Incorporation differently than other series of the same class.

Practical answer.  Generally, the necessary shareholder approval for a venture financing of a California corporation will be (i) a majority of all shares on an as converted to common basis (due to the general stockholder approval requirement to amend the Articles of Incorporation under California law), (ii) a majority of all common stock (due to various provisions triggering a class vote), (iii) a majority of all preferred stock on an as converted to common basis (due to various provisions triggering a class vote), and (iv) any other approval required by the protective provisions in the articles of incorporation, such as a separate series approval or super-majority approval.  The fact that holders of common need to approve an amendment of the Articles of Incorporation to facilitate a typical venture financing for a California corporation is one reason why venture funds prefer Delaware.  Venture funds don’t want common holders to have the ability to block a future financing.

(Side note:  For some reason, it’s “stockholders” in Delaware and “shareholders” in California.  One bit of assorted trivia in case anyone cares.)

Protective provisions give the preferred stock or a series of preferred stock the ability to block certain company actions.

Typical preferred stock protective provisions

Typical preferred stock protective provisions from a term sheet may include:

So long as [any] of the Preferred is outstanding, consent of the holders of at least [50]% of the Preferred will be required for any action that (i) alters any provision of the certificate of incorporation [or the bylaws] if it would [adversely] alter the rights, preferences, privileges or powers of or restrictions on the preferred stock or any series of preferred; (ii) changes the authorized number of shares of preferred stock or any series of preferred; (iii) authorizes or creates any new class or series of shares having rights, preferences or privileges with respect to dividends or liquidation senior to or on a parity with the Preferred or having voting rights other than those granted to the preferred stock generally; (iv) approves any merger, sale of assets or other corporate reorganization or acquisition; (v) approves the purchase, redemption or other acquisition of any common stock of the Company, other than repurchases pursuant to stock restriction agreements approved by the board upon termination of a consultant, director or employee; (vi) declares or pays any dividend or distribution with respect to the [preferred stock (except as otherwise provided in the certificate of incorporation) or] common stock; [or] (vii) approves the liquidation or dissolution of the Company[; (viii)increases the size of the board;] [(ix) encumbers or grants a security interest in all or substantially all of the assets of the Company in connection with an indebtedness of the Company;] [(x) acquires a material amount of assets through a merger or purchase of all or substantially all of the assets or capital stock of another entity;] [or (xi) increases the number of shares authorized for issuance under any existing stock or option plan or creates any new stock or option plan].

These protective provisions are typically contained in the certificate of incorporation of a Delaware company.  I think provisions (i) through (vii) are fairly standard (although I think some of the provisions in brackets are not necessarily standard).  I think that provisions (viii) to (xi), along with anything not listed above, are investor favorable and not as typical in West Coast venture financings.  However, all of these provisions are subject to discussion depending on the negotiation strength of the parties.

Minimum threshold to maintain protective provisions

The company should argue for a minimum number of outstanding shares of preferred stock to maintain protective provision.  For example, if only one share of preferred stock remains outstanding as a result of redemptions or optional conversions to common stock, the holder of the one share should not have the ability to block certain company actions.  However, many protective provisions say that they are effective as long as “any” shares are outstanding.

Voting threshold for protective provisions

The necessary vote to bypass the protective provision is typically set at 50%.  In many cases, the percentage is set higher, such as 66 2/3%, because the investor group consists of multiple investors, and a fund or group of funds that holds a significant amount of the preferred want to ensure that a sufficient percentage of preferred shareholders favor the action.

“Series” protective provisions

Upon a Series B or later financing, the later round may request a separate protective provision.  The company generally would prefer that the preferred stock have a single protective provision as a group, rather than each series of preferred stock having its own protective provision.  A separate protective provision may make sense in a later round of financing where the investor is also receiving a senior (as opposed to pari passu) liquidation preference.  However, the company and investors will want to ensure that a series of preferred stock that represents a small percentage interest of the company or represents a small dollar amount of investment does not receive a separate protective provision.

Board level protective provisions

In some cases, investors request additional board level protective provisions.  The board level protective provisions from the sample investor-favorable NVCA term sheet are:

[So long as [__]% of the originally issued Series A Preferred remains outstanding] the Company will not, without Board approval, which approval must include the affirmative vote of [____] of the Series A Director(s):  (i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee, any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment other than investments in prime commercial paper, money market funds, certificates of deposit in any United States bank having a net worth in excess of $100,000,000 or obligations issued or guaranteed by the United States of America, in each case having a maturity not in excess of [two years]; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[60,000] per year], [or transactions made in the ordinary course of business and pursuant to reasonable requirements of the Company’s business and upon fair and reasonable terms that are approved by a majority of the Board of Directors]; (vii) hire, fire, or change the compensation of the executive officers, including approving any option plans; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; or (ix) sell, transfer, license, pledge or encumber technology or intellectual property, other than licenses granted in the ordinary course of business.

These provisions are not common in West Coast venture financings, but are more common in East Coast venture financings, and standard in venture financings for Cayman incorporated Chinese companies.  As a practical matter, almost all of these provisions will require board approval anyway for good corporate governance.  The issue is whether the Series A director(s) should have the ability to veto these actions despite majority board approval.  This type of control might be reasonable in the context of a joint venture, but may not be reasonable when the Series A director only represents a small fraction of the outstanding shares.

Board level protective provisions are usually placed in the investor rights agreement or document other than the certificate of incorporation.  If these provisions were placed in the articles of incorporation of a California company, the California Secretary of State would reject the articles on the theory that this gives the Series A director more power than other directors.

Drafting issues

Investors wanting protection through protective provisions must make sure that the provisions are drafted carefully and clearly.  In the WatchMark (2004) and Benchmark (2002) cases in Delaware, the certificates of incorporation clearly required the consent of the opposing stockholders to amend their terms as contemplated by a proposed financing. However, the same approval was not necessary for an amendment effected through a merger (with a subsidiary).  Thus, the companies were allowed to achieve a result indirectly that was otherwise prohibited under the protective provisions.  To avoid this result, the certificates of incorporation should have specifically prohibited changes to preferred stock terms “whether effected, directly or indirectly, by means of an amendment, merger, consolidation or otherwise.”

All rights in preferred stock provisions, even if considered standard or customary, must be “expressly and clearly stated.” Courts in Delaware will not imply or presume meaning or language from other provisions of the charter.

In addition, most certificates of incorporation contain a “no impairment” clause. These clauses are provisions that generally prohibit a company from seeking to avoid or impair the rights of the preferred stock. The WatchMark court held that no impairment clauses, like other preferred stock provisions, will be interpreted very strictly. A generic “no-impairment” clause will not provide the preferred stock with any particular protection beyond what is specifically provided in the certificate of incorporation.

A company will want to ensure that certain types of stock issuances do not trigger anti-dilution protection.  This is especially true with full-ratchet anti-dilution protection because the issuance of even 1 share at a price lower than a series of preferred stock will result in an adjustment of the conversion price of all shares of that series of preferred stock.

A list of company-favorable carveouts to anti-dilution protection from a term sheet may include:

There will be no adjustment to the conversion price for issuances of (i) shares issued upon conversion of the Preferred; (ii) shares or options, warrants or other rights issued to employees, consultants or directors in accordance with plans, agreements or similar arrangements, but not to exceed a total of [__________] shares issued after the closing date [or such greater number as unanimously approved by the board]; (iii) shares issued upon exercise of options, warrants or convertible securities existing on the closing date; (iv) shares issued as a dividend or distribution on Preferred or for which adjustment is otherwise made pursuant to the certificate of incorporation (e.g., stock splits); (v) shares issued in connection with a registered public offering; (vi) shares issued or issuable pursuant to an acquisition of another corporation or a joint venture agreement approved by the board; (vii) shares issued or issuable to banks, equipment lessors or other financial institutions pursuant to debt financing or commercial transactions approved by the board; (viii) shares issued or issuable in connection with any settlement approved by the board; (ix) shares issued or issuable in connection with sponsored research, collaboration, technology license, development, OEM, marketing or other similar arrangements or strategic partnerships approved by the board; (x) shares issued to suppliers of goods or services in connection with the provision of goods or services pursuant to transactions approved by the board; or (xi) shares that are otherwise excluded by consent of holders of a majority of the Preferred.

Investors and the company will argue about the scope of the carveouts and potentially the number of shares in any given careveout.  In order for some of the carveouts to apply, the investors may require that the issuance of stock be unanimously approved by the board or approved by the directors nominated by the preferred stock.

A company generally wants flexibility in the carveouts to avoid anti-dilution protection being triggered and bothersome amendments to the certificate of incorporation to waive anti-dilution adjustments.  Although an anti-dilution adjustment may be waived by a specific shareholder, I’m not sure the waiver would be valid against a subsequent holder of the shares that did not know about the waiver.  Therefore, a properly drafted certificate of incorporation should allow for the waiver of an anti-dilution adjustment upon a certain vote of the preferred stock or applicable series of preferred stock, without the need to amend the certificate of incorporation.