To take advantage of escalating first day trading prices for many technology companies, venture capitalists often routinely seek initial public offering (IPO) participation rights as part of their pre-IPO investments. These participation rights, whether in the form of a firm option or a best efforts undertaking, grant the recipient the right to purchase shares offered in the company's IPO on the same terms as other IPO participants. While granting IPO participation rights may initially appear to be legitimate deal sweeteners, the staff of the Securities and Exchange Commission (SEC) has taken the position that such rights may constitute unlawful offers to sell unregistered securities.
The SEC staff views any agreement to grant IPO participation rights made within one year of the issuer's IPO as an "offer" of a security under the Securities Act of 1933. This offer must qualify for an exemption from registration to avoid violating Section 5 of the Securities Act, which prohibits offers of securities for which a registration statement has not been filed. The SEC staff has indicated that a grant of IPO participation rights will not be deemed to be an "offer" of securities subject to Section 5 if the IPO is commenced more than one year after the granting of such rights.
The SEC staff considers IPO participation rights granted within one year of the issuer's IPO to be an ongoing offering of the underlying securities. Any attempt to register the securities underlying the IPO participation rights is viewed by the SEC as a violation of Section 5(c) of the Securities Act, which prohibits an offer of registered securities made prior to filing a registration statement covering such securities. The purchaser of the securities offered in violation of Section 5 is entitled to rescind the purchase for up to one year and the SEC will require the issuer to include appropriate disclosure regarding the possibility of rescission in the issuer's registration statement.
To avoid a Section 5 violation, the issuer must grant the IPO participation rights pursuant to an exemption from registration, such as the Section 4(2) exemption for private placements of securities. The private placement exemption, however, may be destroyed if the grant of IPO participation rights is integrated with the issuer's IPO. Under the integration rules applied by the SEC, separate offerings may be deemed to be part of a single offering which must either be registered under the Securities Act or qualify for an exemption from registration.
Rule 152 under the Securities Act provides a safe harbor from integration for issuers commencing a public offering following the consummation of a private offering. The private offering of the IPO participation rights should be deemed completed for purposes of Rule 152, and not subject to integration with a subsequently commenced IPO, if the issuer complies with the limitations set forth in the Black Box Incorporated and Squadron Ellenoff, Pleasant & Leher SEC no-action letters. In Black Box Incorporated, the SEC stated that a private placement is completed on the date the agreement to purchase securities is signed provided the purchaser's obligations are binding and subject only to satisfaction of conditions that are not within the purchaser's control. In Squadron, Ellenoff, Pleasant & Leher, the SEC cautioned that the position taken in its Black Box no-action letter is limited to unregistered offerings made to Rule 144A qualified institutional investors and no more than two or three large institutional accredited investors.
Although the SEC has yet to adopt a formal policy or rule with respect to IPO participation rights, the staff of the SEC has made clear that it regards any agreement granting these rights within one year of the issuer's IPO as an unlawful offer to sell unregistered securities absent an exemption from registration under the Securities Act. In light of the staff''s current position, issuers presented with a demand for IPO participation rights are well advised to consider:
- conditioning the grant of IPO participation rights on 12 months elapsing before the IPO;
- conditioning exercise of the rights granted on 12 months elapsing (regardless of when the company goes public);
- making sure the investors qualify as either "qualified institutional investors" or "institutional accredited investors," and
- offering restricted shares with resale registration rights instead of IPO participation rights.