Presented by Bart Greenberg
Haynes and Boone, LLP
OC Tech Coast Angels
Member Education Session
April 25, 2012
© 2010 Haynes and Boone, LLP

© 2010 Haynes and Boone, LLP

Market Conditions Impact Terms
• Shortage of willing investors leads to aggressive terms
• Desire by Investors to “correct” prior valuation errors ( i.e.
, overvaluations) and pull up returns on whole portfolio may lead to more aggressive terms
• Desire by Investors to avoid future errors may lead to more aggressive terms, such as by imposing self-adjusting valuations, guaranteed returns, downside protection, more bridge financings
© 2010 Haynes and Boone, LLP

Prior Rounds Impact Terms
• Severe down round/cramdown (leads to most aggressive terms)
• Flat round (could be considered a
win
in unfavorable market conditions)
• Up round (best chance to get reasonable or favorable terms)
© 2010 Haynes and Boone, LLP

Valuation
• Means many different things
• $2.5 million pre-money with $2.5 million new money could mean:
– Original investors get $2.5 million if sold for $5 million
– Original investors + optionees (current or all future) get $2.5 million if sold for $5 million
– Original investors + founders and optionees (current or all future) will each have equivalent ownership percentages if
“ go public ” (and convert to common stock) – but not necessarily under other liquidity scenarios
• Conversion concept vs. liquidation concept
© 2010 Haynes and Boone, LLP

© 2010 Haynes and Boone, LLP

Dividends
Considerations
• Priority of Payment
•Common
•Other Preferred
• Dividend/Coupon Rate
• Cumulative vs.
• Non-Cumulative
• Form of Payment
•Cash “coupon”
•Payment-in-Kind Securities
(PIKs)
© 2010 Haynes and Boone, LLP

Dividends
Pre-
Bubble
• Non-mandatory, non-cumulative
8% per year
Post-
Bubble
• Mandatory, cumulative 8% per year
• More Extreme : Mandatory, cumulative, payable in kind up to 15% per year
© 2010 Haynes and Boone, LLP

Dividends
“Annual $_____ per share dividend on the Series ___
Preferred Stock, payable when and if declared by Board, prior to any dividends paid to the Common Stock; dividends are [not] cumulative. No dividends will be declared or paid on the Common Stock unless and until a like dividend has been declared and paid on the Series ___ Preferred Stock.”
© 2010 Haynes and Boone, LLP

Liquidation Preference
Considerations
• Should the holder have a
“preferred” return before other equity holders?
• When should the preference apply ( e.g.
, non-conversion contexts such as a merger or upon liquidation)?
• Key Characteristics:
• Priority of Distribution
• Amount of Preference
• Participation Rights
© 2010 Haynes and Boone, LLP

Liquidation Preference
A
Return cost only, or else convert
B
Cost + annual
ROI
(“AROI”) or else convert
C
Cost + AROI to PS; same amount per share to CS; then pro rata participation
D
Cost + AROI to PS; negotiated amount to
CS; then pro rata participation
E F
Cost +
AROI to PS; cost + AROI to CS; then pro rata participation
Cost +
AROI to PS; then pro rata up to multiple of
PS cost; or else convert
G H
Cost + AROI to PS; then pro rata participation
Multiple of cost to PS; then pro rata participation
More favorable to common holders
More favorable to preferred holders
© 2010 Haynes and Boone, LLP

Liquidation Preference
Pre-
Bubble
• • 1X purchase price, plus participation rights up to 3X
Post-
Bubble
• 1X to 3X with some participation rights
(the lower the X, the greater the participation rights)
• Participation Rights are sometimes subject to a management carve out
• More extreme : 3X purchase price, plus participation rights with no cap
© 2010 Haynes and Boone, LLP

The “Waterfall”
First: Creditors Satisfied
Second: Distribution to holders of preferred stock
Third: Distribution to holders of common stock (with possible participation by holders of preferred stock)
© 2010 Haynes and Boone, LLP

The “Waterfall”
(an illustration)
Amount Available for Distribution: $15,000,000
Term Sheet: 1x preference for Series A, 1x participation) First Second Third
Creditors
Series A*
0
0
0 0
$4,100,000 $4,100,000
Common Stock
(including option pool)
0 0 $6,800,000
Total
$0.00
$8,200,000
$6,800,000
$15,000,000
Term Sheet: 3x preference for Series A, full participation
First Second Third Total
Creditors
Series A*
Common Stock
(including option pool)
0
0
0
0 0
$12,300,000 $1,350,000
0 $1,350,000
$0.00
$13,650,000
$1,350,000
$15,000,000

Liquidation Preference
“ First pay the original purchase price [plus premium] plus accrued dividends (if any) on each share of Series ___
Preferred Stock. Thereafter, Series ___ Preferred Stock participates with Common Stock on an as-converted basis.
”
© 2010 Haynes and Boone, LLP

Liquidation Preference
“ First pay the original purchase price plus accrued dividends (if any) on each share of Series ___
Preferred Stock. Thereafter, Series ___ Preferred
Stock participates with Common Stock on an asconverted basis until the holders of Series ___
Preferred Stock receive an aggregate of [ _ ]X original purchase price.
”
© 2010 Haynes and Boone, LLP

Liquidation Preference
“ First pay the original purchase price [plus premium?] plus accrued dividends on each share of Series ___ Preferred Stock. The balance to holders of Common Stock.
”
© 2010 Haynes and Boone, LLP

Redemption
Considerations
• Who can trigger?
• Percentage of preferred holders/individually
• Company (rare)
• Priority among other holders
• Staging of Redemption
• Device to force conversion
• Form of Payment
• Legal Restrictions
© 2010 Haynes and Boone, LLP

Redemption
Pre-
Bubble
• Not Common
Post-
Bubble
• At option of holders after 5 years at purchase price plus accrued dividends
© 2010 Haynes and Boone, LLP

Redemption
“ Series ___ Preferred Stock redeemable at the election of holders [of 66-2/3rds] of the outstanding
Series ___ Preferred Stock] on or after
____________ at a price equal to the original purchase price [plus accrued dividends] [plus ___% per year] or as soon thereafter as legally permissible.
”
© 2010 Haynes and Boone, LLP

Redemption
“ [ See Example 1 ], to the extent of 1/3 of the shares of Series ___ Preferred Stock on the [____], [____] and [____] anniversary dates of the Closing or as soon thereafter as legally permissible[, but in no event will more than 1/3 of the outstanding shares of
Series ___ Preferred Stock (plus 1/3 of the aggregate accrued dividends) be redeemed in any
12 month period.] ”
© 2010 Haynes and Boone, LLP

Conversion Rights
Considerations
• The number of shares of common stock, if any, into which preferred stock converts: preferred stock share price (fixed)
Conversion Price
• Typically Based on Certain
Triggering Events
• Election by percentage of holders of preferred stock
• IPO
© 2010 Haynes and Boone, LLP

Antidilution Adjustments
Considerations
• Way to “fix” earlier valuation errors on conversion ( i.e
. allocate most or all of risk of down round to common stock)
• Three Types of Adjustments
• “Full Ratchet”
• “Narrow-Based” Weighted
Average
• “Broad-Based” Weighted
Average
• Specified Exceptions
© 2010 Haynes and Boone, LLP

Antidilution Adjustments
Pre-
Bubble
• Standard broad-based weighted average adjustment
Post-
Bubble
• Narrow-based weighted average adjustment
• More extreme: Full ratchet adjustment for a period; then narrow or broadbased weighted average adjustment
© 2010 Haynes and Boone, LLP

Antidilution Adjustments
(an illustration)
Scenario:
Common Stock Outstanding
Series A Preferred
Series B Preferred
Adjustments (Upon Series B)
1,000,000 shares
1,000,000 shares at $1.00
(or $1,000,000)
1,000,000 shares at 75¢
(or $750,000)
• Series A Conversion Ratio Prior to Series B = 1:1
• Upon Series B, Series A Conversion Ratio adjusted as follows:
Type of Adjustment
Full Ratchet
Narrow-Based
Broad-Based
Conversion Ratio
1:1.333
1:1.143
1:1.091
© 2010 Haynes and Boone, LLP

Antidilution Adjustments -
• If stockholder does not purchase pro rata share in subsequent offering, stockholder loses benefit of antidilution provisions.
• In extreme cases, non-participating stockholders must convert to common stock
(sometimes at less than 1:1), thereby losing protective provisions of preferred stock.
• “Pay to Play” minimizes fears of major investors that small investors will benefit by having major investors continue providing needed equity, particularly in troubled economic times.
© 2010 Haynes and Boone, LLP

Antidilution Adjustments
“ Conversion ratio for Series ___
Preferred Stock adjusted on
[ratchet/[broad or narrow] weighted average] basis in the event of a dilutive issuance [so long as investor purchases full pro rata share of dilutive issuance (
“ pay to play
”
).]
”
© 2010 Haynes and Boone, LLP

Antidilution Adjustments
“ Any Existing Holder that does not fund its Pro
Rata Amount by the Initial Closing shall have its
Equity Securities automatically converted at a ratio of 10 to 1 to a new series of Common Stock that retains no voting rights; provided however, that to the extent an Existing Holder partially meets its Pro
Rata Amount, such holder shall retain a corresponding portion of its Equity Securities, and may choose the respective portion to retain.
”
© 2010 Haynes and Boone, LLP

Antidilution Adjustments
“ Dilutive issuance ” shall not include: (i) up to
______ shares of Common Stock issued pursuant to a stock option plan approved [unanimously/by a majority] of the Board of Directors; (ii) Common
Stock issued upon conversion of the Preferred
Stock; (iii) stock issued in any IPO in which the
Preferred Stock is converted into Common Stock; or (iv) stock issued in connection with mergers or acquisitions approved [unanimously/by a majority] of the Board of Directors.
”
© 2010 Haynes and Boone, LLP

Protective Provisions
Considerations
• Control Provisions
• Board Seats
• Voting Agreements
• Other Protections
© 2010 Haynes and Boone, LLP

Protective Provisions
Pre-
Bubble
• Investor approval of: senior securities, sale of company, payment of dividends, liquidation, change of rights
Post-
Bubble
• Investor approval of senior or pari passu securities, sale of company, payment of dividends, change of rights, change of business, incurrence of debt over specified limit, annual budgets and variances, acquisitions of other businesses, grant of exclusive rights in technology, appointment or termination of CEO
© 2010 Haynes and Boone, LLP

Protective Provisions
“ Votes on an as-converted basis, but also has
[class/series] vote as provided by law and on (i) the creation of any senior [or pari passu] security, [(ii) payment of dividends on [Common Stock/on any class of Stock]],[(iii) any redemptions or repurchases of Common Stock or
Preferred Stock [except for purchases at cost upon termination of employment], (iv) any liquidation, dissolution or winding up of the Company; (v) any merger, acquisition, recapitalization, reorganization or sale of all or substantially all of the assets of the Company, (vi) an
© 2010 Haynes and Boone, LLP

Protective Provisions
increase or decrease in the number of authorized shares of Series [ _ ] Preferred Stock or Common Stock, (vii) any
[adverse] change to the rights, preferences and privileges of the Series [ _ ] Preferred, [(viii) an increase or decrease in the size of the Board], [(ix) [material] amendments or repeal of any provision of the Company
’ s Charter or
Bylaws]; [(x) the issuance of any additional shares of capital stock (or options) to the Company ’ s founders,] and
[(xi)] authorization of any amount of indebtedness in excess of $____.]
”
© 2010 Haynes and Boone, LLP

© 2010 Haynes and Boone, LLP

Representation and Warranties
Considerations
• Scope/Coverage
• By the Company
• By the Founders
( e.g.
, technology)
© 2010 Haynes and Boone, LLP

Closings
Considerations
• Lump Sum at Closing
• Staging of Investment
• Passage of Time
• Milestones
© 2010 Haynes and Boone, LLP

Closings
Pre-
Bubble
• Single Tranche Investment
Post-
Bubble
• Single Tranche Investment
• More Extreme: Milestone-Based Tranches
© 2010 Haynes and Boone, LLP

Conditions to Closing
Considerations
• Satisfactory Completion of
Due Diligence
• Exemption or Qualification of Shares under Applicable
Securities Laws
• Filing of Amendment to
Charter to Establish Rights and Preferences of the
Preferred Stock
• Opinion of Counsel to the
Company
© 2010 Haynes and Boone, LLP

Employee Matters
Considerations
• Employment
Agreements with
Founders
• Obligation for All
Employees/Consultants to Enter into Company’s
Standard Inventions and Proprietary
Information Agreement
© 2010 Haynes and Boone, LLP

Expenses
Considerations
• Company Typically
Pays Reasonable Fees and Expenses of
Investors’ Counsel
• Consider Cap on
Obligation
© 2010 Haynes and Boone, LLP

© 2010 Haynes and Boone, LLP

Registration Rights
Considerations
• Types of Registration Rights
• Demand Rights
• Piggyback Rights
• S3 Rights
• Termination of Rights
• Limitation on Subsequent
Rights
• Absolute prohibition
• Permitted if Subordinate
• Allocation of Expenses
© 2010 Haynes and Boone, LLP

Registration Rights
“ Beginning on the earlier of [3-5] years from
Closing, or [three/six] months after the Company ’ s
IPO, [1-2] demand registrations [for underwritten public offerings] upon initiation by holders of at least [30]% of outstanding Series ___ Preferred
Stock (or Common Stock issuable upon conversion of the Series ___ Preferred Stock or any combination thereof) for aggregate proceeds in excess of $_______.
”
© 2010 Haynes and Boone, LLP

Registration Rights
“ Investors in Series __ Preferred Stock will have
[unlimited] piggyback registration rights subject to pro rata cutback at the underwriter
’ s discretion.
Full cutback upon the IPO; [30% minimum inclusion thereafter]. Investors will not be subject to cutback unless all other selling shareholders are excluded from registration.
”
© 2010 Haynes and Boone, LLP

Registration Rights
“ [Unlimited] S-3 Registrations of at least $500,000 each [upon initiation by holders of at least [20%] of the outstanding Series ___ Preferred Stock (or
Common Stock issuable upon conversion of the
Series ___ Preferred Stock or any combination thereof)]. [No more than two S-3 Registrations in any 12 month period.] ”
© 2010 Haynes and Boone, LLP

Registration Rights
“ Registration rights terminate [(i) [3-7] years after the IPO;] or (ii) when [the Company is publicly traded and] all shares can be sold [in any 90-day period] under Rule 144, whichever occurs first.][, provided that this clause (ii) shall not apply to any
5% holder deemed to be an affiliate of the
Company.] ”
© 2010 Haynes and Boone, LLP

Market Stand-Off
Considerations
• Time of Lock-Up
• Who Controls Decision
• Investors
• Underwriter
• Equal Application
• Obligation to Execute
Underwriter’s Form of
Lock-Up Agreement
© 2010 Haynes and Boone, LLP

Market Stand-Off
“ Prior to the Closing, all shareholders shall agree that in connection with the IPO not to sell any shares of Preferred
Stock or Common Stock issuable upon conversion thereof for a period of up to [180] days following the IPO
[(provided directors and officers of the Company and [5]% shareholders agree to the same lock-up. Such shareholders also shall agree to sign the underwriter
’ s standard lock-up agreement reflecting the foregoing.
”
© 2010 Haynes and Boone, LLP

Right of First Offer
Considerations
• Who Owns the Right?
• All holders of preferred stock
• Holders of at least [____] percentage of preferred stock
• Determination of
Percentage
© 2010 Haynes and Boone, LLP

Right of First Offer
Pre-
Bubble
• Right to maintain pro-rata ownership in later financings
Post-
Bubble
• Right to maintain pro-rata ownership in later financings
• More Extreme : right to invest 2X prorata ownership in later financings
© 2010 Haynes and Boone, LLP

Right of First Offer
“ The Investors shall have a pro rata right, based on their percentage equity ownership of [Preferred
Stock] [Common Stock, on a fully diluted basis], to participate in subsequent financings of the
Company (excluding [ See List of Specified
Exceptions to Antidilution Adjustments ]. Such right will terminate immediately prior to a Qualified
Public Offering.
”
© 2010 Haynes and Boone, LLP

Financial Information
Considerations
• Financial Statements
• [Audited] annual statements
• Unaudited monthly/quarterly statements
• [1-5] Year Projections
• Other Material
Information
© 2010 Haynes and Boone, LLP

Board of Directors
Considerations
• Determination of Authorized
Number of Directors
• Voting Agreement Among
Shareholders
• Class Votes
• Specific Identification
• Independent Members of
Board
• Use of an Advisory Board
• Board Observation Rights
© 2010 Haynes and Boone, LLP

Board of Directors
“ [The Company ’ s Articles of Incorporation shall provide that the] Board shall consist of ____ members, with the holders of a majority of Series ___ Preferred Stock entitled to elect
____ member(s) [and the holders of a majority of the
Common Stock entitled to elect ____ member(s)]. [The
Company and the Investors intend to select ____ outside director(s) with relevant industry experience as soon as possible after Closing.] Board composition at Closing shall be _______, [with vacancy].
”
© 2010 Haynes and Boone, LLP

© 2010 Haynes and Boone, LLP

Restrictions on Transferability
© 2010 Haynes and Boone, LLP

Rights of First Refusal
Pre-
Bubble
• Right to purchase any shares proposed to be sold by employees
Post-
Bubble
• Right to purchase any shares proposed to be sold by employees
• More extreme : right to purchase any shares proposed to be sold by any shareholder
© 2010 Haynes and Boone, LLP

Rights of First Refusal
“ Any [vested] Common Stock acquired by [employees] [founders]
[shareholders] shall be subject to a right of first refusal of [the Company]
[the Investors] to repurchase any stock, at the bona fide offer price.
”
© 2010 Haynes and Boone, LLP

Co-Sale Rights
Pre-
Bubble
• Right to sell alongside any founder that sells shares
Post-
Bubble
• Right to sell alongside any founder that sells shares
• More extreme : Right to sell alongside any shareholder that sells shares
© 2010 Haynes and Boone, LLP

Co-Sale Rights
“ Until the IPO, the Investors also shall have the right to participate on a pro rata basis in transfers of any shares of [Preferred Stock or] Common Stock [held by the Founders or any [major] shareholder], [and a right of first refusal on such transfers, [subordinate to] [prior to] the Company
’ s right of first refusal.
[Any shares not subscribed for by an Investor may be reallocated among the other eligible Investors.] ”
© 2010 Haynes and Boone, LLP

Drag-Along Rights
Pre-
Bubble
• None
Post-
Bubble
• None
• More extreme : Right to force
• shareholders to sell company upon board and majority shareholder vote
© 2010 Haynes and Boone, LLP

Drag-Along Rights
“ So long as the Investors own shares of Series ___
Preferred Stock representing at least [25]% of the
Company
’ s Common Stock on a fully-diluted basis
(as determined by ]), the Investors shall have drag-along rights with respect to securities of any of the Founders or principal Common Stock holders in the event of a proposed sale of the Company to a third party (whether structured as a merger, reorganization, asset sale or otherwise).
”
© 2010 Haynes and Boone, LLP

Founder Vesting
Pre-
Bubble
• 3- or 4-year vesting with some up-front vesting
Post-
Bubble
• 4-year vesting with no-up front vesting
• More extreme : 5-year vesting and/or performance standards
© 2010 Haynes and Boone, LLP

Founder Vesting
“ If a Founder voluntarily terminates his or her employment with the Company or is terminated for cause, then the [Company/the Investors] will have the right to repurchase 100% of the Founders ’ shares less [1/48]th of those shares for each complete month of service the employee served with the Company.
”
© 2010 Haynes and Boone, LLP

Founder Vesting
“ Upon termination of the employment of the shareholder, with or without cause, the Company may repurchase at cost any shares subject to the repurchase option. The Company ’ s repurchase option shall lapse by [___ percent (__%)] of the unvested portion in the event such Founder is terminated without Cause or Constructively
Terminated as a result of and within six (6) months prior to or twelve (12) months following a Change in
Control.
”
© 2010 Haynes and Boone, LLP

© 2010 Haynes and Boone, LLP

Capitalization
“ The Company ’ s capital structure before and after the Closing is set forth below [including founder ’ s shares to be issued prior to the Closing]:
”
Security
Common – Founders
Common – Employee Stock Pool
Issued
Unissued
Common – Warrants to Debt Holders
Series A Preferred
Total
Pre-Financing
# of Shares
4,077,670
%
73.7
--
1,456,311
--
--
26.3
--
--
5,533,981
--
100.0
Post-Financing
# of Shares
4,077,670
%
40.5
--
1,456,311
75,000
--
14.5
0.7
4,466,019
10,075,000
44.3
100.0
© 2010 Haynes and Boone, LLP

Publicity
• “ The Company will not discuss the terms of this Term
Sheet with any person other than key officers, members of the Board of Directors of the Company or the Company ’ s accountants or attorneys without the written consent of Investor, except as required by law.
In addition, the Company shall not use the Investor
’ s name in any manner, context or format (including, reference on or links to websites, press releases, etc.) without the prior review and approval of Investor.
”
© 2010 Haynes and Boone, LLP

No Shop
• “ From the signing date hereof until 5:00 P.M. Pacific
Standard Time on __________, the Company and the
Founders agree that they shall not solicit, encourage others to solicit, encourage or accept any offers for the purchase or acquisition of any capital stock of the Company, of all or any substantial part of the assets of the Company, or proposals for any merger or consolidation involving the
Company, and they shall not negotiate with or enter into any agreement or understanding with any other person with respect to any such transaction.
”
© 2010 Haynes and Boone, LLP

© 2010 Haynes and Boone, LLP
Bart Greenberg
Partner
18100 Von Karman Avenue, Suite 750
Irvine, California 92612 bart.greenberg@haynesboone.com
949.202.3037
70