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Negotiating the Preferred Stock Term Sheet
    in Today’s Market Place
    Presented by Bart Greenberg
    Haynes and Boone, LLP

    OCTANe Foundation for Innovation’s Building Blocks Series

    July 21, 2011




© 2010 Haynes and Boone, LLP
Certain Preliminary Matters




© 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
Defining the Terms of the
                      Preferred Stock




© 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-         • Non-mandatory, non-cumulative
                  Bubble        8% per year



                  Post-        • Mandatory, cumulative 8% per year
                               • More Extreme: Mandatory, cumulative,
                  Bubble         payable in kind up to 15% per year




© 2010 Haynes and Boone, LLP
Dividends

            Example

             “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                   B         C              D               E               F              G               H
Return cost         Cost +     Cost + AROI     Cost + AROI     Cost +          Cost +         Cost + AROI     Multiple of
only, or else       annual     to PS; same     to PS;          AROI to PS;     AROI to PS;    to PS; then     cost to PS;
convert             ROI        amount per      negotiated      cost + AROI     then pro       pro rata        then pro
                    (“AROI”)   share to CS;    amount to       to CS; then     rata up to     participation   rata
                    or else    then pro rata   CS; then pro    pro rata        multiple of                    participation
                    convert    participation   rata            participation   PS cost; or
                                               participation                   else convert




                                   More favorable to                    More favorable to
                                   common holders                       preferred holders




© 2010 Haynes and Boone, LLP
Liquidation Preference


              Pre-             •• 1X purchase price, plus participation
              Bubble              rights up to 3X




                               • 1X to 3X with some participation rights
               Post-             (the lower the X, the greater the
               Bubble            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                       Total

      Creditors                 0          0             0           $0.00
      Series A*                 0      $4,100,000    $4,100,000   $8,200,000

      Common Stock              0          0         $6,800,000   $6,800,000
      (including option
      pool)                                                       $15,000,000

    Term Sheet: 3x preference for Series A, full participation
                               First     Second        Third         Total

      Creditors                 0          0             0           $0.00
      Series A*                 0      $12,300,000   $1,350,000   $13,650,000

      Common Stock              0          0         $1,350,000    $1,350,000
      (including option
      pool)                                                       $15,000,000




            * Original investment of $4,100,000
© 2010 Haynes and Boone, LLP
Liquidation Preference

   Example 1: Full Participation

                    “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

      Example 2: Cap on Participation Rights

            “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 as-
            converted basis until the holders of Series ___
            Preferred Stock receive an aggregate of [ _ ]X
            original purchase price.”




© 2010 Haynes and Boone, LLP
Liquidation Preference

      Example 3: Non-Participating

            “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-         • Not Common
                  Bubble



                  Post-        • At option of holders after 5 years at
                  Bubble         purchase price plus accrued dividends




© 2010 Haynes and Boone, LLP
Redemption

   Example 1: Lump Sum
            “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

   Example 2: Three Tranches
            “[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-          • Standard broad-based weighted
                 Bubble          average adjustment



                  Post-        • Narrow-based weighted average
                  Bubble         adjustment
                               • More extreme: Full ratchet adjustment
                                 for a period; then narrow or broad-
                                 based weighted average adjustment




© 2010 Haynes and Boone, LLP
Antidilution Adjustments (an illustration)

  Scenario:
              Common Stock Outstanding      1,000,000 shares

              Series A Preferred            1,000,000 shares at $1.00
                                                     (or $1,000,000)
              Series B Preferred            1,000,000 shares at 75¢
                                                     (or $750,000)
  Adjustments (Upon Series B)
          • Series A Conversion Ratio Prior to Series B = 1:1
          • Upon Series B, Series A Conversion Ratio adjusted as follows:
             Type of Adjustment          Conversion Ratio
             Full Ratchet                    1:1.333
             Narrow-Based                    1:1.143
             Broad-Based                     1:1.091



© 2010 Haynes and Boone, LLP
Antidilution Adjustments - Pay to Play

     • 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

   Example 1: With Pay to Play
            “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

   Example 2: Pay to Play with Cram Down
            “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

   Example 3: Specified Exceptions
            “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

                               • Investor approval of: senior securities,
                Pre-
                                 sale of company, payment of dividends,
                Bubble
                                 liquidation, change of rights


                               • Investor approval of senior or pari
                               passu
                                 securities, sale of company, payment of
                Post-            dividends, change of rights, change of
                                 business, incurrence of debt over
                Bubble           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

   Example
            “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

     Example (cont.)
               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
Defining the Terms of the
             Stock Purchase Agreement




© 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
                               • When will the Investors
                                 go “at-risk”?
                                 • Lump Sum at Closing
                                 • Staging of Investment
                                    • Passage of Time
                                    • Milestones




© 2010 Haynes and Boone, LLP
Closings



                Pre-
                               • Single Tranche Investment
                Bubble



                 Post-         • Single Tranche Investment
                 Bubble        • 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
Defining the Terms of the
           Investors’ Rights Agreement




© 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

   Example 1: Demand 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

   Example 2: Piggyback 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

   Example 3: S3 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

   Example 4: Termination

         “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

   Example
            “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-           • Right to maintain pro-rata ownership in
                Bubble           later financings




                Post-          • Right to maintain pro-rata ownership in
                Bubble           later financings
                               • More Extreme: right to invest 2X pro-
                                 rata ownership in later financings




© 2010 Haynes and Boone, LLP
Right of First Offer

   Example
            “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

   Example
            “[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
Defining the Terms of
                           Other Agreements




© 2010 Haynes and Boone, LLP
Restrictions on Transferability



     • Rights of First Refusal
     • Co-Sale Rights
     • Drag-Along Rights



© 2010 Haynes and Boone, LLP
Rights of First Refusal


                  Pre-         • Right to purchase any shares proposed
                  Bubble         to be sold by employees




                               • Right to purchase any shares proposed
                  Post-          to be sold by employees
                  Bubble       • More extreme: right to purchase any
                                 shares proposed to be sold by any
                                 shareholder




© 2010 Haynes and Boone, LLP
Rights of First Refusal

      Example
            “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-           • Right to sell alongside any founder that
                Bubble           sells shares




                               • Right to sell alongside any founder
                 Post-           that sells shares
                 Bubble        • More extreme: Right to sell alongside
                                 any shareholder that sells shares




© 2010 Haynes and Boone, LLP
Co-Sale Rights

   Example
            “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-            • None
               Bubble



                               • None
                Post-          • More extreme: Right to force
                Bubble         • shareholders to sell company upon
                                 board and majority shareholder vote




© 2010 Haynes and Boone, LLP
Drag-Along Rights

   Example
            “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-           • 3- or 4-year vesting with some up-front
                Bubble           vesting




                               • 4-year vesting with no-up front vesting
                 Post-
                               • More extreme: 5-year vesting and/or
                 Bubble
                                 performance standards




© 2010 Haynes and Boone, LLP
Founder Vesting

   Example 1: Single Trigger
            “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

   Example 2: Double Trigger
            “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
Certain Term Sheet Terms




© 2010 Haynes and Boone, LLP
Capitalization

   Example
            “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]:”

                                                         Pre-Financing                  Post-Financing
             Security                            # of Shares            %     # of Shares               %
             Common – Founders                   4,077,670             73.7   4,077,670                40.5
             Common – Employee Stock Pool
                   Issued                            --                --         --                   --
                   Unissued                      1,456,311            26.3    1,456,311               14.5
             Common – Warrants to Debt Holders       --                 --      75,000                 0.7
             Series A Preferred                      --                 --    4,466,019               44.3
             Total                               5,533,981            100.0   10,075,000              100.0




© 2010 Haynes and Boone, LLP
Publicity

   Example
     • “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

   Example
     • “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
Questions?

                                   Bart Greenberg
                                          Partner

                               18100 Von Karman Avenue, Suite 750
                                      Irvine, California 92612

                               bart.greenberg@haynesboone.com
                                         949.202.3037
                                                                    70
© 2010 Haynes and Boone, LLP

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Negotiating the Term Sheet in Today's Market

  • 1. Negotiating the Preferred Stock Term Sheet in Today’s Market Place Presented by Bart Greenberg Haynes and Boone, LLP OCTANe Foundation for Innovation’s Building Blocks Series July 21, 2011 © 2010 Haynes and Boone, LLP
  • 2. Certain Preliminary Matters © 2010 Haynes and Boone, LLP
  • 3. 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
  • 4. 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
  • 5. 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
  • 6. Defining the Terms of the Preferred Stock © 2010 Haynes and Boone, LLP
  • 7. 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
  • 8. Dividends Pre- • Non-mandatory, non-cumulative Bubble 8% per year Post- • Mandatory, cumulative 8% per year • More Extreme: Mandatory, cumulative, Bubble payable in kind up to 15% per year © 2010 Haynes and Boone, LLP
  • 9. Dividends Example “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
  • 10. 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
  • 11. Liquidation Preference A B C D E F G H Return cost Cost + Cost + AROI Cost + AROI Cost + Cost + Cost + AROI Multiple of only, or else annual to PS; same to PS; AROI to PS; AROI to PS; to PS; then cost to PS; convert ROI amount per negotiated cost + AROI then pro pro rata then pro (“AROI”) share to CS; amount to to CS; then rata up to participation rata or else then pro rata CS; then pro pro rata multiple of participation convert participation rata participation PS cost; or participation else convert More favorable to More favorable to common holders preferred holders © 2010 Haynes and Boone, LLP
  • 12. Liquidation Preference Pre- •• 1X purchase price, plus participation Bubble rights up to 3X • 1X to 3X with some participation rights Post- (the lower the X, the greater the Bubble 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
  • 13. 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
  • 14. The “Waterfall” (an illustration) Amount Available for Distribution: $15,000,000 Term Sheet: 1x preference for Series A, 1x participation) First Second Third Total Creditors 0 0 0 $0.00 Series A* 0 $4,100,000 $4,100,000 $8,200,000 Common Stock 0 0 $6,800,000 $6,800,000 (including option pool) $15,000,000 Term Sheet: 3x preference for Series A, full participation First Second Third Total Creditors 0 0 0 $0.00 Series A* 0 $12,300,000 $1,350,000 $13,650,000 Common Stock 0 0 $1,350,000 $1,350,000 (including option pool) $15,000,000 * Original investment of $4,100,000 © 2010 Haynes and Boone, LLP
  • 15. Liquidation Preference Example 1: Full Participation “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
  • 16. Liquidation Preference Example 2: Cap on Participation Rights “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 as- converted basis until the holders of Series ___ Preferred Stock receive an aggregate of [ _ ]X original purchase price.” © 2010 Haynes and Boone, LLP
  • 17. Liquidation Preference Example 3: Non-Participating “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
  • 18. 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
  • 19. Redemption Pre- • Not Common Bubble Post- • At option of holders after 5 years at Bubble purchase price plus accrued dividends © 2010 Haynes and Boone, LLP
  • 20. Redemption Example 1: Lump Sum “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
  • 21. Redemption Example 2: Three Tranches “[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
  • 22. 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
  • 23. 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
  • 24. Antidilution Adjustments Pre- • Standard broad-based weighted Bubble average adjustment Post- • Narrow-based weighted average Bubble adjustment • More extreme: Full ratchet adjustment for a period; then narrow or broad- based weighted average adjustment © 2010 Haynes and Boone, LLP
  • 25. Antidilution Adjustments (an illustration) Scenario: Common Stock Outstanding 1,000,000 shares Series A Preferred 1,000,000 shares at $1.00 (or $1,000,000) Series B Preferred 1,000,000 shares at 75¢ (or $750,000) Adjustments (Upon Series B) • Series A Conversion Ratio Prior to Series B = 1:1 • Upon Series B, Series A Conversion Ratio adjusted as follows: Type of Adjustment Conversion Ratio Full Ratchet 1:1.333 Narrow-Based 1:1.143 Broad-Based 1:1.091 © 2010 Haynes and Boone, LLP
  • 26. Antidilution Adjustments - Pay to Play • 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
  • 27. Antidilution Adjustments Example 1: With Pay to Play “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
  • 28. Antidilution Adjustments Example 2: Pay to Play with Cram Down “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
  • 29. Antidilution Adjustments Example 3: Specified Exceptions “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
  • 30. Protective Provisions Considerations • Control Provisions • Board Seats • Voting Agreements • Other Protections © 2010 Haynes and Boone, LLP
  • 31. Protective Provisions • Investor approval of: senior securities, Pre- sale of company, payment of dividends, Bubble liquidation, change of rights • Investor approval of senior or pari passu securities, sale of company, payment of Post- dividends, change of rights, change of business, incurrence of debt over Bubble 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
  • 32. Protective Provisions Example “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
  • 33. Protective Provisions Example (cont.) 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
  • 34. Defining the Terms of the Stock Purchase Agreement © 2010 Haynes and Boone, LLP
  • 35. Representation and Warranties Considerations • Scope/Coverage • By the Company • By the Founders (e.g., technology) © 2010 Haynes and Boone, LLP
  • 36. Closings Considerations • When will the Investors go “at-risk”? • Lump Sum at Closing • Staging of Investment • Passage of Time • Milestones © 2010 Haynes and Boone, LLP
  • 37. Closings Pre- • Single Tranche Investment Bubble Post- • Single Tranche Investment Bubble • More Extreme: Milestone-Based Tranches © 2010 Haynes and Boone, LLP
  • 38. 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
  • 39. 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
  • 40. Expenses Considerations • Company Typically Pays Reasonable Fees and Expenses of Investors’ Counsel • Consider Cap on Obligation © 2010 Haynes and Boone, LLP
  • 41. Defining the Terms of the Investors’ Rights Agreement © 2010 Haynes and Boone, LLP
  • 42. 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
  • 43. Registration Rights Example 1: Demand 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
  • 44. Registration Rights Example 2: Piggyback 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
  • 45. Registration Rights Example 3: S3 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
  • 46. Registration Rights Example 4: Termination “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
  • 47. 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
  • 48. Market Stand-Off Example “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
  • 49. 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
  • 50. Right of First Offer Pre- • Right to maintain pro-rata ownership in Bubble later financings Post- • Right to maintain pro-rata ownership in Bubble later financings • More Extreme: right to invest 2X pro- rata ownership in later financings © 2010 Haynes and Boone, LLP
  • 51. Right of First Offer Example “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
  • 52. Financial Information Considerations • Financial Statements • [Audited] annual statements • Unaudited monthly/quarterly statements • [1-5] Year Projections • Other Material Information © 2010 Haynes and Boone, LLP
  • 53. 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
  • 54. Board of Directors Example “[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
  • 55. Defining the Terms of Other Agreements © 2010 Haynes and Boone, LLP
  • 56. Restrictions on Transferability • Rights of First Refusal • Co-Sale Rights • Drag-Along Rights © 2010 Haynes and Boone, LLP
  • 57. Rights of First Refusal Pre- • Right to purchase any shares proposed Bubble to be sold by employees • Right to purchase any shares proposed Post- to be sold by employees Bubble • More extreme: right to purchase any shares proposed to be sold by any shareholder © 2010 Haynes and Boone, LLP
  • 58. Rights of First Refusal Example “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
  • 59. Co-Sale Rights Pre- • Right to sell alongside any founder that Bubble sells shares • Right to sell alongside any founder Post- that sells shares Bubble • More extreme: Right to sell alongside any shareholder that sells shares © 2010 Haynes and Boone, LLP
  • 60. Co-Sale Rights Example “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
  • 61. Drag-Along Rights Pre- • None Bubble • None Post- • More extreme: Right to force Bubble • shareholders to sell company upon board and majority shareholder vote © 2010 Haynes and Boone, LLP
  • 62. Drag-Along Rights Example “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
  • 63. Founder Vesting Pre- • 3- or 4-year vesting with some up-front Bubble vesting • 4-year vesting with no-up front vesting Post- • More extreme: 5-year vesting and/or Bubble performance standards © 2010 Haynes and Boone, LLP
  • 64. Founder Vesting Example 1: Single Trigger “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
  • 65. Founder Vesting Example 2: Double Trigger “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
  • 66. Certain Term Sheet Terms © 2010 Haynes and Boone, LLP
  • 67. Capitalization Example “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]:” Pre-Financing Post-Financing Security # of Shares % # of Shares % Common – Founders 4,077,670 73.7 4,077,670 40.5 Common – Employee Stock Pool Issued -- -- -- -- Unissued 1,456,311 26.3 1,456,311 14.5 Common – Warrants to Debt Holders -- -- 75,000 0.7 Series A Preferred -- -- 4,466,019 44.3 Total 5,533,981 100.0 10,075,000 100.0 © 2010 Haynes and Boone, LLP
  • 68. Publicity Example • “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
  • 69. No Shop Example • “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
  • 70. Questions? Bart Greenberg Partner 18100 Von Karman Avenue, Suite 750 Irvine, California 92612 bart.greenberg@haynesboone.com 949.202.3037 70 © 2010 Haynes and Boone, LLP