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Expected to know what is in the readings No Book! o Primary Sources Practical Law Company VC Investment Docs ***READ THE ANNOTATIONS.

Next Class o Choice of Entity Corporate/business drivers of decisions you make Tax Decisions o Ken Barth, speaker

Alice Wilkerson ask Axiom Law Exam o Open book, open note, open internet no people help; work independently o Probably 10 questions, 10 points each Maybe 150 word limit; if you know what youre talking about, could answer in 10 o Released: November 28 get it out of the way first; then exams start Dec. 3 Also last day to withdraw. Class Participation = some meaningful percent o Humor him How to Get Fired Your First Year in Big Law: o Keep thinking like a law student We are taught to spot issues; have to learn how to think; dont get paid to find problems but to come up with solutions Dont limit yourself there are many answers within a certain framework o Be tentative and needy Take shots; show that you think Instead of what do you want me to do here? Heres what I think we should do and heres why o Dont take ownership of a project Better to err on the side of too much initiative than no initiative But dont get too ahead of yourselfknow what you dont know o Use hedge words Be confident in how you talk Avoid I believe and it is our position that instead, Ive thoroughly researched this. o Believe in the myth of meritocracy Need to be known as the smartest, hardest working person in the room The worst thing you can be is the best kept secret Someone else will take credit for all your work o Do not believe that all secretaries are created equal Be nice to all of them o Play with your iPhone in meetings Expected to catch what those senior to you dont catch

o Email like youre texting your friends Before sending out an email, ask: Are you making the clients life easier? Did you make the client look good by picking you? Are you making yourself and the firm look good? Assignment: turn in by COB Friday Draft a term sheet: Client wants to raise $500k interested investing; founder wants to make sure he gets good chunk of equity for his sweat founder wants to make sure theres enough there to incentivize new hires (eg software developers, etc); wants to give away as little of company as possible; the angel investor wants to make sure that if everything goes bad that he gets his money out first, and wants something to compensate him for the use of his money (even though knows will make a big pile when company goes public) basically wants to be paid for the risk; doesnt want to be diluted by people who are paying less for the company wants protection; angel wants a seat at the table; angel wants to sell shares as soon as possible (is there a lockup?); angel wants to get his money back if company doesnt exit within 5 years ?

Monday, August 27, 2012 1. Dictionary for terms a. Investorpedia b. Practical law guide 2. Go to a. MOOC 3. Law a. Need to be familiar with Delaware corporation law i. Formation ii. How do you amend the charter (ie certificate of incorporation) iii. Voting rights 4. Choice of Business Entity a. C corp b. S corp c. LLC d. LP e. Sole proprietorships, GPs, LLLPs, etc not as common 5. Considerations a. Ownership reqs i. C Corp 1. One or more stockholders 2. No restrictions on types of owners a. Ie can be other corps ii. S Corp 1. 1-100 stockholders 2. w/ exceptions, only US individuals and certain trusts and exempt organizations can be stockholders 3. only eligible US entities can make S Corp designation a. if doesnt meet reqs of S Corp, may automatically convert to C Corp iii. LLC 1. One or more members; 2. Two or more reqd if want to be taxed as pship 3. Decide to be taxed as individuals or parternships 4. No restrictions on types of owners iv. LP 1. Two or more partners a. Limited b. General 2. No restrictions on types of owners b. Form of Equity i. C Corp 1. Capital stock a. Held by one or more stockholders b. Common i. Most basic form of ownership ii. Repd by physical certificate, generally 1. or electronic form c. preferred i. generally has same rights but used in same fashion as common stock 1. becomes relevant during liquidation a. gets paid back before common stockholders; anything leftover goes to them 2. Corp has limited number of shares it can issue

3. Distributions must be proportionate to stock ownership if reqd by state law ii. S Corp 1. Capital stock held by one or more stockholders a. ONLY common stock i. But there can be differences in voting rights among shares of common stock 1. (everyone will get paid at the same time though) 2. Distributions must be proportionate to stock ownership if reqd by state law 3. S Corp vs C Corp a. C Corp can have qualified small business stock i. S Corp cannot iii. LLC 1. Percentage of membership interests are held by one or more members 2. Permissible to classify membership interests into diff classes with diff rights and preferences 3. Distributions do not need to be proportionate to stock ownership if reqd by state law 4. Distribution liquidation and voting preferences can be specified in the LLC agreement iv. LP 1. Two classes of partners a. General partner i. Must have at least one b. Limited partner i. silent partner 2. Distributions do not need to be proportionate to stock ownership if reqd by state law 3. LP agreement can specify distribution preferences c. Organizational docs i. C Corp and S Corp 1. Certificate of incorporation (charter) filed w/ sec of state 2. Governing doc: by-laws a. Stockholders may also enter into a stockholders agreement 3. To become S Corp, eligible US entity makes timely S Corp election on IRS form 2553, no more than two months and 15 days after the beginning of the tax year the election is to take effect a. If you dont file in time, you will be subject to corporate level as well as shareholder level tax for the year ii. LLC 1. Formation = certificate of formation filed with sec of state 2. Governing doc: LLC agreement a. In TX, no requirement of written LLC agreement i. In that case, default laws of TX apply 3. d. Tax i. C Corp 1. Double taxation a. Taxed at corp and stockholder level 2. Can participate in tax- free reorganizations under IRC section 368 3. Only salary paid to stockholder-employee is subject to employment tax; any other income is not subject to employment tax ii. S Corp 1. pass through entity

a. Taxed at SH level only unless S Corp was formerly C Corp i. Some states dont recognize ??? 2. Can participate in tax- free reorganizations under IRC section 368 3. Only salary paid to stockholder-employee is subject to employment tax; any other income is not subject to employment tax iii. LLC 1. Taxed at member level only 2. Cannot participate in tax free reorgs (oppo of above) 3. All trade or business income of the LLC is considered self-employment income to members and is subject to self-employment tax iv. LP 1. Taxed at partner level only 2. Cannot participate in tax free reorgs (oppo of above) 3. All trade or business income of the LLC is considered self-employment income to members and is subject to self-employment tax e. Liability i. C Corp and S Corp 1. Stockholders liability is limited to the amount of capital contributed a. Therefore safer wrt those kinds of risks i. Piercing the corp veil exists as a possibility, though 1. Butttttt VERY tough standard to meet though, so likely wont be able to do it ii. LLC 1. Members liability is limited to the amount of capital contributed iii. LP 1. Limited to amount of capital contributed (by a limited partner) a. Can be deemed GP though based on how much control of the business they actually have i. What constitutes control though? Not very clear 1. But in most states, will give you a list of the following things will not be deemed partner actions 2. GP has unlimited liability f. Mgmt. i. C Corp/S Corp 1. Board of directionrs; a. Designate officers to mng day to day ops b. Certain major decisions need to ba pproved by stockholders 2. BOD may delegate certain decision making to committees 3. There is well developed body of corp case law ands statutes which provides greater certainty but less flexibility than other forms a. generally always true, but def true in TX, NY, and DE ii. [***Chu says Diego will send ppt] g. Employee incentives i. **Carried interest exemption h. Capital raising 6. Ken Barth Portrait of a Serial Entrepreneur a. [insert ppt] 7. Grading the Term Sheets: the takeaways a. Should be non-binding i. shall agrees to do and will = definite words of agreement 1. his preference = USE WOULD b. VC prefers corporation they dont care about tax advantages 8. Ken Barth Takeaways

a. Negotiation: comes down to if you can convince your client that you are right 9. Waterfall: how to order things when getting paid out by investors1 a. Capital structure : who gets the money first b. Debt prioritized over equity c. 2 types of debt: i. Secured first 1. Among them, settled by inter agreements ii. Unsecured second iii. + TRADE CREDITORS 1. eg landlord, lawyers, etc iv. + BRIDGE LOAN 1. usually to keep the company together till they go find the VC and put it in the series A a. lender will be required to convert her shares to series A round at the same price those preferred stock owners are paying i. but how is this fair? early investors take more of the risk than those that come in months later 1. some answers: a. get to convert at a discount b. warrants: option to buy in the future (in practice: no different from stock option except that it is granted to non-employees) i. d. Equity (stock represents what the owners get when everything else is paid off) i. Preferred 1. Paid first a. Preference in liquidation, voting, dividends i. Subsequent rounds of financing = these are lettered 1. Is this participating preferred stock? 2. As a lawyer, you have to figure out who gets what down here (A1, A2, B, C, D different investors in each round) a. This is the challenge 3. C & D might be late stage ventures they will get in there w/ agreements to move up the capital stack get principal back, interest, and warrants (at same time as creditors?) 2. however, if the company is doing well, equity is much more expensive than debt a. meaning worth more? didnt really get this point that he was making 3. Can be made to look like debt, with: a. Interest rate etc? b. Repayment schedule mandatory redemption of preferred stock c. Affirmative and negative covenants to creditors is equivalent to voting rights here 4. Creating series of preferred stock: have to provide for it in the charter and follow corporate law (he wants us to look at VCCL?): a. Rights preferences and limitations in charter in the form of an amendment to the charter or amendment and restatement of the charter i. Difference b/w the two -- restatement: restates everything; a lot easier much more commonly done so as to avoid ambiguities 1. Under corporate law: have to have votes to do all this stuff (amend)

There are a lot of ways to skin this cat

b. Corporate law 5. pay to play a. can have provision that says investors have to participate in subsequent investment rounds i. may have mandatory conversion to common ii. Common 1. One vote per share, then what is remaining after preferred stock is paid e. Other obligations/rights: 1. Ancillary VC voting rights 2. Etc f. Poison Pill2 i. Provisions to prevent hostile takeover 1. Eg wrt a tech company = rights to tech and licensing agreements ii. Covenants not to sue 1. But may [somehow ?] handcuff the company g. Back to Stockholder Approval To Amend the Charter (see lawyers job above): i. In meeting ii. By proxy iii. Action by written consent 1. Need to find out which applies: a. Some laws say has to be done unanimously (ie every stockholder has to sign) b. Some laws say by number of people it takes to pass in mtg h. Blank Check Preferred Provision i. Charter says from time to time can issue preferred stock basically however bd of dirs wants 1. Typically would not see this in start-up context not common 2. As investor, you dont want this: a. Have no control over whether can issue rights senior to yours 3. Public company acquisitions process defense: may see part of the poison pill 10. Michael Pennington, Investment Banker w/ First Southwest a. Balance Sheet i. Assets how you generate capital (intellectual, people, widgets, etc) ii. Liabilities/ Equity how the firm pays for those assets b. Wrt capital structure: i. The higher the security of your investment, the lower your expected return c. Financial Sponsor: invest money in companies (eg private equity firm) i. Treat the company like a security/any other investment: expected returns; scheduled exit period d. Eg Tech Startup i. Capitalization/securities: 1. Probably cant support much debt: in the beg, prob have light cashflow; plus lender has no claim on your assets a. So if company goes belly up, lenders cant come in and claim money i. So probably need funding (equity) b. Later in the company, can probably support some debt i. [Missed why] e. Valuation there are a lot of tricks in here that can be done can make it such that the licenses become perpetual if theres a change in control to what extent do we need to know about this stuff?

a. Job as lawyer: convince them to vote, waive time periods, etc

i. Most schmos think their company is worth more than it is or have no idea f. Liquidation preference: can eg ask for 3x money back before you get a dime i. So theres more that goes into cap structure than just valuation g. Role of leverage i. All things being equal, inverse relationship exists bw invested capital and ROI ii. OPM (other peoples money) iii. If leverage can be supported, can enhance investment returns h. LBO Capital Structure i. Not just debt and equity often has multiple loans and multiple securities; can become very complex i. all things being equal, the less money you can put in the better it is for you at the end of the day i. eg low leverage guy prob cant support all the debt 1. need to evaluate the projections, overlaid with new capital structure a. investment banker will check to make sure company is w/in all the covenants i. remember: these are all projections j. EBIDTA, Arbitrage, Multiples i. He talked about thse, but not quite sure what they are and how they factored in and more importantly what I need to know about them k. Lenders i. Once letters of intent are signed, lenders will come in and evaluate co in same way private equity investors would (wrt covenants, etc) l. Projections: where do they come from? i. Weighted average of what company can do over time from revenue perspective m. When attys get involved: 11. [insert Lauras notes from Sept 17] 12. speaker prefers to use debt: a. over series a financing b. why i. get your money back before everybody else ii. cheaper and easier to process 1. particularly for the lawyer 13. Reviewing the Term Sheet Assignment some thoughts, explanations, considerations: a. possibly bridge loan why? b. how to value the company i. complete voodoo! 1. whatever sells c. interest rates i. need to think about what goal you want to hit ii. also think about how to adjust for the risk iii. payment in kind = pay with same stuff you are holding 1. preferred stock traunch then can pay interest with more preferred stock a. problem potentially: creates income tax liability issue d. [may have missed some stuff] e. convertibility i. preferential: obligation to convert f. qualified financing i. trigger = sale of more debt, equity, common equity can define. ii. Security 1. What kind

2. How much 3. What will trigger 4. this is all about expectations; you set the number iii. Whats the use of the financing? iv. WANT it to convert want it to be self-executing 1. Into what? How much of the next round do you want to get? 2. Market range = 25% a. That means a series A guy gets a discounted rate (ie if valued t $1 a share gets it at $.80 a share) g. ** want to make sure you have the same terms as the other people h. term; payment i. if company not meeting performance milestones converts to common ? ii. do you want to give the company the ability to pre-pay the loan? 1. Will they miss out on the big payoff iii. Partially address the issue: 1. If you give the $ and there is not qualified financing, there is a provision: if liquidity event happens, Ill get 2x back a. Or if rep investor, if there is a liquidity event, I get greater of 2x back or whatever my return would be if I had converted at that purchasing price [ie as if you had converted and got a piece of the equity] i. this will protect you on the upside 1. [lessor of in the term sheet he sent us = a typo] i. liquidity event: i. definition on sample term sheet 1. what is missing? a. If someone wants to buy directly from founder? i. ^^ was not captured 1. could be possible that there is a right of first refusal, though so that may cover in case of sale a. but highly unlikely in bridge loan context j. warrant coverage in brackets; it is another way to cover for risk of angel investor instead of discount on offering price i. we want it gone so have it terminate on a certain date k. closing: i. first closing 1. correlates to amt raised up to x ii. do you want the loan secured by assets 1. what assets? a. w/ tech company, probably very little l. [did I miss subordination discussion?] m. Amendment provision i. Person with more skin in the game has more say. ii. ***very important iii. example 1. can amend with majority vote however if it affects one persons rights greatly that person must consent n. expenses & exclusivity o. label all provisions as binding and non-binding, whatever youd like them to be 14. Dave Haley a. [handout of slides] 15. Insert Notes from Alice Wilkerson Discussion (wrote in her doc)

Equity Incentive Compensation Definition. Non-cash compensation that represents an ownership interest in a company or ties the value of an award to the value of the company as represented by the value of a share of company stock. method of compensating higher ups that is tied to the value of ____; nobody is ever an owner it is a creature of kx; but there is tax law required but otherwise, not tied to anything like ERISA Purpose. Align the interests of management and shareholders (i.e., skin in the game). Retain key employees and contributors. it is typically something that vests Motivate performance to achieve targeted financial objectives. Allow for wealth accumulation based on financial performance of the company. Secondary wealth accumulating plan on top of retirement plans; Recruit sought-after talent in a competitive market place. Types of Equity Incentive Compensation. Full-Value Awards. Awards equal to, or representing, the full value of a share of company stock. Whatever you get = full value of share of stock; easiest way = give stock but not typical makes that person an owner whther they work there or not Restricted Stock. Outright grant of company stock that is subject to one or more restrictions which typically take the form of a time-based vesting schedule or attainment of certain performance goals. Is actually stock; has restrictions attached that have to vest before you become an owner Shares of restricted stock are issued and outstanding on the date of grant (held in escrow). Shares of restricted stock include voting and dividend rights. typically includes; creature of kx though so may not Upon lapse of the restriction, restricted stock becomes simply stock in the company. More and more common: performance based stock makes more sense; watchdog groups (public filings which make sense and dont) this is what they look for you have to do more than just breathe

Restricted Stock Units (RSUs). Grant of an unfunded promise to issue a specific number of shares of company stock (or a cash payment) at a future time once vesting conditions have been satisfied. @ time granted, really just a promise

Shares of company stock covered by RSUs are not considered to be issued and outstanding until shares of company stock are actually issued. May be settled in shares of company stock or cash. If paid in cash, never get voting rights or dividends The grantee is not a shareholder until shares of company stock are actually delivered upon settlement of the RSUs which generally means that dividends are not paid on RSUs and there are no voting rights on RSUs. (The award may include dividend equivalents.) May be settled after the vesting date, allowing for further taxation deferral. There is a savings component to this RSUs vs. Restricted Stock. Phantom Stock. Grant of an unfunded promise to pay an amount equal to the value of a certain number (or percentage) of shares of company stock at a future time once vesting conditions have been satisfied. Generally very similar to an award of RSUs. Appreciation Awards. Awards have value only as the value of a share of company stock exceeds a predetermined level. Stock Options. Grant of right to purchase shares of company stock at a predetermined price (the strike price or the exercise price). Incentive Stock Options (ISOs). Option that can be granted only to employees and only if such options meet certain requirements (as specified by the Internal Revenue Code). ONLY grantable to employee, defined narrowly as have to know what company they are working for subject to some tax treatment that may be appealing Plan must include a specified share reserve. Strike price must not be less than 100% of fair market value on grant date (110% of fair market value for 10% owners). Amount first exercisable in any calendar year cannot exceed $100,000. public company: timing decision needs to be relatively close in time (day before) and cannot be backdated private: good for 12 months unless oyu know something has occurred to make it unreasonable [ admin ease ] $100k = based on grant value o balance rolling awards, though company has to know so it fits the rules IF IT MESSES UP, NO REAL PENALTY JUST BECOMES UNQUALIFIED STOCK OPTION THAT HAS DIFF TAX TREATMENT

Maximum 10-year term (maximum 5-year term for 10% owners). Must exercise within 3 months of termination of employment (1 year for disability). Plan must be approved by stockholders. True of public and private ?? Nonqualified Stock Options (NQSOs). Option that does not qualify as an ISO. can be anything you want them to be pretty much (subject to a few restrictions) May be granted to non-employee members of the Board of Directors and consultants. Strike price may be set at less than 100% of fair market value on grant date (but will subject the NQSO to Section 409A requirements). Stock Appreciation Rights (SARs). Grant of an unfunded promise to pay an amount equal to the appreciation in value of company stock over a predetermined price (the strike price or the exercise price). No exercise price is actually paid. Appreciation FMV may be paid in cash or in stock. Accounting Treatment Typically these are settled in cash have to be accounted for Compensation expenses to company Variable accounting treatment Taxation of Equity Incentive Compensation. Restricted Stock.3 Grant. Not a tax event. (absent 83b election) Lapse of Restriction. The grantee has taxable income for each shares of restricted stock in an amount equal to the fair market value of a share of company stock less any amount paid for the stock. The grantee will owe federal and employment tax, as well as, any state and local tax on such amount. Withholding Requirements. General withholding rate is 25% (of the Form W-4 rate) but restricted stock, upon lapse of the restriction, is subject to supplemental wage withholding requirements. Supplemental wage payments that exceed $1 million are subject to withholding at 35%. Upon the lapse of the restriction, the grantee holds company stock so withholding may be satisfied by: Surrender of a certain number of newly-earned shares to the company. Deduction from the grantees salary (can be done over a number of pay periods). Payment by check on the vest date or within a specified period after vesting.

Wasnt really paying attention to/missed everything that is grey.

Swapping already-owned company stock. Sale of Stock. The grantee has taxable income in an amount equal to the fair market value of the stock on the date of sale less the basis of the stock. The basis is the fair market value of the stock on the date the grantee pays ordinary income tax on the grant (either the date the restrictions lapse or the date on which a Section 83(b) election is made). Section 83(b) Election. Is available on restricted stock. Not subject to Section 409A. Restricted Stock Units. Grant. Not a tax event. Vesting/Settlement. Under broad-based RSU plans, the delivery of shares, and the corresponding taxation, almost always occurs at vesting. The grantee has taxable income for the delivered shares of company stock in an amount equal to the fair market value of a share of company stock less any amount paid for the stock. RSUs may include an additional deferral feature such that (i) the grantee can delay distribution, or (ii) the grant provides that distribution will occur upon a set event after vesting. (All additional deferrals must comply with Section 409A). If the grant is subject to a deferral feature, the grantee has taxable income only once the shares are delivered. Withholding Requirements. Federal Income Tax General withholding rate is 25% (of the Form W-4 rate) but subject to supplemental wage withholding requirements. Supplemental wage payments that exceed $1 million are subject to withholding at 35%. Typically shares or cash due upon settlement of the RSUs is withheld by the company to satisfy the withholding obligations. Employment Tax FICA/FUTA Taxes for Social Security, Medicare, and unemployment (FICA/FUTA) may not be deferred beyond vesting. If the amount is taxed for FICA/FUTA before such amount is paid to the grantee, no additional FICA/FUTA amounts will be owed at the time of payment. Sale of Stock. The grantee has taxable income in an amount equal to the fair market value of the stock on the date of sale less the basis of the stock. The basis is the fair market value of the stock on the date the grantee pays ordinary income tax on the grant. Section 83(b) Election. Is not available on restricted stock units. Unlike restricted stock, RSUs do not include a transfer of property at grant. So there is no property that is subject to a substantial risk of forfeiture which is required for purposes of taxation under Section 83. Subject to Section 409A. Phantom Stock. The tax treatment for phantom stock is generally identical to the tax treatment associated with RSUs. Stock Options. Incentive Stock Options.

Grant. Not a tax event. Exercise. Not a tax event. (Alternative Minimum Tax issues) Withholding Requirements. No withholding requirements even if shares are immediately sold. Sale of Stock. Dependent upon when the shares of company stock are sold. Disqualifying Disposition Occurs if stock is sold before two years from the date of grant and one year from the exercise of the option (referred to as the Holding Period). Tax (ordinary income) will equal the lesser of (1) the spread at exercise, or (2) the excess of the sales price over the exercise price. May also have capital gains tax if the sales price exceeds the fair market value of the stock on the date of exercise. Sale After the Holding Period Capital gains tax on the difference between the sales price and the exercise price. Nonqualified Stock Options. Grant. Not a tax event. Exercise. An amount equal to the spread at exercise will be ordinary income and taxed at exercise. Withholding Requirements. Withholding taxes must be collected at exercise. General withholding rate is 25% (of the Form W-4 rate) but subject to supplemental wage withholding requirements. Supplemental wage payments that exceed $1 million are subject to withholding at 35%. Sale of Stock. Capital gains tax on the difference between the sales price and the fair market value of the company stock on the date of exercise. Subject to Section 409A if the exercise price is set at less than fair market value of a share of company stock on the date of grant. Stock Appreciation Rights. The tax treatment for SARs is generally identical to the tax treatment associated with NQSOs. However, because SARs can be settled in cash by the company, there may be no subsequent sale of stock. Treatment in a Corporate Transaction. Dependent upon type of equity award held by the grantee. Dependent upon the terms of the plan pursuant to which the equity award was granted. Ideally a plan will contain maximum flexibility for the treatment of awards in a corporate transaction. Assumption vs. substitution. Can trade Cancellation of the awards. Cash out of the awards. (What happens to out-of-the-money options or SARs?) Does exec have to exercise or can you automatically cash him out?

they have to affirmatively cancel the option (even though w/o consideration and the value has changed) not a problem with full value awards; the only question wrt those is Acceleration of vesting upon a change of control. Single trigger event. The minute you change control, you vest Double trigger event.change control + terminated Equity awards in the new/surviving entity. Roll over of management equity. Purchase of new equity. Compensatory awards of equity. Tax law implications Section 409A defines change of control very specifically. Applicable Tax Law. Section 83. Applicable to awards resulting in a transfer of property. Can only e done w/ restricted stock and options (and options have to be awarded before they vest) these are actual property; every other incentive above is a promise Generally awards are taxed when they are no longer subject to a substantial risk of forfeiture (i.e., the grantee vests in the award or the restriction placed on the award lapses). As an alternative, the grantee can elect to be taxed within 30 days of the date of grant by filing an election with the IRS (called a Section 83(b) Election). Under a Section 83(b) Election, the grantee recognizes the tax on the award on the date of grant. This sets the basis and starts the holding period for purposes of determining short-term or long-term capital gains. A Section 83(b) Election is available for (i) restricted shares, and (ii) options exercise before vesting. There are some potential downsides to a Section 83(b) Election: Because the grantee is not the owner of the shares of company stock subject to the Section 83(b) Election, such shares cannot be used to satisfy withholding. The grantee typically has to affirmatively pay the withholding taxes at grant (e.g., write a check for such amounts) or agree to additional salary withholding. If the grantee does not vest in the shares of company stock, the grantee cannot recover the taxes paid under the Section 83(b) Election. If the stock price decreases, the grantee has paid taxes earlier than required and on a higher value than necessary. (Sale of the stock upon vesting will generate a capital loss.)

Section 409A. where she spends 98% of her time; if you have deferred and equity compensation, have to meet certain rules plan has to specifically say when amt is going to be paid (hampers ability to accelerate payments); Enron Law Applies to all nonqualified deferred compensation which is any amount that vests in one year but is paid in a later year. For equity incentive purposes applies to restricted stock units, phantom stock, and SARs or NQSOs issued in the money. Distribution of deferred compensation amounts is very restricted and can only be paid on (1) separation from service, (2) disability, (3) death, (4) specified time or pursuant to a fixed schedule, (5) change in ownership, or (6) unforeseen emergency. Very limited ability to delay or accelerate payment. Limits Use of In The Money NQSOs and SARs Because a grantee cannot elect the date on which the NQSO or SAR will be exercised, the grantee is unable to control when the grantee purchases stock or cashes out the SAR. Section 409A requires that such awards be exercised only on the date provided for in the plan or award agreement. Very specific plan document requirements. Must irrevocably specify the amount, time of payment, and form of payment of deferred compensation. Generally not permit accelerate of time or schedule of payments under the plan. (Haircut provisions are no longer allowed). Generally not permit the delay of the time or schedule of payments under the plan except in accordance with the redeferral requirements. Acceleration of vesting is permitted so long as the distribution event is not changed. Very specific plan valuation rules which must be met in order to set the exercise price for NQSOs and SARs to make them exempt from Section 409A. Exceptions to Section 409A. Short-Term Deferral Payments. By mar 15? Vest and Pay Distributions. SARs and NQSOs granted (i) with an exercise price at least equal to the fair market value of a share of company stock on the date of grant, and (ii) with no additional feature of deferral. Stock covered by the SAR or NQSO must be service recipient stock. If deferred compensation fails to comply with Section 409A: PENALTIES are egregious when fall to executive if miss 409A Deferred compensation is included in income when no longer subject to a substantial risk of forfeiture. Includes all aggregated amounts.

May not have a corresponding payment event. Penalty tax equal to 20% of the amount included in income. Taxed to the employee. Interest is assessed on the tax underpayments. Section 162(m). Section 162(m) limits deductible compensation paid to certain officers (CEO, CFO, and next highly compensated officer) of publicly held corporations to $1 million. Performance-based compensation is not subject to this limitation. Solely public company issue Compensation paid solely on account of attainment of one or more pre-established performance goals. have to be not for certain when they are established; cannot be already met when they are determined Requires compensation committee that consists of two or more outside directors and that must certify that the performance goals were obtained. Stockholders must approve the performance goals pursuant to which performance-based compensation is awarded. (Re-approval every 5 years.) Awards cannot vest on the basis of service. Plan must state (i) eligible class of employees, (ii) business criteria on which the performance goal is based, and (iii) maximum amount of compensation that could be paid to any employee or the formula used to calculate the amount of compensation. Equity compensation can be performance-based compensation. There are special rules for options and SARs: Stockholder approval is good if the information presented includes (i) the maximum number of shares that can be granted to any employee during the specified period, (ii) the class of eligible employees, and (iii) the exercise price. Amount of compensation to be paid must be based solely on an increase in stock value after the grant date. In The Money options or SARs can never be performance-based compensation. a. Take Aways i. incentive stock option structure is creature of tax law 1. employees overseas who dont pay US tax: ii. in addition to restricted stock options, restricted stock grants 1. get stock up front a. have to pay for it i. if you dont, taxed as income (compensation) 1. sometimes called cheap stock or bargain stock b. or give it as loan but once forgive it, have to tax as income i. then employee asks to bonus him that money 1. this is called grossing up 16. Deal Algebra a. Review the video (linked in the syllabus) i. According to Wilson, this guy can teach it better than he can

b. A = L + E i. Assets of a startup = the idea 1. Sometimes repped in form of business plan (chu calls this a bunch of hopes and dreams) ii. Liability of a startup = there arent really any iii. Equity its mostly equity c. How much do you need? BUDGET i. Investor wants to know how much he gets for whatever that amount is? 1. What is the company worth? a. [Pre-Money] Valuation. i. A company that just has an idea ? how much is it worth? 1. at this point in the game, always go back and look at the assumptions ii. value today iii. where all the negotiation is b. Post Money Valuation = i. Pre-money investment + pre money valuation +post money investment 2. it looks like all of this is assets ii. variables are how much money you want and what your pre-money valuation is d. shares outstanding i. ? ? e. fully diluted number: means all outstanding options are fully exercised f. the incentive is to grow the company (for those given shares) g. you do this cycle every time you have new money coming in or you issue new shares whats already there is just the pre-money valuation h. if you dont have enough shares, you have to go back and amend the charter i. under corp law, need: 1. board vote 2. shareholder vote a. becomes a problem when it is no longer all insiders i. ie angel investors, series A investors etc 1. series A investor has protective provisions too ususally ii. this is all something to do with how much you were authorized to issue and you ran out 1. but I guess I dont understand when you would run out iii. have to know where you are incorporated bc that changes how many SH votes are reqd 1. TX: 2/3 2. DE: majority i. drag-along rights earlier investors have to sell i. use this to force people to vote in favor of a deal ii. can add you cant drag me along unless clauses 1. conditions iii. [missed a lot] iv. goes from working the economics to the legal part 1. where you need to navigate j. again, WATCH THE VIDEO. i. + READ THE ARTICLE ON VALUATION 17. Sherman ChuBasics of Venture Capital a. Background i. Grayhawk ii. Typically looking for 8x 10x ROI

b. c.





1. (Dont necessarily need billion dollar IPOs to get there) iii. typically invest in early growth stage ie already have some kind of revenue 1. evidently it is a misnomer that VCs always back ideas right out of the gates 2. early growth = $2MM - $8MM a. this often drives pre-money valuation 3. Investments of 3-8MM + a. >20% participation + b. seat on the board VCs usually come in b/w commercialization + growth i. Before that, its fam, friends, and angels Impact on the economy: i. Revenues 1. For ever $1 invested, creates $6.27 ii. [missed GDP stat] 1. .2% of GDP? a. But about 11% of employment in private sector Preferred exits: i. IPO ii. M&A iii. [chart] 1. Cross-over in terms of volume : M&A started equaling IPO in 2002 a. SOX! i. (became overly burdensome for smaller companies to go public) fund cycle = 10-12 years i. fund raising 2-3 ii. investment period 3-5 iii. harvest period 3-7 1. cant control all your exits (so may stretch out) due diligence4: i. management ii. market iii. tech/product/service iv. bus/econ model v. go to market strategy/growth plan vi. exit strategy vii. [something] this is what they look for/at i. also like to see commitment : execs who come in investing own capital

18. Off of our VC talk a. inverted pyramid VC starts w/ like 200 prospects, narrows it down to 5. Then we come in b. he does like 80% of the work before we show up c. put yourself in clients shoes, make them feel comfortable; put it in terms that they understand d. NVCA term sheet he sent us a while back: i. Issuer-friendly: highlights all problems like a checklist ii. [this is what I used] iii. this is how a term sheet should look and feel 1. (things have to feel and look a certain way) a. (if you make it look right, youre going to be far far ahead)

What is S & P + 12?

iv. non-binding/indicative term sheet @ the top 1. but there may be some things you want binding v. Expenses are important 1. Drives into the VCs compensationcomes right out of 2% mgmt. fee 2. Help them make it cost-effective process vi. Choice of Law 1. Most will pick DE 2. [maybe missed some stuff] vii. provide for multiple closings viii. coat-tailing 1. marquee value to having smart people invest with you ix. how do I capture the value that I just brought to the table? Better terms? x. Amount raised 1. Simple 2. Inluciding conversion of bridge notes: a. Bridge notes are convertible b. This makes it easier to reach that hurdle xi. Original purchase price: 1. Weve talked about how to get there a. WATCH THE VIDEO 2. Valuation = black magic, according to speaker last week xii. BE CLEAR ON THE TERM FULLY DILUTED 1. be clear. Be clear. Be clear. xiii. Pre-money/post-money: 1. Have it 2. Parenthetical: make absolutely clear that fully diluted includes employee pool; post capitalization? xiv. Next Section: Cap table include as exhibit 1. Shows structure of the investment 2. [will send] 3. shows who owns what xv. CHARTER 1. Dividends a. Do you need dividends or not? i. If dealing with early stage/pre-revenue5: 1. As investor, when it is time to convert, you get a bigger chunk b. Most of the time, you see alternative 1: i. [Missed this] c. Alternative 2: i. You are going to pay a rate 2. Liquidation preference6 a. You get your money back before everyone else i. Key: in the event of dissolution or winding up of the company? b. Participation i. Looks like, from his math in class which I totally missed, you want fully participating preferred stock? Or is that just series b? If so why? ii. This is a critical term 3. Exit
5 6

Euphemism for NO MONEY (thats what a startup is no sales yet) is this still under CHARTER?







i. Assets 1. Liquidation does not include 2. deemed liquidation event a. that is how you capture that ii. Stocks 1. direct 2. merger Voting Rights a. As investor of company, youre not running it b. this is how you get control rights c. 2 types: i. as a class ii. and/or on an as converted basis with the other commons 1. same thing as fully diluted basis, I think is what he is saying? Protective provisions a. Some examples: i. Ownership limitation so long as you own this many shares, you can vote such and such way ? ii. Time limitation is a possibility iii. Seniority iv. Something about negative covenants that I missed? 1. These seem to be about keeping money in the company and money leakage? v. Anti-dilution provision7 1. Dilution adjustment options: a. Weighted average: i. Weighted average of all your sales b. Ratchet: i. Instead of 1/1 conversion ratio, get to convert8 for more shares = higher percentage of diluted common ii. More commonly used, did he say? b. Some people call them veto rights, blockers, stoppers Issuances that do not trigger anti-dilution adjustment a. Issue shares among series A preferred i. They have right to convert any time ii. So if you issue common stock, should not trigger Series A investors who dont come back a. Go from series A holder to a couple of options i. Common stock holder ii. Are they all options, or all characteristics? Redemption Rights a. If valuation doesnt go up, then co has no money to pay you RRs b. Need to say how they can be triggered: i. Has to be a certain time eg 5 years ii. Who can exercise only upon vote of majority? Stock purchase agreement : roadmap

a. IPO b. Sale

Not sure if what is below the negative covenants line are all exmaples of negative covenants, or even if neg covenants and what is or isnt below is part of a set of examples of protective provisions 8 where does the new ratio come from?

a. May have provision that says IF WE CLOSE THIS DEAL YOU WILL PAY FOR MY EXPENSES i. this is good for VCs, so it doesnt dip into their compensation 19. 4 basic documents9 a. [already went thru term sheet] i. what provision goes in what document? b. Series A Preferred Stock Agreement10 i. this is the roadmap of the deal 1. term sheet really is, but no one sees it after the definitive agreements are done ii. any blank lines: make a guess; put in brackets what you think it should be tells client you are stepping up with a guess and you are asking the client to step in, but not do the work for you (ie dont just leave it blank) iii. section 1: mechanics: 1. 1.1 = obligation a. co will file cert of incorporation i. this is the big deal creates the preferred stock that has all the rights 2. 1.2 a. multiple closings agreement b. says can pay purchase price for stock or cancel for converted ? i. ^ thats how you do this 3. 1.4 use of proceeds a. important, often overlooked iv. Capitalization round how you know what youre buying 1. # of shares. Wrt to what? 2. In the charter: how many shares in what kind of shares you are authorized to issue a. For voting and dividend purposes, you are concerned about outstanding i. Thats your denominator 1. Treasury stock: company buys back stock a. Is it outstanding b. If it is, does it count for determining who gets dividends? For who gets to vote? i. need to check for texas 3. if theres not enough common stock, have to amend the charter a. takes shareholder vote, etc b. ^^^ dont want these hurdles; so need the corp to reserve certain amounts i. so in drafting, corp reserves x amt of common stock to be converted to series a preferred v. Section 2.5: valid issue of shares 1. This is important. a. Watered stock = a liability i. Ie agreed upon compensation has not been paid company can come back to you vi. 2.8: unique to startups company owns or possesses [or believes it can acquire] 1. forward looking provision-- probably hard to litigate! vii. 83b elections Imitation is the highest form of flattery ie use FORMS/stuff that other people have already done! look at a minimum of 3 different provisions and then decide how you want them to be shaped need to be able to tell him why
9 10

there is a 2012 update, but we have the 2010 NVCA version; will not matter for our purposes tho

viii. 3.7 ix. purchaser is a credited investor x. typically no indemnification provision that you might see in acquisition context c. Certificate of Incorporation12 i. the big doc; has all the juice ii. amended and restated iii. [missed something maybe?] iv. 4th article: capitalization v. [missed some stuff about reserving stock/issuing new stock][and during different phases] vi. rights preferences powers etc of preferred stock 1. are contractual a. cts will read narrowly vii. liquidation 1. after pay series a, remaning assets will be distributed among. Based on number of shares by each holder, treating them as if converted a. ^^ this is what a participation feature would look like b. ^^ this is where you build in caps, etc 2. defines deemed liquidation event a. should read all of the commentary to that what a deemed liq event is viii. direcotrs 1. this is what a VC has to foresee 2. how many can you appoint? 3. who can remove? a. Makes sense if series A can appoint, can also remove ix. Veto rights/protective provisions 1. Typically tied to liquidation events x. Conversion ratios xi. 4.4 dilution 1. additional shares of common stock provision = how you get addl common stock, duh 2. very important concept to work thru xii. 4.4.4 (p. 23): formulation for broad based weighted average solution 1. as opposed to ratchet a. anway, here is the formula13 2. p.24 has full ratchet much simpler xiii. 4.9 certificate of adjustment xiv. mandatory conversion
11 12

1. recall: 2 ways to give stock a. option i. here, cant start cap gains treatment clock till you exercise 1. end up paying more than twice the rate b. grant i. so they can start the clock running on cap gains treatment 1. if you hold it for a year or longer, you get 15% break 2. if you take 83b election, starts counting restricted stock as cap gains today11

is this right?

For this and all other docs, not really going over everything; will have to read and understand; will go over any questions we may have

throw some numbers out and try it, says Chu

1. when company goes public, you want everyone to convert a. create the clean capital structure here 2. also says what kind of IPO xv. Chu says a lot of ink is wasted on redemption but as a practical matter has never seen that happen xvi. DE law says you can put a provision in that limits liability for breaches of duty of care, not loyalty though 1. Those are the two fiduciary duties in DE a. never protected for self-dealing b. ^^ make sure to put that provision in if you are in DE xvii. investors rights agreement 1. what it is a. series A stock is issued as private stock subject to exemption which allows co to sell the stock to the shareholder i. if you want to sell that stock , it has to be registered or there has to be an applicable exception 1. as stockholder, ask co to register your stock for sale thru brokers transaction a. registration rights provision is key i. [hint: they call it rej rights, not reg rights] 2. 2 types a. demand i. you and other series a people can demand; dont have to wait for anyone else ii. talk about who can exercise and whose securities are subject to registration 1. common stock you recve from conversion of preferred, typically or always? b. Did I miss the second? c. Piggyback rights14 i. Usually unlimited ii. Biggest problem: too many shares xviii. 2.11: market standoff agreement 1. lockup, wherein you cant sell your stock for certain period of time so the share price wont be tanked 2. this provision grants lockup 3. also wont engage in hedging or other derivative transactions that has the effect of selling a. no swap transactions, etc 4. should say either everyone else has to sign lockups or if you are early released, I want to be treated equally xix. major investors entitled to financial information (section 3 observer rights) ie knock on the door 1. observer: someone who gets to sit in the board meeting who doesnt get a vote xx. rights to future stock issuances 1. if co issues more stock, I have right to purchase my pro rata shares a. so you dont get diluted xxi. amendment provision 1. who gets to approve an amendment and doesnt a. complicated provision 20. John Fee speaker on serial entrepreneur

is this the second type of investor right or is this an additional provision?

21. a. Practical experience for lawyers b. Chu is on the panel of experts people who want to be attys who make deals are given fact pattern and post 2 min videos, and then peers review then, most viewed vids are reviewed by panel of experts c. He is considering making a round of us posting and commenting (peer reviewing) part of the exam

22. Acquisition Process a. Setup: i. we have found an angel investor, there are series a,b,c,d investors things are going well. When can we sell? b. Basic Acquisition Structure i. Asset deal vs stock deal 1. Why would anyone want to buy assets: cherry pick the liabilities; take what you want a. B.A.S.S.: BUY ASSETS, SELL STOCK i. Tax consequence: you get a step up in basis, so difference is less; plus can take depreciation ii. Or if buy stock, take 338(h)(10) election -- can treat as if bought assets so you get the step up15 b. Cherry picking can be difficult i. For example, each requires an action to sell the asset 2. Vs figure out who the sharholders are and buy their stock assign it w/ stock [buying?] power 3. With assets, the seller is the company a. Certain tax goes to gvt b. Then, after tax ie on the net, declare a distribution OR liquidate the company i. Then that amount gets distributed to shareholders taxed at 15% 1. this is double taxation 4. However, with selling stock, just taxed on sale of stock which is capital asset so only taxed once at 15% a. THAT IS WHY YOU BUY ASSETS AND SELL STOCKS gets you more money that way ii. 338(h)(1) election [on an asset?]: 1. deemed sale 2. seller says pay me for it a. so there is a gross up i. ***the buyer might want this bc the benefit is the stepped up basis ii. (less gain = less tax, which is what happens with step up basis) iii. 338(h)(10) eligibility: 1. S Corp 2. Member of consolidated group a. so if buying stock, take this election and save buyer LOTS of $$ c. Initiating a deal the Initial Contact Phase i. Shermans inverted pyramid that is how he finds a deal kiss a lot of frogs

Should focus on this not a lot of people know this.

1. But @ this phase, need a confidentiality agreement (bc you are showing people your IP, which is all youve got) a. Chu says dont avtually need confidentiality agreements if you can manage the disclosure i. Ie instead of showing you a client list, show your top 10 customers 1. There are different ways to sanitize things b. Theres also a clean room ii. Confidentiality Agreement 16 1. When: a. Before you show them anything 2. What does it do a. Restrictions i. You will not disclose 1. but can disclose to representatives (consultants, lawyers, etc) a. reps must honor confidentiality agreements i. buyer is responsible for any breaches17 2. only on need to know basis ii. You will not use18 1. Except for the purposes 2. [missed a lot of this] 3. Use negotiated transaction betwee the parties 4. Backdoor Standstill a. [missed a lot of this] b. fall-away b. Residuals i. Anything I see and can remember, I can use 1. This kinda sucks for the target a. Resist it? c. Non-Solicit i. A tech company has IP AND PEOPLE ii. Have to limit it though 1. Limit it to key employees or put actual names a. or put those Ive been exposed to/interacted with 2. general solicitation exception a. if someone answers an ad on, no breach 3. also intentional active recruiting is a breach 4. time limit = fundamental a. (only lasts a certain amt of time) 23. Speaker: GC of Howard Hughes Corp, Peter ____________: Structuring a Deal and Tax Restructure Tax Free Re-orgs a. Tax Free Re-Orgs i. Really only apply to corps Pretty much the same thing as an NDA but it is a fiction of practice just called different things in different contexts, but they are the same
16 17 18

Most people dont like signing, obvs see Martin Marietta v. Vulcan

1. Not non-corp entities 2. Has to be corp on both sides (ie not w/ LLC; S Corp works though, even though its pass thru) b. NAMES REFERRED TO BELOW (eg a b etc deals) all come from statute19 A stands for Acquirer; i. The easiest deal is the 368a aka the a deal: T merges into A 1. really simple 2. can use any stock 3. SCOTUS case: 38% of stock = amt that has to be given as consideration for it to still qualify as tax free merger (see below) a. If it isnt tax free, then taxed at T level but then it is also a deemed liquidation so you get taxed there too i. So dont screw this up. 1. NOW REGS say 40% of the consideration has to be stock a. nice for those who want cash, bc can give them 60% b. 60% is BOOT any non-stock consideration 2. can be voting, non-voting, common, or preferred 4. Other judicial reqs (may also be in regs now, he wasnt sure) a. Insist on opinions from lawyers from both targets (A and T) as to whether it will be a tax free re-org i. Even if it gets screwed up, A gets benefits gets step up in basis 1. T has the pressure b. THIS GOES INTO THE REP LETTER; i. also includes continuity of business clauses 5. generally relaxed reqs to be an a merger a. compliance with state law? b. enough consideration? 6. What if stock value goes down during waiting period? (such that its no longer 40% of the valuation) a. regs say locked in value of day of signing is ok 7. all of the liabilities of T come over by operation of law a. whether known or unknown, contingent 8. even though as are easy, takes a lot of due diligence (see ) 9. bc it is tax-free, A gets a carry over basis a. no step up 10. you have to recognize tax on the boot a. have to recognize gain to the extent of boot i. but may be subject to LTCG (long term cap gain) 1. but not taxed on the stock (which has carry over basis)(plus you get to tack the holding period) a. so tax free re-org may be a bit of a misnomer partially tax free ii. a b deal stock for stock swap 1. what happens: A gives its stock to T shareholders in exchange for T stock 2. 2 major reqs a. have to get at least 80% of T stock i. 80% of voting power 1. here that means right to elect directors (for purposes of this law/tax law in general) ii. and 80% all other any classes of other (perhaps non-voting) stock

368(a)(1)(a) referenced as an a 368(a)(1)(b) referred to as b

1. (this is control) b. has to be solely for voting stock of A i. NO BOOT. 1. This is why it gets tricky -- $1 of boot will blow the whole deal a. This is what keeps people from doing bs, but they do get done b. Bc things you wouldnt think of as boot are treated as boot i. Eg a stay on bonus, assumption of a liability, etc A paying Ts expenses (ie lawyers) c. Here, if doesnt qualify for tax free treatment it is pretty much as if you sold your stock i. so no taxing at double level, just one iii. c deal acquisitive reorg, kinda like a + b 1. what: a. get all of Ts assets for stock of A i. T has to liquidate; stock of A goes up to Ts shareholders 2. Very easy to screw up 3. Asset sale, which is subject to two levels of tax if dont satisfy statutory reqs of c 4. Here, unless expressly assume liabilities/contractually they come over by law, they dont come over a. So if you are worried about liabilities, this might be the deal for oyu i. But T probably doesnt want to do a c bc doesnt want to keep on the liabilities after the deal is done (that were not expressly assumed) 5. Boot relaxation a. 20% b. but liabilities can be boot i. and can usually be enough to assume the 20% 1. so not really practical unless you are company that has very little or no debt 6. (all known liabilities typically come over in a c) c. triangulars i. A, newly created sub acquisition sub 1. Doing all these things mentioned above but w/ the AS a. Depending on which survives (T or AS), will either have 82d or 82e20 2. For example, if want to do an a, T merges into AS, but consideration is the parents stock (A) ii. This is just instead of the parents straight merging, use the AS 1. The acquirer is actually a subsidiary iii. Probably has to be direct AS probably has to be first tier subsidiary (ie not so far down the chain) d. these are acquisitive re-orgs e. divisive re-orgs i. Parent and Sub parent distribs subs stock out to shareholders 1. This is a classic spinoff a. This is d i. Lots of statutory reqs ii. If it doesnt qualify, then double taxation 1. Parent taxed as if sold stock and distributed(typically a taxable event)

whatever the fuck

2. Plus then shareholders taxed at dividend level ii. Or a split up 1. Same as a spinoff () except ___?___ f. THIS IS ALL DOMESTIC. i. Gets more complicated across borders 1. You can do tax free re-orgs across borders, but they are very complicated a. 367 24. Letter of Intent a. Item #2 on syll for Oct 29 b. Preliminary Agreement what we kick off an acquisition with c. Investment banker markets the target i. Prepare a book ii. Goes out and finds prospective buyers d. NON-BINDING i. **** just like term sheet ii. EXCEPT FOR PROVISIONS RELATING TO EXPENSES AND EXCLUSIVITY 1. (This is also true of term sheet) e. more sophisticated ones say: i. sales-y language ii. we are serial type buyers 1. these are different/stand outs f. asset vs stock acquisition i. remember BASS (buy asset sell stock) want higher basis 1. so buyer should say we want to buy the business a. and seller will prob say we want to sell stock g. additionally, Escrow i. hold back as security for breaches of reps and warranties 1. should fit the deal a. (however, Chu says typically 10-15%) ii. eg if straight up purchase from private seller, less than 10% may be approp iii. eg on the other hand if seller is genseral electric, you assume theyll be able to step up for breaches of reps and warranties 25. Mark Cuban a. Look at the industy incumbents what are they doing wrong? b. To win the war, dont go where it is saturated look where other people arent c. Think about how someone want to put you out of business d. Know what business you are in i. CUBAN says he is not in the basketball industry hes in the entertainment industry 26. [missed a class get notes from laura] 27. November 12, 2012 a. See ABA deal point study b. Form 8k i. Report on material events of a public company ii. This usually happens to be an acquisition. c. Clients really want to know that they arent being taken advantage of schmuck insurance. d. See table of contents i. The presentation is structured much like a deal. (slide 10). e. Dont argue to statistics. Argue to the deal. f. Analysis of privately traded companies 28. The larger the company the fewer 8ks will be followed because of blowback. a. They dont want ppl to know how they do deals. b. 8ks put the buyer at an advantage 29. Deferred Closing v. Simultaneous

a. Deferred Closing: i. Letter of Intent ii. Negotiate iii. Sign Agreement iv. Then you have a period (conditions to closing) 1. Here is when you get third party consent, etc for things like office leases, etc. 2. You have to see if you can get transfer of software licenses. 3. There are anti-assignment clauses in the initial agreement between vendor and target. a. If the agreement is silent, you should be able to assign it but it is typically going to be a state law issue. b. This is a prime example of why the governing law statute is so important. The choice of law for the transaction does not apply to other agreements (like leases, etc) 4. This period worries people a lot. a. It is almost like you are advertising that there are damaged goods 5. Closing Conditions a. You sit the client down and say what absolutely must happen in order of the deal to close. b. You need to create walk-rights. A way for the buyer to walk away from the deal. v. 30% of the time you have a simultaneous deal and close 1. which is pretty great because you dont have this deferred closing period to deal with. 30. Something to continually remember is that different industries have different practices, like technology, healthcare, etc. a. Entrpenurial sellers do not get as much of an advantage as financial sellers 31. Look at the TLC stock-purchase agreement a. You could have the most simple structure/agreement and could get a little more complicated b. Working capital i. Current assets 1. Cash 2. Account receivables ii. Current liability 1. Trade payables a. Lawyer bills b. Rent c. Loans from 3rd party due in less than a year c. When you do a deal, you want to make sure that the working capital on closing is the same as that on the day you signed the agreement. i. This is called a working capital adjustment. ii. So you say that if WC is more or less than X amt, someone gets paid. The money needs to come from somewhere bc someone is getting their value. 1. This is a two-way adjustment. 2. Often, the buyer makes a clause where they wouldnt pay for an escalated WCA. d. Slide 17: Usually the buyer is going to prepare the closing balance sheet. i. The seller is worried that they are going to prepare this in an unfair manner. ii. There are a lot of materiality qualifiers in GAAP (ie grey areas). e. Slide 18: separate escrow account i. You dont want the seller to escape to Tahiti with the money, so you can do either a 1. Escrow account OR 2. A holdback

a. This is often preferred bc its a security for breach, and it is less expensive than escrow. ii. You will want to make some sort of remark that if it doesnt exceed a certain threshold, no payment. f. Slide 20: There is a drastic difference in buyer and sellers valuation of the company, so you can bridge the valuation gap with an earnout. i. So the lawyer has to come up with all of these metrics to determine the post-closing earnout period. ii. Factors to base earnouts on 1. Revenue 2. Profits a. Where are expenditures going to applied to manipulate profits. iii. Considerations 1. Who is running the business? 2. What if they close certain profit-making sections of the corporation on business? iv. You will see from the slide that only 1/3 of the time are deals closed via earnout, but they are discussed in virtually every deal. 1. How long is the earnout period going to be? As seen from the bar graph, the times really vary. 32. See Slide 22: a. These are seller friendly provisions. b. So the buyer is going to have provisions, like we are going to run company in the way we say fit. 33. States have varying provisions a. TX does not have any implied obligation to good faith and fair dealing. b. Delaware however says you have to work with the other in good faith and fair dealing. i. Here the ct and jury can imply terms as if the seller had been smart enough to think about it. c. If it is considered a security, it could give the seller the right to rescind the entire day. 34. Slide 23: Even if you trust the buyer in an earnout, seller is going to be worried of a change of control (purchase by different company). a. So a seller is often going to say that you can sell the company but earnout accelerates and money is due. b. If you are the seller, you need to address the issue of change of control because this is completely beyond your control. c. On the other hand, the buyer is not going to like acceleration bc the money may not have been earned. 35. Slide 24: Express disclaimer of fiduciary relationship a. It is important to include this. b. 36. Deal Points Study overview of acquisition a. [need notes from laura from eye puff day] b. Pervasive Qualifiers in Reps and Covenants i. Target is in compliance with all laws = representation you would typically see in agreement 1. You are seller 2. Buyer has an interest in ^ that representation 3. How would you qualify the unqualified flat rep? a. Add to sellers knowledge b. Add applicable to applicable laws c. Except as disclosed in schedules21

just bc disclosed in disclosure schedule, do not have to take it as buyer; can put cap on disclsoures

d. As of a certain date e. Qualify compliance material compliance i. May add instead except for violations that are not materially adverse effects (MAEs) 1. See slide 26 a. What does prospects mean? i. This is a problem. Seller will say it is too ambiguous a term and try to get it out. ii. Problem though: but in tech company w/ prerevenue, what does it have other than prospects? Eg biotech company waiting for drug to be approved iii. Most of the time you will see this agreement; most of the time you will see prospects eliminated iv. If cant get prospects in though see slide 28 v. Adds or could reasonably be expected to have materially adverse effect forward looking vi. the piano will land on his head vii. sometimes called prospects light clause viii. this forward looking provision is in practically every deal see slide 27 ix. could vs should vs is reasonably expected. Nuances that will make a difference x. definition of MAE gets discussed at every deal ii. Carve Outs could be MAE except for this carve out 1. Eg a MAE walk right / MAE carve outs a. since date of the agreement, no MAE has occurred / target hasnt suffered MAE b. but there are some things out of your control eg changes in the economy , industry i. THESE ARE NOT MAES 1. Eg if there is a terrorist attack, that is not on me you need to close the deal! c. Typical: major transaction 2. Included practically 87% of the time 3. Slide 35? = quick references for general carve outs 4. MAE carve outs to the MAE a. GOOD EXAMPLE: Economic downturn not a MAE; but if disproportionately affects target, that is a MAE i. Eg see slide 37 iii. Sellers knowledge 1. Risk Allocation/Risk of the Unknown a. Seller doesnt know what he doesnt know i. Seller allocates risk of the unknown some to buyer b. However, buyer says you know the co/industry so you are in better position to know i. if there had been a flat rep, buyer would say hell know c. at least one case says to the best of my knowledge shifts responsibility to buyer i. Chu says not a ot of ppl know about this so lets keep it to ourselves 2. Knowledge definied

a. Actual i. Seller will typically say actual knowledge (constructive knowledge is better for buyer) ii. This is the minority iii. Actual knowledge + investigation constructive knowledge 1. Bc should have known b. Vs Constructive 3. Additional issue in negotiating: whose knowledge are you talking about? a. Manager sees smoking gun vs janitor sees smoking gun. Should co be charged with knowledge of that? b. Typically says of X Y Z seller wants to define who those people are (so you can go to them and find out what is in their head) c. Buyer wants it to be broad eg role-based d. See slide 42 4. Think about Ken Lay defense he knew nothing, so what good is it to have him in the knowledge qualifier? 5. Not all risks are created equal a. Probability, likelihood, amount, when could this happen c. Representations and Warranties22 i. Slide 46 ii. Synonymous in US 1. However, fundamental diff: a. Representations: facts about facts; how something is sky is blue b. Warranties: forward looking sky will be blue iii. Why? 1. Gives basis for indemnification 2. Gives basis for due diligence 3. As closing addition on date of closing, all reps and warranties are true a. Give basis for walking the deal iv. No undisclosed liabilities, slide 46 1. Need to assess risk of the unknown = risk on buyer a. Balance sheet liabilities i. Can accept liability included on the balance sheet if thats what it says most of the time it has been audited, so thats another set of eyes 1. But ^^^^ relying on what auditors do will not be enough b. Ordinary course of business incurred liabilities v. Catch all reps 1. Full disclosure rep a. Put 10(b)(5) like provision in the formulation is way more target friendly! i. Than say just relying on the anti fraud act; bc though securities laws would apply, have to prove scienter ie intent to deceive and reliance w/ 10(b)(5) ii. So IF PUT IT IN REPS, all have to prove is that the rep was wrong! 1. So put it in the rep iii. Can also say to targets knowledge.? This is also more target friendly?23
22 23

used synonymously under US practice; do mean diff things under UK practice, though not sure I understand why

b. vi. Line Item Reps 1. Personal property a. Say it is in good working order; say they own it 2. IP 3. Employment d. Conditions to Closing i. Slide 57 : only applies to deferred closing deals 1. ie one day you sign, one day you close a. as opposed to simultaneous sign and close 2. this is a dangerious time for buyer and seller bc things could change ii. Slide 58 the Bring Down Condition 1. MAE HAS OCCURRED, SO PRICE IS COMING DOWN24 2. All reps/warranties are accurate as of closing date a. Makes all reps and warranties into sep closing condiditon 3. Issues: a. When must they be active? i. Single trigger: at closing? ii. Double trigger: at closing and at signing? b. How accurate? (reps and warranties must be accurate) i. How wrong can sellers reps be w/o giving buyer a walk right? ii. 3 formulations: 1. accurate in all respects a. (most buyer favorable) 2. accurate in all material respects 3. MAE qualification a. Says do not constitute or cannot be reasonably expected to constitute iii. A DE ct has never found an MAE saying YOU COULD HAVE CLOSED you always can close! iv. Double materiality issue v. Slide 56 1. Back door MAE clause a. Covers the changes right there b. Illustrates how the bring down provision works i. need to always check for this c. how to cut off the back door rep: since the balance sheet date, up to the date of this agreement isolates the rep i. negates the bring down aspect 2. this is a back stop against the unknown its just in case a. bc an MAE has never been found except by TN ct 3. its a walk right of last resort 4. may give some negotiation leverage e. say you have a known risk what can you do: i. indemnification ii. purchase price iii. add specific closing condition that it has to go away [w/o costing a lot] by closing date via specific closing addition 1. FIGURE OUT WHAT HAS TO BE THERE IN ORDER FOR YOU TO CLOSE f. ALL THE REPS AND WARRANTIES WORK TOGETHER 37. MISC negotiation points

Is that right?

a. BASKET i. Deductible or threshold ii. Probably requires holdback/escrow b. CAPS i. Seller doesnt want unlimited liability ii. Typically somewhere bw 10-25% c. Survival period of reps and warranties how long do they last as basis for indemnity claim? i. Typically 12-18 mos 1. thats how long buyer has to come back to seller on indemnity claim a. MAE carve outs are also carve outs to indemnity period eg tax claims can go on longer eg 6 years; environmental claims i. Usually something so big you want to carve out the survival period ii. Also say shouldnt apply to things you knew were wrong; if you know were wrong, you lied 38. Slide 75 a. Fun and more advance b. Sandbagging provision i. Right to indemnification not affected by any investigation conducted or knowledge acquired during the deal 1. So do all the diligence 2. Buyer saying no knowledge I gained or should have gained mattersif violates reps or warranties, seller still liable a. Targets arg: dont close and sue me after if you knew something was wrong youre sandbagging me! i. But buyer will say its the benefit of the bargain regardless of what he knows or should have known, if those are not right he gets to sue you ii. Slide 77: pro-sandbag/BOB provision occurs a lot; anti sandbagging is minority 1. If youre going to raise the anti arg, do it with the client in the room iii. Silent on this: trending up 1. let the chips fall what they may and see what the cts say a. depends what state/ct you are in i. kx state: have right to rely on kx withouth having to prove relied on rep = buyer win 1. eg NY, DE, ii. tort state: in order for you to prove misrep, you have to prove you relied on that rep (seller: if knew something was wronga dn closed over that breach, then you obviously did not rely on it) = seller wins 1. eg CA, TX a. eg if you go silent on this seller wins 39. DILIGENCE a. 2 documents: b. due diligence for private mergers and acquisitions c. due diligence request list what you typically send to target and request i. material contracts, some examples of impt ones 1. anti-assignment clause/change in control clauses a. agreement cant be assigned to any other party i. way around = soft sale ii. its like a change of control restriction but this will affect stock sale or merger

2. Terms a. Have to be able to rely on the revenue stream for a while so this is important i. Also conversely when it will expire 3. Liquidated damages a. Typically see provisions in the event that agreement is terminated or material breach is not cured in XX days (eg 30) 4. Indemnities a. Vary from industry to industry b. Calculation of risk byproduct of 2 factors: i. Market dynamics ii. What you find in diligence 1. (And whatevers associated with that) c. eg i. limitation of liability ii. carve-outs to liability cap 5. Reps and Warranties a. not talked about during diligence phase, actually 6. general disclaimer on consequential damages (indirect; punitive) a. includes liability cap carve out i. typically related to fraud, gross neg, personal injury, etc 7. IP related clauses a. IP = property comes with bundle of rights i. Entails licenses carve out the rights you are willin to grant 1. Exlusive? 2. Perpetual? 3. Irrevocable? 4. Transferrable? a. can go as far as you want wrt defininig actual use i. general? ii. Particular development? b. Overly broad license i. PROBLEMATIC 8. Choice of law provision 9. MFN clause most favored nation/country clauses25 10. Non-competes a. Barriers to markets i. Bring in experts 11. Source code escrow a. Software provider will typically still own; so wont transfer sole ownership d. IP ownership in general i. Copyrights

1. theres magical language you need to look out for here: antiassignment looks like this agreement cannot be assigned by operation of law a. meant to pick up merger iii. CHANGE of control will usually be defined 1. Separate from anti-assignment clause, which basically restricts a party from assigning the agreement (which is different from change in ownership)

what ?? how relevant? how important? Exclusivity?

1. GENERALLY IP developer under kxual arrangement : its assumed that that IP thats developed is owned by the person paying for the services a. work pay for hire? doctrine b. the problem with software: it isnt one of those categories i. theres case law out there that says you cant really rely on this 1. catch-all provision: 2. IP that is jointly developed creates host of new problems a. Default = jointly owned b. Dont need joint approval to license i. there is a war as to who is first to strike a deal 1. need to know who owns it (specify) ii. Royalties and licensing fees 1. Want to know this when doing IP licensing iii. Disclosure schedules = exceptiosn to reps and warranties 1. Schedules on their own are just schedules eg when employees will be terminated e. Most diligence done by purchaser i. Some targets require counsel to conduct diligence as well 1. Why: If they dont, theres no way to verify what purchaser says are issues with your co a. Becomes impt when it comes time to agree w/ schedules 40. USE NVCA.ORG FOR EXAM a. Look to COI for required vote to pass whatever kind of transaction i. Typically required vote = drafted in the negative 1. Typically a list of events protective provisions of the term sheet a. Need to understand how to come up with valuation on a per share basis b. Calculating cap tables, waterfalls, adjustments i. Down round 1. Adjustments of price and cap table c. COI again, look for required vote for particular transaction i. May specify what process is for : 1. Voting in particular directors 2. How many directors a particular series of stock class gets d. Stockholders agreement/voters agreement i. Drag along ii. Contractual obligation to vote in favor of a deal vs an express assent that manifests stockholders intent to vote 1. If you are a drafter, draft it such that if As approve the deal, Bs do hereby expressly assent to the deal26 e. Registration rights/agreement hard time conceiving of a question for this f. Focus will be on COI and stockholder/voting agreement i. Sometimes lumped into one, which is really convoluted g. How to answer: KEEP IT SHORT AND SUCCINCT i. respond to questions: short answer yes or no ii. pursuant to section x of agreement, stockholders have this right/contractually obligated to x. 1. Dont need whole reasoned analysis if you can point to a contract provision a. Keep it almost like an outline WITH THE ANSWER FIRST i. YES OR NO FIRST ii. OR DOLLAR FIGURE FIRST THIS WAS ON LAST YEARS EXAM; Bs didnt want to take the deal but they were contractually obligated to, so you had to ID that risk

1. Verbosity will get you no points h. Need to know how to calc waterfalls i. In COI 1. Will set forth liquidation preference diff classes of series of stockholders a. Based on proposed stockholder agreements, need to calc i. There should be a waterfall spreadsheet you can plug in 1. USE AND ANNOTATE a. Based on how many classes/series you have i. Need to know how to do liquidation preference j. What issues do you see? Heres whats most important if asked that: i. What type of target company tech based 1. IP licenses, IP indemnities liability caps prob to do with what he always mentions about little equity etc k. Morningstar 10k wizard can use to look at public co structures to get familiarity l. Maybe look at that meet website i. Also startup lawyer website? 41. EXAM a. written portion due at registrar Monday by 9 AM b. exam pin number on every page w/ 1 of 2, 2 of 2 c. each question limited to 150 word answers d. i. clients video have till midnight Thursday to post 2 min video ii. after that, assigned reviews 1. have till 9 AM Monday to get it done a. will select 3 pairs written reviews are limited to 150 words