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Negotiating the Term Sheet

Springboard: New England Bootcamp October 13, 2004

Common Vs. Preferred Stock

• Management tends to hold common stock – Founders stock – Options • Professional investors, both angels and venture capitalists, want preferred stock – More control over decisions – Better economic terms • Interests of common and preferred differ and management will be negotiating against venture investors during financing or sale of company – Every new round of financing dilutes founder shares

• The purpose of the presentation is to – Provide an understanding of the common methods used by preferred investors to protect their investment – Look at the impact of the terms on common shareholders – Make you an educated negotiator

Preferred Stock Provisions
Liquidation Preference – In the event of liquidation or sale, preferred stockholders are entitled to amount of original purchase price (or some multiple) before common shareholders – Participating preferred continues to participate with common on “as converted” basis – If not enough cash to pay all preferred at original price, share pro rata with other preferred stockholders (though priority issues among different series of preferred) Concerns of Common Stockholders – If payout to preferred stockholders is very high before any payments to common stockholders, will management continue to be motivated?

Preferred Stock Provisions (cont.)
Anti-dilution Protection – If the company issues new shares at a price below the conversion price of the preferred stock, the conversion price is adjusted to eliminate the dilutive effects of the new stock, although “pay-to-play” requires investors to keep investing to maintain this provision – This gives more shares on conversion: full ratchet (adjust at last round price) vs. weighted average Concerns of Common Stockholders – Market conditions may require a “down round”, but unless “pay-to-play” clause, preferred shareholders get more shares without contributing more cash

Anti-Dilution Example
Full Ratchet
First Round: $2 million Conversion price: $2/share Common shares on conversion: 1,000,000 Second Round: $1 million Conversion price: $1/share Common shares on conversion: 1,000,000 New conversion price First Round: $1.00 Additional shares 1,000,000 Total shares on conversion: 3,000,000

Weighted Average Ratchet
First Round: $2 million Conversion price: $2/share Common shares on conversion: 1,000,000 Second Round: $1 million Conversion price: $1/share Common shares on conversion: 1,000,000 New conversion price First Round: $1.50 Additional shares 333,333 Total shares on conversion: 2,333,333

Preferred Stock Provisions (cont.)
Participation in Future Rounds of Financing – Preemptive Right - the preferred stockholders have the right to maintain their pro rata interest in the company – Right of First Offer - the preferred stockholders as a whole can take the entire amount of the financing Concerns of Common Stockholders – This provision limits the flexibility to bring in new stockholders that might add more value than existing preferred stockholders

Preferred Stock Provisions (cont.)
Right of First Refusal – In the event of sale of new equity, the company must first offer the shares to preferred stockholders to allow them to maintain their pro rata interest – This is the opposite of Liquidation Preference Concerns of Common Shareholders – This provision limits the flexibility to bring in new shareholders that might add more value than existing preferred stockholders

Preferred Stock Provisions (cont.)
Dividends – Cumulative - dividends may accrue at some fixed rate until paid (typically upon liquidation or redemption, sometimes conversion) – When and If Declared - dividends may be paid at a specific rate only when and if declared by the Board – Parri Passu with Common - no cash dividends paid to common stockholders unless the preferred stockholders receive comparable dividend on an “as converted” basis Concerns of Common Stockholders – Common stockholders stand behind preferred stockholders when sharing profits. If dividends accrue, may be difficult for common to get any return.

Preferred Stock Provisions (cont.)
Protective Provisions – Long list of items must be approved by 51- 67%(or more) of preferred stockholders, including: sale, merger or liquidation of company; sale of shares with equal or more rights; issuance of debt over some $ amount; increase in board size; amendment to charter; payment of dividends on common, etc. – Preferred stockholders may elect majority of board seats Concerns of Common Stockholders – Takes some control away from management and puts preferred stockholders in position to block certain transactions, including the sale of the company

Preferred Stock Provisions (cont.)
Voting Rights – Preferred stockholders have right to vote shares on an “as converted” basis – Except for election of directors and Protective Provisions, vote with common as single class Concerns of Common Stockholders – Preferred stockholders have rights of ownership as well as benefits of priority over common

Preferred Stock Provisions (cont.)
Redemption - May be Optional or Mandatory – Company must repurchase preferred stock (generally in annual installments) at election of preferred after some period of time (typically 3-6 years), or upon a date certain, at the redemption price (e.g., original purchase price plus dividends or some stated fixed return) – Penalties for failure to redeem (reduction in conversion price, control of the Board) Concerns of Common Stockholders – This provision treats preferred stock like debt, which needs to be paid back with interest

Preferred Stock Provisions (cont.)
Automatic Conversion – Preferred stock always has right to convert to common stock at any time, and will automatically convert into common stock upon IPO above certain dollar amount and share price. However, if dollar thresholds not met, IPO must be approved by preferred stockholders Concerns of Common Stockholders – Unless company can meet required dollar amount and share price of IPO, preferred can hold up offering and demand special rights

Preferred Stock Provisions (cont.)
Rights of First Refusal/Co-Sale on Founder Sales – Right of First Refusal - if Founder receives bona fide 3rd party offer for his or her shares, the preferred stockholders have the right to purchase shares on the same terms as the 3rd party – Co-Sale Rights - the preferred stockholders can sell on a pro rata basis some of their shares to the 3rd party Concerns of Common stockholders – This may limit the ability of Founders to attract willing buyer for their stock

Preferred Stock Provisions (cont.)
Drag-Along Right – Typically requires all stockholders to vote for and participate in any sale transaction approved by a specified percentage of the preferred stock Concerns of Common stockholders – Allows preferred stockholders to force a sale of the company which may be on terms that do not provide any return to the common stockholders

Preferred Stock Provisions (cont.)
Vesting of Founders’ Stock – Preferred stockholders may impose vesting restrictions on Founders’ stock such that if the Founder leaves the company before her stock has fully vested, the company may repurchase the unvested shares at their original cost Concerns of Common Stockholders – Founders want to be rewarded for their sweat equity and prefer that at least a portion of their stock be vested immediately. What happens in the event of termination without cause or death or disability? What is the right vesting period? Timely 83(b) tax filings are critical.

Preferred Stock Provisions (cont.)
Registration Rights – Even after conversion to common in an IPO, preferred stockholders may have rights requiring the company to register their common shares for sale and pay their expenses Concerns of Common Stockholders – The sale of these shares can depress stock price and compete with company in raising funds

Impact of Options
• Venture rounds can reduce management equity and often compensate with large option packages • Must balance management ownership/dilution • Investors consider stock options when looking at shares outstanding • Investors focus on “overhang” or options granted but not exercised as percentage of total shares • If overhang is too high, it may be difficult for company to sell new shares

Other Agreements
• Repurchase Agreement: – Management/employees agree to sell shares back to company if leave before certain date – Concern: may lose benefit of sale or IPO • Tag-Along Agreement: – Management agrees will not sell stock without giving other investors right to pro rata participation in sale – Concern: Need to find buyer for more stock

Other Agreements (cont.)
• Warrant Agreement: – Investors get the right to buy stock at a set price. Can be contingent on certain conditions such as company not meeting numbers. – Concern: Additional dilution with no upfront cash put into company

Negotiating Term Sheet
• Some terms are entirely non-negotiable • Others depend on competitive situation • Best case: receive several term sheets and see who is offering best deal • Need good venture lawyer • Make the term sheet as complete as possible • Do not want any surprises in documents