Negotiating Series A Term Sheets

11.20.13

Benjamin M. Hron

Bhron@mccarter.com

617.449.6584

@HronEsq

James F. Coffey

jcoffey@mccarter.com

617.449.6533

@hopbos

Twitter #mecic

Refresher: What is a Term Sheet

♦ Control Terms v. Economic Terms♦ Standard Agreements

– Stock Purchase Agreement– Charter– Investor Rights Agreement– Voting Agreement– Right of First Refusal and Co-Sale Agreement

♦ Term Sheet to Closing

Refresher: Part I covered Control Terms

♦ Voting Rights and Board Seats♦ Investor Protective Provisions♦ Information Rights♦ Vesting of Founders’ Equity♦ Right of First Refusal and Co-Sale♦ Drag-Along

Refresher: Control Terms Key Takeaways

♦ Board composition and director election determines who controls the company

♦ Obtaining approval of actions from directors is simpler than obtaining consent from investors

♦ If founders’ equity is subject to vesting, get credit for time served

♦ Limit investor right to compel a sale♦ Pay attention to thresholds for Series A votes

Part II: Economic Terms

♦ Valuation and the Option Pool Shuffle♦ Dividends♦ Liquidation Preference♦ Anti-dilution♦ Pre-emptive Rights and Pay-to-Play♦ Redemption Rights♦ Registration Rights

Valuation and the Option Pool Shuffle

The Original Purchase Price is based upon a fully-diluted pre-money valuation of $[_____] and a fully-diluted post-money valuation of $[______] (including an employee pool representing [15-20]% of the fully-diluted post-money capitalization).

Valuation and the Option Pool Shuffle

♦ Valuation – Just one of several the economic terms– Need to consider terms as a package– Model outcome in various exit scenarios

♦ Option Pool Shuffle– Option pool is typically 15-20% of post-FDC– If included in pre-money FDC

� reduces the effective valuation� “phantom” increase to the post-money valuation� shifts dilution to existing stockholders

Dividends

Alternative 1: Dividends will be paid on the Series A Preferred on an as-converted basis when, as, and if paid on the Common Stock

Alternative 2: The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a liquidation or redemption]. For any other dividends or distributions, the Series A Preferred will participate with the Common Stock on an as-converted basis.

Alternative 3: Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board.

Dividends

♦ Range from 5-10%♦ Typically convert when Series A converts♦ Key Issues

– Try to eliminate/delay accruing dividends– Fight cumulative dividends– Strongly resist compounding dividends

♦ Value of dividends can add up– Most important in middle-of-the-road exit

Liquidation Preferences

In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

Non-participating Preferred Stock: First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. The balance of any proceeds shall be distributed pro rata to holders of Common Stock.]

Liquidation Preferences

In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

Full participating Preferred Stock: First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.

Cap on Preferred Stock participation rights: First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).

Liquidation Preferences

Deemed Liquidation Event:A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event, thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise]. [The Investors' entitlement to their liquidation preference shall not be abrogated or diminished in the event part of the consideration is subject to escrow in connection with a Deemed Liquidation Event.]

Liquidation Preferences

♦ Most important economic term after valuation♦ 3 Types

– Non-participating – Founder favorable– Full Participating – Very Investor favorable– Capped Participating – Investor favorable

♦ Investors get 1-3x (plus dividends) before others♦ Participating preferred also shares with Common♦ Applies to any exit, not just liquidation (ex. sale)

Anti-dilution

In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula:

Weighted Average:CP2 = CP1 * (A+B) / (A+C)

CP2 = Series A Conversion Price after new issueCP1 = Series A Conversion Price prior to new issueA = Shares deemed outstanding prior to new issue B = Consideration received for new issue divided by CP1

C = Shares issued in the subject transaction

Anti-dilution

In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula:

Full-ratchet: The conversion price will be reduced to the price at which the new shares are issued.

Anti-dilution

♦ Conversion Ratio = Conversion Price / Sale Price♦ Adjusts conversion price for “down” rounds♦ Weighted Average:

– Proportionate to size and price of down round– May be “broad” or “narrow”

♦ Full Ratchet: – Adjusts conv. price to equal price in down round– Red Flag: investor is aggressive on terms

♦ Exceptions for certain share issuances

Pre-emptive Rights and Pay-to-Play

Pre-emptive Rights: All [Major] Investors shall have a pro rata right to participate in subsequent issuances of equity securities of the Company (with standard exceptions). In addition, should any [Major] Investor choose not to purchase its full pro rata share, the remaining [Major] Investors shall have the right to purchase the remaining pro rata shares.

Pay-to-Play: [Unless the holders of [50-67]% of the Series A elect otherwise,] on any subsequent [down] round all [Major] Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the [Major] Investors. All shares of Series A Preferred of any [Major] Investor failing to do so will automatically [lose anti-dilution rights] [lose right to participate in future rounds] [convert to Common Stock and lose the right to a Board seat, if applicable].

Pre-emptive Rights and Pay-to-Play

♦ Types of Pre-emptive Rights– Right to maintain %– Right to purchase a multiple of %– Right to purchase (collectively) 100%

♦ Over-Allotment Right♦ Limitations

– Major Investors– Pay-to-Play– Use or Lose (Pay-to-Play Lite)

Redemption Rights

The Series A Preferred shall be redeemable from funds legally available for distribution at the option of holders of at least [50-67]% of the Series A Preferred commencing any time after [the fifth anniversary of the initial Closing Date] at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends]. Redemption shall occur in three equal annual portions. Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].

Redemption Rights

♦ Right to force redemption after ~5 years♦ Creates an “exit” option, but rarely (never?) used♦ May create leverage to force other exits♦ Key Issues

– Optional v. Mandatory– Time before right matures– Length of time allowed for payout– Consequences of failing to redeem

Registration Rights

Demand Registration: Upon earliest of (i) [three-five] years after the Closing; or (ii) [six] months following an initial public offering (“IPO”), persons holding [__]% of the Registrable Securities may request [1 or 2] (consummated) registrations by the Company of their shares.

S-3 Registration: The holders of [10-30]% of the Registrable Securities will have the right to require the Company to register on Form S-3, if available for use by the Company.

Piggy-back Registration: The holders of Registrable Securities will be entitled to “piggyback” registration rights, subject to the right of the Company and its underwriters to reduce the number of shares proposed to be registered to a minimum of [20-30]% and to complete reduction on an IPO at the underwriter’s discretion. In all events, the shares to be registered by holders of Registrable Securities will be reduced only after all other stockholders’ shares are reduced.

Registration Rights

♦ Demand: Usually limited to 1 or 2♦ S-3: Usually limited to 1 or 2 per year♦ Piggy-back♦ Issues

– Threshold % to exercise Demand rights– Earliest date Demand rights may be exercised– # of Demand rights and frequency of S-3 rights– Minimum IPO price for Demand rights

♦ Founders may be able to get subordinate S-3 and Piggyback rights

Economic Terms: Key Takeaways

♦ Dividends and liquidation preferences can have significant impact on economics

♦ Option pool should be sufficient for near future♦ Understand if option pool is in pre-money♦ Full ratchet anti-dilution is very investor favorable♦ Pay-to-Play helps mitigate anti-dilution in down-

round financing♦ Pre-emptive Rights should not prevent the

company from raising more money♦ Don’t sweat Registration Rights

Other Terms

♦ Tranches and Milestones♦ Conditions to Closing♦ Reps & Warranties♦ Payment of Investor Expenses

– Should be contingent on closing– Cap (typically $35K-$50K)

McCarter & English LLP

Benjamin M. Hronbhron@mccarter.com

617.449.6584@HronEsq

Questions?

James F. Coffeyjcoffey@mccarter.com

617.449.6533@hopbos