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VENTURE CAPITAL FINANCING:DOWN ROUNDS AND CRAM-DOWN FINANCINGS

SEPTEMBER 2004

CURTIS L. MOWEIL, GOTSHAL & MANGES LLPREDWOOD SHORES, CALIFORNIA

Copyright © 2004All Rights Reserved.

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OUTLINE SUMMARYPage

I. INVESTOR FAVORABLE TERMS ........................ 1A. Valuations..................................................... 3B. Enhanced Liquidation Preferences ................ 5

1. High Liquidation Preferences ............ 52. Participating Preferred Stock ............. 7

C. Price Protection Provisions............................ 81. Broad-Based Weighted Average

Formula............................................102. Narrow-Based Weighted Average

Formula............................................113. Full Ratchet Adjustment ...................124. Pay-to-Play Provisions......................13

D. Redemptions ................................................141. Timing..............................................182. Redemption Price .............................183. Eligibility .........................................20

E. Protective Provisions....................................20F. Staggered Financings ...................................24

II. DOWN ROUNDS AND “WASHOUT” ANDCRAM-DOWN FINANCINGS...........................................26

A. Down Rounds ..............................................261. Dilution ............................................262. Anti-Dilution Protection ...................283. More Favorable Terms .....................294. Under Water Securities.....................295. Corporate Changes ...........................31

B. “Washout” and Cram-Down Financings.......321. Market Checks..................................372. Explore Alternatives to Financing.....383. Financial Advisor or Appraisal .........384. Disinterested New Investors .............385. Special Committees ..........................396. Stockholder Approval.......................417. Rights Offering.................................42

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8. Improved Terms ...............................439. Written Record .................................43

APPENDIX A ....................................................................45APPENDIX B ....................................................................61ILLUSTRATION OF ANTI-DILUTIONADJUSTMENTS ...............................................................61

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VENTURE CAPITAL FINANCING:CURRENT TERMS, DOWN-ROUNDS AND CRAM-

DOWN FINANCINGS

CURTIS L. MO1

WEIL, GOTSHAL & MANGES LLPREDWOOD SHORES, CALIFORNIA

This outline provides a brief, practical summary ofterms and conditions encountered in venture capitalfinancings of private companies, including in so-called “downrounds” and “washout” or “cram-down” financings. Tax andaccounting considerations are beyond the purview of thisoutline, and we urge you to consult with specialists in thoseareas in considering these issues. The below represents theviews of the authors, and not necessarily those of Weil,Gotshal & Manges LLP. Although every effort has beenmade to provide accurate information in these materials,neither Weil, Gotshal & Manges LLP, nor any of its membersmake any warranty, expressed or implied, or assume any legalliability or responsibility for the accuracy or completeness ofany information contained herein.

I. INVESTOR FAVORABLE TERMS

Beginning in mid-2000, the public equitycapital markets experienced a major slowdown,sending public company valuations substantiallylower. The related loss of investor confidence,uncertainty in the financial markets, and sudden selloff in entire sectors including the Internet “bubbleburst,” rippled through the venture capital market as

1 The author would like to gratefully acknowledge the invaluableassistance of Peter S. Buckland a Corporate Associate at Weil, Gotshal &Manges LLP, Redwood Shores, California, in the preparation of thisarticle.

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investors weighed whether, when and how to resumeinvesting in the turbulent market.

As a result, venture capital investors wereforced to reevaluate existing portfolio companies andto determine which should survive and which shouldbe liquidated or otherwise shut down. The survivingcompanies faced a distressed financing market andthose not luckly enough to have substantial capitalreserves were often forced to seek additional fundingat lower valuations than previous rounds. Therelatively few companies that were able to close flat orslightly higher valuation rounds (because of the“right” management team, business plan, marketopportunity, investor interest and other ingredients forsuccess) faced tough investment terms, protractedinvestor due diligence processes, and difficult choices.Investors began focusing on downside protection (notgetting “burned” by a bad investment), more efficientuses of capital and an exit strategy involving a sale ormerger of the company rather than an IPO.

Often lacking the funds to retain a financialadvisor (or fearing a perceived stigma of “needing” afinder to raise capital and provide much-neededadvice), venture capital-backed companies haveincreasingly relied upon experienced corporatesecurities counsel for advice on what are fair marketterms and customary practice in the venture capitalindustry. A thorough working knowledge ofmarketplace trends can sometimes be a life-or-deathmatter for companies struggling for financing intoday’s environment.

The following are common terms that arenegotiated in the context of distressed fundingenvironments and, in particular, in down-round

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venture financings. Appendix A contains samples ofseveral of these types of provisions.

A. Valuations

Due to the absence of any public tradingmarket for their securities, private company valuationsare highly subjective. One has only to pick up an IPOprospectus to see the boilerplate “Our stock price maybe subject to fluctuations” risk factor to confirm thatbankers, lawyers and companies responsible for publicdisclosure in those deals routinely hedge against therandom, unpredictable nature of newly-publiccompany stock prices. Ultimately, the venture capitalplayers negotiate at arm’s length to determine thestock price for private companies, often based less ondiscounted cashflow analysis or other sophisticatedfinancial valuation tools, than on comparablecompany (both public and private) or transactionvaluations and the relative percentage ownership stakethat an investor desires (and existing stakeholders arewilling to give up) in the company or leave open foremployee pools or other investors. In other words, inthe absence of a firm market, valuations aredetermined by what a willing buyer (the investor) iswilling to pay a willing seller (the company) for thepieces of the company ownership pie, each trying tostrike the best deal it can.

Accordingly, investors are heavily influencedby depressed stock market prices of comparablepublic companies, and the potentially longer lead timebefore venture-backed companies can now expect toturn the corner to profitability, experience a financialmarket recovery, and be able to consummate an IPO,sale or other transaction in which the investors canliquidate and exit their appreciated investment. These

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factors have resulted in low company valuations(relative to valuations in the late 1990s, but more likethe valuations of the late 1980s and early 1990s) andgreater percentage ownership stakes for investors, inorder to provide higher potential returns ascompensation for the greater perceived investmentrisk.

However, large changes in valuation for earlystage companies may be less important than theyappear2. Consider the following example. Assume acompany obtains a $10 million pre-money valuationfor a $5 million venture round. The hypotheticalcompany is giving up a 33.33% ownership stake andthe existing stockholders (founders and employees)will retain around 66.66% of the company afterclosing. Now, assume instead that the pre-moneyvaluation was only $5 million. The same $5 millioninvestment would give outside investors a 50.0%ownership stake, leaving the founders and employeeswith 50.0% ownership of the company. Even thoughthe valuation of the company has been cut by half, thepercentage ownership of existing stockholders hasdecreased by only 16.66%.

Companies should take into account a host ofother terms now more likely to turn up in term sheets,which can seriously limit the company’s flexibility inthe future or prejudice the company in future venturefinancing rounds when subsequent investors insist onreceiving the same rights.

2 The effect of low valuations in more mature venture-backed companieshowever, including possible substantial dilution for existing stockholders,the imposition of punitive provisions such as “pay-to-play” features andrelated employee incentive measures, are often extreme and complex.These issues are addressed in detail later in this article.

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B. Enhanced Liquidation Preferences

1. High Liquidation Preferences

In making equity investments, venturecapitalists have historically purchased convertiblepreferred stock containing liquidation preferences inthe event of a liquidation, sale, merger, consolidationor other change of control of the company. In itspurest form, the holder of the security receives suchholder’s original purchase price prior to, and inpreference to, other stockholders in liquidationproceeds upon any such “liquidity event” – in otherwords, the holder gets its money back first before anyamounts are distributed to other stockholders. If theholder would receive more from the transaction as acommon stockholder than as a preferred stockholder,it would choose to convert its preferred stock intocommon stock and receive the greater proceeds.

However, investors in earlier stage companiesin particular are currently demanding multiples oftheir original investment amount as a liquidationpreference, almost as a “make whole” premium toprotect against a low return on investment in the eventthe company liquidates or is sold prematurely at a lowvaluation (or rather to discourage or prevent such anoutcome). Investors have negotiated for such multiplepreferences even though they reserve a class or seriesstockholder voting right to veto any such liquidityevent (as discussed in more detail below). Thepractical effect is that founders, employees and othercommon stockholders will not receive any liquidationproceeds unless the company is sold or liquidated foran amount greater than the aggregate liquidationpreference, after taking into account the prior claimsof creditors and other senior claimants.

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Later stage investors encounter aggregateliquidation preferences requiring major increases inthe companies’ enterprise values before they canrealize their preference or expected investmentreturns. To protect against this outcome, some newinvestors are increasingly seeking to obtain apreference above and beyond that of the existingpreferred stockholders.

In other cases, investors negotiate forexorbitant liquidation preferences. High multipleliquidation preferences (even 5x or 6x are not unheardof), even in later stage rounds at relatively highervaluations, increase the aggregate preferred stockliquidation preferences to unrealistic exit valuations,rendering junior securities, such as common stock andstock options, worthless. In our above hypothetical,imagine if the investors had a 500% liquidationpreference. In the first scenario, the investors wouldreceive all of the liquidation proceeds if the companywere liquidated (at its current $15 million valuation),and the company would need to more than double invalue (to an aggregate value of $35 million) before theholders of common stock and stock options (typicallythe company’s founders and employees) received anamount equal to or approaching the initial $10 millionvaluation. Now imagine if the company was engagedin its third round of financing, raising $20 million at a$50 million pre-money valuation with the a 500%senior liquidation preference. The company wouldhave to more than double in value before the priorinvestors received any of the liquidation proceeds andthe founders and employees would still likely notreceive any liquidation proceeds. To the extent thatequity incentives are important to attract or retaintalent, the company would be severely handicapped by

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having all its common stock and options “underwater” as a result of this investor preference.

2. Participating Preferred Stock

To compound matters, many investors insiston “participating” preferred stock, alone or incombination with high liquidation preferences.Participating preferred stock entitles the holder toshare in its liquidation preferences as well as theremaining liquidation proceeds pro rata with commonstockholders on an as-if-converted basis. Rather thanhaving to choose between the return on investment topreferred stockholders and that to commonstockholders, the investor is entitled to both (over $28million in our $35 million liquidation example above).Essentially, participating preferred stock allows theholder to “get his cake and eat it too,” never having toconvert its preferred stock into common stock in orderto share in the residual upside value.

This has been justified in a number of ways,including the argument that the preferred stockholderis risking capital for the unproven venture and shouldbe entitled to get its money back first (through aliquidation preference) before sharing shoulder-to-shoulder with other equityholders in the upside valueenabled by such investor’s valuable capital.Ultimately, the participating preferred stockholder islimiting its downside exposure by retainingpreferential terms, while receiving the unlimitedupside potential of common stockholders. Thecommon stockholders will feel that they are bearinggreater risk for the same reward, and may fear that theparticipating preferred stockholder will not bemotivated to sell the company at anything butastronomical levels and, therefore, for a long time.

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Common middle-of-the-road solutions includecapping the participation amount so that there is avaluation level at which the holder will be forced toconvert its shares to common stock in order to share inthe potential upside value (typically 2 to 5 times theamount of its original investment), or setting a floorvaluation for the liquidity event above which the classor series of preferred stock does not have a veto votingright to block the event.

C. Price Protection Provisions

Venture capital investors typically protectagainst dilution from subsequent issuances of equitysecurities by, among other things:

• retaining a special class or series stockholdervoting right or restrictive covenant right to vetosubsequent issuances of equity securities (asfurther discussed below under “ProtectiveProvisions”),

• obtaining a contractual preemptive right topurchase enough subsequently issued securities tomaintain their pro rata ownership interests in theissuer company, and

• in the case of a subsequent financing at a lowervaluation (commonly referred to as a “down-round”) or other dilutive issuance, receiving anadjustment to the conversion price of theirpreferred stock, convertible debt instrument or,sometimes, warrants or other equity derivativesecurities.

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The latter price-based anti-dilution adjustmentis usually phrased broadly to cover any issuances ofequity securities at a price or for consideration lessthan the price paid for the protected class or series ofsecurities. However, investors normally will agree tocarve out exceptions that do not trigger an adjustment,such as:

• conversion of the protected security,

• stock-on-stock dividends and distributions,

• exercise or conversion of outstanding options,warrants or convertible securities, and

• issuances under stock option plans or equityincentive plans of a specified number of shares(typically 10 to 25% of the company’s equitycapital on a fully-diluted basis, depending on thedevelopmental stage of the Company).

The company should also seek to obtaincarve-outs for:

• issuances to lenders, lessors, vendors, suppliers,landlords or others doing business with thecompany (e.g., equity “sweeteners” given toobtain more favorable borrowing or lease terms),at least up to a certain percentage (often 2 to 5%)of the company’s equity capital on a fully dilutedbasis, and

• issuances for mergers, acquisitions, strategicalliances, joint ventures, in-progress transactionsor other situations where the business purpose andbenefit are viewed as worthy of taking aconversion price adjustment out of the equation.

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In many cases, the parties negotiate “pigeon-hole”exceptions, with capped amounts of dilutive securitiesthat can be issued under certain of these exceptions.Companies and their counsel should carefullyconsider the nature and amount of carved-out dilutiveissuances in order to preserve future flexibility for thecompany’s maturing business. They may want toseek parallel exceptions in preemptive rights, vetoprivileges and other similar investor rights triggeredby such dilutive issuances.

The key then becomes the pre-determinedformula for adjusting the conversion price. Theadjustment allows the holder to receive a greaternumber of shares of common stock (and thus a greaterpercentage ownership stake) in the company uponconversion of the protected security, the amount ofwhich will vary depending on the type of formula. Itis important to realize that, even before conversion,any such adjustment will often have the effect ofshifting voting power to holders of the convertiblesecurity since they are typically entitled to vote suchsecurity on an as-if-converted basis.

We will consider three common price-basedanti-dilution adjustment formulas:

1. Broad-Based Weighted Average Formula

In a weighted-average adjustment formula, theimpact of the dilutive issuance is based on the relativepercent that the equity sold in the dilutive financingbears to the total equity of the company, including theinvestors’ shares. The dilutive effect is spread amongthe investors’ original investment price and the newdilutive issuance price by weighting their relative

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value in arriving at a blended conversion price. Asbaseball enthusiasts can appreciate, just as there arebatting averages, slugging percentages, on-baseaverages and other endless hitting statistics, there are anumber of ways to weight the relative pricecontributions, which depend largely on what securitiesare factored into the formula.

In most cases, under a “broad-based” weightedaverage anti-dilution adjustment formula, theconversion price is adjusted on a weighted averagebasis which takes into account all common stockoutstanding on a fully-diluted basis after giving effectto the exercise or conversion of all outstandingwarrants, options, convertible securities or otherequity derivative securities. An example of suchformula and its operation appears in Appendix B.Another typical formulation adjusts the conversionprice based on outstanding common stock andissuances of all common stock equivalents at pricesboth greater or lesser than the applicable conversionprice in effect at the time of the dilutive issuance,which yields the same result in effect. In either case,this type of formula dampens the magnitude of thecorrective adjustment the most by spreading thedilutive effect over the most possible securities.

2. Narrow-Based Weighted Average Formula

While there are various formulations, under a“narrow-based” weighted average anti-dilutionadjustment formula, the conversion price is adjustedon a weighted average basis which only takes intoaccount currently outstanding common and preferredstock, or outstanding common stock and issuances ofcommon stock equivalents at a price lower than thethen applicable conversion price (e.g., in-the-money

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options), or in extreme cases, only the protectedsecurity and the dilutive issuance itself. An exampleof such formula and its operation appears in AppendixB. In any such case, this type of formula provides anintermediate adjustment by spreading the dilutiveeffect over various prices to arrive at a blendedconversion price greater than the dilutive issuanceprice.

3. Full Ratchet Adjustment

The strongest price protection for investors is a“full ratchet” adjustment, in which the conversionprice is simply lowered to the dilutive issuance price.Since this is at the other extreme from no adjustmentat all, the investor receives the most additionalcommon stock upon conversion of the protectedsecurity. Common stockholders, optionholders andholders of other securities who do not have ratchetprotection are heavily diluted by a full ratchetadjustment. In addition, a full ratchet feature of anexisting preferred stock can have the effect ofreducing the incentive for new investors to invest indown rounds because the resulting ratchet adjustmentwill increase the fully diluted percentage ownershipinterest, and therefore percentage voting power, of theprior investor entitled to the adjustment. Such a resultmay require waivers of the adjustment (if possible),renegotiation of a higher bottom limit for the ratchetadjustment, amendment of the terms of the security toaccomplish such waiver or modified ratchetadjustment, or even a recapitalization of the companyto make the company fundable. Counsel should becareful to consider potential changes of control, andrelated consequences, triggered by extreme conversionprice movements.

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4. Pay-to-Play Provisions

An issuer providing investors with full ratchetantidilution protection faces the dilemma that thosesame investors can get the benefit of the lowest pricein later financing rounds as their preferred conversionprice, without even providing more capital to thecompany. Both the company and the lead investors ina venture round may want to provide a strongincentive for co-investors to make long-term financingcommitments to the company, even if they have alesser ownership stake. Individual “angel” investorswho provide small amounts of early stage capital andcorporate strategic investors who bring industryexpertise, customer contacts or commercialrelationships to the table are typically one-timeinvestors in the company and are usually not expectedto participate in later rounds. By contrast, althoughnot obligated to do so, traditional venture investmentfirms are generally expected to provide new capital inlater financings of their portfolio companies.

A common method of motivating investors toprovide follow-on financing is to include, in theoriginal financing terms, a “pay-to-play” provision inwhich existing investors who do not participate inlater rounds of financing for the issuer lose preferredstock rights or privileges, such as price-based anti-dilution protection, liquidation preferences, special orgeneral voting rights and redemption privileges, oreven the right to convert to common stock outright.This provision is usually structured as an automaticconversion upon failure to participate to the investor’sfull pro rata extent (such as pursuant to a preemptiveright to purchase sufficient securities in the round tomaintain pro rata ownership), into a “shadow” seriesof preferred stock resembling the original series but

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lacking the eliminated right or privilege, or intocommon stock, as the case may be.

While a “pay-to-play” provision may be aninsurance policy for a company that its investors willstep up to the plate and fund the company’s laterrounds, these provisions can be hotly debated amongdifferent investor groups with different agendas in“split” rounds (that is, financings with multipleinvestors) and can be defused ultimately with specialclass or series voting rights to veto subsequentissuances of capital stock. In the latter case, the classor series of preferred stock burdened by the “pay-to-play” provision can assemble enough votes tocondition their approval of a down round financing,for instance, upon waiver or elimination of the “pay-to-play” provision. Therefore, “pay-to-play”provisions generally work best when there is afunding-committed investor that controls the class orseries of capital stock subject to the provisions.

D. Redemptions

Historically, investors typically insisted uponthe right to require the company to redeem their shares5, 6 or 7 years, for example, after the investment fortheir original investment amount plus a fixedpercentage return (often 8-10%). This provided theinvestors with leverage to force some kind of exittransaction when a company had survived but had notbecome very successful.

However, prior to the market downturn, it hadbecome customary in venture financing term sheetsfor preferred stock not to be mandatorily redeemable.One can speculate that investors perceived less risk ona case-by-case basis or could more easily achieve

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portfolio-wide returns in the bull market, and werewilling to trade away the minimal downside protectionof pulling out their money in a redemption severalyears thereafter for other concessions made bycompanies unwilling to be saddled with the potential“time bomb” of having no funds to perform theredemption obligation after the company wasfaithfully sticking to the cash burn rate in its businessplan. Companies further argued that redemptionprivileges would deter future investors by raisingconcerns that new financing proceeds would be usedto redeem previously issued preferred stock.

In addition, there are state statutory limits onredemptions of capital stock. Section 151(b) of theDelaware General Corporation Law provides that thestock of any class or series may only be redeemed solong as immediately following such redemption, thecorporation has outstanding one or more shares ofstock that together have full voting powers, whether ornot such share or shares are redeemable (usually not aproblem). More importantly, Section 160 of theDGCL prohibits a corporation from using its funds orproperty to purchase its own stock when thecorporation’s capital is “impaired” or when thepurchase would cause a “capital impairment.” Acorporation’s capital is impaired when the corporationdoes not have a surplus (defined as the excess, if any,of the value of its net assets over the aggregate parvalue of its outstanding capital stock). If thecorporation has no surplus, stock repurchase paymentscan be made from net profits for the fiscal year inwhich the payment is made and/or the preceding fiscalyear (the celebrated Delaware “nimble dividend”).Also, no redemption can be made when thecorporation is insolvent or would be renderedinsolvent by the redemption.

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California corporations have more onerousrestrictions. Section 500 of the CaliforniaCorporations Code, which applies both to Californiacorporations and “quasi-California” corporationsincorporated outside California, establishes twoseparate tests for the legality of a redemption ofcapital stock. Under the retained earnings test, aredemption may not be made unless the retainedearnings of the corporation immediately prior theretoexceeds the amount of the proposed distribution.Under the asset-liability ratio tests, issuers mustsatisfy a two-part test. The first prong of the testrequires that immediately after the redemption, theassets of the corporation (other than goodwill,capitalized research and development and deferredcharges) would be equal to at least 1-1/4 times theliabilities of the corporation (excluding deferred taxes,deferred income and other deferred credits). Thesecond prong of the test requires that the current assetsof the corporation be at least equal to its currentliabilities after making the distribution, or if theaverage earnings of the corporation before incometaxes and interest expense of the two preceding fiscalyears was less than the average interest expense of thecorporation of those fiscal years, at least equal to 1-1/4times its current liabilities. Also, no redemption canbe made when the company is insolvent or would berendered insolvent by the redemption. If these testsare not met, the company is not obliged to honor itsredemption promises (see California CorporationsCode 402(d)). Moreover, if redemption is madeanyway, shareholders who receive the proceeds from aredemption and knew there was a violation, anddirectors who approve such a redemption in violationof Section 500 are liable to the corporation and itscreditors for the amount of the redemption and interest

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thereon. In our experience, few early-stage companieshave the excess tangible net worth or working capitalto meet these tests.

Notwithstanding the above company concernsand legal limits, investors now frequently requestredemption privileges for a variety of reasons.Obviously, the investors can limit their losses andavoid a total write-off of their investment throughearly redemption. This shield is a “Catch-22” sincethe company may not have the money to redeem theshares by the time the investors can actually have theirshares redeemed. But as an offensive tool, investorscan use the threat of redemption to put pressure on thecompany to achieve a liquidity event within a fixedtime horizon or sooner, or to grant other concessionsto investors, such as warrants or board seats.Investors can also use redemptions as an orderly wayto wind down a company, saving time and money inthose situations where even management agrees thatdissolving the company is in the best interests of all ofthe parties.

Theoretically, it may even turn out thatredemption economically favors the companybecause, at the time of redemption, the redemptionprice is lower than the price of the company’scommon stock into which the preferred stock isconvertible. In order to avoid being forced to hastilyconvert in order to avoid a redemption call in thissituation, and thus losing their preferred rights, mostventure investors provide that redemption is at theiroption, never that of the company.

Assuming the redemption is an investor “put”option (that is, the investor can cause the company toredeem the preferred stock), the parties must agree in

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the charter upon at least the following principalredemption terms:

1. Timing

In the case of an investor put option,the company’s best interest is served bydeferring the redemption as long as possible toenable it to raise additional financing, matureand become cashflow positive, therebyreducing or eliminating the insolvency threatof being unable to perform the redemption.The principal consideration is how much timethe company will need to buy in order toachieve a liquidity event (which usually retiresthe preferred stock by converting it intocompany common stock or consideration of anacquiror) or develop sufficient financial assetsto defease the redemption privilege. Typicallythese days, early-stage companies are able tonegotiate for no-put protection for four toseven years.

The investor must balance its finaldeadline for achieving a liquidity event againstthe risk that the redemption privilege backfiresas described above. Once the parties agreeupon the initial redemption date, they canstructure the redemption in one lump sum orstagger the redemption over time in tranches(for instance, in several annual installments).

2. Redemption Price

It appears that, in the majority of deals,redemption is at the original issuance priceplus any accrued and unpaid dividends, so that

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the investors are getting their money back withno appreciation.3 Note that investors actuallylose the time value of the money this way,unless a fixed rate of return is factored into theredemption price or dividends are cumulative,in which case they in effect receive a coupon.Many investors rationalize this as only relevantin a downside scenario when they are reducingtheir stakes to cut their losses becauseinvestors would not want to put their sharesback to the company if the company is doingwell and they stand to profit from theinvestment. This provides the company withcomfort that the investors will not put theirshares back if the fair market value of theunderlying common stock is above the originalpurchase price of the preferred stock. In otherwords, the provision becomes irrelevant if atthe time of the put, the company is worth morethan the post-money valuation at the time ofthe venture investment giving rise to theredeemable preferred stock.

On the other hand, if the redemption isa call option, investors will insist on “makewhole” premiums to preserve the return ontheir investment against a shortened maturity,or at least premiums to the projected fairmarket value at the future redemption date toavoid being bought out at what turns out to bea discount. Due to the uncertainty inprojecting future value, few venture investors

3 This may be due in part to Internal Revenue Code Section 305, whichtheoretically treats redemption premiums as constructive distributions ofthe preferred security over the pre-redemption term, resulting in taxable“phantom” income to the holder equal to the fair market value of thedeemed distributions.

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in our experience are willing to grant calloptions.

3. Eligibility

Companies granting a put redemptionprivilege often want to reserve the privilegeonly for major investors who hold either aminimum number of shares of the preferredstock or a minimum percentage ownership ofthe entire company. Sometimes, companieseven grant contractual repurchase rights to aselect few investors instead of incorporatingthe redemption privilege into their charter as aclass or series privilege. Most companies alsotry to require each holder to make redemptionelections, so that large investors cannot electon behalf of the entire class or series.

E. Protective Provisions

Venture investors typically obtain special classor series voting rights requiring their approval aspreferred stockholders before the company undertakescertain actions. These actions commonly include:

• Amending the charter or bylaws to adverselyaffect the rights, privileges and preferences of thepreferred stock,

• Declaring or making dividends or distributions oncommon stock or junior securities,

• Repurchasing or redeeming common stock orjunior securities,

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• Changing the size or composition of the board,especially where the venture investors have boardrepresentation rights,

• Issuing securities on parity with, or senior to, thepreferred stock,

• Issuing common stock or junior securities atdilutive prices or other than pursuant to employeepools, mergers, acquisitions, joint ventures,financing or leasing arrangements or other“buckets” approved by the board or within agreedupon size limits,

• A merger, consolidation or sale of the company,and

• A voluntary liquidation, dissolution,recapitalization or winding up of the company.

These actions would change the venture financingdeal post-closing, directly dilute the preferred stock orconstitute extraordinary transactions. Used this way,the veto privilege is thus an obvious protection againstactions which undermine the investment.

However, more recently, investors haveexerted greater control over portfolio company affairsby adding additional actions for their approval, manyof which have traditionally required board approval(in some cases, with the consent of the investors’representatives on the board) such as:

• Change in nature or line of business,

• Incurring debt above fixed dollar amounts ordebt/equity ratios,

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• Making capital expenditures or entering intocontracts obligating the company to spend morethan fixed dollar amounts,

• Increasing option pools or permitting acceleratedoption vesting,

• Acquisitions of other companies, licenses of amaterial portion of the company’s assets or othertransactions outside the ordinary course ofbusiness,

• Approval of the annual budget and changes in thebudget above a specified dollar amount,

• Changes in executive management, and

• Creation of subsidiaries.

Companies complain that these consentrequirements burden the company and limit itsflexibility in operating its business, and areunnecessary especially where the investors have boardrepresentation and, therefore, the ability to influencedecisions on these items. They try to require preferredstockholders to vote together as a class, in order toavoid having to obtain the consent of each series ofpreferred stock separately, and they argue for simplemajority votes instead of super-majority votingthresholds. In any event, companies often resistgiving any particular investor or group of investors ablocking right simply because they own enough sharesto form a voting block large enough to control theclass or series of preferred stock having the protectiveprovision.

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Investors reply that they merely want thecompany to run these extraordinary items by theinvestors, who will naturally comply if it is ineveryone’s best interest. Their board representation isa minority of the board and, thus, the investors reallyhave no final say in corporate governance otherwise.Each series has its own concerns, having come in atdifferent valuations with different liquidationpreferences. In particular, matters such as amendingthe charter or bylaws to adversely affect the preferredstock, should be a matter of self-determination foreach series, rather than losing control over the destinyof one’s own series. Particular investors apply thatlogic to their own stake and insist on super-majorityvoting requirements that effectively give them ablocking position.

And so, back and forth the debate goes. Oftenlost in all this is the impact of voting rights ofcommon stockholders, which as a class must approvethe terms of the preferred stock, including theforegoing protective provisions, unless the charterprovides for “blank check” preferred stock to bedesignated by the board and the investors havepermitted the company to set aside shares for issuancein this manner (which many venture investors do notpermit). We frequently find that the founders of thecompany, who are no longer part of the executivemanagement team of the company after several roundsof venture financing or who may have departed thecompany after it got off the ground, are large ormajority common stockholders. Accordingly,founders can hold out on approval of restrictiveprotective provisions or other harsh terms at the verymoment the company is struggling to put togetherfinancing, and play “chicken” with the investorsseeking these terms. Founders may be unhappy with

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the dilution from successive financings (after all, theyonce owned the whole company) or the direction ofthe company. As a result, founders may complicatethe deal by making it a three-way negotiation, andwithhold their approval until they receive cheapwarrants, board representation or other concessions.Practitioners should consider the rights and powers ofeach corporate constituency in early planning stagesof any financing.

F. Staggered Financings

Venture capital investors have long committedmore than their initial funding amount to portfoliocompanies to cover financing needs through the lifecycle of the companies prior to their liquidity events(typically IPOs or sales of the companies in which theinvestors can exit their investments). The process canbe analogized to a bank financing construction of abuilding, in which the bank lends portions of the totalamount of money needed to complete the project ininstallments only after the foundation is set, thebuilding is framed, wiring and pipes are installed, andeach other construction phase is completed. In thepast, the construction loan analogy has beendistinguishable because venture investors wouldinvest in different rounds at different (typicallyhigher) valuations, reflecting the growth andincreasing maturity of the company.

However, in recent years there has been anoticeable increase in “staggered” financings at thesame valuation, whereby the total investment amountfor a single financing round is split up into tranchesthat are funded in stages only after agreed uponmilestones are satisfied. These milestones are oftenbased on business plan projections or promises made

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to investors during due diligence, thereby forcing thecompany to live by its forecasts or future plans inexchange for the full funding to occur.

Structuring the staggered financingcommitment raises a variety of issues, aside from thestraightforward business deal. The company will wantmilestones that are clearly drafted and within itscontrol to the greatest extent practicable. Given thedifficulties that investors are facing, the companyshould request that transaction documents specify theconsequences to investors that fail to make theirmilestone payments in a timely fashion. Investorboard or stockholder voting control, restrictiveoperating covenants or similar terms in the venturefinancing documents, however, may frustratesatisfaction of the milestones. In addition, there is asubstantial risk that if valuations fall substantially, theinvestor will claim that any given milestone has notbeen met, leaving the company with only legalrecourse, which practically speaking, is too expensiveand time consuming to be a viable alternative for ayoung company with no funds. The company mayalso argue that it should not resatisfy the initial closingconditions at consummation of each tranche, on thetheory that but for satisfaction of the milestones, theinvestors would have funded the entire investmentamount in the first closing.

On the other hand, investors often wantmilestones to be flexible enough to adapt to changingmarket or company conditions, which can create a“moving target” problem for the company. Investorsmay want reassurance at each closing that there are nolegal prohibitions on further funding, companycounsel will opine to the same legal matters upon

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which the investors funded in the first place, and otherconditions for initial funding are still satisfied.

II. DOWN ROUNDS AND “WASHOUT” ANDCRAM-DOWN FINANCINGS

A. Down Rounds

Current market conditions, coupled with thereality that private company valuation is an art, not ascience, and more the product of arms-lengthnegotiation, have dramatically decreased valuations ofventure-backed companies in recent years. Likepublic investors, venture investors are again focusedon profitability, sound business plans and provenmanagement teams, and are spending more time duediligencing fewer investments made at much lowervaluations.

Many venture funds continue to concentrate oncleaning up their portfolios and funding existingportfolio companies that need to stay afloat.Companies have and continue to implement deep cost-cutting measures and layoffs, and exit non-corebusiness lines, to keep their burn rates at attractivelylow levels for investors.

As a result, many companies are being forcedto raise funds in “down rounds” – so called becausethe equity securities are sold at valuations lower thanfor prior financings. These down rounds raise anumber of issues.

1. Dilution

Existing investors and stockholders experienceimmediate and frequently substantial dilution from

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down rounds. This is due to the fact that theirownership interests, together with employee pools ofoutstanding options, are compressed into the lowervaluation. Indeed, the pre-money valuation in a downround is not only lower than the post-money valuationfor the previous financing round, it does not evenleave extra valuation room for options and othersecurities issued in the intervening period between thefinancing rounds. Therefore, a common stockholderwill own proportionately less of the company thansuch holder did immediately prior to the down round,and such holder’s shares will be worth less.

To illustrate, consider our original hypotheticalcase of a $5 million initial venture financing round ata $10 million pre-money valuation. If the price pershare was $1.00, then the investor would purchase5,000,000 shares worth $5 million and receive anapproximate 33.33% ownership stake. Now imaginethat the company needs to raise another $5 million in afollow-on financing round at a $5 million pre-moneyvaluation. Even assuming no issuances of capitalstock in the interim, the new investors would payaround $0.33 per share to buy approximately15,000,000 shares of the new series of preferred stock,representing a 50% ownership stake in the company.The first round investor, assuming no anti-dilutionadjustment to its investment, would be left with stockworth approximately $1,666,667 (a $3,333,333 write-down from the $5 million investment, or a two-thirdloss on the investment) and representing a 16.66%ownership stake in the company (nearly 35% less thanbefore the down round, wiping out nearly two-thirdsof the investor’s preexisting voting power). If thecompany has granted options or warrants or issuedstock in the interim, the first round investor is left witheven less.

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2. Anti-Dilution Protection

As discussed above in “Price ProtectionProvisions,” the prior venture investors can protectagainst the dilutive effect of a down round byobtaining weighted average or full ratchet adjustmentsto their preferred stock conversion price. Exercisingpreemptive rights to participate in the down round willnot avoid the dilution of previously purchasedsecurities (and may turn out eventually to be “goodmoney chasing bad money”), but price protectionprovisions can prevent or minimize such dilution bygiving the holders additional stock underlying thosesecurities – commonly referred to as “repricing” theprior round (a misnomer because only the conversionprice is reset).

Depending on the type and amount ofadjustment, holders of common stock, options,warrants or other junior securities are diluted morethan they otherwise would be by the down round.Their securities receive no adjustment while thepreferred stockholder with price protection does.Therefore, the value of their securities as a componentof the company’s overall capitalization is decreasedinto a shrinking sliver of the pre-money valuation forthe down round, and the preferred stockholder’sconversion price adjustment further dilutes thepercentage ownership of the common stockholdersand optionholders, who are typically the founders,managers and employees of the company. This canmake it difficult to obtain their stockholder approvalfor the financing (if needed) without readjusting theconversion price upwards, and make it difficult toattract and retain employees unless “top-up” option

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grants, “in-the-money” option arrangements, cashbonuses or other concessions are made.

In a down round, it is critical for the companyto calculate the anti-dilution adjustments to existingseries of preferred stock as it considers the terms ofthe new financing, keeping in mind that the lower theprice of the new round, the larger the percentage ofthe company that will be owned by the existingpreferred investors in relation to all other currentstockholders after the financing.

3. More Favorable Terms

If investors take a hard line on valuations, theyare also more likely to drive a hard bargain on non-price terms. Indeed, if the lower price reflects theadded risk of the venture, they will tend to protectagainst that risk more aggressively by insisting onstaggered funding, high liquidation preferences, seniorliquidation preferences, participating preferred,cumulative dividends, even stronger price protectionprovisions than prior investors, mandatory redemptionclauses, increased board control, broad protectivevoting rights, senior registration rights, senior co-saleor tag-along rights to sell out alongside others, take-along rights to require other securityholders to sell outin deals they strike with third parties, and a whole hostof other restrictive terms. Many of these are discussedin detail above. Left with no other financingalternatives and facing insolvency, the company mayhave no choice but to accede to these demands.

4. Under Water Securities

The terms sought by down round investorsoften force the investors to compromise, or the

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company to make third party concessions, becausethey impact other securityholders or employees whosecooperation in the investment and the venture areneeded. As discussed above, heavy dilution ofexisting common stockholders and junior preferredinvestors (exacerbated by the anti-dilution adjustmentsfor previous venture investors) can make it difficult toobtain their approval, as stockholders, of the proposedtransaction, or cause a significant employee retentionproblem, unless the valuation or anti-dilutionadjustments are revisited, the company adjustsownership with additional option or warrant grants, orthe company and the investors make other concessionsto those constituencies.

Similarly, if the new investors demand a highliquidation preference or participating preferred stock,the preexisting securities may be essentially worthless.Consider our hypothetical down round financing inwhich the new investors are willing to invest another$5 million at the lower $5 million pre-moneyvaluation. If the terms for the new series of preferredstock include a 500% liquidation preference, then theother securityholders would receive nothing if thecompany were liquidated or sold at any valuation lessthan $25 million. Optionholders may not only haveexercise prices greater than the new down round price,but existing preferred stockholders would actually beexposed to a greater potential loss (in our example, atotal loss) than their investment write-down.

This term alone often leads preexistingsecurityholders to the bargaining table for fear ofbeing disenfranchised. Their leverage usually rests inclass or series voting rights on the financing (forinstance, under state corporate laws or the terms ofprior venture rounds) or their indispensability as

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founders, managers or key employees of the company.As further discussed below, the company may evenwind up being recapitalized in order to accommodateall these constituencies. As a compromise, theliquidation preference sought by investors may bemoderated or junior securityholders may be givenspecial voting rights or other protections against thecompany liquidating without leaving any residualvalue for them.

5. Corporate Changes

It should come as no surprise that down roundsare often accompanied by belt-tightening andcorporate governance measures. In particular, ventureinvestors are requiring companies to cut costs, engagein layoffs and furloughs, and otherwise reduce theirburn rates before investing. Investors are alsoconditioning investments on management changes,changes in business plans, and other fundamentalchanges to companies. The lower valuation uponwhich investors invest, anti-dilution adjustments,changes in board composition and other contractualprovisions can give down round investors board orsecurityholder voting control of the company,allowing them to implement these steps even afterclosing.

Down round investors are typically highlymotivated to stay actively involved in the company inorder to monitor and manage their investment, and aremore likely than most investors to exercise corporategovernance control over the company. Like mergersand acquisitions in which companies must plan theirpost-closing integration, down rounds are more likelyto succeed in the long run (and less likely to blow upafter closing) if “social issues” surrounding corporate

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governance and future operating plans are resolvedbeforehand so that the parties can set theirexpectations properly. Some social issues arisingfrom down rounds—such as marketplace andcustomer perception of the company, employeereaction to the news that the company is declining invalue, management distraction by the financingprocess, and upheaval among company constituenciesfrom onerous financing terms—may never beresolved, and are simply costs of doing the deal.

B. “Washout” and Cram-Down Financings

In a number of deals, companies desperate forfinancing in order to survive are accepting venturefinancing at drastically reduced valuations, leading todramatic dilution of existing securityholders. The pre-money valuations are so low that preexisting stock andoptions are virtually worthless. With no otheralternative for the company to remain viable, holdersof preexisting securities are forced to accept thesecram-down terms as their only hope for eventuallyrealizing any value upon their securities.

In order to create some residual value foremployees holding under-water options, clean up theircapital structure, or shed their past corporate financehistory, some companies have engaged inrecapitalizations designed to provide a “fresh restart”for the companies. In such scenarios, outstandingpreferred stock is converted to common stock so thatthe preferred stockholders share pari passu withholders of common stock and options, frequently thefounders, management and employees of the companywho would otherwise have little equity incentive tomake the company succeed or approve the transaction,for that matter. Alternatively, existing preferred

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stockholders may waive anti-dilution adjustmentsarising from the down round, or the company and newinvestors may agree upon “top-up” option grants orother employee benefits and incentives as part of thetransaction.

Even though these “washout” financings andrecapitalizations may rescue a company on the brinkof collapse, they can expose the directors,management and majority stockholders of thecompany to liability for breach of fiduciary duty, andpotentially lead to rescission of the transaction. If thecompany turns out to be successful later on, non-participants in the washout round who lost out on thesubsequent equity appreciation may accuse thecompany and its directors of conflicts of interest, lackof due care in undertaking the transaction, failure todisclose the company’s prospects or other informationmaterial to their investment decision in voting upon ordeciding whether to invest in the transaction, or otherimproprieties.

These issues were on public display in theseminal case of Michael Kalashian et al. v. Advent VILimited Partnership et al. (“Alantec”)4, involvingAlantec Corp., a Silicon Valley-based manufacturer ofcomputer networking equipment. In a nutshell, thefounders of Alantec saw their ownership stake in thecompany drop from 8% to less than 0.007% as a resultof a series of financings in 1990-1991 after thefounders had left the company. In early 1996, Alantecwas acquired by Fore Systems Inc. for approximately$820 million. The founders sued the company, itsboard, and several venture capital fund investors in the

4 Michael Kalashian et al. v. Advent VI Limited Partnership et al., CaseNo. CV-739278 (Sup. Ct. Santa Clara Co., filed March 23, 1994).

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company for fraud, breach of fiduciary duty, andvicarious liability based on conspiracy. They claimed,among other things, that venture capitalists sitting onthe board of Alantec, believing that the founders hadtoo much stock in the company in view of theirdiminished roles in the company, conspired todeliberately dilute the founders by issuing themselvesadditional stock below the true fair market value ofthe company, while giving away common stock to thenew management of the company simply to permitthem to vote those shares in favor of the newfinancings. Among other things, the defendantscountered that, at the time of the financings, Alantecwas on the verge of bankruptcy, was unable to line upany other financing sources, and had to issue the stockto new management in order to retain and motivatethem to run the company. While the case settled outof court, the plaintiffs successfully withstood motionsfor summary judgment.

Two recent Delaware cases further illustratethe problems and potential pitfalls of cram-downfinancings, in particular where the investors and thecompany impose “pay-to-play” provisions orrecapitalizations with similar objectives. InBenchmark Capital Partners IV, L.P. v. JuniperFinancial Corp. et. al. and Canadian Imperial Bank ofCommerce (“Juniper Financial”)5, BenchmarkCapital Partners (“Benchmark”) sued its financiallydistressed portfolio company, Juniper Financial Corp.,a number of directors of Juniper, and CanadianImperial Bank of Commerce (“CIBC”), a later stageinvestor in Juniper, for their respective roles in a

5 Benchmark Capital Partners IV, L.P. v. Juniper Financial Corp. et. al.and Canadian Imperial Bank of Commerce., C.A. No. 19719 (Court ofChancery of the State of Delaware, July 15, 2002), aff’d, No 680-2002(Supreme Court of the State of Delaware, April 16, 2003).

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“wash-out” financing of Juniper. Like Alantec, theJuniper Financial case raises allegations of breach offiduciary duties by controlling stockholder investorsand questions the ability of companies to pursue thesefinancings at the expense of previous investors. Inaddition, Benchmark argued that the company wasobligated under its charter not to take any action thatwould impair the protective privileges and anti-dilution rights held by Benchmark as a holder of thecompany’s preferred stock. The motion for injunctiverelief requested in the case by Benchmark, to preventthe recapitalization, was denied by the Court ofChancery on relatively narrow technical groundsinstead of the core fiduciary duty issues at the heart ofthe case,6 and the judge presiding over the motionappeared to signal strong hesitation to interfere inwhat the Court considered a commercial transactionbetween sophisticated parties.7

In another case between two prominentventure capital firms, Weiss, Peck and Greer, LLC(“WPG”) brought suit against Hummer WinbladVenture Partners (“Hummer”) its individual partners,questioning the validity and implementation of a pay-

6 Among other things, the Court refused to invalidate the merger used bythe company to overcome the charter’s anti-impairment clause andauthorize the new dilutive series of preferred stock, since the charter’sprotective provisions cited by Benchmark did not expressly prohibitmergers to accomplish such charter amendments. Id. at 291.7 In balancing the equities, the Court stated: “While loss of ashareholder’s right to vote would certainly be a factor that must be givenserious weight in this analysis, when viewed in light of the factual settingof this case, I am of the opinion that Benchmark’s risks are minor whencompared to those which would likely result from depriving Juniper offinancing through the Series D Transaction. Considering that Benchmarkwould recover nothing (or almost nothing) if Juniper were forced intoliquidation, my conclusion that the equities tip in favor of Juniper isbolstered even more.” Id. at 44.

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to-play provision in a financing of Quiver, Inc. In,Weiss, Peck and Greer, LLC et. al. v. HummerWinblad Venture Partners et. al. (“Quiver”)8, WPGalleges that Hummer, as a controlling shareholder inQuiver, Inc. and one of the individual partners ofHummer, as a member of the board of directors ofQuiver, Inc., breached fiduciary duties owed to WPGand gave itself a “sweetheart deal” by approving andimplementing a “cram-down” financing that punishedprior investors unwilling or unable to further fund thecompany. Hummer denied the claims of breach offiduciary duty along the lines of the defensespresented in Alantec. Pending further adjudication,Quiver raises serious concerns about the validity of“pay-to-play” provisions, when and how they can beimplemented and the meaning of “interested” directorsin venture capital backed companies. If nothing else,the fact that some venture capital firms have beenwilling to bring lawsuits to mitigate what in the pastwas perceived as investment risk, could have achilling effect on the ability of companies to raisefollow-on venture financing in distressed situations.

The Alantec, Quiver and Juniper Financiallitigations have been wake-up calls to the venturecapital community. Companies, investors and theircounsel should be sensitive to common issues andtactics for addressing such issues in heavily dilutivefinancing transactions. In order to defend againstcollateral attack, the company and its board need tobuild a strong record that the transaction was carefullyconsidered on a fully informed basis by the board, wasthe best strategic alternative available to the company,

8 Weiss, Peck and Greer, LLC et. al. v. Hummer Winblad VenturePartners et. al., C.A. No. 19893-NC (Court of Chancery of the State ofDelaware).

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was approved by securityholders of the company (if atall) only after full disclosure of all materialinformation, and was completely above-board in allmaterial respects. There are a number of toolsavailable to build this record, depending on thesituation at hand:

1. Market Checks

The company and its board should conductthorough, ongoing market checks to determinewhether the washout financing terms are the bestvalue reasonably attainable in the marketplace. Inmanagement buyout situations, courts have placedgreat emphasis on whether companies set upappropriate processes for conducting market checks,as evidenced by board minutes and other suchdocumentation as described below, rather than simplyselling out to insiders without an auction or efforts toseek competitive bids. Ideally, companiescontemplating dilutive financings should solicitinterest from as many credible financing sources aspracticable, to provide support for the valuation andterms and to counter claims that the board failed to actin good faith, prudently or on an informed basis.

In this regard, counsel should be careful toavoid exclusivity provisions in a term sheet. Eitherthe company should refrain from executing a termsheet or entering into other binding arrangements thatlimit its flexibility until a thorough market check canbe conducted, or the company should limit the scopeof any exclusivity to maintaining the confidentiality ofthat particular proposal (i.e., the company will notshop that term sheet, but can continue to solicitinterest from others). Otherwise, the company could

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be accused of handcuffing itself before it can take thisand other steps to minimize its liability exposure.

2. Explore Alternatives to Financing

The company and its board should fullyexplore all alternatives to financing, including a saleof the company or liquidation. If the company isnearly bankrupt, it may very well be the case thatthere are no buyers so a sale is not feasible, andliquidation will not even satisfy creditors, much lessreturn any value to stockholders. However, whereverpossible, the company should avoid limiting itsoptions to heavily dilutive financings, if it can be soldat a higher valuation or resort to other avenues ofmaximizing stockholder value.

3. Financial Advisor or Appraisal

If the company has the financial resources todo so, it should consider engaging an investmentbanking firm or other securities institution to assist infundraising, conduct orderly market checks, explorestrategic alternatives, assess the industry andcompetitive landscape, advise on valuation and terms,provide a fairness opinion to support the board’sdetermination, or render an appraisal of the company’sstock to support the down round valuation.Sometimes the outsourced expertise alone is morevaluable than the valuation services, in which even theappropriate basis for valuation (e.g., going concern,comparable transaction or companies, liquidationanalysis, discounted cashflow analysis) is often opento debate.

4. Disinterested New Investors

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In exploring all available alternatives, thecompany should bring in a new investor to lead theround and negotiate the price if possible. A companyengaging in a washout round led by existing investorsand insiders may appear to lack the objectivity of anew investor leading the round. Even if existinginvestors participate in the round with the new leadinvestor, the new lead investor will re-negotiate thevaluation with the company based on the investor’sown fresh due diligence process, and help establishthat the price and terms were negotiated on an arms-length basis. The company and its preexistinginvestors normally will be motivated to bargain for thehighest possible valuation and best terms since they (i)will be diluted by the new investor, often to an extentunsalvageable by price-based anti-dilution provisionseven if they are full ratchet adjustments, and (ii) maybe made to stand in line behind the new lead investorin exercising valuable rights such as liquidationpreferences and registration rights. If the new leadinvestor imposes some of the investor-favorable termsdiscussed above, or insists on control of the new seriesof stock, the board will at least have a clear record thatthe new lead investors, and not the directors orexisting investors, imposed such terms on thecompany.

5. Special Committees

The company may want to establish a specialcommittee of the board of directors to handle thetransaction, especially if the board has venturecapitalists who will invest in the financing or areotherwise interested in the transaction. The specialcommittee should conduct market checks, explorestrategic alternatives, negotiate the transaction, andmake recommendations to the full board. Ideally, the

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special committee would consist of disinteresteddirectors, as well as representatives of diluted classesor series of capital stock (e.g., prior preferredstockholders and common stockholders) who couldlook out for their special interests. In Alantec,members of the board who clearly represented theinterests of the common shareholders approved anearly, though heavily dilutive, financing round,thereby providing an affirmative defense for thedefendants.

Unfortunately, it is often difficult to identifytruly disinterested directors. Many directors ofventure-backed companies have conflicts of interestbecause they are members of management orrepresent venture investors that stand to lose or gain inthe deal, they hold options in the company that will bedirectly affected by the deal, or they will receive“refresher” option grants in the deal to gross them upfor the dilution they will experience. Since existingpreferred stockholders having anti-dilution protectionwill be diluted to a lesser extent, and commonstockholders and optionholders will bedisproportionately affected as a result, even existingstockholders are not similarly situated and can differin their view of a transaction, depending on who iswashed out. Even if one can identify a few trulydisinterested directors, many directors areuncomfortable serving on the boards of troubledcompanies, much less being primarily responsible for“hail Mary” transactions, due to the very sameliability concerns they could help insulate thecompany from. If the company is unable to assemblea special committee, it should at least limit the role ofinterested directors in the process to the greatest extentpossible.

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6. Stockholder Approval

Companies may want to consider obtainingstockholder approval of the transaction, especially ifthe board has conflicts of interest, if the interests ofthe common stockholders or other juniorsecurityholders are not represented on the board, or ifthe board wishes to build a stronger record by havingstockholders bless the transaction. Counsel shouldnote that the consent solicitation or formal stockholdermeeting process, coupled with preparation andcirculation of information statements or otherproxy/consent solicitation materials (which in turnmay need to be filed and reviewed by state blue skyauthorities as solicitation materials), will most likelydelay closing precisely at the time when the companyis desperate for financing to continue operations.Also, there is a potential risk that the transaction maybe rejected by stockholders once they realize that thetransaction will wash them out.

However, the approval process can beaccomplished as part of a rights offering tostockholders allowing them to participate in thefinancing as an investor (see discussion below), andapproval by common stockholders can provide astrong affirmative defense for the transaction. In fact,merely notifying stockholders in advance of thetransaction, while not estopping them fromcomplaining later, may elicit any grass roots supportor opposition and serve as a litmus test for commonstockholder sentiment toward the transaction. Noticeof the transaction without contemporaneousopposition may also serve as evidence thatstockholders in fact were not interested inparticipating in the round and supporting the companyat its time of need, and instead regretted passing on

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the opportunity only when it became apparent theymissed out on a big windfall.

7. Rights Offering

The company should always consider offeringthe new stock, on the same terms as all otherinvestors, to existing securityholders of the company,even if they do not enjoy preemptive rights. The offerto participate in the new financing round on the sameterms provides a means for existing securityholders toprotect themselves against dilution, and can helpsupport a record of good faith and fair and equaltreatment of all securityholders of the company.Indeed, the Alantec plaintiffs argued that thedefendant directors’ fiduciary duties required them toopen up the dilutive financing rounds to all othershareholders.

A rights offering, however, can be expensiveand time consuming, and may not completely cleansethe transaction since other investors, especiallyfounders and employees holding common stock, maynot have the financial resources to participate in a newround of financing on the same terms as a financialinvestor with deep pockets. Also, the company mayhave many non-accredited or unsophisticatedsecurityholders (for instance, low-level employeeswho have exercised options) who must be excludedfrom the offering in order to preserve a privateplacement exemption from registration under theSecurities Act of 1933, as amended, or to comply withstate blue sky requirements. The company may evensimply be unable to reach securityholders and notifythem of the transaction or rights offering (e.g.,departed employees).

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Typically, in a rights offering, the companygives other securityholders the right to participate on apro rata basis in the dilutive financing, and delivers aninformation statement or other documents detailingthe transaction and the rights offering. Practitionersshould be aware that state blue sky laws may requirefiling and review of solicitation materials in theabsence of federal securities law preemption. Thereare no standard forms or requirements for thesedisclosure documents, and practice varies widely fromregistration statement disclosure levels to relativelyshort correspondence warning of the company’s diresituation and extreme dilution faced by non-participating stockholders. However, the disclosuredocuments can create independent liability tostockholders if they contain material misstatements oromissions.

8. Improved Terms

The company can support its claim that thetransaction was bargained in good faith at arms-lengthby seeking pro-company terms. For instance, thecompany can lower liquidation preferences, eliminateparticipating preferred features, add pay-to-playprovisions, water down protective veto provisions,increase its employee pool on a post-money basis, orotherwise improve upon the terms in its last round offinancing. Or the company can seek futureperformance-based milestones which, if achieved,reprice the down round, trigger upward adjustments inthe conversion price of the dilutive security, or lead toimproved terms for the company.

9. Written Record

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Counsel needs to document the financing andcorporate approval process carefully and diligently.Board minutes should contain a clear record of themarket checks, outside financial advice, evaluation ofstrategic alternatives, special committees and othermeasures to neutralize self-dealing and conflicts ofinterest, efforts to protect diluted equity stakeholders,and other steps taken in the process of completing thefinancing. Plaintiffs will closely scrutinize the board’sdeliberative process to determine if, and courts will bemore inclined to uphold a transaction if it appears that,the board fully explored all other alternatives, acted ingood faith and in the best interests of the company, asopposed to self-interest, and only disproportionatelydiluted other securityholders as a last resort in order toget the best deal reasonably possible under thecircumstances.

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APPENDIX A

SAMPLE PROVISIONS FOR VENTURE CAPITAL

FINANCING TRANSACTIONS

LIQUIDATION PREFERENCE

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

[Version 1 - (Non-Participating Preferred Stock]

Payments to Holders of Preferred Stock. In the eventof any voluntary or involuntary liquidation, dissolution orwinding up of the Corporation, the holders of shares ofPreferred Stock then outstanding shall be entitled to be paidout of the assets available for distribution to its stockholdersbefore any payment shall be made to the holders of CommonStock by reason of their ownership thereof, an amount equalto the greater of (i) [__ times] the applicable Original IssuePrice of the Preferred Stock, plus any dividends declared butunpaid thereon, or (ii) such amount per share as would havebeen payable had each such share been converted intoCommon Stock pursuant to Section [ ___] immediately priorto such liquidation, dissolution or winding up (the amountpayable pursuant to this sentence is hereinafter referred to asthe “Preferred Stock Liquidation Amount”). If upon any suchliquidation, dissolution or winding up of the Corporation theremaining assets available for distribution to its stockholdersshall be insufficient to pay the holders of shares of PreferredStock the full aforesaid preferential amount to which theyshall be entitled, the holders of shares of Preferred Stock shallshare ratably in any distribution of the remaining assetsavailable for distribution in proportion to the respectiveamounts which would otherwise be payable in respect of the

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shares held by them upon such distribution if all amountspayable on or with respect to such shares were paid in full.

Payments to Holders of Common Stock. After thepayment of all preferential amounts required to be paid to theholders of Preferred Stock, the holders of shares of CommonStock then outstanding shall be entitled to receive theremaining assets of the Corporation available for distributionto its stockholders as otherwise set forth in this Certificate ofIncorporation.

A merger or consolidation (other than one in whichstockholders of the Company own a majority by voting powerof the outstanding shares of the surviving or acquiringcorporation) and a sale, lease, transfer or other disposition ofall or substantially all of the assets of the Company will betreated as a liquidation event (a “Deemed LiquidationEvent”), thereby triggering payment of the liquidationpreferences described above [unless the holders of [___]% ofthe Preferred Stock elect otherwise].

[Version 2 - Fully Participating Preferred Stock]

Preferential Payments to Holders of Preferred Stock.In the event of any voluntary or involuntary liquidation,dissolution or winding up of the Corporation, the holders ofshares of Preferred Stock then outstanding shall be entitled tobe paid out of the assets available for distribution to itsstockholders, before any payment shall be made to the holdersof Common Stock by reason of their ownership thereof, anamount equal to the applicable Original Issue Price of thePreferred Stock, plus any dividends declared but unpaidthereon. If upon any such liquidation, dissolution or windingup of the Corporation the remaining assets available fordistribution to its stockholders shall be insufficient to pay theholders of shares of Preferred Stock the full amount to whichthey shall be entitled, the holders of shares of Preferred Stock

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shall share ratably in any distribution of the remaining assetsavailable for distribution in proportion to the respectiveamounts which would otherwise be payable in respect of theshares held by them upon such distribution if all amountspayable on or with respect to such shares were paid in full.

Distribution of Remaining Assets. After the paymentof all preferential amounts required to be paid to the holdersof shares of Preferred Stock, the remaining assets availablefor distribution to the Corporation’s stockholders shall bedistributed among the holders of the shares of Preferred Stockand Common Stock, pro rata based on the number of sharesheld by each such holder, treating for this purpose all suchsecurities as if they had been converted to Common Stockpursuant to the terms of the Certificate of Incorporationimmediately prior to such dissolution, liquidation or windingup of the Corporation. The aggregate amount which a holderof a share of Preferred Stock is entitled to receive under thisSection [______] is hereinafter referred to as the “PreferredStock Liquidation Amount.”

A merger or consolidation (other than one in whichstockholders of the Company own a majority by voting powerof the outstanding shares of the surviving or acquiringcorporation) and a sale, lease, transfer or other disposition ofall or substantially all of the assets of the Company will betreated as a liquidation event (a “Deemed LiquidationEvent”), thereby triggering payment of the liquidationpreferences described above [unless the holders of [___]% ofthe Preferred Stock elect otherwise].

[Version 3 - Cap on Preferred Stock ParticipationRights]

Preferential Payments to Holders of Preferred Stock.In the event of any voluntary or involuntary liquidation,dissolution or winding up of the Corporation, the holders of

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shares of Preferred Stock then outstanding shall be entitled tobe paid out of the assets available for distribution to itsstockholders, before any payment shall be made to the holdersof Common Stock by reason of their ownership thereof, anamount equal to the applicable Original Issue Price of thePreferred Stock, plus any dividends declared but unpaidthereon. If upon any such liquidation, dissolution or windingup of the Corporation the remaining assets available fordistribution to its stockholders shall be insufficient to pay theholders of shares of Preferred Stock the full amount to whichthey shall be entitled, the holders of shares of Preferred Stockshall share ratably in any distribution of the remaining assetsavailable for distribution in proportion to the respectiveamounts which would otherwise be payable in respect of theshares held by them upon such distribution if all amountspayable on or with respect to such shares were paid in full.

Distribution of Remaining Assets. After the paymentof all preferential amounts required to be paid to the holdersof shares of Preferred Stock, the remaining assets availablefor distribution to the Corporation’s stockholders shall bedistributed among the holders of the shares of Preferred Stockand Common Stock, pro rata based on the number of sharesheld by each such holder, treating for this purpose all suchsecurities as if they had been converted to Common Stockpursuant to the terms of the Certificate of Incorporationimmediately prior to such dissolution, liquidation or windingup of the Corporation. The aggregate amount which a holderof a share of Preferred Stock is entitled to receive under thisSection [____] is hereinafter referred to as the “PreferredStock Liquidation Amount;” provided, however, that if theaggregate amount which the holders of Preferred Stock areentitled to receive under this Section [___] shall exceed[$_______] per share (subject to appropriate adjustment in theevent of a stock split, stock dividend, combination,reclassification, or similar event affecting the Preferred Stock)(the “Maximum Participation Amount”), each holder of

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Preferred Stock shall be entitled to receive upon suchdissolution, liquidation or winding up of the Corporation thegreater of (i) the Maximum Participation Amount and (ii) theamount such holder would have received if such holder hadconverted his, her or its shares of Preferred Stock intoCommon Stock immediately prior to such dissolution,liquidation or winding up of the Corporation (the greater ofwhich is hereinafter referred to as the “Preferred StockLiquidation Amount”).”

A merger or consolidation (other than one in whichstockholders of the Company own a majority by voting powerof the outstanding shares of the surviving or acquiringcorporation) and a sale, lease, transfer or other disposition ofall or substantially all of the assets of the Company will betreated as a liquidation event (a “Deemed LiquidationEvent”), thereby triggering payment of the liquidationpreferences described above [unless the holders of [___]% ofthe Preferred Stock elect otherwise].

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REDEMPTION

[Version 1 - Mandatory Redemption as of a certain date]

Subject to the rights of Preferred Stock whichmay from time to time come into existence, this corporationshall redeem, from any source of funds legally availabletherefor, the Preferred Stock [in ________ [quarterly][annual] installments beginning on ___________, andcontinuing thereafter on each ___________, ________,________ and _________ (each a “Redemption Date”) until___________, whereupon the remaining Preferred Stockoutstanding shall be redeemed]. The corporation shall effectsuch redemptions on the applicable Redemption Dates bypaying in cash in exchange for the shares of Preferred Stockto be redeemed a sum equal to $________ per share ofPreferred Stock (as adjusted for any stock dividends,combinations or splits with respect to such shares) plus alldeclared or accumulated but unpaid dividends on such shares(the “Redemption Price”). The number of shares of PreferredStock that the corporation shall be required under thisparagraph to redeem on any particular Redemption Date shallbe equal to the amount determined by dividing (i) theaggregate number of shares of Preferred Stock outstandingimmediately prior to the Redemption Date by (ii) the numberof remaining Redemption Dates (including the RedemptionDate to which such calculation applies). Any redemptioneffected pursuant to this paragraph shall be made on a pro ratabasis among the holders of the Preferred Stock in proportionto the number of shares of Preferred Stock then held by suchholders.

[Version 2 - Redemption at Option of Majority of Holdersof Preferred Stock]

Subject to the rights of Preferred Stock whichmay from time to time come into existence, at any time after

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_____________, but within thirty (30) days (the “RedemptionDate”) after the receipt by this corporation of a writtenrequest from the holders of not less than a [_____%] majorityof the then outstanding Preferred Stock that all or some ofsuch holders’ shares be redeemed, and concurrently withsurrender by such holders of the certificates representing suchshares, this corporation shall, to the extent it may lawfully doso, redeem the shares specified in such request by paying incash therefor a sum per share equal to $__________ per shareof Preferred Stock (as adjusted for any stock dividends,combinations or splits with respect to such shares) plus alldeclared or accumulated but unpaid dividends on such shares(the “Redemption Price”). Any redemption effected pursuantto this paragraph shall be made on a pro rata basis among theholders of the Preferred Stock in proportion to the number ofshares of Preferred Stock then held by such holders.

[Version 3 - Redemption at Option of IndividualShareholder]

Subject to the rights of Preferred Stock which may from timeto time come into existence, at the individual option of eachholder of shares of Preferred Stock, this corporation shallredeem, on ____________ of each year commencing with____ and continuing thereafter (each a “Redemption Date”),the number of shares of Preferred Stock held by such holderthat is specified in a request for redemption delivered to thiscorporation by the holder on or prior to the __________immediately preceding the applicable Redemption Date, bypaying in cash therefor, $_____ per share of Preferred Stock(as adjusted for any stock dividends, combinations or splitswith respect to such shares) plus all declared or accumulatedbut unpaid dividends on such shares (the “RedemptionPrice”); provided, however, that the Corporation shall not berequired under this paragraph to redeem from any particularholder (i) in connection with the initial Redemption Dateupon which such holder’s shares of Preferred Stock are being

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redeemed, a number of shares of Preferred Stock greater than______% of the aggregate number of shares of PreferredStock held by such holder immediately prior to suchredemption, and (ii) in connection with the secondRedemption Date upon which such holder’s shares ofPreferred Stock are being redeemed, a number of shares ofPreferred Stock greater than fifty percent (50%) of theaggregate number of shares of Preferred Stock held by suchholder immediately prior to such redemption.

[Version 4 - Redemption at the Option of theCorporation]

Subject to the rights of Preferred Stock whichmay from time to time come into existence, this corporationmay at any time it may lawfully do so, at the option of theBoard of Directors, redeem in whole or in part the PreferredStock by paying in cash therefor a sum equal to theRedemption Price. Any redemption effected pursuant to thisparagraph shall be made on a pro rata basis among the holdersof the Preferred Stock in proportion to the number of sharesof Preferred Stock then held by them.

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ANTIDILUTION PROTECTION

Conversion Price Adjustments of Preferred Stock forCertain Dilutive Issuances. The Conversion Price of thePreferred Stock shall be subject to adjustment from time totime as follows:

If the corporation shall issue, after the dateupon which any shares of Preferred Stock were first issued(the “Purchase Date” with respect to such series), anyAdditional Stock (as defined below) without consideration orfor a consideration per share less than the Conversion Pricefor such Series in effect immediately prior to the issuance ofsuch Additional Stock, the Conversion Price for suchSeries in effect immediately prior to each such issuance shallforthwith (except as otherwise provided in this clause) beadjusted

[Ratchet Formula: to a price equal to theprice paid per share for such Additional Stock.]

[Narrow-Based Formula: to a price equal tothe quotient obtained by dividing the total computed underclause (x) below by the total computed under clause (y) belowas follows:

(x) an amount equal to the sumof

(1) the aggregate purchase priceof the shares of the Preferred Stock sold pursuant to theagreement pursuant to which shares of Preferred Stock arefirst issued (the “Stock Purchase Agreement”), plus

(2) the aggregate consideration,if any, received by the corporation for all Additional Stockissued on or after the Purchase Date for such series;

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(y) an amount equal to the sumof

(1) the aggregate purchase priceof the shares of Preferred Stock sold pursuant to the StockPurchase Agreement divided by the Conversion Price for suchshares in effect at the Purchase Date for such series, plus

(2) the number of shares ofAdditional Stock issued since the Purchase Date for suchseries.]

[Broad-Based Formula: to a price determinedby multiplying such Conversion Price by a fraction, thenumerator of which shall be the number of shares of CommonStock outstanding immediately prior to such issuance plus thenumber of shares of Common Stock that the aggregateconsideration received by the corporation for such issuancewould purchase at such Conversion Price; and thedenominator of which shall be the number of shares ofCommon Stock outstanding immediately prior to suchissuance plus the number of shares of such Additional Stock.For the purpose of the above calculation, the number ofshares of Common Stock immediately prior to such issuanceprior to such issuance shall be calculated on a fully-dilutedbasis, as if all shares of Preferred Stock had been fullyconverted into shares of Common Stock and any outstandingwarrants, options or other rights for the purchase of shares ofstock or convertible securities had been fully exercise as ofsuch date.]

“Additional Stock” shall not include:

(i) securities issuable upon conversion of anyof the Series A Preferred, or as a dividend or distribution onthe Series A Preferred; (ii) securities issued upon theconversion of any debenture, warrant, option, or other

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convertible security; (iii) Common Stock issuable upon astock split, stock dividend, or any subdivision of shares ofCommon Stock; and (iv) shares of Common Stock (or optionsto purchase such shares of Common Stock) issued or issuableto employees or directors of, or consultants to, the Companypursuant to any plan approved by the Company’s Board ofDirectors [including at least [_______] Series A Director(s)][(v) shares of Common Stock issued or issuable to banks,equipment lessors pursuant to a debt financing, equipmentleasing or real property leasing transaction approved by theBoard of Directors of the Corporation [, including at least[_______] Series A Director(s)].

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PAY-TO-PLAY PROVISIONS

The below paragraph provides standardlanguage for a pay-to-play provision. Inclusion of thisprovision will require the authorization of a derivativeseries of preferred stock (e.g., Series A-1 Preferred Stock)which typically has all the attributes of the originalseries of preferred stock, except for the price-basedantidilution rights, other antidilution rights, protectiveprovisions or other rights. Sometimes, the PreferredStock converts to Common Stock.

Special Mandatory Conversion.

(i) At any time following the Purchase Date, if (a) theholders of shares of Preferred Stock are entitled to exercisethe right of first offer (the “Right of First Offer”) set forth inSection ___ of the [Investors’ Rights Agreement] dated_____________ by and between this corporation and certaininvestors, as amended from time to time (the “RightsAgreement”), with respect to an equity [or debt] financing ofthe corporation (the “Equity Financing”), (b) this corporationhas complied with its notice obligations, or such obligationshave been waived, under the Right of First Offer with respectto such Equity Financing and this corporation thereafterproceeds to consummate the Equity Financing and (c) suchholder (a “Non-Participating Holder”) does not by exercise ofsuch holder’s Right of First Offer acquire his, her or its ProRata Share (as defined in Section ___ of the RightsAgreement) offered in such Equity Financing (a “MandatoryOffering”), then all of such Non-Participating Holder’s sharesof Preferred Stock shall automatically and without furtheraction on the part of such holder be converted effective upon,subject to, and concurrently with, the consummation of theMandatory Offering (the “Mandatory Offering Date”) into anequivalent number of shares of [Series A-1 Preferred Stock];provided, however, that no such conversion shall occur in

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connection with a particular Equity Financing if, pursuant tothe written request of this corporation, such holder agrees inwriting to waive his, her or its Right of First Offer withrespect to such Equity Financing. Upon conversion pursuantto this paragraph, the shares of Preferred Stock so convertedshall be cancelled and not subject to reissuance.

(ii) The holder of any shares of Preferred Stock convertedpursuant to this paragraph shall deliver to this corporationduring regular business hours at the office of any transferagent of the corporation for the Preferred Stock, or at suchother place as may be designated by the corporation, thecertificate or certificates for the shares so converted, dulyendorsed or assigned in blank or to this corporation. Aspromptly as practicable thereafter, this corporation shall issueand deliver to such holder, at the place designated by suchholder, a certificate or certificates for the number of fullshares of the [Series A-1 Preferred Stock] to be issued andsuch holder shall be deemed to have become a shareholder ofrecord of [Series A-1 Preferred Stock] on the MandatoryOffering Date unless the transfer books of this corporation areclosed on that date, in which event he, she or it shall bedeemed to have become a shareholder of record of [Series A-1 Preferred Stock] on the next succeeding date on which thetransfer books are open.

(iii) In the event that any [Series A-1 Preferred Stock]shares are issued, concurrently with such issuance, thiscorporation shall use its best efforts to take all such action asmay be required, including amending its Articles ofIncorporation, (a) to cancel all authorized shares of [Series A-1 Preferred Stock] that remain unissued after such issuance,(b) to create and reserve for issuance upon Special MandatoryConversion of any [Series A] Preferred Stock a new Series ofPreferred Stock equal in number to the number of shares of[Series A-1 Preferred Stock] so cancelled and designated[Series A-2 Preferred Stock], with the designations, powers,

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preferences and rights and the qualifications, limitations andrestrictions identical to those then applicable to the [Series A-1 Preferred Stock], except that the Conversion Price for suchshares of [Series A-2 Preferred Stock] once initially issuedshall be the Series A Conversion Price in effect immediatelyprior to such issuance and (c) to amend the provisions of thisparagraph to provide that any subsequent Special MandatoryConversion will be into shares of Series ___-2 PreferredStock rather than Series ___-1 Preferred Stock. Thiscorporation shall take the same actions with respect to theSeries ___-2 Preferred Stock and each subsequentlyauthorized Series of Preferred Stock upon initial issuance ofshares of the last such Series to be authorized. The right toreceive any dividend declared but unpaid at the time ofconversion on any shares of Preferred Stock convertedpursuant to the provisions of this paragraph shall accrue to thebenefit of the new shares of Preferred Stock issued uponconversion thereof.]

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PROTECTIVE PROVISIONS

Subject to the rights of Preferred Stock whichmay from time to time come into existence, so long as anyshares of Preferred Stock are outstanding, this corporationshall not without first obtaining the approval (by vote orwritten consent, as provided by law) of the holders of[Preferred Stock which is entitled, other than solely by law, tovote with respect to the matter (including, without limitation,the Preferred Stock), and which Preferred Stock represents atleast a majority of the voting power of the then outstandingshares of such Preferred Stock] [at least a majority of the thenoutstanding shares of Preferred Stock]:

(a) sell, convey, or otherwise dispose of orencumber all or substantially all of its property or business ormerge into or consolidate with any other corporation (otherthan a wholly-owned subsidiary corporation) or effect anytransaction or series of related transactions in which morethan fifty percent (50%) of the voting power of thecorporation is disposed of;

(b) alter or change the rights, preferences orprivileges of the shares of Preferred Stock so as to affectadversely the shares;

(c) increase or decrease (other than by redemptionor conversion) the total number of authorized shares ofPreferred Stock;

(d) authorize or issue, or obligate itself to issue,any other equity security, including any other securityconvertible into or exercisable for any equity security[(i)] having a preference over, or being on a parity with, thePreferred Stock with respect to voting, dividends or uponliquidation[, or (ii) having rights similar to any of the rights ofthe Preferred Stock under this Section 6;

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(e) redeem, purchase or otherwise acquire (or payinto or set aside for a sinking fund for such purpose) anyshare or shares of Preferred Stock or Common Stock;provided, however, that this restriction shall not apply to(i) the repurchase of shares of Common Stock fromemployees, officers, directors, consultants or other personsperforming services for the Company or any subsidiarypursuant to agreements under which the Company has theoption to repurchase such shares at cost or at cost upon theoccurrence of certain events, such as the termination ofemployment [provided further, however, that the total amountapplied to the repurchase of shares of Common Stock shallnot exceed $_________ during any twelve (12) month period]or (ii) the redemption of any share or shares of PreferredStock otherwise than by redemption in accordance withsubsection __;

(f) amend the Corporation’s certificate ofincorporation or bylaws;

(g) change the authorized number of directors ofthe corporation;

(h) enter into any financial commitments orexpenditures over $_________;

(i) create any material liens upon the assets andproperties of the Corporation;

(j) exclusively license all or substantially all ofthe Corporation’s intellectual property in a single transactionor series of related transactions; or

(k) engage in substantial acquisitions or changesin business or enter into any new lines of business, jointventure or similar arrangement.

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APPENDIX B

ILLUSTRATION OF ANTI-DILUTIONADJUSTMENTS

A startup company, the Next Best Thing, Inc., whichdevelops cutting edge widgets, is incorporated. The foundersbelieve that given the success of other companies in the sameindustry and the then current market conditions, the companycan go public in a few years. The company issues commonstock to its two founders and thereafter, has the followingcapitalization structure:

# of Shares %Common Stock (founders) 3,500,000 77.78%Stock Option/Stock IssuancePlan (shares reserved)

1,000,000 22.22%

TOTAL 4,500,000 100%

Seed Financing

Two months after the company’s incorporation, thefounders reached the limit on their credit cards for the initialcosts incurred in starting and operating the company. In thisregard, one of the founder’s mentors (the “Angel Investor”),agreed to invest $50,000 in seed money into the company, soas to allow the Company to continue operating its businessuntil it is able to receive venture financing.

In exchange for the $50,000 in seed money, the AngelInvestor received 500,000 shares of Common Stock at apurchase price of $0.10 per share.

After the infusion of the $50,000 equity investmentfrom the angel investor, the capitalization of the company,including the corresponding ownership percentage of thecompany, was as follows:

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# of Shares %Common Stock (founders) 3,500,000 70%Common Stock (angelinvestor)

500,000 10%

Stock Option/Stock IssuancePlan (shares reserved)

1,000,000 20%

TOTAL 5,000,000 100%

Series A Financing

Later, after making significant advances in its researchand development efforts, the company sought $5 million inventure capital, and received three term sheets, negotiating a$5 million pre-money valuation. After weighing these termsheets, the company selected its investors and entered intodefinitive investment agreements. The purchase price was$1.00 per share of Series A preferred stock, representing thepre-money valuation of $5 million (5,000,000 shares with avalue of $1.00 per share). Post-financing, the capitalizationof the company, including the corresponding ownershippercentage of the company, was as follows:

Pre-Financing Post-FinancingCapitalization # of Shares % # of Shares %Series A Preferredstock

0 0% 5,000,000 50%

Common Stock(founders)

3,500,000 70% 3,500,000 35%

Common Stock(angel investor)

500,000 10% 500,000 5%

Stock Options 1,000,000 20% 1,000,000 10%Total Number ofShares

5,000,000 10,000,000

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Series B Financing

Thereafter, the company released a beta version of itstechnology and received favorable reviews from customers.However, the company required an additional $10 million tocomplete the commercial roll-out of its product. Accordingly,the company sought additional investors. Within months, thecompany negotiated a $20 million pre-money valuation with anew lead investor and its existing investors. The purchaseprice was $2.00 per share of Series B preferred stock,representing a pre-money valuation of $20 million(10,000,000 shares with a value of $2.00 per share).

Post-financing, the capitalization of the company,including the corresponding ownership percentage of thecompany, was as follows:

Pre-Financing Post-FinancingCapitalization # of Shares % # of Shares %Series BPreferred stock

0 0% 5,000,000 33.33%

Series APreferred stock

5,000,000 50% 5,000,000 33.33%

Common Stock(founder)

3,500,000 35% 3,500,000 23.33%

Common Stock(angel investor)

500,000 5% 500,000 3.33%

Stock Options 1,000,000 10% 1,000,000 6.67%Total Number ofShares

10,000,000 15,000,000

Series C Financing

Within the next nine months, the company had signedup three customers and had generated significant revenues.Despite its three customers and the experiences of other

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companies within the last year, the company was not yetready to go public and had to raise $36 million of additionalcapital. The company negotiated a $90 million pre-moneyvaluation with investors. The purchase price was $6.00 pershare of Series C preferred stock, representing a pre-moneyvaluation of $90 million (15,000,000 shares with a value of$6.00 per share).

In conjunction with the financing, the boardrecognized that the company needed to increase the size of itsstock option pool to attract and retain its talent, and subject tostockholder approval, approved an increase, on a post-financing basis, of the stock option pool by 3,000,000 shares.

Post-financing, the capitalization of the company,including the corresponding ownership percentage of thecompany, was as follows:

Pre-Financing Post-FinancingCapitalization # of Shares % # of Shares %Series C Preferredstock

0 6,000,000 25%

Series B Preferredstock

5,000,000 33.33% 5,000,000 20.83%

Series A Preferredstock

5,000,000 33.33% 5,000,000 20.83%

Common Stock(founder)

3,500,000 23.33% 3,500,000 14.58%

Common Stock(angel investor)

500,000 3.33% 500,000 2.08%

Stock Options 1,000,000 6.67% 4,000,000 16.67%Total Number ofShares

15,000,000 24,000,000

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Series D Financing

Now, the company has released the second version ofits product but has only signed up a total of seven customers,less than the number of customers anticipated in thecompany’s business plan. While the company has significantrevenues, it needs an additional $10 million to expand itsmarketing capabilities to reach profitability. However, thecapital markets are closed to the company and the stock priceof public companies in the same industry have declinedtremendously. Given this environment, the company can onlynegotiate a $30 million pre-money valuation, which isapproximately a 67% decrease in valuation. The purchaseprice is $1.25 per share of Series D preferred stock,representing a pre-money valuation of $30 million(24,000,000 shares with a value of $1.25 per share).

Because the Series D financing will be a “downround,” as discussed above (the price per share of Series Dpreferred stock is less than the price paid in the previousSeries C round of financing), there will be anti-dilutionadjustments in accordance with the rights governing thepreferred stock, as set forth in the articles/certificate ofincorporation. The chart below indicates the number ofshares of each series of preferred stock, as calculated usingthe broad based, narrow-based and full ratchet anti-dilutionadjustments, which are discussed above.

A basic broad based weighted average anti-dilutionformula may be expressed as follows:

CS +(AC/CP) NCP = CP * CS + AS, where

CS = Common stock outstanding (on a fullyconverted basis) prior to the dilutive issuance,

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AC = Aggregate consideration paid for thesecurities causing the dilutive adjustment,

CP = Conversion price prior to theadjustment of the series of preferred stockbeing adjusted,

AS = Number of shares of securities (on anas-converted basis) causing the dilutiveissuance, and

NCP = New conversion price.

In applying the broad based weighted average formula usingthe capitalization of the company, the “new” Series Bconversion price would be $0.75 per share, and thus theconversion ratio for the Series B preferred stock would be$1.00/$0.75 = 1.33. As a result of this higher conversionratio, the company would need to issue 1,666,666 additionalshares of common stock upon conversion to the holdersthereof, in order for the holders to maintain their ownershippercentage of the company. Similarly, the “new” Series Cconversion price would be $1.50 per share, and thus theconversion ratio for the Series B preferred stock would be$2.00/$1.50 = 1.33. As a result of this higher conversionratio, the company would need to issue 2,000,000 additionalshares of common stock upon conversion to the holdersthereof, in order for the holders to maintain their ownershippercentage of the company. In sum, the company using thisbroad based weighted average formula would issue anadditional 3,666,666 shares of common stock due to the downround, and the percentage ownership of the commonstockholders would decrease from an aggregate of 16.66% to11.21% post financing.

A basic narrow based weighted average formula maybe expressed as follows:

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NCP = (X1 + X2) / (Y1 + Y2), where

NCP = New conversion price,

X1 = Aggregate consideration paid for sharesof series of preferred stock with respect towhich adjustment is being made,

X2 = Aggregate consideration paid foradditional stock since the date of first issuanceof series of preferred stock with respect towhich adjustment is being made,

Y1 = Number of issued shares of series ofpreferred stock with respect to whichadjustment is being made, and

Y2 = Number of shares of Additional Stockissued since the applicable Purchase Date.

In applying the narrow based weighted average formula usingthe capitalization of the company, the “new” Series Cconversion price would be $3.28 per share, and thus theconversion ratio for the Series C preferred stock would be$6.00/$3.28 = 1.83. As a result of this higher conversionratio, the company would need to issue 4,956,522 additionalshares of common stock upon conversion to the holdersthereof, in order for the holders to maintain their ownershippercentage of the company. Note that the company would notissue additional shares of Series B preferred stock. In sum,the company using a narrow based weighted average formulawould issue an additional 4,956,522 shares of common stockupon conversion due to the down round, and the percentageownership of the common stockholders would decrease froman aggregate of 16.66% to 10.82% post financing.

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As discussed above, with a full ratchet adjustment, theprice per share of the diluted stock would automaticallydecrease to the per share price of the dilutive stock. In theabove case, the full ratchet adjustment would require thecompany to issue an additional 25,800,000 shares of commonstock upon conversion, and the percentage ownership of thecommon stockholders would decrease from an aggregate of16.66% to 6.93% post financing.

If the valuation of the company were decreased evenfurther, which is not unheard of in this current environment,the company would be even further diluted and issueadditional shares of preferred stock.

As you can see, lawyers cannot fear math in this areaof practice.

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Post-financing and depending on the anti-dilution protection afforded to the preferred stock, the capitalization of the company is as follows*:

Pre-Financing Broad Based Narrow Based Full RatchetNo. of Shares % Ownership No. of Shares % Ownership No. of Shares % Ownership No. of Shares % Ownership

Series D Preferredstock

0 0% 8,000,000 22.43% 8,000,000 21.65% 8,000,000 13.84%

Series C Preferredstock

6,000,000 25% 8,000,000 22.43% 10,956,522 29.65% 28,800,000 49.83%

Series B Preferredstock

5,000,000 20.83% 6,666,666 18.69% 5,000,000 13.53% 8,000,000 13.84%

Series A Preferredstock

5,000,000 20.83% 5,000,000 14.01% 5,000,000 13.53% 5,000,000 8.65%

Common Stock(founder)

3,500,000 14.58% 3,500,000 9.81% 3,500,000 9.47% 3,500,000 6.06%

Common Stock(angel investor)

500,000 2.08% 500,000 1.40% 500,000 1.35% 500,000 0.87%

Stock Options 4,000,000 16.67% 4,000,000 11.21% 4,000,000 10.82% 4,000,000 6.91%Total Number ofShares

24,000,000 35,666,666 36,956,522 57,800,000

*These calculations assume that the new investor does not require a recalculation of the new per share price after the antidilution

shares are issued, which results in circular multiple adjustment calculations. Often new and existing investors negotiate the number of

antidilution adjustments that will be made in connection with a particular financing.