Venture Capital Term Sheets

Venture Capital Term Sheets April, 2009 Sources of Capital  Self Funding  Angel  Venture Capitalists (VCs)  Corporate Investment (Strategic Investment) hutchlaw.com 2 Capital Structure of Typical Start Up  Founders:  Employees:  Investors: Common Stock (Vesting over time) Common Stock Options (With vesting over 4 years) Convertible Preferred Stock hutchlaw.com 3 Angel Investors = High Net Worth Individuals with High Risk Appetite  Early stage preference  Usually “one and done”  Terms offered by company rather than investors  Less sophisticated on terms and value  Less “value-added”  Endangered species? hutchlaw.com 4 How to Approach Angels  Individuals (network)  Other successful entrepreneurs  Organized Groups (TIG, Atlantis, PAN, CAP, CHAP)    One signature for all dealings Follow-on investments possible Better preparation for institutional rounds hutchlaw.com 5 Venture Capital Requirements  25-30% Internal Rate of Return  Market Size / Position  Management Team  “Bet on Jockeys, not Horses”  Clear Exit Strategy hutchlaw.com 6 Current Venture Capital Environment  Plenty of Capital in the System?  $28 billion committed in 2008 (21% decline)  Investors More Cautious with Deals  Potential Exits Uncertain and Delayed  Valuations Declining  Have We Bottomed Out?  Terms Heavily Negotiated hutchlaw.com 7 4 Principles of Term Sheets 1 2 3 4 Valuation Exit Strategy Down-Side Protection Control hutchlaw.com 8 Principles of Term Sheets 1 Valuation hutchlaw.com 9 Valuation Calculation Capitalization Pre-Money (shares) Outstanding Common Stock Outstanding Preferred Stock Outstanding Stock Options Reserved Stock Options 2,000,000 0 100,000 200,000 2,300,000 Post-Money (shares) 2,000,000 2,000,000 100,000 200,000 4,300,000 Valuation: Series A Preferred Purchase Price = $2.00 per share) $4.6 million $8.6 milliion hutchlaw.com 10 Principles of Term Sheets 2 Exit Strategy hutchlaw.com 11 Acquisition Liquidation Preference  Multiple of Liquidation Preference  Preferred gets multiple times investment back before Common gets any money  Participating Preferred  Preferred gets investment back first, remaining proceeds shared between Common and Preferred pro-rata  Limited or Capped Participation  Preferred gets investment back first, remaining proceeds shared between Common and Preferred until Preferred reaches a multiple of investment (usually 2x – 5x) and remainder goes to Common  Non-Participating Preferred  Preferred gets investment back first, remaining proceeds go to Common hutchlaw.com 12 Effect of Liquidation Preference Hi-Tec, Inc. has 2,000,000 shares of Series A Preferred outstanding that was purchased for $1.00 per share and 2,000,000 shares of Common Stock outstanding. It has just been acquired for $15M. How is the money divided? hutchlaw.com 13 Effect of Liquidation Prefere nce 4x Multiple of Liquidation Preference with Full Participation: 1. Preferred receives 4x liquidation preference ($8M). 2. The remaining $7 million is split pro rata between the Common and Preferred ($3.5 million each). Total return Preferred Common 11.5 million 3.5 million hutchlaw.com 14 Effect of Liquidation Preference, cont. 1x Liquidation Preference Participation Capped at 4x: 1. Preferred receives liquidation preference ($2M). 2. The remaining $13M is split pro rata between the Common and Preferred until Preferred receives $8M (i.e. $6 million each). 3. The remaining $1M goes to the Common Stock holders. Total return Preferred Common 8 million 7 million hutchlaw.com 15 Effect of Liquidation Preference Non-Participating Preferred: 1. Preferred receives liquidation preference ($2M). 2. The remaining $13M goes to the Common, but because the Common holders will receive more than the Preferred holders, the Preferred holders will convert into Common and all holders will be treated equally. Total return Preferred Common 7.5 million 7.5 million hutchlaw.com 16 Liquidation Preference Summary Current Trends  Multiple Liquidation Preferences  15% of financings  1x – 2x = 70% (down from 80% in Q407)  2x – 3x = 20%  >3x = 10% (up from 0% in Q407)  Participating Preferred  57% of financings  51% were uncapped (up from 41% in Q407) Source: Fenwick & West LLP – Trends in Terms of Venture Financings in the San Francisco Bay Area (Fourth Quarter 2008) hutchlaw.com 17 IPO  Registration Rights    Demand Rights S-3 Rights Piggy Back Rights hutchlaw.com 18 Principles of Term Sheets 3 Down-Side Protection hutchlaw.com 19 Down-Side Protection Anti-Dilution Protection  Ratchet (Largest adjustment) Conversion price of Preferred adjusted down to price of dilutive issuance  Broad based weighted average (Least adjustment) Conversion price of Preferred adjusted down based on a weighted average of outstanding securities, including options and warrants  Narrow based weighted average (Medium adjustment) Conversion price of Preferred adjusted down based on a weighted average of outstanding capital stock – does not include options and warrants hutchlaw.com 20 Down-Side Protection  Don’t Forget Exclusions     Option pool of limited size Mergers / acquisitions Warrants for banks / leasing companies Strategic transactions hutchlaw.com 21 Anti-Dilution Calculation Facts: Hi-Tec, Inc. has:    3,000,000 shares of Common Stock, 5,000,000 shares of Series A Preferred Stock Options to purchase 2,000,000 shares of Common Stock outstanding. The Series A Preferred Stock was sold at $1.00 per share. Hi-Tec, Inc. now would like to issue 4,000,000 shares of Series B Preferred Stock at $0.50 per share. How is Series A Preferred Stock affected? hutchlaw.com 22 Anti-Dilution Calculation, cont. Ratchet: Series A initially converts to Common on a 1:1 ratio based on its purchase price $1.00/$1.00. After the issuance of Series B, the conversion price is ratcheted down to $0.50. The new conversion ratio is calculated as follows: $1.00/$0.50 (or 1:2). So, for every 1 share of Series A converted, the holder will receive 2 shares of Common. So, the 5,000,000 shares of Series A will convert into 10,000,000 shares of Common Stock. hutchlaw.com 23 Anti-Dilution Calculation, cont. Broad-Based Weighted Average: Formula: (all outstanding securities) x Conversion Price + Amount Raised All outstanding securities + New Securities Issued Calculation: (3,000,000 + 5,000,000 + 2,000,000) x $1.00 + $2,000,000 = 0.8571428 3,000,000 + 5,000,000 + 2,000,000 + 4,000,000 Conversion Ratio: $1.00 ÷ $0.8571428 = 1.166 So, the 5,000,000 shares of Series A will convert into 5,833,333 shares of Common Stock. hutchlaw.com 24 Anti-Dilution Calculation, cont. Narrow-Based Weighted Average: Formula: (Common + Preferred) x Conversion Price + Amount Raised Common + Preferred + New Securities Issued Calculation: (3,000,000 + 5,000,000) x $1.00 + $2,000,000 = 0.8333333 3,000,000 + 5,000,000 + 4,000,000 Conversion Ratio: $1.00 ÷ $0.8333333 = 1.2 So, the 5,000,000 shares of Series A will convert into 6,000,000 shares of Common Stock. hutchlaw.com 25 Down-Side Protection - Summary Current Trends  Ratchet = 2%  Weighted Average = 98%  No Anti-Dilution Protection = 0% Source: Fenwick & West LLP – Trends in Terms of Venture Financings in the San Francisco Bay Area (Fourth Quarter 2008) hutchlaw.com 26 Two companies financed under exactly the same conditions A Tale of Two Term Sheets Initial Capitalization   3,000,000 founders shares 2,000,000 shares initially reserved for options Series A Financing  Raises $5M at a $5M pre-money valuation Series B Financing  Raises $2M at a $5.5M pre-money valuation (and adds 1M shares to option pool) Series C Financing  Raises $21M at a $63M pre-money valuation (and adds 1M shares to option pool) at a $84M post-money valuation hutchlaw.com 27 Key Financing Terms  Company A  Narrow-based weighted average anti-dilution protection Participating Preferred capped at 4x Liquidation Preference   Company B   Ratchet Anti-Dilution 4x Participating Preferred with no cap hutchlaw.com 28 Cap Tables Following Last Financing Company A Common Options Series A Series B Series C 3,000,000 4,000,000 5,000,000 (6,000,000) 4,000,000 5,666,666 Company B Common Options Series A Series B Series C 3,000,000 4,000,000 5,000,000 (10,000,000) 4,000,000 7,000,000 Common Ownership: 13.24% Common Ownership: 10.71% hutchlaw.com 29 Payout Scenarios  $40M acquisition?   Company A: $1.6 million (or 4%) Company B: -0-  $100 million acquisition?   Company A: Approximately $10.5 million (or 10.5%) Company B: -0-  $200 million acquisition?   Company A: Approximately $23.7 million (or 11.85%) Company B: Approximately $9.4 million (or 4.7%)  $500 million acquisition?   Company A: Approximately $66.2 million (or 13.24%) Company B: Approximately $41.6 million (or 8.32%) hutchlaw.com 30 Down-Side Protection - Redemption  Forced liquidity: Zombie companies  Timing: 5-7 years  Amount (all at once or percentage)  Forced exercise during certain period or “any time” after target date  Statutory limits on share repurchase hutchlaw.com 31 Principles of Term Sheets 4 Control hutchlaw.com 32 Control Board of Directors  Key Rights    Appoint and fire officers Set policy/Make major decisions Issue options  Number of directors  Investors: Election of BOD members by “series” or “class” vote hutchlaw.com 33 Control Protective Provisions Must obtain approval of the Preferred to:  Authorize additional shares of stock  Create a new series of stock with equal or greater rights  Complete a merger/sale of assets  Change the size of Board of Directors hutchlaw.com 34 Control Typical Additional Investor Rights  Information Rights  Co-Sale Rights  First Refusal Rights  Preemptive Rights hutchlaw.com 35 Hutchison Law Group  Serving the Southeast’s life science and technology communities.  Represent companies of all sizes, with a strong focus on emerging growth companies from inception through exit.  Serve clients along the Southeast corridor from Maryland to Florida.  Extraordinary depth and experience in law, technology and business. hutchlaw.com 36