Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 1 APPENDIX A Issuer Digital Devices, LLC, a California limited liability company ( the “Company”). Same Same Purchaser Mount Malibu Ventures, LLC, a Delaware limited liability company (“Malibu Ventures” or “Purchaser”). Same Same. No material securities law concerns regarding § 502. See separate analysis. Security 10% Series A Convertible Preferred Shares (the “Series A”, or the “Preferred Shares”). 0% Series A Convertible Preferred Shares. Digital would prefer to pay the lowest required dividend. Conversion is par for the course. Will want Series A Stock to be subordinate to all secured and unsecured company debt. Provide for in stock K. The annual dividend requirement will be set based on the conditions in the market for capital. Supply and Demand. The more difficult money is to come by the higher a dividend MV can ask for. MV will just allow any dividends not paid to roll over so they can get more common stock on conversion. Given the high valuation on the company, a 10% annual dividend yield seems reasonable. Purchase Price $1.00 per Common Share (“Purchase Price”), after an appropriate stock-split. Shares are currently $2500 each. So we need a 2500:1 stock split. MV Position Amount $10.0 million (the “Total Purchase Price”), for 18% of the fully-diluted equity of the Company. Same – this is fantastic for Digital. MV is valuing the company at $55M!!! Digital’s founders will retain control of the company and 200x their individual equity! MV Position Conversion Convertible at option of holder initially at rate of one Common Share for each Preferred Share, subject to adjustment as provided below for dilutive issuances. The initial conversion price, subject to adjustment, is $1.00 per share. Will want to strike dilution adjustments. MV Position The Preferred Shares will be Digital should not care about the Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 2 automatically converted (at the then-applicable conversion price) into Common Shares of the Company in the event of a Qualifying IPO. “Qualifying IPO” means an underwritten public offering of Common Shares of the Company (a) in which the gross proceeds to the Company equal or exceed $30 million, and (b) in which the public offering price per share is not less than 5 times the then-applicable conversion price of the Preferred Shares and (c) immediately after which the implied value of the Common equity of the Company held by nonaffilliate equals or exceeds $80 million (a “Qualifying IPO”). float and non-affiliate share and shareholder amounts. It only needs to care that in the event of an underwritten common stock initial public offering the preferred shares shall convert to common shares. Anti-Dilution Customary anti-dilution protection shall be provided for mergers, reorganizations, consolidations, stock splits, stock dividends, stock combinations, recapitalizations, reclassifications, certain distribution of cash, securities (including options, rights or warrants to acquire Common Shares) or property, repurchases of common equity securities or other similar events. The conversion rate shall be adjusted for future issuances of Common Shares (or rights, options or warrants to acquire Common Shares) below the conversion price of the Preferred Shares or No Favored Nations Status. Anti-Dilution will lock up 18% of the company such that the founders will dilute much faster when subsequent equity financings are carried out. This is problematic for Digital’s founders and good for MV. Anti-Dilution will be a strongly required provision by Malibu, and given that they are valuing the company so highly, they are going to get it. Digital may be able to do away with the favored nations clause, but it looks like that is not terribly material as this anti-dilution provision is comprehensive. 2 Kinds of adjustments: Arithmetic and value. Here MV wants both and it seems reasonable to allow both. Weighted average formula vs. full ratchet. The outcome of the negotiation will be a function of who has the leverage, and here I think that MV has the leverage because giving such a high Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 3 below the then fair market value of the Common Shares, on a “full ratchet” basis. The conversion rate shall also be adjusted for future redemptions, repurchases or other acquisitions of Common Shares (or rights, options or warrants to acquire Common Shares) in excess of the fair market value of the Common Shares. If the Company has issued or issues securities with more favorable anti-dilution protections than the antidiluutio provisions applicable to the Preferred Shares, such more favorable anti-dilution protections shall also be applicable to the Preferred Shares. valuation. Therefore they will get their full ratchet. Dividends/Distributions The holders of the Preferred Shares shall be entitled to receive in kind (i) annual cumulative dividends at the rate of 10% of the liquidation preference per Share, and (ii) dividends or distributions when, as and if dividends or distributions are paid on the Company’s common membership interests, or the Company’s Common Shares after a rollup into a corporation, as the case may be (shares are referred to collectively as the “Common Shares”), in an amount equal to the dividend or distribution that would have been received had the Preferred Shares been converted into Common The timing definition is fine. The amount and cumulative provisions are problematic – if only from the perspective of trying to get the best deal for the company. Digital may not be able to pay dividends, so the cumulative dividends may become problematic from an ownership and control and dilution standpoint. MV will get dividends, but perhaps in a lower amount. Suggest 5% and see if we can meet half way. MV will as part of the due diligence process verify that the operating agreement allows for enough of any taxable net income to be passed through as a distribution to the members in accordance with the members tax liability; and if the operating agreement omits this they will see to it that this is changed. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 4 Shares immediately prior to the record date for the Common Shares dividend or distribution, as the case may be. Ranking The Preferred Shares will rank senior to all other equity securities of the Company with respect to distributions upon liquidation, unless all of the holders of the Preferred Shares consent to the issuance of senior or in pari passu equity securities. Digital wants Pro-rata (parri passu) distribution of assets to all equity holders upon liquidation. The founders should not be subordinate to the Series A investors. Although last if first out is a general rule. Could suggest senior to all other capital stock of the company except subordinated to any series of senior preferred stock hereafter created by the board and subordinated to any debt of the company LIFO will probably win and MV will get it’s provision, again do to their negotiating leverage. . The company has used its entire credit line, therefore it must need cash and this is a lot of it! Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 5 Mandatory Redemption Preferred Shares will be mandatorily redeemed on the sixth anniversary of the Closing Date at a cash redemption price equal to 110% (compounded rate) of the Purchase Price. No – this may force a company liquidation if not enough cash available. This is a sticking point. It’s hard to accept cash for equity that could liquidate the company if things don’t go according to plan. No deal if MV isn’t flexible. Redemption at Holder’s Option The holders of the Preferred Shares may require the Company to redeem all or a portion of the Preferred Shares held by such holders at the Redemption Price (a) in connection with or upon any Change of Control (to be defined) or (b) at any time after the fourth anniversary of the issuance of the Preferred Shares if a Qualifying IPO is not completed prior to such fourth anniversary date. Only on change of control, not after 4th anniversary. Investors invest in people so tying the investment to the people is good business. Any other redemption is trying to reduce downside risk inherent to an equity position and could be potentially damaging to the company’s financial position. Digital version. Liquidation Preference In the event of a liquidation, dissolution or winding up of the Company, the holders of the Preferred Shares shall be entitled to receive, in preference to the holders of Common Shares and all other equity securities ranking junior to the Preferred Shares with respect to distributions upon liquidation, an amount per share equal to two times the original purchase price per share of the Preferred Shares plus all accrued but unpaid dividends and distributions. The remaining assets available for distribution to holders of equity securities shall be divided, subject to the rights of any senior equity securities, pro rata delete the two times per share price and insert “original purchase price” A sale of all or substantially all of the assets, a consolidation or merger being considered a liquidation is standard. Digital Position. There is no rational basis to justify a 2x return upon liquidation. It will be negotiated to 1x the purchase price of the shares. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 6 among the holders of the Preferred Shares (on an asconveertedto-Common Shares basis), the holders of the Common Shares and the holders of any other class of equity security entitled to participate with the Common Shares in distributions upon liquidation. A consolidation or merger of the Company or a sale of all, or substantially all, of the Company’s assets shall be deemed to be a liquidation or winding up of the Company. Voting The Preferred Shares will vote, on an as-converted-to-Common basis, with the holders of the Common Shares on all matters submitted to a vote of holders of the Common Shares. Digital may not want to accede voting control to MV on such matters as shareholder’s might traditionally vote on. This would especially be the case if MV was purchasing more of the company % wise. Perhaps Digital can offer the election of at least 1 board member to preferred shareholders but no common stock like voting rights. Or perhaps Digital won’t care since 18% is not enough to control on any given issue. But Digital must be concerned with the powers given to other investors in future financings. Due to leverage, I think that MV will come out on top here as this will be a large issue to them. Information Rights The Company shall provide the holders of Preferred Shares access to all books This is standard to to be expected, EXCEPT: Digital Digital Position will prevail unless there is a compelling rational basis or interest on the Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 7 and records of the Company and shall deliver to each such holder (i) monthly, quarterly and annual financial statements, (ii) copies of all filings made with the Securities and Exchange Commission, (iii) notification of any material defaults or litigation, (iv) copies of the Federal Tax returns of each of the CEO and the CFO, (v) a comprehensive disclosure of all trade secrets of the Company, and (vi) any other information reasonably requested. cannot disclose trade secrets as they may lose trade secret status – that is unless an NDA is signed and physical security around the secrets is kept tight; also, the federal tax returns of the CEO and CFO are not material. part of MV as to the terms that Digital wants to strike. Registration Rights The holder of the Preferred Stock will have three demand registration rights to cause the Company to register the Common Shares issued upon conversion of the Preferred Shares on Form S-1, unlimited registrations on Form S-3 ( if the Company is entitled to use that Form) and unlimited piggy back registration rights. Such registration rights shall have priority over all registration rights previously granted. The expenses of such registrations (excluding underwriter discounts and commissions) shall be borne entirely by the Company. It is understandable that the VC’s will want demand registration rights – they want liquidity. However, the company will want to avoid the cost of offerings (especially on S-1, as S-3 is for company’s already registered therefore is much cheaper). Perhaps the registration rights can be conditioned. The three rights would allow for different blocks of shares to be registered at different times. Digital could condition the preferred share rights upon a certain amount of cash on hand, revenue or net sales targets, or time I think a compromise will be reached that balances the company’s financial needs with the needs of the investors to have their stock be liquid. Unlimited S-3 and piggy back rights do not add material cost to the company, so that will stay. I think that that the S-1 rights will remain on demand but Digital will be able to negotiate certain conditions precedent and with a minimum time between exercise of the S-1 rights and another rS-1 or S-1. Alternatively, the cost of such registrations could be partially or totally borne by the preferred shareholders in the event of an exercise of these rights, after all they are the one initiating the filing. There will also be a condition that at least 20% or 30% of the shares of common stock issued or issuable upon conversion of the preferred shares be registered in each filing. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 8 duration to make sure that the rights are not exercised in a manner detrimental to the company. Another issue is the fact that these registration rights have priority over the Croessus /DDP registration rights. This seems indefinite in that one party have registration rights does not preclude another party from having them, although it may mean that all parties cannot be certain at what point an investment group might force the company to go public. They all have unlimited piggyback rights though so at least if one decides to force an S-1 registration everyone else can also go liquid. Further, I think that registration rights for all classes of stock have to be subject to underwriters cutbacks on a proraat basis (and definitely not on a first registered basis). Lastly, the company will have to be rolled up into a C-corp in the event an IPO is planned. Stockholders Agreement The Purchaser will not be required to adhere to the transfer restriction provisions of the Operating Agreement, except that the Purchaser will have a right of first refusal to purchase any Common Shares held by the members (which right is superior to any rights held by the other members (Typo??) ) on the same terms and conditions being offered by them. Transfer restrictions are good in a closely held company because the management /director /shareholder mix involved personal relationships and is a careful balance. Digital will want to balance the needs of VC liquidity with the ability to control the mix of people involved. A middle ground would be a common shareholder right of first refusal followed by a company right of last refusal to purchase the shares offered by MV on the same terms as any prospective bona fide purchaser. That way Digital could come in and keep the controlling group of shareholders to the planned mix of people and not allow outsiders to gain any control. I think that the right of first refusal held by MV to purchase Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 9 shares of Common being sold by the members is a bit overzealous and gives them great implied power. No one can ‘get out’ without MV increasing their share of ownership in the company. Protective Provisions So long as the Purchaser and its affiliates own at least 5% of the Purchaser’s original investment (either in the form of Preferred Shares, Common Shares issuable upon conversion thereof, or a combination thereof), the prior consent of the holders of a majority of the thenoutsttandin Preferred Shares will be required before the Company or any of its subsidiaries may (i) enter into mergers, liquidations and recapitalizations, (ii) declare dividends or repurchase equity securities, (iii) engage in affiliate transactions (other than fair market leases of space necessary for company operations), (iv) alter officer compensation plans or otherwise amend the employment terms of any senior executives or other key employees or amend the terms of the Employment, Non-Disclosure and Non-Competition Agreements, (v) affect the rights of the holders of the Preferred Shares, (vi) materially change its business, (vii) make certain investments, acquisitions or dispositions, issue securities or incur debt, (viii) adopt an employee stock option or stock 5% is a very low bar. This essentially gives the preferred shareholders power over the board of directors and allows for a 95% divestiture in a liquidation event. I’ve seen 35% or 40% as more reasonable. It would be appropriate to include the alteration of the articles of organization or operating agreement in here as an item preferred shareholders must approve. Digital can probably suggest that as an alternative and in exchange get items (iii), (iv), (vii) and (ix) stricken. MV has a rational basis to want to protect the value of its investment. Issuance of more shares is material to valuation, therefore it is appropriate to give them the right to approve or 30-40% ownership of original purchase requirement. The rest of Digital’s terms will probably be negotiated in as there is a very good rational basis for the argument put forth in column 2. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 10 incentive plan (other than the Approved Option Plan (as defined below), (ix) amend or otherwise alter any existing material contracts or enter into any other material contracts or permit any subsidiaries to amend or otherwise alter any existing material contracts or enter into any other material contracts (whether any contract is material shall be determined in good faith by Malibu Ventures in its sole discretion, or (x) make political contributions to candidates for public office who are not approved by Malibu Ventures. disapprove more equity issances. However, this could and should be done on a right of first refusal basis where the company, acting at the behest of the board must offer any new securities to the current preferred shareholders, and if they refuse to buy then the company can go to outside investors. The holders of Preferred Shares shall be entitled to participate in all future issuances of common equity securities (including rights, options, warrants and convertible, exercisable or exchangeable securities) so as to maintain their percentage equity interest in the Company, subject to customary exceptions, e.g., shares issued upon exercise of stock options, warrants and convertible securities. This can be problematic for a company as its growth slows as it may keep other investors from coming in. But with all the negative covenants in this term sheet the VC’s have power over this anyways. Fine, this implements my discussion above. MV position. Co-Sale Rights Except for Permitted Transfers, in the event that any Founder sells any Common Shares (or other securities convertible into or exercisable or exchangeable for Common Shares) in a private sale to a third party, the holders of Preferred Shares shall have the right to The first part is fine. VC’s invest in people and if a founder is getting out they may want to get out. Although I’m surprised that the wording isn’t a little more precise in determining if any First part will remain. Second part will be re-negotiated. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 11 sell, on the same terms and conditions, all of their Preferred Shares (or Common Shares issued upon conversion of Preferred Shares) on an as-converted bases to such third party. “Permitted Transfers” means and includes sales or transfers by a Founder to spouse, children, grandchildren and trusts therefore or family trusts (to be defined), provided, however, that any such transferee agrees in writing prior to such transfer to be bound by the terms and conditions of the transfer restrictions set forth in the Securities Purchase Agreement and in the Stockholders Agreement (or Amended Operating Agreement, as the case may be) and any and all other agreements and/or other instruments to which such transferring Founder is a party. In addition, Malibu Ventures may “drag along” all holders of Common Shares in a sale of Common Shares or other transfer of the business and assets of the Company initiated by the Purchaser, at an implied equity evaluation of the Company in excess of $50 million. incoming member must purchase both the departing founder’s interest AND MV’s interest if MV elects to sell. The second part is problematic. It gives MV the power to sell the company and all the other shareholders have to go along with it, so long as the valuation is high enough. The current fully diluted valuation is $57M, so $50M seems low. Since VC’s want a 30-40% annual ROI, there seems to be a rational basis for drag along rights only in the event of a $100M valuation. Digital’s founders would probably like to abolish this all together as it lessens their right to control their own destiny. What if they want to remain a shareholder because they feel their value will continue to grow? Board of Directors The holders of the Preferred Shares, voting as a single class, shall have the right to appoint two members of the Company’s Board of General rule is the right to appoint one board member for the class of shares. However two board Digital position. No waiver of fiduciary duty and 1 or 2 board seats. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 12 Directors (each such appointed director a “Preferred Shares Director”). The Preferred Shares Directors shall have fiduciary duties only to Malibu Ventures and its Affiliates. members is not unheard of, especially when the VC is bringing in such a large valuation. Also, waiver of fiduciary duty is a strange request, and not one that other shareholders would ever want to grant. This is a make or break deal provision. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 13 Employment Agreements Each of the CEO and the CFO will execute and deliver to the Company Employment Agreements with the following principal elements: ◦ Term -Five years ◦ Compensation and Benefits -To be negotiated, but not less than currently provided in each case. ◦ Six-year covenant not to compete upon the termination of employment for any reason or no reason. ◦ Exclusive venue and jurisdictions for resolution of disputes in the Federal or State courts in the Borough of Manhattan, New York City. Employment K’s are one way streets for the benefit of employees. Six year covenant no to compete is void in CA and unenforceable. Venue and choice of law in NY makes no sense, if it is even enforceable. A CA court would probably throw it out, especially if not bargained for by people with equal power at arms length. Here employment K’s are just one part of a large deal. The rest is fine. Digital Position. Indemnification The Company shall indemnify the Purchaser and its Affiliates, partners, members, officers, directors, employees, agents and representatives against any demand, claim, or action by any third party (including derivative actions brought through or in the name of the Company) in connection with (i) the status or conduct of the Company, (ii) the execution, delivery and performance of the documents entered into in connection with the purchase of the Preferred Shares and the transactions contemplated thereby, or (iii) the indemnified party’s role with the Company or No indemnification against derivative actions. If Preferred shareholders abuse the company they should be liable. That’s why we are not waiving fiduciary duties, even if such a thing could be done. The rest is fine. Digital position. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 14 such transactions, in each case, except to the extent of any willful misconduct or gross negligence of the indemnified party. Expenses The Company will pay for up to $500,000 of the fees and expenses incurred by the Purchaser (including counsel fees and expenses) in connection this transaction (including all fees and expenses incurred by the Purchaser in connection with the issuance of the Preferred Shares by the Company to the Purchaser), whether or not the Preferred Shares financing Closes. $500,000 is a lot. Agenda’s are not aligned if the company pays. The VC’s should want to lower the transaction cost, but if the company is paying they get a free lunch. Digital can probably negotiate middle ground where $100k is paid if the transaction closes, with everything above it paid by MV, and if the transaction doesn’t close due to no fault of digital then digital pays nothing. Alternately digital may have to agree to some transaction cost even in a no fault abortion. Digital Position. Lock-Up The Founders and all employees and investors who purchased any securities of the Company in all current and prior rounds of financing agree not to transfer any equity interest in the Company (except for Permitted Transfers) until the 180th day after the completion of a Qualifying IPO, or such shorter period following a Qualifying IPO as may be determined in the reasoned judgment of the Standard black out period that an underwriter would require anyways. The underwriter discretion clause is good. Underwriter has more market knowledge and is an arms length third party. MV position. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 15 managing underwriter of such Qualifying IPO. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 16 Approved Option Plan The Company will adopt a stock option plan (referred to as an “Approved Option Plan”) which provides for the grant of options to employees and directors of the Company to purchase not more than a number of Common Shares representing 5% of the outstanding Common on a fully-diluted basis, at an exercise price per share as of the date of the grant not less than the lesser of (i) Fair Market Value or (ii) the then applicable conversion price of the Preferred Shares (such share number and exercise price to be appropriately adjusted in the event of any subdivision, combination or similar action with respect to the Common Shares), which options shall cliff-vest ratably over five years. Cliff vesting pro-rata over 5 years is fine. 5% is on the low end of options allowances. With 15% as the upper end. Price has to be FMV other wise you have a taxable event as far as the IRS is concened, and if lower, you have an SEC violation problem. Probably settle on 10% options vesting allowance. Rest is fine. Term Malibu Venture Position Digital Position Endgame Position $ASQVenture Capital Term Sheet.doc.doc 17 Annex B The following Financial Highlights of Digital Devices, LLC are for periods ended December 31 ($ 000’s Omitted): Statement of Operations Data 2003 2004 2005 2006 (Forecast) 2007 (Forecast) Net Sales 1,890 8,540 11,100 14,985 20,980 COGS 945 3,843 4,995 6,744 9,441 Gross Profit 945 4,697 6,105 8,241 11,539 SG&A 318 1,213 1,576 2,128 2,980 R&D 3,020 2,935 2,220 2,500 2,500 Operating Income/EBITDA (2,393) 549 2,309 3,613 6,059 CAPEX 1,000 1,000 500 500 500 Depreciation & Amort. 200 400 462 562 662 Interest 120 240 240 240 240 LLC Taxes -0--0--0--0--0-Tax Payment Distributions to SHs 1 -0--0-611 1,068 1,960 Net Income (Loss) (2,713) (91) 996 1,743 3,197 Balance Sheet Data Total Assets 1,050 1,810 2,310 2,810 3,310 Total Liabilities 2,000 2,000 2,000 2,000 2,000 Retained Earnings (2,713) (2,804) (1,808) (65) 3,132 SH Equity (3,663) (2,994) (1,498) 745 4,442 1 Pursuant to the LLC Operating Agreement, the Company is required to distribute to Shareholders an amount equal to 38% of the taxable income passed through to them, to enable them to pay the taxes thereon. This Forecast does not give effect to a possible Roll-Up.