Early Stage Financing Negotiating the Term Sheet

Early Stage Financing: Negotiating the Term Sheet BioE2E June 5, 2002 Introduction  David Saul, Partner, Corporate Securities, Life Sciences Group, Wilson Sonsini Goodrich & Rosati, Palo Alto, CA  Practice focused on all aspects of representation of medical device and biotech private start-up companies through small-cap public companies Leading law firm representing many of the world’s most successful technology companies at all stages of their growth, as well as the investment banks and venture capital firms that finance them. Full service law firm with Life Sciences/Intellectual property practices that include: General corporate and securities representation, licensing and other technology transactions, patents, IP counseling, IP litigation, and trademarks The firm is headquartered in Palo Alto, California, with offices in Austin, Kirkland, McLean, New York, Salt Lake City, and San Francisco.  Wilson Sonsini Goodrich & Rosati, www.wsgr.com.    Negotiation Hot Buttons    Valuation Liquidation Preference Anti-Dilution Protective Provisions Preemptive Rights Board Composition ROFR & Co-Sale Worth the Fight     Leverage Overview of the Term Sheet   “Summary” of key deal points for streamlined negotiation or information to prospective investors. Typically non-binding, though you should not “change the deal” without recirculating. ALWAYS get your attorney involved in the drafting and negotiation of a Term Sheet Seed Round, Company drafts, except when VC takes control Your lawyer has to live with it….YOU have to live with it.    VALUATION Valuation Overview Valuation is the key determinant of the extent of dilution suffered by the founders in a financing. The Price of Money Source of tension: The investor wants to get more for less vs. the founder who wants to give up less for more.   Lower Valuation = Greater Dilution Higher Capitalization = Greater Dilution Valuation  “Fully Diluted” Concept     All outstanding Common Assumes exercise of any warrants Any outstanding Preferred on an “as converted to common” basis The ENTIRE option pool Customary: 12-18% of Total Cap (Used and Unused) Extreme: the “CMGI Model” – 20% Unallocated  “Refreshing” / Creating the Option Pool   Valuation (Cont.) Example of “Fully Diluted” impact 1.0MM share Option Pool requires additional 333,333 shares of Preferred Stock  $3.0MM / 6.0MM sh. = $0.50 / sh.  25% Ownership of the Company for 2.0MM shares $3.0MM Dollars / 7.0MM shares = $0.429 25% of the Company for 2,333,333 shares Founders diluted by additional 4%  Add a 1.0MM sh. Option Pool:    Valuation Discussion    Series A Valuations Option Poolexpect  What to Negotiation Dilution drivers  Key vs. Dollars LIQUIDATION PREFERENCES Liquid. Pref. Overview In the likely exit scenario involving a merger, rather than an IPO, liquidation preference determines the size of the slice that investors get versus founders / employees. Mechanics of how the total consideration available to shareholders is distributed. Liquidation Preference  “Plain Vanilla:” Founder Favorable  1X Preference, then Common Full Participating Preferred feature. 1x to Preferred, remainder shared pro rata between Preferred and Common  Investor Favorable   Blended  2X - ? Participating Preferred: 1x to Preferred and then Preferred and Common share pro rata to a point after which Common gets the rest    Voluntary Conversion What to expect How do you negotiate this one? ANTI-DILUTION PROTECTION Anti-Dilution Overview In the down-round context, determines the extent of additional shares deemed issued to former investors who purchased at a higher price. Results in additional dilution to founders/employees. Anti-Dilution Protection       Broad-based weighted average: adjustments based upon the price and shares issued of new securities relative to total capitalization and previous share price. “Full-ratchet”: Regardless of the number of new shares issued, previously higher priced shares are fully adjusted to the new price Modified Full-ratchet Conceptually, early on, with company-set valuations, fullratchet is acceptable, but can you get rid of it? What to expect How do you negotiate this one? The Small(er) Stuff Overview Control of major corporate events. Control of day-to-day operations? Philosophical issues. Protective Provisions  Typical acceptable provisions    Adversely affect Preferred Stock rights Amending the articles or bylaws Merger or acquisition Entering into transactions with $ > x Adding Board members Non-standard vesting Don’t your investors really want YOU to run the company  Additional controls     Are any of these worth the fight?  Preemptive Rights Preemptive Rights, sometimes referred to as “Right of First Offer” or “Right of First Refusal,” allow investors to maintain their percentage ownership of the Company/Preferred in subsequent financing rounds. Money is money?  Board Composition    Board seats guaranteed to founders/investors by operation of articles and voting agreements. Control: Typically not an issue in early stages Longevity: Typically not an issue in early stage, but should be ROFR & Co-Sale   Places limitations on key founders’ rights to transfer shares without giving the Company and key investors a right to participate Founders’ focus should be on   Exclusions Major investor threshold  Concerns? Now you’re ready to do battle with the investors…. with the help of your legal counsel!