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Creating Deal Velocity: Creating Deal Velocity: Deal Terms that Really MatterDeal Terms that Really Matter

John Hession, PartnerMcDermott Will & Emery LLP

[email protected]

Building Successful MedTech Companies: Financing Strategies for Entrepreneurs


So . . who is So . . who is McDermott?McDermott?So . . who is So . . who is McDermott?McDermott?

International Law Firm: 10th in US, specializing in Corporate Transactions, Intellectual Property, Financings, Acquisitions, Health Care, Life Sciences, Government Affairs & Regulatory Matters, Labor, Litigation, Trusts & Estates

14 Offices spanning the Globe: Boston, NYC, DC, Chicago, Miami, Los Angeles, Orange County, Palo Alto, San Diego, London, Munich, Düsseldorf, Rome, Brussels


Yeah, so …Yeah, so …who is Johnny who is Johnny Hession?Hession?

Yeah, so …Yeah, so …who is Johnny who is Johnny Hession?Hession?

Former High School Teacher, Former Sales Rep for BurroughsBurroughs, Office Products Division (Legion of Honor in Sales – top 10% in first two years)

Now: Advisor & Attorney for emerging-growth, technology companies from cradle, through financings, through strategic alliances, through culmination


Representative Representative ExperiencesExperiences

Representative Representative ExperiencesExperiences

125 Acquisitions125 Acquisitions: representing Buyers & Sellers: Silknet Software ($4.2B merger with Kana); Excel Switching ($1.2B sale to Lucent); i-Prospect.com ($50M, bought by Aegis plc); Eigner ($22M, bought by Agile); Netlink ($185M, by Cabletron); Mainspring (bought by IBM); Feanix ($50M earn out to Axon plc); Apama UK (bought by Progress)

175 VC & Angel Financings175 VC & Angel Financings: representing either companies or VC investors: Turbine ($15m, Highland & Polaris); Polaris ($16M investment in Meridio, Northern Ireland); TD Capital ($5m investment in Contour Semiconductor); Powerspan ($30m, Rockport, Beacon Energy, First Energy Corp.); Highland ($20M in AMP Resources)

100+ Strategic Alliances100+ Strategic Alliances: representing ALWAYS the small tech company against IBM, Microsoft, AOL, Tandem, Compaq, HP, Apple, Samsung, EMC, Allied Signal, Pratt & Whitney, GE, Lucent, Alcatel

25+ Public Offerings25+ Public Offerings: Silknet, Excel Switching, CVC Products, Mainspring, Integrated Genetics, Focus Enhancements, Netegrity, Tecogen, Astea International, Alloy Systems, DynaGen, Mortgage.com


The Venture Industry, The Venture Industry, 20072007


More dollars raised in 2003-2005, despite economic downturn in technology

Fewer firms, but with more $$$ per firm Larger deal sizes, and higher minimum

investment per company Liquidity HorizonLiquidity Horizon back to 5-8 years

5 years for IT 7/8 years for biotech EXTREMELY tough market for start-ups




Return expectations are aggressive: 50+% IRR for early-stage, 35-45% IRR for first institutional round, 18-25% IRR for mezzanine round

The Market is crowded with early-stage companies seeking financing – but professional and institutional money has moved up market to later stage deals

Angels eclipse the Venture Capital investment in seed and early-stage sectors by 10x order of magnitude

----


Venture Capital Median Amount Raised By Round Type

$5.2 $5.7 $6.0$7.7

$9.4 $8.6 $9.6 $10.0$7.3 $7.8

$6.0 $7.0 $6.6 $6.0 $6.5 $6.6 $6.0 $6.0 $7.0 $6.5

$0

$5

$10

$15

$20

$25

1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03

Med

ian

Am

ount

Rai

sed

($ M

)

$0

$5

$10

$15

$20

$25

All Rounds Seed Round First Round Second Round Later Stage

Source: E&Y / VentureOne

The Future = The Past


Current Market Current Market ConditionsConditions


Technology financing markets rebounded in last two years

Financings have heated up in last year

Competition for first institutional financing rounds becoming fevered

Anecdotal evidence that valuation & term skirmishes waged for perceived “good deals”: complete team & product with customers, early revenues




Improvement in underlying technology markets: IT spending is returning, projected to increase in 2007

Pre-$$ Valuations back to 1997 Pre-Bubble levels – approximately: $2.5-$3.0m Seed; $5.5m First;

$13.0m Second Round Deals are moving faster to completion

2 to 4 months now typical, cycles compressing


The Valuation GameThe Valuation GameThe Valuation GameThe Valuation Game

Deal Valuation is a function ofDeal Valuation is a function of:Amount raising now and ultimate cost of capital, rounds of financing

Valuations on alternative deals, comparable investments (find it on Venture One)

Number of other interested VC funds calling – “The Lemming Phenomenon” and “Nothing Beats a Good Deal like Competition”

Transaction structure and deal terms improving valuation: participating preferred, Board composition, control mechanisms


The Valuation GameThe Valuation GameThe Valuation GameThe Valuation Game Deal Terms Can Improve Valuation:

Board Composition and # of seats for VCs

Cumulative Dividends: compounding, accruing dividend

Liquidation Preference: 2x-3x return of capital, plus Participating Preferred

Anti-Dilution Adjustments: “ratchet” anti-dilution versus weighted-average

Option Pool for future hires: maybe 15-18% of fully-diluted capitalization

Organic Change-Covenant Control: veto rights on sales or other acquisitions, new financings, incurrence of debt, stock or options above a permitted threshold




Median pre-money valuations improved over last few years

Bay Area median pre-money valuations slightly higher than East Coast

Note: Data corrupted by size & cost of capital required for each industry, average round size, number of rounds required




More recent anecdotal evidence indicates median valuations increasing as competition for “good deals” heating feverishly

Life science valuations may have stabilized, perhaps due to poor IPO after-market performance recently of some entrants

VC funds aggressively putting money to work ($60 Billion overhang in VC capital!)

2008 Forecast: more funds coming to market, more capital to invest, maybe more overhang?

Still Extremely Tough for early stage




Median % ownership by investors increased in 2006-07: received more company for less $$$ invested

Median Investor Equity Ownership %: First Round = 50% First Round = 50%

Second Round = 39%Second Round = 39%

Later Round = 28%Later Round = 28%


Deal Terms & Deal Terms & StructuringStructuring

Common StockCommon StockSame Risk as FoundersLittle Structural Flexibility

Preferred StockPreferred StockStructural FlexibilityDifferent Valuation for Management’s SharesManipulate IRRUpside Guarantees, Downside Protection

Convertible Note & WarrantsConvertible Note & WarrantsProtection of PrincipalInterest as Current Return, Deduction for Interest

Warrants as Sweetener


Preferred Stock Deal Preferred Stock Deal TermsTerms

Liquidation Preferences

Participating Preferred

Cumulative Dividends

Cash-Out Election on Sale

Anti-Dilution Protection

Class Voting/Veto Rights

Board Composition


More Deal TermsMore Deal Terms

“Play or Pay” - “Play or Lose” Provisions

Mandatory Redemption Registration Rights

Piggy-BackDemandShort-Form S-3 Rights

Preemptive Rights, Rights of First Offer, Rights of First Refusal


Preferred Stock Deal Preferred Stock Deal TermsTerms

Basket (the “PoolPool”) for Management Shares

Noncompetition, Nonsolicitation Agreements

Employment/Severance Agreements for Founders and Management

Vesting, Buy-Back of Founders’ Stock

Co-Sale & Rights of First Refusal on Management, Founders’ Shares


Liquidation PreferenceLiquidation Preference

Recoup Principal

Investor Receives Priority over Management

Option to Recoup Principal Amount or Choose to Convert Preferred

Economic Effect in Event of Acquisition or Sale of Company

Issue: Do Founders Get Liquidation Preferences Too?


Liquidation PreferenceLiquidation PreferenceLiquidation PreferenceLiquidation Preference

All later-stage rounds now have senior liquidation preferences

Multiple liquidation preferences are abating, except for recapitalizations, or perceived “high valuation” for early-stage financing most = 2x preference; but some as high as

3x-5x! argue for vanishing preference as a multiple

of capital rather than IRR hurdle: multiple of capital is flat over time; IRR hurdle increases over time with compounding effect


Cumulative DividendsCumulative Dividends

Built-In Return; Rates Vary from 8%--12%

Dividend Accumulates Until Paid on an Acquisition, Redemption, Liquidation or Cash-Out Election Event, Public Offering?

PIK Dividends: Payment-in-Kind, Tax Issues abound for Foreign LPs

Issue: Dividend Should be Forfeited on Voluntary Conversion or Public Offering Event - Investor Loses the Built-In Return if Company Achieves IRR Better Than the Dividend


Participating PreferredParticipating Preferred

Investor Gets $$$ Back & Then Participates in All Residual Amounts on an “As-Converted” Basis!!! So-called “PIG Preferred”! THIS IS THE BIG THIS IS THE BIG KAHUNAKAHUNA!!

Potentially Disastrous Impact on Founders’ equity if Sale or Acquisition Does Not Yield a Decent Return

Investor Recovers the Investment (including dividends) & Then Plays Again in Upside Gain

Issue: Resist It! Get an “IRR Hurdle”/ Multiple of Capital Threshold Such that Investor Forfeits This Right


Participating PreferenceParticipating PreferenceParticipating PreferenceParticipating Preference

Participating preferences are the “receding norm” many are uncapped (always receive return

of capital), some are capped at 2x-3x or receive as-converted participation

evidence of liquidation preference also paid on IPO

participation features among series can create conflicts and lead to anomalous results

Resetting or washing out old preferences is the biggest challenge

Participating Preferred is disappearing for “hot” deals


Anti-Dilution ProtectionAnti-Dilution Protection

If Subsequent Rounds of Financing are Dilutive as to Price, Investor Gets to Reprice the Old Money at Today’s Dilutive Valuation

Ratchet Formula: If Company Issues 1 Share at Lower Price, Conversion Rate of Preferred is Reduced to Lower Price !!!!

Weighted-Average Formula: Factors in Overall Impact of Total Shares Issued in New Dilutive Round and Adjusts Old Conversion Rate Based on Impact on Total Capitalization


Anti-Dilution ProvisionsAnti-Dilution ProvisionsAnti-Dilution ProvisionsAnti-Dilution Provisions “Weighted-Average” is still market standard

Full Ratchets appear in later rounds, below minimal levels or within specified time frames

Full ratchetFull ratchet may appear in early rounds early rounds as as quid pro quo for higher pre-money valuationquid pro quo for higher pre-money valuation

Full Ratchets in early rounds may haunt investors when later round investors demand the same deal terms

Cold Weather SyndromeCold Weather Syndrome: East Coast VCs: East Coast VCs used anti-dilution and ratchetanti-dilution and ratchet more frequently than Bay Area VCs!


““Play or Lose” Play or Lose” ProvisionsProvisions

Investor Does NOT Receive Benefit of Price Anti-Dilution Protection if Investor Does Not Play for Full Pro-Rata Share in any New Dilutive Financing

Incentive for Investors to Play in Dilutive Financings and Support the Company

Ensures that Investment Syndicates will Remain United in Support


Play-or-Lose Play-or-Lose ProvisionsProvisions

Play-or-Lose Play-or-Lose ProvisionsProvisions

Most deals still do not have “Pay-to-Play” or “Play-or-Lose” provisions doubled-edged sword nature is an issue

When used, typical provision calls for conversion to common, not just loss of anti-dilution protection

Trigger is no longer pro rata participation; now set at share of insider investor allocation to apply to inside rounds


Class Voting RightsClass Voting Rights

Investor has Ability to Block\Veto Important Corporate Transactions

Mergers, Sales of Stock or Assets

Issuances of Additional Preferred

Grant of Excessive Options to Employees

Incurrence of Debt

Sales or Transfers of Technology

Issue: Separate Class Voting Rights Should Disappear if Preferred Holds Less than Certain % of Equity


““Drag Along” RightsDrag Along” Rights

“Merger Extortion Device”: Investor has Ability to compel a Liquidity event: i.e., sale or mergerStated percentage of Investors (maybe 67% of a round or all preferred) determine that Company should be sold

Board determines that Company should be sold

Result: Minority stockholders are “dragged along” in the sale process, a “Forced March to the Merger Alter” -- with waiver of appraisal


Mandatory RedemptionMandatory Redemption

Investor Wants Money Back After Time (5-7 years)

Depends on Stage of Company and Venture Fund Investing, Business Plan and Profitability Model, Expectations of Liquidity Events

Redemption for Dollars Invested, Dollars Plus Cumulative Dividends, Stated Return, or Fair Market or Appraised Value

Delinquent Redemptions ??? Increase in Conversion Rate for “Blown Redemption” – potentially ruinous to management


Mandatory Mandatory RedemptionRedemption Mandatory Mandatory

RedemptionRedemption Mandatory redemption seems to be an

peculiar East Coast phenomenon Begins in years 5-6, in annual install-

ments (2-3 increments) Redemption typically greater of

liquidation preference plus dividends or Fair Market Value (without liquidity discount – i.e., deemed sale of company)

Redemption = Forced sale of company rather than payout of redemption price


Failed RedemptionFailed Redemption Failed RedemptionFailed Redemption

Penalties for failed redemption: “Board Takeover” right

Conversion of unredeemed portion to promissory note

Increase in conversion rate on preferred

Complexity of timing of redemption with multiple series of preferred


Basket For Management Basket For Management PoolPool

Get Agreement From Investors: Certain % of Capitalization Set Aside as Option Pool for Future Employees or to Reward Existing Talent

Share Equally Dilution Presented by “Basket” or Option Pool -- On Pro Rata Basis -- by Investors & Founders

Pool or Basket Typically Represents 15%-18%-18%-20% of Total Fully-Diluted Capitalization, Post-Financing – but comes out of pre-money !


Non-Competition Non-Competition AgreementsAgreements

Investors are Backing People & Ideas -- Want Assurances Key Employees Will Not Leave to Form Competitive Venture

Time Periods for Post-Employment Non-Competition: 1 Year – 18 months (beyond that = unenforceability risk)

Consideration Needs to Support a Covenant Not To Compete

Issues: Should NonCompete expire if Person is Terminated Without Cause, or Downsizing?


Vesting & Buy-Out Of Vesting & Buy-Out Of FounderFounder

Investors Require Founders or Managers with Cheap Equity To Give Back Some Shares and Be On a Vesting Schedule -- If Person Leaves Before Stock is Fully Vested, Portion of Equity Can be Repurchased at Original Cost

Issues: How Much Vested at Time of Investment? What Happens to Shares if Terminated w/o Cause or Voluntarily, Death/Disability? Vesting Period: Annual/Quarterly/Monthly? Buy-Out Price?


Board CompositionBoard Composition

Investor Representation Often Tracks $$

Management Needs Representation too

Importance of Outside Directors critical

5 Directors Is Often the Magic Number

Follow the “Martini Rule” for VCs on Board

Ask me about the “Martini Rule”

www.mwe.comwww.mwe.com

© 2004 McDermott Will & Emery McDermott operates its practice through separate legal entities in each of the countries where it has offices.

VentureOne: VentureOne: Deal Terms SurveyDeal Terms SurveyVentureOne: VentureOne:

Deal Terms SurveyDeal Terms Survey

Fourth Edition


Participating PreferredParticipating PreferredParticipating PreferredParticipating Preferred

Companies raising first institutional round of financing were more likely to experience participating preferred

Series A: 73% of survey had Participating Preferred in first round of financing

Second Round: 54.5% had Participating Preferred (last year Second Round = 79.3%)

Third Round: 65.4% = Participating Preferred


Cap on Participating Cap on Participating PreferredPreferred

Cap on Participating Cap on Participating PreferredPreferred

41% of Survey respondents had a cap on the multiple of investment return; 59% did not

47.4% reported a “participation cap” when the round was at an enhanced valuation

Caps of 2x were most common (55.9% = 2x Cap; 31% = 3x Cap; 13%>4x Cap))


Cumulative DividendsCumulative DividendsCumulative DividendsCumulative Dividends

48% of Survey respondents reported Cumulative Dividend structures

8% was the median dividend rate Companies closing second rounds

were least likely to report a Cumulative Dividend structure

East Coast deals reported higher percentage of Cumulative Dividend structures


Cumulative DividendsCumulative DividendsCumulative DividendsCumulative Dividends

49.5% of First Round respondents reported Cumulative Dividend

42.2% of Second Round respondents reported Cumulative Dividend

50.0% of Third/Later Round respondents reported Cumulative Dividend


Staged FinancingsStaged FinancingsStaged FinancingsStaged Financings

26% of First Round respondents reported Staged Financing fund raisings

Key Triggers: Product Development: 30.4%

Set Passage of Time: 21.4%

Specific Customers Landed: 12.5%

Key Managers Hired: 12.5%

Revenue Targets Achieved: 14.3%


Company ControlCompany ControlCompany ControlCompany Control

Median Amount of Company Sold: First Round: 40% (previously

50%), with median amount raised at $5M (from $5.3M)

Second Round: 33%

Third/Later Round: 26%


Company Control: Company Control: FoundersFounders

Company Control: Company Control: FoundersFounders

Median Founders Ownership After Round: First Round: 31.5%

Second Round: 15%

Third/Later Round: 10%


Anti-Dilution ProtectionAnti-Dilution ProtectionAnti-Dilution ProtectionAnti-Dilution Protection

64.3% of First Round respondents reported Weighted-Average Anti-Dilution (vs 13.3% = Full Ratchet)

64.6% of Second Round respondents reported Weighted-Average Anti-Dilution (vs 15.4% = Full Ratchet)

66.7% of Third/Later Round respondents reported Weighted-Average Anti-Dilution (vs 20.5% = Full Ratchet)


Size of Option PoolSize of Option PoolSize of Option PoolSize of Option Pool

Median Ownership Percentage allocated to Option Pool = 15%

First Round = 15%

Second Round = 15% !!!

Third/Later Round = 15% !!!

Mean = 14.6% -- Median = 15%

Ranges reported from 11% to 18.8%

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