Negotiating the Preferred Stock Term Sheet

© 2010 Haynes and Boone, LLP

Negotiating the Preferred Stock Term Sheet

Presented by Bart GreenbergHaynes and Boone, LLP

OC Tech Coast AngelsMember Education SessionApril 25, 2012


Certain Preliminary Matters


Market Conditions Impact Terms

• Shortage of willing investors leads to aggressive terms

• Desire by Investors to “correct” prior valuation errors (i.e., overvaluations) and pull up returns on whole portfolio may lead to more aggressive terms

• Desire by Investors to avoid future errors may lead to more aggressive terms, such as by imposing self-adjusting valuations, guaranteed returns, downside protection, more bridge financings


• Severe down round/cramdown (leads to most aggressive terms)

• Flat round (could be considered a “win” in unfavorable market conditions)

• Up round (best chance to get reasonable or favorable terms)

Prior Rounds Impact Terms


• Means many different things

• $2.5 million pre-money with $2.5 million new money could mean:

– Original investors get $2.5 million if sold for $5 million

– Original investors + optionees (current or all future) get $2.5 million if sold for $5 million

– Original investors + founders and optionees (current or all future) will each have equivalent ownership percentages if “go public” (and convert to common stock) – but not necessarily under other liquidity scenarios

• Conversion concept vs. liquidation concept

Valuation


Defining the Terms of the Preferred Stock


ConsiderationsConsiderations

Dividends

• Priority of Payment•Common•Other Preferred

• Dividend/Coupon Rate• Cumulative vs. • Non-Cumulative• Form of Payment

•Cash “coupon”•Payment-in-Kind Securities (PIKs)


Pre-Bubble

• Non-mandatory, non-cumulative

8% per year

Post-Bubble

• Mandatory, cumulative 8% per year• More Extreme: Mandatory, cumulative, payable in kind up to 15% per year

Dividends


“Annual $_____ per share dividend on the Series ___

Preferred Stock, payable when and if declared by Board,

prior to any dividends paid to the Common Stock; dividends

are [not] cumulative. No dividends will be declared or paid

on the Common Stock unless and until a like dividend has

been declared and paid on the Series ___ Preferred

Stock.”

Example

Dividends


ConsiderationsConsiderations• Should the holder have a

“preferred” return before other equity holders?

• When should the preference apply (e.g., non-conversion contexts such as a merger or upon liquidation)?

• Key Characteristics:• Priority of Distribution• Amount of Preference• Participation Rights

Liquidation Preference


More favorable to preferred holders

More favorable to common holders

A B C D E F G H

Return cost only, or else convert

Cost + annual ROI (“AROI”) or else convert

Cost + AROI to PS; same amount per share to CS; then pro rata participation

Cost + AROI to PS; negotiated amount to CS; then pro rata participation

Cost + AROI to PS; cost + AROI to CS; then pro rata participation

Cost + AROI to PS; then pro rata up to multiple of PS cost; or else convert

Cost + AROI to PS; then pro rata participation

Multiple of cost to PS; then pro rata participation



Pre-Bubble

•• 1X purchase price, plus participation rights up to 3X

Post-Bubble

• 1X to 3X with some participation rights (the lower the X, the greater the participation rights)• Participation Rights are sometimes subject to a management carve out• More extreme: 3X purchase price, plus participation rights with no cap



Third: Distribution to holders of common stock (with possible participation by holders

of preferred stock)

Second: Distribution to holders

of preferred stock

First: Creditors Satisfied

The “Waterfall”


First Second Third Total

Creditors 0 0 0 $0.00

Series A* 0 $4,100,000 $4,100,000 $8,200,000

Common Stock(including option pool)

0 0 $6,800,000 $6,800,000

$15,000,000

First Second Third Total

Creditors 0 0 0 $0.00

Series A* 0 $12,300,000 $1,350,000 $13,650,000

Common Stock(including option pool)

0 0 $1,350,000 $1,350,000

$15,000,000

Term Sheet: 1x preference for Series A, 1x participation)

Term Sheet: 3x preference for Series A, full participation

* Original investment of $4,100,000

Amount Available for Distribution: $15,000,000

The “Waterfall” (an illustration)


“First pay the original purchase price [plus premium] plus

accrued dividends (if any) on each share of Series ___

Preferred Stock. Thereafter, Series ___ Preferred Stock

participates with Common Stock on an as-converted

basis.”

Example 1: Full Participation



“First pay the original purchase price plus accrued

dividends (if any) on each share of Series ___

Preferred Stock. Thereafter, Series ___ Preferred

Stock participates with Common Stock on an as-

converted basis until the holders of Series ___

Preferred Stock receive an aggregate of [ _ ]X

original purchase price.”

Example 2: Cap on Participation Rights



“First pay the original purchase price [plus

premium?] plus accrued dividends on each

share of Series ___ Preferred Stock. The

balance to holders of Common Stock.”

Example 3: Non-Participating




Redemption

• Who can trigger?• Percentage of preferred

holders/individually • Company (rare)

• Priority among other holders

• Staging of Redemption

• Device to force conversion

• Form of Payment

• Legal Restrictions


Pre-Bubble

• Not Common

Post-Bubble

• At option of holders after 5 years at purchase price plus accrued dividends

Redemption


“Series ___ Preferred Stock redeemable at the

election of holders [of 66-2/3rds] of the outstanding

Series ___ Preferred Stock] on or after

____________ at a price equal to the original

purchase price [plus accrued dividends] [plus ___%

per year] or as soon thereafter as legally

permissible.”

Example 1: Lump Sum

Redemption


“[See Example 1], to the extent of 1/3 of the shares

of Series ___ Preferred Stock on the [____], [____]

and [____] anniversary dates of the Closing or as

soon thereafter as legally permissible[, but in no

event will more than 1/3 of the outstanding shares of

Series ___ Preferred Stock (plus 1/3 of the

aggregate accrued dividends) be redeemed in any

12 month period.]”

Example 2: Three Tranches

Redemption



Conversion Rights

• The number of shares of common stock, if any, into which preferred stock converts:

preferred stock share price (fixed) Conversion Price

• Typically Based on Certain Triggering Events

• Election by percentage of holders of preferred stock

• IPO



Antidilution Adjustments

• Way to “fix” earlier valuation errors on conversion (i.e. allocate most or all of risk of down round to common stock)

• Three Types of Adjustments

• “Full Ratchet”• “Narrow-Based” Weighted

Average• “Broad-Based” Weighted

Average• Specified Exceptions


Pre-Bubble

• Standard broad-based weighted

average adjustment


Post-Bubble

• Narrow-based weighted average adjustment

• More extreme: Full ratchet adjustment for a period; then narrow or broad- based weighted average adjustment


Scenario:

Common Stock Outstanding 1,000,000 shares

Series A Preferred 1,000,000 shares at $1.00(or $1,000,000)

Series B Preferred 1,000,000 shares at 75¢(or $750,000)

Adjustments (Upon Series B)

Type of Adjustment Conversion Ratio

Full Ratchet 1:1.333

Narrow-Based 1:1.143

Broad-Based 1:1.091

• Series A Conversion Ratio Prior to Series B = 1:1

• Upon Series B, Series A Conversion Ratio adjusted as follows:

Antidilution Adjustments (an illustration)


• If stockholder does not purchase pro rata share in subsequent offering, stockholder loses benefit of antidilution provisions.

• In extreme cases, non-participating stockholders must convert to common stock (sometimes at less than 1:1), thereby losing protective provisions of preferred stock.

• “Pay to Play” minimizes fears of major investors that small investors will benefit by having major investors continue providing needed equity, particularly in troubled economic times.

Antidilution Adjustments - Pay to Play


“Conversion ratio for Series ___

Preferred Stock adjusted on

[ratchet/[broad or narrow] weighted

average] basis in the event of a dilutive

issuance [so long as investor

purchases full pro rata share of dilutive

issuance (“pay to play”).]”

Example 1: With Pay to Play



“Any Existing Holder that does not fund its Pro

Rata Amount by the Initial Closing shall have its

Equity Securities automatically converted at a ratio

of 10 to 1 to a new series of Common Stock that

retains no voting rights; provided however, that to

the extent an Existing Holder partially meets its

Pro Rata Amount, such holder shall retain a

corresponding portion of its Equity Securities, and

may choose the respective portion to retain.”

Example 2: Pay to Play with Cram Down



“Dilutive issuance” shall not include: (i) up to

______ shares of Common Stock issued pursuant

to a stock option plan approved [unanimously/by a

majority] of the Board of Directors; (ii) Common

Stock issued upon conversion of the Preferred

Stock; (iii) stock issued in any IPO in which the

Preferred Stock is converted into Common Stock; or

(iv) stock issued in connection with mergers or

acquisitions approved [unanimously/by a majority]

of the Board of Directors.”

Example 3: Specified Exceptions




Protective Provisions

• Control Provisions• Board Seats• Voting Agreements• Other Protections


Pre-Bubble

• Investor approval of: senior securities, sale of company, payment of dividends, liquidation, change of rights

• Investor approval of senior or pari passu securities, sale of company, payment of dividends, change of rights, change of business, incurrence of debt over specified limit, annual budgets and variances, acquisitions of other businesses, grant of exclusive rights in technology, appointment or termination of CEO

Post-Bubble



“Votes on an as-converted basis, but also has

[class/series] vote as provided by law and on (i) the

creation of any senior [or pari passu] security, [(ii) payment

of dividends on [Common Stock/on any class of Stock]],[(iii)

any redemptions or repurchases of Common Stock or

Preferred Stock [except for purchases at cost upon

termination of employment], (iv) any liquidation, dissolution

or winding up of the Company; (v) any merger, acquisition,

recapitalization, reorganization or sale of all or substantially

all of the assets of the Company, (vi) an

Example



increase or decrease in the number of authorized shares

of Series [ _ ] Preferred Stock or Common Stock, (vii) any

[adverse] change to the rights, preferences and privileges

of the Series [ _ ] Preferred, [(viii) an increase or decrease

in the size of the Board], [(ix) [material] amendments or

repeal of any provision of the Company’s Charter or

Bylaws]; [(x) the issuance of any additional shares of

capital stock (or options) to the Company’s founders,] and

[(xi)] authorization of any amount of indebtedness in

excess of $____.]”

Example (cont.)



Defining the Terms of the Stock Purchase Agreement


• Scope/Coverage

• By the Company

• By the Founders (e.g., technology)


Representation and Warranties



Closings

• When will the Investors go “at-risk”?• Lump Sum at Closing• Staging of Investment

• Passage of Time• Milestones


Pre-Bubble

• Single Tranche Investment

Post-Bubble

• Single Tranche Investment

• More Extreme: Milestone-Based Tranches

Closings



Conditions to Closing

• Satisfactory Completion of Due Diligence

• Exemption or Qualification of Shares under Applicable Securities Laws

• Filing of Amendment to Charter to Establish Rights and Preferences of the Preferred Stock

• Opinion of Counsel to the Company



Employee Matters

• Employment Agreements with Founders

• Obligation for All Employees/Consultants to Enter into Company’s Standard Inventions and Proprietary Information Agreement



Expenses

• Company Typically Pays Reasonable Fees and Expenses of Investors’ Counsel

• Consider Cap on Obligation


Defining the Terms of the Investors’ Rights Agreement



Registration Rights

• Types of Registration Rights• Demand Rights• Piggyback Rights• S3 Rights

• Termination of Rights• Limitation on Subsequent

Rights• Absolute prohibition• Permitted if Subordinate

• Allocation of Expenses


“Beginning on the earlier of [3-5] years from

Closing, or [three/six] months after the Company’s

IPO, [1-2] demand registrations [for underwritten

public offerings] upon initiation by holders of at

least [30]% of outstanding Series ___ Preferred

Stock (or Common Stock issuable upon

conversion of the Series ___ Preferred Stock or

any combination thereof) for aggregate proceeds

in excess of $_______.”

Example 1: Demand Rights

Registration Rights


“Investors in Series __ Preferred Stock will have

[unlimited] piggyback registration rights subject to

pro rata cutback at the underwriter’s discretion.

Full cutback upon the IPO; [30% minimum

inclusion thereafter]. Investors will not be subject

to cutback unless all other selling shareholders are

excluded from registration.”

Example 2: Piggyback Rights

Registration Rights


“[Unlimited] S-3 Registrations of at least $500,000

each [upon initiation by holders of at least [20%] of

the outstanding Series ___ Preferred Stock (or

Common Stock issuable upon conversion of the

Series ___ Preferred Stock or any combination

thereof)]. [No more than two S-3 Registrations in

any 12 month period.]”

Example 3: S3 Rights

Registration Rights


“Registration rights terminate [(i) [3-7] years after

the IPO;] or (ii) when [the Company is publicly

traded and] all shares can be sold [in any 90-day

period] under Rule 144, whichever occurs first.][,

provided that this clause (ii) shall not apply to any

5% holder deemed to be an affiliate of the

Company.]”

Example 4: Termination

Registration Rights



Market Stand-Off

• Time of Lock-Up

• Who Controls Decision• Investors• Underwriter

• Equal Application

• Obligation to Execute Underwriter’s Form of Lock-Up Agreement


“Prior to the Closing, all shareholders shall agree that in

connection with the IPO not to sell any shares of Preferred

Stock or Common Stock issuable upon conversion thereof

for a period of up to [180] days following the IPO

[(provided directors and officers of the Company and [5]%

shareholders agree to the same lock-up. Such

shareholders also shall agree to sign the underwriter’s

standard lock-up agreement reflecting the foregoing.”

Example

Market Stand-Off



Right of First Offer

• Who Owns the Right?• All holders of preferred stock• Holders of at least [____]

percentage of preferred stock

• Determination of Percentage


Pre-Bubble

• Right to maintain pro-rata ownership in

later financings


Post-Bubble

• Right to maintain pro-rata ownership in

later financings

• More Extreme: right to invest 2X pro-rata ownership in later financings


“The Investors shall have a pro rata right, based on

their percentage equity ownership of [Preferred

Stock] [Common Stock, on a fully diluted basis], to

participate in subsequent financings of the

Company (excluding [See List of Specified

Exceptions to Antidilution Adjustments]. Such right

will terminate immediately prior to a Qualified

Public Offering.”

Example




Financial Information

• Financial Statements• [Audited] annual statements• Unaudited monthly/quarterly

statements

• [1-5] Year Projections• Other Material Information



Board of Directors

• Determination of Authorized Number of Directors

• Voting Agreement Among Shareholders• Class Votes• Specific Identification

• Independent Members of Board• Use of an Advisory Board• Board Observation Rights


“[The Company’s Articles of Incorporation shall provide that

the] Board shall consist of ____ members, with the holders

of a majority of Series ___ Preferred Stock entitled to elect

____ member(s) [and the holders of a majority of the

Common Stock entitled to elect ____ member(s)]. [The

Company and the Investors intend to select ____ outside

director(s) with relevant industry experience as soon as

possible after Closing.] Board composition at Closing shall

be _______, [with vacancy].”

Example

Board of Directors


Defining the Terms of Other Agreements


• Rights of First Refusal

• Co-Sale Rights

• Drag-Along Rights

Restrictions on Transferability


Pre-Bubble

• Right to purchase any shares proposed

to be sold by employees

Post-Bubble

• Right to purchase any shares proposed to be sold by employees• More extreme: right to purchase any shares proposed to be sold by any shareholder

Rights of First Refusal


“Any [vested] Common Stock acquired

by [employees] [founders]

[shareholders] shall be subject to a

right of first refusal of [the Company]

[the Investors] to repurchase any stock,

at the bona fide offer price.”

Example

Rights of First Refusal


Pre-Bubble

• Right to sell alongside any founder that

sells shares

Post-Bubble

• Right to sell alongside any founder that sells shares• More extreme: Right to sell alongside any shareholder that sells shares

Co-Sale Rights


“Until the IPO, the Investors also shall have the right

to participate on a pro rata basis in transfers of any

shares of [Preferred Stock or] Common Stock [held

by the Founders or any [major] shareholder], [and a

right of first refusal on such transfers, [subordinate

to] [prior to] the Company’s right of first refusal.

[Any shares not subscribed for by an Investor may

be reallocated among the other eligible Investors.]”

Example

Co-Sale Rights


Pre-Bubble

• None

Post-Bubble

• None• More extreme: Right to force • shareholders to sell company upon board and majority shareholder vote

Drag-Along Rights


“So long as the Investors own shares of Series ___

Preferred Stock representing at least [25]% of the

Company’s Common Stock on a fully-diluted basis

(as determined by ]), the Investors shall have

drag-along rights with respect to securities of any of

the Founders or principal Common Stock holders in

the event of a proposed sale of the Company to a

third party (whether structured as a merger,

reorganization, asset sale or otherwise).”

Example

Drag-Along Rights


Pre-Bubble

• 3- or 4-year vesting with some up-front

vesting

Post-Bubble

• 4-year vesting with no-up front vesting

• More extreme: 5-year vesting and/or

performance standards

Founder Vesting


“If a Founder voluntarily terminates his or her

employment with the Company or is terminated for

cause, then the [Company/the Investors] will have

the right to repurchase 100% of the Founders’

shares less [1/48]th of those shares for each

complete month of service the employee served with

the Company.”

Example 1: Single Trigger

Founder Vesting


“Upon termination of the employment of the

shareholder, with or without cause, the Company

may repurchase at cost any shares subject to the

repurchase option. The Company’s repurchase

option shall lapse by [___ percent (__%)] of the

unvested portion in the event such Founder is

terminated without Cause or Constructively

Terminated as a result of and within six (6) months

prior to or twelve (12) months following a Change in

Control.”

Example 2: Double Trigger

Founder Vesting


Certain Term Sheet Terms


“The Company’s capital structure before and after the Closing

is set forth below [including founder’s shares to be issued prior

to the Closing]:”

Example

Pre-Financing Post-Financing

Security # of Shares % # of Shares %

Common – Founders 4,077,670 73.7 4,077,670 40.5

Common – Employee Stock Pool Issued Unissued

--

1,456,311

--

26.3

--

1,456,311

--

14.5

Common – Warrants to Debt Holders -- -- 75,000 0.7

Series A Preferred -- -- 4,466,019 44.3

Total 5,533,981 100.0 10,075,000 100.0

Capitalization


• “The Company will not discuss the terms of this Term

Sheet with any person other than key officers,

members of the Board of Directors of the Company or

the Company’s accountants or attorneys without the

written consent of Investor, except as required by law.

In addition, the Company shall not use the Investor’s

name in any manner, context or format (including,

reference on or links to websites, press releases, etc.)

without the prior review and approval of Investor.”

Example

Publicity


• “From the signing date hereof until 5:00 P.M. Pacific

Standard Time on __________, the Company and the

Founders agree that they shall not solicit, encourage others

to solicit, encourage or accept any offers for the purchase

or acquisition of any capital stock of the Company, of all or

any substantial part of the assets of the Company, or

proposals for any merger or consolidation involving the

Company, and they shall not negotiate with or enter into

any agreement or understanding with any other person with

respect to any such transaction.”

Example

No Shop

70


Questions?

Bart GreenbergPartner

18100 Von Karman Avenue, Suite 750Irvine, California 92612

[email protected]

949.202.3037

Documents

Negotiating the Preferred Stock Term Sheet