Getting the Deal Done: Due Diligence and Term Sheets - April 2011 By: Lucy Stark and Stephanie Berberich

Getting the Deal Done:
Due Diligence and Term Sheets
 By: Lucy Stark and Stephanie Berberich

              April 2011

Due Diligence

         What is Due Diligence and Why
               Are We Doing it??

 “Diligence is a great teacher.” – Ancient proverb

Key Due Diligence Areas

 Capitalization
 Intellectual Property
 Organizational Documents
   – Governing documents, i.e., articles of
     incorporation, bylaws, operating agreements,
     shareholders’ agreements
   – Documentation of all company actions, i.e.,
     Board meeting minutes, actions by consent
 Financials and financing activities
 Customer / Material Contracts

How and Why to Prepare in
Advance for Due Diligence
 Good record-keeping is critical

 It’s not too late to start now

 It’s not too early to get good advice

Negotiating Deal Terms

 Know Your Target Investor(s) and
  Negotiate Accordingly
  – Get good legal advice early in the process
  – Friends and Family – common equity
  – Angel Investors – bridge loan, common or stripped-down
    preferred
  – Institutional Investors (Venture Capital and/or Private Equity) -
    preferred

 Economics
  – Valuation Considerations (Pre-Money Valuation)
  – Milestone Financings

Bridge Financing

 Concept: Used for interim financing when future pre-
  money valuations are uncertain
   – Helps with friends/family and angel investors – lack of sophisticated
     valuation analysis
   – Invested amount senior to other equity and in some cases investor takes a
     security interest in the Company’s assets
   – Loan amount converts at same price and terms as next qualified financing
   – Interest also converts to equity or paid in cash
   – If change of control prior to financing, often converts into equity at some
     agreed price prior to change of control
   – Possible Warrant Coverage:
        [Agreed percentage] x Loan Amount = Warrant Shares
                Financing Price per share

Pre-Money Valuation

 Term Sheet Provision:
  “[$1.00] per share (the “Original Purchase Price”). The Original
  Purchase Price represents a fully-diluted pre-money valuation of
  [$5,000,000]. A capitalization table showing the Company’s capital
  structure immediately prior to the Closing is attached.”

 Concept: The value of the Company prior to the proposed
  financing
   – Pre-money valuation is a negotiated dollar amount which creates
     agreed ownership/voting percentages
   – Divide pre-money valuation by current outstanding numbers of
     shares plus reserved options to provide purchase price per share of
     Preferred Stock
   – Useful fiction for financing: Preferred Stock and Common Stock are
     worth the same

Liquidation Preference

Term Sheet Provision: Participating or Not?
 “In the event of any liquidation or winding up of the Company, the holders of the Series A
 Preferred shall be entitled to receive in preference to the holders of the Common Stock a per
 share amount equal to the Original Purchase Price plus any declared but unpaid dividends
 (the “Liquidation Preference”). [After the payment of the Liquidation Preference to the
 holders of the Series A Preferred, the remaining assets shall be distributed ratably to
 the holders of the Common Stock on a pro rata basis.] [After the payment of the
 Liquidation Preference to the holders of the Series A Preferred, the remaining assets
 shall be distributed ratably to the holders of the Common Stock and the Series A
 Preferred on a common equivalent basis.] A merger, acquisition, sale of voting control or
 sale of substantially all of the assets of the Company in which the shareholders of the
 Company do not own a majority of the outstanding shares of the surviving corporation shall be
 deemed to be a liquidation.”

Liquidation Preference

 Concept: Preferred stockholders get their money back first
  on liquidation (merger, sale) of the Company

   – Liquidation includes change of control
   – Simple Preference
        Investors get money back (or increased multiple) off the top,
         common stock gets residual
       Investors will convert to common stock if they will get more money that
         way
   – Participating Preferred
       Investors get money back first, then share with common stock on an as-
         converted basis
       Sometimes capped
       If uncapped, preferred stock will only convert on IPO

Dividends

Term Sheet Provision:
 “The Series A stockholders shall be entitled to receive [non-] cumulative dividends at a
 rate of 8.0% of the Original Purchase Price per annum, in preference to any dividends on
 the Company’s Common Stock payable [when, as and if declared by the Board]
 [whether or not declared by the Board]. Any declared but unpaid dividends are
 payable upon a liquidation, sale of the Company, redemption, or conversion of the Series
 A Preferred Stock.”

 Accruing Dividends - Cumulative vs. Non-
  Cumulative
  – Company should negotiate for Non-Cumulative Dividends

 Dividends Paid In-Kind
  – Consider Valuation Issues and Dilutive Impact

Anti-dilution Provision
Term Sheet Provision:

  “The conversion price of the Series A Preferred will be subject to a [narrow-based]
  [broad-based] weighted average [full-ratchet] adjustment to reduce dilution in the
  event that the Company issues additional equity securities (other than ____ shares
  reserved as employee shares described under “Employee Pool” below and certain other
  customary exceptions) at a purchase price less than the applicable conversion price.
  The conversion price will also be subject to proportional adjustment for stock splits, stock
  dividends, recapitalizations and the like.”

Anti-dilution Protection
   Concept: Conversion Ratio for Preferred Stock is increased if future
    rounds of financing are below the purchase price paid by Preferred Stock

   Full Ratchet – adjust conversion price to price paid by investors in future round.
    Example:
     – Current conversion ratio: Original Price $1.00 = 1:1 conversion ratio
                                   Conversion Price $1.00

     – Adjusted conversion ratio: Original Price $1.00 = 2:1 conversion ratio
                                  Conversion Price $0.50

   Weighted average
     – Adjust conversion price by formula, accounts for size of financing and how
       much lower the price
     – Always less adjustment than full ratchet

Redemption

Term Sheet Provision:

 “[At the election of the holders of at least [a majority] [two-thirds] of the
 Series A Preferred, the Company shall redeem the outstanding Series
 A Preferred in three annual installments beginning on the [fifth]
 anniversary of the Closing. Such redemptions shall be at a purchase
 price equal to the Original Purchase Price plus declared and unpaid
 dividends.]”

Redemption

 Concept: At some negotiated point, the investors can sell
  their Preferred Stock back to the Company for at least their
  original investment amount
   – Gives leverage to investors to force a sale or a recapitalization and
     prevents founders from sitting on a cash-cow company
   – Protects investors from a drifting company
   – *Rarely exercised*
   – Negotiating Points:
        Sometimes a Drag Along Right is tied to a redemption default
        Supermajority Board Vote Upon Redemption Default
        Company wants to stagger out redemption payments over time

Protective Provisions

Term Sheet Provision:
  “Consent of the holders of at least [a majority] [two-thirds] of the Series A Preferred
  shall be required for any action that (i) alters or changes the rights, preferences or
  privileges of the Series A Preferred, or (ii) increases or decreases the authorized number
  of shares of Common or Preferred Stock, (iii) creates (by reclassification or otherwise)
  any new class or series of shares having rights, preferences or privileges senior to or on
  a parity with the Series A Preferred, (iv) results in the redemption of any shares of
  Common Stock (other than pursuant to equity incentive agreements with service
  providers giving the Company the right to repurchase shares upon the termination of
  services), (v) results in any merger, other corporate reorganization, sale of control, or
  any transaction in which all or substantially all of the assets of the Company are sold, (vi)
  amends or waives any provision of the Company’s Articles of Incorporation or Bylaws
  relative to the Series A Preferred, (vii) increases or decreases the authorized size of the
  Company’s Board of Directors, or (viii) results in the payment or declaration of any
  dividends on any shares of Common or Preferred Stock.”

Protective Provisions
 Concept: Gives investors veto rights over major or fundamental
  Company decisions
   – Often involves directly using investors’ money, adversely affecting
     investors’ rights, ability to sell, or next round of funding

   – Stockholder right, can vote differently than at the board level

   – No fiduciary duty owed by investor to Company or other
     stockholders

   – Negotiating Points:
       Try to keep these limited for Company flexibility
       Insist on Board carve-outs

Preemptive Rights

Term Sheet Provision (Preemptive Right):
  “Each Investor of holding at least [$500,000] of
  Series A Preferred will be entitled to subscribe for
  up to such Stockholder’s pro rata share of any
  future issuances by the Company of equity
  securities, with customary exceptions.”
Concept: allows investors the right to maintain their
  percentage interest (with some common
  exceptions for employee equity, etc.)

Right of First Refusal

 Term Sheet Provision:
    “Prior to a Qualified IPO, the Company and then the holders of Series
    Preferred shall have the right of first refusal to purchase any securities of
    the Company offered for sale by any selling holder of Series A Preferred or
    “Stockholder” (as defined in the Co-Sale Agreement) except with respect to
    shares transferred to permitted transferees.”

 Concept: Keeps ownership of company’s equity
  in same hands by offering first the company, and
  then the investors, the right to purchase shares
  being offered. If not exercised, followed by tag-
  along (co-sale) and drag along rights.

Co-Sale Rights

Term Sheet Provision (Co-Sale or Tag-along
  Right):
  “If any Management Stockholder proposes to sell, cumulatively after
  the Closing, more than ten percent (10%) in the aggregate of the
  number of shares of Common Stock held by such Management
  Stockholder at Closing, the holders of Series A Preferred will have the
  right to sell to such purchaser such Series A Preferred holder’s pro rata
  share of the Company’s Series A Preferred (and Common into which
  converted) and Common Stock.”
Concept: If stockholder is selling, investors can
 require the buyer to purchaser an equivalent
 percentage of their shares – can make it very
 difficult to sell shares to third parties. Investors
 don’t want founders and key managers disposing
 of their stake.

Drag-Along Rights

Term Sheet Provision:

 “In the event that [the Company’s Board and] the holders of at least _____%
 of the Series A Preferred approve a sale of the Company or all or substantially
 all of the Company’s assets (an “Approved Sale”), whether by means of a
 merger, consolidation, sale of stock or assets, or otherwise, all holders of
 equity securities of the Company shall consent to, vote for, and raise no
 objections to the Approved Sale and shall take all necessary and desirable
 actions in connection with the consummation of the Approved Sale. ”

Drag-Along Rights

 Concept: At some negotiated point and upon the vote of certain
  investors, such investors can force the stockholders to vote in
  favor of a transaction and/or sell their interests.

   – Shows up in a majority of transactions but RARELY EXERCISED
     (except to pull along minor stockholders)
   – Gives leverage to investors to force a sale
   – Negotiating Points:
        Extend Drag-Along Right to some future date
        Investors may negotiate extensive conditions to the terms of the
         Drag-Along Right to protect themselves – don’t want to sell
         except for cash or marketable securities or if have to live with
         sale terms that are unacceptable

Question & Answer Session

                 The End
                Thank you!
                     Lucy Stark
                   (303) 295-8493
              mlstark@hollandhart.com

                Stephanie Berberich
                  (303) 295-8396
            snberberich@hollandhart.com