Term Sheets and Convertible Notes: Structuring the Deal Spring 2013 Venture Fair and Forum San Francisco May 7-9, 2011 Term Sheets and Convertible Notes: Structuring the Deal May 8, 2013 Jonathan S. Storper and Leslie A. Keil jstorper@hansonbridgett.com and lkeil@ hansonbridgett.com Hanson Bridgett LLP 425 Market Street, 26th Floor San Francisco, CA 94105 415-777-3200

Convertible Note Basics Term: length of time before repayment 6 months to 24 months – 5 yrs. renegotiating is costly Conversion: Optional or Automatic Optional – Investors Automatic - Company Point of Conversion (time and rate) Company wants automatic Discount: 20% Additional feature upon conversion to yield larger % in company Problem is it may offset new $ Discount for coming in early Prepayment: Company probably will spend $ and investor wants the conversion Maybe friends and family round Interest Rate: Return on note 6-8% limits on % (10% limit) Usury exceptions Warrant Coverage: Option to buy more shares How much? (10-20%) Ability to participate in next round Security: If you can get it Secured / Unsecured and bankruptcy Company pushes against it; funds may push for it Covenants: Promises to prevent company from going out and doing bad things What you can do with the $ How you operate Consents you must seek from investors Ratios Key Points: Term Conversion: Optional or Automatic Discount Prepayment? Interest Rate Warrant Coverage Security Covenants

Examples Total loaned = $1,000,000 Automatic Conversion upon “Qualified Financing” Qualified Financing = $2,000,000 Loan converts into equity according to the following formula: (Balance of loan + interest accrued) Per Share price in Qualified Financing Thus, if $2,000,000 raised in a Qualified Financing at $1.00 a share, amount loaned converts into 1,000,000 shares; if $2,000,000 raised at $0.50 a share, the amount loaned converts into 2,000,000 shares Effect of 20% Discount: Discount applies to the per share price at which the loan would otherwise convert. If the $1,000,000 loan would otherwise convert at $1.00 a share, the discounted conversion price becomes $0.80 a share, yielding 1,250,000 shares on conversion rather than 1,000,000 If the $ $1,000,000 loan would otherwise convert at $0.50 a share, the discounted conversion price becomes $0.40 a share, yielding 2,500,000 shares on conversion rather than 2,000,000

Term Sheet Basics What is a Term Sheet? Is it Binding? No Shop NDAs Fees What is a Term Sheet? Basic deal terms Got your bridge round (convertible note) Outline of major terms - usually preferred These terms are “Standard” ? (negotiated) VCs prepare; for angels usually company Is it Binding? Yes / No Not usually but it’s an outline Not easy to deviate (investors walk) No Shop: Binding Keep feet to fire Helps get deal done (30-90 days) NDAs: Binding Even if deal doesn’t close Injunctive relief Fees: VCs want you to pay: you want to cap Angels – both parties pay their own fees

Deal Basics Type of Security Purchasers – Accredited v. Nonaccredited Documents to get the deal done Type of Security: Common usually founders and F & F Convertible debt Straight debt and warrants Preferred Purchasers – Accredited v. Nonaccredited: Accredited - $1 million net worth - $200 / 300 k Sophisticated - Who will you sell to? – unaccredited – not patient, more disclosure, higher cost How much: 1. currently, for every round, often see 2 down rounds 2. build in reserves, add time for this market (early stage Documents to get the deal done: Rep statement Stock purchase Investor rights Registration Rights Agreement Employment Agreements IP Assignment Private offering memo Purchase agreement Investor rights agree Co-sale Share Securities filings

Dividends When paid Noncumulative v. Cumulative When paid: Delegated by Board Investors want a preference for receipt prior to the founders Set return (6-9%) 8% typical Noncumulative v. Cumulative: Noncumulative – expires every year Cumulative – doesn’t expire Used to rarely see cumulative, but now if you put off dividend then in last years, cumulative for all years! New – mandatory dividend payments and penalties for nonpayment New – dividends tied to product launch

Liquidation Preference Liquidation Preference – change of control What is it? Before common How much $ on liquidation event Liquidation event: M&A, change control, IPO How much? (1x, 2x original) Participating? What happens after paying liquidation; participants like common With remainder of common stock or not? Capped? If participating Limitation (i.e. 3x original) Trigger Change in control – sometimes license (let’s say exclusive) Events (winding up and dissolving; sale; IPO, merger / acquisition) What is it? How Much? Participating? Capped? Trigger

Examples Assume a Series A Preferred round that raises $1,000,000 based on a $2,000,000 pre-money valuation $1 + $2 = $3 1/3 = 33% Thus, upon the closing, the preferred investors will own 33% on a fully diluted basis Assume a sale for $10,000,000 Liquidation Preference = 1x non-participating Preferred investors get $1,000,000 if they do not convert to common Preferred investors get $3,333,333 if they convert to common Liquidation Preference = 1x participating Preferred investors get $4,000,000 if they do not convert to common ($1,000,000 + $3,000,000) Liquidation Preference = 1x participating capped at 3x Preferred investors get $3,000,000 if they do not convert to common

Conversion Optional Automatic Ratio 1:1 Conversion – Right of investor or requirement of company to convert from preferred to common Optional: At investor election; certain time or event Automatic: Company requirement (IPO clears out cap table; majority vote; on sale – drag them along) Ratios: Starts at 1 to 1; can be adjusted up if you have to

Antidilution What is it? Weighted Average Antidilution: Investor protection on pricing Typical provision Protection for in down round Someone buys in for less Investor protection for pricing Add just the conversion price Ratchet: - Harsh – price guaranty (ratchet) (1990s); Coming back (1st year down round) It’s worse for management Carve-outs: Negotiations – over carve out Options to employees (usually common); Stock to preferred vendors, landlords, advisors Incentive pool (Employees/Incentive) Dividend stock or strategic partners What is it? Weighted Average Narrow- includes preferred and common Broad- includes preferred, common, options, warrants, others Ratchet Carve-outs Weighted average Narrow – includes preferred and common; worse for management Broad – includes preferred common options, warrants, others; better for management

Difference Between Broad and Narrow Weighted Average The definition of Stock Outstanding Broad: includes Common, Preferred, options, warrants, etc. Narrow: includes only the Preferred The more narrow, the larger the adjustment to the conversion price = greater punitive to Founders

Example: Ratchet Assume: $1,000,000 raised in Series A at $1.00 per share Pre-money valuation = $3,000,000 Series A converts to common on a 1:1 basis Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total) $500,000 raised one year later in Series B at $0.50 a share Pre-money valuation = $2,000,000 Series B converts to common on a 1:1 basis Thus, Series B owns 20% of the Company on as-converted basis (i.e., 1,000,000 out of 5,000,000 total) No anti-dilution protection, Series A owns 20% of Company after the sale of the Series B (1,000,000 shares out of 5,000,000 total).  Full ratchet anti-dilution protection, then the conversion price for the Series A Preferred is reduced from $1.00 per share to $0.50 per share. Thus, full ratchet means that upon conversion, Series A entitled to receive 2,000,000 shares of common stock rather than 1,000,000 shares of common stock. 

Weighted Average Formula AP = OP x CSO + (NM/OP) CSO + AS AP= Adjusted conversion price (after the application of weighted avg anti-dilution) OP= Old conversion price (before the application of weighted avg anti-dilution) CSO= Number of shares of Common Stock Outstanding immediately prior to dilutive issuance [the difference between Broad and Narrow] NM= New Money raised as a result of the dilutive issuance AS= Number of Additional Shares issued in the dilutive issuance

Example: Broad Based Weighted Average Assume: $1,000,000 raised in Series A at $1.00 per share Pre-money valuation = $3,000,000 Series A converts to common on a 1:1 basis Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total) $500,000 raised one year later in Series B at $0.50 a share Pre-money valuation = $2,000,000 Series B converts to common on a 1:1 basis Broad-based weighted average anti-dilution provision: $1.00 x 4,000,000 + ($500,000/$1.00) = $0.90 4,000,000 + 1,000,000 Thus, the adjusted conversion price is $0.90 and the conversion ratio is adjusted to 1:0.9 Upon conversion, Series A with broad based weighted average protection would be entitled to receive 1,111,111 shares of common stock (compared to 1,000,000 shares with no anti-dilution protection and 2,000,000 shares with full ratchet protection).  This will have a much less punitive effect on the company's founders and management than a full ratchet anti-dilution provision

Example: Narrow Based Weighted Average Assume: $1,000,000 raised in Series A at $1.00 per share Pre-money valuation = $3,000,000 Series A converts to common on a 1:1 basis Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total) $500,000 raised one year later in Series B at $0.50 a share Pre-money valuation = $2,000,000 Series B converts to common on a 1:1 basis Narrow-based weighted average anti-dilution provision: $1.00 x 1,000,000 + ($500,000/$1.00) = $0.75 1,000,000 + 1,000,000 Thus, the adjusted conversion price is $0.75 and the conversion ratio is adjusted to 1:0.75 Upon conversion, Series A with narrow based weighted average protection would be entitled to receive 1,333,333 shares of common stock (compared to 1,000,000 shares with no anti-dilution protection, 1,111,111 with broad-based weighted average protection and 2,000,000 shares with full ratchet protection).  More punitive effect on the company's founders and management than broad based weighted average, but still less than a full ratchet anti-dilution provision

Redemption Mandatory – 5 years (investors may give this up) Optional Redemption – (go to company and require buyback) Mandatory: Companies don’t like / want a partner Optional: Option on activity, time, event Price - price paid + dividends not paid + return

Board of Directors Total number Number elected by common Number elected by preferred Outside directors? Advise at least 5 Angels elect as group Series A won’t yield control How much do they own 3 in CA (engaged and not too many) Odd # Put the big names on advisory board and not make Board too large They will ask for compensation depending on role

Protective Provisions Voting In General What Protective Provisions Cover Senior securities Liquidation, change of control Amendments of Articles, Bylaws Change rights of preferred Information Rights Change in corporate purpose How long are they in effect? Early round: minority but keep watch as dilution occurs Preferred votes as though they converted Majority or more Preferred wants to vote as separate class (each new round!) Don’t get handcuffed in running your business

Registration Rights Demand Piggyback S-3 Registration Rights: Don’t try and negotiate Standard Right to common stock that preferred converts into and get them registered Terminates when you can sell without registration Demand: Triggering events force registration Investor has right to demand registration after time (1 year after IPO); (rights to cut back or delay by company) Need flexibility Piggyback: Onto management Right of investor to piggyback onto the company pool – company pays cost, including lawyer Right to register – investor wants transferability Company will want right to limit S-3: Short form More for public companies (can use 1 year after IPO) Less expensive Issues: # of shares, investors Legal and accounting expenses which Company will want to avoid Company will want amount of securities to be greater than a certain amount (say $1 mil) to avoid frivolous regulation and associated expenses

Miscellaneous Right of First Offer (Right to make first offer) Right of First Refusal (Right to make last offer) Co-Sale (Right to participate in the sale) Exceptions – certain amount of shares each year; family members; estate planning purposes Closing Conditions Right of First Offer: If 50% or more of Series A preferred is outstanding Company issues stock then Investor has pro rata RTS (as converted basis) If you go sell, investor gets rights to buy up to current % ownership Right of First Refusal: Series A investors must allow other Series A to buy Investor gets right to buy founder shares on same terms Co-Sale: Right to participate in sale Tag along – right of investor to sell when others sell (pro rata) Drag along – company forces sale of shareholders who don’t agree Closing Conditions: Before investors close they may require milestones (contracts, patents, NDA, management lockup, board seat)

Angel Killers No Term Sheet Variance from Term Sheet Hiding the Ball/Due Diligence Surprises Cap Table Problems Management Structure/Team Material Contracts & Agreements Board composition No Clear Exit Strategy Too Many Cooks Lack of IP Material Contracts & Agreements: Not signed or in default

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