© 2010 haynes and boone, llp negotiating the preferred stock term sheet presented by bart greenberg...
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© 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
© 2010 Haynes and Boone, LLP
Certain Preliminary Matters
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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
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• 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
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• 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
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Defining the Terms of the Preferred Stock
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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)
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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
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“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
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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
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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
Liquidation Preference
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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
Liquidation Preference
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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”
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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)
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“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
Liquidation Preference
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“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
Liquidation Preference
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“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
Liquidation Preference
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ConsiderationsConsiderations
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
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Pre-Bubble
• Not Common
Post-Bubble
• At option of holders after 5 years at purchase price plus accrued dividends
Redemption
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“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
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“[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
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ConsiderationsConsiderations
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
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ConsiderationsConsiderations
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
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Pre-Bubble
• Standard broad-based weighted
average adjustment
Antidilution Adjustments
Post-Bubble
• Narrow-based weighted average adjustment
• More extreme: Full ratchet adjustment for a period; then narrow or broad- based weighted average adjustment
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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)
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• 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
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“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
Antidilution Adjustments
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“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
Antidilution Adjustments
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“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
Antidilution Adjustments
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ConsiderationsConsiderations
Protective Provisions
• Control Provisions• Board Seats• Voting Agreements• Other Protections
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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
Protective Provisions
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“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
Protective Provisions
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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.)
Protective Provisions
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Defining the Terms of the Stock Purchase Agreement
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• Scope/Coverage
• By the Company
• By the Founders (e.g., technology)
ConsiderationsConsiderations
Representation and Warranties
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ConsiderationsConsiderations
Closings
• When will the Investors go “at-risk”?• Lump Sum at Closing• Staging of Investment
• Passage of Time• Milestones
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Pre-Bubble
• Single Tranche Investment
Post-Bubble
• Single Tranche Investment
• More Extreme: Milestone-Based Tranches
Closings
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ConsiderationsConsiderations
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
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ConsiderationsConsiderations
Employee Matters
• Employment Agreements with Founders
• Obligation for All Employees/Consultants to Enter into Company’s Standard Inventions and Proprietary Information Agreement
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ConsiderationsConsiderations
Expenses
• Company Typically Pays Reasonable Fees and Expenses of Investors’ Counsel
• Consider Cap on Obligation
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Defining the Terms of the Investors’ Rights Agreement
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ConsiderationsConsiderations
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
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“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
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“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
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“[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
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“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
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ConsiderationsConsiderations
Market Stand-Off
• Time of Lock-Up
• Who Controls Decision• Investors• Underwriter
• Equal Application
• Obligation to Execute Underwriter’s Form of Lock-Up Agreement
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“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
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ConsiderationsConsiderations
Right of First Offer
• Who Owns the Right?• All holders of preferred stock• Holders of at least [____]
percentage of preferred stock
• Determination of Percentage
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Pre-Bubble
• Right to maintain pro-rata ownership in
later financings
Right of First Offer
Post-Bubble
• Right to maintain pro-rata ownership in
later financings
• More Extreme: right to invest 2X pro-rata ownership in later financings
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“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
Right of First Offer
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ConsiderationsConsiderations
Financial Information
• Financial Statements• [Audited] annual statements• Unaudited monthly/quarterly
statements
• [1-5] Year Projections• Other Material Information
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ConsiderationsConsiderations
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
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“[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
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Defining the Terms of Other Agreements
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• Rights of First Refusal
• Co-Sale Rights
• Drag-Along Rights
Restrictions on Transferability
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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
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“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
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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
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“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
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Pre-Bubble
• None
Post-Bubble
• None• More extreme: Right to force • shareholders to sell company upon board and majority shareholder vote
Drag-Along Rights
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“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
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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
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“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
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“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
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Certain Term Sheet Terms
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“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
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• “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
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• “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
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Questions?
Bart GreenbergPartner
18100 Von Karman Avenue, Suite 750Irvine, California 92612
949.202.3037