© 2010 Haynes and Boone, LLP Negotiating the Preferred Stock Term Sheet Presented by Bart Greenberg Haynes and Boone, LLP OC Tech Coast Angels Member Education Session April 25, 2012

© 2010 Haynes and Boone, LLP Certain Preliminary Matters

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP Defining the Terms of the Preferred Stock

© 2010 Haynes and Boone, LLP Considerations Dividends Priority of Payment Common Other Preferred Dividend/Coupon Rate Cumulative vs. Non-Cumulative Form of Payment Cash “coupon” Payment-in-Kind Securities (PIKs)

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP “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

© 2010 Haynes and Boone, LLP Considerations 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

© 2010 Haynes and Boone, LLP More favorable to preferred holders More favorable to common holders ABCDEFGH 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

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP 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”

© 2010 Haynes and Boone, LLP FirstSecondThirdTotal Creditors000$0.00 Series A*0$4,100,000 $8,200,000 Common Stock (including option pool) 00$6,800,000 $15,000,000 FirstSecondThirdTotal Creditors000$0.00 Series A*0$12,300,000$1,350,000$13,650,000 Common Stock (including option pool) 00$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)

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP Considerations 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

© 2010 Haynes and Boone, LLP Pre- Bubble Not Common Post- Bubble At option of holders after 5 years at purchase price plus accrued dividends Redemption

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ [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

© 2010 Haynes and Boone, LLP Considerations 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

© 2010 Haynes and Boone, LLP Considerations 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

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP Scenario: Common Stock Outstanding1,000,000 shares Series A Preferred1,000,000 shares at $1.00 (or $1,000,000) Series B Preferred1,000,000 shares at 75¢ (or $750,000) Adjustments (Upon Series B) Type of AdjustmentConversion Ratio Full Ratchet1:1.333 Narrow-Based1:1.143 Broad-Based1:1.091 Series A Conversion Ratio Prior to Series B = 1:1 Upon Series B, Series A Conversion Ratio adjusted as follows: Antidilution Adjustments (an illustration)

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP Considerations Protective Provisions Control Provisions Board Seats Voting Agreements Other Protections

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP Defining the Terms of the Stock Purchase Agreement

© 2010 Haynes and Boone, LLP Scope/Coverage By the Company By the Founders (e.g., technology) Considerations Representation and Warranties

© 2010 Haynes and Boone, LLP Considerations Closings When will the Investors go “at-risk”? Lump Sum at Closing Staging of Investment Passage of Time Milestones

© 2010 Haynes and Boone, LLP Pre- Bubble Single Tranche Investment Post- Bubble Single Tranche Investment More Extreme: Milestone-Based Tranches Closings

© 2010 Haynes and Boone, LLP Considerations 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

© 2010 Haynes and Boone, LLP Considerations Employee Matters Employment Agreements with Founders Obligation for All Employees/Consultants to Enter into Company’s Standard Inventions and Proprietary Information Agreement

© 2010 Haynes and Boone, LLP Considerations Expenses Company Typically Pays Reasonable Fees and Expenses of Investors’ Counsel Consider Cap on Obligation

© 2010 Haynes and Boone, LLP Defining the Terms of the Investors’ Rights Agreement

© 2010 Haynes and Boone, LLP Considerations 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ [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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP Considerations Market Stand-Off Time of Lock-Up Who Controls Decision Investors Underwriter Equal Application Obligation to Execute Underwriter’s Form of Lock-Up Agreement

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP Considerations Right of First Offer Who Owns the Right? All holders of preferred stock Holders of at least [____] percentage of preferred stock Determination of Percentage

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP Considerations Financial Information Financial Statements [Audited] annual statements Unaudited monthly/quarterly statements [1-5] Year Projections Other Material Information

© 2010 Haynes and Boone, LLP Considerations 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

© 2010 Haynes and Boone, LLP “ [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

© 2010 Haynes and Boone, LLP Defining the Terms of Other Agreements

© 2010 Haynes and Boone, LLP Rights of First Refusal Co-Sale Rights Drag-Along Rights Restrictions on Transferability

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP Pre- Bubble None Post- Bubble None More extreme: Right to force shareholders to sell company upon board and majority shareholder vote Drag-Along Rights

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP Certain Term Sheet Terms

© 2010 Haynes and Boone, LLP “ 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 Capitalization

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP “ 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

© 2010 Haynes and Boone, LLP 70 Questions? Bart Greenberg Partner Von Karman Avenue, Suite 750 Irvine, California