Negotiating the Preferred Stock Term Sheet Presented by

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

Prior Rounds Impact Terms • 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) © 2010 Haynes and Boone, LLP

Valuation • 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 © 2010 Haynes and Boone, LLP

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

Dividends Considerations • 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

Dividends Pre. Bubble • Non-mandatory, non-cumulative Post. Bubble • Mandatory, cumulative 8% per year • More Extreme: Mandatory, cumulative, payable in kind up to 15% per year © 2010 Haynes and Boone, LLP 8% per year

Dividends Example “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. ” © 2010 Haynes and Boone, LLP

Liquidation Preference 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 © 2010 Haynes and Boone, LLP

Liquidation Preference A Return cost only, or else convert B Cost + annual ROI (“AROI”) or else convert C D E F G H 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 More favorable to common holders © 2010 Haynes and Boone, LLP More favorable to preferred holders

Liquidation Preference Pre. Bubble Post. Bubble © 2010 Haynes and Boone, LLP • • 1 X purchase price, plus participation rights up to 3 X • 1 X to 3 X 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: 3 X purchase price, plus participation rights with no cap

The “Waterfall” First: Creditors Satisfied Second: Distribution to holders of preferred stock Third: Distribution to holders of common stock (with possible participation by holders of preferred stock) © 2010 Haynes and Boone, LLP

The “Waterfall” (an illustration) Amount Available for Distribution: $15, 000 Term Sheet: 1 x preference for Series A, 1 x participation) First Second Third Total Creditors 0 0 0 $0. 00 Series A* 0 $4, 100, 000 $8, 200, 000 Common Stock (including option pool) 0 0 $6, 800, 000 $15, 000 Term Sheet: 3 x preference for Series A, full participation 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 $15, 000 * Original investment of $4, 100, 000 © 2010 Haynes and Boone, LLP

Liquidation Preference Example 1: Full Participation “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. ” © 2010 Haynes and Boone, LLP

Liquidation Preference Example 2: Cap on Participation Rights “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 asconverted basis until the holders of Series ___ Preferred Stock receive an aggregate of [ _ ]X original purchase price. ” © 2010 Haynes and Boone, LLP

Liquidation Preference Example 3: Non-Participating “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. ” © 2010 Haynes and Boone, LLP

Redemption Considerations • Who can trigger? • Percentage of preferred holders/individually • Company (rare) • • • © 2010 Haynes and Boone, LLP Priority among other holders Staging of Redemption Device to force conversion Form of Payment Legal Restrictions

Redemption Pre. Bubble • Not Common Post. Bubble • At option of holders after

Redemption Example 1: Lump Sum “Series ___ Preferred Stock redeemable at the election of holders [of 66 -2/3 rds] 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. ” © 2010 Haynes and Boone, LLP

Redemption Example 2: Three Tranches “[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. ]” © 2010 Haynes and Boone, LLP

Conversion Rights Considerations • 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

Antidilution Adjustments Considerations • 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

Antidilution Adjustments 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 © 2010 Haynes and Boone, LLP

Antidilution Adjustments (an illustration) Scenario: Common Stock Outstanding 1, 000 shares Series A Preferred 1, 000 shares at $1. 00 (or $1, 000) Series B Preferred 1, 000 shares at 75¢ (or $750, 000) Adjustments (Upon Series B) • Series A Conversion Ratio Prior to Series B = 1: 1 • Upon Series B, Series A Conversion Ratio adjusted as follows: Type of Adjustment Conversion Ratio Full Ratchet 1: 1. 333 Narrow-Based 1: 1. 143 Broad-Based 1: 1. 091 © 2010 Haynes and Boone, LLP

Antidilution Adjustments - Pay to Play • 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. © 2010 Haynes and Boone, LLP

Antidilution Adjustments Example 1: With 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”). ]” © 2010 Haynes and Boone, LLP

Antidilution Adjustments Example 2: Pay to Play with Cram Down “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. ” © 2010 Haynes and Boone, LLP

Antidilution Adjustments Example 3: Specified Exceptions “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. ” © 2010 Haynes and Boone, LLP

Protective Provisions Considerations • Control Provisions • Board Seats • Voting Agreements • Other

Protective Provisions Pre. Bubble • Investor approval of: senior securities, sale of company, payment of dividends, liquidation, change of rights • Investor approval of senior or pari Post. Bubble © 2010 Haynes and Boone, LLP 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

Protective Provisions Example “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 © 2010 Haynes and Boone, LLP

Protective Provisions Example (cont. ) 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 $____. ]” © 2010 Haynes and Boone, LLP

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

Representation and Warranties Considerations • Scope/Coverage • By the Company • By the Founders

Closings Considerations • When will the Investors go “at-risk”? • Lump Sum at Closing

Closings Pre. Bubble Post. Bubble © 2010 Haynes and Boone, LLP • Single Tranche

Conditions to Closing Considerations © 2010 Haynes and Boone, LLP • 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 Considerations • 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

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

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

Registration Rights Considerations • Types of Registration Rights • Demand Rights • Piggyback Rights • S 3 Rights • Termination of Rights • Limitation on Subsequent Rights • Absolute prohibition • Permitted if Subordinate • Allocation of Expenses © 2010 Haynes and Boone, LLP

Registration Rights Example 1: Demand Rights “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 $_______. ” © 2010 Haynes and Boone, LLP

Registration Rights Example 2: Piggyback 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. ” © 2010 Haynes and Boone, LLP

Registration Rights Example 3: S 3 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. ]” © 2010 Haynes and Boone, LLP

Registration Rights Example 4: Termination “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. ]” © 2010 Haynes and Boone, LLP

Market Stand-Off Considerations • 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

Market Stand-Off Example “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. ” © 2010 Haynes and Boone, LLP

Right of First Offer Considerations • 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

Right of First Offer 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 2 X prorata ownership in later financings © 2010 Haynes and Boone, LLP

Right of First Offer Example “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. ” © 2010 Haynes and Boone, LLP

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

Board of Directors Considerations • 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

Board of Directors Example “[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]. ” © 2010 Haynes and Boone, LLP

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

Restrictions on Transferability • Rights of First Refusal • Co-Sale Rights • Drag-Along Rights

Rights of First Refusal Pre. Bubble Post. Bubble © 2010 Haynes and Boone, LLP • Right to purchase any shares proposed to be sold by employees • 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 Example “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. ” © 2010 Haynes and Boone, LLP

Co-Sale Rights 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 © 2010 Haynes and Boone, LLP

Co-Sale Rights Example “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. ]” © 2010 Haynes and Boone, LLP

Drag-Along Rights Pre. Bubble Post. Bubble © 2010 Haynes and Boone, LLP • None

Drag-Along Rights Example “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). ” © 2010 Haynes and Boone, LLP

Founder Vesting 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 © 2010 Haynes and Boone, LLP

Founder Vesting Example 1: Single Trigger “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. ” © 2010 Haynes and Boone, LLP

Founder Vesting Example 2: Double Trigger “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. ” © 2010 Haynes and Boone, LLP

Certain Term Sheet Terms © 2010 Haynes and Boone, LLP

Capitalization Example “The Company’s capital structure before and after the Closing is set forth

Publicity Example • “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. ” © 2010 Haynes and Boone, LLP

No Shop Example • “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. ” © 2010 Haynes and Boone, LLP