Venture Capital

A Practical Guidebook for Business Owners, Managers and Advisors

(Fifth Edition)
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DANIEL H. ARONSON BERGER SINGERMAN

Venture Capital
A Practical Guidebook for Business Owners, Managers and Advisors
(Fifth Edition)

by Daniel H. Aronson

RR DONNELLEY

Copyright Daniel H. Aronson 2011. All rights reserved. All or part of this book has been or may be used in other articles, presentations, outlines and/or programs published, prepared, delivered or made available by the author. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage, retrieval, or transmission-system process, without the authors prior written permission. Daniel H. Aronson is a Shareholder, and Group Leader of the Corporate and Securities Practice, of Berger Singerman, P.A. The views expressed herein are solely those of the author. This is the 5th edition of this treatment and work. The author wishes to extend special thanks to partners and associates at his current and former law firms (including Berger Singerman colleague Iryna Ivashchuk) for their contributions, support, guidance and assistance with respect to various portions of this GUIDEBOOK. This GUIDEBOOK is intended solely as an educational introduction to, and not an exhaustive treatment or analysis of, the topics and matters addressed. It is not designed to provide, and does not constitute or include, legal, accounting, tax, or professional opinions or advice on any topic or matter, and should not be relied upon for that purpose.

VENTURE CAPITAL:
A PRACTICAL GUIDEBOOK FOR BUSINESS OWNERS, MANAGERS AND ADVISORS BY DANIEL H. ARONSON

TABLE OF CONTENTS
Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi About the Author. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii INTRODUCTION
SECTION

............................................................1
OF

I: SOURCES

CAPITAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Owners; Friends and Family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Earnings (Company-Generated Funding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Commercial and Bank Loans; Government Loans and Aid . . . . . . . . . . . . . . . . . . . . . . 4 Strategic Alliances; Joint Ventures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Private Placements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 FIG. 1Securities Law Considerations for Private Offerings: What You Need to Know . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Venture Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Going PublicThe IPO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Practical Tip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
SECTION

II: VENTURE CAPITAL INVESTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Pursuing Venture Capital: Opportunities & Challenges . . . . . . . . . . . . . . . . . . . . . . . . 16 Choosing and Making the Most of a VC Partner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Practical Tip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
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Venture Capital Fundamentals: Understanding Venture Capitalists and the Investment Process; Planning and Preparing for a VC Transaction . . . . 20 1) Understand the business model and goals of VC investors . . . . . . . . . . . . . . . . 20 2) Understand and be prepared for the investment processfrom initial contact through funding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Figure: Common Mistakes in Pursuing Venture Capital . . . . . . . . . . . . . . . . . . . . . 24 Practical Tip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 3) Assemble and build a strong management and advisory team . . . . . . . . . . . . . 28 4) Present a clear, compelling opportunity via the business plan . . . . . . . . . . . . . 29 Practical Tip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 5) Be preparedget and keep your house in order . . . . . . . . . . . . . . . . . . . . . . . . 32 Practical Tip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 FIG. 2Early Planning Considerations: Entity Selection & Structural Considerations in Organizing a Business Venture . . . . . . . . . . . . . . . . . . . . 33 Key Objectives of VC InvestorsWhat Makes Venture Capitalists Tick? . . . . . . . 35 1) Maximizing the Upside . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Figure: Life Cycle of a Venture Capital Fund . . . . . . . . . . . . . . . . . . . . . . . . 37 2) Protecting the Downside . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3) Monitoring and Influencing Progress and Development . . . . . . . . . . . . . . . . . . 43 4) Pursuing and Effecting Exit Strategies and Liquidity . . . . . . . . . . . . . . . . . . . 46 Practical Tip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Practical Tip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Considerations in Obtaining Venture Funding and Negotiating Terms in Distressed Markets and Down Rounds . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Understanding the challenges. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Approaching the (limited) opportunities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 What terms and approaches are important?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Reality check before signing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Figure: Funding & Liquidity Cycle of a VC-Backed Portfolio Company . . . . . . . . 60
SECTION

III: WHAT TO EXPECT IN A VC TRANSACTION: KEY STRUCTURES, FEATURES, AND ATTRIBUTES (UP CLOSE) . . . . . . . . . . . . . . . . . . . . 61 1) Equity Securities and Economic Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

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Convertible Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Liquidation Preference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Participating Preferred Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Conversion (Optional And Mandatory) Features . . . . . . . . . . . . . . . . . . . . . 63 Dividend Features/Accruing Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Anti-Dilution Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Staggered, Tranched And Milestone-Based Financings . . . . . . . . . . . . . . . . . . 64 Pay-to-Play Provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Use of Other Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 2) Governance and Control Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 Board of Directors Provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Management Controls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Veto, Negative Covenants and Other Protective Provisions . . . . . . . . . 67 Founder and Management Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 3) Liquidity Terms & Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Valuation issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 First Refusal and Preemptive Purchase Rights. . . . . . . . . . . . . . . . . . . . . . . 69 Registration Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 1) Demand Rights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 2) Piggyback Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 3) S-3 Registration Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Drag Along Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Redemption Right (or Put) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Alignment of Founder and Management Incentives . . . . . . . . . . . . . . . . . . 71 4) Protection of Intellectual Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 Angel Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 1) More money, and more deals (at early stages) . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 2) Dynamics, available funding and deal size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 3) Approach varies widely; dictates access and availability . . . . . . . . . . . . . . . . . 74 4) Angel Groups and Clubs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 SUPPLEMENTAL MATERIALS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . following page 76 Annex A: Illustrative Series A Investment Transaction Term Sheet . . . . . . . . . . . . . A-1 Annex B: Glossary of Venture Capital Terms and Jargon . . . . . . . . . . . . . . . . . . . . . . B-1 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I-1

FOREWORD

Danny Aronsons Venture Capital Guidebook is a must read for entrepreneurs, emerging business owners and venture capital investors. I have known Danny for nearly ten years. He has forgotten more than I ever knew about doing investment deals, from early stage angel and venture capital all the way through leveraged buyouts and recapitalizations. In his Venture Capital Guidebook, Danny allows us all to benefit from his considerable experience, with highly important and relevant content for businesses of all stages pursuing external funding. Venture capital investment is well suited for a small set of opportunities and, in this day and age and under current market conditions, is not easy to secure. The Venture Capital Guidebook provides practical insight into the venture fundraising process, as well as useful tips on dos and donts in interacting with venture capitalists. I suggest particularly close attention to Common Mistakes in Pursuing Venture Capital on page 24. To all of you who are reading this book with the hopes of raising external capital, I wish you the best luck in doing so. If you are reading Dannys book before you start (or even during the fundraising process), you will be light-years ahead of your peers in navigating the fundraising terrain.

Alan J. Taetle General Partner Noro-Moseley Partners

vi

ABOUT THE AUTHOR

DANIEL H. ARONSON is a Shareholder of Berger Singerman, P.A. (www.bergersingerman.com), where he serves as Group Leader of the firms Corporate and Securities Practice. Mr. Aronson focuses his practice on mergers and acquisitions, private equity and venture capital transactions, public and private securities offerings, other sophisticated finance and capital market transactions and counseling public and private businesses concerning strategic business, finance, restructuring, governance and transactional matters. His practice includes assisting clients (whether start-up or Fortune 100 companies)from initial formation through financing, expansion, alliances, go-public, acquisitions and salein structuring, negotiating, documenting and successfully closing a wide variety of business transactions. An active leader and participant in the development and growth of the venture capital arena in Florida and a member of the Florida Venture Forum Board of Directors since 1990, Mr. Aronson served as Chairman of the Florida Venture Forum in 1997-98, as Chair or Co-Chair of the Florida Venture Capital Conference in 1999, 2001 and 2002, and is a long-standing member of the Forums Executive Committee. He was appointed by Floridas Governor to the Board of Directors of the States Capital Development Advisory Committee, and has also served as a member of the Board of Directors of a state-sponsored venture capital fund of funds. In addition, he serves on the Executive Advisory Board of the Center for Entrepreneurship and Innovation at the University of Floridas Warrington College of Business Administration. Mr. Aronson is an Adjunct Professor at the University of Florida Levin College of Law and has served as a visiting lecturer at the Florida International University College of Business Administration, Nova Southeastern University College of Law, New York University School of Law, University of Miami School of Law and the University of Florida Warrington College of Business Administration. Mr. Aronson received his J.D. degree from New York University School of Law, where he served as Editor-in-Chief of the Annual Survey of American Law, and his B.A. degree from Vanderbilt University, where he graduated Phi Beta Kappa, summa cum laude. Prior to joining Berger Singerman, he was an Equity Partner of Bilzin Sumberg Baena Price & Axelrod, LLP (Miami, FL 2007-10); Principal Shareholder of Greenberg Traurig, P.A. (Miami and Ft. Lauderdale, FL 1992-2007), where he served as co-head of the National Corporate Practice and the Private Equity & Venture Capital Practice; Partner of Steel Hector & Davis (Miami, FL - 1989-92); Corporate Associate at Wachtell, Lipton, Rosen & Katz (New York, NY 1984-89); Law Clerk to U.S. District Judge Morey L. Sear (New Orleans, LA 1983-84); and Judicial Intern to the United States Supreme Court (1981).
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INTRODUCTION
Venture capital: more art than science, more journey than destination, and clearly much more than merely a financing or capital-raising transaction. There are many definitions and descriptions of what constitutes venture capital. In its barest terms, perhaps the essence is best captured by this description: funds invested in growing, innovative enterprises in which both the potential for great profit and the risk of complete loss are considerable. Venture capital funding, for many years now, has been the driving force behind highly innovative people and businesses that couldnt attract traditional lenders or investors. Starting, nurturing, and developing a business, finding and enlisting the right management team, partners, and advisors, obtaining stage-appropriate funding, exploiting alliance and growth opportunities and, ultimately, executing an exit strategy are all parts of a dynamic and challenging process, which, in many ways, defies common or business sense and the skill set of many entrepreneurs and business owners. Raising equity capital at the various stages of a companys development and during different market cycles is particularly tricky and troublesome for the uninitiated. At the time of publication, the venture industry (and entrepreneurial business community) are in what I would call a state of cautious optimism. Since the U.S. real estate/housing (and related credit markets) bubble burst in late 2007, all of the relevant data pointsfundraising by venture capital funds, investments in portfolio companies, mean values and investment amounts, and exit/liquidity transactionshave been down significantly across virtually all sectors and company development stages. While 2010 is showing signs of promise and recovery, the proof remains to be seenand of course the venture industry is both dynamic and cyclical. As discussed further below, cycles can and do influence investment postures, timeframes and terms. This GUIDEBOOK is intended as an introduction to the process of finding and securing institutional venture capital funding for an early-stage or emerging business, as well as a primer and refresher course for more seasoned private companies and managers that continue to seek equity funding. While not an exhaustive treatment of the subject, it is designed to provide practical information and helpful pointers to entrepreneurs, business owners, managers, and advisors seeking to source, negotiate, document, and close one or more equity funding rounds with venture capital investors. In addition to the Text, two ANNEXES serve as resources to aid the capital-seeking business owner and manager: ANNEX A is an illustrative and annotated (with commentary) Term Sheet for a Series A preferred stock investment financing, suggesting possible terms (and their implications) from both the investors and the companys position. ANNEX B sets forth a glossary of venture capital terms, phrases, and jargon, which should assist in navigating and understanding the many unique (and sometimes bizarre) words and phrases often used by experienced participants in venture capital negotiations and transactions. Words and phrases in this GUIDEBOOK which are italicized are

defined and given context in ANNEX B. Readers should refer to these ANNEXES, as appropriate, throughout their review of this GUIDEBOOK. Given the market conditions prevailing at the time of publication, Ive included a new Section in the GUIDEBOOK focused on considerations in distressed market and down round venture investment transactions. There are opportunities to seize upon, obstacles to avoid, and challenges to overcome, over the course of the capital-raising process. Venture capital funds seek overall returns of at least three to five times invested capital over a 10-year fund period. On the company side, funding is typically raised in stages or rounds (and over the life of a businesss development), with each raise viewed not in isolation but rather as part of a larger dynamic development and capitalization process. In order for a company to attract venture funding, it must be advantageously positioned in a large addressable market and demonstrate credible, sizeable revenue projections. Of course, there is no substitute for proven, skilled, dedicated managers, committed and aligned partners, and experienced, deal-tested advisorsnot to mention a fair sprinkling of luckin achieving success in the development and funding of an emerging business.

SECTION I: Sources of Capital

When access to funding is vital to a businesss growth and development (as it usually is), the business owner must make a thoughtful evaluation of the available options. An emerging business can seek to obtain needed capital in a number of ways, and no one particular source of capital is always best for all circumstances. The business owners ultimate decision of which source (or combination of sources) to tap at any particular time will require a balancing of considerations, risks and costs, including an assessment of the advantages, disadvantages, requirements and timing of each source (not to mention what is reasonably available). This section surveys the principal funding alternatives. Owners; Friends and Family The simplest and most direct source of capital for a business is funds from existing owners. Owner-funding occurs in virtually every emerging business and is a critical first step in the capital-raising process. The main benefits of using existing owners funds are the ease and speed with which money can be raised (with relatively little complication and expense) and the maintenance of control over the business by the existing ownership group. Using owner-funding also delays outside ownership (and, therefore, dilution of existing ownership, control, and other issues) until a later, hopefully higher, valuation level is reached. Financing through owner-funding also serves as a tangible demonstration of the owners or founders commitment to the business (a factor of significance to most venture capitalists and institutional investors). The most significant disadvantage of owner-funding is that this source of capital is usually quite limited and will not satisfy a growing businesss ongoing capital needs. Most emerging businesses also seek and receive funding, particularly at the early stages, from family members and friends of the founders and existing owners. This friends and family funding offers the advantages of speed, simplicity, generally favorable valuation and terms, and expansion of stockholder ownership, on a limited basis, to known and presumably friendly sources. On the other hand, raising capital from friends and family might give rise to personal conflicts and issues. Additionally, existing owners could be viewed as taking advantage of the relationship with friends and family or their lack of sophistication, experience, or insight into the funding process (including on matters such as valuation, terms and follow-in financings). Finally, uninitiated investors (thought to be friendly) may bring unrealistic expectations and difficult demands regarding having a say in the operating matters, the amount and timing of potential returns on investment, the need for and difficulty in raising subsequent rounds, and delays and extended time-frames in achieving business profitability or any real exit transaction.

Earnings (Company-Generated Funding) Internal earnings and cash flow often are not thought of as a source of capital for the expanding company in need of funding. If sufficient and if managed properly and effectively, earnings and cash flow can and sometimes do provide interim funding for development and growth. In fact, proof that a business can live, grow and thrive within its means for some period may be important to venture capital investors. Some companies have also been successful in obtaining favorable terms from customers and suppliers as a means of managing and improving cashflows. Typically, however, for a business pursuing a high-growth strategy or otherwise requiring significant capital, funds from earnings, cash flow and favorable terms will not be sufficient to meet the businesss critical, ongoing needs (in areas such as research, development, expansion, retooling, new executive hires, marketing and sales, growth through acquisitions, or other capital-intensive campaigns). In addition, internally generated funds may not provide a consistent or reliable funding source and, if looked to as the sole source of funding, could leave the business unable to take advantage of important opportunities as and when they arise. Commercial and Bank Loans; Government Loans and Aid First, a discussion of debt/loans versus equity/stock financing is useful. The principal advantage of debt financing is that the business owner (borrower) is able to maintain and avoid dilution of his or her equity interest (ownership, control, and upside potential). In addition, the interest costs of debt financing are known (or calculable) and are tax-deductible, and debt holders have no claim on future earnings, or growth and success in the business once the debt is paid off. The main disadvantage of debt financing is that the business owes the debt (i.e., it is reflected as a liability on the balance sheet) and must pay it back, principal plus interest (and perhaps other charges), on a scheduled basis. Some commercial lenders require personal guarantees from owners as a condition to making loans. Required debt payments reduce cash flow and profits, and dire consequences can follow from non-compliance with debt covenants (of which there can be many). For example, failure to make a timely payment, or to meet a financial covenant, can result in losing control of the business to debt holders. Secured debt also affords the lender/debt holders a security interest in, and thus rights to, the businesss assets on default and foreclosure. Equity, on the other hand, is long-term capital (of the nature of ownership), which does not require repayment absent some special redemption requirement or similar feature. By adding to net worth, equity improves a businesss creditworthiness (which can improve payment terms from vendors and enable or facilitate lease financing or even bank borrowing). Additionally, an equity investment from a sophisticated financing source connotes external market validation of the companys business model by a (presumably) objective outsider. Of course, the impact of this stamp of approval is greater if the investment comes from a recognized, reputable funding source. Also, equity

investors, unlike many commercial lenders, usually do not impose personal liability on owners and do not take a security interest in the companys assets. The unlimited upside benefit and potential of equity (combined with certain preference features), as opposed to debt with its fixed and limited payments and returns, is what motivates venture capital investors to fund emerging businesses. Of course, debt and equity funding are not mutually exclusive. Most businesses, over time, utilize a mixed balance of both. Some venture capital investors use convertible debt, debt features and bridge loans as well. Banks and other commercial lenders can provide a source of capital to growing businesses beyond the seed, development and early stages. For the most part (i.e., for all but the largest and most mature businesses), banks look to asset and security-based lending, and not future cash flow or prospect-based lending. Thus, most early-stage and emerging businesses will find it difficult, if not impossible, to satisfy prevailing lending criteria and bank underwriting requirements, which include providing valuable security, an equity cushion, and ample cash flow for the timely repayment of principal and interest. As a result, in the development and early stages, unless hard-asset security and appropriate personal guarantees are provided, this route is usually not available. An emerging or early-stage business may also determine to consider seeking loans or other financial assistance from the Small Business Administration (SBA) and other government sources. There have been a number of initiatives and efforts over recent years to increase the funding available to small businesses and to ease and reduce the complex criteria, paperwork, and review required to obtain government financial assistance. SBAguaranteed loansfor those who qualifymay be available at lower interest rates and with less recourse risk and longer maturities (and other more favorable terms) than typical bank or commercial loans. This option can prove to be worthwhile for the right companyone that can both satisfy the applicable criteria and tackle the application and funding process. Government financing, though, is simply not available for many businesses andgiven the extensive and time-consuming application, evaluation, and qualification processrequires patience, diligence, and some measure of endurance. For the most part, this is a longer-term option, best combined with other avenues for raising funding. In 1958, Congress created the Small Business Investment Company (SBIC) program. SBICs, licensed by the SBA, are privately owned and managed investment firms. With their own capital and with funds borrowed at favorable rates with an SBA guaranty, SBICs can provide growth and expansion capital and loans to small businesses, both new and already established, in order to build bridges of support between private equity investors and small companies and communities across the country.1

1.

For further information regarding the Small Business Administration, SBA financing programs and SBICs, visit the SBAs website at www.sba.gov/financialassistance.
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Strategic Alliances; Joint Ventures A strategic alliance, partnership, or joint venture with a more established operating company may also serve as a means to raise needed capital (or to avoid having to raise funding for specific functions or needs that can instead be provided by the partner). Typically, in such a case, the established company is interested in some aspect ofor the future opportunity presented bythe capital-seeking business, such as its proprietary position, technology potential, research prowess, product/market channels, location in the manufacture/distribution chain, or potential as a customer and/or supplier. A strategic alliance usually serves to facilitate the achievement of goals other than raising capital, including access to research and development, new technology, manufacturing capabilities, distribution channels and markets, customers, and management personnel, as well as an enhanced ability to compete. Funding can also be provided through strategic arrangements and relationships with customers, vendors, suppliers, and others with whom the company does business or who are familiar with the companys business, products, services, capabilities, and market. Capital-related advantages can also be obtained by acquiring or adding symbiotic or value-added businesses, services, or product lines, or by disposing of (or discontinuing) non-core or drag businesses, services, or product lines. Tread carefully here: For the emerging business, an established strategic partner which is pursuing the arrangement to pursue and fulfill its own interests and goalstypically has far greater experience and resources, and those resources can be deployed (with great vigor) if underperformance occurs or if a dispute or conflict arises. The alliance can and often does limit the fund-seeking businesss flexibility to pursue its natural business course, or to engage in future alliances, acquisitions, and capital transactions. Furthermore, the emerging business may find itself controlled in many respects, or its future substantially affected or limited, by a much larger company focused on its own agenda and priorities, which may not include, as the highest priority or at the most critical time, the successful growth and development of the emerging business. Dependency, as opposed to independence, can ensue. In any strategic alliance, the protection of the businesss confidential and proprietary information (which must be shared at some point in the evaluation process and beyond) presents complex and difficult issues which must be evaluated, planned for, and addressed with great care. If an emerging business is pursuing a strategic alliance solely or even primarily to raise capital, it probably should not be considering the alliance at all. Successful alliances are often bet-the-business relationships, which require a common vision in a joint enterprise, as well as a substantial commitment from management and personnel and the devotion of (often scarce) time, attention, and resources. Before entering into a strategic alliance, management should carefully consider, together with experienced advisors, issues such as flexibility to operate and grow the business, now and in the future, protection/control of intellectual property and other assets (which may be key to the businesss upside potential), and freedom to operate independently and pursue later affiliations, growth, financings, and exit strategies.
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Private Placements One of the more traditional, tried-and-true methods of raising equity capital is the private offer and sale of securities to a limited number of (typically unaffiliated) investors. Depending upon the circumstances, a private placement can be a cost-effective means of raising capital, usually at expansion and later stages of development. Private sales of securities may be accomplished with or without engaging a professional placement agent. Business owners should proceed cautiously before engaging a placement agent and research any such agents background and experience for appropriate qualifications (including regulatory registrations applicable to those who assist in selling securities for compensation) and recent, relevant experience with similar companies. Before engaging a placement agent, the company should negotiate and document the terms of the engagement, including retainers, fees, expense reimbursement, term and termination, performance requirements, and any exclusive or fee tail provisions (which survive termination). Expect the private offering process to take significant time and resources, including to consider and engage a placement agent, prepare an offering memorandum (short or long-form), identify suitable investors (and, optimally, a lead investor), conduct a road show (management presentation) of sorts, circle investor interest, negotiate terms (including valuation and investors rights), prepare and finalize documentation, and sign the investment agreements and close the transaction. Also, the business will likely be subject toand thus management will need to prepare fora rather extensive due diligence investigation (the result of which may be a change in interested investors and investment terms). From a business perspective, private placements have some elements of both venture capital transactions and initial public offerings. Compared to an initial public offering, the private placement typically requires less due diligence, preparation, and documentation by the company/issuer and is subject to far less regulation (e.g., no registration or disclosure filing must be prepared or submitted for Securities and Exchange Commission (SEC) review) and expense; compared to a venture capital transaction, the private placement usually requires somewhat less due diligence and documentation by the company and generally involves less negotiation and revision of documents and deal terms. In many cases, if the private placement offering is not pre-sold or conducted by a reputable, experienced placement agent with a solid, relevant track record, the company faces a greater risk of non-consummation, after substantial effort and expense, than it might face with other alternatives.

SECURITIES LAW CONSIDERATIONS FOR PRIVATE OFFERINGS: WHAT YOU NEED TO KNOW Venture capital transactions involve the offer, issuance and sale of securities (typically, preferred stock). As such, they are subject to a regulatory processand related compliance issuesunder both federal and state securities laws. For transactions where the only offerees and purchasers are substantial, established, domestic venture capital funds (VCs) and where no compensation is being paid to any finders, brokers, employees, or others in connection with the financing, compliance is rather straightforward. It can be handled by experienced counsel through the offering, documentation, and closing process. Nevertheless, as in any equity funding, a plan must be designed and implemented to address securities law compliance issues. A primer on some of the most significant considerations follows. For starters, every issuance and sale of securities in the United States (or, more specifically, relying on or using U.S. interstate commerce) must either be registered through the appropriate filing and registration process with the Securities and Exchange Commission (SEC) or qualify for an applicable exemption from registration. Given the expense, timing, and burdens associated with the registration process, it is vitally important to qualify for an applicable exemption (unless you truly desire to register and go public, after a full appreciation of the preparations, costs, requirements, and implications). The most widely used and relied upon exemption in venture capital and other institutional capital-raise transactions is the so-called private placement (or nonpublic offering) exemption, provided under Section 4(2) of the Securities Act of 1933, as amended (the 1933 Act). Unfortunately, Section 4(2), which exempts transactions by an issuer not involving any public offering, provides no real guidance as to how to comply with the exemption. After many requests and much prodding, the SEC promulgated Regulation D (hereafter Reg D) in 1982.* It provides (through Rule 506) a transactional safe harbor, which permits companies, with relative certainty, to meet the Section 4(2) exemption from registration. Through Reg D, the SEC has promulgated rules that allow the sale of billions of dollars of securities by hundreds of companies (referred to as issuers) each year without public registration. Here are some highlights of Reg D and its safe harbor transactional exemption from registration:
* Despite the adoption of Reg D, many private placements (including venture capital investments) continue to be effected in reliance solely on Section 4(2) rather than Reg D. Section 4(2) is often relied upon where the offering is made to a small group of very high net worth and sophisticated investors. Where the offering is more widespread or where there is concern regarding identification and qualification of all offerees, Reg D is more frequently invoked (because of its clear and objective standards).

 The safe harbor is not exclusive. For issuers unable to comply with the strict

requirements of the regulation, Section 4(2) continues to be available for sales to offerees who are capable of fending for themselves (per the 1953 Supreme Court Ralston Purina case**) if they are provided with information enabling an informed investment decision. Section 4(2) and Rule 506 (the heart of Reg D nonpublic offering exemption) apply only to issuers. Subsequent sales (known as resales) are restricted and may be effected only in reliance on another, separate exemption from registration. Rule 504, for certain offerings of $1 million or less, and Rule 505, for certain offerings of $5 million or less, were adopted pursuant to the SECs exemptive authority under 1933 Act Section 3(b) (re: small offering exemptions). Rule 506, for offerings of any dollar amount, is clearly the most common safe harbor in venture capital and substantial private placement transactions. It has the following elements: Unlimited dollar amount of offering. Purchasers limited to an unlimited number of accredited investors plus up to 35 non-accredited (but sophisticated) investors. Accredited investors (as judged at the time of sale)*** include: banks, broker-dealers, insurance companies, trusts and other entities with more than $5 million in assets (not formed solely for purposes of the investment), directors and executive officers of the issuer, and wealthy individuals (i.e., persons with a net worth alone or with a spouseof at least $1 million (the value of a persons primary residence is excluded from the net worth calculation)****, or with annual income of $200,000 individually/$300,000 jointly with spouse in each of the two prior years). No informational/disclosure requirements for accredited investors, but specific, rather extensive information (which varies based on the issuers nature and offering size) must be provided to each non-accredited investor. General advertising and general solicitation is prohibited, as well as solicitation (including conditioning the market) by the issuer or its representatives that publicizes the offering or is designed to attract investor interest. The focus here is on the manner of the offeringamong other things, offers may not be made (or involvement in any offering solicited) by general media
** SEC v. Ralston Purina Co., 346 U.S. 119 (1953).

*** Under Reg D, a person is an accredited investor if the issuer has a reasonable belief that s/he is (even if it is later determined that s/he was not accredited) or if the person in fact satisfies the requirements in the definition. Issuers typically use questionnaires and representations from investors to establish reasonable belief.

to unidentified persons who had no preexisting, substantive relationship with the issuer (or the authorized offeror). Resales of securities are restricted (i.e., once purchased, these securities may not be resold without registration under the 1933 Act or exemption therefrom), and certain precautions must be undertaken to prevent nonexempt resales. Form D must be filed within 15 days after the first sale of securities in a Reg D offering (this filing is required to ensure a valid Rule 506 exemption and to ensure exemption from most state securities law requirements). Notwithstanding the Form D filing requirement, the availability of the Reg D exemptive rules (and corresponding exemption from registration under the 1933 Act) is not conditioned upon filing of a Form D. Anti-fraud rules apply to all exempt offerings. Accordingly, disclosures, information, and communications connected with the offer or sale of securities should be carefully prepared and scrutinized for possible errors, misstatements, and omissions. The burden of proving compliance with any registration exemption (and all of its applicable requirements) lies with the issuer; accordingly, the issuer must know the rules and keep good records supporting its compliance. For securities offerings to a broad group of employees, consultants and/or advisors, Rule 701 provides a limited exemption from registration for offers and sales of securities by non-public companies pursuant to certain compensation benefit plans or written contracts (in compliance with the limitations in Rule 701).
**** In addition to excluding the individuals primary residence from the net worth calculation, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), signed into law on July 21, 2010, requires the SEC to review periodically the Reg D net worth standard and to consider modifications for the protection of investors, in the public interest, and in light of the economy. Dodd-Frank Act, H.R. 4173, 111th Cong. 413 (2010). In response to questions raised regarding the DoddFrank Act revisions to Reg D, the SEC Staff offered interpretative guidance (pending the issuance of amendments to Reg D to reflect the new accredited investor standard) to the effect that a mortgage or other indebtedness secured by the primary residence up to the fair market value of the residence can be excluded from the net worth calculation. However, if the amount of such indebtedness is greater than the fair market value of the primary residence, the excess liability must be deducted from the investors net worth. Prior to the enactment of the Dodd-Frank Act, the value of an individuals primary residence was included in the calculation of his or her net worth for purposes of determining accredited investor status. Under the Dodd-Frank Act, the SEC is also required, by July 2011, to issue rules that would disqualify so-called felons and other bad actors from utilizing Rule 506 under Reg D. The actual amendments to Reg D, as well as SEC actions and interpretations regarding the definition of accredited investor and the net worth standard, should be actively monitored.

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 State securities laws (also called blue sky laws) in states in which any pur-

chaser of securities is deemed to reside must also be reviewed, considered, and met, on a state-by-state basis. Rule 506-compliant offerings (but not other Section 4(2) exempt offerings) preempt state securities registration laws (as a result of the National Securities Markets Improvement Act of 1996), with the limited exception of state-mandated notice filings and fee requirements. Particularly thorny issues can arise under state securities laws in connection with false or misleading offering disclosures or any time a person (who is not a registered broker-dealer) is compensated in connection with the offer or sale of securities. Beware of integration principles: When two or more offerings, which appear to be exempt when considered separately, take place in relatively close proximity, they might be bundled or viewed as a single non-exempt transaction (and one bad apple can spoil the entire barrel in this context). Rule 502 provides a safe harbor from integration for offerings completed six months before or started six months after other offerings of securities of a similar class. Failure to satisfy an exemption from registration (whether through Reg D, Section 4(2), or otherwise) can have serious consequences, not the least of which are a right of rescission for the purchasers (i.e., the right to get all of their purchase money back), a possible injunction against the offering while in progress, and possible civil or criminal investigations and proceedings (with related fines, penalties and sanctions) initiated by the SEC or other regulatory authorities. Private placements must be structured to satisfy available exemptions from the registration requirements of federal and state (blue sky) securities laws and regulations. These regulationswhich are subject to continuing SEC rule proposals, guidance and scrutinyapply to and strictly regulate the offering process, offeree suitability, disclosure and information requirements, publicity and communications, and the sale (and resale) of the issuers securities. Venture Capital Venture capital funding is, simply put, risk-equity investing by professionally managed investment funds, providing seed, start-up, early-stage, expansion-stage and laterstage funding to high-growth-trajectory private companies (from small start-ups to larger, more mature businesses). Venture capital has served as both an important engine of U.S. macroeconomic growth and a driving force in the development and commercialization of science, technology and business products and solutions. The venture capital market provides a critical link between innovation and finance, and fills a significant void in available financing alternatives, by providing selected fund-seeking businesses with access to a pool of capital especially attuned and tooled for illiquid, high-risk ven11

ture investments. Venture capital funding always involves a longer-term, illiquid equity investment in a company believed to have exceptional growth potential (and exit opportunities). These investments are usually structured as the purchase of convertible preferred securities (sometimes combined with available subordinated, unsecured debt). In addition to providing critical funding, venture capital investments can and should bring an important strategic partner, resources, and discipline to the businessin such areas as talent recruitment, sales and marketing, strategy and budgeting, scale and growth, industry networking and best practices, and assistance with future capital raises and exitsdepending upon the venture investors objectives, background and experience, as well as chemistry and relationship fit. Venture capital investments are made by professionally managed venture capital funds (which are referred to as VCs), but may also be madewith a somewhat different approach and orientationby established companies (often, through an investment subsidiary or division), investment companies, investment funds (including hedge funds), insurance companies, and high-net-worth individuals (so-called angels or angel investors).2 VC firms are typically organized as limited partnership funds, which raise their own funding from large institutional investors and very wealthy individuals. In the late 1960s, venture capital was consideredby the few who took interestas an asset pool with approximately $3.0 billion in total assets;3 today, venture capital is a mainstream asset class, with more than $75 billion in assets under management. Venture capital investors are said to have target, compound (annual) investment returns in the 30% and greater range. (During the late 1990s, returns reached the 50%+ range; for 2000-2003 and 20082009, any positive return at all, on an annual basis, would have been considered a notinsignificant victory.) Given that VC firms are professionally managed (and disciplined) and that portfolio investments (i.e., investments in selected companies) carry a high degree of risk and lack of liquidity (or available exit strategies), expect sourcing venture capital to involve substantial due diligence, intensive business, strategic, and financial planning, and aggressive negotiation of valuation, deal structure, preferential rights, insider and founder obligations and restrictions, as well as other terms. This GUIDEBOOK contains an expansive discussion of venture capital transactions in Section II.
2. For companies that do not have substantial capital needs (or which are otherwise not appropriate for venture capital investment), so-called Angel funding should be considered. See Angel Investing, beginning on page 73. Notwithstanding that America was discovered and colonized through venture capital funded expeditions, Georges Doriot, the first French student at Harvard Business School (and later a popular professor there), has been acclaimed as perhaps Americas first venture capitalist and the founder of modern venture capital. In 1959, an investment firm led by Doriot American Research and Development Corp. (ARDC), invested $70,000 (and loaned $30,000) in exchange for 70 percent of Digital Equipment Corp. When Digital Equipment went public nine years later, ARDCs stake was worth a reported $38.5 million; in 1972, ARDC reportedly sold its Digital Equipment holdings for $450 million. Dorian and ARDC went on to invest in over 100 technology focused start-ups.

3.

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Going PublicThe IPO The initial offer and sale by a company, through one or more lead underwriters and a syndicate of underwriting firms, of its registered and publicly tradable common shares to a pool of public investors is known as an initial public offering or IPO. In recent years, the public markets have been characterized by turmoil and dysfunction andto say the leasthave not been kind to VC-backed companies pursuing an IPO. Since the height of the IPO market in 2000 (a frothy year when over 200 such companies went public just before the internet bubble burst), very few venture-backed companies in the U.S have been able to close an IPO.4 Accordingly, planning for and pursuing an IPO has become a very limited (and sometimes not even considered) exit strategy, available only to a very limited number of best-positioned companies that find themselves at a point of maturity, readiness and appeal at precisely the time an IPO market window is open. An IPO is effected by means of a detailed disclosure document, called a prospectus, which is included in a registration statement filed with, subject to review by, and eventually (the issuer hopes) declared effective by the SEC. The registered shares are typically also listed or quoted on a stock exchange or quotation system, most prominently the New York Stock Exchange (or Big Board) or NASDAQ Stock Market.5 As part of an IPO, the managing underwriters conduct a marketing program (known as the road show), following the preparation, printing, and distribution of a preliminary prospectus (known as a red herring). Strict rules restrict underwriting firm analysts from participating in the offering. Ultimately, if successful, a book of underwriters (and purchasers below them) are circled, the IPO is priced and closed with the sale and public trading of registered shares, and with the net proceeds going to the company and, in some cases, also to selling stockholders (which often includes some or all of the VC investors shares). Once a company is public, the reporting, governance and regulatory compliance burdens for the company and its officers, directors, and significant stockholders are rigorous (and time-consuming, expensive and ongoing). Life as a public company poses many risks and challengesnot the least of which are living in a public bubble and trying to preserve an entrepreneurial culture. Given the substantial effort, expense, and risks and the extensive preparations, restrictions, and disclosuresinvolved in achieving a successful SEC registration and public offering, the IPO route is available and appropri-

4.

According to Dow Jones VentureSource (Third Quarter 2010 press release and venture capital market data slides), from 2001 through the third quarter of 2010, a total of 359 VC-backed companies in the U.S. completed IPOs. In 2008 through the third quarter of 2010, only 47 of such companies completed IPOs. Since 2000 (when nearly 30% of all exits were effected via an IPO), only a small fraction of VC-backed companies have been successful in completing a liquidity event or exit strategy through an IPO. The shares registered in most VC-backed IPOs are listed on NASDAQ (i.e., The NASDAQ Stock Market). Some VC-backed issuers are choosing to list their securities on foreign stock exchanges, including the London Stock Exchanges AIM market.
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5.

ate for a limited number of companies, management teams, and business owners. And many VC-backed companies that have successfully effected IPOs have struggled to maintain their entrepreneurial talent, culture and zeal. As the data and experience over the past decade have revealed, no amount of advance planning and preparation can overcome an unreceptive or adverse market for IPO (or new issue) stocks. Market receptiveness to new stock issues, in general or in your industry, can change quickly and dramatically, so timing is everything. When appropriate, well managed, and successful, an IPO can be an efficient and effective means of raising substantial equity capital (at closing and in the future), providing funding, liquidity, increased net worth, employee compensation and acquisition currency, name recognition, and other advantages, but various risks, requirements, costs, and disadvantages must be considered as well.6 PRACTICAL TIP: Choosing the right source of funding for your business is neither a one-time nor a one-size-fits-all matter; it is part of a dynamic, ongoing process. With each round, actively research the alternatives realistically available and the relevant players, and focus your search, with the assistance of advisors and gatekeepers, on those sources or combination of sources that offer the best fit with your specific funding needs, development stage, management team, resources, industry, and plans.

6.

For a detailed discussion concerning IPOs and the public offering process, see Halloran et al., Venture Capital & Public Offering Negotiation, 3rd Edition, Volume 2 (Aspen Law & Business, 2010).
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SECTION II: Venture Capital Investing

Venture capital investing, as noted previously, is more art than science, and more a process or journey than an end result or destination. There is no standard, accepted definition of what constitutes venture capital (though Ive offered a bare-essentials one above). As addressed in this GUIDEBOOK, venture capital is best described as investments by professionally managed (VC) funds in pursuit of extraordinary, longer-term financial returns, through minority equity ownership and participation in entrepreneurial, highgrowth private companies. The practice of venture capital defies easy definition, reflecting the breadth and diversity of both venture capitalists (and other sophisticated investors in high-growth private companies) and the businesses in which they invest. Venture capital (again, for purposes of this GUIDEBOOK) does not include a variety of other popular venture or investment strategies, such as bridge loans for an IPO or acquisition, buyouts, turnaround investments in distressed companies, or investments in large, mature companies. For the most part (and unless noted otherwise), this GUIDEBOOK focuses on a companys first VC investment, commonly referred to as an A Round.7 Lets be clear on one thing from the start: it is extremely difficult to secure venture capital funding, and venture capital is not (and should not be) for every emerging or entrepreneurial business with solid growth prospects. Only a small fraction of the businesses that pursue VC funding are ultimately successful in receiving it. The VC industry has witnessed significant consolidation in recent years, and VC fund representatives (who devote attention to numerous tasks and functions, including nurturing, developing, overseeing, and cultivating exits for existing portfolio companies) have limited time and resources to devote to sourcing new investments. Accordingly, capital-seeking business owners are well-advised (1) to consider, develop and pursue a Plan B strategy (which often involves a combination of additional existing owner and friends and family funding and boot-strapping), and (2) to inform and educate themselves on the process and dynamics surrounding venture capital funding (in particular, which VC investors to approach and how, and what VC investors are looking for and why). This includes planning and preparing to maximize the opportunities for attracting real and sustained venture fund interest, surviving a rigorous due diligence examination, arriving at a fair and appropriate valuation, negotiating the terms and conditions of the investment, and, ultimately, closing on the critical funding they seek. Even if the VC pursuit proves unsuccessful, this approach, preparation and discipline can prove to be extremely valuable in
7. For a glossary of terms, jargon, and phrases commonly encountered in venture capital transactions and used by VC market participants, see ANNEX B, Glossary of Venture Capital Terms and Jargon, beginning on page B-1.

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successfully operating and growing any business and in entering into partnerships of all varieties with sophisticated parties. Pursuing Venture Capital: Opportunities & Challenges There are numerous advantages intrinsic to venture capital as a source of equity funding. First, a VC firm typically provides a single source of substantial equity funding with little, if any, regulation or red tape. Additionally, VC fundswhose principals often include persons with prior career experience as entrepreneurs, executives, scientists and engineerscan and should be value-add partners, providing access to and assistance with important drivers and enhancers of business growth and success. This includes bringing value and discipline in such areas as strategy, governance, budgeting and reporting, and achievement of milestones; strategic, expansion, marketing and financial advice (gleaned, hopefully, from experience with similar best of breed portfolio companies operating in your industry); help with management recruitment and retention; introductions to potential customers, suppliers, partners, and acquisition prospects; assistance with future financing rounds and introductions to known financing sources and investment bankers; and help and guidance with exit/liquidity strategies and execution. Finally, VC funds tend to be sophisticated and experienced (serial) investors and can be expected to conduct themselves professionally and efficiently. Through your investor and advisory teams network (and experience, contacts and available databases), you can learn much about, and evaluate the history, approach, focus, objectives, commitment, personnel, and track record of, most VC firms. The process of engaging and accessing venture capital, however, is not like hitting a light switch. It can be expected to involve a lengthy, difficult, and trying process (particularly the first go-round). Some portfolio company managers have bemoaned the additional day job [they] held for much of the year preceding the investment closing. Getting introduced to, setting up an initial meeting (and holding meetings) with, being prepared and actively listening, and capturing the interest of appropriate VC investors takes time (sometimes months), persistence, and sustained effort (not to mention the ability to weather a few disappointments). Because of the experience and sophistication of VC representatives and the requirements of VC funds (and the fact that you can only make a first impression once), the company should undergo substantial introspection and internal preparation as a prelude to a VC funding round and to prepare for the inspection it will be subjected to and its transition to becoming a portfolio company (with one or more sophisticated, focused, demanding, and independent partner-investors). This includes undertaking corporate, governance, capitalization, tax and record-keeping housekeeping, management team building, business planning (and a very frank assessment of such matters as strengths, weaknesses, and competition) and polishing your executive summary and pitch (or elevator speech), accounting/financial statement work, and the thoughtful preparation of credible financial budgets and forecasts. In addition, youll need to identify and address

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arrangements and transactions with family members and affiliates, and likely upgrade your attention to and documentation of existing financial arrangements, contracts, employee arrangements, regulatory matters, and the protection of confidential information and intellectual property. Some have expressed the view that VC funding is expensive money, since venture capitalists are highly skilled valuation and terms negotiators who seek extraordinary financial returns and typically require complex and extensive investment, preference, governance, and exit protections. In a typical VC transaction, control and governance provisions must be considered and addressed, such as the VC investors level of board participation and its input in, and veto rights over, important strategic, financial, follow-on investment, growth and even operating decisions. In effect, this is the quid pro quo for the funding and value-add partnership you re achieving. You can expect these considerations to result in the loss of some degree of control and flexibility (and likely a new regime of advance preparation, reporting, and accountability). Further, venture capital is structured as permanent capital stock (or equity interests); thus, once the dust settles, there will be no unilateral means for the company to reverse a completed transaction or redeem the stock sold in the transaction or terminate the significant agreements and restrictions. Finally, and importantly, VC investorswith negotiated governance, control and liquidity rights in hand and a time horizon in mindtypically look to exit the investment over a three- to six-year period, which can result in a misalignment of interests with founders, managers, employees and other owners of common stock. The manyand sometimes conflicting and competingconstituencies and interests in a venture must be balanced and ultimately addressed in some fashion in the process of arriving at the final investment and related agreements and closing. Choosing and Making the Most of a Venture Capital Partner Raising capital from one or more venture capital funds is much more than simply effecting a capital-raising transaction; it is the formation of an active, long-term partnership in which representatives of the VC firm typically become strategic consultants and advisors, as well as members of (and rather vocal voices on) the board of directors.8 The VC firmincentivized by its investment position and the need to realize investment returnscan and properly should function as a value-added partner, assisting and guiding the business in its funding, development, growth, plan-achievement, governance and ultimate exit strategy.

8.

The board of directors of a VC-backed portfolio company is not a mere formality which meets annually to ratify and approve various agreements and transactions. Once the VC investment closes, the board of directors will take on the role of command central, and will function (consistent with the VC investment agreements) as the governance, oversight, compliance and approval body of the company. Considerable management time and attention will need to be devoted to preparing reports and reporting, preparing for and attending board and committee meetings, and managing the board and committee process.

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With a substantial amount of funds chasing a relatively small group of promising, high-growth emerging companies, some capital-seeking business owners and managers are faced with several interested VCs and proposed term sheets and, as a consequence, have a choice concerning which firm(s) should become their investment funding partner(s). This choice should not be taken lightly. Selecting the right partner can be as important as bringing the right idea to market at the right time, and can even signal a turning point that shapes a ventures future success. In selecting the right VC partner, business owners and managers should research, consider and evaluate a variety of factors, the importance of which will vary from venture to venture. This requires a pro-active, concerted effort, in concert with the advisory team (as well as existing investors and board members), in advance of sending out executive summary business plans or seeking indications of interest from potential funding sources. Prior to selection, the company should research, question and assessand, once the funding is closed, should work actively to take advantage ofsome or all of these factors: How well the VC firm understands your business, market and industry (which can be measured, in part, by the background and experience of its professionals, the thoughtfulness of the firms approach, questions and due diligence and, of course, the quantity, comparability and success of the firms other portfolio investments in your companys industry and market). The VC firms level of interest in and commitment to your company and transaction (among other things, given your stage of development), and its desire and willingness to reach a shared vision in the growth and development of the company. The VC firms (and its designated representatives) commitment to devote time, effort and resources to the company and its development and growth; the availability of senior firm representatives (who will be the point persons for your company), including the number and extent of other portfolio company/board of director commitments, should also be assessed; also, the quality, depth and diversity of the VC firms professional staff, consultants, and external services network, as well as its relevant industry contacts and perceived reputation. Good fit and chemistry with the VC firms designated representative, including your comfort in spending significant time with the representative, and a shared strategy, approach and point of view; his/her smarts, creativity, flexibility, responsiveness, openness and honesty; and the representatives devotion and passion for contributing to portfolio companies, level of planned involvement in oversight, management and operational matters, and ability to function calmly in a crisis (remember, you will be spending a lot of time with this new partner). The VC firms patience (e.g., anticipated timeframe for achieving operational and growth milestones and ultimate exit strategies) and record for dealing with portfolio companies that have experienced delays, issues and difficulties in achieving important goals along the way.

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 The VC firms ability (based on prior experience), willingness and expectation to

provide or assist in securing capital in the future; also, the ability of the VC firm to attract other VC and funding sources and capital market participants (including strategic investors, financial sponsors and investment banks) to the current round and follow-on investment rounds. (Note that a single capital raise may beand often isinsufficient to fund an emerging companys entire business and development plan to exit/liquidity event.) The VC firms views on the depth, coverage and adequacy of your management team, and the VC investors track-record, willingness and ability to assist in recruiting, hiring and retaining critical management personnel (including through its portfolio companies, relationships and network of contacts); also, the VCs views on fair compensation for the management team (you should expect a significant emphasis on incentive compensation designed to align the interests of managers and the VC firm in the businesss progress, plan-achievement and ultimate success). The specific investment terms, preferences, restrictions and conditions the VC firm is imposing as a condition to its investment (including those relating to governance, controls, reports, restrictions and exits). Like any sound and healthy business partnership, the company-VC firm relationship requires real and substantial investment and serious, sustained effort to make it work. The advisory teamwhich should be deep with experience in the venture market and venture capital investment transactionscan provide invaluable insight and information concerning these and other matters of interest that can help to guide selection of one or more VC firms suitable to partner with as well as post-closing good partnering practices. Researching, assessing, and making a careful selection of a VC firm to provide important funding to your business is essential to transforming a one-time funding event into a long-term, value-added strategic partnership. Those who devote the time, effort and resources to a proper and considered selection, and a two-way-street partnership, should be well rewarded. PRACTICAL TIP: The keys to improving your companys chances of successfully raising venture capital include: being uniquely and strongly positioned in a large and rapidly growing market; assembling a strong, cohesive management team; preparing a clear, concise business and execution plan; working with experienced advisors; and understanding potential investors needs, objectives, and goals.

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Venture Capital Fundamentals: Understanding Venture Capitalists and the Investment Process; Planning and Preparing for a VC Transaction
Entrepreneurs and emerging-business owners often ask: What can I do to improve my chances of landing venture capital funding? Several keys are outlined below, but most of it boils down to this: make sure your business is advantageously positioned in a rapidly growing market, assemble a strong and cohesive management team, prepare a clear, credible business plan with realistic financial forecasts, engage and consult wellrespected and experienced advisors, and understand and anticipate the needs and goals of your potential investors. 1) Understand the business model and goals of VC investors Venture capital investing is serious business. VC funds are in the business of investing funds and overseeing portfolio investments to create exceptional internal rates of return (net of management fees) for their investors. The internal rate of return dictates the success and, in some cases, survival of VC funds, nowin terms of satisfied investorsand in the futurein terms of attracting new and repeat investors to later, hopefully successive, funds raised by the VC firm. To attract real VC interest and attention, the VC firm must ultimately be persuaded that a particular investment opportunity will exceed the firms track record for return on invested capital: typically, a return of 30% to 50% or more per annum. (That is, the VC firm wants to make three to five times its investment or more, over its planned investment horizon.) For the VC firm to achieve this level of return, some investments must perform much better than average (homeruns) to make up for the many expected unsuccessful or flat investments. In addition, given the limited lifespan of a VC fund (typically, 10 years), these internal rates of return must be generated within a defined time horizon (typically, three to six years for any portfolio investment). In a completed funding transaction, the VC investor will become an equity owner of the target business, typically holding convertible preferred stock. The VCs initial percentage of ownership varies and depends upon a number of factors (principally, the amount invested and the agreed pre-money valuation). Most venture funds, at least initially, do not desire an ownership position that exceeds 35% to 45%, largely because they want existing owners and managers to keep substantial skin in the game. The minority investment position also evidences a commitment to leave day-to-day management control in the hands of managers (with oversight and direction by the VC). Most VC funds seek to validate the investment prospects market (and its place in that market) to ensure that the potential portfolio company is positioned in a market that can support the level of growth necessary to yield the VCs anticipated investment returns. Typically, the VC will look for a large, rapidly growing or relatively unstructured market, with no dominant or entrenched leaders and very little or poorly organized competition. These market dynamics offer an emerging companywith certain competitive

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advantagesthe potential to enter, grow, and sustain a strong position in the market. Thus, the capital-seeking business owner should analyze and defineas precisely as possiblethe size and expected growth rate of the selected market, as well as the forces driving competition and the companys unique, proprietary and competitive advantages, to assess the companys opportunity within the market. A word on valuation: VC firms are skilled valuation negotiators and are very focused on making investments at an appropriate, risk-adjusted, pre-money valuation. Many business owners view valuation as the all-important issue (since valuation drives the dilution in ownership that the founders and other owners will incur as a result of the VC investment). Yet valuation and ownership percentage should be considered along with other issues, including those identified above,10 as well as the specific features of the security to be issued and the terms and conditions of, and rights and obligations in, the investment transaction. Recognize that there are many risks attendant to an investment in an emerging private company and that valuation is not an exact science; it involves an inherently subjective process (notwithstanding that valuation negotiations may be based on tried-and-true methodologies). Youre embarking upon a long-term investment-based partnership, which will require give-and-take, guided by a win-win outlook and perspective, in the structuring and negotiation process.11 Of course, for the deal to be done, both founders/owners and VCs will have to compromise and, at the same time, work to satisfy the other partys concerns and objectives. Its to neither partys advantage to engage in protracted and contentious negotiations or to insist on overly protective positions or unreasonable requirements. Maximization of returns and wealth creation are often best facilitated by an emphasis on the collective building of a strong, successful company, rather than on squeezing every last penny out of valuation negotiations. More than a few VC investment negotiations have failed as a result of fixed positions and irreconcilable differences of opinion on valuation.12 2) Understand and be prepared for the investment processfrom initial contact through funding Institutional VC firms look at hundreds, even thousands, of investment opportunities and business plans each year. Larger VC firms reportedly review, on average, between 1,500 and 2,000 plans and opportunities a year. And VC funds often co-invest with other VCs (forming a Club), with one VC firm taking the lead. Accordingly, the capital-seeking

10. See Choosing and Making the Most of a Venture Capital Partner, beginning on page 17. 11. For an interesting and considered discussion regarding valuation standards and guidelines in a venture capital context (and relevant resources regarding same), see the National Venture Capital Association website, at www.nvca.org (Valuation Guidelines). 12. Key motivators and behavioral drivers of VC funds, and their impact on deal negotiations, structure and terms, are discussed under Key Objectives of VC InvestorsWhat Makes Venture Capitalists Tick?, beginning on page 35.

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business owner should be mindful of the VC investment processwhich, from initial contact to funding, typically takes three to six months and sometimes longer. This process which is built by and for VC firmsfollows a certain logic, cadence and rhythm. Successfully obtaining venture funding requires that the owners (including founders) and managers properly address, and endure and survive, the introduction, screening, meeting, interest-capturing, due diligence, valuation, negotiation, documentation, and closing processes. A summary of the steps in a typical investment process follows (note that not all of these steps occur in every process, and that these steps and sub-steps do not always occur in this order or sequence). HOMEWORK AND INITIAL CONTACTFor the fund-seeking business owner, the process begins with homework: research, investigation, and assessment of the potential VC audience in an effort to qualify the audience and increase the likelihood of locating appropriate, interested investors. Owners will want to determine the current focus and bias of VC funds, if possible, because many VCs have preferences (their sweet spot) based on the size of the investment, investment round, stage of development of the company, experience of the management team, geographic location, market, and industry. You should also assess the VCs strengths, resources, reputation, value-adds (and level of commitment and involvement), and prior portfolio investments. Then, there is the matter of making initial contact. For the uninitiated, its worth noting that you will have to be prepared to do a fair amount of groundwork before you marshal and make your first contacts. Because VCs receive so many business plans and investment opportunities, most seek, and devote more time and attention to reviewing, opportunities forwarded by gatekeeperstypically, persons who are known to and respected by the VC (or its representatives or advisors), who have worked with the company and its insiders or management or who have subjected the business plan to some degree of pre-screening (e.g., attorneys, accountants, bankers, recruiters, or consultants). Fund-seeking business owners (particularly those located outside Silicon Valley, New York City, and Boston) are well-advised to enlist, engage, and work closely with one or more of these gatekeepers in order to fashion a contact strategy and make the initial contacts count.13 Before making an initial contact, among other things, youll need to have a current and compelling executive summary business plan and a polished and practiced elevator speech (and, for those serious about the process, youll need to be prepared to deliver a full business plan and financial forecasts upon request).14
13. Roughly half of the VC funds in the U.S. are members of the National Venture Capital Association (www.nvca.org), which sells its annual membership directory and also has a searchable online directory. Venture Capital institutes and conferences, certain business school websites, internet search engines, and internet networking sites can also provide supplemental VC identification and contact resources. 14. As discussed elsewhere herein, before divulging confidential, proprietary or sensitive information you should consult counsel regarding a well-managed information exchange process and the different means and approaches of safe-guarding your information, including via use of a non-disclosure or confidentiality agreement and secure data room.

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SCREENINGMost of the opportunities submitted (an estimated 80% to 90%) are screened out and eliminated after a very brief scan because they do not fit with the VCs objectives, criteria, and preferences, or because they were poorly thought out, prepared, or introduced. Most typically, companies are screened out because of their stage of development, location, management depth/experience, market or industry focus, market size, competitive dynamics, or amount of investment requested. Unfortunately, in almost all cases, VCs dont tell you when or why youve been screened out. A CLOSER LOOK; INITIAL MEETING(S)Those that survive the initial screening process (10% to 20%) are subjected to some level of further review and light-testing, which may include a full read of the business plan, financial information, and projections; preliminary inquiries and background checks with local network contacts and others; and telephone calls to respond to specific questions and provide additional information. VCs which are local (or within reach) may choose to do some or all of this in an in-person meeting. Less than half of this group (i.e., around 5% of the total pool) will be presented with the opportunity to meet with principals of the VC firm (except, perhaps, for a friendly happen to be in town, perhaps we can meet and say hello visit). If provided with this opportunity, the business owner/manager should take it quite seriously, and be prepared. This is a milestone of sorts in the investment process. The VC may want to explore further the business plan, market, solution, use of funds, competitive dynamics and prospects, and (more importantly) will likely seek to take measure of the owners and of the strength, character, experience and depth of the management team. DUE DILIGENCE; INITIAL VALUATION DISCUSSIONSSurviving the screening, preliminary review, and initial meeting phases signals an important accomplishment, given that less than 2% to 3% of the total pool make it this far. Some measure of enhanced engagement will now ensue, and the company will undergo a greater level of (and perhaps more formal) scrutiny, usually preceded by the VCs delivery of a detailed due diligence request list. Some VC funds defer much of the detailed investigation to after the Term Sheet/LOI stage (but all typically conduct some level of diligence at this phase on market, opportunity, financial and/or management matters). Any one or more of the following may be requested or scheduled at this stage: meetings with key members of management (and, perhaps, customers, suppliers, and other business relations); office/facility tours; review of competitive and market analyses (and back-up); and a more intensive inquiry and review of business drivers, competition and market penetration, customer relationships, technology and intellectual property, operations, management, and financial statements and projections. Company insiders should continue their own questioning of and due diligence on the VC firm (and the representatives who will likely be involved with this portfolio investment).

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Common Mistakes in Pursuing Venture Capital Stories abound about entrepreneurs and emerging business owners who, in the process of seeking venture capital funding for the first time, make costly yet avoidable blunders, ensuring a premature end to the investment screening process. Heres a list of Top 10 Mistakes in Pitching for Venture Capital: 1. Failing to treat a first call or meeting with the respect and preparation it deserves; talking too much (about too little) and failing to actively listen (and respond truthfully to questions asked) Telling half-truths or presenting a half-baked business plan (including with vague, unrealistic or even unobtainable plans, forecasts, milestones or statements); also, presenting a weak, incomplete, disorganized or messy executive summary or business plan (your executive summary/business plan will likely be the first impression you make on the VC audiencemake sure you proofread it, and that projections are realistic and supported by some kind of defensible studies or data) Failing to have your act together (and corporate, financial and accounting house) in order Focusing too much on the idea and too little on the market, the solution, the use of investment funds, management, targeted marketing and plan execution A strategy or solution that requires a lot of funding to reach validation milestones (and/or not having a clear validation plan for the use and deployment of the funds youre seeking to raise) Too much hair and complicationhaving many/various undocumented arrangements and relationships, or non-arms-length affiliations, or perhaps outstanding disputes, with investors, lenders, partners, employees, customers, suppliers or others Failing to properly explain future projections in the context of past performance (in particular, past customers, revenues, profits and capital and cash flow management) Dissingor failing properly to respect and addresscompetition and barriers to entry and growth (what is the current and expected competition and what are your true competitive advantages!) A board of directors (or senior management team) which (i) includes inexperienced (or no value-add) investors, (ii) is geographically dispersed, or (iii) is aspirational (in the works or on the come) only (who is your current committed team and how will they execute!)

2.

3. 4. 5.

6.

7. 8.

9.

10. A management team that suffers from but fails to appreciate fully one or more of the above

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During this stage, the VC and the company will likely commence discussions regarding the appropriate valuation (or ball-park and approaches for arriving at same) for the business, predicated on the amount of funding in question, the financial data and forecasts provided by management, the VCs due diligence investigation to date, and the VCs internal financial model. Of course, most of these data points will evolve and will be works in progress over the course of valuation discussions. The companys advance preparation of detailed, reasonable, and credible financial projections, with clearly articulated assumptions, is critical. If things are going smoothly, the VC may also introduce some level of discussion regarding proposed transaction structure and deal terms at this stage. Expect due diligence inquiries and information exchanges, and the related consideration of valuation (and the metrics of and inputs to reach an agreed valuation and its impact on deal terms), to continue throughout the course of discussions and negotiations. The agreed valuationwhich VCs often push for some level of agreement on early in the processtogether with the agreed level of funding will ultimately dictate the percentage of the company that the VC will receive and the founders, managers and previous owners. Significantly enhanced due diligence (including regarding financial forecasts, customers, contracts, intellectually property, and applicable legal and regulatory matters) is often undertaken after the Term Sheet/LOI is signed and at the same time the definitive documents are being negotiated. Sometimes VC funds engage outside consultants to assist with their evaluation. Throughout the due diligence process, which can be expected to take three to eight weeks or longer (but which does not end until just before the closing occurs), management should be in close contact with the (lead) VC firm in an effort to gauge and respond to concerns and stay on top of the VCs continued interest and enthusiasm in moving forward. If indications are not favorable or if VC interest ceases, you should seek to ascertain why and how to avoid a similar result with other potential (VC or other) investors, by debriefing the departing VC, for example, on the perceived weaknesses or flaws in the company, its plan or strategy, its management, or the process. Management should also seek the return of all previously provided confidential documents and information (a procedure for which should have been addressed before the commencement of information exchanges).

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PRACTICAL TIP: During the investment process, the company will likely be asked to provide information and materials to numerous parties. It is important to take appropriate stepsincluding a confidentiality (or non-disclosure) agreement, a secure data room*, and an agreed information-exchange processto ensure that intellectual property, trade secrets, and sensitive information are managed and protected throughout the negotiation and investment process.

TERM SHEET/LOIIf a company survives the initial due diligence phase and continues to attract the interest and attention of the VC firm(s) after initial discussions of valuation and deal structure/terms, a term sheet or letter of intent (LOI) will be presented by the VC firm. The term sheet is offered to ensure that the parties are on the same page regarding the principal terms of the proposed investment before significant additional resources are expended. Once agreed upon, it will become the marching orders for the VCs counsel to prepare appropriate draft investment agreements and documents. The parties (in particular, the company) are best served by a detailed term sheet that makes clear what the parties intend (and avoids summary jargon) and resolves as many important issues as is reasonably possible.15 The presentation of a preliminary term sheet can take place earlier in the process depending on the style, cadence, and appetite of the VC, its comfort with the investment opportunity, actual or perceived investor competition, and the amount of due diligence anticipatedas a reality check before proceeding with a significant (and expensive) due diligence effort. The company should seek and obtain the benefit of counsel during the term sheet/LOI stage. LOIswhich for the most part are prepared to embody non-binding indications of interestoften include binding agreements that survive after a particular investment negotiation has been terminated or abandoned. In addition, what binding (versus non-binding) agreements should be included, what level of detail is appropriate, which issues should be tackled or deferredand the impact of these questions on negotiations and the progress of the investment transactionare all key strategic questions with legal overlays that are best explored and addressed with the benefit of experienced
* A secure data room is a protected location where detailed, sensitive information and documents are collected and made available for review by interested parties who are provided access. It can be actual (a physical location within the companys or its agents or counsels offices) or electronic (known as a virtual data room, or VDR). The latter is a secure, dedicated website providing authorized users with limited, sequential or full electronic access to an online repository of information and documents relevant to the target company and/or a particular transaction.

15. An illustrative, annotated term sheet (with commentary) for a Series A preferred stock investment transaction is included as ANNEX A to this GUIDEBOOK.
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counsel. Its also worth noting that (i) VC representatives have a significant advantage (in terms of sophistication and experience in these matters), and thus the founders, managers and owners are often in a disadvantageous position to appreciate the significance of, or to negotiate, important investment, securities, governance, and other terms, and (ii) it may be difficult to renegotiate terms and conditions contained in the agreed term sheet or LOI when the draft definitive documents are served up by the VCs counsel. SYNDICATION/CLUB FORMATIONSome venture investment rounds are conducted entirely by one VC fund (particularly in smaller and A rounds). In many instances, however, the VC fund you initially contacted and proceeded with will syndicate the investment (thereby forming a Club for the investment). The syndicate or Club will be lead by a lead investor, which typically invests 20% to 50% (or more) of the round. The lead investor will worktogether with the companyto attract additional VC (and sometimes other sophisticated) investors for the balance of the round. This may raise issues of multiple due diligence efforts and multiple counsel. If possible (and this should be an early and clear priority), it should be agreed that only the lead investor (and its counsel) will run the documents and the diligence process on the investor group side. NEGOTIATIONS, DEFINITIVE AGREEMENTS, AND FUNDINGIf your company survives the due diligence investigation and valuation discussions and reaches agreement with the (lead) VC on a term sheet or LOI, absent a change in circumstances or market conditions, there is a reasonably good chance that you will proceed to signed definitive agreements (i.e., the final investment agreements, embodying the legal terms and provisions relating to and governing the investment) and funding at a closing. The timing of this phase will depend upon the level of detail in the term sheet; the preparations, sophistication, experience and responsiveness of the business owners and their counsel; the resolution of any critical pacing issues; the VCs approval process and other commitments at the time; and, of course, the absence of surprises or bumps in the road. On the companys side, the VC transaction will require that certain approvals be obtained (e.g., Board and stockholder approval and required approvals or consents from third parties), and may require that certain agreements be amended (or better documented) and that the business entity be converted from an LLC to a corporation. Negotiations should be conducted in the spirit of (and embracing) the respect, fairness, good faith, and reasonableness in approach incident to embarking upon a long-term partnership, and not merely a one-time financing event. Absent any special closing conditions (e.g., entry into credit facilities, regulatory approvals or third-party consents), closing and funding may occur simultaneously with or shortly following the signing of definitive agreements. The closing (funding) is the last step in the investment process. At the closing, among other things, the funds (net investment proceeds) are delivered by the investor(s) to the company, and the stock certificates (evidencing the investment instruments) are delivered by the company to the investor(s). Upon the closing, the company becomes a VC portfolio company. In most cases, there is a single closing and funding event; in some cases, there are multiple or tranche closings based upon time, agreed milestones, specific deliverables or other factors.
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3) Assemble and build a strong management and advisory team It has often been said that the three most important attributes of any company seeking venture capital are management, management, and management. The critical nature of a management teams depth, integrity, experience, and competence (including its ability to execute the plan and deal with change) cannot be overstated. Thus, senior management (i.e., the management personnel that will oversee and be responsible for the key drivers and critical functions of the business) will be an important, central focus of VC evaluation and due diligence. Depending on the companys stage of development, VCs will expect to see a management team characterized by: a strong track record; a proven skill set, including substantial recent and relevant experience (and success); honesty and integrity; completeness in depth and coverage; interpersonal chemistry and the ability to work together (including under stressful, difficult and sometimes unanticipated conditions); the ability to work closely with new, active partners who will play a significant oversight role and demand accountability; and a strong understanding of the business, its markets, competition, challenges, and the industry in which it operates. Each of the businesss critical functionse.g., operations, finance, human resources, product design and development, production, compliance/quality control, sales and marketingshould be under the direction of an experienced manager who can stand on his or her own and can withstand the scrutiny of the VCs due diligence. And, of course, each member of the management team must have bought into the businesss growth plan and milestones, the VC investment and goforward partnership, and plans for the future.16 A brief note on the importance of outside professional advice and advisors. Selecting, engaging, and working closely with respected, experienced outside advisorscounsel, accountants and consultants (as necessary or appropriate)early, often and throughout the process can be crucial to a fund-seeking businesss success in starting off on the right foot, developing the business in a logical, proper and compliant fashion, and gaining the confidence of and funding from VCs and other sophisticated financing sources. Inattention to and missteps and defects in the proper building of the companys platform (including regarding charter documents, capitalization/stock issuances, customer and vendor contracts, regulatory compliance, employee arrangements, and protection of confidential information and intellectual property) can cost more than 10 times to fix what could (and in many cases should) have been effected with competent advisors assistance and guidance from the beginning and in the early stages. Along the path from inception through growth, development and funding, experienced advisors can add tremendous value and rigor to the process of building the platform in a manner consistent
16. Prior to closing its investment in a company, VC investors will require that certain agreements between the company and key employees be put in place. These typically include an employee stock purchase agreement (providing for the purchase of stock or LLC interests under an agreed form of incentive and/or option plan with agreed exercise and vesting provisions) as well as a confidentiality, proprietary information and inventions assignment agreement.
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with industry, market and regulatory standards, and to preparing the company for the stringent due diligence, negotiation, documentation and funding requirements of potential VC and other investors. In times where opportunity windows can be very brief, and in a world characterized by constant change and where timing is everything (and delay can mean the difference between a successful closing and an aborted deal), the company should do everything it can to anticipate demands of important (future) partners and relationships, and avoid possible hiccups associated with a lack of proper planning, preparation, responsiveness and documentation. Advisors should have significant and relevant experience to be helpful in guiding and navigating the venture capital investment process, surviving and learning from various crises (or unexpected events), seizing upon opportunities, and avoiding problem areas. VCs rely heavily on their counsel to drive and manage the due diligence process as well as the transaction structure, terms and documentation. Advisors should be positioned (and willing) to call upon their contacts and make appropriate introductions (e.g., to potential management recruits, board members, technical consultants, strategic partners, funding sources, and other advisors). They can also be instrumental in providing some sense of credibility and an outsiders experience-tested assessment of and perspective on the company, its plan and prospects, as well as its platform, structural, contract and other holes, investment prospects, and management team. 4) Present a clear, compelling opportunity via the business plan The written business plan is the centerpiece for piquing the interest of potential venture capital investors and introducing them to your business. In fact, many VC and equity investors will not proceed, even with preliminary discussions, unless a written business plan has been prepared. Since VCs routinely review many business plans, yours should sing: it must present a compelling business and investment opportunity; be current, clear and credible; be well-organized, proof-read and free from typos or errors; and include what is commonly called a teaser (or executive summary), in which you boil the plan down to a concise, two- to five-page executive summary. The teaser is often used as the first information exchange with potential investors to attract interest in your business and the investment opportunity. While many business plans tend to have various elements in common and share the same objectives, it would be a mistake to rely upon a form template or copy the plan of another (albeit similar) business. Business plans should express the uniqueness and identity of your business and opportunity. There are many resources available and consultants accessible to assist you in formulating a solid business plan, but managements time, commitment, perseverance and attentionthrough initial construction, ongoing input and vetting, and revised draftswill be required and will be the distinguishing factor in any successful plan. The business plan should address the components (or drivers) that are key to plan execution and success of your business, including:

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 OVERVIEW (EXECUTIVE SUMMARY)The companys business, products, services,

and the market segment it is in (or plans to be in), with a clear discussion of the variables key to business success, such as key personnel, technology, intellectual property, design, R&D, production, sales and marketing, distribution channels, customers, direct and indirect competition, strategic partners, etc.; include a clear statement of what distinguishes this business from current or likely future competitors. VC investors are interested in how the business is uniquely positioned to take advantage of a large and growing market and how you will rapidly grow the business (including its revenues and ultimately cash flows and profits) in view of current and future competition. BUSINESS CONCEPTA clean, fair description of the business, its products/services, key development milestones and target market. MANAGEMENTBackground, experience, relevant track record, commitment, and skills; what each member of management uniquely adds, his or her function in and coverage of the key operations/components of the business, and what the team collectively brings to the companys plan execution and growth. HISTORYSummary of the companys development and achievements to date, including key operational, management, financial, investor/investment, intellectual property and technology, sales-traction and other milestones, contributing to its current state and value and future prospects. COMPETITIVE ADVANTAGEWhat is the problem your company is positioning to solve, and what solution does your company provide (and how so); identify proprietary or differentiated products or services, intellectual property protection (strategy, stage, and execution), and technology dynamics; licensing arrangements, strategic relationships, and alliances; and anything else that provides a competitive and/or unique advantage over other market entrants and participants. Be prepared to defend, with supporting documentation, all intellectual property protection claim or statements. FINANCIAL STATEMENTS AND PROJECTIONSPrior annual financial statements (best if audited) and financial projections for a three-to-five year period; should be vetted with accountants and other advisors, scrubbed for reasonableness and credibility, and addressed in the overall presentation; projections should be accompanied by reasonable and reasonably detailed assumptions. CAPITALIZATIONSummary of the companys capital structure and capital (stock or LLC interest) ownership, including owners and investors and investment capital received to date. This summary, presented in table format, is referred to as a Cap Table. The companys capital needs, and how and over what period capital will be used and deployed, should also be addressed (this is often done via a Sources & Uses Table). RISKS AND OTHER CONSIDERATIONSDetailed business plans submitted for VC investment consideration should include a frank and candid assessment of the problems, issues, and challenges that the business faces or will face as it proceeds to grow and execute on its plan. (Every business faces challenges, and this discussion begins the process of building credibility with potential VC investors.)
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There are many approaches to and aspects of proper business plan information gathering, preparation, vetting, updating, and dissemination, which are beyond the scope of this GUIDEBOOK. And, as noted above, there are professional business plan consultants, as well as numerous books, materials, and (hardcopy and online) resources, that address business planning (and even provide how to guides in formulating a sound business plan). Importantly, business plans are dynamic and can provide a valuable go-forward tool for business assessment, budgeting and planning, as well as management accountability. Care should be taken, and experienced counsel should be consulted, regarding (i) the protection of confidential, proprietary, and sensitive information, (ii) the formulation, review, and distribution of forward-looking statements, predictions, and forecasted operating or financial information, and (iii) the use of a business plan as a precursor to the offer, issuance and sale of securities (particularly to anyone with whom the issuer/company does not have a previous, substantial relationship).17 VC fund representatives critically evaluate you, your team (and how you conduct yourselves), your business and plan at every step in the process. The business plan (even if in draft form), the teaser, the information in the data room (and your management of this), and all other forms of communication to potential investors serve as important touchstones for this evaluation of you as a potential investment prospect. They should be crafted to convey strong understanding, ownership, accuracy, consistency, and credibility. Accordingly, your business plan should constantly be scrubbed to ensure that it does not contain or refer to untrue or misleading statements or unrealistic forecasts, estimates, or assumptions, including regarding matters relevant in determining valuation. Remember, the VC fundraising effortand the concurrent due diligence investigatory processcan take many months and can experience many starts and stops, twists and turns; your previously provided business plan (drafts), budgets, and projections will live on, and you may have to explain later the basis for certain statements and assumptions made, the accuracy of these and the reasons why you were unable to meet expectations and forecasted results. PRACTICAL TIP: Venture capital investors will critically evaluate you, your team, and your business at every step in the process. The business plan (even if in draft form), teaser (executive summary), financial projections, responses to due diligence requests, and all other forms of communication serve as important touchstones for this evaluation and thus should be crafted and delivered to convey strong understanding, accuracy, confidence, consistency, and credibility.

17. See Securities Law Considerations for Private Offerings: What You Need to Know, beginning on page 8.
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5) Be prepared (and ready for inspection)get and keep your house in order As noted previously, VC investors, at various points in the process, will expect to perform rather extensive and ongoing due diligence on the subject company, its business, products/services, intellectual property, technology, financial condition and results, operations, management and prospects. As fund fiduciaries, VC professionals have a duty to review, analyze and understand these matters and related risks and uncertainties, andperhaps most importantlyhow the company, with the new capital invested and the VC as a partner, is expected to grow, succeed and ultimately generate exceptional investment returns. Each VC firm has its own approach, discipline, demands, cadence, and routine for performing this function (and some use outside consultants to assist in specialized areas). The important lesson here: when the VC firm is sufficiently interested that it is ready to conduct a meaningful due diligence investigation (typically preceded by a detailed due diligence request list and perhaps a due diligence timetable), the company must be ready to respond. If your fund-seeking company is not prepared for this process, you should expect, at best, a delay in the process and questions regarding the seriousness and commitment of the company and its management team and, at worst, a sense that there is something amiss and a loss of interest altogether by the VC firm. By getting and keeping your business house in order and being prepared for intensive due diligence and the venture fundraising process in advance, you will have identified holes and filled them (or developed an approach to fill them), anticipated issues and resolved them (or similarly developed an approach to address them), and you will be in a position to educate (and respond to critical questions posed by) potential investors and others, thus facilitating and perhaps even lifting investment interest. Accordingly, any business owner seriously committed to a capital raising process simply must ensure that appropriate pre-planning and preparations have been undertaken (and should start well before initial contacts are commenced). This process will require management commitment and time, and some level of funding; prior instances of corner-cutting, failure to properly address issues or complete inattention due to lien cash flows, limited personnel or other causeswill have to be addressed. These preparations should be part of the plan and budget leading to a capital raise, as certain facets will require concerted management attention and the services and assistance of outside advisors, including counsel, accountants and (in appropriate cases) consultants. PRACTICAL TIP: Through sensible advance planningand preparing for the questions, demands, and due diligence requirements of VC investorsyou can distinguish your business from the pack. Making sure that your house is in order before you engage venture capitalists will demonstrate your seriousness and competence, and allow you to focus on the real issues and challenges that undoubtedly will come up in the investment process. While being prepared will not guarantee successful funding, not being prepared will almost certainly result in unfavorable consideration from the potential investor audience.
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EARLY PLANNING CONSIDERATIONS: ENTITY SELECTION & STRUCTURAL CONSIDERATIONS IN ORGANIZING A BUSINESS VENTURE Entity Selection (Limited Liability Company vs. Traditional Corporate Form) There are significant choice of entity considerations in organizing a business venture (and selecting an appropriate form of business entity). The most common choices are the traditional corporation form and the limited liability company (LLC). The vast majority of VC investments are in corporations (as opposed to LLCs). A summary discussion of the relevant considerations follows. LLCs LLCs can offer a flexible, useful and tax-advantaged vehicle under the right circumstances. The principle advantages of LLCs include: pass through status (of income and tax deductible losses) for federal income tax purposes; single-level tax on sale of assets (i.e., buyers receive a stepped-up basis in the assets); limited liability for equity owners/members/participants; freedom and flexibility to design and implement, by contract (via the operating agreement), special provisions regarding governance, voting and economic rights and preferences (e.g., common and preferred securities interests may be used, and sweat equity may be provided for, although this requires consideration of taxable compensation issues), as well as board, management and fiduciary duty matters; and charging order protection for equity owners/members with creditors (i.e., a members creditor may not levy upon and seize that members membership interest in the LLC but rather is limited to obtaining a charging lien upon the membership interest). LLCs, however, may pose some distinct challenges or disadvantages worthy of consideration in the planning process. The principle disadvantages of LLCs include: complexity (in LLCs with multiple equity owners)more detailed client education, issue resolution, documentation and contract drafting and negotiation may be requiredthis can translate into more vetting, drafting, redrafting, and higher costs; less understanding of the LLC compared to the traditional corporate forms (which often translates into some delay, more vetting and drafting and higher costs);

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 considerable time, effort and expense can be expected when new equity own-

ers/members are added, or when developing and implementing incentive compensation plans and/or modifying the LLC operating agreement; and a rather immature and undeveloped body of law surrounding LLCs (and thus courtsparticularly those outside Delaware and New Yorkhave had relatively little experience to date in interpretations, disputes and controversies arising out of or involving LLCs). The investing world, at present, has somewhat mixed views on LLCs. Institutional and sophisticated investors (who consistently engage in investment transactions with a view to exiting over a defined time horizon) are increasingly utilizing, investing in and favoring LLC vehicles in appropriate circumstances. However, investors funded by pension money or foreign (non-U.S.) persons may not, and some angel, venture capital and institutional private equity investors still choose not to, invest in ventures structured as LLCs. The issues created by pension and foreign person investment capital can be (and, with some frequency, is being) addressed by funds establishing so-called blocker corporations as the investment vehicle. Corporations Many entrepreneurs and emerging business owners (and their initial management teams) continue to utilize the corporation as the platform vehicle. Where the contemplated initial ownership of a venture consists of a relatively small group of human (i.e., non-entity) U.S. investors (who do not require any preferential interests, distributions or returns), an S corporation (i.e., a corporation, typically organized in Delaware, which makes an S election under the Internal Revenue Code), is often the vehicle or business entity of choice. The principle advantages of the traditional corporation form include: simplicity in organizing a corporation (usually in Delaware*) and making an S election (where appropriate) with the IRS;
* Delaware is generally the preferred jurisdiction for incorporation of venture-backed companies for a number of reasons, including: (1) the Delaware General Corporation Law (the DGCL) is a modern, current and internationally recognized (and much copied) corporation statute which is updated annually, with the input of experienced legal practitioners, to take into account new business and case law developments; (2) Delaware offers a well-developed body of case law interpreting the DGCL, which provides a level of consistency and certainty in business, finance and transactional planning; and (3) Delaware has a separate business court (the Court of Chancery), which is widely recognized as the nations leading business court system, where judges preside over cases exclusively involving business, governance, finance and transactional law matters.

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 greater general familiarity and acceptance (a greater availability of

tested/proven form documents and agreements providing for incorporation, governance, securities and transactional matters); more mature and extensive body of case law; employment tax benefits to S corporation stockholder-employees; and simpler and more efficient exits (and related tax strategies and implications) The principal disadvantages of the traditional corporate form include: strict and inflexible requirements for S status (running afoul of the rules can mean a loss of pass-through tax status, and thus the loss of single-level tax on a sale of assets); nowhere near the flexibility offered by LLCs; and for S corporations, limit on the number of stockholders (who must also be U.S. citizens). Be Thoughtful About Entity Selection Given these considerations (in addition to any specific interests or considerations that may be applicable to any given business or venture), a balancing of interests analysis should be employed (early in the entity selection process), based on the particular facts and circumstances of the planned business venture, and taking into account (among other things) planned owners and ownership interests, tax attributes, near-term wants and possible/probable future needs and strategies. In particular, a gaze into the crystal ball regarding future funding plans, and possible exit strategies, and the needs and sophistication of owners and third parties who may be part of these processes, is a worthy (if not invaluable) endeavor in the early planning stages. Experienced counselwho after all are skilled at wiring, adapting and defending business entitiescan be instrumental in strategic structuring, as well as avoiding poor or ill-informed choices, in your empire building endeavors through proper entity selection.

Key Objectives of VC InvestorsWhat Makes Venture Capitalists Tick?

Just as a business manager must actively and continuously seek to understand the wants and needs of target customers, so too should the fund-seeking business owner seek to gain an appreciation of the perspective, goals, and objectives of potential investors. Armed with a solid understanding, owners and managers can save time, energy, and resources; plan for and anticipate investor needs; and more effectively consider, structure, and negotiate the investment transaction and surrounding agreements to meet owner goals.

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There are four principal objectives that influence a venture capitalists approach and behavior in the investment transaction process. The mating dance, due diligence process, and negotiations, and the structure, terms, and attributes of the investment itself18, largely flow from and are dictated by the VCs implementation and treatment of these objectives (and resolution of related issues): Maximizing the Upside (and potential investment returns) Protecting the Downside (and risks associated with the investment) Monitoring and Influencing Progress and Development (through governance and control mechanisms) Pursuing and Effecting Exit Strategies and Liquidity 1) Maximizing the Upside (and potential investment returns) RETURN ON INVESTMENTVenture capital firms are typically organized as funds, with the management of the fund (its general partner) serving in a fiduciary capacity to the funds limited partner investors (and with the managers typically also putting their own capital in play). VC funds seek deal flow in the form of investments in portfolio companies on an investment-by-investment basis, which can be sold or liquidated over a defined time horizon at (hoped-for) exceptional rates of return. Put simply, VC funds are in the business of realizing a net return on investment (ROI) across their portfolio of investments, at substantially higher return levels than other alternatives limited partners could choose to invest in, including from competing venture funds. These returns are necessary to justify the risks and indefinite periods of illiquidity inherent in investing in immature, high-growth private companies and to cover the firms operating expenses and override incentive compensation. By achieving exceptional rates of return, VC funds ensure their survival and success in the life-cycle of fundraising, investment, building/ramping, and liquidity (via executing on an exit strategy) and harvesting returns.

18. For a detailed discussion of structure, terms, and attributes commonly found in VC investment transactions (and influenced by venture capitalists core objectives), see Section III of this GUIDEBOOK, beginning on page 61, as well as ANNEX A, an illustrative Series A investment transaction term sheet (with commentary).

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Life Cycle of a Venture Capital Fund

Fundraising

Exit / Liquidity and Returns

Selection, Due Diligence & Investment

Building, V alue Adds & Exit-Ramping

VC FUNDS DIRECTIVE AND INCENTIVESVC funds are typically organized as limited partnerships: the management and investment professionals in the VC firm collectively serve as the funds general partner, while the investors in the fund become limited partners. Limited partners usually contribute 99% of the capital in exchange for the right to 80% of the net realized gains (net of the general partners annual management fee of 1.5% to 2.5% of the funds assets, to cover salaries, overhead and other operating expenses).19 The general partners 20% override (also known as the carry or carried interest) creates a powerful incentive to maximize the value of the funds investments and ROI. VC fundswhich realize the value of their portfolio investments through exits and liquidity events (most commonly, a company sale or initial public offering)look for overall returns of at least five times their investment over a seven-to-ten year fund period.20 To ensure their upside in the structure and contractual provisions surrounding their investment, VCs commonly look to the following features, terms and provisions:
19. The percentages referred to in this paragraph, which roughly reflect industry averages at the time of publication, vary depending upon market conditions and fund focus, size and maturity (and, of course, prior track record, results and returns). The management fee is sometimes structured to decrease in later years of the funds life (to reflect the smaller amount of remaining capital being put to work, and to put an emphasis on the General Partner earning the carried interest). In recent years, given depressed returns, limited partners have been applying pressure on VC funds to tweak terms in their favor. 20. See Pursuing and Effecting Exit Strategies and Liquidity, beginning on page 46. For illustrative purposes, to realize five times total invested capital (i) over a three-year period translates to a 71% compounded annual ROI, (ii) over a five-year period translates to a 38% compounded annual ROI, and (iii) over a seven-year period translates to a 25.8% compounded annual ROI.
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 Valuation and (fully-diluted) ownership percentage at closing Liquidation preferences and participating preferred features Dividend provisions21 Optional and mandatory conversion provisions (whereby the preferred stock is

converted into common stock)

Anti-dilution protections and related provisions In certain cases, staggered, staged and tranched (milestone-based) financings

RIGHT SIZING THE INVESTMENTWhile owners and managers will have their own views as to the amount of outside investment capital required or appropriate at a given stage of development, the VC will apply its independent analysis and perspective (as well as its fund requirements or protocols) to assess and determine the appropriate amount of funding, and capital resources, the company will need to fund its short- and medium-term plans, to remove or significantly reduce risks and to fund contingencies. Such capital (and capital resource) planning has been increasingly important in recent years when followon investors have been difficult, and sometimes impossible, to attract when needed. TIMINGAs the saying goes, timing is everything. In no area is this more true than in venture capital investing. The VC seeks to make its investment at the appropriate and most opportunestage in the companys life cycle. In other words, over an investment horizon of two to five years, the company must be able to achieve the growth and execute upon an exit strategy necessary for the VC to liquidate some or all of its investment and realize its desired rate of return for its VC fund investors. Venture investors in early-stage companies may seek to time their investment, with the obligation to fund (usually, at the initial agreed valuation) arising only if certain agreed milestones or inflexion points are met with success. However, because milestones are difficult to gain agreement on (and define with certainty) and because most companies want all the funding to be provided at one closing, the vast majority of VC financings are one-shot deals, with the agreed valuation, at the time of closing, appropriately reflecting future uncertainties. PLAN AND PROJECTIONSVenture capitalists must be able to chart and track the businesss course through growth, development, operational milestones, customer and revenue traction, profitability, and exit. This is essential for mapping the companys progress and evaluating capital needs and exit opportunities (and the timing of these). In order to achieve this, the VC must study and ultimately embrace the companys strategy, growth plan and related budget, and must construct a detailed, justifiable and reasonably obtainable set of operating and financial projections, typically covering three to five years. This analysis may result in a company not making the cut because it is too early (or, some21. In VC transactions, dividends are rarely mandatory (as cash is preserved to fund the growth of the business). Usually, they are paid if, as and when declared by the board of directors. Sometimes, the VC investor(s) require that a stated dividend accrues and is paid only upon a sale, redemption of preferred stock or other deemed liquidation event (which rarely if ever includes an IPO).
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times, too late) to capture the desired or optimal growth in value. The VCs objective will be to invest in the company prior to a significant increase in value, typically through the achievement of one or more substantial development milestones and/or ramping up of customers, revenues, or profits. MANAGEMENTDEPTH, RIGHT PEOPLE AND TAILORED INCENTIVESMost VCs subscribe and cling to the view that they do not invest in companies or products, they invest in people. After all, it is the peoplemanagement and key personnelwho make it all happen. Since these persons (particularly in early stage ventures) are often entrepreneurial, a challenge for the VC is, consistent with its own objectives, to craft and oversight an incentive structure in which (i) the VC supports and does not interfere with the proper functioning of managers and operation of the business, and (ii) management is provided with market-appropriate pay and real financial upside and incentives aligned with the VCs interests (creating a win-win scenario). The investment transaction, and related agreements, will also be structured to ensure that managers and certain owners have and keep skin in the game. The alignment of incentives and related compensation planning must be dynamic and flexible, continuing to work as the company grows, receives subsequent rounds of funding, and pursues and effects exit strategies. Of course, the structure needs to accommodate management additions and departures, and the VC will want the flexibility to make management changes and adjust compensation and incentives if that course best facilitates the growth and success of the business and its returns upon exit.22 CUSTOMARY STRUCTURE AND DOCUMENTSVC transactions have developed and evolved certain customary styles and forms, including extensive (sometimes believed onerous) due diligence and documentation utilized to ensure that the VCs key objectives are analyzed, addressed, agreed to and implemented. Fund-seeking business owners genuinely interested in VC funding must be willing to consider and work with what has become market and customary (and VC fund-required) structures, documents, and provisions. These include (as discussed elsewhere in this GUIDEBOOK) convertible preferred stock, with preferences, dividends, conversion rights, liquidation rights, and other superior economic features; anti-dilution protections; preemptive purchase rights and limitations on stock transfers; registration, co-sale, and other exit-related provisions; board membership and board oversight rights; management oversight, budgeting and periodic reporting requirements; and special governance (including consent, veto and information) rights and provisions. The principal investment agreements and documents utilized in a typical A Round investment transaction (also discussed elsewhere in this GUIDEBOOK) include the following:23

22. See Alignment of Founder and Management Incentives, beginning on page 71. 23. VC investors in some A round deals combine and simplify these documents and agreements. Illustrative (and annotated, with alternative provisions and commentary) forms of these and other VC transaction related agreements and documents can be found on the National Venture Capital Association website, at www.nvca.org (Model Legal Documents).

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 STOCK (OR SECURITIES) PURCHASE AGREEMENTa contract between the company

and the purchasers (i.e., the VC and other investors in the round), and sometimes also the founders, providing for matters relating to the purchase and sale of securities by the company (also called the issuer). These include provisions addressing the type and amount of securities to be purchased and sold, the purchase price, representations and warranties by the company (and sometimes the founders), investment representations by the purchasers, covenants relating to the transaction, indemnities, and conditions to closing. The stock purchase agreement typically does not include obligations on the part of any parties after the closing(s) has occurred. RESTATED CERTIFICATE (OR ARTICLES) OF INCORPORATION AND CERTIFICATE(S) OF DESIGNATION (covering one or more Series of preferred stock)this document, often referred to as the charter, is a creature of state law (in the state in which the company is incorporated) and is filed with that states secretary of state.24 The charter sets forth the rights, preferences, terms and provisions of the subject security (typically, convertible preferred stock). Provisions in the charter include: size and election of board members; how board and stockholder meetings may be called; and preferred stock dividend, liquidation preference, conversion rights/obligations, antidilution adjustments, voting (and veto) and protective provisions, and redemption rights/obligations. INVESTOR RIGHTS AGREEMENTa contract between the company and the purchasers that usually contains and addresses registration rights, covenants regarding rights to financial and other information, board observer rights (if any), other affirmative and negative covenants, and rights of first refusal on new issuances of securities by the company. VOTING AGREEMENTa contract between the company, the purchasers and key common stockholders (including founders and management) that contains agreements on the size and composition of the board (and related matters), remedies, and term, and which may contain so-called drag-along rightsin essence, rights that allow the purchasers (the VC investor(s)) or the holders of a specified percentage of outstanding shares to require all stockholders to approve, vote for and participate in a sale, change of control and/or deemed liquidation event of the company.25

24. The charter is a public record, not a contract. It can only be amended in compliance with the applicable state corporation statute, which usually requires (1) both board and stockholder approval, and (2) subsequent filing of the amended charter with the secretary of state. 25. The drag-along right facilitates the VCs exit strategy and prevents holdouts from blocking a sale of the company (or other significant liquidity transaction) where the buyer is only interested in buying 100% stock (or equity) ownership (or where 100% participation and/or approval is otherwise required). Care should be exercised in agreeing to drag-along rights, particularly in cases where the VC investor has negotiated special (e.g., participating preferred) economic rights and thus where being forced to go along with a VC-approved transaction may not be in the common stockholders best interests.
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 RIGHT OF FIRST REFUSAL AND CO-SALE AGREEMENTa contract between the com-

pany, the purchasers and key common stockholders (including founders and management) the principal purpose of which is to impose restrictions on transfers of stock owned by founders and management. Thus, where founders or management propose to sell shares they own to a third party, the agreement usually requires that the founders/management give the company first, and the (VC) investors second, notice of the proposed sale and grants the company/investors a right of first refusal to purchase the shares (on a pro rata basis) or, alternatively, allows the investors to sell a pro rata portion of their shares alongside the selling management/founder stockholders. 2) Protecting the Downside (and risks associated with the investment) Given the substantial risk and illiquid nature of venture capital investments, no amount of due diligence or financial modeling, or attention to structure and protective provisions, can protect a VC from the occasional failure and loss of investment. In fact, the inherent risk of failure and the difficulty of achieving success in terms of return on investment is often what makes the investment attractive in the first instance. Notwithstanding this, certain structural mechanisms and protective terms have evolved and become customary to help VCs obtain maximum protection of its capital investment in portfolio companies (whether the company underperforms, goes sideways, or fails). For the uninitiated, the documents drafted and served up by the VCs counsel will appear overly onerous and unfair. However, these documents and many of the provisions they include have become rather customary and, in many cases, the company will have few (if any) other places to go for equity funding of like amount or at this stage in its development. As a general proposition, market investment documents contain terms favorable to investors. As well, business owners should appreciate that, from an independent, outside perspective, the risk of non-performance, failure or inability to realize a return on investmentand thus the need for protections (particularly in view of the amount of capital placed at risk)is very real. Experienced, deal-tested advisors can provide valuable guidance in understanding and navigating the complex weave of contractual requirements and in negotiating terms to the owners maximum advantage (or minimum acceptable disadvantage). Some of the often-utilized structural mechanisms and protective terms (guarding the downside) include:26

26. For a more detailed and extensive discussion of the strategies, mechanisms, and provisions employed (to protect the downside) in distressed markets and follow-on down rounds, see Considerations in Obtaining Venture Funding and Negotiating Terms in Distressed Markets and Down Rounds, beginning on page 50.
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 Use of convertible preferred stock (and surrounding provisions)with economic,

control and other rights and protections not given to holders of common stock (who are typically founders, employees and prior round investors)27 Liquidation preference (and participating preferred) provisions, providing the VC investor(s) with a preferred return upon a liquidation or deemed liquidation (typically, merger, sale of substantially all the assets, and majority change of ownership) of the company Anti-dilution price protectionswhere an adjustment provision is triggered if the company later issues equity securities at a price which is less than the price paid by the VC investor(s) (comparing the securities on a converted to common basis); these provisions typically include certain exceptions, e.g., for shares issued under stock incentive plans, to facilitate acquisitions or to certain strategic partners or lenders Staggered, tranched and milestone-based investment closings where (i) a limited amount of capital is funded at an initial closing, and (ii) the investor(s) obligation to fund the balance, in one or more later tranches (or closings) and at the same valuation, is conditioned on the companys satisfaction of certain agreed milestones or deliverables Board and preferred stockholder veto rights (often also referred to as protective provisions) on issues impacting the rights or value of the preferred stock or concerning actions resulting in a change in direction, variation from budget, material new licenses or increased borrowings, changes in senior management or auditors, etc. Pay to play provisionswith features designed to penalize existing investors who do not participate in a later round of financing and/or to reward existing investors who do participate Redemption (or put) rightwhere the VC investor(s) have the right to require the company to repurchase their preferred securities at a specified price (typically, investment price plus accrued dividends, with payment made in installments over an agreed period) if the company has not closed a sale, initial public offering or other specified liquidity event within a specified number of years (typically, five to seven years); this provision is rarely (if ever) utilized, but is intended to provide leverage to VC investors to ensure that management, before a specified date, actively pursues and closes a sale of the company or other substantial liquidity event (with respect to the VCs investment) Grant, vesting, exercise and other restrictions included in employee incentive compensation plans and option and restricted stock grants
27. Although not considered mainstream for VC investments, some VCs (and other sophisticated investors) have structured all or part of their investment as debt or convertible debt (which may be secured by the companies assets, will have priority on liquidation of assets to all equity securities, and which benefit from other legal and contractual rights and restrictions.
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 Other covenants and protectionsincluding the obligation of the company to main-

tain D&O insurance from a solid insurer of a minimum specified amount and key man life insurance in specified minimum amounts on specified individuals 3) Monitoring and Influencing Progress and Development (through governance and control mechanisms) Anytime a business proposes to add a significant equity owner, a thoughtful, transparent discussion should take place regarding the game plan and related timeline for the companys use of investment proceeds, achievement of key milestones (e.g., key management hires, customer penetration, revenue and profitability hurdles, regulatory approvals, product prototype(s), and product testing/validation), organic and external growth, and ultimate liquidity or exit. And, as part of this, issues concerning the governance of the businesswho will have a seat at the table (board membership), and what say or veto rights will the owner constituencies have over key issues, in good and not-so-good timeswill need to be considered and addressed. Founders, managers and other insiders initial concern regarding these issues (sometimes expressed as a loss of control) is often exaggerated and unfounded. Venture capitalists, as a general rule, have no desire to run, or get intricately involved in, the day-to-day operations of the company (so long as it is proceeding in accordance with the agreed plan). However, VCs can be expected to insist upon (1) being kept informed and current concerning the business, management, competitive position, growth (internal and via acquisitions), capital resources, financial condition and results of operations of the company, and (2) ensuring that the company stays on, or ahead of, the agreed plan (consistent with the related agreed budget). Each venture capitalist will implement a report, information exchange and communications regime and processtypically centered around monthly reports, fairly frequent board meetings and the budgeting processto satisfy its needs in this regard. To the delight of most portfolio companies, VCs function as true value added partners, bringing investment, financial and other expertise, experience, contacts, encouragement, and proven success to and for the benefit of the company. As a formal matter, governance and control mechanisms are agreed to and documented through various provisions included in three of the principal documents commonly used in VC transactions: the Certificate (or Articles) of Incorporation (and related designation of preferred stock) and Bylaws, the Investor Rights Agreement, and the Voting Agreement. As a practical matter, and absent a crisis, virtually all matters regarding governance of the business, and controls or restrictions on non-plan activities, are worked out in informal sessions and information exchanges, board of directors meetings and through the budgeting process. Some of the often-utilized structural mechanisms and control provisions which VCs incorporate into the investment agreements include the following: BOARD GOVERNANCE PROVISIONSThe centerpiece of governance of a portfolio company is the board of directors (and the information provided to, robust consideration
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of, and important decisions required to be made by the board). For the uninitiated entrepreneur or business owner, once the investment transaction closes, the board of directors becomes far more than a formality, and assumes the role of a centralized information-flow and strategic decision-making focal point of the company. The board oversees and dictates the direction of the company; hires, oversees, and compensates senior management (and sets incentive bonus targets); ensures that appropriate controls are in place; reviews and approves significant contracts, financings, capital commitments, and acquisitions; reviews detailed periodic, sometimes monthly, information and reports; reviews and approves the annual (and quarterly updates of) budget and plan; reviews and approves quarterly and annual financial statements; and ensures that the company is proceeding in accordance with the agreed strategy and plan. Accordingly, given this central role and in connection with a planned investment transaction, important issues regarding the board of directors will need to be considered and resolved, including: the boards size and composition the number of members the VC (or new investors) will be entitled to designate and elect the number of members the founders (and existing owners) will be entitled to designate and elect whether independent board members will be required (and how they will be selected)28 the actions and matters that will require board approval the precise level of approval required for any specific actions or matters (and the extent to which one or more of the VC (or new investor) designated board members approval will be required what board committees will be required (e.g., governance, audit, compensation, etc.), and what the authority and composition of that committee will be whether any parties will be granted board observer rights (and the ability of certain non-board members to receive board-level notices, information, and reports)29 MANAGEMENT CONTROLSWhether through the board of directors (and/or committees of the board) or through contractual veto or control provisions, provisions surrounding senior management are also important to venture capitalists (and thus

28. The board composition-related provisions utilized in many VC transactions (regarding VCbacked portfolio companies) include a requirement that there be one or more independent directors (with relevant market and/or industry experience), typically designated by the VC (or new investors) and reasonably acceptable to the founders (and/or existing owners). 29. Board observers do not owe fiduciary duties to the company and, absent contractual restrictions, do not have confidentiality obligations regarding materials and information they receive. In addition, observers should be excused from any portion of a board or committee meeting at which attorney-client privileged information is discussed.
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included in the transaction agreements). Before the transaction is closed, employment and restrictive covenant agreements for senior management, as well as the form of (and perhaps initial grants under) an employee incentive compensation plan, are usually negotiated and put into place. Many VCs require that they have reasonable approval rights with respect to the selection, hiring, compensation and termination of key senior management, and also have control over (or, at a minimum, a voice in) decisions regarding the terms and provisions (e.g., size of award, exercise price, vesting terms, etc.) of incentive compensation grants. Finally, through negative covenants (and so-called veto rights), certain actions, arrangements and transactions may not be pursued by management absent board (or, in some cases, stockholder) approval. Together, these provisions provide for important checks and balances on the persons charged with the day-to-day management and operation of the business in which the VC has invested substantial capital. VETO, NEGATIVE COVENANTS AND OTHER PROTECTIVE PROVISIONS have become standard in VC transactions. These provisions are effected through two essential mechanisms (and iterations of them): (i) requiring a class vote of the preferred stock (and thus giving the holders of the preferred stock a veto right), a specified or greater-thanmajority (preferred) stockholder vote,30 or other special voting rights or requirements of stockholders; and (ii) requiring a board vote, or a special board vote (e.g., one joined in by the VC-designated and/or independent directors). Actions by the company over which VC (or new) investors may seek to require such veto, blocking or control rights include: authorizing or issuing equity securities senior to or pari passu with the preferred stock a sale (including sale of all or substantially all the assets), change of control or deemed liquidation of the company amending any provision in the companys charter or organizational documents in a way that adversely affects the rights or preferences of the preferred stock increasing or decreasing the authorized number of directors constituting the board redeeming or purchasing any outstanding company securities (other than pursuant to the incentive compensation plan, employment agreements or other VC-approved agreements) declaring or paying dividends on any capital stock incurring indebtedness or making capital expenditures over a specified dollar amount taking any action which is materially (or more than X%, individually or in the aggregate) in variance with the approved budget
30. An important corollary issue with these protective (stockholder voting) right provisions is determining the appropriate percentage threshold that applies (e.g., majority, 66-2/3%, 75%, 80%). In some cases, there are multiple protective provisions with different levels of approval requirements. To assess the appropriate protective/veto thresholds, it is important to analyze the post-financing pro forma capitalization table (after the final ownership numbers have been worked out). Remember that the VC investor(s) (and representatives) you are dealing with in the investment transaction negotiations may be different than the ultimate holders of preferred stock.
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 increasing the number of shares reserved for issuance under the companys

incentive plans and agreements

entering into any new line of business, or significantly changing the nature or focus

of the companys business

creating any subsidiaries which are not wholly-owned and/or taking any of the fore-

going actions via any subsidiaries 31 FOUNDER AND MANAGEMENT PROVISIONSIn most cases, the capital-seeking business is substantially dependent on one or more founders and/or key members of management, whose lossor diminished commitmentwould clearly be detrimental to the company. Founders and senior managers, naturally, have an interest in clearly defining, structuring, and protecting their participation in the businesss governance and management, as well as their continued role, position, employment, and compensation following the VC investment. The agreements and related restrictions are usually addressed in two categories: 1. STOCK OWNERSHIP AND INCENTIVESVC investors are intent on making sure that equity holdings (including previous holdings by founders and others who have contributed to the business) are right-sized and facilitate win-win decision-making and plan implementation. Thus, VC investors may insist that vesting provisions be (retroactively) imposed on some of the founders shares. VCs will also negotiate the overall size of the equity incentive plan reserve or pool (typically, in the range of 10% to 20% of fully-diluted shares post-financing), vesting schedules and terms for options and restricted stock grants and whether founders will be entitled to participate. 2. EMPLOYMENT AND RESTRICTIVE COVENANT AGREEMENTSVCs are not wild about employment agreements for founders or even for management in earlier stage ventures (they are more frequently used for senior management brought in at later stages). As a means of both protection of the business and some measure of control, VCs typically (almost always) require that, as a condition to the investment closing, (i) key management personnel and founders enter into non-competition agreements, and (ii) all personnel and (IP and/or technology engaged) consultants sign confidentiality and assignment of invention agreements. 4) Pursuing and Effecting Exit Strategies and Liquidity As noted previously, VC funds are in the business of investing their capital to realize exceptional internal rates of return. These returns are created, and are only realized, if

31. The length and detail included in the list of protective provisions varies from VC to VC, with East Coast-based VCs tending to have somewhat longer and more detailed lists. Consideration should be given as to whether certain of the identified protective provisions should more appropriately be addressed at the Board level (e.g., requiring the approval of the board or the board including board members designated by the VC investors). This provides for a more informal and collegial way of addressing these issues (and also can avoid certain formalities, expenses and chasing of consents or approvals).

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and when some measure of liquiditythe ability to sell for or otherwise receive cash attaches to the securities the VC received when it initially invested in the portfolio company. Liquidity, in turn, is the function of the company availing itself (typically, with the VCs guidance, input and sometimes control) of one or more exit strategies. Exit transactions, like other major developmental milestones, have many facets, present many challenges and can require months, even years, of prior positioning, planning and preparations.32 Strategies providing liquidity include the following: SALE OF THE BUSINESS. The prevailing exit strategy of choice, particularly given recent and current market conditions, is the outright sale of the business, whether through merger, consolidation, sale of stock, or sale of assets. Preparations for and control over the decision to sell the company (and the timing of any such decision) are key, so the VC investor will require a say, if not control or veto rights, regarding this decision. Control (and the resolution of governance and approval issues) at the Board and/or stockholder level is also important as the sale of a company typically requires the approval of both the Board and stockholders. Whether the buyer is strategic (i.e., an operating company in the same industry and/or market) or financial (e.g., a buyout or private equity fund or hedge fund) can greatly influence the approach, due diligence requirements, timing, negotiation, documentation, and terms and conditions of a sell-side transaction. Given the importance of a properly timed and executed sale exit, VCs arestarting as early as shortly after the investment closingpursuing the strategy of developing the corporate platform, instilling budget and financial discipline, improving and adding to the management team, ramping up sales and financial performance, and achieving other milestones in contemplation of the companys sale. Accordingly, the game plan will incorporate these tasks and milestones (and managements incentive compensation may, in some measure, be dependent on achieving them). Control over the decision to sell the company (and possible drag-along rights and the specific thresholds and terms of these) will be a key area of focus here. Company insiders can expect the VC investor(s) to require a say in, if not control or veto rights over, these decisions. Capital-seeking companies must keep in mindat all phases of developmentthat much of the attraction in a sale is the depth, commitment, focus, and creativity of the management team and key employees. As a result, companies should consider and develop appropriate equity ownership, incentive compensation and employment plans and arrangements well in advance of a transaction, to ensure the continued retention and dedication of key personnel.

32. Challengeswhich experienced counsel can be instrumental in addressinginclude navigating and resolving a myriad of charter, bylaw, loan, investment agreement, and incentive plan and employment agreement issues (and preferences, priorities, rights and obligations) to clear the way to and effectuate the exit, and addressing (likely) board member conflicts of interest.

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PRACTICAL TIP:

Given the current state of our markets (regarding exit transactions), most VCs are from shortly after the investment closingpursuing the strategy of developing the corporate platform, improving the management team, ramping up performance, and achieving other milestones, all in contemplation of a sale transaction (and the likely demands of potential strategic and financial buyers), while at the same time not forelosing the opportunity to plan for and pursue an IPO.

INITIAL PUBLIC OFFERING. An initial public offering (IPO) is the first underwritten public offer and sale of shares of the companys common stock (typically) to a large and diverse group of institutional and individual (retail) investors. An IPO transaction will not be appropriate for most VC-backed companies, and involves very extensive preparations, build-outs and filings, and very substantial costs. This highly regulated process typically results in the shares being listed or quoted on a recognized exchange (e.g., the New York Stock Exchange or NASDAQ Stock Market) and a free-trading market for these shares. It also results in various stringent and ongoing reporting, disclosure and other obligations of the company and its officers, directors, and significant stockholders. Depending on market conditions and other factors (such as negotiated rights and requirements imposed by underwriters), shares owned by founders, management, and VCs may also be registered and sold in the IPO, but typically such sales are limited. Registration rights (usually embodied in the Investor Rights Agreement)33 and similar contractual provisions are designed to permit the VC to control or influence the share registration process, and to permit registration and sale of its investment interest first, before the founders and other insiders and common stockholders. Demand rights, piggyback rights, S-3 rights, offering expenses and various limitations and exclusions34 are all the subject of discussion and negotiation (and these rights and provisions, which can be both time-consuming and expensive to the company if exercised, are of increasing importance as and when the IPO market stabilizes and proceeds to some stage of normalcy). Once the company has completed its IPO (or other share registration) and thus has gone public, the VC may also achieve its desired liquidity (after a lock-up period required by the underwriters) through open market sales. These sales must be made in compliance with Rule 144 under the federal securities laws or through a secondary (or

33. For a more detailed discussion of registration rights, see Registration Rights, beginning on page 69. 34. Demand rights refer to rights entitling a specified percentage-in-interest of investors to require the company to register shares of common stock received upon conversion of their preferred shares. The right is usually not effective until at least six months after the IPO is consummated (or by a certain date if no IPO has occurred).
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follow-on) registered public offering of securities, with the pecking order and other terms for sales in such offering established through the agreed registration rights.35 Of course, the ability to consummate an IPO depends upon many factors (a discussion of which is beyond the proper focus of this GUIDEBOOK).36 These factors include the relative health, depth, and receptiveness of the stock market and, in particular, the market for new issues (by companies in industries comparable to yours)in terms of industry, size, maturity, and other dynamicsat the time the IPO registration process is completed (thus, requiring some crystal ball gazing as the company spends its way toward a hopefully successful registration process). In addition, companies contemplating an IPO must consider (and should obtain expert advice regarding) the regulatory, reporting and disclosure regime and burdens to which public companies, their directors, officers, and insiders are subject. Sweeping changes in the regulatory landscape impacting IPOs and public companies have been effected (and will continue) as result of the Sarbanes-Oxley Act, the Dodd-Frank Act, SEC rulemaking, and related and other changes in New York Stock Exchange, NASDAQ, FINRA37 and other listing standards and rules. Companies contemplating going public must be mindful of the increased importance of careful, well-in-advance planning and preparation (as well as the considerable costs and possibility of an unsuccessful offering). PRACTICAL TIP:

Given choppy markets and the regulatory environment, planning and preparation has increased in importance. Exit and liquidity-related rights and obligations will be negotiated and embraced in the VC investment agreements. Long before an IPO, cultivate relationships with investment bankers; obtain compliant audited financial statements (and ensure auditor independence); establish and document internal controls and procedures (and remedy all deficiencies); address insider arrangements and transactions; build a solid board of directors; and attend to corporate governance matters.

35. Rule 144 (under the Securities Act of 1933) was recently expanded and liberalized, providing significantly more flexibility and fewer conditions, for VC and other significant stockholders to sell their shares in the public market following an IPO. For further discussion regarding registration rights commonly addressed in VC transactions, see Registration Rights, beginning on page 69, as well as ANNEX A, an illustrative Series A investment transaction term sheet (with commentary). 36. See also Going PublicThe IPO, beginning on page 13, and the resource materials referenced therein. 37. FINRAor the Financial Industry Regulatory Authorityis the largest independent regulator for all securities firms doing business in the U.S. Its mission is to protect American investors by making sure the securities industry (including its brokerage firms and registered securities representatives) operates fairly and honestly.
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OTHER EXITS AND PATHS TO LIQUIDITY. The most prominent, sought after and successful exit strategies have been discussed above. Of course, a VC could also sell all or part of its investment position in the company to another VC, private equity fund, or other third party. This does not happen often and may be a sign of trouble (or of a fund nearing its termination date). Partial liquidity can also be gained through a recapitalization, dividends, and stock repurchases, but these are not usually preferred exits. Finally, where there are assets of value (and indebtedness and other priority claims dont exceed that value), liquidity can be obtained through a liquidation, wind-up and distribution of assets. Put simply, if the companys outright sale or initial public offering cannot be accomplished after diligent effort within the planned time horizon (plus some reasonable extension), then the VCs liquidity options become limited, and Plan B considerations kick in. Remember, given its preferred position, advantageous rights and the other attributes of its investment, if the VCs position is not good, the position of the founders, previous owners, managers, and other insiders will usually be worse. This scenario triggers a new, often complex and troublesome, phase for the business and its owners: regroup and reset expectations, reconfiguring and recapitalizing, (possibly) identifying new capital and investors (and dealing with their demands and terms), and execution challenges. Considerations in Obtaining Venture Funding and Negotiating Terms in Distressed Markets and Down Rounds In times of economic and market distress and dislocation, obtaining needed funding (including follow-on, subsequent round funding) becomes more important and more difficult, with deal structures and terms (for those fortunate enough to receive funding) favoring new investors. Although VCs and other well-capitalized investors likely will have negotiating leverage, fund-seeking business owners and managers have certain techniques and tools at their disposal to protect their interests, leverage their position, and negotiate terms to their advantage. Venture capitalists seek out businesses run by strong management teams who distinguish themselves from their competition, position themselves to exploit large and growing markets, and adapt, navigate, and execute to build value in good times and bad. Much like the economy and public company investment and trading markets, venture capital is a cyclical business and industry. These cycles have come and gone in the past (although theyve come more frequently than gone in recent years). They will do so again. The question is simply this: which business ventures will successfully navigate the obstacles and seize on the opportunities to raise needed capital, and survive and even thrive, when challenged with distressed markets or other unfavorable conditions? As noted previously, obtaining VC funding is a challenge of the highest order, which only can be overcome by the right combination of company attributes (e.g., management talent and depth, proprietary products or services, market positioning, sizeable and

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sustainable growth, and substantial potential return on investment), investor appetite and focus (and the right fit with the investor(s), in terms of size of investment, market/industry sweet spot, stage or maturity preference, and value-adds) and timing (in many cases, dictated by a combination of the above plus a fair sprinkling of luck and circumstance). Obviously, obtaining venture funding in times of economic distress and/or market turmoil makes the challenge all the greater. Understanding the challenges Much has been written, spoken, and blogged in recent years about all the dysfunction, dislocation, and challenges, particularly concerning economic, credit, employment and market conditions adversely impacting public and private U.S.-based companies. There is more than enough bad news to go around, and many experts and commentators believe thatalthough some promising signs and pockets of increased activity have emergedan end to the downturn is not yet in sight. These conditions obviously have impacted the venture capital market, as evidenced by a number of fairly well publicized data points: Through the second quarter of 2010 (as compared to 2009), venture financings (both in terms of number of transactions and aggregate dollars invested) were, with few exceptions, down significantly across all regions, industries, and stages of development.38 Exit and liquidity transactions closed by venture-backed companies (whether through IPOs, which have been nearly non-existent, or sale transactions) are down to near historic lows.39 Early stage financings and Series A rounds are down significantly (both in terms of number of transactions and aggregate dollars invested).40 Angel and angel-led investment rounds also are believed to be down substantially (due to steep declines in many angels personal net worth and increased conservatism in approaching new private, illiquid investments). Venture capital financings that are successfully closing largely have been characterized by (i) long, extended due diligence investigations (both pre- and post- term sheet or letter of intent); (ii) mostly follow-on (e.g., Series B, C and D) investments by existing venture capital and other investors; (iii) later stage, growth and expansion stage investments in select industries; and (iv) in the early stage space, best of breed companies, run by experienced management teams, well positioned in a large, high-

38. PricewaterhouseCoopers and National Venture Capital Association 2010 Money Tree Report (Q2 2010 Results) based on data provided by Thomson Reuters (www.pwcmonetree.com) (the Q2 2010 Money Tree Report). 39. Dow Jones VentureSource Q2 2010 Liquidity Data (www.venturesource.com). 40. PricewaterhouseCoopers and National Venture Capital Association 2009 Money Tree Report (VC Investments Q2 2010Charts re: Investment Deals and Dollars by Stage).
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growth market, often with a business model and focus that takes advantage of current market dislocations, and/or with a strategic or joint venture partner in place. Approaching the (limited) opportunities Opportunities for attractive venture capital investments can be found and closed, despite and in some cases because of the difficult economic, investment, credit, and market conditions. To do so, however, requires a thoughtful examination and understanding of what VC funds are doing (and what influences their investment behavior), as well as a look at what happened following the last substantial venture market dislocation (in 2002, after the burst of the Internet bubble). In a distressed economic climate and market, it is especially important to understand that VCs operate as fiduciaries and managers of Funds (pools of investable capital), where only (albeit a very important) part of their function and duty is to identify, meet the management of, diligence, come to terms with and fund new portfolio companies. VC personnel perform other important functions, and, in distressed times, the urgency and combination of these other functions can occupy most of their time. These functions include communicating with the Funds limited partners (i.e., the investors in each fund) and assisting portfolio companies with, among other things, management changes, business repositioning, add-on acquisitions, credit and loan issues and, of course (for those deemed worthy), additional funding and exit/liquidity transactions. With depressed market valuations and limited exit opportunities, VCs find themselves with mature, later stage portfolio companies that require continuing substantial oversight and capital infusions to reassess and refocus priorities, stabilize, grow (or perhaps survive), and reposition for exit opportunities. So, what are the opportunities for VCs, and how does this affect companies (and entrepreneurs, owners, and managers) seeking VC funding? Logic would dictate, and a survey of the post-2001 era of VC investing confirms, that economic distress and market downturns result in lower valuations (including for very good, well positioned companies), lessened competition (as many companies will be distracted or adversely impacted to the point that focus is diminished, growth is not an option and survival is threatened), market dislocation (the flip-side of which is market opportunity) and thus highly attractive investment opportunities. Venture capitalists have long recognized thissome of the best-performing VC funds in history produced their vintage performance years by providing substantial capital, as well as business-building, teambuilding, and market-positioning experience and assistanceduring harsh economic times and low valuation environments. Of course, portfolio company managements must be good and agile partners, adapt quickly to change, think out of the box, and sometimes even reinvent themselves or their business models. When this works, and the economy and markets eventually recover, the portfolio company regains its footing and is well-positioned to grow, perform, exploit opportunities, and pursue exit strategies with greater focus, in a more robust market, and at a higher valuation. In times of

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economic and market distress, the capital raising process should be approached with care and sensitivity and with a recognition that there likely will be stops and (re)starts, disappointments and resets, and that the process will require considerable time, planning, adjustments, and patience. What terms and approaches are important?41 In challenging and difficult times (including poor economic conditions affecting business models and prospects, and the increased need and competition for investment dollars), deal structures and terms typically favor new investors. In many cases (when fresh capital must be raised to survive), existing owners are the only ones available to fund the company until the economy recovers and markets (and available investment dollars) move to some semblance of normalcy. Assistance and counsel from experienced advisorsbefore structure and terms are agreed upon and through documentation, negotiation, and closingis critical. Venture capital investors are professional and deal-tested negotiators, often assisted by teams of advisors. Although VCs likely will have negotiating leverage (with time working in their favor), fund-seeking business owners and managers have certain techniques and tools at their disposal to protect their interests and leverage their position. By working closely with experienced advisors conversant with venture capital transactions and participants, portfolio company founders, managers, and insiders can gain an edge in navigating the process, positioning themselves, and negotiating terms to their advantage during challenging times. While each companys leverage and circumstances will vary, there are some practical realities, contractual protections, and legal considerations that business owners and managers should understand and evaluate in negotiatingto the companys maximum advantage under the circumstancesa venture capital investment transaction (whether the first VC round or a follow-on round). Negotiation strategy, throughout this fluid and dynamic process, should be thoughtfully considered and crafted as well. In this regard, it is often a mistake to fight on every point. The capital-seeking business should consider, based on its own unique position, strengths, attributes, and circumstances, the terms it cares (or should care) most strongly about, and be prepared to give ground on other terms. In short, it is important to determine what is most important for the business, existing owners and key personnel and future prospects, and focus most intently on (the terms that drive) those items. The following are likely the most relevant structures and provisions that will be negotiated, and also provide some important process considera-

41. In addition to the text that follows, see Section III of this GUIDEBOOK, beginning on page 61, for a detailed discussion of the various terms commonly included in a VC term sheet and transaction, as well as ANNEX A hereto, which offers an illustrative Series A investment transaction term sheet (with commentary).
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tions, for a VC investment transaction effected in challenging economies and markets or in a down round financing.42 VALUATIONThe agreed pre-money valuation dictates the percentage of total company equity the new investor(s) will get (and, conversely, the founders, existing owners and managers will be left with) when the investment transaction closes. Valuation certainly is important, and entrepreneurs and business owners should obtain assistance in understanding and arriving at a fair valuation (or valuation methodology). Not infrequently, however, existing owners become fixated on a specific valuation (or value level), and some even fall on their sword when new investors do not get all the way there. Remember that if needed funding is not obtained all owner equity may become worthless. LIQUIDATION PREFERENCE AND PARTICIPATING PREFERRED STOCKThe liquidation preference (of the securities issued to the new investors) is perhaps the most critical economic term in a VC transaction. Put simply, this provision ensures that the new investors get their money back (perhaps, and then some) before other, junior investorowners receive anything. In addition, VC investors often insist on receiving participating preferred stock, which ensures that (in a sale or deemed liquidation event) they get both their liquidation preference and then share pro rata in whatever funds are available for distribution to common stockholders.43 In challenging markets and in down rounds (or where investors otherwise have leverage), investors may seek multiple liquidation preferences (e.g., where they would be entitled to receive two or three times their investment back before other owners would receive anything).44 This provision correlates with and affects other provisions, and is worth emphasizing in negotiations. Fight hard to keep the liquidation preference at one times the investment (or, failing that, to provide
42. In a down round financing, a company issues securities (typically, convertible preferred stock or preferred LLC interests) to investors at a value (on a per share or per unit basis) that is less than that paid by previous investor-owners (or in a previous round). This translates into the new investors (i) paying a lower price per share, and (ii) typically receiving certain rights and preferences that are superior to those granted to the previous rounds investor-owners. While prior (including initial) investors may have negotiated contractual protections (usually in the form of anti-dilution provisions) when they invested, as a condition to the consummation of most downround financings, the new investors usually require that existing investors waive such protections. Founders and common stockholders typically have no anti-dilution protections (and thus are adversely impacted both by down round financings and by new investor anti-dilution protections). 43. See Section III of this GUIDEBOOK, beginning on page 61, for a detailed discussion of the term convertible preferred stock, the security of choice for VC investors (although, in certain distressed deals and bridge rounds, convertible notes have been utilized as well). 44. According to the Dow Jones Venture Capital Deal Terms Report (2009 Edition) (the 2009 Deal Terms Report), of the 200 U.S. company responses received in the survey, 76.9 percent reported a liquidation preference associated with their latest financing at a one times (1X) return, while 6.4 percent reported a liquidation preference greater than a two times (2X) return.
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for circumstances or performance conditions where an agreed multiple liquidation preference would drop to one times the investment). ANTI-DILUTION PROTECTIONThese provisions provide for protection and adjustments in the event the company subsequently raises capital through the issuance of equity securities (or securities convertible into or exercisable for equity securities) at a lower valuation (or at a lower price per share or unit).45 If the company is involved in a follow-on round of financing, it will first have to sort through and address existing stockholders anti-dilution protections. Anti-dilution protection comes in two forms. In challenging markets and in down rounds (and where VC investors have clear leverage), certain investors may seek full ratchet protection. Full ratchet provisions adjust the exercise price or conversion ratio of a security to the lowest price at which any securities (including convertible securities, options, and warrants) are issued in a future round (without regard to the number of shares issued). Since companies cannot guarantee that future capital raises will be at up or even flat valuations because of current economic and market conditions, proceeding in the face of a full ratchet provision could result in substantial voting and economic dilution to previous owners (including management).46 Companies must be aware of the different types of anti-dilution provisions and their potential consequences. If full ratchet is requested, negotiate hard for the second form of protection, broad-based weighted average anti-dilution protection47 (or, failing that, to provide for a time-based sunset provision on the full ratchet and/or other conditionsperhaps including where the company raises a specified amount of capital at an equal or higher valuationunder which the full ratchet provision gives way to a weighted average provision). Appropriate carve outs from the operation of anti-dilution provisions also should be considered based on the companys particular circumstances, leverage, capital structure, and plans.
45. This form of protection is sometimes referred to as price anti-dilution protection. All VC transactions also include structural anti-dilution adjustmentse.g., where the conversion ratio or price is adjusted for stock splits, stock dividends, and similar events. 46. Venture capitalists are well aware of the importance of managers and key employees to the success of a venture (including its management, growth, navigation of challenges, and ultimate pursuit and execution of an exit transaction), and in creating appropriate structures and arrangements to align interests and incentivize performance. This awareness is not lessened, and in some ways may be heightened, in the context of successfully closing a funding transaction under distressed conditions (or in a down round). See the discussion in the text that follows regarding Employee Retention Bonus Plans. 47. A full-ratchet anti-dilution provision is most favorable to VC investors. According to the 2009 Deal Terms Report, less than 15% of the companies responding said that their investors required full-ratchet protection. By contrast, weighted-average anti-dilution provisions (whether broad-based or narrow-based)accounting for nearly 60% of respondents to the 2009 Deal Terms Report surveyprovide for more balanced protection, since they take into account the dilutive impact of the issuance in question based on such factors as the number of shares and the price involved in the dilutive issuance and the number of shares outstanding before and after such issuance.

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For example, there is generally an exception for grants under the companys incentive compensation plans; sometimes, other potentially dilutive stock issuances are excepted (e.g., warrants or shares issued in acquisitions, and to strategic partners and lenders). Some companies have been successful in insisting on a pay-to-play condition on exercise of anti-dilution protectionsi.e., in order for a VC (or other preferred stockholder) to take advantage of the anti-dilution protections, it must have participated in the dilutive financing round in question at its full pro rata allocation. DRAG-ALONG RIGHTSVC investors often request (or insist on) so-called drag-along rights.48 Put simply, armed with these rights, if the new investors (or a certain required percentage of them) support a later proposed merger, sale or change of control transaction, they can (essentially) force all other owners to go along with it (and to vote or consent in favor of it). This could include a deal (depending on the all-important liquidation preferences) in which those owners who are dragged along get little or nothing. In distressed markets and down rounds, investors may request more onerous and restrictive drag-along rights. Unless the company has real leverage, it is often difficult to eliminate these rights, so (1) negotiate and limit as best you can, and (2) focus on the liquidation preferences (and other important implicated provisions). MILESTONE, TRANCHED OR STAGED INVESTINGIn milestone (also known as staged or tranched) financings, the investor agrees to fund only a portion of the total agreed capital raise (e.g., enough working capital to get the company operating and/or achieve one or more specific objectives that contribute to an increase in valuation) at an initial closing, with the balance fundedat the same initial valuationbased on the achievement of agreed milestones or deliverables or the lapse of agreed time periods. The milestones are usually based on operational or financial benchmarks included in the companys budget and plan. Tranched financings appear most common for early stage (first round) life sciences companies. Tread cautiously here. Defining milestones and conditions, and thus being assured that the investor does not have (or take) an out on future commitments, can be difficult, distracting, and time-consuming. Managers may be faced with funding uncertainty and the constant pressure to raise funds. Also, valuation (which is locked in from the first tranche, even though the balance of funding is being provided after the com-

48. According to the 2009 Deal Terms Report, of the 200 U.S. company responses received in the survey, 70.5 percent reported that their financing round included a drag-along right in favor of the investors. 49. There are of course contrarian views (voiced by investors) with respect to staged financings. A staged payment in a first round can be an alternative to having to complete two (full) roundsbetter to have management focusing on company development as opposed to a new fundraising effort. In addition, some VCs believe that staged financings provide a useful tool in enforcing spending discipline (of course, there are other ways to achieve that end, including an agreed budget and spending process). In any event, with the exception of life science and biotech investments (which have important, clearly definable development milestones), and certain first round/early stage investments (particularly in the IT space), staged financings remain the exception.
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pany matures and tackles important value-enhancing objectives), should be reviewed carefully. These provisions potentially put the company in a vulnerable, disadvantageous position. Negotiate hard for a single closing, and a fully funded round.49 EMPLOYEE RETENTION BONUS PLANSDown roundswhich as noted above may include enhanced liquidation preferences and other provisions for new (preferred stock) investors which depress the value (if any) of common stock in liquidity eventscreate challenges in retaining and incentivizing key personnel. And in distressed circumstances, the need for focused and motivated management and key employees couldnt be greater. Down round issuers may deploy tailored employee retention bonus or phantom stock plans to fill the breach. Unlike stock option and restricted stock plans (which provide upside participation via common stock ownership, and which only have value after all liquidation preferences are paid), employee retention bonus and phantom stock plans grant employees with contractual rights to participate in liquidity events irrespective of stock ownership. Typically, these plans are structured so that (i) an employee is only eligible to participate only if he remains in the employ of the company through the liquidity event, (ii) some threshold minimum level of proceeds must be available to investors. Some of these plans provide for employee participation caps, as well as an outside sunset date if no liquidity event has occurred by then. Existing preferred stockholder liquidation preferences and veto/consent rights should be reviewed carefully in structuring (and considering approval of) these plans, andif implementedconsideration should be given to referencing or including them in the corporate charter. TREATMENT OF EXISTING OWNERSIn distressed circumstances and down round financings, it is important to take steps to treat all owners fairly, to provide full and fair information and to invite and encourage participation by all (not only a good idea, but not doing so may result in claims, lawsuits, and/or liability).50 Keep your owners up to

50. To this end, a company involved in a down round financing (particularly where insiders are involved as investors) should strongly consider a rights offering to all existing stockholders (including founders and employees). This would provide them with the right to participate in the financing transaction (typically, at the same price and on the same terms as the VC and/or later investors) and thereby maintain their equity stake and/or minimize dilution. Distressed circumstances can bring significant additional burdens and responsibilities upon, or present conflicts for, members of the board of directors (or board of managers) of venturebacked enterprises. If a down-round financing is pursued, you can expect existing owners to be unhappy both with the decline in value and the further dilution (and restrictive terms) they likely will face in the next round. Complaints, demands, claims, and litigation may result, including claims of breach of fiduciary duties (in particular, the duty of loyalty) and even fraud (based on incomplete, inaccurate or misleading information), particularly where venture capitalists and other insiders are on the board or are believed to be exercising influence to their advantage. Accordingly, it is important that board members understand their fiduciary duties (early and often) and take appropriate steps to structure decision-making, address conflicts and discharge their duties (and keep a proper record of same), to minimize the potential for claims and liability and to ensure that there are appropriate protections in place regarding limitation of liability, indemnification and D&O insurance coverage.

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speed, manage their expectations and show them you care about and need and appreciate them (of course, doing so without empowering them to raise disputes or prevent or delay a financing can be tricky). Remember that often the best and least difficult (and sometimes only) place to raise future funding is from existing owners. In addition, in some cases (depending on negotiated contractual rights), the existing owners may have you over a barrel (in more ways than one): they may have the right to block a deal, or may sue if they believe their rights have been breached or that they are being treated unfairly or not being told the full story. If a litigation results, this can be distracting, expensive, and time-consuming, and may scare off future investors until the matter is fully resolved. The foregoing list of structures and features (and related issues) that may be deployed (or arise) in distressed circumstances or a down round is illustrative and not exhaustive. Depending on a companys specific attributes, leverage, condition, and circumstances, the creativity and imagination of its counsel, and the willingness and demands of new (including VC) investors, other structures, terms and provisions can be important to negotiate, craft and implement, including regarding board representation, pay-to-play provisions,51 cumulative dividend entitlements, enhanced redemption and other rights and protections for participating investors, more rigorous veto/protective provisions, sunset provisions and performance adjustments, specific representations, warranties and indemnities and customized closing conditions. Reality check before signing Venture capital and sophisticated investment transactions can experience many stops and starts, twists and turns, and often end up in a place quite different (and with terms and conditions quite distinct) from where they started (i.e., as embraced in the initial business understanding, term sheet or letter of intent). Sometimes very significant, negative changes in the deal documents are requested or required just prior to closing. Business owners and managers, after months of meetings, due diligence, business and market changes and fluctuations and back-and-forth negotiations and drafting sessions, particularly during distressful times, can lose sight of what the objectives, expectations, and limits of the financing were (and are), and whether the investment transaction, as presented in draft and definitive documents prepared for signing and consummation, substantially achieves those objectives and works within appropriate limits and expectations. One reason for this is the amount of time, effort, angst, and expense invested to bring the business to the point of a definitive investment funding agreement (where,
51. Pay-to-play provisions, discussed elsewhere in this GUIDEBOOK, impose sanctions on investors who do not continue to fund their pro rata share of future (down round) equity financings. If the investor does not play, it suffers specific adverse consequences, including, for example, automatic conversion to common stock or a shadow (less favorable) preferred stock, loss of the right to participate in future rounds, loss of anti-dilution protections, loss of veto rights, and/or loss of board representation rights. More onerous and rigorous versions of pay-to-play provisions are often considered in distressed markets and down round financings.
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in this market, there may be few alternatives to raise needed capital). Notwithstanding this, and particularly when a down-round financing is on the table, it is important to reflect, weigh, consult, and evaluate whether the transaction, agreement and terms that have finally presented themselves are actually the best thingon balance and all things and relevant constituencies consideredfor the company to proceed with at the time. For some, the answer may be simple: there is no real alternative here; all other potential sources of capital have been exhausted, and without this capital now there will be no company and everyones investment will be worthless. For others, alternatives (including not closing the round and continued boot-strapping until, hopefully, economic and/or market conditions improve) may be available.

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Funding & Liquidity Cycle of a VC-Backed Portfolio Company

(an Illustration)

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SECTION III: What to Expect in a VC Transaction: Key Structures, Features, and Attributes (Up Close)
While the very concept of a venture investment can be intimidating enough for the uninitiated, the structure, terms, attributes, and documentation of a VC transaction and the related rights, restrictions, and protections can be mind-numbing. In many ways these matters defy any notion of common or business sense, pointing to the obvious need for advisors with extensive and relevant experience in approaching transactions of this sort. It is important for any serious candidate for or prospective recipient of VC funding to become familiar with the structure, features and attributes of a typical VC investment transaction.52 1) Equity Securities and Economic Features CONVERTIBLE PREFERRED STOCKClearly the accepted medium of VC investing, convertible preferred stock is the most common form of equity security issued and used in VC transactions. This form of capital stock provides the VC (and other purchasers in the round) with a priority and preference on dividends, distributions, and liquidation over common stock and, in most cases, over other (junior) series of preferred stock, yet it offers all the upside potential of common stock because it is convertible into common stock (at an agreed conversion ratio, subject to anti-dilution adjustments). It also presents important tax and valuation advantages. For example, the special and preferential features of preferred stock permit a discounted valuation of common stock; accordingly, option and other stock-based grants to management and employees (exercisable for or relating to common stock) may be issued at exercise prices discounted to the price paid by investors for preferred stock (among early-stage companies, discounted pricing of one-third to one-fifth of the preferred stocks price is not unusual). LIQUIDATION PREFERENCEThis is the amount, fixed in the preferred stock instrument, that the holder of preferred stock is entitled to be paid, upon a merger, sale or liquidation (including deemed liquidation) of the company or upon redemption of the preferred stock, in advance of and with priority over any payment or distribution to the holders of common stock or junior series of preferred stock. Normally, the liquidation preference is fixed at the original purchase price (on a per-share basis) paid at the closing of the investment transaction (in some cases, plus an accrued dividend that is payable only upon a liquidation event). VCs have been known to request (and, in some

52. In addition to the text that follows, see ANNEX A to this GUIDEBOOK, which offers an illustrative Series A investment transaction term sheet (with commentary). It includes a detailed listing and description of the various terms, features, and provisions commonly included in a VC term sheet and transaction involving a Series A preferred stock financing round.
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circumstances, have obtained) super or multiple liquidation preferences on their preferred shares. Such a provision provides the holder of preferred stock with the right to receive more than the purchase price back before the balance (if any) of the sale or liquidation proceeds is distributed to the other stockholders. Deemed liquidation events typically include a merger or sale of the company and sale of all or substantially all its assets and may also be defined to include certain change of control transactions (e.g., a transaction or series of related transactions in which more than 50% of the shares change ownership) unless a specified percentage of the preferred stock determines not to treat such a transaction as a deemed liquidation event. PARTICIPATING PREFERRED STOCKAs noted above, generally (with regard to preferred stocks), in the event of a merger, sale, or liquidation (including a deemed liquidation) of the company, the preferred stockholders first and as a priority receive an amount equal to the original purchase price (the liquidation preference) plus accrued and unpaid dividends before the founders, executives, and other common stockholders get a cent. Participating preferred stock entitles the holder not only to receive the stated liquidation preference, but also to receive a pro rata share (assuming conversion of its shares into common stock) of the balance of remaining proceeds available for distribution to stockholders.53 Where participating preferred stock is used, founders, management and other common stockholders may be disappointed when a triggering transaction occurs. They may then learn that the combination of giving the VC investor the first bite (via payment of the liquidation preference) plus including the VC investors preferred share holdings (on an as-converted-to-common basis) in the ultimate distribution results in a substantially lower per-share proceeds available for distribution to the common stockholders. Moreover, this provision can lead to a non-alignment and divergence of interestsupon sale or deemed liquidation eventsat certain transaction-value levels, including in instances where the VC investors (because of their participating preferred rights) favor the transaction while the founders, owners, and managers oppose it. Companies (founders and existing stockholders) should strongly resist this form of preferred stock or attempt to limit its application or effect by, for example, insisting on a cap on the participation right (usually expressed as some multiple of the liquidation preference) or providing that the right will not apply if the VC investorsthrough redemptions, stock sales, dividends and distributionshave realized some agreed return on investment.

53. According to the 2009 Deal Terms Report, (i) approximately two-thirds of the 200 U.S. companies responding to the survey said they issued participating preferred stock in their latest financing round, and (ii) in more than 40 percent of the financings surveyed, caps or limits on the preferred stock participation rights were employed (with a cap of two times being the most common).
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CONVERSION (OPTIONAL AND MANDATORY) FEATURESConvertible preferred stock provides the holder with the right (but not the obligation) to convert its shares into common stock, at any time and in the holders discretion, at a specified conversion ratio (subject to agreed anti-dilution adjustments). In order to clean up and simplify the companys capital structure at the IPO stage, convertible preferred stock typically provides for automatic or mandatory conversion into common stock upon consummation of a Qualified IPO (sometimes referred to as a QPO).54 The negotiated terms of the preferred stock may also require automatic or mandatory conversion to common stock when (i) the conversion is approved by the holders of more than a specified percentage of the preferred shares, or (ii) a qualified sale55 transaction is consummated. DIVIDEND FEATURES/ACCRUING DIVIDENDSPreferred stocks often provide for a dividend (of 4% to 10%), which must be paid before any dividend may be declared or paid on the common stock or junior preferred stock, thus giving a priority yield to the holders of preferred stock. In almost all investments in early-stage and emerging companies, however, dividends on preferred stocks are not current and, in most cases, are not cumulativemeaning that dividends do not accrue from year to year until paid. Instead, they are paid if, as and when declared by the board of directors (with a presumption that dividends will never be declared to preserve cash for the growth of the business). If the parties agree to an accruing dividend (and such is included in the preferred stock terms), then a stated but unpaid dividend would accrue and become payable to preferred stockholders only upon merger, sale or other deemed liquidation event or upon redemption of the preferred stock. Accruing dividends rarely are due or payable upon an IPO (or QPO) transaction. In cases where an accruing dividend is provided for and becomes payable, the dividend effectively increases the liquidation preference of the VCs preferred stock interest. Although not common, the parties could also agree to (i.e., the VC investor could request or insist upon a cumulative dividend (entitlement). Thus, the dividend amount would normally accrue, cumulatively, from the date of issuance until the date ultimately paid or satisfied. While normally paid in cash, these dividends can also be payable via the issuance of additional shares (know as a PIK or Payment-In-Kind dividend) or by the adjustment of conversion rights (particularly in cases where the company does not have a lawful source for the payment of dividends). Although these dividends boost prospective returns to investors, they can put a strain on the companys cash flow and thus a drag on its development.
54. A Qualified IPO is usually defined as a firm-commitment underwritten initial public offering of a specified total amount (gross proceeds), as provided in the relevant agreement. The specified amount is designed to be sufficiently large to ensure that the IPO shares will be listed and traded on a major stock exchange. 55. A Qualified Sale is usually defined as a sale, merger or similar business combination transaction in which the per-share (on a common equivalent basis) sale price exceeds certain agreed return-on-investment parameters.
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ANTI-DILUTION PROVISIONSVC investors commonly seek protection from the dilutive effects of subsequent issuances of equity securities or rights, warrants, or options to purchase, or securities convertible into or exchangeable for, such securities. Dilutive issuances in future down-round financings are of particular concern to VC investors, because they may indicate that the agreed valuation in the prior investment round in which the VC participated was inflated or overvalued. Typically, an anti-dilution protection provision works by adjusting the conversion price of an investors securities in order to maintain the investors relative percentage interest in the company, or in some measure minimize the dilutive impact of a down round financing. The principal focus of negotiation here will be on what formula or standard is used to adjust the conversion price of the investors securities, and what exceptions there should be to the application of the conversion adjustment. Although there are a number of variations, two types of adjustment formulas are typically used: full ratchet and weighted average. A full-ratchet anti-dilution provision is most favorable to VC investors; it operates by reducing the conversion price of the previously issued preferred shares to match the price paid in the dilutive issuance, regardless of how many shares are issued in the dilutive issuance. Thus, the previous conversion price ratchets down to the price in the new dilutive issuance. By contrast, weighted-average anti-dilution provisions (whether broad-based or narrow-based)56 provide for more balanced protection, since they take into account the dilutive impact of the issuance in question based on such factors as the number of shares and the price involved in the dilutive issuance and the number of shares outstanding before and after such issuance. Under this formula, the conversion price is adjusted to the weighted average of the purchase price of the previously issued shares as well as the shares sold in the dilutive (or down round) issuance. STAGGERED, TRANCHED AND MILESTONE-BASED FINANCINGSAs previously discussed, in milestone (also known as staggered, staged or tranched) financings, the investor agrees to fund only a portion of the total agreed capital raise (e.g., enough working capital to get the company operating and/or achieve one or more specific objectives that contribute to an increase in valuation) at an initial closing, with the balance fundedat the same initial valuationbased on the achievement of agreed milestones or deliverables or the lapse of agreed time periods. The milestones are usually
56. In weighted-average anti-dilution provisions, the conversion ratio is adjusted based on a comparison of (i) the number of shares issued in the later (dilutive) round at the lower price, and (ii) the number of shares of the company considered to be outstanding. Broad-based versus narrow based formulas are distinct in what securities are considered outstanding for purposes of calculating the adjustment. The broadest formulation (leading to the smallest adjustment) includes all outstanding common and preferred shares (on an as-converted basis) plus all shares issuable upon exercise of outstanding options, warrants and rights and all shares issuable upon conversion of convertible securities. The narrower formulation typically includes outstanding common stock and preferred stock (on an as-converted basis) only.
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based on operational or financial benchmarks included in the companys budget and plan. Tranched financings appear most common for early stage (first round) life sciences companies, and work best where the funding amount needed is large and where the milestones are easily defined (e.g., completion of a clinical trial, hiring of a key executive or signing of a customer contract). Defining milestones and conditions, and thus being assured that the balance of the round will be funded, can be difficult, distracting, and time-consuming. Also, valuation (which is locked in from the first tranche, even though the balance of funding is being provided after the company matures and tackles important value-enhancing objectives), should be reviewed carefully. PAY-TO-PLAY PROVISIONSPay-to-play provisions (which can take many different forms) have the central goal of sanctioning or disadvantaging existing preferred stockholders who dont continue to support the company by participating (fully pro rata) in a subsequent down round. Alternative varieties of pay-to-play provide an incentive (and enhanced rights and economic features) to existing stockholders who do invest (fully pro rata) in later down-round financings. Variations of sanctions on non-participating stockholders (i.e., those who dont play) include (i) outright conversion of all preferred shares to common shares, and (ii) conversion of existing preferred shares into a new series of preferred shares with inferior rights (e.g., junior or reduced liquidation preference, reduced dividend rights, elimination of anti-dilution protections, etc. Alternatively, some pay-to-play structures emphasize incentives for those who participate in later down rounds, e.g., by permitting those who play to exchange their existing preferred shares for a new series of preferred stock with superior rights and features and/or to protect larger portions of their existing preferred shareholdings via increased (beyond pro rata) participation in the down round financing. Implementation of these provisions in future rounds of funding requires attention to consent (and veto) rights of existing holders. USE OF OTHER SECURITIESWhile convertible preferred stock is clearly the most commonly used security in VC-lead investment transactions, some venture capitalists have utilizedunder a variety of market conditions and circumstancesother securities (sometimes combined with preferred stock) as a means of boosting returns, providing enhanced security and/or getting a deal closed expeditiously. A brief discussion of alternative securities and structures that may be utilized follows. COMMON STOCKThe ultimate vehicle for equity upside in a corporation common stockcould also be used for a VC investment. Once all debts and preferred security interests are satisfied, the entire net balance is available for the benefit of common stockholders. More likely, common stock (coupled with a fair sprinkling of investor rights) would be used in an angel or friends and family financing round. WARRANTSA warrant is the right to purchase a specified number of shares of common (or preferred) stock at a fixed price and during a specified time period. In certain situations (as part of the valuation discussion), warrant coverage (i.e., warrants to purchase a specified number or percentage of shares of common stock) is granted to the investors, typically as a deal sweetener: the VC investors receive a warrant to

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purchase an additional number of shares at the investment price (or, in some cases, at a discount to the investment price) in addition to the shares of stock that they purchase in the transaction. Warrants may also be utilized to reward lenders for the risk of making a loan (or, similarly, to reward landlords or vendors), with the number of shares subject to the warrant typically based on a percentage of the loans principal amount. DEBT/CONVERTIBLE DEBTIt is extremely rare for a VC transaction to be structured as a debt-only investment. Having said this, in some circumstances (read: a real need for capital, now, with no third party available to provide it), VCs will provide a bridge loan, used to fund operations while the company resolves issues, tackles milestones and prepares for an investment round (and while potential investors, concurrently, conduct due diligence, negotiate the definitive terms of the investment, and/or proceed with other preliminary matters prior to closing). Such a bridge loan is usually convertible into equity (common stock), on an agreed conversion formula (with antidilution adjustments), at the companys next completed equity financing. 2) Governance and Control Features As described and discussed in detail above,57 a variety of structures, terms and provisions have become commonplace in VC transactions which address issues concerning the governance of the business (including control over important decisions and actions). Among other things, venture capitalists can be expected to insist upon (1) being kept informed and current concerning the business, management, competitive position, growth (internal and via acquisitions), capital resources, financial condition and results of operations of the company, and (2) ensuring that the company stays on, or ahead of, the agreed plan (consistent with the related agreed budget). As a formal matter, governance and control mechanisms are agreed to and documented through various terms included in three of the principal documents commonly utilized in VC transactions: the Certificate (or Articles) of Incorporation (and related designation of preferred stock) and Bylaws, the Investor Rights Agreement, and the Voting Agreement. As a practical matter, and absent a crisis, virtually all matters regarding governance of the business, and controls or restrictions on non-plan activities, are worked out in informal sessions and information exchanges with management, board of directors meetings and through the budgeting process. The most often deployed governance and control mechanisms which VCs incorporate into the investment agreements address the following issues and matters:

57. See Monitoring and Influencing Progress and Development (through governance and control mechanisms), beginning on page 43.

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BOARD OF DIRECTORS PROVISIONSThe centerpiece of governance of a portfolio company is the board of directors (and the information provided to, robust consideration of, and important decisions required to be made by the board). The board of directors, following closing of the A round, becomes far more than a formality, and assumes the role of a strategic decision-making focal point of the company. The board is responsible forand thus must be informed regarding and will have control overthe overall direction of the management and affairs of the business. Accordingly, given this central role and in connection with a planned investment transaction, important issues regarding the board of directors will need to be considered and resolved, including:
The boards size and composition the number of members the VC (or new investors) will be entitled to designate

and elect
the number of members the founders (and existing owners) will be entitled to

designate and elect

whether independent board members will be required (and how they will be

selected)
the actions and matters that will require board approval the precise level of approval required for any specific actions or matters (and the

extent to which one or more of the VC (or new investor) designated board members approval will be required MANAGEMENT CONTROLSWhether through the board of directors (and/or committees of the board) or through contractual veto or control provisions, provisions surrounding senior management are also important to venture capitalists (and thus included in the transaction agreements). These mechanisms provide for important checks and balances on the persons charged with the day-to-day management and operation of the business in which the VC has invested substantial capital. Before the transaction is closed, employment and restrictive covenant agreements for senior management are usually negotiated and put into place. Many VCs require that they have reasonable approval rights with respect to the selection, hiring, compensation and termination of key senior management, and also have control over (or, at a minimum, a voice in) decisions regarding the terms and provisions (e.g., size of award, exercise price, vesting terms, etc.) of incentive compensation grants and plans. Finally, through negative covenants (and so-called veto rights), certain actions, arrangements and transactions may not be pursued by management absent board (or, in some cases, stockholder) approval. VETO, NEGATIVE COVENANTS AND OTHER PROTECTIVE PROVISIONSThese provisions have become standard in VC transactions, and are the central control valve for VC input into the business and leverage over important decisions regarding the business and its future. These provisions are effected through two essential mechanisms (and iterations of them): (i) requiring a class vote of the preferred stock (and thus giving the holders of the preferred stock a veto right), a specified or greater-than-majority (preferred) stockholder vote, or other special voting rights or requirements of stock-

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holders; and (ii) requiring a board vote, or a special board vote (e.g., one joined in by the VC-designated and/or independent directors). Actions by the company over which VC (or new) investors may seek to require such veto, blocking or control rights include:
authorizing or issuing equity securities senior to or pari passu with the preferred

stock
a sale (including sale of all or substantially all the assets), change of control or

deemed liquidation of the company

amending any provision in the companys charter or organizational documents in

a way that adversely affects the rights or preferences of the preferred stock
redeeming or purchasing any outstanding company securities (other than pur-

suant to the incentive compensation plan, employment agreements or other VCapproved agreements) declaring or paying dividends on any capital stock incurring indebtedness or making capital expenditures over a specified dollar amount taking any action which is materially (or more than X%, individually or in the aggregate) in variance with the approved budget entering into any new line of business, or significantly changing the nature or focus of the companys business FOUNDER AND MANAGEMENT PROVISIONSIn most cases, the capital-seeking business is substantially dependent on one or more founders and/or key members of management, whose lossor diminished commitmentwould clearly be detrimental to the company. The VC-required agreements and related restrictions are usually addressed in two categories: (1) Stock ownership and incentivesVC investors are intent on making sure that equity holdings (including previous holdings by founders and others who have contributed to the business) are right-sized and facilitate win-win decision-making and plan implementation. Thus, VC investors may insist that vesting provisions be (retroactively) imposed on some of the founders shares. VCs will also negotiate the overall size of the equity incentive plan reserve or pool (typically, in the range of 10% to 20% of fully-diluted shares post-financing), vesting schedules and terms for options and restricted stock grants and whether founders will be entitled to participate. (2) Restrictive covenant agreementsAs a means of both protecting the business and achieving some measure of control, VCs typically (almost always) require that, as a condition to the investment closing, (i) key management personnel and founders enter into non-competition agreements, and (ii) all personnel and (IP and/or technology engaged) consultants sign confidentiality and assignment of invention agreements.

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3) Liquidity Terms & Considerations VC funds are in the business of investing their capital to realize exceptional internal rates of return. These returns are created, and are only realized, if and when some measure of liquiditythe ability to sell for or otherwise receive cashattaches to the securities the VC received when it invested in the portfolio company. Liquidity, in turn, is the function of the company (or the VC) availing itselftypically, with the VCs guidance, input and sometimes controlof one or more exit strategies. Considerations and mechanisms surrounding exit and liquidity issues include the following: VALUATION ISSUESThe agreed valuation, together with the amount of the investment, drives the determination of the percentage of equity securitiesand thus ownershipthat the VC will receive (and that the founders, managers, and other owners will retain) at the closing of the investment transaction. Pre-money valuation is the theoretical value of the company before the VC funding is received. It is calculatedas a matter of mathby multiplying the number of outstanding, fully diluted shares of the company before the investment, times the purchase price per share in the investment transaction. Post-money valuation is the pre-money valuation plus the amount of funds invested in the transaction. The VC investor, of course, focuses the business owners attention on the pre-money value (and the difference in the pre- and post-money values). The valuation of private companies and their securities is a subjective and many-faceted exerciseinvolving more art than scienceand depends more on negotiating leverage, market factors, and the need for funding (and available funding options) than on traditional valuation methodologies (or even the beat-down financial forecast). FIRST REFUSAL AND PREEMPTIVE PURCHASE RIGHTSPreemptive purchase rights, which are rights to purchase stock in future offerings by the company on the same price and terms as offered to other purchasersare standard in VC transactions. The purpose of the preemptive purchase right is to enable the VC investor to maintain its percentage ownership in the company despite future capital raises introducing new investors to the company. VC investors also typically request (or insist upon) rights of first refusal as part of their transactions. These are rights to purchase the shares of a selling stockholder (usually the founders and other significant existing owners) before those shares can be sold to a third party. Typically, the company gets the first right to purchase shares and then the VC (and other preferred stock) investors get the second right (on a pro rata basis). The right of first refusal helps to ensure the planned and orderly transfer of founders shares. Various exceptions to these rights are commonly negotiated. REGISTRATION RIGHTSThese rights and related contractual provisions (usually embodied in the Investor Rights Agreement) are designed to permit the VC to control or influence the share registration process, and to permit registration and sale of its investment interest first, before the founders and other insiders and common stockholders.

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There are essentially three types of rights negotiated: Demand rights, piggy-back rights, and S-3 registration rights (and, incident to these, expense reimbursements and various limitations and exclusions). These provisions, which can be both time-consuming and expensive for the company if exercised, are of increasing importance as and when the IPO market stabilizes and proceeds to some stage of normalcy. 1) DEMAND RIGHTSA demand registration right allows the investor to require the company to register a specified number or percentage of the investors shares in a public securities offering, even if the company was not otherwise planning to commence or conduct such an offering. Usually, the demand right must be requested by the holders of a specified number of shares, with the demand right applying to some percentage of the common shares issuable upon conversion of the preferred shares (importantly, the right applies to the underlying common stock, not the preferred stock). Typically, this right is not operative until at least six months after the companys initial public offering (or by an agreed outside date, if an IPO has not occurred by then), is limited to one or perhaps two registrations, and is subject to exceptions and cut backs. For example, the managing underwriter will have the discretion to cut back the number of shares included in the registration, or the company may not be required to register shares if SEC Rule 144 or a comparable rule is available to permit open market sales of the shares. 2) PIGGYBACK RIGHTSA piggyback registration right allows the investor to have its common shares (obtained upon conversion of preferred shares) included in a public offering (and related registration statement filed with the SEC) that the company is conducting at its own initiative for itself or other stockholders. These rights are usually not applicable to the IPO transaction. Piggyback registration rights are always subject to cutback rights, which provide a means for determining whose shares are included in the offering and whose (or what percentage of whose) may be excluded, when there are too many shares for the underwriters or broker-dealers to sell in the offering. The decision as to how many shares to sell is based on market conditions and, ultimately, the judgment of the managing underwriter (in an underwritten offering). Typically, piggyback rights are not available if SEC Rule 144 or a comparable rule is available to permit open market sales of the shares. VC investors often request that cutbacks be effectuated first against founders and other insiders before reducing the investors shares. 3) S-3 REGISTRATION RIGHTSAn S-3 registration right allows the investor to require the company, once it is eligible, to register a specified number or percentage of the investors shares, multiple times, under a short-form registration statement on Form S-3 (assuming the company is eligible to use such form) if the investors intend to sell at least a minimum specified number of shares. An S-3 registration right is like a demand right, but less burdensome and expensive to the company because of the availability of the S-3 short form. The issue of counsel and expenses must be addressed. Because of reforms to Rule 144, this right will not likely be important to any investors unless they are (at the time they wish to sell) affiliates of the company.

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Drag Along Rights VC investors usually request (or insist on) so-called drag-along rights. Put simply, armed with these rights, if the new investors (or a certain required minimum percentage of them) support and agree to the terms of a later proposed merger, sale (including sale of all the stock), or liquidation event, then all stockholders (who sign the Voting Agreement) are required to vote in favor of the transaction, enter into any required agreements, and sell their shares in the transaction. This could include a transaction (depending on the all-important liquidation preferences) in which those owners who are dragged along get little or nothing. Redemption Right (or Put) Redemption (or put) rights. If these rights are in place, then the VC investor(s) (and other preferred stockholders) have the right to require the company to repurchase their preferred securities at a specified price (typically, investment price plus accrued dividends), with payment made in installments over an agreed period, if the company has not closed a sale, initial public offering or other liquidity event within a specified number of years (typically, five to seven years). This provision is rarely (if ever) utilized, but provides leverage to VC investors pressure management, before a specified date (and after a significant investment period), actively to pursue and close a sale of the company, IPO or other substantial liquidity event (with respect to the VCs investment). Alignment of Founder and Management Incentives The active commitment, engagement and efforts of founders and management will be central to the success of the venture. The VC will want to ensure that the interests of the founders, managers, and key employees, as well as the compensation of and incentives afforded to all significant personnel, are aligned with the VCs interests in maximizing the value of its investment and timely pursuing available exit strategies. There are several mechanisms to consider here. a) Initial position and vesting As a starting point, the VC will want the founders, managers, and key employees to have sufficient skin in the game to motivate performance and thus maximization of the value of the business. VCs look favorably upon founders and managers who have invested in themselves and are prepared to stay the course and to share in the risk of possible failure. Venture investors have been known to request, particularly in earlystage ventures, that some portion of the founders shares retroactively vest (i.e., become earned and nonforfeitable) in stages and only after continued employment with the company or the passage of an agreed timeframe. The number of shares deemed already vested and the vesting schedule for the balance of the shares are both subject to negotiation. The VC also may require restrictions on the ability of founders and managers to sell their shares over a defined period, prior to an IPO or sale of the company.

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b) Equity-based compensation plans, grants, and agreements Before a VC investment transaction is closed, the form of and perhaps initial grants under an employee incentive compensation plan are usually discussed, negotiated and put into place. Many VCs require, as part of the investment agreements, that they have reasonable approval rights with respect to the terms and provisions (e.g., size of award, exercise price, vesting terms, etc.) of incentive compensation grants. Companies are increasingly adopting broader and more flexible incentive compensation plans. Properly crafting management (and key employee) compensation and incentives requires focus and discipline and involves a complex, dynamic, ongoing process and dialogue, which companies can expect VC representatives to be an important part of. Key issues regarding the incentive compensation plan will be the size of the reserve or option pool (typically 10% to 20% of fully-diluted shares post-financing), the vesting and exercise terms, and whether founders will be eligible to participate. In addition, a key issue often negotiated is whether vesting will be accelerated, partially or in full, upon a merger, sale or change of control of the company. Accelerated vesting may take effect upon a closing of a transaction (with no other requirement, referred to as a single trigger), or may apply only a qualifying transaction closes and the employee is terminated within a specified period following the transaction (referred to as a double trigger). c) Restrictive covenant agreements As previously noted, and as a means of both protecting the business and achieving some measure of control over personnel matters, VCs typically (almost always) require that, as a condition to the investment closing: i) key management personnel and founders enter into non-competition agreements, and ii) all personnel and (intellectual property- and/or technology-engaged) consultants sign confidentiality and assignment of invention agreements. 4) Protection of Intellectual Property Where a key product or some form of intellectual property (IP) or proprietary technology is important to the success of the company, VCs will require assurances (in the form of representations and warranties, and related indemnities, in the Securities Purchase Agreement), in advance of closing, of the companys ownership rights, its ability to protect those rights, and of no infringement of IP rights owned or controlled by others. Part of this assurance will occur during the due diligence process, in which the company will be required to provide assurances that any employees who previously worked for other companies in the companys market or industry are not bringing or using that previous employers confidential or proprietary information and are not otherwise working or conducting themselves in violation of their previous employment (or restrictive covenant) agreements. Assignment of invention (and confidentiality) agreements have also become standard and will be required.
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Angel Investing
An important and developing source of start-up and early-stage capital, which has become more prevalent (and necessary) recently, is funding from so-called angel investors: wealthy individuals who desire and are willing to invest time and money in companies in relatively early stages of development that have both the right fit, risk profile and investment return potential for which the angel is looking. For many years, angel investors have provided much needed capital to companies at development stages where they are not quite ready or able to attract VC interest. In addition, and increasingly, certain angel investors (and angel groups) are teaming up with VC investors, to provide A round and even expansion stage investment capital to appropriate portfolio companies and ventures. Like venture capitalists, angel investors can also be important, value-added partners and advisors to emerging businesses (which are often not only strapped for cash but extremely lien on help), providing a crucial boost or bridge in the early, often fragile, stages of development. This can include providing an independent outside (sometimes sobering) perspective, networking with contacts who can help the business, gaining expert advice and assistance where needed, and building credibility and respect. 1) More money, and more deals (at early stages) Although there isnt much in the way of comprehensive and credible data on angel investing and returns,58 a number of studies published on angel investing have concluded that, when compared to institutional VC investing, angels invest more money in far more companies (at least 10 times more). This is particularly true in seed and early-stage financings, where angel investment has long played a crucial role. In addition, anecdotally, angel investing (since late 2009) has been witnessing a bit of a resurgence and increase. By some accounts, there are over 250,000 active angel investors in the U.S., and over 12,000 angel groups. 2) Dynamics, available funding and deal size Because of the dynamics of institutional VC funding, the minimum first-round investment by most VC firms is now thought to be between $2.5 million and $5 million. VC funds in the U.S. have gone through some consolidation and, as a consequence of that and market conditions, theres been an increase in the size of funds and the number of portfolio companies, often without a commensurate increase in the VC firms professional staffing. It takes a VC fund as much time to analyze, perform due diligence on,

58. The Kauffman Foundation and Angel Capital Education Foundation published a study in November 2007 focused on the returns achieved by angel investor groups, and offering certain clues and strategies to enhance angel investment performance. The study, entitled Angel Investors in Groups Achieve Investment Returns In Line with Other Types of Equity Deals, can be found on the Kaufman Foundation website (at www.kauffman.org).

73

negotiate and invest in, and oversee a small investment as it does a large one. These dynamics have given rise to a tremendous void for entrepreneurs. managers and owners of start-up and early-stage businesses seeking capital of between $100,000 and $2 million. Angel investors can and do fill this void, flying below the VC radar and providing critical funding at these lower levels.59 3) Approach varies widely; dictates access and availability The emerging business will find that receiving funding from an angel (or group of angels) presents many of the issues discussed earlier in this GUIDEBOOK inherent in venture capital investments, but there are significant differences as well. Institutional VC investors are organized as professionally managed investment funds. The investors (limited partners) in VC funds are typically large institutions, pension plans, endowments, corporations, and some very wealthy individuals. VC funds employ professional staff and consultants to assist in identifying investment prospects, research, market analysis, all varieties of due diligence, valuation, negotiation, documentation, closing, monitoring/nurturing/overseeing portfolio investments, networking with other portfolio companies or contacts, developing, pursuing and executing exit strategies, and communicating with fund investors. VC funds are deliberately structured and staffed in a singularly focused (and rather disciplined and predictable) effort to make significant investments in promising companies to create exceptional investment returns for fund investors. VCs also often invest in companies (i) in a variety of stages of development and doing business in a variety of markets and industries, and (ii) located long distances from the principal offices of the fund. In comparison, many angel investors operate on their own, taking a lone ranger approach. The individual angel is often a successful entrepreneur who has cashed out (in a successful sale transaction), a member of a wealthy family, a prominent (often retired) executive, or a very high-income professional. Such angels have been and can be a considerable and vital resource to the companies they invest in and add value to. What is clear about these angel investors, as compared to VC funds, is that they have much smaller amounts of capital to invest (so you may need multiple angels or angel groups) and have limited time, expertise and resources available to identify, contact, perform due diligence on, value, negotiate, document, or close (or post-closing, guide or oversee) a given investment opportunity. Angel investors also usually desire (and, because of the early stage, need) to be actively involved with the company, employing their knowledge,

59. Although the prevailing trend toward larger VC funds (raising more and more capital) has given rise to an emphasis on larger (i.e., higher aggregate dollar amount) investment transactions, the intensely competitive environmentand pursuit of higher returnshas also caused some venture capitalists to consider and pursue smaller (initial) investments in earlier stage companies. In early stage deals, VC funds have also been known to co-invest with angel investors (especially where those angel investors are limited partners in, advisors to, or proven referral sources to the fund).
74

passion, expertise, experience and contacts to assist in the companys direction, management, growth, and development (as well as funding). Because of this, angels typically invest in what they know (i.e., the market or industry in which they made their name or fortune or served as an executive or board member), relatively close to home, and alongside other investors and stockholders the angel knows, trusts, and respects. What is unclear (and what varies widely) is precisely what motivates or dictates a particular angel investmentto get it from expressed interest to funding closing. Clearly, some level of risk analysis and prospective investment return is a given. Butparticularly with individual angelsthere are other, less tangible or visible, even emotional (and thus rather unpredictable) factors that can influence an angels investment choices, cadence and appetite. These factors may revolve around any of all of: investing only in the industry or sector the angel came from or is most familiar with; socially responsible investing; investing with other like-minded investors (and joining a collegial, like-minded group); goal-oriented investing; source-specific investing; and stage-specific investing (to name a few). The amount of time a given angel is willing or able (given other interests and commitments) to devote to this activity (sole passion vs. current pastime) and all of its components and iterations also can vary widely. Based on these factors, understanding the wants, timing and demands of, and ensuring the right fit with, a particular angel investor is paramount (from both the angels and the companys perspective). Locating this needle in the haystack can be time-consuming, frustrating and difficult (replete with numerous starts and stops). 4) Angel Groups and Clubs Partly because of limitations in the lone ranger approach and partly in response to the difficulty of finding and sourcing angel investors, pools, networks, clubs, and groups of angels (collectively, Angel Groups) are being organized around the country. And recent times have witnessed a significant increase in Angel Group organization, sophistication and investing.60 Although the approach and structure of these groups varies widely, the goal is common. By joining together, an Angel Group can (among other things): see more deal flow take advantage of a broader, more diverse base of knowledge, expertise, experience, and contacts 61

60. See the statistics, resources and guidance for entrepreneurs included on the Angel Capital Association and Angel Capital Education Foundation websites, at www.angelcapitalassociation.com and www.angelcapitaleducation.org. 61. This can be instrumental in sourcing and analyzing potential investment opportunities, markets and industries; performing due diligence; formulating a recommendation for investment; negotiating, documenting, and closing an investment; nurturing and fostering development; introducing business facilitators; and assisting with later rounds of funding.
75

 reduce investment risk by strategically using its collective base of knowledge,

expertise, experience, and contacts (or, in some cases, by employing staff) to better source, research, and screen nonstarters, to identify important gaps, milestones and predicates to an initial investment, to facilitate introductions to follow-on funding sources, and to provide value-added assistance in the fields of expertise of its participants enhance networking and strategic relationships 62 Most of the existing Angel Groups focus on investments in specific geographic areas, markets, or industries. Their approach to investing varies from pure networking (where opportunities are presented to the group at periodic meetings and each angel determines whether and to what extent (s)he wants to proceed or invest), to something more analogous to a fund approach (where each angel commits or contributes capital to a limited partnership fund or other investment vehicle, then the group or a committeeafter the identification, due diligence and initial risk/appeal/returns analysis has been conducted, votes on which ventures to invest in and how much to invest). Issues of co-investing by individual angels (or new outsiders) have to be considered and resolved. While Angel Groups have enjoyed significant progress and development (and some measure of success), and have been important players in the early stage venture investment arena, this area remains a work in progress.

62. Networks with access to significant capital resources and a track record of investing have become highly sought afterand thus attract more deal-flow and better investment opportunities.

76

ANNEX A: Illustrative Series A Investment Transaction Term Sheet

The following Illustrative (Series A) Term Sheet has been prepared and edited based on my experience with Series A term sheets and early stage venture capital negotiations and transactions. In assembling this document, I reviewed many term sheets and letters of intent used (as a starting point) in Series A venture capital financings. I also examined term sheets available through venture capital industry, educational and fund online and other resources (including www.NVCA.org), as well as draft commentary prepared by an American Bar Association (Business Law SectionVenture Capital & Private Equity) subcommittee on which I serve (and in which I participated). Where relevant or appropriate, alternative provisions and commentary have been noted. Please refer to the body of this Guidebook, as well as ANNEX B, while perusing the Term Sheet and considering appropriate alternative provisions and related considerations. Terms and language enclosed in brackets are variable, to be retained, adjusted, modified, or deleted as necessary or appropriate for a particular negotiation or transaction. Words and phrases presented in italics are discussed in the body of this Guidebook and/or defined in ANNEX B. This Term Sheet is presented for illustrative, educational, and informational purposes only, and (in certain respects) is over-inclusive. It does not constitute or include legal or professional advice as to any particular facts, positions, negotiations, or transactions.

A1

[NAME OF COMPANY]

TERM SHEET
FOR SERIES A PREFERRED STOCK FINANCING
[________ ___, 20__]

This Term Sheet summarizes the principal terms of the Series A Convertible Preferred Stock financing of [_____________], Inc., a [Delaware] corporation (the Company). The securities issued to [_____________] (the Investor)1 will have the characteristics, terms, and provisions described in this Term Sheet. In consideration of the time, effort, and expense devoted and to be devoted by the Investor with respect to the investment contemplated by this Term Sheet (the Transaction), the [Expenses (in Section 2), No Shop (in Section 6), and Confidentiality (in Section 6)] provisions of this Term Sheet shall be binding and enforceable obligations of the Company, whether or not the financing Transaction is ultimately consummated. No other legally binding or enforceable agreements or obligations are intended to be, or are, created under this Term Sheet, until and unless definitive agreements are executed and delivered by the parties. This Term Sheet is not a commitment to invest, and is conditioned upon the Investor completion of due diligence, legal review, and documentation all to the satisfaction of the Investor. The binding and enforceable provisions of this Term Sheet, and the rights and obligations of the parties hereunder, shall be governed and construed in all respects by the internal laws of the State of [Delaware]. 1. KEY INVESTMENT TERMS Closing Date & Document Preparation: The Transaction will be consummated at a closing (the Closing)2 expected to take place no later than [_______ __, 20__], or as soon as practicable following the parties execution and delivery of the definitive purchase and other agreements and satisfaction of the conditions to closing specified therein. [It is planned that the signing of definitive agreements and the Closing will take place simultaneously on the same day.]3 As soon as practicable following the Companys acceptance of this Term Sheet, the Investor will cause its counsel to prepare all of the agreements and documents necessary to complete the Transaction, and deliver same to the Companys counsel.

A2

NOTES
1. It is not uncommon for multiple Investors (venture capital funds, angel investors and perhaps others) to co-invest in a Series A financing round, in which case the Term Sheet must be adapted accordingly and there may be additional issues to consider and addressacross various provisionsas well. Where there are several VC investors, some of the Series A Preferred rights may be made available only to a Major or Significant VC holder of Series A Preferred shares. Funding may occur at multiple, staged closings (although this is generally not favorable to the Company and can give rise to various issues and complications). Unless there are specific reasons for not doing so (e.g., regulatory filings/waiting periods/approvals, third party consents, or other actions that are best addressed after a stock purchase agreement is signed), it is often preferable that the stock purchase agreement and other definitive agreements be signed at the same time that the Closing occurs.

2. 3.

A3

Issuer: [_____________] (the Company) Investor(s): [_____________] (and its affiliates) [and such other investors as the Investor and the Company mutually agree upon] Amount of Investment: $[__],000,000.004 Security: Series A Convertible Preferred Stock (the Series A Preferred), initially convertible into [__]% of the fully diluted shares of Common Stock of the Company. Price per Share: $[___] per share (the Original Purchase Price), based on the pre- and postClosing capitalization of the Company set forth in the Cap Table below. Pre-Money Valuation: The Original Purchase Price is based upon a fully-diluted pre-money valuation of the Company of $[__________], and a fully-diluted post-money valuation of the Company of $[__________] (including an employee stock/incentive pool representing not more than [__]% of the fully diluted post-money capitalization). Capitalization: The Companys capital structure and capital stock ownership, before and after Closing, is set forth in the Cap Table below:
CAP TABLE (PRE AND POST-CLOSING CAPITALIZATION)
SECURITIES PRE-CLOSING % OF SHARES POST-CLOSING % OF SHARES

Common StockFounders Common StockEmployee Pool5 Issued/Granted Unissued/Available for Grant [Common StockWarrants] Series A Preferred Stock TOTAL:

____% ____% ____% ____% ____% ____% ____%

____% ____% ____% ____% ____% ____% ____%

Use of Funds: The net proceeds of the Transaction will be used solely for [______________] (consistent with an initial budget and plan to be reviewed and approved by the Investor prior to Closing), for working capital, and for general corporate purposes.6 The [Investors and the]7 Companys fees and expenses relating to the Transaction will be paid by the Company at closing.

A4

NOTES
4. 5. If more than one Investor is included (at the Term Sheet phase), the identity and investment amount of each should be included. To the extent the Company does not have a stock pool or reserve (via an authorized stock option, restricted stock, or omnibus incentive compensation plan) in place before the Transaction, the matter will be discussed in some detail as negotiations proceed and, in virtually all cases, an employee incentive plan (and perhaps initial grants) will be implemented at Closing. If any investment proceeds are expected to be used for purposes other than the funding of the agreed growth plan and working capital, they should be discussed early and included in the term sheet. This might include the payment of all or a portion of founder and/or insider debt or advances. If this provision (i.e., reimbursement by the Company of the Investors expenses) is retained, it typically is negotiated to include a cap or limit on the total amount the Company is required to reimburse.

6.

7.

A5

Balances at Closing: At Closing, the Company will have minimum cash and working capital balances, and maximum indebtedness, in amounts which are consistent with the [_____ ___. 20__], financial statements previously delivered to the Investor.]8 2. PURCHASE & SALE OF SERIES A PREFERRED SHARES (Stock Purchase Agreement Terms) Definitive Agreement: The purchase and sale of Series A Preferred shares shall be effected pursuant to a Stock Purchase Agreement (SPA) between the Investor, the Company [and the Founders]9, to reflect the terms and provisions in this Term Sheet and to be in form and substance reasonably acceptable to the Investor and the Company. Representations and Warranties; Covenants: The SPA will include (i) standard representations and warranties and covenants from the Company [and the Founders], and (ii) investment representations from the Investor. [Among other things, the Company will be operated (and compensation awarded, dividends paid, funds expended, and indebtedness incurred) solely in the ordinary course of business consistent with past practice, from signing of definitive agreements through Closing.] Conditions: The SPA will include standard conditions to Closing, including, among others, (i) satisfactory completion of operational, financial and legal due diligence;10 (iii) the filing of an amendment to the Companys Certificate of Incorporation (the Charter), authorizing and establishing the rights, preferences, and limitations of the Series A Preferred shares; (iv) execution and delivery by the other parties thereto of certain agreements, certificates and documents referenced in this Term Sheet (or otherwise provided in the SPA), including (a) execution and delivery by each founder and other key employee identified by the Investor of [one] year noncompetition and non-solicitation agreement in form reasonably acceptable to the Investor11, and (b) execution and delivery by each founder, employee and consultant (in the case of consultants, those who have had access to, involvement in or influence over Company confidential information, trade secrets, inventions or technology) of a proprietary information and inventions assignment agreement in form reasonably acceptable to the Investor; [(v) audit of the Companys financial statements in form and substance reasonably acceptable to the Investor]; and (vi) an opinion of counsel to the Company in form and substance reasonably acceptable to the Investor.

A6

NOTES
8. As part of the valuation discussion, the Investor may seek comfort that the Companys financial position at Closing is substantially as assumed (or promised) when it valued the Company and determined the appropriate amount of its investment (and the material terms of the Transaction). Thus, the Investor may ask for confirmation, at the Term Sheet stage, of certain key financial data points as of Closing. Most often, these include cash, working capital and debt. The Investor may request/demand that the Founders personally sign the Stock Purchase Agreement (SPA), and/or make certain specific representations and warranties (and provide indemnification for any breach thereof) with regard to certain key matters that the Investor believes are important (and desires to flag in the Term Sheet from the start). These might include matters related to ownership of technology and capitalization (e.g., prior issuances and redemptions of securities). Founders frequently (strongly) resist these provisions, and they are included in a minority of VC deals (unless Founders are receiving liquidity in the investment transaction or there are specific technology ownership concerns).

9.

10. In the event that the SPA is signed in advance of the Closing (and thus the signing and Closing will be separated by some period of time), it is not advisable, from the Companys perspective, for the Investor to be entitled to an open-ended due diligence out during this period. The Investors due diligence should be completed by the signing of the SPA. 11. Non-competition and similar restrictions (other than in connection with the sale of a business) are unenforceable in California, and may not be enforceable (or may be subject to significant limitations on enforceability) in other jurisdictions as well. Some VC investors do not require such agreements out of concern that they could be disruptive to the business or that employees will request additional consideration in exchange for signing them (indeed, such additional consideration may be necessary in some jurisdictions to support enforceability). Other investors take the position that the Board should determine, on a case-by-case basis, whether any particular key employee should be required to sign such an agreement before or at Closing.

A7

Draft Agreements & Counsel: Investors counsel will prepare all of the documents necessary to complete the Transaction. It is anticipated that draft Transaction documents will be delivered to the Companys counsel within [five] business days of the Companys acceptance of this Term Sheet. Expenses: Contingent upon closing the Transaction, the Company shall pay the Investors legal fees and expenses with respect to the Transaction (including in respect of negotiating, conducting due diligence, documenting and closing the Transaction), up to a maximum of $[________], which shall be payable at the Closing.12 If the Transaction does not proceed to closing, each party shall bear and pay its own fees, costs, and expenses. Counsel to Parties: The parties will be represented in the Transaction by the following counsel: Companys Counsel: [insert name, firm and contact information] Investors Counsel: [insert name, firm and contact information] 3. TERMS OF SERIES A PREFERRED SHARES (Amended and Restated Certificate of Incorporation) Dividends: The Series A Preferred will carry an annual, non-cumulative dividend, at the rate of [___]% per annum, which will be payable [(i) upon a Deemed Liquidation Event (as defined below) or redemption, and (ii) in all other cases,] on an as-converted basis when, as, and if dividends are declared and paid on the Common Stock).13 Liquidation Preference: In the event of a liquidation (including any Deemed Liquidation Event, as defined below), dissolution, or winding up of the Company, the proceeds shall be paid as follows: First, [one] times the Original Purchase Price plus accrued dividends14 shall be paid on each share of Series A Preferred. Thereafter, the Series A Preferred shall participate with the Common Stock on an as-converted basis until the holders of the Series A Preferred receive an aggregate of [___] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence.15

A8

NOTES
12. Wherever the negotiation on payment of Investors counsels fees and expenses ends up, the last sentence in Section 1 (under Use of Funds, also addressing such fees and expenses) should be revised as necessary to be consistent. 13. Dividend provisions come in many shapes and sizes. The most basic form of dividend is one that is simply paid on an as-converted basis when, as and if dividends are declared and paid on the common stock. Dividends in a fixed amount that are payable quarterly or annually are extremely rare in VC transactions. Cumulative dividendswhich accrue and cumulate regardless of whether the board ever declares a dividend and which effectively increase the liquidation preferenceare also rare for VC-backed companies. In some cases, VC Investors urge that dividends (at a fixed rate per share) accrue and cumulate and become payable (only) upon a liquidation event or redemption. Rarely, however, are cumulative dividends payable upon a conversion event. Another alternative is to give the Company the option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value. The latter alternative is referred to as PIK (payment-in-kind) dividends. 14. Depending upon the dividend feature, the plus accrued dividends language might instead read plus declared and unpaid dividends. 15. The Liquidation Preference is the central economic term of preferred stock, and is subject to some variation. The provision included above provides for a participating preferred provision with a cap on the participation right and is fixed at one times (1x) the original purchase price. Without the cap, it would be a full participating preferred. Another variety is one that simply provides a liquidation preference but no participation feature (in which case, the preferred is protected with the liquidation preference feature, but gains the upside equity value through the conversion featurewhich would be exercised immediately prior to a liquidity event such as a merger, sale or IPO).

A9

A sale, merger or consolidation of the Company (with an unaffiliated third party, for a bona fide business purpose and effecting a change of control16), and a sale, transfer, lease, or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a Deemed Liquidation Event), thereby triggering payment of the liquidation preference described above [, unless the holders of at least [___]% of the Series A Preferred then outstanding elect otherwise in writing]. Conversion: Optional Conversion: The Series A Preferred shall be convertible into shares of Common Stock, at the option of the holder, without the payment of additional consideration at any time or from time to time. Initially, the conversion ratio shall be one-to-one (1:1) for shares of Common Stock, which ratio shall be subject to adjustment for stock dividends, splits, combinations, and similar events and as described below under Anti-Dilution Protection.17 Mandatory Conversion: Each share of Series A Preferred shall automatically convert into Common Stock, at the then applicable conversion rate, in the event of: (i) the closing of a [firm commitment] underwritten public offering covering primary sale of the Common Stock [at a public offering price of at least $[__] per share (i.e., at least [___] times the Original Purchase Price)18, and] with [net/ gross] proceeds to the Company of at least $[___] million (a QPO); or (ii) upon the vote or written consent of the holders of at least [__]%19 of the shares of Series A Preferred then outstanding. Anti-Dilution Protection: In addition to normal and customary anti-dilution protections (e.g., proportional adjustment for stock dividends, splits, combinations, and similar events), in the event that the Company issues additional equity securities (or securities convertible into or exchangeable or exercisable for equity securities) at a purchase price that is less than the then-current Series A Preferred conversion price, then such conversion price shall be adjusted based on a broad-based weighted average antidilution adjustment provision.20 The following securities issuances shall not trigger any anti-dilution adjustment (Excluded Issuances): (i) securities issuable upon conversion of any of the Series A Preferred, or as a dividend or distribution on the Series A Preferred; (ii) securities issued upon the conversion of any convertible security or upon the exercise of any warrant or option; (iii) Common Stock issuable upon a stock split, stock dividend, or any subdivision of shares of Common Stock; and (iv) shares of Common Stock (or options to purchase such shares) issued or issuable to employees or directors of, or consultants to, the Company pursuant to any incentive compensation or

A10

NOTES
16. Some term sheets provide more expansive lists of triggering transactions, including definitions for the term change of control (usually a transaction in which more than 50% of the outstanding voting power of the company is transferred to a third party). 17. Optional conversion provisions are standard. Although the preferred holder is provided the right to convert its preferred shares to common shares at any time, the most likely situation in which a preferred holder would elect to convert is where the holder determines (e.g., immediately prior to a liquidation event, such as a merger, sale or IPO) that conversion to common stock would result in a higher return to the holder than remaining a preferred stock holder (and receiving the liquidation preference and participation rights, if any, incident to such ownership). Accordingly, the relationship and interplay between the conversion rights and the liquidation preference rights is important. 18. The price per share trigger is sometimes included (at the behest of VC Investors) to ensure that a minimum (and substantial) return is achieved before the company can go public and force conversion of the Investors shares. As a practical matter, the Investor typically will have the ability to control, or will have certain controls over, any decision by the Company to go public. The Company should also consider requesting a provision allowing a non-QPO to become a QPO if an adjustment is made to the conversion price for the benefit of the Investor (or above some level of benefit), so that the Investorin such casedoes not have the power to block a public offering. 19. These provisions are negotiated, with the percentage typically ranging from 33.3% to 66.6%. As with all percentage vote/consent thresholds, consideration should be given to the post-financing Cap Table and whether any single Investor (or group of affiliated Investors or their transferees) can either control or block the vote or consent. 20. To avoid any possible confusion, best practice is to include in the term sheet (or otherwise confirm) the specific formula that will be used. Special anti-dilution provisions (here, protection in the event of a down round) come in several varieties. Broad-based weighted average protection (of the type included above) is clearly the most commonly used formulation. Narrow-based weighted average protections are used infrequently. Full ratchet provisions (more favorable to the Investor) can be quite onerous and are typically strongly resisted by the company. If the Company lacks negotiating leverage and must agree to some form of full ratchet anti-dilution protection, then it should seek to negotiate limitations on the applicability or severity of such provision (e.g., limited duration, pay-to-play, percentage ownership cap, share price floor, etc.).

A11

similar plan approved by the Companys Board of Directors (the Board or Board of Directors) [which approval shall include at least [_______] Series A Director(s) (as that term is defined below)].21 Voting Rights: The Series A Preferred shall vote together with the Common Stock on an as-converted basis, and not as a separate class, on all matters submitted to a vote of stockholders, except (i) [so long as at least [__]% of the Series A Preferred are outstanding,] the Series A Preferred, as a class, shall be entitled to elect [_____] members of the Board (the Series A Directors), (ii) as provided under Protective Provisions below, or (iii) as required by law. The Companys Charter will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred Stock and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock.22 Protective Provisions: [So long as at least [__]% of the Series A Preferred are outstanding,] in addition to any other vote or approval required under the Companys Charter or By-laws, the Company shall not, without the written consent of the holders of at least [__]% of the Series A Preferred then outstanding, either directly or by Charter amendment, merger, consolidation, or otherwise: (i) alter, amend or repeal any provision of the Companys Charter or By-laws in a manner adverse to the Series A Preferred;23 ( ii) create or authorize the creation of or issue any new class or series of equity securities, or of securities convertible into or exercisable for any equity security, having rights, preferences or privileges senior to [or on parity with] the Series A Preferred, or issue additional or increase the authorized number of shares of Series A Preferred; (iii) create or authorize the creation of any debt security, or enter into new (or extend existing) loans or lines of credit, if the Companys aggregate indebtedness would exceed $[_______] [other than equipment leases or bank lines of credit] [unless such debt security and/or lines of credit have received the prior approval of the Board {with at least ____ Series A Directors joining in such approval}]; (iv) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, [other than (a) stock repurchased from former employees or consultants in connection with the cessation of their employment/services, pursuant to existing contract rights, stockholders agreements, incentive compensation plans, or as approved by the Board [with at least [____] Series A Directors joining in such approval]; or (b) as a result of the Companys exercise of its right of first refusal pursuant to the Right of First Refusal and Co-Sale Agreement described under Section 5 below; (v) organize or hold capital stock in any subsidiary that is not a wholly-owned subsidiary, or sell, transfer or otherwise dispose of any subsidiary stock or all or substantially all of any subsidiary assets;

A12

NOTES
21. VC investors can be expected to request a number of provisions as checks on certain required Board actionsproviding that the Company (or Board) may not take or effect certain actions without the vote, consent, or approval of all or a specified number of the Investors designated and elected directors. See also the Protective Provisions section below. Obviously, these provisions need to be reviewed and negotiated with care, as they present the possibility that the Investor(s) may block these actions (notwithstanding that they may be approved by Founders and common stockholders and be in the best interests of the Company and its stockholders as a whole). 22. In certain states (e.g., California), companies may not opt out of the statutory requirement of a separate class vote by common stockholders for certain matters (including authorization of shares of common stock). This provision in the term sheet effects an opt-out of Section 242(b)(2) of the Delaware General Corporation Law (the DGCL). 23. Note that DGCL Section 242(b)(2) provides that if any proposed charter amendment would adversely alter the powers, preferences, and special rights of a series of preferred stock, but not similarly adversely alter the powers, preferences, and special rights of the entire class of all preferred stock, then the holders of that series are entitled to a separate class vote on the amendment.

A13

(vi) increase or decrease the size of the Board; (vii) liquidate, dissolve or windup the affairs of the Company, or effect any merger, consolidation or other Deemed Liquidation Event[; (viii) engage in any business other than the business engaged in by the Company at the time of Closing; (ix) terminate the existing or appoint a new chief executive officer; or (x) change the Companys accounting practices or auditors from those in effect or place at the time of Closing].24 Redemption Rights: The Series A Preferred shares shall be redeemable from funds legally available therefor at the option of the holders of at least [__]% of the Series A Preferred then outstanding commencing any time after the [fifth (5th)] anniversary of the Closing at a price equal to the Original Purchase Price [plus all accrued and unpaid dividends].25 The redemption price shall be payable over three years in equal annual installments.26 Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for the Series A Preferred of any holders who expressly opt out)]. [Pay to Play Provision: [Unless the holders of at least [__]% of the Series A Preferred elect otherwise,] [and unless the pay-to-play purchase requirement is waived by the Board {(which waiver shall include at least ____ Series A Directors)},] on any subsequent down round investment transaction, the Investor shall be required to participate by purchasing its full pro rata share of the securities set aside by the Board for purchase by the Investor. Any Investor failing to do so (with respect to all Series A Preferred shares held by such Investor) will automatically, whether via conversion to another series of preferred stock or otherwise, [lose their anti-dilution protection rights] [lose their right to participate in future rounds] [lose their voting rights and veto/protection provision rights][have its shares of Series A Preferred converted to Common Stock and lose their right to designate or elect a Board seat, if applicable].27]

A14

NOTES
24. This is a relatively long list of protective provisions (over which the Investor will have a veto right), and an Investor may request others. These provisions are not standard or formulaic, and should be reviewed and negotiated with care and with the specific needs and objectives of the Company, and planned relationship (and shared governance) with the Investor, in mind. In addition, consideration should be given as to whether certain of the items are more properly the subject of Board approval and should be moved to the Board-approval-only (with Series A Director approval) list. See Matters Requiring Series A Director Approval in Section 4 below. If non-standard (and seemingly very onerous) protections are acceded to, then any non-objectively verifiable covenants should be placed in the voting agreement (and not the charter) so that disputes can be addressed as breaches of contract actions and possibly resolved through arbitration or some other specified alternative dispute resolution mechanism. 25. While in practice these rights are seldom (if ever) actually exercised, the right to force a redemption after a considerable investment period provides the Investor with leverage to cause management to plan for and effect an acceptable exit or liquidity event within a defined time horizon. 26. Due to applicable statutory restrictions, it is unlikely that the Company will be able (i.e., legally permitted) to redeem the preferred shares in the very circumstances where investors most want it. Thus, the Investor may request certain penalty provisions to take effect if a redemption is requested but the Company is unable (due to available cash) to effect it. Examples of penalties include (i) providing that the redemption amount is divided into (a) a cash payment in the maximum amount the Company is legally permitted to pay on the redemption date, and (b) the balance in the form of a one-year or two-year, interest-bearing note to each unredeemed holder of Series A Preferred, and (ii) providing that a majority of the Series A Preferred is entitled to elect a majority of the Board until the redemption amount is paid in full. 27. Pay-to-play provisions, although frequently discussed, remain the exception, not the rule, in VC investment transactions. They come in various forms, and (where utilized) are often the subject of intense negotiation. Company counsel must keep in mind the interests of all owners and investors in these provisions, and some (larger) VC investors have even required that the pay-to-play provisions apply to any future financing, including flat and up rounds. If the consequence for failure to play is losing some but not all rights (e.g., anything other than a forced conversion to common stock or loss of a contractual, as opposed to a charter-provided, right or preference), the charter will need to include so-called blank check preferred stock (and perhaps other) provisions to the extent necessary to enable the Board to designate and issue a shadow series of preferred stock with more limited rights and/or preferences in the event an investor fails to participate and the pay to play provision is activated.
A15

4. INVESTOR RIGHTS AGREEMENT TERMS Registration Rights Provisions: All shares of Common Stock issuable upon conversion of the Series A Preferred will be deemed Registrable Securities for purposes of registration rights.28 Series A Preferred holders shall have demand, S-3 and piggyback registration rights, as follows: DEMAND REGISTRATION RIGHTS: Upon the earlier of (i) [three to five] years after the Closing, or (ii) [six] months following an initial public offering of the Companys common stock (IPO), the holders of [25 to 49]% of the outstanding Registrable Securities may require [one] [two] consummated SEC registrations of their shares. The aggregate offering price for such registration may not be less than $[7.5-15] million. A registration will count for this purpose only if (i) [all] [at least ____% of the] Registrable Securities requested to be registered are registered with the SEC, and (ii) the public offering which is the subject of the registration closes, or the registration is withdrawn at the request of the Investor (other than as a result of a material adverse change to the Company). S-3 REGISTRATION RIGHTS: The holders of [10%-35%] of the Registrable Securities will have the right to require the Company to register on Form S-3, if available for use by the Company pursuant to applicable SEC rules, Registrable Securities for an aggregate offering price of at least $[1-5] million. There will be no limit on the aggregate number of such Form S-3 registrations, provided that there are no more than [two] per year. PIGGYBACK REGISTRATION RIGHTS: The holders of Registrable Securities will be entitled to piggyback registration rights on all registration statements of the Company, subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered to a minimum of [20-33]% on a pro rata basis and to complete a reduction in an IPO at the underwriters discretion. In all events, the shares to be registered by holders of Registrable Securities will be reduced only after all other stockholders shares are reduced [, subject to the right of the Founders first to sell up to [__]% of their Common Stock in an IPO or follow-on public offering]. REGISTRATION EXPENSES: The direct, out-of-pocket registration expenses (exclusive of stock transfer taxes, underwriting discounts and commissions) shall be borne by the Company. The Company will also pay the reasonable fees and expenses[, not to exceed $________,] of one special counsel to represent all the participating stockholders.29 The holders of Registrable Securities shall bear any expenses to be paid by them on a pro rata basis.

A16

NOTES
28. Founders and management sometimes also seek limited registration rights in appropriate circumstances. 29. Registration of securities in a public offering is a very expensive proposition (and, of course, the most expensive registration is the IPO). Generally, registration expenses include SEC filing fees, attorneys fees and expenses, accounting and audit fees and expenses, printing expenses, and the travel and other costs associated with a road show.

A17

LOCK-UP/MARKET STAND OFF: The Investor (and all holders of Registrable Securities) shall agree in connection with an IPO, if requested by the managing underwriter, not to sell or transfer any shares of Common Stock for a period of up to 180 days (plus up to an additional eighteen (18) days to the extent necessary to comply with applicable regulatory requirements) following the IPO (provided that all directors and officers of the Company [and all {1 5}% or greater stockholders] agree to the same lockup provision). [The lock-up agreement shall also provide that any discretionary termination or waiver of the restrictions in such agreement by the Company or the underwriter(s) shall apply to holders of Registrable Securities, pro rata, based on the number of shares held.] TRANSFER OF RIGHTS: Registration rights may be transferred to (i) any partner of any holder which is a partnership, (ii) any family member or trust established for the benefit (from an estate planning perspective) of any individual holder, or (iii) any transferee who acquires at least [__],000 shares of Registrable Securities; provided, in each case, that the Company is given written notice thereof and each such assignee expressly assumes the obligations of any holder of Registrable Securities under the Investor Rights Agreement. TERMINATION: The Investors (and all holders of Registrable Securities) registration rights shall terminate on the earliest of (i) when [all] [at least [___]% of the] shares of an Investor are eligible to be sold without restriction under Rule 144(k) of the Securities Act within a 90-day period, or (ii) the [third to fifth] anniversary of the IPO [, or (iii) a Deemed Liquidation Event]. No future registration rights may be granted without the consent of the holders of at least [a majority] of the Registrable Securities, unless such rights are clearly subordinate to the Investors registration rights. Management and Information Rights: A Management Rights letter from the Company, in a form reasonably acceptable to the Investor, will be delivered prior to Closing to each Investor that requests one.30 The Investor (by and through its designated representatives) will be granted access to Company facilities and personnel during normal business hours and following reasonable advance notice. In addition, the Company will deliver to such Investor (i) annual and quarterly [and monthly] financial statements, and such other information as determined by the Board; (ii) thirty (30) days prior to the end of each fiscal year, a comprehensive operating budget and plan forecasting the Companys revenues, expenses, and cash position on a quarterly [month-to-month] basis for the upcoming fiscal year; and (iii) promptly following the end of each calendar quarter, a current capitalization table [, certified by the CFO].

A18

NOTES
30. If a pension plan covered by the Employee Retirement Security Act of 1974 (an ERISA Plan) invests in a VC fund, then all of the funds assetssuch as its investments in portfolio companiesare treated as assets of the ERISA Plan (and thus must be held in trust, with certain transactions prohibited), absent an exemption. Under one ERISA exemption, a VC fund is not deemed to hold ERISA plan assets if it qualifies as a venture capital operating company (a VCOC). To qualify as a VCOC, the fund must have at least 50% of its assets invested in venture capital investments; an investment in a portfolio company qualifies as such a venture capital investment if the fund obtains certain management rights with respect to the portfolio company. In order to build a case for an exemption from the ERISA Plan asset rules, VC funds generally ask each of their portfolio companies to sign a management rights letter in connection with the funds initial investment in the company.

A19

Right to Participate Pro Rata in Future Investment Rounds: The Investor shall have a pro rata right, based on its percentage equity ownership in the Company (assuming the conversion of all outstanding preferred shares into Common Stock and the exercise of all options outstanding under the Companys incentive compensation plans), to participate in subsequent issuances of equity securities by the Company (excluding those issuances listed as Excluded Issuances at the end of the Anti-Dilution Protections section of this Term Sheet) at the same price and on the same terms made available to other purchasers. In addition (if there is more than one Investor), should any Investor choose not to purchase its full pro rata share, the remaining Investors shall have the right to purchase the remaining pro rata shares. Matters Requiring Series A Director Approval: [So long as the holders of Series A Preferred are entitled to elect a Series A Director,] the Company will not, without Board approval, which approval must include the affirmative vote of [one] [at least [____] of] the Series A Director(s): (i) make any loan or advance to any person, including any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of an employee stock, option or incentive plan approved by the Board; (ii) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, company, or other entity unless it is wholly-owned by the Company; (iii) incur aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget and/or capital plan, other than trade credit incurred in the ordinary course of business; (iv) guarantee any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (v) make any investment inconsistent with any investment policy approved by the Board; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any family member or associate (as defined in Rule 12b-2 under the Securities Exchange Act) of any such person [except transactions in the ordinary course of business and pursuant to requirements of the Companys business that are approved by a majority of the Board]; (vii) hire, fire, or change the compensation of any of the Companys executive officers, including approving any new or modifying any existing incentive compensation or option plans or awards; (viii) sell, transfer, assign, license, pledge or encumber material technology or intellectual property, other than licenses granted in the ordinary course of business; (ix) enter into any corporate strategic relationship or alliance involving the payment, contribution or assignment by or to the Company of assets greater than $[____],000.00, or (x) change the principal business of the Company, enter into any new line of business, or exit the current line of business.31

A20

NOTES
31. See footnote 21 above regarding Protective Provisions (veto rights of the Series A Preferred holders).

A21

Board of Directors Matters: The Series A Directors shall be elected to the Board as noted in Section 3 (under Voting Rights) above. [Each Board committee] [The Boards executive, audit and compensation committees] shall include at least one Series A Director. The Board shall meet at least [monthly] [quarterly], unless otherwise agreed by a majority vote of the Board. The Companys Board shall designate [audit, nominations, and compensation] committees, each of which shall include at least one Series A Director and at least one independent director. The Companys Charter shall include provisions providing for maximum limitation of liability and indemnification of (and advancement of expenses to) Board members under applicable law. The Company will procure and bind D&O insurance with a carrier and in an amount satisfactory to the Board. The Company shall enter into an indemnification agreement with each Series A Director [and, as requested, each affiliated fund] in form reasonably acceptable to such director. In the event the Company merges or consolidates with another entity and is not the surviving corporation, or transfers all or substantially all of its assets, proper provisions shall be made so that successors of the Company shall assume the Companys obligations with respect to indemnification of directors. Employee Stock Options: Immediately prior to the Closing, [______] shares will be added to the Companys employee incentive plan [stock option] pool, resulting in an aggregate unallocated pool of [_____] shares of Common Stock.32 Unless otherwise approved by the Board (or a committee established by the Board)[, which approval must include the approval of [the] [at least __ ] Series A Director(s)], all employee stock options and shares of restricted stock shall vest as follows: [25% after one year, with the remaining shares vesting {annually/quarterly/ monthly} and equally over the next thirty-six (36) months]. Key Person Life Insurance: The Company shall procure and maintain life insurance on the lives of each Founder [and _________] from an insurer and in an amount satisfactory to the Board. The proceeds of such policies shall be payable to the Company. 5. RIGHT OF FIRST REFUSAL/CO-SALE AGREEMENT TERMS Right of First Refusal/Right of Co-Sale (Come-Along or Take-Me-Along): The Company first and the Investor second shall have a right of first refusal with respect to any shares of capital stock of the Company proposed to be sold or transferred by the Founders [and officers or employees of the Company holding more than [two] percent of the outstanding Common Stock (assuming conversion of

A22

NOTES
32. This provision should be adjusted as appropriate to fit the facts of the company in question. If no equity incentive (stock option, restricted stock, etc.) plan is in place, then the Term Sheet will typically require establishment of such a plan, in form and substance reasonably acceptable to the Investor, at or prior to the Closing.

A23

preferred stock and including shares subject to incentive and stock option awards)], with a pro rata right of oversubscription for Investors on shares not subscribed or purchased by other Investors. Before any such person may sell shares, s/he must give the Investor an opportunity to participate in such sale (on a basis proportionate to the number of shares held by the seller and those held by the participating Investors). These rights of first refusal and co-sale shall be subject to certain customary and agreed exceptions.33 Termination: All rights under the Right of First Refusal/Co-Sale Agreement shall terminate upon the earliest of (i) an IPO, and (ii) such time as [no] [fewer than [__]% of the] Series A Preferred shares remain outstanding[, and (iii) a Deemed Liquidation Event]. 6. VOTING AGREEMENT TERMS Board of Directors: At the [initial] Closing, the Board shall consist of [____] members, comprised of (i) [Name(s)] as the members of the Board designated by the holders of the Series A Preferred (i.e., the initial Series A Directors); (ii) [Name] as the member of the Board designated by [the Founders] [the holders of Common Stock]; (iii) the person then serving as the Companys Chief Executive Officer, and (iv) [____] person(s) who are not employed by or affiliated with the Company or the Investor and who are mutually acceptable to [the Founders and the Investor] [the other members of the Board]. Directors who are not employees shall be entitled to reimbursement of reasonable out-of-pocket costs and expenses for attendance at meetings of the Board. [Drag Along: The Founders and all current and future holders of greater than [1]% of the outstanding Common Stock (assuming conversion of preferred stock and whether then held or subject to the exercise of options) shall be required to enter into an agreement with the Investor providing that such stockholders will vote their shares in favor of a Deemed Liquidation Event or other transaction in which 50% or more of the voting power of the Company is transferred [for a price that is (on a common equivalent basis) greater than [two] times the Original Purchase Price of the Series A Preferred, provided that such price is distributed in accordance with the liquidation preference terms substantially as described herein], and which is approved by [the Board] [and the holders of [__]% of the then outstanding shares of Preferred Stock, on an as-converted basis (the Electing Holders)]. The liability of each stockholder in such transaction shall be several (and not joint) and shall not exceed the stockholders pro rata portion of any claim, and the consideration to be paid to stockholders in such transaction shall be allocated as if the consideration were proceeds to be distributed to Company stockholders in a liquidation under the Companys then-current Charter.34]

A24

NOTES
33. Certain exceptions are typically negotiatede.g., estate planning and de minimis transfers, any sale in a change-of-control transaction (where all stockholders are treated the same), and any bona fide gift to a charitable organization. 34. Other terms and conditions that must be satisfied before a drag-along can be invoked are typically negotiated as part of the Voting Agreement negotiation and drafting process.

A25

[Sale Demand Right: Upon written notice from the [Electing Holders], the Company shall initiate a process intended to result in a sale of the Company (whether by merger, sale of stock, sale of assets or otherwise.] Termination: All rights under the Voting Agreement shall terminate upon the earliest of (i) an IPO, and (ii) such time as [no] [fewer than [__]% of the] Series A Preferred shares remain outstanding[, and (iii) a Deemed Liquidation Event]. 7. OTHER MATTERS [Founder Stock Vesting: Each Founder shall own all of his/her existing stock holdings outright, subject to the Companys right to purchase [up to a total of __% of] such stock at original cost. The repurchase right covers [__]% of each Founders stock for the first [12 months] following the Closing; thereafter, the right lapses in equal [monthly] increments over the following [36] months.]35 No Shop: The Company [and the Investor] agree(s) to work in good faith and expeditiously toward definitive agreements and a Closing consistent with the terms and provisions described herein. The Company and the Founders agree that they will not, for a period of [45-90] days from the date this Term Sheet is accepted, take, or permit to be taken on their behalf, any action to solicit, initiate, encourage or assist in the submission of any proposal, negotiation, or offer from any person or entity (other than the Investor) relating to the issuance or sale by the Company of any of its capital stock [or the acquisition, sale, transfer, lease, license or other disposition of the Company or of all or any material portion of the stock or assets of the Company] and shall notify the Investor promptly of any inquiries by any third parties with respect to any of the foregoing. Confidentiality: The Company will not disclose the terms of this Term Sheet to any person other than the members of the Board, officers, employees who need to know (to assist with the Investors due diligence investigation), and the Companys attorneys and accountants and other potential investors in this Transaction acceptable to the Investor, without the prior written consent of the Investor. Information Requests: The Company agrees to provide Investor with the information necessary to complete a due diligence, operational and legal review satisfactory to the Investor, including making its personnel, business, and financial books and records available to Investor and its representatives during normal business hours following reasonable advance notice.

A26

NOTES
35. VC investors sometimes request redemption rights on, or the retroactive vesting of, Founders previously owned shares, particularly in early stage financings where the amount of capital, effort, or ingenuity invested by Founders can be out of proportion to their stock ownership (or the pre-money valuation proposed). These provisions are also included to discourage Founders from leaving the Company or selling their stock prematurely. This is a matter for discussion and negotiation. Suffice it to say that Founders typically (vigorously) resist these provisions, and many VC investment transactions do not include them.

A27

Finders/Brokers: Neither the Founders nor the directors, officers or any stockholder of the Company has engaged or used any finder, broker, agent or other person who is or may be entitled to any fee or other compensation with respect to (or as a result of a closing of) the Transaction. Expiration: This Term Sheet automatically expires at 5:00 p.m. [New York City] time, on [________ __, 20__], if not accepted by the Company [and the Founders] by that time and date. This Term Sheet sets forth a framework for proceeding with the Transaction outlined herein. The [Expenses (in Section 2), No Shop (in Section 6) and Confidentiality (in Section 6)] provisions of this Term Sheet shall be binding and enforceable obligations of the Company; provided, however, that the obligations under such provisions shall terminate and expire upon the earlier of (i) the abandonment of discussions by the parties with respect to the agreements and transactions contemplated by this Term Sheet, and (ii) the parties execution and delivery of one or more definitive agreements providing for the Transaction. No other legally binding or enforceable obligations or agreements are intended to be, or are, created until and unless one or more definitive agreements are executed and delivered by the parties. This Term Sheet is not a commitment to invest, and is conditioned upon the Investors completion of due diligence, legal review, and documentation, all to the satisfaction of the Investor. Executed and delivered by each of the parties below (or its duly authorized officer) on this [___] day of [_________], 20[__].36 INVESTOR [Legal Name of Investor] ________________________ By: Its: COMPANY [Legal Name of Company] _______________________ By: Its:

[FOUNDERS] __________________________ Name: __________________________ Name: __________________________ Name:

A28

NOTES
36. Although practices vary, many VC investors request (and some require) that term sheets be signed by both the Company and Founders. While the legally binding effect of a signed term sheet is uncertain (particularly when the term sheet says it is nonbinding but also when rights and obligations are described summarily and in general terms), many VCs believe the Founders (and the Company) are less likely to back out once a term sheet is signed. Counsel should be engaged and consulted before a term sheet (or letter of intent) is finalized or signed. In addition, it is importantin order to avoid confusion and make way for a clear path forwardthat the final agreed form of term sheet be exchanged in a way (whether by letter or email) that indicates the parties acceptance of and agreement with the term sheet.

A29

ANNEX B: Glossary of Venture Capital Terms and Jargon

As even the most casual observer will notice, venture capital has a language all its own (although some of the terms and phrases are shared with buyout transactions, private equity, and even M&A transactions). Understanding the lexicon is important in approaching and engaging in this activity and market. Accordingly, a guide to some of the most frequently used terms and jargonas used by venture capitalists and other market participantsshould be useful. This GLOSSARYwhich has been assembled from many sources (including the authors experience, defined terms in investment documents and university and industry website resources)provides such a guide and should be read in conjunction with the body and the illustrative Series A term sheet (ANNEX A) included in this GUIDEBOOK. The following is a list of terms and jargon commonly used in venture capital discussions, presentations, negotiations, term sheets, agreements, and transactions. The list is incomplete, and some definitions may have local, geographic, or industry variations. Words and phrases included in the definitions that appear in italics are defined elsewhere in the GLOSSARY.

A Round (or A Round)

A funding or financing round in which Series A preferred stock is issued and sold to outside investors. This is typically the first institutional venture capital financing round (but may also include angel investors, angel groups and other sophisticated investors). The A in the name comes from the use of Series A Preferred Stock, the securities issued in the round. A person (including an individual, bank, trust, fund, or other entity) meeting certain net worth or income qualifications such that it is considered sufficiently resourced and sophisticated to make investment decisions without the need for regulatory protections. Regulation D under the Securities Act provides a safe-harbor exemption for private placements to accredited investors (so that these offerings need not be registered with the SEC). Requirements to meet the accredited investor standard are discussed in the body of this GUIDEBOOK under Securities Law Considerations for Private Offerings: What You Need to Know, starting on page 8. See Cumulative Dividends and Dividends.

Accredited Investor

Accrued Dividends

B1

Advisory Board

A group of outside advisors to a portfolio company, typically with expertise, experience and/or contacts in the companys industry and/or markets, formed for the purpose of providing informal guidance, advice and assistance to the companys management concerning a variety of strategic, business, and operating matters. An advisory board does not have the formality, role, or fiduciary duties of the companys board of directors. An affiliate of a specified person is another person controlling, controlled by, or under common control with the specified person. This tracks a definition in SEC rules often used in venture capital transaction documents. The SEC deems a companys directors and executive officers, as well as controlling stockholders, to be affiliates of the company. See Covenant. See Letter of Intent. A loan the value of which exceeds the value of all underlying collateral. Typically, a high net worth individual (often an accomplished entrepreneur and/or business executive) who provides funding (and, in appropriate cases, other value adds) to start-up and early-stage businesses. Angel investments usually precede investments by venture capital funds and usually provide seed and early stage capital of less than $1-2 million. See Angel Investing, beginning on page 73 of this GUIDEBOOK. Organizations, associations, clubs, and networking groups of angels formed for the purpose of studying, facilitating and executing angel investments in start-up and early-stage businesses. See Angel InvestingAngel Groups and Clubs, beginning on page 75 of this GUIDEBOOK.

Affiliate

Affirmative Covenant Agreement-in-Principle Airball

Angel; Angel Investor; Angel Investment

Angel Groups

Anti-Dilution Protection A provision (usually, in a contract or instrument providing for a or Provision security, such as an option, warrant, or convertible security) that protects an owner/investor from dilution of its ownership interest due to future issuances and sales of capital stock by the company/issuer. For the mechanisms providing for adjustments to counteract dilution and maintain percentage ownership, see Weighted Average and Full Ratchet.

B2

Anti-Fraud Rules

Rules and regulations, promulgated under federal and state securities laws, that prohibit (and provide for penalties and remedies in the event of) fraud, which includes material misstatements and omissions of material information (necessary to make a statement, in light of the circumstances in which it is made, not misleading), in connection with the offer and sale of securities. A process, typically run by senior management of a company with the assistance of an investment banker and counsel, to put a company up for sale; manage the due diligence/information flow process; pursue interest, involvement and offers from potential purchasers (strategic and/or financial) most likely interested in (and thus most likely to pay top dollar for) the company; and ultimately to sell the company at an optimal price to the highest bidder and on the best terms. A feature of a convertible security, whereby that security, upon the occurrence of certain specified events or transactions, automatically and mandatorily converts (without any action on the part of the holder or the issuer) into (and becomes) shares of common stock. See also Convertible Preferred Stock. A funding or financing round, following the A round, in which Series B preferred stock is issued and sold to outside investors (usually, VC investors). This can be effectuated through existing and/or new investors. Subsequent funding rounds are referred to as C, D, and so on. One one-hundredth (1/100) of a percentage unit. For example, 50 basis points equals one-half of one percent. Interest rates on loans are often quoted in terms of an index plus a margin, and the margin is often described in basis points, such as LIBOR or Prime plus 400 basis points. Specific dollar limitations on indemnity claims or other provisions provided under an agreement (typically an investment or purchase agreement). For example, the agreement may provide that one party may bring indemnity claims against the other only if the aggregate amount of all claims exceeds a specified dollar amount. The specified dollar amount is the basket. A deductible basket means that the specified dollar amount is entirely exempt from, and only the excess over that amount is subject to, indemnity claims. A threshold (or dollar-one) basket means that once the specified dollar amount (in the basket) is exceeded, the indemnified person can recover the full amount of all claims (from the first dollar).

Auction

Automatic Conversion

B Round

Basis Point (or bp)

Basket

B3

Beneficial Ownership

Refers to equitable rather than record ownership of securities (a term commonly used in venture capital documents). For purposes of Sections 13(d) and 13(g) of the Exchange Act, a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, relationship, or otherwise, has or shares (1) voting power, which includes the power to vote or to direct the voting of, such security; or (2) investment power, which includes the power to dispose of, or direct the disposition of, such security. A product that is being tested by potential (also called Beta) customers prior to being formally marketed, sold and launched into the marketplace. Preferred stock that has been authorized in the charter of a corporation, but (i) the terms (and rights, preferences, and limitations) have not yet been designated by the board of directors; and (ii) the stock has not yet been issued or sold to investors. Thus, shares of the authorized preferred stock (as authorized in the charter) may be designated, issued, and sold (pursuant to board of director action) at a later date, with no requirement or need for stockholder vote or approval. See also Certificate of Designation. See Veto Rights. Individual state laws that address (and, to some extent, regulate) the offer, issuance and sale of securities, and persons (brokers, dealers, advisors and finders) who act to facilitate the offer, issuance and sale of securities. These laws are intended to protect the investing public against fraudulent actions and transactions in connection with the sale of securities. A contractually provided right for an investor (or its designee) to attend all regular and special meetings of the board of directors (and often meetings of board committees). This also typically includes the right to receive information and notices that are provided to board (and committee) members. Importantly, a board observer does not have the right to vote as a board member and generally does not owe the company (as a board member) fiduciary duties or (absent a contract on point) confidentiality obligations.

Beta Product

Blank Check Preferred Stock

Blocking Rights Blue Sky Laws

Board Observer Rights

Board of Directors; Board The governing body (a group of individuals) of a corporation (or other business entity), charged with oversight of the management and direction of the corporation (or other business entity). Individual board members (directors) are elected (usually annually) by stockholders (or equity interest holders) to serve on the

B4

board, and they owe certain fiduciary duties to the corporations stockholders (all in accordance with the charter documents and applicable state law). Venture capital funds typically have the right to designate and elect a specified number of board members (and, together with founders/management, to designate and elect one or more independent directors). See also Independent Director and Voting Agreement. Book Value The value of the common stock of a company as shown on its balance sheet is its book value. Without getting overly technical, this is defined as total assets minus liabilities minus preferred stock minus intangible assets. When discussing the book value of an asset, this typically is based on the assets original cost less accumulated depreciation. Actions implemented by a start-up or other undercapitalized business to minimize (or squeeze) expenses, work relationships, utilize existing resources, and/or build cash flow (and margin, if any), thereby reducing, delaying, or eliminating the need for external capital funding. A failure to adhere to the terms of a covenant included in an investment, financing or other contract. Temporary (and sometimes emergency) limited funding that will eventually be replaced by permanent capital (from equity investors or debt lenders). In venture capital, a bridge loan or financing is usually provided in the form of a short-term note (4 to 12 months) that is convertible into preferred stock. Typically, the bridge lender has the right to convert the note to preferred stock at a price that is discounted from the price of the preferred stock issued in the next financing round. The loan, which is sometimes accompanied with warrants (in favor of the bridge lender), is intended to bridge the borrower to its next round of financing. The repetition (or the later making current) of representations and warranties (included in an investment or purchase agreement) after the date on which they were originally made (i.e., the agreement or signing date), principally in the context of conditions to the obligations of the parties to close an investment or acquisition transaction. For example, at the signing of a purchase agreement, the company may represent (in the purchase agreement) that X is true. A bring down at closing is where the company makes that same representation again at the closing. Accordingly, the representation is tested as to accuracy (with remedies for breach) both at the contract signing date and the closing date.

Bootstrapping

Breach of Covenant

Bridge Financing

Bring-Down

B5

Broad-Based The most commonly used form of anti-dilution protection (and Weighted Average related adjustment mechanism) incorporated in convertible Anti-Dilution Protection preferred stocks and used in venture capital transactions. See Weighted Average and the discussion regarding Anti-Dilution Protections in the GUIDEBOOK, beginning on page 55. Burn Rate The rate at which a business (usually a start-up or early stager with little or no revenue) expends its available cash over a defined period. This is usually expressed on a monthly or weekly basis. A legal presumption that most judgments made by the board of directors of a corporation are presumed to be correct (i.e., in the best interests of the corporation and its stockholders) and will not be second-guessed by the reviewing court, so long as they are made in good faith, on an informed basis, without conflict or selfinterest, and in a manner reasonably believed to be in the best interests of the corporation. This rule is grounded in state corporation law (i.e., the governing law of the state in which the corporation is organized), and thus may vary from state to state in application. A dynamic document, often used (among other things) to incite interest by VC and other potential investors and introduce them to a business, that describes a business venture and opportunity. A business planwhich is not a form and should express the uniqueness and identify of the business describedtypically includes the following sections: executive summary, business concept (market need and solution), management, history, competitive advantage, capitalization, financial statements and projections and risks and other considerations. See Present a clear, compelling opportunity via the business plan, beginning on page 29 of this GUIDEBOOK. A sector or subset of the private equity industry. Buyout also refers to the acquisition of a majority, controlling interest of a target company by an outside investor or group of investors (usually a buyout, LBO or private equity fund) (such a buyout is referred to as an LBO or leveraged buyout). If the buyout is led by the existing senior management team of the target company, it is referred to as a management buyout. The right to buy a security at a specified price (or price range) within a specific time period. See also Option. A maximum limit on indemnity claims or other terms and provisions under a definitive agreement. Also referred to as a ceiling.

Business Judgment Rule

Business Plan

Buyout

Call Option; Call

Cap

B6

Participating preferred stock may have the participation feature subject to a cap (and thus an investor is not entitled to receive more than a specified amount). Capital Call When a venture capital (or private equity) fund manager (usually a general partner in a limited partnership) requests or requires (pursuant to a previous pledge or commitment) that an investor in the fund (a limited partner) provide additional capital to the fund. Typically, the limited partners agree to a maximum investment amount, and the general partner makes a series of requests/demands for capital over time to the limited partners as opportunities arise to invest in portfolio companies. The units of ownership (such as common stock and preferred stock) in a corporation, usually evidenced by stock certificates, as authorized in the corporations charter (consistent with the state of incorporations corporate laws). See also Equity Securities. A table showing the capitalization of a company, which typically includes all securities issued by the company, and the identity and security/share ownership of each security-holder (or, at least, of the significant ones). The Cap Table also lists the form of security (whether equity or debt), such as common stock, preferred stock, options, warrants, senior debt, mezzanine debt and subordinated debt. Regarding a venture capital (or private equity) fund organized as a limited partnership, the general partners share of the capital gains generated through the funds performance (via liquidity events with respect to portfolio investments). Typically, a fund must return the capital invested in it by limited partners (plus any agreed hurdle rate or preferred rate of return) before the general partner can share in the gains of the fund. The general partner will then receive its agreed carried interest (also known as its carry or promote), which is the agreed share or split (with the limited partners) of the remaining gains. The carried interest (and not the management fee) is the general partners principal financial incentive to perform well and generate strong fund returns. A certificate filed by a corporation with the appropriate state agency (of the state of incorporation) attesting to the board of directors designation of the terms, rights, preferences, and limitations of a series of blank check preferred stock. Once filed, the Certification of Designation becomes a part of the corporations charter (and the authorizing instrument of the security in question).

Capital Stock

Capitalization (or Cap) Table

Carried Interest; Carry

Certificate of Designation

B7

Change of Control; Change of Control Provision

A provision in an agreement under which one partys change of control (as defined) triggers certain rights of another party, such as the right to terminate the agreement, or the acceleration or vesting of certain rights, interests, benefits or obligations under the agreement. What constitutes a change of control is often defined by reference to a transaction (e.g., merger, consolidation or share exchange), the sale or transfer of ownership of a specified percentage or amount of voting stock or assets, or a significant change in the composition of the board of directors (or other governing body). The principal governing document of a corporation or company, as authorized under the governing corporate law of the state of organization, prepared and filed when the company is first formed. Typically named the certificate of incorporation or articles of incorporation in the case of a corporation, or the certificate of formation in the case of a limited liability company. A contractual provision in a venture capital (or private equity) funds governing documents which provides that, over the life of the fund (and gains and losses on disposition of portfolio investments), the funds managers will not receive a greater share of the funds distributions than what they agreed and bargained for. Generally, this means that the general partner of the fund may not keep more than a specified percentage (e.g., 20%) of the funds cumulative gains (and thus must return any excess to the funds limited partners). The process of consummating (or the consummation and conclusion of) an investment transaction or financing round in which the requisite final (executed and delivered) legal documents and investment funds are exchanged and delivered. At the closing of an investment transaction, the investor receives the securities purchased, and the company receives the funds paid for such securities. An investment transaction in which several fund investors invest side by side in the same round or transaction. Although this term is most commonly used in private equity fund and buyout deals, it is also used in multi-fund venture capital transactions. The total or maximum amount of capital (or Commitment) (funding) committed or pledged to a venture capital (or private equity) fund by its limited partners and available for the purchase of or investment in portfolio companies.

Charter

Clawback

Closing

Club Deal

Committed Capital (or Commitment)

B8

Common Stock

The most basic form of equity ownership, and unit of ownership, in a corporation. Common stock is the most junior form of equity security (in terms of dividends, liquidation and other rights). Usually, company founders, management, employees, and friends and family own common stock, while outside investors (including VC funds) purchase and own preferred stock. Holders of common stock are entitled to vote for the election of directors and other matters requiring a stockholder vote; to the payment of dividends (if, as, and when declared and paid); and to distribution of all remaining proceeds in liquidation (after the claims of the secured and unsecured creditors and bondholders, government required payments, and the liquidation preferences of the preferred stockholders are satisfied). A stand-alone agreement or a provision in a letter of intent or definitive agreement, whereby one party agrees to treat as confidential, and not to disclose to others, non-public, proprietary, sensitive and possibly other documents and information received from the other party or its agents. Sometimes also called an NDA or non-disclosure agreement. The ratio used to determine the number of shares of stock into which a convertible security may be converted. In a venture capital transaction, this most commonly refers to the ratio that determines, at any point in time, the number of shares of common stock into which shares of convertible preferred stock may be converted (subject to adjustment by virtue of the operation of the antidilution provisions). Rights under which shares of preferred stock (or other convertible securities) may be converted into (and become) shares of common stock. Conversion can be automatic or mandatory (in certain specified events, such as a qualified sale, qualified IPO, satisfaction of financial performance targets, and/or approval by a specified vote of preferred stock holders), or voluntary (i.e., at the option of the holder). These rights are typically protected by anti-dilution provisions. A type of capital stock in a company that is both (i) preferred stock, and (ii) convertible into shares of common stock at a specified conversion ratio (subject to adjustment by virtue of the operation of the anti-dilution provisions). This form of capital stock provides the holder with a priority and preference on dividends, distributions, and liquidation over common stock and, in many cases, over other (junior) series of preferred stock. Convertible preferred stock is clearly the accepted medium and most commonly used form of security in venture capital investment transactions.

Confidentiality Agreement

Conversion Ratio

Conversion Rights

Convertible Preferred Stock

B9

Convertible Security

A security of a company that by its terms is convertible into or exchangeable for another security (usually common stock) of the same company (e.g., convertible preferred stock, convertible notes, and convertible debentures can be convertible into shares of common stock). See also Convertible Preferred Stock. See Charter. A legal entity organized under state law through the filing of a charter. The corporation is owned by its stockholders (or stockholders), managed by its officers, and overseen/directed by its board of directors. A corporation can achieve certain tax advantages for its stockholders if it makes a proper and timely S-election with the Internal Revenue Service. See S Corporation and Pass-Through Entity. See Tag-Along Rights. A legal promise in a definitive agreement that obligates a party either to take an action (referred to as an affirmative covenant), refrain from taking an action (a negative covenant), or that requires the maintenance or achievement of some defined economic or financial measure (a financial covenant). For example, in an investment transaction agreement, the company may agree not to incur more than a specified amount of additional indebtedness (a negative covenant). A funding round in which new investors (usually bringing substantial capital into the company and/or as part of a down round) demand and receive new preferred securities and contractual provisions that significantly reduce (or dilute) the ownership percentage (and rights and protections) of previous investors. Usually, as a result of a cram-down round, the new investors gain majority and controlling ownership of the company. See also Wash-out Round. A definitive agreement under which one or more parties (the lenders) provide loans or credit facilities (i.e., funds available to be borrowed), such as a term loan and/or revolving loan or facility, to another person (the borrower), subject to compliance with certain agreed covenants and remedies if there is an event of default. The credit agreement (which is usually secured by a mortgage and/or security agreement) typically provides for the most senior, secured credit arrangements of a borrower.

Corporate Charter Corporation

Co-Sale Rights Covenant

Cram-Down; Cram-Down Round

Credit Agreement

B10

Cumulative Dividends

The right of a holder of capital (typically preferred) stock to receive accrued (and previously unpaid) dividends at, a specified rate and since the original issuance of the stock, in full before any dividends may be paid to the holders of any other, junior class or series of capital stock (including common stock). Thus, dividends may accrue and accumulate at a fixed rate (e.g., 4% to 9% per annum) or may simply be paid when, as, and if declared by a companys board of directors. Because venture-backed portfolio companies typically need to conserve cash (and thus do not pay dividends), employing a cumulative dividend feature means the liquidation preference of the underlying preferred stock is increased by an amount equal to the cumulative accrued dividend. Cumulative dividends are often waived (or inapplicable) if the preferred stock converts to common stock prior to an IPO, but may be included in the liquidation preference (or as an adjustment to the conversion ratio) for other purposes, including in any specified deemed liquidation event. The place or location in which a target or portfolio companys (usually confidential) material documents, instruments, contracts, plans, books, and records are placed for access and examination by potential investors in connection with their due diligence investigation. When populated, secured, maintained and accessed electronically (via secured website access), the Data Room is also referred to as a virtual data room or VDR. A term used by venture capitalist funds to express the volume or number of potential portfolio investments the fund reviews during any given period. Generally, longer-term notes issued to a number of investors (actually lenders, referred to as debenture holders) pursuant to an indenture and a debenture purchase agreement. The debenture, like a note, evidences the borrowing of and the obligation to repay the funds used to purchase the debenture. See also Note. A security evidencing a loan from a purchaser (lender) and a debt obligation of a company (or issuer of the debt security). Examples include notes and debentures. The obligation evidenced by a debt security is in many ways functionally equivalent to a bank loan, but the terminology is different: a lender makes loans to a borrower under a credit agreement or facility, while an issuer issues and sells debt securities to a purchaser, pursuant to an indenture or note (or debenture) purchase agreement. The principle features of a debt security are the principal amount, interest rate, covenant and default provisions, and maturity or term (and/or termination provisions).

Data Room

Deal Flow

Debenture

Debt Security

B11

Deemed Liquidation Event

An important definitional term included in preferred stock designations (regarding a particular series of preferred stocks rights, preferences and limitations) which defines when the payment of the liquidation preference is (and perhaps dividends and amounts payable in a redemption are) triggered. Although these matters are subject to negotiation (and involve interplay with other provisions, including veto rights/protection provisions), deemed liquidation events are often defined to include mergers, consolidations, sales (including of all or substantially all the assets), and changes of control (as defined). See Liquidation Preference and Participating Preferred Stock. The final form of signed written agreement, typically to undertake and consummate a transaction (e.g., a venture capital investment or acquisition transaction), which by its terms is legally binding and enforceable (subject to the satisfaction or waiver of certain specified conditions). See Registration Rights. A reduction in the percentage ownership, or in the value of equity security holdings, of a given stockholder (e.g., a founder, manager, employee, or previous investor) caused by the issuance, or potential issuance, of additional equity securities (or rights to acquire, convert into or exchange for equity securities). See Anti-Dilution Protection. An individual member of a corporations board of directors, usually elected annually by the corporations stockholders. An exhibit (or schedule) attached to a definitive agreement (usually an investment or acquisition agreement) that describes exceptions to the representations and warranties (and, in some cases, covenants) of the parties included in the agreement. Sometimes also called a schedule of exceptions. Once a definitive agreement is prepared by the investors counsel, it is the issuers obligation to prepare appropriate, complete, and responsive disclosure schedules (which will form part of the definitive agreement). This scheduling process is part of the investors due diligence investigation. A valuation methodology under which the present value of all future cash flows expected to be generated by a business is calculated (via discounting by applying a discount rate), based on generally accepted valuation tools and assumptions.

Definitive Agreement

Demand Rights Dilution

Dilution Protection Director

Disclosure Schedule

Discounted Cash Flow (or DCF)

B12

Distribution

A transfer of cash or securities to a funds limited partner in accordance with the funds (limited partnership) documents. Sometimes distribution also refers to a dividend (usually, a pro rata cash payment) to stockholders. A payment (or distribution) that is authorized and declared by the board of directors, made in respect of and to the holders of shares of capital stock (or of a particular class or series of such stock), on a pro rata basis, as of the dividend record date. Dividends may accrue, and also may be cumulative, non-cumulative, participating, and non-participating. See Cumulative Dividends. A round of funding (i.e., a separate, later investment transaction) in which the valuation of the company (and thus the effective, common-equivalent price per share) is lower than the valuation utilized (and embraced in securities issued and sold) in a previous round of funding. Contractual rights (typically provided in a stockholders agreement or investor rights agreement) that allow one or more investors/stockholders (often those holding a majority or a specified percentage of the outstanding shares) to force (or drag) all other stockholders to agree to and/or participate in a specific action, such as the sale of the company, alongside the initiating investor/stockholder. This provision operates to prevent minority stockholders from blocking a sale of the company (approved by the majority) by refusing to sell their shares. A significant angel or other investor, or venture capitalist, which only attends board meetings and engages in other minimal reporting and relationship activities and rarely if ever offers or provides value-adds, advice, insight, assistance, or introductions to contacts. The fact-finding process in which a potential investor (or lead investor and/or its or their agents) investigates the issuer to assess a potential investment and the accuracy of information provided by the issuer. This process typically involves a review of the issuers business, operations, financial statements and projections, accounting information, operations, personnel, customer relationships, regulatory matters, technology and intellectual property matters, and legal contracts, books, and records; discussions with management; visits to offices and facilities; and review of other pertinent documents and information.

Dividend

Down Round

Drag-Along Rights

Drive-By Investor (or VC)

Due Diligence

B13

Due Diligence Out

A term or provision in a definitive agreement relating to an investment (or acquisition), which gives the investor (or acquirer) party the right to terminate the agreement (and/or not consummate the transaction) if it is not satisfied with the results of its due diligence investigation. Agreements which include a due diligence out are sometimes referred to as options. The state or stage of development of a company after the seed (or formation) stage and before some middle-life or intermediate stage (when it has customers and is generating revenue). Although definitions may vary by audience, geography, and industry, an early stage company typically will have in place a core (but not complete) management team, a developed business plan and proven concept or product (perhaps with initial customers and beginning to make sales), but no established customers, positive cash flow, or profits. An arrangement (usually included in a definitive acquisition agreement) under which the seller(s) of a business is(are) entitled to receive addition future payments (of the nature of purchase price consideration) if certain financial performance metrics are achieved at (or as of periods ending at) specified post-closing dates (typical metrics include revenues, net income or EBIT). A cash-flow based measurement of the operating profitability of a company. These are acronyms for (i) EBITa companys earnings before interest and taxes (EBIT) and (ii) EBITDAa companys earnings before interest, taxes, depreciation, and amortization (EBITDA). These measures are often used by sophisticated investors as a basis for valuing the company and their investment. One often utilized valuation methodology is based on a comparison of (reasonably comparable) private and public companies values as a multiple of EBIT or EBITDA, properly discounted.

Early Stage

Earn Out

EBIT; EBITDA

Elevator Pitch or Speech A very concise, rehearsed oral presentation, lasting not longer than a minute or two (i.e., the duration of an elevator ride), by an entrepreneur (or business owner or manager) to a potential investor concerning the business venture and the compelling nature of the investment opportunity presented. Entrepreneur An individual who, applying principles of entrepreneurship, starts and fosters his or her own business. The application of street smarts, creativity, innovation, hard work, and/or bootstrapping (together with a fair sprinkling of luck) to a business idea or concept so as to start and foster a business that ultimately creates exceptional value.

Entrepreneurship

B14

Equity Securities

Securities evidencing the equity and ownership rights in (the capital stock of) a company or business entity. In a corporation, equity securities include common stock and preferred stock (and sometimes special stock), options, warrants, and rights (including conversion and exchange rights) to acquire these. Together, the equity securities represent the ownership of the company. An event, act, or occurrence that allows a party to a definitive agreement to exercise specific remedies under that agreement, such as the acceleration of the obligation to repay debt (and other amounts) under a credit agreement. See Securities Exchange Act.

Event of Default

Exchange Act

Exclusive or Exclusivity See No-Shop. Exercise Price The price at which an option or warrant can be exercised (i.e., the purchase price for the shares or securities covered by the option or warrant). The means (or plan) by which a companyfor the benefit of its owners and investorsgenerates gains and thereby monetizes its owners investment in the company. This typically comes when the portfolio company merges with or is sold to another company, goes public via an IPO, or recapitalizes (e.g., leverages its balance sheet and pays dividends to and/or purchases securities from stockholders). See Liquidity Event. The state or stage of development of a company (following its early stage) characterized by a complete management team, loyal customers, some level of profitability, and a substantial rampingup of revenues (and, perhaps, of revenue channels). An accounting and financial principle for measuring the value of assets and liabilities, for example, with respect to portfolio company holdings in a VC fund portfolio. The principle requires an assessment (sometimes referred to as mark-to-market) of the market price or market value of an asset or liability, based on a provided or objectively assessed fair value measurement standard. This principle has received a fair amount of attention recently, as the Financial Accounting Standards Board (FASB) has issued definitive guidance (FAS 157) on this long standing GAAP-based principle. A professional evaluation and assessment (usually expressed in an opinion letter) from an investment bank, financial advisor or

Exit Strategy

Expansion Stage

Fair Value

Fairness Opinion

B15

valuation firm as to the fairness from a financial point of view of (the consideration to be paid or provided in) a merger, acquisition, disposition, stock buyback, spin-off or other transaction. A fairness opinion is provided for an agreed fee. Financial Covenant Finder See Covenant. A person or firm who helps to arrange an investment transaction, usually by identifying and introducing one or more potential investors to a fund-seeking company. See Right of First Offer. See Right of First Refusal. The act of purchasing something and then immediately or quickly selling it. Used frequently in relation to an IPO (where some investors who purchase shares in the IPO immediately turn around and sell their shares into the public market). Often management, VCs and other significant stockholders are prohibited from selling shares concurrent with or immediately following an IPO due to a lock-up agreement required by the underwriters (or the lead or managing underwriter). Under a lock-up agreement, the stockholders party thereto must refrain from selling their shares for a stated period following the IPO (usually, six to nine months). Flipping also can refer to the practice of a private equity fund buying and then quickly re-selling a portfolio company. Additional funding and/or financing round(s) effected by a company following its initial round. These are often, but not always, funded by existing investors. See Mandatory Redemption. A requirement sometimes (particularly in early stage ventures) imposed by venture capitalists that a portion of the founders ownership position retroactively vest (in effect, become earned and non-forfeitable) in stages and only after continued employment with the company of after the passage of a specified period of time. Such vesting is designed to ensure that founders do not receive a windfall from their initial (nominally priced) share allocations and to discourage founders from leaving the company or selling their shares prematurely.

First Offer Rights First Refusal Rights Flipping

Follow-On Funding; Follow-On Investment

Forced Buyback Founder Vesting

B16

Founder(s)

The individuals who participate in the creation (and conceptual development) of a business venture. Typically, founders own only common stock, and manage the company until it has sufficient resources to attract and retain professional management. Shares of common stock issued (at nominal prices) to and owned by the companys founders upon (and in connection with) the companys formation. Other persons who participate in the companys formation or very early development (e.g., initial directors, employees and consultants) may also receive Founders Stock. Investment capital or an investment round, typically after the founders have exhausted their own available funds, provided by the family members and friends (close relationships) of the founders of an early stage company. While providing important and much-needed funding, founders should be carefulin completing early friends and family roundsnot to create an ownership structure or composition, or make promises or commitments, that may adversely affect the appetite or participation of professional investors once the company matures and begins to achieve success. An anti-dilution protection mechanism that is favorable to the (new) investor (and can be unfavorable to the company and common and junior preferred stockholders) in the event of a subsequent capital raise effected at a lower valuation (a down round). It adjusts the exercise price or conversion ratio of a security to the lowest price at which securities (including convertible securities, options, and warrants) are issued in a future funding round (without regard to the number of shares issued). As a result of the implementation of a full ratchet, founders, management, employees, and others who own common stock typically suffer substantial dilution. See also Anti-Dilution Protection and Weighted Average. The number of shares of capital stock (typically expressed as outstanding shares) representing the total current and potential ownership of a company, including all issued shares of capital stock, the conversion of all convertible securities, the exchange of all exchangeable securities, and the exercise of all options and warrants. This is an important (i) methodology for calculating any per share ratios (where the denominator is the fully diluted shares); (ii) entry/line item in the Capitalization Table; and (iii) consideration in valuation and option pool discussions (and the negotiation of anti-dilution, incentive plan and other provisions).

Founders Stock

Friends and Family Financing

Full Ratchet

Fully Diluted

B17

Gatekeepers

Intermediaries (such as attorneys, accountants, bankers, headhunters, and consultants) who venture capitalists look to as sounding boards and advisors in sourcing and gaining introductions to potential portfolio company investments. With respect to a venture capital fund organized as a limited partnership, the partner designated and responsible for all aspects of managing the fund, including communicating with limited partners, raising capital for the fund, screening and making portfolio investments, nurturing and overseeing portfolio companies, and assisting with effecting exits and liquidity. The general partner, which is typically organized as an LLC, earns a management fee a percentage of the funds profits (known as the carry or carried interest). See also Limited Partners. A financial incentive or award that, by its terms, discouragesvia clear and substantial adverse economic consequencesfounders, managers and key employees from leaving the company before a specified date or achievement of an agreed milestone. The (middle) stage or state of development of a company when it has already received one or more rounds of funding, has initial customers and is beginning to generate revenue (at an increasing rate) from its proven product or service offerings. Follows the early stage, and precedes the expansion stage. A phrase used to describe a definitive agreement having few, if any, conditions to closing. Once the hell-or-high-water definitive agreement is signed, there are very few outs and thus (as a general proposition) the parties must proceed to closing. The upward-slanting shape of a graph or chart showing revenue, EBIT, customers, or some other financial or operational measure that increases dramatically at some point in the future. Founders and entrepreneurs have been known to craft business plans that include hockey stick chart projections to attract the interest of potential investors (including venture capitalists). The minimum preferred rate of return to limited partners in a venture capital fund (organized as a limited partnership) to be achieved (after the return of limited partner invested capital) before the general partners (or fund managers) carried interest kicks in. A hurdle rate of 10% means that the venture capital fund must achieve a return of at least 10% per annum on invested assets (for its limited partners) before the remaining profits or gains are shared (with the general partner) according to the carried interest arrangement. Also sometimes referred to as the preferred return.

General Partner

Golden Handcuff

Growth Stage

Hell or High Water

Hockey Stick Projections

Hurdle Rate

B18

Incentive Stock Options Stock options that are entitled to favorable tax treatment for the (ISOs) holder under the Internal Revenue Code (e.g., the holder does not pay tax on exercise and can achieve long-term capital gains more easily). ISOs are also subject to certain limitations and restrictions, and (because of less favorable tax consequences to the issuing corporation) are not the stock option of choice for emerging or venture-backed companies. See also Non-Qualified Stock Options. Incorporation The process which results in a business or venture becoming a corporation, via filing a charter with the state of incorporations secretary or department of state. Many businesses choose Delaware as the state in which to incorporate. An organization or facility designed to host, nurture, and assist start-up companies (including business concepts and new technologies) to the point that they become attractive to professional management, angel investors, and even venture capital funds. An incubator typically provides both physical space and many (shared) back-office/administrative services, as well as access to basic legal, accounting, technical and other support services. Incubators typically charge both a fee and a percentage of the equity (or equity upside) for these services. Provisions in a definitive agreement (and sometimes in a separate agreement) providing one party with post-closing remedial rights (i.e., cash compensation for damages) against the other party with respect to breaches by the other party of its representations and warranties or covenants (that survive the closing), as well as the right to recover legal and other fees and expenses incident to pursuing such remedial rights. Indemnities are typically negotiated, and often are subject to a basket, a cap, and other limitations and exclusions.

Incubator

Indemnity; Indemnification

Independent (or) A member of a board of directors who has no ties or affiliations Disinterested) Directors with either company insiders (i.e., founders or management) or outside investors. Voting Agreements (along with charter provisions) often provide for the election of one or more independent directors (typically designated by the VC investor(s) and reasonably acceptable to the founders and other common stockholders). For public companies, SEC and stock exchange rules provide rather elaborate, detailed definitions and requirements regarding independent or disinterested directors. Initial Public Offering (IPO) A corporations first offer and sale of stock to the public, effected pursuant to a registration statement (and prospectus) filed with and declared effective by the SEC under the Securities Act.

B19

Typically, the IPO is underwritten by an investment banking firm (underwrite), with the shares listed or quoted on a national securities exchange (such as the New York Stock Exchange) or stock quotation system (such as the NASDAQ Stock Market). An IPO can provide substantial new investment capital, liquidity for existing stockholders and continuing access to the public capital markets. Inside Round A round of funding in which the investors have all previously invested (usually in the immediately preceding round) in the company. Inside rounds can give rise to valuation and conflict issues (and attendant potential liabilities). Large, asset-rich, professionally managed organizations that (as a core business model) invest capitalon behalf of othersin a variety of investments and asset classes and on a continuous basis. Examples include insurance companies, pension funds, and university and other major endowments. Institution Investors, together with very high net worth individuals, comprise the vast majority of the investors (and limited partners) in venture capital funds.

Institutional Investors

Intellectual Property (IP) Intangible (non-physical), but often very valuable, assets of the business, such as knowledge, know-how, brand, techniques, and unique writings and images, often protected by law via patents, copyrights, and trademarks. The protection of intellectual property can provide for distinct competitive advantages and can be vital to a ventures fundraising and growth prospects. Internal Rate of Return (IRR) The interest rate (expressed as a return on capital invested) at which a specific amount of capital invested today would have to grow in order to reach a specific value at a specific time in the future. This is the standard, accepted benchmark venture capital funds (and their limited partners) utilize to measure, and compare their performance. One of the principal definitive agreements (between the company and the investors/purchasers) in a venture capital investment transaction, typically providing for registration rights, covenants regarding rights to financial and other information, board observer rights (if any), other affirmative and negative covenants, and rights of first refusal on new issuances of securities by the company. Acronym for Initial Public Offering. See Initial Public Offering. Acronym for Incentive Stock Options. See Incentive Stock Options.

Investor Rights Agreement

IPO ISOs

B20

Issuer

A business entity that issues and sells (or proposes to issue and sell) equity securities and/or debt securities as a means of raising capital. In a venture capital investment transaction, the issuer is the corporation or company that is the subject of the financing. Securities (e.g., common stock or certain preferred stock) that have a lower preference or priorityin terms of liquidation preference, dividends, conversion and perhaps other rightsthan other, more senior, securities. The stage or state of development of a company that has proven its concept, achieved significant and increasing revenues (compared to its competitors), and is approaching (or has achieved) break-even or positive cash flow. Typically, a later stage company has completed its expansion stage and is nearing a liquidity or exit event. Acronym for Leveraged Buyout. See Buyout. The person, institutional investor or venture capital fund that organizes, leads (e.g., in such matters as due diligence, valuation, negotiations, documentation, and closing), and typically invests the most capital in a funding round. In seed, start-up and many early stage investments, securing a lead investor is often the critical distinguishing factor between success and failure.

Junior Securities

Later Stage

LBO Lead Investor

Letter of Intent (or LOI) A document, usually in the form of a letter agreement, confirming two (or more) parties intentions to pursue and effect an investment (or acquisition) transaction. It summarizes the material intended terms of the deal, and serves as the basis for (and triggers the start of) substantial due diligence and the preparation of draft definitive agreements. By its terms, a letter of intent is (generally) not legally binding, except that it may include certain binding and enforceable provisions, such as those addressing confidentiality, no-shop agreements, and provisions regarding fees and expenses). Sometimes also referred to as a term sheet (and, to a lesser extent, a memorandum of understanding or agreement in principle). Leverage Commonly refers to the use of or additions to debt (via borrowings or issuance of debt securities) in a companys capital structure in order to achieve results faster than if only available cash is used in order to magnify potential equity returns. With leverage comes the payment requirements, covenants and default provisions inherent in credit facilities and debt securities. The risk is that the business (albeit, with enhanced assets and perhaps revenue), through its cycles, does not generate sufficient net income and cash flow to make the required payments (of principal and interest) on the debt.

B21

Leverage Ratios

Measurements (expressed as ratios) of a companys indebtedness as a multiple of (or as compared to) cash flow or some other financial metric. Typical leverage ratios include Total Debt-to-EBITDA, Toral Debt-to-EBITDA minus Capital Expenditures, and Senior Debt-to-EDITDA. Leverage ratios often serve as the basis of key financial covenants in credit facilities and debt securities. See Buyout. An agreement under which a patent owner (the licensor) grants to a company (the licensee) the right to produce, use, market and/or sell an invention (product or service) under certain circumstances and for a specified term at agreed compensation. A legal entity organized under state law through the filing of a charter (typically, a Certificate of Formation, coupled with the signing of an LLC Operating Agreement). The LLC is owned by its members (or LLC interest holders), and typically is managed by its manager(s) or officers and overseen/directed by its board of managers. Limited liability companies present certain unique advantages (as compared to corporations) regarding governance, flexibility and (flow-through) taxation to owners, but are less accepted and recognized than corporations. See Pass-Through Entity. A passive investor in a limited partnership. With respect to a venture capital fund organized as a limited partnership, high-net-worth individuals and institutional investors that contribute capital to the fund, are not involved in the management of the fund, and enjoy limited liability with respect to actions by the fund. See also General Partner and Limited Partnership. A legal entity organized under state law through the filing of a charter (typically, a Certificate of Limited Partnership, coupled with the signing of a Limited Partnership Agreement) composed of a general partner and various limited partners. This is the most common organizational form adopted by venture capital funds. With respect to a venture capital fund, (1) the general partner manages (and is generally liable for) the fund in exchange for a management fee and percentage of the gains or profits (referred to as the carried interest), and (2) limited partners contribute capital to the fund (and have limited liability and are not involved with the management of the fund) for which they receive income, tax benefits and capital gains. See also General Partner, Limited Partner and Pass-Through Entity.

Leveraged Buyout License

Limited Liability Company (LLC)

Limited Partner (LP)

Limited Partnership

B22

Liquidation

The process of selling off the (remaining) assets of a company, typically followed by (1) the distribution of the sale proceeds, after satisfaction of all debts, priority claims and liabilities, to the companys equity holders, in accordance with their preferences or priorities and on a pro rata basis, and (2) the dissolution of the company. In the context of preferred stock, certain events or transactions (such as a merger, sale or change of control) may constitute a deemed liquidation (thereby entitling the holders to receive the liquidation preference applicable to its shares of preferred stock before any payments are made to common or junior preferred stockholders). An important (defining) economic feature and provision of preferred stock. A liquidation preference is the right of an investor in respect of the securities it owns which include the preference to receive a specific amount if the company is liquidated (or deemed to be liquidated) or if its stock is redeemed in priority to amounts distributed to other (common and junior) securities holders. The liquidation preference is usually fixed at the original investment amount, but also may be fixed at a multiple of that amount. See Liquidation, Multiple Liquidation Preference, and Participating Preferred Stock. A transaction or series of transactions in which owners of all or a significant portion of the capital stock of a company monetize their stock holdings through a sale, merger, IPO, exchange or other transaction in which they receive cash or cash equivalents. See Exit Strategy. Acronym for a Limited Liability Company. See Limited Liability Company. An agreement by an owner of capital stock not to sell his or her shares for a specified period of time. In connection with an IPO (or follow-on public offering), a lock-up agreement, required by the underwriters (or the lead or managing underwriter), prohibits management, VCs and other significant stockholders from selling their shares during a specified period following an IPO (usually six to nine months). Avoiding large sales of stock for some period following an IPO helps to build a base of support for, and manage and stabilize, the market for a public companys shares. See also Flipping. Acronym for a Letter of Intent. See Letter of Intent. Acronym for a Limited Partner. See Limited Partner.

Liquidation Preference

Liquidity Event

LLC

Lock-up or Lock-up Agreement

LOI LP

B23

Management Buyout (MBO) Management Fee

See Buyout.

A fee charged to the limited partners of a (limited partnership) fund by the general partner. The fee, which is typically fixed at a percentage of the limited partners capital commitments to or capital invested by the fund, is designed to cover the costs of managing, operating and administering the fund. See also Carried Interest. See Automatic Conversion.

Mandatory Conversion

Mandatory Redemption The right of a security holder (e.g., the owner of preferred stock) Right (or Put) to require the issuer to redeem (or purchase) some or all of his or her securities at a specified (or determinable) price and after a specified period of time has elapsed. The purchase price is usually the original investment price plus any accrued and unpaid dividends, and is often payable in installments over an agreed time period. Also referred to as a back-end put or forced buyback. Market Capitalization The aggregate value of a business based on the dollar value of all issued and outstanding securities. The market cap is computed by multiplying the number of outstanding shares by the current (market) price per share. Acronym for Management Buyout. See Management Buyout. See Letter of Intent.

MBO Memorandum of Understanding (MOU) Mezzanine or Mezzanine Financing

A layer of financing that has intermediate priority (seniority) in the capital structure of a company. For example, mezzanine debt (also called mez debt) has lower priority than senior debt but usually has a higher interest rate and often includes warrants; at the same time, mezzanine debt has higher priority than subordinated debt and (of course) preferred and common stock. For venture-backed companies, a mezzanine round is generally the round of financing that occurs in later stages and is designed to assist a company in reaching an IPO, sale or other liquidity event. See also Bridge Financing. See Staged Investing.

Milestone-Based Investing Minority Protections

Rights provided to minority or smaller stockholders affording protection against actions taken (or potentially taken) by majority or controlling stockholders. May include veto rights, tag-along rights, preemptive rights, board representation rights, etc.

B24

MOU Multiple Liquidation Preference

Acronym for a Memorandum of Understanding. See Letter of Intent. When the liquidation preference included in a preferred stock is fixed at a multiple of (e.g., two to four times) the amount of the original investment (on a per share basis). See also Liquidation Preference.

Narrow-Based A form of anti-dilution protection (and related adjustment Weighted Average mechanism) incorporated in convertible preferred stocks and Anti-Dilution Protection (infrequently) used in venture capital transactions. See Weighted Average and the discussion regarding Anti-Dilution Protections in the GUIDEBOOK, beginning on page 55. See also Anti-Dilution Protections and Weighted Average. NDA Acronym for a non-disclosure agreement. See Confidentiality Agreement. See Covenant. See Non-Solicit. See Non-Solicit. A provision in an agreement (or letter of intent) whereby the company (and those controlling its ownership) agrees not to market itself to, or solicit or encourage other investment (or acquisition) proposals from, other potential investors (or buyers) during a specified period. By agreeing to a no-shop clause, the company gives the investor (or acquiror) (party to the agreement) an exclusive right during the agreed period to negotiate and enter into a definitive agreement with the company. A contractual provision in which one party (typically, in the context of VC transactions, a founder, manager, employee or consultant) agrees, for a specified period of time following any termination of employment, not to work for a competitor company, form a new competitor company, or engage in activities competitive with the other party. Dividends that are payable to owners of a security (typically, preferred stock) at a specific point in time only (i) if there is sufficient cash available to pay the dividends after all company expenses are paid and obligations provided for, and (ii) as, if, and when declared by the board of directors. If cash flow is insufficient for any reason, the security owners will not receive dividends with respect to that time period and will have to wait until the board of directors declares dividends in the future.

Negative Covenant No-Hire Provision No-Raid Provision No-Shop

Non-Compete

Non-Cumulative Dividends

B25

Non-Disclosure Agreement (NDA) Non-Interference

See Confidentiality Agreement.

A provision in an agreement (often signed by managers and employees) whereby the parties agree not to interfere with the companys relationships with employees, customers, suppliers and/or vendors during a specified period of time following any termination of employment. Stock options that are not eligible to be treated as ISOs (or Incentive Stock Options) for federal income tax purposes. NonQualified Stock Options are the most common and prevalanent form of stock options awarded by venture-backed companies. See also ISOs. A provision in an agreement prohibiting one party for a specified period from soliciting for employment (or engaging in similar conduct) the employees of the other party. Also referred to as a no-raid provision. The provision can also be expressed as a restriction on employing or hiring such employees (as opposed to soliciting them), in which case it is referred to as a no-hire provision. A document that evidences a debt obligation of a company to the holder of the note (specifying, among other things, the principal amount, applicable interest rate, covenants, events of default, and maturity). The company in this case is referred to as the obligor, and the person advancing the funds is referred to as the holder (or purchaser) of the note. Longer-term notes are sometimes called debentures. See Private Placement Memorandum (PPM). The right to purchase equity securities (typically, common stock) in a company at a specified price (referred to as the exercise price) within or over a specified time period. Primarily awarded to management and key employees, typically awarded in the discretion of (and with the terms and provisions determined by) the board of directors or a board compensation committee, pursuant to a stockholder-approved option (or incentive compensation) plan. Options usually become exercisable in installments over a specified period of time (e.g., quarterly over a 3-year period), and the option holder typically must be in the employ of the issuer at the time of exercise. See also ISOs and Non-Qualified Stock Options.

Non-Qualified Stock Options (NQs or NQSOs)

Non-Solicit

Note

Offering Memorandum Option

B26

Option Pool (or Reserve) The number of shares of common stock (or equity interests) that are set aside for issuance upon the exercise of options or other equity-based incentives, to be granted by the board of directors in the future over a period of time (2-3 years) to management and key employees (and perhaps others). The size of the option pool varies (from 10% to 25%), but it averages around 15% of fully diluted shares. Orphan Expression for a start-up company that does not have a VC fund as an investor or stockholder. The number of shares of capital stock that have been issued and are in the hands of investors/stockholders. This does not include treasury shares (issued shares held by the company) or shares that may in the future be issued in the event (i) convertible securities (such as convertible preferred stock or convertible debt) are converted, (ii) exchangeable securities are exchanged, or (iii) options, warrants, or other rights to purchase stock are exercised. A term referring to equal treatment of two or more parties, or of the securities (equally, ratably, with no preference) held by two or more parties, in an agreement. Often used to describe securities that are to be treated as being of equal priority or to share equally and ratably in distributions. A type of convertible preferred stock that has liquidation preference and related features advantageous to the holder (amplifying potential ultimate returns) at the expense of common stockholders. In a participating preferred stock, the holder is entitled not only to receive the stated liquidation preference (usually the original investment amount plus accrued dividends), but also a pro rata share (assuming conversion of its shares into common stock) of the balance of remaining proceeds available for distribution to common stockholders. This may occur with respect to a merger, sale, change of control or other designated deemed liquidation event, and also may relate to dividends (where, after a holder receives its cumulative dividend, it also has the right to receive, on a pro rata as-if-converted basis, any dividend payable on the common stock). Given these features, participating preferred stock has been characterized as a double dip (or having your cake and eating it to), and business founders and owners have sought to eliminate or soften the impact (e.g., via a cap on return or sunset provision) on these provisions. See the discussion of Participating Preferred Stock in the GUIDEBOOK, beginning on page 62.

Outstanding Shares

Pari Passu

Participating Preferred Stock

B27

Pass-Through Entity

A business entity for which there is generally no entity-level income taxation; rather, the entitys owners or partners recognize the income tax burdens and benefits directly (which pass through the entity to the owners or partners), whether or not they have receive a distribution. The most common pass-through entities are S corporations, limited liability companies, limited partnerships, and limited liability (limited) partnerships. A feature of a security pursuant to which dividends (in the case of an equity security) or interest (in the case of a debt security) are paid in the form of additional securities of the same type, instead of cash. A provision in the investment documents (usually in the charter or certificate of designation with respect to the preferred stock series issued in the transaction) imposing sanctions on investors who do not participate (by purchasing their full pro rata share) in future, usually down round, equity financings. If the investor does not play, it suffers specific adverse consequences, including, for example, automatic conversion to common stock or a shadow (less favorable) preferred stock, loss of the right to participate in future funding rounds, loss of anti-dilution protections, loss of veto rights and related protective provisions, and/or loss of board representation rights. Some pay to play provisions are structured to provide rewards and incentives (including superior economic securities, rights and features) to those investors who do participate (by purchasing their full pro rata share) in future (down round) financings. In the context of an agreement, often defined (broadly) to include corporations, partnerships, limited partnerships, limited liability companies, associations, and other business entities, as well as groups of the foregoing and individuals. A contractual commitment by an individual (usually unlimited in nature and reaching to all funds, accounts and assets owned by the individual guarantor) to stand behind a companys obligations and to repay any such obligations with respect to which the company fails to repay or otherwise defaults. See Registration Rights. A professional, registered (typically, with the SEC as a brokerdealer) investment banker or financial advisor that specializes in finding (usually institutional) investors and structuring and closing private placement investment transactions. Placement agents require engagement and indemnification agreements, and work

Payment-in-Kind (PIK)

Pay-to-Play

Person

Personal Guarantee

Piggyback Rights Placement Agent

B28

for a fee (often structured as a retainer with incentive compensation based on the proceeds ultimately raised in the investment transaction). See Private Placement. Portfolio Company A business or company in which a venture capital fund has invested and holds an ownership interest. The value of a portfolio company immediately after (and including the capital provided in) a current funding round. The post-money value is the pre-money value plus the amount of funds invested in the current round. For example, if investors in the current round invest $5 million in a company that is valued at $7 million premoney, the resulting post-money value is $12 million. Acronym for a private placement memorandum. The right of a stockholder to maintain its percentage ownership of a company by participating in future equity funding rounds, through the purchase of additional equity securities (pro rata, on the same price and terms) in such rounds. Sometimes also referred to as a maintenance right. See Hurdle Rate. A type of capital stock (i.e., a class of equity capital ownership of and a unit of ownership) in a corporation, which enjoys special economic, governance and other rights (including a preference or priority regarding payment of dividends and on redemption or in liquidation) not enjoyed by the common stock. See also Convertible Preferred Stock and Liquidation Preference. The (agreed-upon, conceptual) value of a company immediately prior to the current funding round. This value is determined by negotiation, with the VC fund extrapolating same via its financial model, constructed after some measure of financial and projections due diligence, and the application of various valuation methodologies. Pre-money value is calculated (as a mathematical matter, ex post facto) by multiplying the number of outstanding (or fully diluted) shares before the current round, times the agreed (or derived) purchase price per share in the round. See also Post-Money Value. The status of one creditor or security holder having a claim or right (e.g., as to dividends or distributions in liquidation) that is superior to the claims or rights of another creditor or security holder. The superior claim or right is referred to as senior, and the other claim or right is referred to as junior or, in the case of debt, subordinated.

Post-Money Value

PPM Preemptive Rights

Preferred Return Preferred Stock

Pre-Money Value

Priority

B29

Private Equity Fund

A fund typically organized as a limited partnership for the purpose of making equity investments in private (non-public) businesses. Some private equity funds are structured as buyout funds, focused on acquiring all or a controlling equity interest in the target business, with the purchase price typically financed with a significant amount of senior, subordinated, and sometimes mezzanine financing. See Leverage and Buyout. The offer and sale of securities to a limited number of institutional and retail investors, structured so as to be exempt from and not require registration under, the registration requirements of the Securities Act (and applicable state securities laws). In short, a way to raise capital from sophisticated (usually institutional) investors without registering the offering or the securities with the SEC or going the venture capital route. Companies engaged in private placements often engage Placement Agents to assist (and increase chances of success). Note that even exempt private placements are subject to federal and state anti-fraud rules, and regulations with respect to transaction participants (including finders). See also Accredited Investor and Private Placement Memorandum. A disclosure document providing details to potential investors regarding the company (i.e., the issuer raising capital in the subject private placement) and the investment transaction. The PPM typically describes (i) the terms and features of the securities to be offered in a private placement (and details regarding all capital ownership, rights and preferences of other securities and the sources and uses of funds); (ii) a description of the business, business concept, operations, management, product/service, intellectual property and technology, market, marketing/sales, customers, competition, capitalization, financial condition and results of operation, and prospects of the issuer (resembling a detailed business plan); and (iii) the investment considerations (risk factors). Financial projections, with detailed assumptions, are typically included as well. Also referred to as a (private) offering memorandum. An informal term referring to securities that are not registered with the SEC and are not issued by a public company, and that do not trade on any established market or stock exchange. The price per share of private securities is determined by negotiation between the buyer and the issuer. See Carried Interest.

Private Placement; Private Offering

Private Placement Memorandum (PPM)

Private Securities

Promote

B30

Pro Rata

Apportionment based on relative ownership interests (typically, as a percentage of outstanding shares). A formal disclosure document (providing detailed information responsive to SEC standards and requirements) included as part of a registration statement and filed with the SEC in connection with an IPO or other public offering. A corporations offer, issuance and sale of shares to the public pursuant to a registration statement (and prospectus) filed with and declared effective by the SEC under the Securities Act. Typically, public offerings by VC-backed companies are underwritten by one or more investment banking firms (underwriters), and the shares are listed or quoted on a national securities exchange or stock quotation system (such as the New York Stock Exchange of NASDAQ Stock Market). See also Initial Public Offering. The right to sell (or to force the obligated party to purchase) a security at a specified price (or price range) within or following a specific time period. See also Call Option and Redeemable Preferred. An (underwritten, firm commitment) initial public offering that meets certain contractually specified criteria (e.g., a minimum share price and/or minimum gross or net proceeds from the offering). The criteria is usually designed to ensure a sufficiently large and robust IPO such that the (post-IPO closing) publicly traded shares will trade on a major securities exchange (e.g., the New York Stock Exchange or NASDAQ Stock Market). The occurrence of a QPO may trigger certain consequences under the investment documents regarding the preferred stock issued in previous VC or other transactions (e.g., automatic conversion into common stock and loss of various preferred stock and other rights). A sale (or change of control) of a portfolio company that meets certain contractually specified criteria (e.g., minimum gross proceeds or valuation amount, and/or minimum share price multiple vs. the original investment amount). The criteria is usually designed to produce a sufficiently large and robust sale to ensure a solid return to preferred stockholders (in view of their liquidation preference and conversion and other rights). The occurrence of a qualified sale may trigger certain consequences under the investment documents regarding the preferred stock issued in previous VC or other transactions (e.g., automatic conversion into common stock and loss of various preferred stock and other rights).

Prospectus

Public Offering

Put Option

Qualified IPO (QPO)

Qualified Sale

B31

Ratchet Recapitalization

See Anti-Dilution Protection and Full Ratchet. A transaction (or series of transactions) in which a companys capital structure is reorganized (typically involving the injection of new funding, and the issuance or exchange of, and retirement and satisfaction of, certain equity and/or debt securities. Sometimes also includes leverage and the payment of a dividend (referred to as a dividend recap). Preferred stock which, by its terms, must be redeemed at the request of the holder (i.e., the holder has the right to require the issuer to redeem all or part of his or her preferred shares) for a specific amount within or following a specific time period. The redemption feature is also referred to as a put option. The repurchase (and cancellation) by an issuer of its own securities from a holder/owner, prior to their maturity (if any), pursuant to the terms of the securities or a redemption agreement. This may be presented as a right or an obligation of the issuer. The process under which shares of an issuer are registered (via a registration statement filed with and declared effective by the SEC) under the Securities Act in preparation for a sale of the shares to the public in an IPO or other public offering. As part of this process, the SEC typically reviews and comments on the issuers registration statement. Rights of a holder to have his or her securities registered with the SEC (on an appropriate registration statement form) in connection with a later public offering by the issuer. Demand rights require (i.e., permit the holder to force) the holders shares (or a portion thereof) to be so registered (whether or not the issuer is planning on such a registration). Piggyback rights permit the holder to add (or piggyback) its shares (or a portion thereof) onto the issuers or another persons registration statement (and public offering). See Liquidity Terms and Considerations Registration Rights, beginning on page 69 of the GUIDEBOOK.

Redeemable Preferred

Redemption

Registration

Registration Rights

Registration Statement A detailed disclosure document, on a form prescribed by the SEC under the Securities Act (and various related SEC rules and regulations), which is required to be filed with, and ultimately declared effective by, the SEC in order for securities to be offered and sold to the public in a public offering. See also Prospectus. Regulation D (Reg D) A series of SEC-adopted rules (under the Securities Act) that provide transactional safe harbor exemptions for certain private

B32

securities offers and sales from the registration requirements of the Securities Act. See also Private Placement and Accredited Investor, and the relevant discussion in the GUIDEBOOK, beginning on page 8. Representations and Warranties Provisions in a definitive (usually investment or transaction) agreement by which a party makes certain statements of fact as of a specific time (or times), which statements are intended to be relied upon in connection with the subject of the agreement and are binding upon the statement maker (and for which the benefitting parties can pursue remedies in the event of a breach). These factual statements, exceptions to which are usually set forth in a disclosure schedule, are often subject to a negotiated survival period and accompanied by (usually negotiated, with applicable baskets, caps and other limitations) an indemnity obligation from the maker of the statements. See also Indemnification. Shares of stock that may not be traded in the public markets or on public exchanges. Typically, these shares are acquired in a private placement (or pursuant to some exemption from registration but subject to applicable restrictions on resale), and is considered restricted and may not (absent registration) be resold until after an appropriate holding period has expired (e.g., under Rule 144) or an another available exemption from registration is satisfied. The gross proceeds yielded from an investment, over a specific time period, calculated as a percentage of (and thus a return on) the original investment. See the discussion regarding ROI in the GUIDEBOOK, beginning on page 36. A form of senior debt, documented through a revolving credit agreement. Revolving loansup to a maximum principal amount, and subject to the initial and ongoing satisfaction of certain financial and other covenants and avoidance of specified events of defaultcan be borrowed, repaid, and re-borrowed (up to the maximum amount) within the specific maturity of the loan (or facility). A provision, typically in a stockholders agreement or right of first refusal and co-sale agreement, that prohibits a stockholder from selling her/his shares to a third party for a defined period unless s/he has first offered to sell the shares to the issuer and/or the other stockholders (or to other specified stockholders) at the price and on the terms specified by the selling stockholder (and applicable to the proposed third party sale transaction).

Restricted Shares

Return on Investment (ROI)

Revolver; Revolving Credit Facility

Right of First Offer

B33

Right of First Refusal

A provision, typically in a stockholders agreement or right of first refusal and co-sale agreement), that prohibits a stockholder from accepting a bona fide offer made by a third party to purchase the stockholders shares unless and until the issuer and/or other specified stockholders are first given the opportunity to purchase the shares at the same price and on the same terms. In this case, the issuer and/or other specified stockholders have the contractual right to participate in (and perhaps assume the role of the purchaser in) the stock sale transaction.

Right of First Refusal One of the key, principal definitive agreements (between the and Co-Sale Agreement company, the investors/purchasers and key common stockholders) in a venture capital investment transaction, the principal purpose of which is to impose restrictions on transfers of stock owned by founders, management and other significant stockholders. Rights Offering An offering of stock to existing stockholders that entitles them to purchase shares in the new funding round at the same price (sometimes at a discount) and on the same terms as are being offered to new investors in the round, thereby maintaining their equity stake and/or preventing or minimizing dilution. In down rounds, such a rights offering (if disclosed and conducted properly) can head off claims of breach of fiduciary duties, fraud, conflicts and unfair treatment. The marketing process during an IPO or other public offering in which the management of an issuer, together with the underwriters, meet with and make presentations to potential investors and other interested parties (including institutional investors and brokers) to stimulate interest in the issuer and the offering. Acronym for Return on Investment. An investment or funding transaction (or financing event) in which a private company receives funding from outside investors via the issuance and sale of securities to such investors. Venture-backed companies typically need and receive more than one round of funding. The first round or A round typically refers to the first investment transaction involving participation by one or more venture capital funds or institutional investors. See also A Round. A rule (under the Securities Act) promulgated by the SEC that specifies the terms and conditions under which the holder of restricted shares (whether affiliated with the issuer or not) may sell those shares in the public markets (without registration of those shares).

Road Show

ROI Round

Rule 144

B34

S Corporation

A corporation that, by proper and qualifying S election timely filed with the Internal Revenue Service, is generally not required to pay income taxes; instead, like a partnership, its owners/stockholders recognize income tax burdens and benefits, and pay income taxes on their proportion of the corporations profits at their individual income tax rates. See Pass-Through Entity. Acronym for Small Business Investment Company.

SBIC

Schedule of Exceptions See Disclosure Schedule. SEC Acronym for the Securities and Exchange Commission. An independent U.S. regulatory agency responsible for overseeing the securities markets and administering and enforcing the federal securities laws, including the Securities Act and the Securities Exchange Act. The Securities Act of 1933, as amendedthe federal statute that governs and regulates the offer and sale of securities (and, among other things, provides for exemptions from registration and governs the registration process). Also referred to as the 1933 Act.

Securities Act

Securities and Exchange See SEC. Commission Securities Exchange Act The Securities Exchange Act of 1934, as amended; the federal statute that regulates, among other things, the securities markets and exchanges, periodic reporting (Form 8-K, Form 10-Q, Form 10K) by public companies, insider trading, proxy and consent solicitations, and tender offers. Also referred to as the 1934 Act. Security; Securities Legal instrument(s) that represent(s) an equity or debt interest in an issuer. Examples include shares of capital stock (common and preferred), LLC interests, limited partnership interests, warrants, options, notes, debentures, and bonds. Investment capital provided to start-up ventures (which usually have been funded solely by founder capital thus far) at the seed stage. Typically funded by angels and friends and family. The seed round is usually structured as an investment in common stock (perhaps including warrants and special rights) but also may be structured as a loan or convertible loan. The initial stage or state of a venture when it has just been organized and its founders are developing the ventures business plan, product or service, and initial financing plan. Sometimes also referred to as the start-up stage.

Seed Capital; Seed Financing; Seed Round

Seed Stage

B35

Senior Debt

A loan or indebtedness with the highest priority in right of payment from (including in liquidation of) the assets of the borrower (with priority over all other debt and all capital stock), which is usually secured by the assets of the borrower (via a mortgage and/or security agreement). May take the form of a term loan or a revolving facility, in each case under a definitive credit agreement. The preferred stock issued in a companys A round to venture capital (and perhaps other) investors in exchange for muchneeded capital. See A Round, Convertible Preferred Stock, and Preferred Stock. See Stockholders Agreement.

Series A Preferred Stock

Shareholders Agreement Shell

A business entity with no real assets, business, or operations. If such an entity is a public, reporting company, then it is referred to as a public shell. An independent U.S. government agency charged with aiding and assisting small businesses through SBA programs and activities (including with respect to applying for loans and acting as a guarantor on certain small business loans). An company licensed by the SBA to receive government-provided capital for its venture capital and private equity investments. An SBIC will generally have access to $2 in credit (in the form of low-interest-rate loans, drawn down on a deal-by-deal basis) for every $1 that it invests in a portfolio company meeting certain requirements. An investment in a company structured to be funded in stages (or tranches or installments), with the initial installment funded at the first closing and then subsequent installments funded if the company meets certain specified milestones (e.g., key management hires, customer penetration, revenue hurdles, regulatory approvals, product prototypes, product testing/validation, etc.) or if an agreed time period lapses. Also referred to as milestonebased investing. A business or venture in its formative or seed stage. See Capital Stock. See Option, Incentive Stock Options, and Non-Qualified Stock Options.

Small Business Administration (SBA)

Small Business Investment Company (SBIC)

Staged Investing

Start-up Stock Stock Option

B36

Stock Pool Stockholder (or Shareholder) Stockholders Agreement

See Option Pool. A holder (or owner) of capital stock in a corporation.

An agreement among the stockholders of a corporation typically regulating the governance of the company, the ownership and transfer of its equity securities, and other matters. Often contains provisions relating to preemptive rights, drag-along rights, tagalong rights, rights of first offer/refusal, buy-sell arrangements and sometimes veto rights. Relatively large and established businesses that (from time to time) invest in relatively young and less established ventures in their industry, and thus adding strategic value to their investments (and alliances) through industry experience, expertise, distribution and supply chain, and contacts. Strategic investors are often interested in some aspect ofor the future opportunity presented bythe smaller business (investment prospect), such as its proprietary position, technology potential, research prowess, product/market channels, location in the manufacture/distribution chain, or potential as a customer and/or supplier. The status of one creditor or security holder having a claim or right (e.g., as to dividends or distributions in liquidation) that is junior or subordinate to the claims or rights of another creditor or security holder. The junior claim or right is referred to as subordinated (or junior), while the other claim or right is referred to as senior or priority. See also Priority and Senior Debt. A loan or indebtedness which is subordinated (and thus junior or inferior) in right of payment from (including in liquidation of) the assets of the borrower. Senior lenders often require an express subordination (or inter-creditor) agreement acknowledging the subordination. Subordinated debt is sometimes also called highyield debt (given the high interest rate it bears). Representations and warranties and covenants in a definitive agreement that, by their terms, continue to operate and be effective (and thus serve as the basis of an indemnity and/or damage claim if breached) after the closing are said to survive the closing. The period during which such representations and warranties and covenants continue to operate (and serve as the basis of an indemnity and/or damage claim) post-closing pursuant to the agreement is referred to as the survival period. Thus, the survival period operates as a contractually specified statute of limitations, within which period proper claims must be brought.

Strategic Investor(s)

Subordinated

Subordinated Debt

Survival; Survival Period; Survive

B37

Sweat Equity

Equity ownership received (typically, by founders, employees, and consultants in the very early stages) as a result of and in exchange for work, dedication, or expertise (the sweat), as opposed to cash investment. Contractual right of a minority investor or stockholder (typically provided in a stockholders agreement or right of first refusal and co-sale agreement) to sell some or all of its stock (on a pro rata basis) along with (and at the same price and on the same terms as) the founders or other stockholder(s) burdened by provision, if either the founder(s) or other stockholder(s) elects to sell some or all of its shares to a third party. In this way, the minority investor/stockholder is permitted to tag along and co-sell its stock with the selling (usually controlling or significant) stockholders. Also referred to as co-sale rights. The transfer of control of a company (typically via the acquisition of a majority or more of its equity ownership interests). The recipient of funding in an investment transaction. For example, in a typical venture capital transaction, the target is the issuer of the preferred stock; upon the closing, the target becomes a portfolio company of the investing venture capital fund or funds. Target also refers (in the M&A context) to the company or business entity that is being acquired in an acquisition transaction. An investment that returns to its investors (at least) 10 times the initial amount of capital invested. A bank loan (senior debt) in a fixed principal amount and made for a specific period of time (the end of which is referred to as maturity). See also (and contrast with) Revolver. A summary document confirming the intention of the parties (typically, investor(s) and issuer) with respect to an investment funding transaction and outlining the material terms of the transaction. See also Letter of Intent. See Staged Investing. The state of being out of the money. An option or warrant is underwater if the option or warrant exercise price is greater than the current fair market value of the underlying stock. An investment banking firm engaged by an issuer (via an underwriting agreement) to manage the process of marketing and selling new securities to the public in a public offering. Underwriters

Tag-Along Rights

Takeover

Target

Ten Bagger

Term Loan

Term Sheet

Tranche Investing Underwater

Underwriter

B38

usually work through a syndicate of investment banks, led by a lead or managing underwriter, to maximize the sale and distribution of securities in the offering. See also Public Offering. VDR Venture Capital Fund Acronym for Virtual Data Room. See Data Room. A fund typically organized as a limited partnership for the purpose of making equity investments in private businesses believed to have exceptional growth potential (and the promise of yielding super-sized returns on the funds capital through exit and liquidity transactions). Rights granted to certain stockholders (or to some or all of a class or series of shares) to vote on or approve certain specified actions or transactions by an issuer (e.g., additional equity financings, borrowings or capital expenditures over a specified amount, an IPO, sale or other change of control, transactions with affiliates). Thus, without the vote or consent of the stockholders holding these rights, the action in question may be vetoed or blocked. Veto rights are one type of minority protection. Also sometimes referred to as blocking rights or protective provisions. A contract between the company, the VC investor(s) and other purchasers in an investment round and key common stockholders (including founders and management) that contains agreements, including obligations to vote, on such matters as the size and composition of the board (and related matters), remedies, and term, and which may contain drag-along rights and obligations as well. Stock giving the holder the right to vote for the election of the issuers board of directors generally (and not just upon the occurrence of certain events, such as the failure to pay dividends or breach of a covenant). A security that provides the holder with the right to purchase stock (or equity securities) at a pre-determined price (referred to as the exercise or strike price) within or over a specified time period. Similar to an option, but typically issued to third parties (not directors, employees, or insiders) in connection with loans or the issuance of debt securities. A financing round whereby previous investors, founders, and management/employees suffer substantial dilution (and loss of rights). As a result of a washout round, the new investors usually gain majority ownership and control of the issuer. See also Cram-Down Round.

Veto Rights

Voting Agreement

Voting Stock

Warrant

Washout Round

B39

Weighted Average

A type of anti-dilution protection (and related adjustment) mechanism, which applies a weighted average formula to adjust the exercise price or conversion ratio of a security downward based on the sale price and number of common equivalent shares issued by the company (in a subsequent down round) after the issuance of the first security. Although there are a number of variations, the most common forms of weighted average protection fall into two categories: broad-based and narrow-based. Broad-based weighted average anti-dilution protection is the most commonly used antidilution formulation in venture capital transactions. In essence, the effect of the share issuances in the down round is spread over a large number or broad base of shares (all fully diluted outstanding shares, including shares issuable upon exercise of outstanding options and warrants and upon conversion of outstanding convertible securities). In a narrow-based weighted average anti-dilution provision (a protection more favorable to the investor), the effect of the share issuance in the down round is spread over a smaller number or base of shares (e.g., issued and outstanding shares or preferred shares only). See Weighted Average and the discussion regarding Anti-Dilution Protections in the GUIDEBOOK, beginning on page 64.

B40

INDEX
A Round ........................................................................B-1 Accredited Investor...............................................9-10, B-1 Accrued Dividends See Cumulative Dividends and Dividends ......63, B-1 Advisory Board .........................................................44, B-2 Affiliate.............................................................................B-2 Affirmative CovenantSee Covenant..........................B-2 Angel ...............................................................12, 73-76, B-2 Groups and Clubs ........................................75-76, B-2 Investor ...............................................................73, B-2 Investment .........................................12, 51, 73-76, B-2 Anti-Dilution Protection ..........55-56, 64, A-10 - A-12, B-2 Anti-Fraud Rules.......................................................10, B-3 Auction .............................................................................B-3 B Round ........................................................................B-3 Basket...............................................................................B-3 Beneficial Ownership .....................................................B-4 Beta Product................................................................... B-4 Blank Check Preferred Stock .......................................B-4 Blocking RightsSee Veto Rights ................................B-4 Blue Sky Laws...........................................................11, B-4 Board of Directors...............17, 43-45, 67, A-22, A-24, B-4 Board Observer Rights.............................................44, B-4 Bootstrapping............................................................15, B-5 Bridge Financing.......................................................66, B-5 Broad-Based Weighted Average Ratchet....................55, 64, B-6 Burn Rate .........................................................................B-6 Business Judgment Rule................................................B-6 Business Plan .......................................................29-31, B-6 Call Option.......................................................................B-6 Cap....................................................................................B-6 Cap Table ...........................................................30, A-4, B-7 Capital Call ......................................................................B-7 Capital Stock ...................................................................B-7 Carried Interest....................................................37-38, B-7 CarrySee Carried Interest ...............................37-38, B-7 CeilingSee Cap.............................................................B-6 Certificate of Designation........................................40, B-7 Change of Control...........................................................B-8 Charter .......................................................................40, B-8 Choice of EntitySee Entity Selection ............33-35, B-8 Clawback .........................................................................B-8 Closing......................................................................A-2, B-8 Closing Conditions .........................................................A-6 Club; Club Deal...................................................21, 27, B-8 Committed Capital..........................................................B-8 Common Mistakes in Pursuing Venture Capital...........24 Common Stock..........................................................65, B-9 Confidentiality Agreement...................................A-26, B-9 Conversion.......................................................63, A-10, B-9 Automatic/Mandatory ............................63, A-10, B-9 Optional ..................................................................A-10 Ratio ..........................................................................B-9 Rights.........................................................................B-9 Convertible Preferred Stock .............................39, 61, B-9 Convertible Security.............................................A-6, B-10 Corporation ........................................................34-35, B-10 Co-Sale RightsSee Tag-Along Rights ......A-22 - A-24, B-10 Covenant ................................................................A-6, B-10 Cram-Down....................................................................B-10 Credit Agreement..........................................................B-10 Cumulative Dividends ............................................63, B-11 Data Room...............................................................26, B-11 Debenture ......................................................................B-11 Debt Financing....................................................................4 Debt Security.....................................................42, 66, B-11 Deemed Liquidation Event...............45, 61-62, A-10, B-12 Definitive Agreement............................................A-6, B-12 Delaware General Corporation Law (DGCL) .....34, A-13 Demand RightsSee Registration Rights .....48, 70, B-12 Dilution ..........................................................................B-12 Disclosure Schedule .....................................................B-12 Discounted Cash Flow .................................................B-12 Distressed Market..............................................50-52, B-12 Distressed Investing....................................................50-59 Dividend(s) ......................................................63, A-8, B-13 Dodd-Frank Act ................................................................10 Down Round ................................................50-51, 54, B-13 Drag-Along Right ..............................40, 56, 71, A-24, B-13 Due Diligence....................................................23, 25, B-13 Out ...........................................................................B-14 Early Stage.....................................................................B-14 Earnings Before Interest and Taxes (EBIT) .............B-14 Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).................................B-14 EBITSee Earnings Before Interest and Taxes.......B-14 EBITDASee Earnings Before Interest, Taxes, Depreciation and Amortization ............................B-14 Elevator Pitch (or Speech)..............................16, 22, B-14 Employee Retention Bonus Plan..............................55, 57 Entity Selection..................................................33-35, B-13 Equity ................................................................................4-5 Equity-Based Compensation Plans ....................42, 67, 72 Equity Security..............................................................B-15 ERISA .............................................................................A-19 Event of Default............................................................B-15 Exchange ActSee Securities Exchange Act...........B-15 Exclusive AgreementSee No-Shop .............................B-15

I1

Exercise Price ...............................................................B-15 Executive Summary .............................................16, 22, 30 Exit; Exit Strategy ..................................36-37, 46-50, B-15 Expansion Stage ...........................................................B-15 Fiduciary Duties ...................................33, 44, 57, B-2, B-5 Financial CovenantSee Covenant ...........................B-16 Financing .......................................................................B-16 Bridge ......................................................................B-16 Friends and Family..........................................3, B-17 Seed ..........................................................................B-16 FINRA ................................................................................49 Finder ...................................................................A-28, B-16 First Offer RightsSee Right of First Offer..............B-16 First Refusal RightsSee Right of First Refusal......B-16 Follow-On Funding/Investment ..................................B-16 Forced BuybackSee Mandatory Redemption........B-16 Founder....................................................................46, B-16 Vesting ...............................................46, 71, A-26, B-16 Founders Stock ............................................................B-17 Friends and Family Financing ................................3, B-17 Full Ratchet .......................................................55, 64, B-17 Funding & Liquidity Cycle of a VC-Backed Portfolio Company.....................................................60 Gatekeepers.............................................................22, B-18 General Partner.............................................................B-18 Georges Doriot..................................................................12 Going PublicSee Initial Public Offering (IPO) ......B-18 Governance Provisions....................................43-44, 66-68 Growth Stage.................................................................B-18 Hockey Stick Projections ............................................B-18 Hurdle Rate....................................................................B-18 Incentive Stock Options...............................................B-19 Incubator........................................................................B-19 Information Rights........................................................A-18 Initial Public Offering (IPO) .................13-14, 48-49, B-19 Inside Round .................................................................B-20 Institutional Investors ..................................................B-20 Intellectual Property (IP) ......................................72, B-20 Internal Rate of Return (IRR) .....................................B-20 Investor Rights Agreement.........40, 48, A-16 - A-22, B-20 IPSee Intellectual Property......................................B-20 IPOSee Initial Public Offering .................................B-19 IRRSee Internal Rate of Return...............................B-20 ISOsSee Incentive Stock Options ...........................B-20 Issuer ..............................................................................B-21 Joint Venture .............................................................6, B-21 Kauffman Foundation ......................................................73 Key Person Life Insurance...........................................A-22 Later Stage .....................................................................B-21 Lead Investor...........................................................27, B-21 Letter of Intent (LOI) ........................................26-27, B-21 Limited Liability Company (LLC)....................33-34, B-22

Limited Partners ...........................................................B-22 Limited Partnership......................................................B-22 Liquidation .....................................................................B-23 Liquidation Preference .........54-55, 61-62, A-8 - A-9, B-23 Liquidity EventSee Exit.................................36-37, B-23 Liquidity Terms ............................................................69-72 LLCSee Limited Liability Company ..................33-34, B-23 LOISee Letter of Intent.............................................B-23 Lock-up ..........................................................48, A-18, B-23 Management Controls...........................................44-45, 67 Management Fee...........................................................B-24 Mandatory Redemption ...................................42, 71, B-24 Market Capitalization ...................................................B-24 Memorandum of Understanding (MOU) See Letter of Intent.................................................B-24 Milestone-Based Investing See Staged Investing ........................56-57, 64-65, B-36 Minority Protections.....................................................B-25 MOUSee Memorandum of Understanding.............B-25 Multiple Liquidation Preference ...........................62, B-25 Narrow-Based Weighted Average Ratchet ..........64, B-25 NASDAQ Stock Market....................................................13 NDASee Non-Disclosure Agreement ......................B-25 Negative CovenantSee Covenant.....................67-68, B-25 No-Hire ProvisionSee Non-Solicit...............................B-25 No-Raid ProvisionSee Non-Solicit ..............................B-25 No-Shop................................................................A-26, B-25 Non-Compete ................................................................B-25 Non-Disclosure Agreement (NDA).............................B-26 Non-Qualified Stock Options (NQs or NQSOs)........B-26 Non-Solicit .....................................................................B-26 Note ................................................................................B-26 NQSee Non-Qualified Stock Options......................B-26 NQSOSee Non-Qualified Stock Options.................B-26 Option.............................................................................B-26 Option Pool..............................................................72, B-27 Organizing a Business Venture ..................................33-35 Outstanding Shares ......................................................B-27 Pari Passu ......................................................................B-27 Participating Preferred Stock .........................54, 62, B-27 Pass-Through Entity..........................................33-35, B-28 Payment-in-Kind (PIK) ...................................63, A-9, B-28 Pay-to-Play Provision .......................56, 58, 65, A-14, B-28 Personal Guarantee ......................................................B-28 Piggyback RightsSee Registration Rights ........70, B-28 PIKSee Payment-in-Kind..........................................B-28 Placement Agent.......................................................7, B-28 Portfolio Company .................................................27, B-29 Post-Money Value ...................................................69, B-29 Preemptive Rights.........................................69, A-20, B-29 Preferred Stock .............................................................B-29 Pre-Money Value ...............................................54, 69, B-29

I2

Private Equity Fund......................................................B-30 Private Offering ...............................................7, 8-11, B-30 Private Placement ...........................................7, 8-11, B-30 Private Placement Memorandum (PPM)...................B-30 Protective Provisions See Veto Rights ..........................17, 40, 45-46, 67-68, A-12 - A-14, A-20, B-30 PPMSee Private Placement Memorandum ............B-30 Projections .............................................................30, 38-39 Prospectus ...............................................................13, B-31 Public Offering ..............................................................B-31 Put Option................................................................71, B-31 QPOSee Qualified IPO.....................................63, A-10, B-31 Qualified IPO...........................................................63, B-31 Qualified Sale ..........................................................63, B-31 Red Herring .......................................................................13 Redemption .......................................................42, 71, B-32 Registration ...................................................................B-32 Demand .......................................32, 40, 70, A-16, B-32 Form S-3 .................................................70, A-16, B-32 Piggyback ................................................70, A-16, B-32 Rights ................................48, 69-70, A-16 - A-17, B-32 Statement ..........................................................13, B-32 Regulation D.........................................................8-11, B-32 Representations and Warranties.........................A-6, B-33 Restricted Shares....................................................10, B-33 Restrictive Covenant Agreements..........................46, 68, 72 Return on Investment (ROI) .................................36, B-33 Revolver; Revolving Credit Facility............................B-33 Right of First Offer .......................................................B-33 Right of First Refusal ..................41, 69, A-22 - A-24, B-34 Right of Refusal and Co-Sale Agreement ..41, A-22 - A-24, B-34 Rights Offering ........................................................57, B-34 Road Show ....................................................13, B-34, B-36 ROISee Return on Investment...........................20, B-33 Rule 144 .............................................................49, 70, B-34 S Corporation..................................................34-35, B-35 SBA; Small Business Administration ...............................5 SBICSee Small Business Investment Company...5, B-35 SECSee Securities and Exchange Commission ..........................................B-35

Securities Act (or 1933 Act) ....................................8, B-35 Securities and Exchange Commission ....................7-8, B-35 Securities Exchange Act (or 1934 Act)......................B-35 Seed ................................................................................B-35 Capital .....................................................................B-35 Financing ...............................................................B-35 Round ......................................................................B-35 Stage.........................................................................B-35 Senior Debt....................................................................B-36 Series A Preferred Stock See A Round and Convertible Preferred Stock..B-36 Small Business Investment Company (SBIC)...........B-36 Staged Investing .....................................56-57, 64-65, B-36 Start-up...........................................................................B-36 Stock OptionSee Option, Incentive Stock Options, and Non-Qualified Stock Options ....................A-22, B-36 Stock PoolSee Option Pool......................................B-36 Stock Purchase Agreement ............................40, A-6 - A-8 Stockholders Agreement ............................................B-37 Strategic Alliances..............................................................6 Strategic Investors........................................................B-37 Subordinated Debt........................................................B-37 Survival; Survival Period .............................................B-37 Sweat Equity..................................................................B-38 Tag-Along Rights ......................................A-22 - A-24, B-38 Termination..........................................................A-18, B-38 Term Loan ......................................................................B-38 Term Sheet....................................................Annex A, B-38 Underwater..............................................................13, B-38 Use of Funds ...................................................................A-6 Valuation................................................21, 25, 54, 69, B-39 Venture Capital ........................................1, 11-12, 15, B-39 Venture Capital Fund ..................................12, 36-37, B-39 Veto Rights .......17, 42, 45-47, 67-68, A-12 - A-14, A-20, B-39 Virtual Data Room (VDR)......................................26, B-39 Voting Agreement .........................................40, A-24, B-39 Voting Rights .................................................................A-12 Warrant ...............................................................65-66, B-39 Washout Round .............................................................B-39 Weighted Average .............................................55, 64, B-40

I3

RR DONNELLEY AT A GLANCE
More than 146 Nearly $9.85 billion Nearly 55,000 600+ Nearly 160 240 800+ More than $1.8 billion Years in operation 2009 net sales Employees Global locations Manufacturing locations 2010 Fortune 500 rank Issued and pending patents Capital investment over the past five years

HBVC2011