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Raising Capital: Securities Law Compliance Related to Private and Public Offerings and Resales of Shares Stephanie L. Chandler, Esq. PowerPoint PPT Presentation


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Raising Capital: Securities Law Compliance Related to Private and Public Offerings and Resales of Shares Stephanie L. Chandler, Esq. Texas Advanced Paralegal Seminar (TAPS) Wednesday, September 17th San Antonio, Texas. Stephanie L. Chandler.

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Raising Capital: Securities Law Compliance Related to Private and Public Offerings and Resales of Shares Stephanie L. Chandler, Esq.

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Raising Capital: Securities Law Compliance Related to Private and Public Offerings and Resales of SharesStephanie L. Chandler, Esq.

Texas Advanced Paralegal Seminar (TAPS)

Wednesday, September 17th San Antonio, Texas


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Stephanie L. Chandler

  • Partner: Business Transactions (Corporate/Securities/M&A)

  • Firm-wide Section Head: Technology Section

    University of Nebraska

    B.S.B.A. in Finance

    University of Virginia

    Juris Doctorate


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Starting Place: Registration Required

  • All offerings must be registered with the SEC

  • Unless, that offering is exempt from Registration


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  • Advantages

  • Complete exit of ownership

  • Provides liquidity

  • Diversification of wealth

  • Avoid family succession issues

  • Disadvantages

  • Difficult transition for long-term owner

  • Tax issues

  • Continued involvement in management

  • Potential need to accept note or stock as part of consideration received

Sale of Company

Partial Sales

Transfers to Family/ Estate Planning

  • Partial sale

  • IPO (Initial Public Offering)

  • ESOP (Employee Ownership)

  • Family limited partnerships

  • Estate freezes through recapitalizations

  • Gifting

  • Advantages

  • Liquidity and diversification

  • Higher valuation multiples (IPO)

  • Retain some ownership

  • Capital for growth

  • Upside potential

  • Disadvantages

  • Retained interest/ limited exit

  • Regulatory/market oversight (IPO)

  • Expensive process (IPO)

  • Subject to veto power on major decisions

  • Accountability to a partner


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Offer vs. Sale

  • Offer triggers compliance requirements

  • Compliance must happen before selling process starts


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Privately negotiated sales

Must not involve any general solicitation or general advertising

Section 4(2)* - the private-offering exemption - “transactions by an issuer not involving any public offering”

* Securities Act of 1933(the “Securities Act”)

Private Offerings = Exempt


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Requirements under 4(2)

The purchasers of the securities must:

  • have sufficient knowledge and experience in finance and business matters to evaluate the risks and merits of the investment (“sophisticated investor”), or be able to bear the economic risk of investment;

  • have access to the type of information normally provided in a prospectus; and

  • agree not to resell or distribute the securities to the public.


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Regulation A

Exempts public offerings not exceeding $5 million in any 12-month period

must file an offering statement (called a “Form 1-A) with the SEC for review

Regulation D

Safe harbor promulgated by the SEC under Section 4(2)

Most common and today’s focus

Desire Definition


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Reg D

  • Rule 504 provides an exemption for the offer and sale of up to $1 million of securities in a 12-month period

  • Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period.

  • Rule 506 provides another exemption for sales of securities under Section 4(2).


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“Accredited Investor”

  • a bank, insurance company, registered investment company, etc.

  • an employee benefit plan

  • a charitable organization, corporation or partnership with assets ≥ $5 million

  • a director, executive officer or general partner of the company selling the securities

  • a business in which all the equity owners are accredited investors

  • a natural person with a net worth of at least $1 million

  • a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000

  • a trust with assets of at least $5 million


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“Integration”

  • Whether the sales are part of a single plan of financing.

  • Whether the sales involve issuance of the same class of securities.

  • Whether the sales were made at or about the same time.

  • Whether the same type of consideration was received.

  • Whether the sales were made for the same general purpose


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Rule 504

  • Up to $1 million of securities in a 12-month period

  • Rule 504 is the typical means to accomplish a “friends and family” or “seed capital” offering


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Rule 505

  • Up to $5 million in any 12-month period

  • Unlimited number of “accredited investors” and 35 other persons

  • Do not need to satisfy the sophistication or wealth standards


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Rule 506

  • Unlimited number of “accredited investors” and 35 “sophisticated” nonaccredited investors

  • Popular if Integration is a concern

  • Popular to comply with Blue Sky (National Securities Markets Improvement Act of 1996 (NSMIA) removed offerings under Rule 506 from state regulation)


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Why Only Accredited Investors?

  • Private placement memorandum (“PPM”) that meets Reg D requirements = $$$$$

  • If more than $1 million is raised in a 12-month period, Rule 504 is not available

  • Under Rule 505 and 506, a PPM would be required to offer securities to nonaccredited investors

  • Even if not required, delivering a PPM or at least a detailed business plan is probably advisable for liability and marketing reasons, particularly in fulfilling the antifraud requirement.


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Amendments to Reg D

  • New exemption from the registration requirements of the Securities Act for offers and sales to “large accredited investors” where a limited form of written announcement would be permitted (Rule 507)

  • Updated definition of “accredited investor” (Rules 505 and 506)

  • Shortens integration safe harbor from six months to 90 days


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Definitional Changes


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Paralegal’s Role

  • Blue Sky Analysis

    • Requirements for each state if not a 506

    • Form D Filing Fees and Filing Office

  • Preparation of Form D Filings

  • Form U-2


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Board of director resolutions

Shareholders resolutions if stock not authorized

Stock purchase agreement or subscription agreement

Accredited investor questionnaire

Certificate of Designations/ Amended and Restated Articles of Incorporation or Certificate of Formation

Paralegal’s Role:Other Documents


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Paralegal’s Role:Other Documents

  • Investors’ rights agreement - registration rights and rights of first refusal

  • Co-sale agreement - rights of investors to share in any premium and participate in sales of the company’s stock by founders and other major stockholders

  • Voting agreement - agreements among investors and other major stockholders as to the rights to vote for certain transactions or the right to elect a certain number of members of the Board of Directors.

    Note: Back of Presentation is Overview of Deal Terms


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Other Exemptions

  • Section 4(6) – exempts offers and sales of securities to accredited investors when the total offering price is less than $5 million and for which a Form D has been filed.

  • Rule 701 - exempts sales of securities if made to compensate employees according to a written plan of compensation.


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Take Aways …

  • All Shares issued in Private Offerings are Restricted

  • Registration or Exemption applies to Transaction not piece of paper


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Initial Public Offering

  • Registered with the SEC

  • Underwritten

  • i.e. Google, Rackspace...

$$

Invest in Growing Operations and Revenue


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Documents

  • Registration Statement

    • filed with the SEC

      • Part I: Prospectus

      • Part II: Additional information

        • Expenses

        • Director indemnifications

        • Exhibits (including employment agreements for key employees and other material contracts)

    • Take away – www.sec.gov great place for forms

    • Several types of registration statements

      • Form S-1: The form for an IPO of a U.S. company

      • Less detailed forms:

        • Form S-3: Most simplified securities registration

        • Form S-4: Business combination or exchange offer

        • Form S-8: Shares offered to employees under employee benefit plans


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Documents

  • Prospectus: describes:

    • The securities being offered

    • The company’s business

    • Financial statements

    • Biographies of officers and directors and compensation

    • Any other material information.

  • Must be declared effective by the SEC (appears to comply on its face with the various rules governing disclosure)


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Documents

  • Underwriting Agreement

    • Firm Commitment Offering - underwriter buys all of the shares and bears the risk that the investors will not follow through on their orders

    • Best Efforts Offering - here the underwriter, acting as an agent, agrees to do its best to sell the offering to the public, but does not buy the securities outright and does not guarantee that the issuing company will receive any set amount of money

  • Listing application: the application to become listed on a national exchange such as the NYSE, AMEX or NASDAQ.


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Alternative Public Offering (APO) which is the combination of a reverse merger with a simultaneous Private Investment of Public Equity (PIPE).

It allows companies an alternative to the IPO as a means of going public while raising capital.

In the reverse merger, the private company becomes public by merging with or being acquired by a public “shell” company.

IPO vs. APO


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Securities Exchange Act of 1934

  • Regular Reports

  • Proxy filings

  • Beneficial ownership reports

  • Transaction reporting by officers, directors and ten percent shareholders (Section 16)


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Sale of Restricted Shares

  • Rule 144

    • Allows public resale of restricted and control securities if a number of conditions are met

    • Rule change effective February 15, 2008


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Recent Changes

  • Shortened the holding period requirement

  • Relaxed Rule 144 filing requirements

  • Eliminated the manner of resale restrictions applicable to non-affiliates


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Rule Changes


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Rule Changes


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Paralegal’s Role

  • Shareholders Representation Letters

  • Broker’s Representation Letters

  • Preparation of Form 144 Filings


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Stephanie L. Chandler, Esq. Jackson Walker L.L.P.

210.978.7704

[email protected]

112 E. Pecan Street, Ste. 2400

San Antonio, Texas 78205

www.jw.com


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Getting Comfortable with Investor Terminology

  • NVCA Model Legal Documents

    • www.nvca.org - Model Legal Docs Button

  • Offering Terms

    • Closing Date

    • Investors

    • Amount Raised

    • Price Per Share

    • Pre-Money Valuation

    • Capitalization


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Investors

  • Investor No. 1: Gringotts VC: 5,000,000 shares at $1.00 per share

  • Investor No. 2: Ollivanders VC: 1,000,000 shares at $1.00 per share


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Amount Raised

  • $6,000,000, including $500,000 from the conversion of Subordinated Convertible Promissory Notes of Gringotts VC

  • $1,000,000 to be invested at the Closing

  • $2,000,000 to be invested upon completion of a prototype of the Firebolt

  • $2,000,000 to be invested upon achieving actual manufacturing of the Firebolt

  • $1,000,000 to be invested upon achieving initial sales of $250,000


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Price Per Share

  • $1.00 per share (based on the capitalization of the Company set forth below) (the “Original Purchase Price”).


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Pre-Money Valuation

  • The Original Purchase Price is based upon a fully-diluted pre-money valuation of $4,000,000 and a fully-diluted post-money valuation of $10,000,000 (including an employee pool representing 10% of the fully-diluted post-money capitalization).


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Capitalization


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Charter

  • Dividends

  • Liquidation Preference

  • Voting Rights

  • Protective Provisions

  • Optional Conversion

  • Anti-Dilution Provisions

  • Mandatory Conversion

  • Pay-to-Play

  • Redemption Rights


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Dividends

  • Example: The Series A Preferred will carry an annual 10% cumulative dividend compounded annually, payable upon a liquidation or redemption. For any other dividends or distributions, participation with Common Stock on an as-converted basis.


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Liquidation Preference

  • In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

    Alternative 1 (non-participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. The balance of any proceeds shall be distributed to holders of Common Stock.


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Liquidation Preference (cont.)

  • Alternative 1 (non-participating Preferred Stock) – the Math:

    • Assume Hogwarts sold for $100,000,000

    • If no conversion, Series A would receive $6,000,000 (money back only)

    • If Series A converts, it would receive $60,000,000 ($100,000,000 SP times 60% ownership percentage)


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Liquidation Preference (cont.)

  • In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

    Alternative 2 (full participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock on an as-converted basis.


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Liquidation Preference (cont.)

  • Alternative 2 (full participating Preferred Stock) – the Math:

    • Assume Hogwarts sold for $100,000,000

    • If no conversion, Series A would receive $6,000,000 (money back) plus 60% of the $94,000,000 balance, or $56,400,000 – total of $62,400,000

    • If Series A converts, it would receive $60,000,000 ($100,000,000 SP times 60% ownership percentage)


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Liquidation Preference (cont.)

  • In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

    Alternative 3 (cap on Preferred Stock participation rights): First pay one times the Original Purchase Price plus accrued dividends and unpaid dividends on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock on an as-converted basis until the holders of Series A Preferred receive an aggregate of 5 times the Original Purchase Price.


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Liquidation Preference (cont.)

  • Alternative 3 (cap on Preferred Stock participation) – the Math:

    • Assume Hogwarts sold for $100,000,000

    • If no cap, Series A would receive $6,000,000 (money back) plus 60% of the $94,000,000 balance, or $56,400,000 – total of $62,400,000

    • Assuming a 5x cap, Series A would receive $6,000,000 (money back) plus 60% of the $94,000,000 balance, but limited to 5x $6,000,000, or $30,000,000 – total of $36,000,000


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Liquidation Preference (cont.)


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Voting Rights

  • The Series A Preferred Stock shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except (i) the Series A Preferred as a class shall be entitled to elect two (2) members of the Board (the “Series A Directors”), one of whom shall be designated by Gringotts VC and one of whom shall be designated by a majority of the Series A Preferred Stock, (ii) as provided under “Protective Provisions” below or (iii) as required by law.


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Protective Provisions

  • So long as any shares of Series A Preferred are outstanding, the Company will not, without the written consent of the holders of at least 66 2/3% of the Company’s Series A Preferred, either directly or by amendment, merger, consolidation, or otherwise:

    (i) liquidate, dissolve or wind-up the affairs of the Company, or effect any Deemed Liquidation Event;

    (ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws;

    (iii) create or authorize the creation of or issue any other security having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred;

    (iv) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, other than stock repurchased from former employees or consultants in connection with the cessation of their employment/services, at the lower of fair market value or cost; or

    (v) increase or decrease the size of the Board of Directors.


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Conversion

  • Optional Conversion:

    The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”


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Conversion and AntiDilution

  • Assume 1,000,000 new shares issued at $0.50 per share

  • Anti-Dilution Provisions (Weighted Average)

    CP2 = CP1 * (A+B) / (A+C)

    CP2 = $1.00 * (10,000,000 + ($500,000/$1.00)

    10,000,000 + 1,000,000

    CP2 = $1.00 * 10,500,000

    11,000,000

    CP2 = $1.00 * .95

    CP2 = $0.95

    • Conversion Ratio = 1.05 shares of Common for every 1 share of Preferred

  • Anti-Dilution Provisions (Full Ratchet) – The Math:

    • New Series A Conversion Price reduced to $0.50 per share

      • Conversion Ratio = 2 shares of Common for every 1 share of Preferred


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    Conversion (cont.)

    • Mandatory Conversion:

      Each share of Series A Preferred will automatically be converted into Common Stock at the then applicable conversion rate in the event of the closing of a firm commitment underwritten public offering with a price of five times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and net proceeds to the Company of not less than $30,000,000 (a “QPO”), or (ii) upon the written consent of the holders of 66 2/3% of the Series A Preferred.

    • Does not mean company is expected to IPO


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    Pay-to-Play

    • Unless the holders of 66 2/3% of the Series A elect otherwise, on any subsequent down round all Investors are required to participate to the full extent of their participation rights, unless the participation requirement is waived for all Investors by the Board (including vote of the Series A Director). All shares of Series A Preferred of any Investor failing to do so will automatically [lose anti-dilution rights] [lose right to participate in future rounds] [convert to Common Stock and lose the right to a Board seat if applicable].


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    Redemption Rights

    • The Series A Preferred shall be redeemable from funds legally available for distribution at the option of holders of at least 66 2/3% of the Series A Preferred commencing any time after the fifth anniversary of the Closing at a price equal to the Original Purchase Price, plus all accrued but unpaid dividends. Redemption shall occur in three equal annual portions. 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 any Series A holders who affirmatively opt-out).


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    Registration Rights

    • Demand Registration:

      • Upon earliest of (i) five years after the Closing; or (ii) six months following an initial public offering (“IPO”), persons holding 66 2/3% of the Registrable Securities may request two registrations by the Company of their shares. The aggregate offering price for such registration may not be less than $30 million. A registration will count for this purpose only if (i) all Registrable Securities requested to be registered are registered and (ii) it is closed, or withdrawn at the request of the Investors (other than as a result of a material adverse change to the Company).


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    Registration Rights (cont.)

    • Registration on Form S-3:

      • The holders of 30% 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, Registrable Securities for an aggregate offering price of at least $1 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.


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    Registration Rights (cont.)

    • Piggyback Registration:

      • 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 30% on a pro rata basis and to complete reduction on an IPO at the underwriter’s 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.


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    Registration Rights (cont.)

    • Lock-Up:

      • Investors shall agree in connection with the IPO, if requested by the managing underwriter, not to sell or transfer any shares of Common Stock of the Company for a period of up to 180 days following the IPO (provided all directors, officers, wizards and witches of the Company and 5% stockholders agree to the same lock-up).


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    Pre-Emptive Rights

    • All Investors shall have a pro rata right, based on their percentage equity ownership in the Company (assuming the conversion of all outstanding Preferred Stock into Common Stock and the exercise of all options outstanding under the Company’s stock plans), to participate in subsequent issuances of equity securities of the Company. In addition, 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.


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    Demand Registrations

    Form S-3 Registrations

    Piggyback Registrations

    Expenses

    Lock-up

    Management andInformation Rights

    Right to Participate in Future Rounds (Pre-Emptive Rights)

    Matters Requiring Investor Director Approval

    Non-Competition and Non-Solicitation Agreements

    Non-Disclosure and Development Agreements

    Board Matters

    Employee Stock Options

    Key-Person Insurance

    IPO Directed Shares

    QSB Stock

    Termination

    Investor Rights Agreement


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    Matters Requiring Series A Director Approval

    • So long as any shares of Series A Preferred remains outstanding the Company will not, without Board approval, which approval must include the affirmative vote of the Series A Directors:

      (i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company;

      (ii) 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 a employee stock or option plan approved by the Board of Directors; or

      (iii) incur any aggregate indebtedness in excess of $1,000,000 that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business;

      (iv) change the principal business of the Company, enter new lines of business, or exit the current line of business.


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    Non-Competition, Solicitation and Disclosure Agreements

    • Each Founder and key employee will enter into a one year non-competition and non-solicitation agreement in a form reasonably acceptable to the Investors.

    • Each current and former Founder, employee and consultant with access to Company confidential information/trade secrets will enter into a non-disclosure and proprietary rights assignment agreement in a form reasonably acceptable to the Investors.


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    Right of First Refusal/Co-Sale Agreement and Voting Agreement

    • Right of First Refusal

    • Right of Co-Sale

    • Board of Directors

    • Drag Along

    • Termination


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    Right of First Refusal/Co-Sale

    • Company first and Investors second (to the extent assigned by the Board of Directors,) have a right of first refusal with respect to any shares of capital stock of the Company proposed to be sold by Founders, with a right of oversubscription for Investors of shares unsubscribed by the other Investors. Before any such person may sell Common Stock, he will give the Investors an opportunity to participate in such sale on a basis proportionate to the amount of securities held by the seller and those held by the participating Investors.


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    Board of Directors

    • At the initial Closing, the Board shall consist of five members comprised of (i) Hermione Granger as the representative designated by Gringotts, VC, as the lead Investor, (ii) Lucius Malfoy as the representative designated by the remaining Investors, (iii) Albus Dumbledore as the representative designated by the Founders, (iv) the person then serving as the Chief Executive Officer of the Company, currently Rubeus Hagrid, and (v) 1 person who is not employed by the Company and who is mutually acceptable to the Founders and Investors, who shall initially be Dudley Dursley.


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    Drag Along

    • Holders of Preferred Stock and the Founders shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred, approved by the holders of a 66 2/3% of the outstanding shares of Series A Preferred Stock.


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