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A Beginner’s Guide to Venture Capital Term Sheets: … be smarter than your Venture Capital investor

A Beginner’s Guide to Venture Capital Term Sheets: … be smarter than your Venture Capital investor. About Orrick Quick Overview. BEIJING BERLIN DÜSSELDORF FRANKFURT HONG KONG LONDON LOS ANGELES MILAN MOSCOW MUNICH NEW YORK ORANGE COUNTY PARIS PORTLAND ROME SACRAMENTO

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A Beginner’s Guide to Venture Capital Term Sheets: … be smarter than your Venture Capital investor

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  1. A Beginner’s Guide toVenture Capital Term Sheets:… be smarter than yourVenture Capital investor

  2. About OrrickQuick Overview BEIJING BERLIN DÜSSELDORF FRANKFURT HONG KONG LONDON LOS ANGELES MILAN MOSCOW MUNICH NEW YORK ORANGE COUNTY PARIS PORTLAND ROME SACRAMENTO SAN FRANCISCO SEATTLE SHANGHAI SILICON VALLEY TAIPEI TOKYO WASHINGTON, D.C. • One of the world’s largest and best-regarded law firms • More than 1,100 lawyers in 23 locations in 8 countries • Named to Law 360’s "Global 20“ list of the world's leading global law firms • Focus on emerging companies • More than 1,000 emerging company clients • More than 100 lawyers in the Silicon Valley office, including founding members of Venture Law Group • Relationships with more than 100 venture capital funds 2

  3. About OrrickEmerging Companies Practice • Recognized by Legal500 as one of the top firms in the U.S. for our venture capital and emerging companies practice • Clients include 5 of The Momentum Index’s Top 50 Technology Companies, 8 companies listed in GreenTech Media's Top 50 Greentech Startups, and companies listed among The Wall Street Journal's Top 50 Venture-Backed Companies, BusinessWeek's 50 Best Tech Start-Ups, and VentureWire’s 50 Most Innovative Technology Startups • As one measure of our market presence, we have acted as either company counsel or investor counsel in venture capital financings for 9 of The Momentum Index’s Top 20 Technology Companies 3

  4. Domain KnowledgeRepresentative Internet Clients Sports applications for social networks (Acquired by Yahoo!) TIME: 50 Best Websites 2010 Digital content platform (Kleiner Perkins, DAG Ventures) Red Herring 100 Winner - 2010 Provider of online higher education (Maveron, Spark Capital, Charles River) Independent sports media site (Oak Investment Partners, Crosslink Capital) TIME: 50 Best Websites 2011 Small business outsourcing (Kleiner Perkins, NEA) Online genealogy platform (Charles River, Founders Fund) TIME: 50 Best Websites 2008 Online relationship service (Sequoia Capital, TCV) AlwaysOn Global 250 - 2011 Service and tool for web comments (Union Square, North Bridge) Media and merchandise company (NYSE:MSO) Wedding planning web site (NYSE:XOXO) E-commerce fulfillment and web design (Bessemer Venture Partners) Lead411– 2011 Hottest Companies in So. Calif. Russian travel web site (Accel Partners, General Catalyst) Online short-term loans (Lightspeed Venture Partners) Social network for dating (Bessemer Venture Partners) WSJ– Top 50 Venture-Backed Companies Online learning/collaboration platform (Sequoia Capital, Bessemer Venture Partners) Online payments (Sequoia Capital) 4

  5. Domain KnowledgeRepresentative Social Media Clients Managing comments across the web (Acquired by Twitter) Website for furthering social causes (Founders Fund, NEA) Social network for travel (Benchmark, Omidyar) Momentum Index Top 50 Travel Companies Video distribution via social media (Lightspeed, Gemini Israel, Gimv) Location-based social networking (Acquired by Facebook) TIME: 50 Best Websites 2010 Job search through social networking (DFJ, Polaris Ventures) Crowd funding for the arts (XAnge Private Equity) Social conference directory (Index Ventures) Social ranking site (Anthemis Group) TechCrunch Europas: 2011 Overall Winner Social advertising analytics (Acquired by American Express) Online Q&A knowledge market (Benchmark) TIME: 50 Best Websites 2011 Social event planning (True Seed, Founders Fund Angel) Integrated communication client (Harrison Metal Capital) Social network for travel (Sequoia, True Ventures) Social network for travel (DFJ Esprit) Enterprise social network (USVP, Charles River, Founders Fund) WSJ Top 50 Venture-Backed Companies 5

  6. Domain KnowledgeRepresentative Gaming Clients Professional-grade equipment for gamers (Acquired by SkullCandy) Direct-deal marketplace for game publishers (SK Telecom Ventures, XG Capital) Social game developer (Signia Ventures) Social gaming network (TSE:2432) Social game developer in China (DFJ) Platform for casual and social games (Union Square) OnHollywood 100 - 2010 Online game networking platform (USVP, Altos Ventures) Distribution platform for digital games (Sequoia Capital) Browser-based game developer in China (Investors not disclosed) Online community game developer (DCM, Altos Ventures) Momentum Index Top 20 Game Companies Mobile social network and gaming (DCM, Keytone Ventures) AlwaysOn Global 250 - 2011 Multiplayer online game developer (NASDAQ: PWRD) Social network for video gaming (Atomico Ventures) Developer of social apps and games (Sequoia, DCM, Lightspeed Venture Partners) Momentum Index Top 20 Game Companies Independent games studio (Undisclosed) Persistent world online games (Acquired by Sega) 6

  7. Domain KnowledgeRepresentative Digital Media and Advertising Clients Social internet radio (Investors not disclosed) TIME: 50 Best Websites 2011 Digital media monitoring company (First Round Capital, JAFCO Ventures) Interactive video advertising platform (500 Startups, Credo Ventures) Social media management system (DFJ Espirit) TechCrunch Europas –Best Advertising Startup Platform for sharing video content (DFJ) Full-service, plug-and-play video solutions (Investors not disclosed) OnHollywood 100 - 2010 User-controlled radio (Battery Ventures, First Round Capital) India’s leading ad network platform (Norwest, DFJ, Helion Venture Partners) Momentum Index Top 50 Ad Tech Companies Ad revenue optimization service (DFJ, Helion Ventures, Nexus India Capital) AlwaysOn Global 250 - 2011 Digital advertising optimization (Acquired by iCrossing) Modern media company (August Capital, Focus Ventures, Maveron) Momentum Index Top 50 Ad Tech Companies Leading video upload service for Twitter (Azure Capital Partners, DFJ) OnMedia 100 - 2012 Viral video marketing (Amadeus Capital Partners) Momentum Index Top 50 Ad Tech Companies Online ad solutions (Hummer Winblad, Storm Ventures) Online advertising inventory allocation (Madrona, Sequel, Triangle Peak Partners) OnMedia 100 - 2010 Web-based video encoding SaaS Andreessen-Horowitz, Google Ventures) 7

  8. Domain KnowledgeRepresentative Mobile and Wireless Clients Social “gamification” platform (Norwest, El Dorado, Trinity) LAPTOP: 2011 Top 10 Mobile Startups Augmented reality photo app (August Capital) Mobile app for standardized test prep (Investors not disclosed) MobileBeat Top Consumer Startup – 2010 App analytics and monetization platform (DFJ, Menlo Ventures, InterWest, Union Square) AlwaysOn Global 250 - 2011 App distribution and developer community (Accel, Tiger Global Management) AlwaysOn Global 250 - 2011 Mobile app creation and distribution (Apax Partners, Motorola Ventures) Video-editing app (500 Startups, Quest Venture Partners) Photo sharing app Acquired by Facebook Apple: 2011 iPhone App of the Year Mobile family safety applications (Bessemer Venture Partners) Photo sharing app (500 Startups, Quest Venture Partners) Mobile barcode technology (Alven Capital, XAnge Private Equity) iPhone productivity and collaboration app (Charles River Ventures) Mobile phone virtualization solutions (Chrysalis Ventures, Citrix) Fierce Wireless 15 - 2010 Developer of Talking Tomcat app (Investors not disclosed) Phone and SMS alerts for IT monitoring tools (Baseline Ventures, Harrison Metal Capital) Save web pages to read on any device (Foundation Capital, Google Ventures) 8

  9. Domain KnowledgeRepresentative Enterprise Software Clients Business intelligence platform mapping (SAP Ventures) Enterprise-focused collaboration (Andreessen-Horowitz, Benchmark) Software development and collaboration tools (Investors not disclosed) AlwaysOn Global 250 - 2011 Enterprise collaboration suite (Acquired by SuccessFactors) On-demand lending automation (Crosspoint, Palomar) Identity management solutions (DFJ Frontier, Compass Technology Group) Online digital signatures (Acquired by Adobe) Web-based ERP solutions (Redpoint, Index Ventures) Online collaboration platform (Eden Ventures, Matrix Partners) 2009 Red Herring Europe 100 Employee compensation software (Mitch Kapor, Jeff Bezos) Scalable, memory-optimized database (First Round Capital, nea:seed) Service provider management software (Bessemer, Catalyst Investors) 2010 Red Herring 100 B2B price management and optimization (DCM, Interwest Partners, SAP Ventures) 2010 OnMedia 100 Peer-to-peer videoconferencing (In-Q-Tel) Enterprise social network (USVP, Charles River, Founders Fund) WSJ Top 50 Venture-Backed Companies Communication data solutions (Khosla, Atomico, RRE Ventures) BusinessWeek 2009 50 Best Tech Startups 9

  10. Domain KnowledgeRepresentative Cloud Computing Clients (SaaS, PaaS) Software and services for private clouds (Acquired by RackSpace) Enterprise-focused collaboration (Andreessen-Horowitz, Benchmark) Capital-raising platform for startups (500 Startups, Peter Thiel) Messaging security and infrastructure solutions (FTVentures, Ignition Partners) Platform-as-a-Service (Benchmark, Trinity Ventures) Web-based ERP solutions (Redpoint, Index Ventures) Contacts management (Acquired by Salesforce.com) Unified search engine for the cloud (Sequoia Capital) VentureWire – 2011 50 Most Innovative Tech Startups Fraud prevention solutions (Foundation Capital, Split Rock Partners) Platform-as-a-Service (Acquired by Salesforce.com) Search engine-as-a-service (Acquired by LinkedIn) Service provider management software (Bessemer, Catalyst Investors) 2010 Red Herring 100 Social productivity collaboration SaaS (Acquired by Salesforce.com) SAN-less virtualized datacenter (Khosla, Lightspeed) VentureWire – 2011 50 Most Innovative Tech Startups Automated call center agents (El Dorado Ventures, Intel Capital) Web-based video encoding SaaS (Andreessen-Horowitz, Google Ventures) 10

  11. Emerging Company Needs • Emerging Companies face unique challenges • Success leads to even more challenges Financing IP Protection “Bet the Company” Technology Transactions Formative Counseling Additional Financing Addressing Global Markets Exit Strategies Litigation – Sword and Shield 11

  12. Term Sheets • Why are they important? • European vs. US VCs • VCs vs. Strategic Investors 12

  13. Term SheetsTop 10 Term Sheet Provisions • Liquidation Preference • Anti-dilution Protection • Redemption • Dividends • Pre-emptive Rights • RoFR / Drag / Tag • Founders’ Stock • Protective Provisions • Board Representation • Registration Rights 13

  14. Liquidation PreferenceWhat is it? • Basic definition: • Investors get their money back before anyone else • Legal definition: • “… a right given to holders of a preferred class of shares whereby such holders, in the event of a liquidation event, are entitled to receive their investment back (plus accrued dividends) before the holders of ordinary shares receive anything.” • Why is it important? • gives investors “downside protection” • guarantees the investor that they will see the “first money” out in a liquidation scenario 14

  15. Liquidation PreferenceTips & Tricks • Tips: • run the exit model (a VC has already done so) • multiple liq. pref. & participation reflect state of economy • Tricks: • horizon / time based inflection point • cap / participation removed above $$ value 15

  16. Anti-dilution ProtectionWhat is it? • Basic definition: • Investors get price protection • Legal definition: • “… a mechanism which insures that an investor’s equity stake in a company will not be reduced through subsequent investments in the company at reduced valuations.” • Why is it important? • gives investors “downside protection” • can discourage “down rounds” 16

  17. Anti-dilution ProtectionTips & Tricks • Tips: • full ratchet vs. weighted average • ensure carve-outs are listed • do the math • Tricks: • time-based conversion from full ratchet to weighted average • “pay to play” 17

  18. RedemptionWhat is it? • Basic definition: • Investors get another kind of exit • Legal definition: • “… an investor’s right to require the company to repurchase shares that the investor has purchased (often at a price that is greater than what the investor paid).” • Why is it important? • another form of “downside protection” (or even insurance policy), but investor may exercise this right if they realise that the company has no real prospect of an exit (the “cash cow” scenario) 18

  19. RedemptionTips & Tricks • Tips: • resist, as not all VCs or investors require it • should be justified by the VC • Tricks: • stagger the redemption (⅓ / ⅓ / ⅓) • ensure carve-out for legal ability to do so 19

  20. DividendsWhat is it? • Basic definition: • Investors get additional return on their money • Legal definition: • “… distributions to shareholders from the company’s profits, usually on an annual basis at a specified rate.” • Why is it important? • Investors sometimes want a guaranteed rate of return on their investment 20

  21. DividendsTips & Tricks • Tips: • resist, as not all VCs or investors require it • if have multiple liquidation preferences, may not be justified • Tricks: • non-cumulative • delay commencement of earning / accruing dividends 21

  22. Pre-emptive RightsWhat is it? • Basic definition: • Investors get to avoid dilution (and continue to invest) • Legal definition: • “… a right to acquire shares being issued by the company in future offerings at the same price to be paid by the new investors.” • Why is it important? • allows investors to maintain their same percentage ownership of the company going forward 22

  23. Pre-emption RightsTips & Tricks • Tips: • bargaining tool to concede (US vs. Europe) • do you want to offer round to 50+ shareholder every time? • Tricks: • ensure participation by all in down rounds for protection • list carve-outs (e.g. convertible notes, venture debt) 23

  24. Right of First RefusalWhat is it? • Basic definition: • Investors get first dibs on transfers of shares • Legal definition: • “… a right to acquire shares being sold by existing shareholders to third parties.” • Why is it important? • allows investors to increase their percentage ownership of the company going forward • bargaining tool for the Investor: • complementary (or flip side) to “Co-Sale Right” 24

  25. Right of First RefusalTips & Tricks • Tips: • ensure broad range of carve-outs (including tax planning) • may not want “offer round” if numerous small shareholders • Company may not always be able to purchase • Tricks: • class by class RoFR 25

  26. Drag & TagWhat are they? • Drag Along: • What is it? • “.. if a certain threshold percentage of a company’s shareholders agree to sell their shares, then all other shareholders are obliged to sell their shares in connection with such transaction.” • Why is it important? • insure that a sale of the company will not be blocked by other shareholders • Co-Sale Right: • What is it? • “… rights which entitle an investor to include a percentage of their shares in a purchase by a third party of another shareholder’s sale.” • Why is it important? • investor is able to control the exit of other shareholders, while ensuring that they are able to participate in exits on a pro rata basis 26

  27. Founders’ StockWhat is it? • Basic definition: • Founder no longer really owns his/her shares • Legal definition: • “… the shares held by a founder, typically issued at incorporation, that are subject to reverse vesting.” • Why is it important? • Investor ensures that Founder is incentivised to remain with the company (“golden handcuffs”) • overcomes the “free rider” problem 27

  28. Founders’ StockTips & Tricks • Tips: • know what you’re getting into • define “good leaver / bad leaver” • Tricks: • use bad leaver as the benchmark • bad leaver = fraud, join competitor or “moral turpitude” • credit for “time served” • acceleration -> single & double trigger 28

  29. Protective ProvisionsWhat are they? • Basic definition: • Investors (negatively) control the company • Legal definition: • “…veto rights that are given to investors, or some combination of shareholders, which require the company to obtain the prior consent of the investors before taking various corporate actions.” • Why is it important? • Investors need to have a degree of control over their investments • veto rights over important aspects of the business 29

  30. Protective ProvisionsTips & Tricks • Tips: • define the “laundry list” in term sheet • split consents / vetoes between shareholder and board • Tricks: • consent of investor board member = consent of investor shareholder • carve-outs for “ordinary course of business” & budgeted items 30

  31. Board RepresentationWhat is it? • Basic definition: • Investor oversees the company • Legal definition: • “… a requirement that the investor receives a seat on the company’s board of directors in consideration for their investment.” • Why is it important? • allows the Investor to monitor the status of their investment • should be in the company’s best interest, as Investor should bring degree of experience and guidance to the table 31

  32. Board Representation Tips & Tricks • Tips: • define roles for each board seat (including Founder seat) • keep board lean • part of “Information Rights” that Investor will seek • Tricks: • ownership threshold for board seat • if multiple classes, seats on a class-by-class basis (rather than unique to Investor) 32

  33. Registration RightsWhat are they? • Basic definition: • Investors get to sell if company goes public in the US • Legal definition: • “… contractual rights of investors to require the company to register their shares for sale to the public.” • Why is it important? • Investor’s shares included as part of IPO or secondary • if eventual exist is IPO in the US 33

  34. Registration RightsTips & Tricks • Tips: • resist, as not all European VCs require it • not all that relevant anymore • Tricks: • know the difference between: • “demand” • “piggy back” • don’t waste time on it 34

  35. Helpful Resources • The Funded • www.thefunded.com • Venture Hacks • www.venturehacks.com • Brad Feld & Jason Mendelson: • “Venture Deals: Be Smarter than your Lawyer and Venture Capitalist” • Katharine Campbell: • “Smarter Ventures: A Survivor’s Guide to Venture Capital through the New Cycle” 35

  36. Helpful ResourcesThe VCs and other bloggers • Fred Wilson www.avc.com • Mark Suster www.bothsidesofthetable.com • Brad Feld www.feld.com • Chris Dixon cdixon.org • Nic Brisbourne www.theequitykicker.com • Mandatory reading: • www.bvp.com/portfolio/antiportfolio 36

  37. Thanks 37

  38. Global Office Locations HONG KONGOrrick, Herrington & Sutcliffe 43rd Floor, Gloucester Tower The Landmark 15 Queen’s Road Central, Hong Kong Tel: +852-2218-9100 Fax: +852-2218-9200 LONDON Orrick, Herrington & Sutcliffe (Europe) LLP 107 Cheapside London EC2V 6DN United Kingdom Tel: +44-20 7862 4600 Fax: +44-20 7862 4800 LOS ANGELES Orrick, Herrington & Sutcliffe LLP 777 South Figueroa Street Suite 3200 Los Angeles, CA 90017-5855 U.S.A. Tel: +1-213-629-2020 Fax: +1-213-612-2499 MILAN Orrick, Herrington & Sutcliffe Corso G. Matteotti 10 Milan, 20121 Italy Tel: +39-02-4541-3800 Fax: +39-02-4541-3801 MOSCOW Orrick (CIS) LLC 7 Gasheka Street Moscow 123056 Russia Tel: +7-495-775-4805 Fax: +7-495-775-4806 BEIJING Orrick, Herrington & Sutcliffe LLP Beijing Representative Office 22nd Floor, South Tower Beijing Kerry Centre 1 Guang Hua Road Chaoyang District 100020 Beijing People’s Republic of China Tel: +86 10 8595 5600 Fax: +86 10 8595 5700 BERLINOrrick Hölters & Elsing Kurfürstendamm 185 10707 Berlin Germany Tel: +49 (0)30 885742-0 Fax: +49 (0)30 885742-20 DÜSSELDORF Orrick Hölters & Elsing Heinrich-Heine-Allee 12 40213 Düsseldorf Germany Tel: +49 (0)211-36787-0 Fax: +49 (0)211-36787-500 FRANKFURT Orrick Hölters & Elsing Friedrichstrasse 31 60323 Frankfurt Germany Tel: +49 (0)69-71588-0 Fax: +49 (0)69-71588-588 MUNICH Orrick, Herrington & Sutcliffe LLP Rosental 4 80331 Munich Germany Tel: +49 (89)383980-0 Fax: +49 (89)383980-99 NEW YORK Orrick, Herrington & Sutcliffe LLP 51 W 52nd Street New York, NY 10019-6142 U.S.A. Tel: +1-212-506-5000 Fax: +1-212-506-5151 ORANGE COUNTY Orrick, Herrington & Sutcliffe LLP 2050 Main Street, Suite 1100Irvine, CA 92614-8255 U.S.A. Tel: +1-949-567-6700 Fax: +1-949-567-6710 PARIS Orrick Rambaud Martel 31, avenue Pierre 1er de Serbie 75782 Paris Cedex 16 France Tel: +33-1-5353-7500 Fax: +33-1-5353-7501 PORTLAND Orrick, Herrington & Sutcliffe LLP 1120 NW Couch Street Suite 200 Portland, OR 97209-4129 U.S.A. Tel: +1-503-943-4800 Fax: +1-503-943-4801 ROME Orrick, Herrington & Sutcliffe Piazza della Croce Rossa, 2 00161 Rome Italy Tel: +39-06-4521-3900 Fax: +39-06-6819-2393 SACRAMENTO Orrick, Herrington & Sutcliffe LLP 400 Capitol Mall Suite 3000 Sacramento, CA 95814-4497 U.S.A. Tel: +1-916-447-9200 Fax: +1-916-329-4900 SAN FRANCISCO Orrick, Herrington & Sutcliffe LLP The Orrick Building 405 Howard Street San Francisco, CA 94105-2669 U.S.A. Tel: +1-415-773-5700 Fax: +1-415-773-5759 SEATTLE Orrick, Herrington & Sutcliffe LLP Columbia Center 701 Fifth Avenue Suite 5700 Seattle, WA 98104-7097 U.S.A. Tel: +1-206-839-4300 Fax: +1-206-839-4301 SHANGHAI Orrick, Herrington & Sutcliffe LLP Shanghai Representative Office 47/F Park Place 1601 Nanjing Road West Shanghai 200040 People’s Republic of China Tel: +86 21 6109 7000 Fax: +86 21 6109 7022 SILICON VALLEY Orrick, Herrington & Sutcliffe LLP 1000 Marsh Road Menlo Park, CA 94025-1015 U.S.A. Tel +1-650-614-7400 Fax +1-650-614-7401 TAIPEI Orrick Foreign Legal Affairs Attorneys at LawSuite G, 12th FloorNo. 167 Tun Hua North RoadTaipei 10549Taiwan Tel + 886-2-2714-8100Fax + 886-2-2714-8101 TOKYO Orrick Tokyo Law Offices a gaikokuho joint enterprise Izumi Garden Tower, 28th Floor 6-1 Roppongi 1-Chome Minato-ku, Tokyo 106-6028 Japan Tel +81-3-3224-2900 Tel +81-3-3224-2901 WASHINGTON, D.C. Orrick, Herrington & Sutcliffe LLP The Orrick Building at Columbia Center 1152 15th Street NW Washington, D.C. 20005-1706 U.S.A. Tel +1-202-339-8400 Fax +1-202-339-8500 38

  39. Liquidation PreferenceTraps • Traps: • high pre-money valuation with multiple / participating liq. pref. • liquidation preference on IPO • participation = “double dip” • accrued cumulative dividends • liq. pref. stack from multiple rounds can be oppressive 39

  40. Anti-dilution ProtectionTraps • Traps: • high pre-money valuation with full ratchet • when weighted average ≠ weighted average • miscalculating the liquidation preference (money in vs. per share) 40

  41. RedemptionTraps • Traps: • full redemption at a single date • multiple return (pseudo liquidation preference) • “we have never exercised our right of redemption” • long term debt on the balance sheet (increasing if dividend as well) 41

  42. DividendsTraps • Traps: • cumulative (accumulate at a specified rate) • multiple rounds + liq. pref. + dividends = mountain • effect on redemption • accounting treatment 42

  43. DividendsTraps • Traps: • VC investor only? • super pre-emptive rights to increase %age holding 43

  44. Right of First RefusalTraps • Traps: • VC investor only • timings 44

  45. Founders’ Stock Traps • Traps: • “standard” good leaver / bad leaver • use good leaver as benchmark = out the door “feet first” 45

  46. Protective ProvisionsTraps • Traps: • “standard” protective provisions • straightjacket thresholds • Articles (public) vs. Shareholders’ Agreement (private) 46

  47. Board RepresentationTraps • Traps: • entrenched seat for irrelevant Investor • observers & expenses • director’s fees for Investors 47

  48. Registration RightsTraps • Traps: • more than two “demand” rights • low $$ thresholds to trigger rights • “customary registration rights” 48

  49. MiscellaneousTips (Part 1) • Tips: • co-terminus: “no shop” and projected closing date • include cap table (pre- and post-closing) • cap liabilities under warranties (duration and quantum) 49

  50. MiscellaneousTrick • Trick: • no confidentiality obligation until signed … 50

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