Term Sheet Basics: Negotiating Your VC Deal

1. Term Sheet Basics:Negotiating Your VC Deal Eric A. Klein eric.klein@kmzr.com February 18, 2004

2. Key Components of the Term Sheet for Investors • Establish Agreed Valuation • Upside Return on Investment • Downside Investment Protection • Operational Control/Governance • Other Control Features • Exit Strategies

3. Key Components of the Term Sheet Upside Return: • Dividends • Participation • Convertibility • Warrants Downside Protection: • Liquidation Preference • Dividends • Anti-Dilution Adjustment Mechanisms • Redemption

4. Recent Deal Trends • Later Down Scenario Protection • Liquidation Preference Recovery • Warrants • Bridge Notes with Adjustment or Warrants • Still Significant Variation by Industry on Terms • Technology • Senior, multiple liquidation preferences • Health Care/Life Sciences • 1x liquidation preference • More “vanilla” terms • Still Seeing Significant Founder Re-Vesting • Still Seeing a Lot of Tranche/Milestone Structures

5. Equity Issues andFinancial Engineering: Bridging the Valuation/Risk Gap • Warrants • Liquidation Preference/Dividends • “Frozen” Valuation During Multi-Tranche Deal • Option Plan Size and Structure – Effect on Pre-Money Valuation

6. The Starting Point: The First Colon Type of Security: • Common Stock (< $500,000/$1,000,000) • Preferred Shares (Equity) • Debt Securities with Warrants • Convertible Debentures with Adjustment Features

7. Funding Amount • Amount to be Raised • Lump Sum • Tranches • Fixed Amount v. Max/Min Offering • Special Considerations for a Max/Min Offering: • “Hard” and “soft” time extensions • Allocation among syndicate members • Impact on tranche funding (re-allocation among syndicate members to account for late comers)

8. Investor Mechanics • Investors Identified • Establish Lead(s) • Establish Minimum Amounts to be Invested by Identified Members of the Syndicate • Identify Approval Rights with Respect to Completion of Syndicate • Pre-Money and Post-Money Valuation

9. Dividends • Frequently Payable on Liquidation and Conversion • To Cumulate or not to Cumulate … That is the Question • Accrual and/or Payment can be Triggered by External Events (I.e., Royalty Dividend) • Rate can be Fixed for Variable According to a Specified Formula or Reset upon Events • Failure to Pay can Trigger Issuance of [Additional] Securities

10. Liquidation Preference • Triggers on Sale or Liquidation • Participation, Participation, Participation • Multiple • Hurdles • Fair Market Value Trailers • Inclusion of Unpaid Dividends

11. Anti-Dilution Adjustment Full Ratchet v. Weighted Average: • “Broad Based” Weighted Average: • Protects against dollar (price-based) dilution • Includes all outstanding shares of stock and all options and warrants • “Narrow Based” Weighted Average: • Ownership is increased proportionately to the number of new shares issued • Includes issued and outstanding stock and in-the-money options and warrants Weighted Average

12. Anti-Dilution Adjustment Full Ratchet v. Weighted Average: • Protects Against Percentage Dilution: • Reduces conversion price from original price to lower, current price • Does not take into account the number of securities sold • Results in greater ownership interest for same dollar investment Full Ratchet

13. Redemption • Dates/Timing (3 – 5 Years) • Price (Purchase Price plus Dividends v. Liquidation Preference v. Fair Market Value) • Penalties/Self-Executing Remedies (Board Shift/Board Flip; Company Auction; Change in Conversion/Dividend Rates/Preferences) • Designed to Avoid “Lifestyle Companies” or the “Living Dead” • Limitations Under State Law

14. Redemption What is Quasi-California Applicability? • Basics • A quasi-California corporation is a corporation incorporated outside of California (e.g., Delaware), but which is nonetheless subject to portions of the California Corporations Code • Quasi-California Corporation Test (California §2115) • More than 50% of the corporation’s property, payroll and sales factors are in California (pursuant to the California Revenue and Taxation Code §25129, §25132 and §25134) • More than 50% of the corporation’s outstanding voting securities are held by people with California addresses

15. Redemption What Provisions of the California Corporations Code apply to Quasi-California Corporations? • Annual Election of Directors (CA §301) • Director’s Standard of Care (CA §309) • Liability of Directors for Unlawful Distributions (CA §316) • Indemnification of Directors, Officers and Others (CA §317) • Limitations on Corporate Distributions in Cash or Property (CA §500-505) • Liability of Shareholder Who Receives an Unlawful Distribution (CA §506)

16. Voting Rights • On an “As If” Converted Basis as a Single Class with Common Stockholders, Unless Vote Affects Rights, Privileges and Preferences of the Preferred as a Class • Separate Class as Required by Law and by Agreement

17. Board Representation • Number of Board Seats • Title v. Individual People • Limitations Based on Percentage Ownership (Fully Diluted v. Issued and Outstanding) • Observer Seats and Assumption of Costs Related Thereto

18. … someone to watch over me … Ordinary Protective Provisions: • Changes in Rights, Privileges and Preferences • Redemption or Repurchase of Shares • Increase/Decrease in Number of Directors • Payment of Dividends • Obligations or Expenses Over Certain Limits • Change in Basis or Quality of Key Investor Information (Accounting Methodology)

19. … someone to watch over me … Other Provisions: • Prohibition Against Entry into a “Material” Transaction Unless at Arm’s Length with Bona Fide Third Party • Capital Expenditures • Budget • Strategy/Focus • Increase in Option Pool • Investments, Acquisitions and Divestitures

20. Information Rights • Traditional Rights • Audited Financials and Quarterly Reports • Budgets Prior to Year End • Business Plan

21. Registration Rights • Demand/S-1’s (Who? When? How Many?) • “Piggybacks”/S-3’s • Most Favored Nations Protection • Transferability • Cutbacks

22. Co-Sale/Tag-Along, Rights of First Refusal and Drag Along Rights • Investors May Sell Proportionately in Founder Sale • Company Has Option to Acquire Shares to be Sold by Founders • Ensures Flexibility in Structuring Exit When All Shareholders Are Bound – Very Difficult to Utilize Effectively

23. Pre-Emptive Rights • Optional, but not without Consequence if Pay-to-Play is Included • Is Percentage Available for Purchase Based on Issued and Outstanding or Fully Diluted Number? • Often Result in Automatic Conversion to Common Stock or “Shadow Preferred” or Loss of Future (One or More) Anti-dilution Adjustments if Pro Rata Share Not Acquired • Super Pre-Emptive Right for “Current” Round

24. Contact Information • Eric A. Klein, Esq.Katten Muchin Zavis Rosenman2029 Century Park East, Suite 2600Los Angeles, California 90067Direct Tel: (310) 788-4640Direct Fax: (310) 712-8482E-Mail: Eric.Klein@kmzr.com This presentation does not constitute legal advice and is intended only to spot issues. No attorney-client relationship exists as a result of this presentation.

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