Negotiating the Preferred Stock Term Sheet

1. Negotiating the Preferred Stock Term Sheet Presented by Bart Greenberg Haynes and Boone, LLP OC Tech Coast Angels Member Education Session April 25, 2012

2. Certain Preliminary Matters

3. Market Conditions Impact Terms • Shortage of willing investors leads to aggressive terms • Desire by Investors to “correct” prior valuation errors (i.e., overvaluations) and pull up returns on whole portfolio may lead to more aggressive terms • Desire by Investors to avoid future errors may lead to more aggressive terms, such as by imposing self-adjusting valuations, guaranteed returns, downside protection, more bridge financings

4. Prior Rounds Impact Terms • Severe down round/cramdown (leads to most aggressive terms) • Flat round (could be considered a “win” in unfavorable market conditions) • Up round (best chance to get reasonable or favorable terms)

5. Valuation • Means many different things • $2.5 million pre-money with $2.5 million new money could mean: • Original investors get $2.5 million if sold for $5 million • Original investors + optionees (current or all future) get $2.5 million if sold for $5 million • Original investors + founders and optionees (current or all future) will each have equivalent ownership percentages if “go public” (and convert to common stock) – but not necessarily under other liquidity scenarios • Conversion concept vs. liquidation concept

6. Defining the Terms of the Preferred Stock

7. Dividends Considerations • Priority of Payment • Common • Other Preferred • Dividend/Coupon Rate • Cumulative vs. • Non-Cumulative • Form of Payment • Cash “coupon” • Payment-in-Kind Securities (PIKs)

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

9. “Annual $_____ per share dividend on the Series ___ Preferred Stock, payable when and if declared by Board, prior to any dividends paid to the Common Stock; dividends are [not] cumulative. No dividends will be declared or paid on the Common Stock unless and until a like dividend has been declared and paid on the Series ___ Preferred Stock.” Dividends

10. Liquidation Preference Considerations • Should the holder have a “preferred” return before other equity holders? • When should the preference apply (e.g., non-conversion contexts such as a merger or upon liquidation)? • Key Characteristics: • Priority of Distribution • Amount of Preference • Participation Rights

11. Liquidation Preference More favorable to preferred holders More favorable to common holders

12. Liquidation Preference Pre-Bubble • • 1X purchase price, plus participation • rights up to 3X • 1X to 3X with some participation rights (the lower the X, the greater the participation rights) • Participation Rights are sometimes subject to a management carve out • More extreme: 3X purchase price, plus participation rights with no cap Post-Bubble

13. The “Waterfall” First: Creditors Satisfied • Second: Distribution to holders • of preferred stock • Third: Distribution to holders of common stock (with possible participation by holders of preferred stock)

14. First First Second Second Third Third Total Total The “Waterfall” (an illustration) Creditors Creditors 0 0 0 0 0 0 $0.00 $0.00 Series A* Series A* 0 0 $12,300,000 $4,100,000 $4,100,000 $1,350,000 $8,200,000 $13,650,000 Term Sheet: 1x preference for Series A, 1x participation) Common Stock (including option pool) Common Stock (including option pool) 0 0 0 0 $1,350,000 $6,800,000 $1,350,000 $6,800,000 $15,000,000 $15,000,000 Term Sheet: 3x preference for Series A, full participation Amount Available for Distribution: $15,000,000 * Original investment of $4,100,000

15. “First pay the original purchase price [plus premium] plus accrued dividends (if any) on each share of Series ___ Preferred Stock. Thereafter, Series ___ Preferred Stock participates with Common Stock on an as-converted basis.” Liquidation Preference

16. Liquidation Preference “First pay the original purchase price plus accrued dividends (if any) on each share of Series ___ Preferred Stock. Thereafter, Series ___ Preferred Stock participates with Common Stock on an as-converted basis until the holders of Series ___ Preferred Stock receive an aggregate of [ _ ]X original purchase price.”

17. Liquidation Preference “First pay the original purchase price [plus premium?] plus accrued dividends on each share of Series ___ Preferred Stock. The balance to holders of Common Stock.”

18. Who can trigger? Percentage of preferred holders/individually Company (rare) Priority among other holders Staging of Redemption Device to force conversion Form of Payment Legal Restrictions Redemption Considerations

19. Redemption Pre-Bubble • Not Common Post-Bubble • At option of holders after 5 years at purchase price plus accrued dividends

20. Redemption “Series ___ Preferred Stock redeemable at the election of holders [of 66-2/3rds] of the outstanding Series ___ Preferred Stock] on or after ____________ at a price equal to the original purchase price [plus accrued dividends] [plus ___% per year] or as soon thereafter as legally permissible.”

21. Redemption “[See Example 1], to the extent of 1/3 of the shares of Series ___ Preferred Stock on the [____], [____] and [____] anniversary dates of the Closing or as soon thereafter as legally permissible[, but in no event will more than 1/3 of the outstanding shares of Series ___ Preferred Stock (plus 1/3 of the aggregate accrued dividends) be redeemed in any 12 month period.]”

22. The number of shares of common stock, if any, into which preferred stock converts: preferred stock share price (fixed) Conversion Price Typically Based on Certain Triggering Events Election by percentage of holders of preferred stock IPO Conversion Rights Considerations

23. Way to “fix” earlier valuation errors on conversion (i.e. allocate most or all of risk of down round to common stock) Three Types of Adjustments “Full Ratchet” “Narrow-Based” Weighted Average “Broad-Based” Weighted Average Specified Exceptions Antidilution Adjustments Considerations

24. Antidilution Adjustments Pre-Bubble • Standard broad-based weighted average adjustment Post-Bubble • Narrow-based weighted average adjustment • More extreme: Full ratchet adjustment for a period; then narrow or broad- based weighted average adjustment

25. Type of Adjustment Common Stock Outstanding Conversion Ratio 1,000,000 shares Antidilution Adjustments (an illustration) Series A Preferred Full Ratchet 1:1.333 1,000,000 shares at $1.00 (or $1,000,000) Narrow-Based 1:1.143 Series B Preferred 1,000,000 shares at 75¢ (or $750,000) Broad-Based 1:1.091 Scenario: Adjustments (Upon Series B) • Series A Conversion Ratio Prior to Series B = 1:1 • Upon Series B, Series A Conversion Ratio adjusted as follows:

26. Antidilution Adjustments - Pay to Play • If stockholder does not purchase pro rata share in subsequent offering, stockholder loses benefit of antidilution provisions. • In extreme cases, non-participating stockholders must convert to common stock (sometimes at less than 1:1), thereby losing protective provisions of preferred stock. • “Pay to Play” minimizes fears of major investors that small investors will benefit by having major investors continue providing needed equity, particularly in troubled economic times.

27. Antidilution Adjustments “Conversion ratio for Series ___ Preferred Stock adjusted on [ratchet/[broad or narrow] weighted average] basis in the event of a dilutive issuance [so long as investor purchases full pro rata share of dilutive issuance (“pay to play”).]”

28. Antidilution Adjustments “Any Existing Holder that does not fund its Pro Rata Amount by the Initial Closing shall have its Equity Securities automatically converted at a ratio of 10 to 1 to a new series of Common Stock that retains no voting rights; provided however, that to the extent an Existing Holder partially meets its Pro Rata Amount, such holder shall retain a corresponding portion of its Equity Securities, and may choose the respective portion to retain.”

29. Antidilution Adjustments “Dilutive issuance” shall not include: (i) up to ______ shares of Common Stock issued pursuant to a stock option plan approved [unanimously/by a majority] of the Board of Directors; (ii) Common Stock issued upon conversion of the Preferred Stock; (iii) stock issued in any IPO in which the Preferred Stock is converted into Common Stock; or (iv) stock issued in connection with mergers or acquisitions approved [unanimously/by a majority] of the Board of Directors.”

30. Protective Provisions Considerations • Control Provisions • Board Seats • Voting Agreements • Other Protections

31. Protective Provisions Pre-Bubble • Investor approval of: senior securities, sale of company, payment of dividends, liquidation, change of rights • Investor approval of senior or pari passu securities, sale of company, payment of dividends, change of rights, change of business, incurrence of debt over specified limit, annual budgets and variances, acquisitions of other businesses, grant of exclusive rights in technology, appointment or termination of CEO Post-Bubble

32. Protective Provisions “Votes on an as-converted basis, but also has [class/series] vote as provided by law and on (i) the creation of any senior [or pari passu] security, [(ii) payment of dividends on [Common Stock/on any class of Stock]],[(iii) any redemptions or repurchases of Common Stock or Preferred Stock [except for purchases at cost upon termination of employment], (iv) any liquidation, dissolution or winding up of the Company; (v) any merger, acquisition, recapitalization, reorganization or sale of all or substantially all of the assets of the Company, (vi) an

33. increase or decrease in the number of authorized shares of Series [ _ ] Preferred Stock or Common Stock, (vii) any [adverse] change to the rights, preferences and privileges of the Series [ _ ] Preferred, [(viii) an increase or decrease in the size of the Board], [(ix) [material] amendments or repeal of any provision of the Company’s Charter or Bylaws]; [(x) the issuance of any additional shares of capital stock (or options) to the Company’s founders,] and [(xi)] authorization of any amount of indebtedness in excess of $____.]” Protective Provisions

34. Defining the Terms of the Stock Purchase Agreement

35. Representation and Warranties Considerations • Scope/Coverage • By the Company • By the Founders (e.g., technology)

36. Closings Considerations • When will the Investors go “at-risk”? • Lump Sum at Closing • Staging of Investment • Passage of Time • Milestones

37. Closings Pre-Bubble • Single Tranche Investment • Single Tranche Investment • More Extreme: Milestone-Based Tranches Post-Bubble

38. Conditions to Closing Considerations • Satisfactory Completion of Due Diligence • Exemption or Qualification of Shares under Applicable Securities Laws • Filing of Amendment to Charter to Establish Rights and Preferences of the Preferred Stock • Opinion of Counsel to the Company

39. Employee Matters Considerations • Employment Agreements with Founders • Obligation for All Employees/Consultants to Enter into Company’s Standard Inventions and Proprietary Information Agreement

40. Expenses Considerations • Company Typically Pays Reasonable Fees and Expenses of Investors’ Counsel • Consider Cap on Obligation

41. Defining the Terms of the Investors’ Rights Agreement

42. Registration Rights Considerations • Types of Registration Rights • Demand Rights • Piggyback Rights • S3 Rights • Termination of Rights • Limitation on Subsequent Rights • Absolute prohibition • Permitted if Subordinate • Allocation of Expenses

43. Registration Rights “Beginning on the earlier of [3-5] years from Closing, or [three/six] months after the Company’s IPO, [1-2] demand registrations [for underwritten public offerings] upon initiation by holders of at least [30]% of outstanding Series ___ Preferred Stock (or Common Stock issuable upon conversion of the Series ___ Preferred Stock or any combination thereof) for aggregate proceeds in excess of $_______.”

44. Registration Rights “Investors in Series __ Preferred Stock will have [unlimited] piggyback registration rights subject to pro rata cutback at the underwriter’s discretion. Full cutback upon the IPO; [30% minimum inclusion thereafter]. Investors will not be subject to cutback unless all other selling shareholders are excluded from registration.”

45. Registration Rights “[Unlimited] S-3 Registrations of at least $500,000 each [upon initiation by holders of at least [20%] of the outstanding Series ___ Preferred Stock (or Common Stock issuable upon conversion of the Series ___ Preferred Stock or any combination thereof)]. [No more than two S-3 Registrations in any 12 month period.]”

46. Registration Rights “Registration rights terminate [(i) [3-7] years after the IPO;] or (ii) when [the Company is publicly traded and] all shares can be sold [in any 90-day period] under Rule 144, whichever occurs first.][, provided that this clause (ii) shall not apply to any 5% holder deemed to be an affiliate of the Company.]”

47. Market Stand-Off Considerations • Time of Lock-Up • Who Controls Decision • Investors • Underwriter • Equal Application • Obligation to Execute Underwriter’s Form of Lock-Up Agreement

48. Market Stand-Off “Prior to the Closing, all shareholders shall agree that in connection with the IPO not to sell any shares of Preferred Stock or Common Stock issuable upon conversion thereof for a period of up to [180] days following the IPO [(provided directors and officers of the Company and [5]% shareholders agree to the same lock-up. Such shareholders also shall agree to sign the underwriter’s standard lock-up agreement reflecting the foregoing.”

49. Right of First Offer Considerations • Who Owns the Right? • All holders of preferred stock • Holders of at least [____] percentage of preferred stock • Determination of Percentage

50. Right of First Offer Pre-Bubble • Right to maintain pro-rata ownership in later financings Post-Bubble • Right to maintain pro-rata ownership in later financings • More Extreme: right to invest 2X pro-rata ownership in later financings