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The correction in the U.S. stock markets that began in March of last year ushered in new valuation matrices in which many portfolio company valuations have been reset to 40 percent to 60 percent of what they were a year ago. Faced with an investment landscape marred by failed startups, many VCs are drastically reducing their level of investment activity until the markets turn around. But the advent of the “new” new economy also has created opportunities to realize significant returns for the investor who uses the current buyer’s market to its full advantage in negotiating strategic investments with portfolio companies. In the post-correction environment, investors and their counsel increasingly have been able to obtain from companies certain favorable terms that these companies would have flatly rejected a year ago. This article identifies some of the more significant pro-investor terms that some sophisticated investors and their counsel have been able to obtain in the post-correction environment. The selection of terms described in this article is intended to be illustrative, rather than exhaustive. While this article is written principally from the perspective of the VC, portfolio companies looking to raise financing from sophisticated VCs also may find it useful to better anticipate and respond to the VC’s negotiating strategies. The portfolio company that is on the other side of the negotiations over the terms discussed below will have completed its founders’ and angel financing rounds and perhaps several rounds with financial investors, but likely is being forced to accept a lower valuation in the current round. Such a company has yet to generate significant profits but is not a “pre-bankruptcy” company or a company actually in Chapters 7 or 11 of the bankruptcy code; investment in such companies require special considerations that are beyond the scope of this article. CONVERTIBLE DEBT FINANCING One effective approach to venture investing in the post-correction market used by some financial investors is to purchase a convertible note or other convertible debt instrument, rather than the more traditional convertible preferred stock. By purchasing debt instead of equity, the investor ensures that it will have priority over all classes of equity in the event of bankruptcy. The investor further bolsters its downside protection by securing the indebtedness with some or all of the startup’s assets — typically including its intangibles, and in particular its intellectual property. As a practical matter, however, the security interest usually will provide only limited comfort since it is the rare startup that owns assets of significant value at the time of the original investment. The conversion feature allows the investor to participate in the company’s growth by converting the note into equity at the investor’s choice after the company has become successful (conversion is generally mandatory upon a qualified IPO or sale of the company). One approach is to structure the conversion feature so that if the startup raises at least a fixed minimum dollar amount of financing in a subsequent round, the note converts into equity at a specified discount from the price applicable to other investors in the subsequent round. Sometimes the amount of the discount varies based upon whether the subsequent investor is financial or strategic, with the discount applicable to the strategic round being slightly higher to reflect the generally lower cost of capital from strategic sources. In better economic times, the portfolio company typically gets no argument from the investor when it insists that the deal be structured as a purchase of convertible preferred stock to strengthen the company’s debt-equity ratio as reflected on its balance sheet. Some startups have even convinced their investors (typically strategic investors rather than the more sophisticated financial investors) to accept common stock rather than preferred. But many companies in search of VC cash today have learned the hard way that the balance sheet argument has little persuasive power in a market that measures the half-life of high-tech startups in months rather than years. In short, for investors in the post-correction market, increasingly the rule of the day is “ask and you shall receive” in structuring the VC financing. LIQUIDATION PREFERENCE In the pre-correction market, the liquidation preference provision was fairly standardized and was not heavily negotiated. In particular, the amount of the preference typically was fixed at one time the original investment amount or, in rare cases, 1.5 times the original investment amount. Sophisticated East Coast funds now may be expected to demand a preference equal to five or six times their original investment if the liquidation event is the sale or initial public offering of the portfolio company. The VC’s logic is that it is entitled to the premium for taking the increased risk of an investment in a market in which one of the traditional exit routes, the IPO, is all but closed. One of a company’s more effective comebacks is to demand a cap on the preference — for example, at three times the original investment. The company’s position typically is that, particularly when combined with a participation feature (described below), a preference set at higher than three times the original investment can create a significant impediment to future financings. PARTICIPATION FEATURE A year ago, even financial investors could expect to get only non-participating preferred stock, except in the most extenuating circumstances. Holders of non-participating preferred stock are entitled to get their money back on a sale or liquidation of the Company, with the balance of the proceeds going to the common stockholders. Management and “seed” investors generally favor non-participating preferred stock, since it puts them and later stage investors on the same per-share basis upon a sale of the Company. Since the correction, many financial investors have been demanding, and in many cases receiving, participating preferred stock. Participating preferred stock permits investors to receive their money back first in a sale or liquidation, with the balance being divided among holders of common and preferred stock on a share-for-share basis. The traditional (and, until last March, rarely successful) argument for participating preferred stock is that if the Company is sold shortly after the investment, the founders may make a ton of money, but the investors may not have received much of a return on their investment. The participation feature is also increasingly being sold to the Company as a way for the company’s founders to obtain the higher valuation that is so important to their egos while allowing the investor to achieve a respectable return on investment through the dilutive effect of the participation feature. In some deals, the Company has limited the dilutive effect of the participation feature by negotiating a cap (usually two or three times the share price of the financing) on the participation preference. If the Company is sold or liquidated above the cap, all proceeds in excess of the cap are distributed to common and preferred stockholders on an “as if converted” basis, without any participation feature. ANTI-DILUTION PROTECTION Anti-dilution provisions provide protection to the investor against dilution from issuances of additional shares of common stock at a price per share that is the less than the conversion price. The “weighted average” anti-dilution formula adjusts the conversion price downwards, but not all the way down to the price per share applicable to the subsequent dilutive round, based on the number of new shares issued, the price per share, and the number of shares outstanding prior to such issue. Weighted average anti-dilution formulas can be “broad-based” or “narrow based;” the broad-based weighted average formula is less favorable to the investor because it takes into account unexercised options and outstanding convertible notes and warrants, thereby reducing the conversion rate adjustment in the event of a down round. The less common “full-ratchet” formula is the most aggressive of the pro- investor formulas. Under it, the conversion price is fully reduced to the price of the new issue, regardless of the relative size of the subsequent issue. In the pre-correction environment, the full-ratchet antidilution formula was rare. However, in the post-correction environment, investors are obtaining full-ratchet anti-dilution protection with increasing frequency. For reasons that are not entirely clear, the East Coast VCs seem to be asking for and receiving this protection more often than their West Coast brethren. Full-ratchet anti-dilution protection is increasingly being used as a device to keep the portfolio company honest. In effect, the full-ratchet investor is saying, “put your money where your mouth is — if subsequent rounds are valued at a lower price, we must be full protected against the dilutive effects; but if, as you have represented to us, our round has been fairly priced, this provision will not be called into play.” However, because subsequent investors in a down round would suffer immediate dilution, a full-ratchet anti-dilution provision may make it more difficult for a portfolio company to obtain financing. Therefore, a portfolio company can be expected to vigorously resist the demand for full-ratchet. If a company has agreed to a full-ratchet anti-dilution provision, it may be forced to plea for a waiver from the VCs to which it was granted in order to complete a subsequent financing. Experienced company counsel will often try to limit the VCs leverage to some extent by negotiating for a “pay to play” provision at the time of the VC’s investment. Such a provision has the effect of requiring the VCs to participate in the subsequent round on a pro-rata basis as a condition to the exercise of their antidilution protections in that subsequent round. Company counsel may also attempt to carve out from the scope of the antidilution protections certain limited issuances to employees pursuant to option plans or to strategic partners in connection with equity-based deals approved by the investors. DIVIDENDS In the vast majority of venture capital financing, not much attention is paid to the dividend terms because VCs do not expect the typical cash-starved emerging company to pay dividends. While this tends to be the case in “normal” economic times and investors tend not to complain much about it, in a down market the investor has the leverage to structure dividend terms to maximize its upside. This can be accomplished by requiring the company to pay dividends on a current basis or suffer dilution to its shareholders or erosion of its current management’s control through the VC’s exercise of any one or more of the following rights; � The right to elect additional directors if earned dividends are not paid; � The right to escalate stated dividends if dividends are earned but not paid; and/or � The right to receive cumulative dividends in additional shares of preferred or common stock. In contrast to the typical “giveaway” treatment accorded to the dividend terms in the standard venture capital deal, investors are finding it easier to use the dividend terms in the current buyer’s market to maximize pressure on the portfolio company to perform in accordance with projections or suffer additional dilution and loss of control. WARRANT COVERAGE Warrants have a flexible role in the venture financing; they often are used as an equity “sweetener” that sophisticated investors may attempt to extract for the privilege of putting their cash and good name at risk in the financing. For the troubled company (or, in this market, for virtually any company seeking venture money), warrants can be a way of sweetening the pot for investors who would not otherwise be inclined to risk the taint of a questionable investment. While it was unusual in the pre-correction market for investments in companies with reasonably rosy prospects to be structured to include more than 33 percent warrant coverage, the terms of some more aggressive venture capital investors’ deals can include warrant coverage as high as 50 percent. Obviously, the potential dilution to existing investors under such terms can be considerable, and in general even in this market only a portfolio company in extremis can be expected to cough up such generous warrant coverage. MANDATORY VESTING OF FOUNDERS’ SHARES Mandatory staged vesting of founders’ shares — one of the most bitter pills that investors can ask founders to swallow, and one that founders typically reject — has become more prevalent in post-correction deals. Mandatory vesting subjects founders’ shares that may already be owned free and clear by the founders to forfeiture if the founder leaves the Company before the shares vest. The typical vesting schedule proposed by investors is one-year “cliff” vesting for the first 25 percent to 30 percent of the founder’s shares, with the remainder vesting in equal installments over an 18-24 month period thereafter. In a market in which financial investors increasingly are focused on the quality and experience of management, it is critical to investors in the “new” new economy that management formalize its commitment to the company through an agreement on the vesting of its shares. For their part, founders can be expected to strenuously resist any effort to tie up their equity in the company for an extended period following the investment. An effective compromise is for the founders to be credited for vesting purposes for the time already spent with the company, thereby reducing the total time restriction on free transferability of their shares. However it is played out, the founders’ vesting issue is sure to be contentious. It needs to be handled up front and with sensitivity to the founders’ own liquidity needs to ensure healthy relations between management and investors going forward. DUE DILIGENCE It is almost axiomatic that there is no substitute for a careful and comprehensive legal due diligence examination of the portfolio company. As important as it is in bullish times, due diligence in venture deals becomes even more important in a bear market. Before last year’s correction, there was strong pressure from all sides of the transaction to greatly restrict, and in some cases involving what were rightly or wrongly perceived to be “hot” companies to dispense altogether with, legal due diligence. In one instance, the author in his role as investor’s counsel was flatly told by a director of a West Coast startup that management had no intention of cooperating with the investor’s targeted legal due diligence investigation since “no one does due diligence anymore.” While this director may have been expressing an extreme level of hostility towards the due diligence process even for a West Coast concern, in the current environment, it has become clear that the time frame for private equity financing has lengthened and more investors are taking the time to research the fundamentals of the portfolio company’s business. When market share was the predominant concern, VCs were willing to invest on a collapsed time frame and cut corners or even altogether dispense with legal due diligence based on the understanding that, within 18 months of their investment, they generally could expect to achieve a handsome return through a public offering. With the near-demise of the IPO market, such an exit option is no longer realistic in most cases and sophisticated VCs that are still actively investing are taking the time to conduct appropriate legal due diligence and negotiate deal terms with much more care than before. The better view is that targeted legal diligence, frequently focusing on the intellectual property and related assets of the portfolio company in the case of high-tech investments, is always an appropriate and advisable step to protect the client’s investment. This is all the more true in the case of investments in financially troubled companies (whether such trouble is due to failure to execute or to cash flow constraints because of the generally higher cost of capital in today’s private equity financing marketplace), where the investor insists on taking back a security interest in some or all of the company’s assets and needs to understand with the precision that only a targeted due diligence process can bring to bear the exact assets and liabilities of the target company. CONCLUSION The current economic downturn has brought with it new risks for the venture investor. Not surprisingly, fewer deals are being done and the average deal life is longer than was the case before the market correction of last year. However, for the venture investor who seizes the opportunity presented by the current buyer’s market to control the negotiating process, there are still significant investment values to be realized. In order to fully capitalize on current venture capital investment opportunities, it is important to engage a team of legal and financial advisers that has broad experience in representing VCs in bearish as well as in bullish business cycles and that is well-versed in strategies to obtain the pro-investor terms described in this article. James E. Rosenbluth is a partner in the Boston, Mass. office of Epstein Becker & Green, P.C. He may be reached at [email protected].

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