Lessons Learned From Down Round Financings

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• Lessons LearnedFrom Down Round Financings

Executive Breakfast Briefing November 15, 2001
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Presenters

• John Yates, Moderator Chair, Technology
  Practice Group
• Phone [phone]
• Email jyates_at_mmmlaw.com
• Charles Chuck Johnson, General Partner,
  Noro-Moseley Partners
• Phone [phone]
• Email cjohnson_at_noro-moseley.com
• Phillip Hodges, Partner, Ernst Young
• Phone [phone]
• Email phillip.hodges_at_ey.com
• Rosemarie Thurston - Partner, Emerging Companies
  Practice Group
• Phone [phone]
• Email rthurston_at_mmmlaw.com

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The Setting

• Killer-App Software, Inc.
• Atlanta-based technology company
• Formed in November 1998 by three founders
• Raised Series A round in July 1999 at high
  valuation
• Approximately 10 million to reach cash-flow
  positive
• Strong sales pipeline of prospects, but hasnt
  reached customer revenue objectives to date

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The Problem

• Company begins to falter
• Additional financing is required
• Cash burn is high, and cash will run out in 3-6
  months
• Valuation has eroded
• If no new VC is willing to lead the round,
  insider-priced round
• If new VC leads the round, new terms may be
  crammed down on existing investors forcing them
  to give up negotiated rights

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The Down Round

• Company pursues additional equity capital
• Proposed valuation is substantially below last
  round
• Proposed valuation triggers anti-dilution rights
  of existing investors
• Existing investors (who have representatives on
  Board) have preemptive rights to participate in
  equity financings
• Management stock options will be under water
  after this down round (may be virtually worthless)

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The Term Sheet
Lower valuation together with tough nonprice
terms

• Staggered investment (milestone-based)
• Senior liquidation preference (up to 4x)
• Participating preferred
• Cumulative dividends
• Full ratchet antidilution price protection

• Increased board control
• Broad protective voting rights
• Senior registration rights
• Senior co-sale rights
• Drag-along rights

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A Practical Example

• Company Series A Capitalization
• 1,000,000 shares of Common Stock outstanding
• 1,000,000 shares of Series A Preferred Stock,
  purchased _at_ 1.00/share in July 2000, convertible
  into 1,000,000 shares of Common Stock
• Optionees hold options to purchase 300,000 shares
  (13 of the Company)
• Common stockholders and Series A Preferred
  Stockholders each own 43.5 of the Company

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(A Practical Example)

• Down Round (assuming full-ratchet anti-dilution
  protection for holders of Series A Preferred
  Stock)
• Company issues 20,000,000 shares of Series B
  Preferred Stock to investors _at_ 0.25/share
  (5,000,000 raise) in November 2001, each
  convertible into one share of Common Stock

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(A Practical Example)

• Effect of Down Round on Companys Capitalization
• 1,000,000 shares of Common Stock outstanding
  after funding
• 300,000 options outstanding
• 1,000,000 shares of Series A Preferred Stock,
  convertible into 4,000,000 shares of Common Stock
  after funding
• 20,000,000 shares of Series B Preferred Stock
  outstanding, convertible into 20,000,000 shares
  of Common Stock

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(A Practical Example)

• BEFORE AFTER
• Common - 43.5 Common - 4
• Series A - 43.5 Series A - 16
• Optionees - 13 Series B - 79
• Optionees - 1
• Antidilution adjustments to Series A can have
  impact of washing out common stock and options
• Waiver of anti-dilution would reduce dilution
  to common stockholders and optionholders

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The Cram-Down Financing Condition

• Classic Cram-Down -- financing scheme where
  venture capitalists refuse to invest unless
  earlier investors give up negotiated rights (i.e.
  waive anti-dilution and/or reduce liquidation
  preference and possibly subordinate liquidation
  preference to a new class of senior preferred
  securities having higher liquidation preference,
  i.e., up to 4 times the original price per share)

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Pay to Play

• New investors may require prior preferred
  investors to particpate in down round in order to
  keep antidilution rights (or even require prior
  investors to convert preferred to common stock if
  they dont invest)
• Unless earlier investors are able to put up new
  money for new round, the likelihood of their
  realization of a return on their investment in
  the Company is significantly diminished (i.e.,
  need to pay-to-play in order to preserve
  possible return), but may be good money chasing
  bad money

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Stakeholders who may object

• Holders of Common Stock
• Founders, original investors, employees and other
  minority shareholders
• Optionees with underwater and diluted options
• Strategic warrant holders
• Other preferred shareholders who are impacted
  (forced to give up rights or cannot invest in
  Down Round)

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The Legal Issues for Directors

• Satisfaction of Fiduciary Duties
• Care
• Loyalty
• Business judgment rule generally protects
  decisions of Directors from stockholder challenge
• Effect of conflict of interest (if majority of
  directors are conflicted, business judgment rule
  does not apply)

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Conflicting Interests

• Director who is an existing investor (either
  individually or as a representative of a venture
  fund investor) and/or an investor in the Down
  Round
• Management directors when term sheet provides for
  new management incentives for certain key
  employees as condition to investment.

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(Conflicting Interests)

• Director/Investor with an interest in acquiring
  the struggling Company (possibly at lower
  valuation out of bankruptcy)
• Venture fund director also owes duties to his/her
  employer, and, in the case of most Venture
  Capital firms, its Limited Partners
• As Company nears insolvency or shutdown,
  Directors duties shift from the shareholders to
  the Companys creditors

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Steps to Fulfill These Duties

• Assume youll have to prove the entire fairness
  of the transaction anyway
• Build a record of the Boards full and thorough
  consideration of all available alternatives
  including other liquidation events
• Show that Down Round is fair and was the best
  available option
• Must assume a court will use fairness standard
• Price is the predominant factor
• Hire investment banking firm to
• Explore strategic alternatives
• Conduct market checks
• Advise on valuation and terms
• Render fairness opinion

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(Steps to Fulfill These Duties...)

• Disclose all conflicts of interest (as defined by
  applicable state law) and have decisions passed
  by disinterested Directors
• Consider appointing a special committee of
  independent and disinterested Directors (if there
  are at least two) to negotiate on behalf of the
  Company and make recommendations to the full
  Board
• Where possible, have a new investor lead
  negotiations (helps court view negotiations as
  arms-length)

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(Steps to Fulfill These Duties...)

• If stockholder approval is necessary for the Down
  Round for any reason (i.e., amending charter),
  try to seek stockholder approval of the Down
  Round itself (but make sure you can get it!)
• If stockholders approve the Down Round, better
  insulation from lawsuit for breach of fiduciary
  duties
• Offer Down Round to all (accredited) shareholders
  if possible
• Make sure DO policy is maintained!

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Re-Incenting Managementand Key Employees

• Managements stock and options now have little
  value (common stock is unlikely to receive any
  value in a liquidating event due to magnitude of
  the preferred liquidation preferences and options
  are dramatically underwater)
• Alternative incentive plans include
• Stock option plan allowing for preferred stock
  options with a liquidation preference senior to
  common
• Change of control bonus plans (can be calculated
  based on valuation at sale in a lump sum or fixed
  percentage, generally total pool of 5-10 of
  targeted valuation) with sliding scale to incent
  employees to build the valuation prior to sale
• Issue new round of options at lower exercise
  price (top up grants) or consider repricing

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Accounting Issues Concerning Stock Option
Repricing

• To be provided by Phillip Hodges

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Now What?Revisiting Exit Strategies after the
Down Round

• Down round proceeds may be enough to get company
  cash flow break-even
• Company may raise just enough money to buy it
  time to position for a sale
• If company reaches important revenue milestones,
  an up round may be feasible in the future