Mass MEDIC Building Successful Med Tech Companies Financing

Mass. MEDIC Building Successful Med. Tech Companies: Financing Strategies for Entrepreneurs Creating Deal Velocity: Deal Terms that Really Matter John Hession, Partner Mc. Dermott Will & Emery LLP jhession@mwe. com © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

So. . who is Mc. Dermott? m m International Law Firm: 10 th in US, specializing in Corporate Transactions, Intellectual Property, Financings, Acquisitions, Health Care, Life Sciences, Government Affairs & Regulatory Matters, Labor, Litigation, Trusts & Estates 14 Offices spanning the Globe: Boston, NYC, DC, Chicago, Miami, Los Angeles, Orange County, Palo Alto, San Diego, London, Munich, Düsseldorf, Rome, Brussels © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Yeah, so …who is Johnny Hession? m m Former High School Teacher, Former Sales Rep for Burroughs, Office Burroughs Products Division (Legion of Honor in Sales – top 10% in first two years) Now: Advisor & Attorney for emerging-growth, technology companies from cradle, through financings, through strategic alliances, through culmination © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Representative Experiences m 125 Acquisitions: representing Buyers & Sellers: Silknet Software Acquisitions m 175 VC & Angel Financings: representing either companies or VC m 100+ Strategic Alliances: representing ALWAYS the small tech m 25+ Public Offerings: Silknet, Excel Switching, CVC Products, ($4. 2 B merger with Kana); Excel Switching ($1. 2 B sale to Lucent); i -Prospect. com ($50 M, bought by Aegis plc); Eigner ($22 M, bought by Agile); Netlink ($185 M, by Cabletron); Mainspring (bought by IBM); Feanix ($50 M earn out to Axon plc); Apama UK (bought by Progress) investors: Turbine ($15 m, Highland & Polaris); Polaris ($16 M investment in Meridio, Northern Ireland); TD Capital ($5 m investment in Contour Semiconductor); Powerspan ($30 m, Rockport, Beacon Energy, First Energy Corp. ); Highland ($20 M in AMP Resources) company against IBM, Microsoft, AOL, Tandem, Compaq, HP, Apple, Samsung, EMC, Allied Signal, Pratt & Whitney, GE, Lucent, Alcatel Mainspring, Integrated Genetics, Focus Enhancements, Netegrity, Tecogen, Astea International, Alloy Systems, Dyna. Gen, Mortgage. com © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

The Venture Industry, 2007 m m More dollars raised in 2003 -2005, despite economic downturn in technology Fewer firms, but with more $$$ per firm Larger deal sizes, and higher minimum investment per company Liquidity Horizon back to 5 -8 years Ø 5 m years for IT 7/8 years for biotech EXTREMELY tough market for start-ups © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

The Venture Industry, 2007 m m m Return expectations are aggressive: 50+% IRR for early-stage, 35 -45% IRR for first institutional round, 18 -25% IRR for mezzanine round The Market is crowded with early-stage -companies seeking financing – but professional and institutional money has moved up market to later stage deals Angels eclipse the Venture Capital investment in seed and early-stage sectors by 10 x order of magnitude © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

The Future = The Past Venture Capital Median Amount Raised By Round Type Source:

Current Market Conditions m m Technology financing markets rebounded in last two years Financings have heated up in last year Competition for first institutional financing rounds becoming fevered Anecdotal evidence that valuation & term skirmishes waged for perceived “good deals”: complete team & product with customers, early revenues © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Current Market Conditions m m m Improvement in underlying technology markets: IT spending is returning, projected to increase in 2007 Pre-$$ Valuations back to 1997 Pre. Bubble levels – approximately: Ø $2. 5 -$3. 0 m Seed; $5. 5 m First; $13. 0 m Second Round Deals are moving faster to completion Ø 2 to 4 months now typical, cycles compressing © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

The Valuation Game m Deal Valuation is a function of: Ø Amount raising now and ultimate cost of capital, rounds of financing Ø Valuations on alternative deals, comparable investments (find it on Venture One) Ø Number of other interested VC funds calling – “The Lemming Phenomenon” and “Nothing Beats a Good Deal like Competition” Ø Transaction structure and deal terms improving valuation: participating preferred, Board composition, control mechanisms © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

The Valuation Game m Deal Terms Can Improve Valuation: Ø Board Composition and # of seats for VCs Ø Cumulative Dividends: compounding, accruing dividend Ø Liquidation Preference: 2 x-3 x return of capital, plus Participating Preferred Ø Anti-Dilution Adjustments: “ratchet” antidilution versus weighted-average Ø Option Pool for future hires: maybe 15 -18% of fully-diluted capitalization Ø Organic Change-Covenant Control: veto rights on sales or other acquisitions, new financings, incurrence of debt, stock or options above a permitted threshold © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Current Market Conditions m m m Median pre-money valuations improved over last few years Bay Area median pre-money valuations slightly higher than East Coast Note: Data corrupted by size & cost of capital required for each industry, average round size, number of rounds required © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Current Market Conditions m m m More recent anecdotal evidence indicates median valuations increasing as competition for “good deals” heating feverishly Life science valuations may have stabilized, perhaps due to poor IPO after-market performance recently of some entrants VC funds aggressively putting money to work ($60 Billion overhang in VC capital!) 2008 Forecast: more funds coming to market, more capital to invest, maybe more overhang? Still Extremely Tough for early stage © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Current Market Conditions m m Median % ownership by investors increased in 2006 -07: received more company for less $$$ invested Median Investor Equity Ownership %: Ø First Round = 50% Ø Second Round = 39% Ø Later Round = 28% © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Deal Terms & Structuring m. Common Stock ØSame Risk as Founders ØLittle Structural Flexibility m. Preferred Stock ØStructural Flexibility ØDifferent Valuation for Management’s Shares ØManipulate IRR ØUpside Guarantees, Downside Protection m. Convertible Note & Warrants ØProtection of Principal ØInterest as Current Return, Deduction for Interest ØWarrants as Sweetener © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Preferred Stock Deal Terms m. Liquidation Preferences m. Participating m. Cumulative m. Cash-Out Dividends Election on Sale m. Anti-Dilution m. Class Protection Voting/Veto Rights m. Board © 2004 Mc. Dermott, Will & Emery. All Rights Reserved. Preferred Composition

More Deal Terms m “Play or Pay” - “Play or Lose” Provisions m Mandatory Redemption m Registration Rights ØPiggy-Back ØDemand ØShort-Form m S-3 Rights Preemptive Rights, Rights of First Offer, Rights of First Refusal © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Preferred Stock Deal Terms m. Basket (the “Pool”) for Management Shares Pool m. Noncompetition, Nonsolicitation Agreements m. Employment/Severance Agreements for Founders and Management m. Vesting, Buy-Back of Founders’ Stock m. Co-Sale & Rights of First Refusal on Management, Founders’ Shares © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Liquidation Preference m. Recoup Principal m. Investor Receives Priority over Management m. Option to Recoup Principal Amount or Choose to Convert Preferred m. Economic Effect in Event of Acquisition or Sale of Company m. Issue: Do Founders Get Liquidation Preferences Too? © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Liquidation Preference m m All later-stage rounds now have senior liquidation preferences Multiple liquidation preferences are abating, except for recapitalizations, or perceived “high valuation” for early-stage financing Ø most = 2 x preference; but some as high as 3 x-5 x! Ø argue for vanishing preference as a multiple of capital rather than IRR hurdle: multiple of capital is flat over time; IRR hurdle increases over time with compounding effect © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Cumulative Dividends m. Built-In Return; Rates Vary from 8%--12% m. Dividend Accumulates Until Paid on an Acquisition, Redemption, Liquidation or Cash-Out Election Event, Public Offering? m. PIK Dividends: Payment-in-Kind, Tax Issues abound for Foreign LPs m. Issue: Dividend Should be Forfeited on Voluntary Conversion or Public Offering Event - Investor Loses the Built-In Return if Company Achieves IRR Better Than the Dividend © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Participating Preferred m. Investor Gets $$$ Back & Then Participates in All Residual Amounts on an “As-Converted” Basis!!! Socalled “PIG Preferred”! THIS IS THE BIG KAHUNA! m. Potentially Disastrous Impact on Founders’ equity if Sale or Acquisition Does Not Yield a Decent Return m. Investor Recovers the Investment (including dividends) & Then Plays Again in Upside Gain m. Issue: Resist It! Get an “IRR Hurdle”/ Multiple of Capital Threshold Such that Investor Forfeits This Right © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Participating Preference m m m Participating preferences are the “receding norm” Ø many are uncapped (always receive return of capital), some are capped at 2 x-3 x or receive asconverted participation Ø evidence of liquidation preference also paid on IPO Ø participation features among series can create conflicts and lead to anomalous results Resetting or washing out old preferences is the biggest challenge Participating Preferred is disappearing for “hot” deals © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Anti-Dilution Protection If Subsequent Rounds of Financing are Dilutive as to Price, Investor Gets to Reprice the Old Money at Today’s Dilutive Valuation m. Ratchet Formula: If Company Issues 1 Share at Lower Price, Conversion Rate of Preferred is Reduced to Lower Price !!!! m. Weighted-Average Formula: Factors in Overall Impact of Total Shares Issued in New Dilutive Round and Adjusts Old Conversion Rate Based on Impact on Total Capitalization © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Anti-Dilution Provisions m “Weighted-Average” is still market standard Ø m m m Full Ratchets appear in later rounds, below minimal levels or within specified time frames Full ratchet may appear in early rounds as quid pro quo for higher pre-money valuation Full Ratchets in early rounds may haunt investors when later round investors demand the same deal terms Cold Weather Syndrome: East Coast VCs used anti-dilution and ratchet more frequently than Bay Area VCs! © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

“Play or Lose” Provisions m. Investor Does NOT Receive Benefit of Price Anti-Dilution Protection if Investor Does Not Play for Full Pro-Rata Share in any New Dilutive Financing m. Incentive for Investors to Play in Dilutive Financings and Support the Company m. Ensures that Investment Syndicates will Remain United in Support © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Play-or-Lose Provisions m Most deals still do not have “Pay-to-Play” or “Play-or-Lose” provisions Ø m m doubled-edged sword nature is an issue When used, typical provision calls for conversion to common, not just loss of anti-dilution protection Trigger is no longer pro rata participation; now set at share of insider investor allocation to apply to inside rounds © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Class Voting Rights m. Investor has Ability to BlockVeto Important Corporate Transactions ØMergers, Sales of Stock or Assets ØIssuances ØGrant of Additional Preferred of Excessive Options to Employees ØIncurrence ØSales of Debt or Transfers of Technology m. Issue: Separate Class Voting Rights Should Disappear if Preferred Holds Less than Certain % of Equity © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

“Drag Along” Rights m“Merger Extortion Device”: Investor has Ability to compel a Liquidity event: i. e. , sale or merger ØStated percentage of Investors (maybe 67% of a round or all preferred) determine that Company should be sold ØBoard sold determines that Company should be m. Result: Minority stockholders are “dragged along” in the sale process, a “Forced March to the Merger Alter” -- with waiver of appraisal © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Mandatory Redemption m. Investor Wants Money Back After Time (5 -7 years) m. Depends on Stage of Company and Venture Fund Investing, Business Plan and Profitability Model, Expectations of Liquidity Events m. Redemption for Dollars Invested, Dollars Plus Cumulative Dividends, Stated Return, or Fair Market or Appraised Value m. Delinquent Redemptions ? ? ? Increase in Conversion Rate for “Blown Redemption” – potentially ruinous to management © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Mandatory Redemption m m Mandatory redemption seems to be an peculiar East Coast phenomenon Begins in years 5 -6, in annual installments (2 -3 increments) Redemption typically greater of liquidation preference plus dividends or Fair Market Value (without liquidity discount – i. e. , deemed sale of company) Redemption = Forced sale of company rather than payout of redemption price © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Failed Redemption m Penalties Ø “Board for failed redemption: Takeover” right Ø Conversion of unredeemed portion to promissory note Ø Increase in conversion rate on preferred m Complexity of timing of redemption with multiple series of preferred © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Basket For Management Pool m. Get Agreement From Investors: Certain % of Capitalization Set Aside as Option Pool for Future Employees or to Reward Existing Talent m. Share Equally Dilution Presented by “Basket” or Option Pool -- On Pro Rata Basis -- by Investors & Founders m. Pool or Basket Typically Represents 15%-18%18%-20% of Total Fully-Diluted Capitalization, Post-Financing – but comes out of pre-money ! © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Non-Competition Agreements m. Investors are Backing People & Ideas -- Want Assurances Key Employees Will Not Leave to Form Competitive Venture m. Time Periods for Post-Employment Non. Competition: 1 Year – 18 months (beyond that = unenforceability risk) m. Consideration Needs to Support a Covenant Not To Compete m. Issues: Should Non. Compete expire if Person is Terminated Without Cause, or Downsizing? © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Vesting & Buy-Out Of Founder m. Investors Require Founders or Managers with Cheap Equity To Give Back Some Shares and Be On a Vesting Schedule -- If Person Leaves Before Stock is Fully Vested, Portion of Equity Can be Repurchased at Original Cost m. Issues: How Much Vested at Time of Investment? What Happens to Shares if Terminated w/o Cause or Voluntarily, Death/Disability? Vesting Period: Annual/Quarterly/Monthly? Buy-Out Price? © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Board Composition m. Investor Representation Often Tracks $$ m. Management m. Importance m 5 Needs Representation too of Outside Directors critical Directors Is Often the Magic Number m. Follow Board m. Ask the “Martini Rule” for VCs on me about the “Martini Rule” © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Venture. One: Deal Terms Survey m Fourth Edition www. mwe. com © 2004 Mc. Dermott Will & Emery Mc. Dermott operates its practice through separate legal entities in each of the countries where it has offices.

Participating Preferred m m Companies raising first institutional round of financing were more likely to experience participating preferred Series A: 73% of survey had Participating Preferred in first round of financing Second Round: 54. 5% had Participating Preferred (last year Second Round = 79. 3%) Third Round: 65. 4% = Participating Preferred © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Cap on Participating Preferred m m m 41% of Survey respondents had a cap on the multiple of investment return; 59% did not 47. 4% reported a “participation cap” when the round was at an enhanced valuation Caps of 2 x were most common (55. 9% = 2 x Cap; 31% = 3 x Cap; 13%>4 x Cap)) © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Cumulative Dividends m m 48% of Survey respondents reported Cumulative Dividend structures 8% was the median dividend rate Companies closing second rounds were least likely to report a Cumulative Dividend structure East Coast deals reported higher percentage of Cumulative Dividend structures © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Cumulative Dividends m m m 49. 5% of First Round respondents reported Cumulative Dividend 42. 2% of Second Round respondents reported Cumulative Dividend 50. 0% of Third/Later Round respondents reported Cumulative Dividend © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Staged Financings m m 26% of First Round respondents reported Staged Financing fund raisings Key Triggers: Ø Product Development: 30. 4% Ø Set Passage of Time: 21. 4% Ø Specific Customers Landed: 12. 5% Ø Key Managers Hired: 12. 5% Ø Revenue Targets Achieved: 14. 3% © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Company Control m Median Amount of Company Sold: Ø First Round: 40% (previously 50%), with median amount raised at $5 M (from $5. 3 M) Ø Second Round: 33% Ø Third/Later Round: 26% © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Company Control: Founders m Median Founders Ownership After Round: Ø First Round: 31. 5%

Anti-Dilution Protection m m m 64. 3% of First Round respondents reported Weighted-Average Anti-Dilution (vs 13. 3% = Full Ratchet) 64. 6% of Second Round respondents reported Weighted-Average Anti-Dilution (vs 15. 4% = Full Ratchet) 66. 7% of Third/Later Round respondents reported Weighted-Average Anti-Dilution (vs 20. 5% = Full Ratchet) © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.

Size of Option Pool m Median Ownership Percentage allocated to Option Pool = 15% Ø First Round = 15% Ø Second Round = 15% !!! Ø Third/Later Round = 15% !!! Ø Mean = 14. 6% -- Median = 15% Ø Ranges reported from 11% to 18. 8% © 2004 Mc. Dermott, Will & Emery. All Rights Reserved.