VENTURE CAPITAL AND THE REPRESENTATION OF START UPS

Paul V. Rogers

Covington & Burling

February 27, 2006

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I. Overview

1. Choice of Entity

2. Capital Structures and Venture Financings

3. Employee Incentives

4. Intellectual Property Issues

5. Management Issues

6. Exits or Liquidity Events

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II. How I Got Here

1. History Major in College

2. 3 years at Manufacturers Hanover

3. Hale and Dorr – Boston (14 years)

4. Covington & Burling – DC (6.5 years)

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III. Practice Differences

1. NY – Wall Streeta. Financial Institutionsb. Fortune 500

2. Outside of NYCa. Businessesb. Smaller Financial Institutions

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Practice Differences (cont’d.)

3. Venture “Clusters”a. Silicon Valley

b. Boston

c. Virginia

d. Seattle

e. North Carolina

f. New York

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IV. Characteristics of Clients

1. Entrepreneurial

2. Very Driven – 100 mph

3. Crusaders or Prophets

4. Financial Incentives

5. Cool Technology

6. Short Time Horizons

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V. Characteristics of Venture Capitalists

1. Very Competitive

2. Pressured on Returns to Limited Partners

3. Risk v. Rewarda. Willing to lose entire investment for multiple returnb. 1-2x Return Not Interestingc. 4-10x Return

4. Focus Issuesa. Positiveb. Negative

5. Also Have Short Time Horizons

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VI. Cheat Sheet for a Lawyer for Start Up

1. Ongoinga. Capital Stock

i. Classesii. Ownershipiii. Restrictions

b. Intellectual Propertyi. Protection of Ownershipii. Proper Licensing

In or Out

2. Venture Financinga. Economic Returnb. Control Issuesc. Liquidity

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VII. Choice of Entity

1. Corporationa. Subchapter S

2. Limited Liability Company

3. Partnership

4. Considerations in Choosing Entitya. Types of Stockholdersb. Number of Stockholdersc. Financing Sourcesd. Liquiditye. Taxesf. Liability

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VIII. Capital Structures and Venture Financings

1. Indebtednessa. Loans

i. Principal Amountii. Interest Rateiii. Payment Termsiv. Sources

Angels Friends/Relatives Founders (really equity)

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Capital Structures and Venture Financings (cont’d.)

b. Convertible Debti. Interest bearingii. Payable on date certainiii. Convertible into equity

Option of holder or issuer Designated or undesignated security Pricing

iv. Subordinated to other Indebtednessv. Sources

Similar Valuation Issues

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Capital Structures and Venture Financings (cont’d.)

2. Stockholders’ Equitya. Preferred Stock

i. Convertibleii. Non-convertible

b. Common Stocki. Votingii. Non-voting

c. Additional paid in capitali. Amount paid for shares less par value

d. Retained earnings/accumulated deficit

e. Treasury Stock

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Capital Structures and Venture Financings (cont’d.)

3. Common Stock – General

a. Voting (Can be Non-Voting)

b. Dividends (Junior Status)

c. Liquidation (Junior Status)

i. Percentage Ownership No preferences Rare to Have Classes

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Capital Structures and Venture Financings (cont’d.)

4. Preferred Stock – Generala. Redeemable

i. Date certainii. Occurrence of event (e.g., IPO)

b. Classic or Straight (usually no short term redemption)

c. Convertibled. Participating

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DEBT

EQUITY

Debt Security Equity Security

LOANS/NOTES

CONVERTIBLE NOTES

REDEEMABLE PREF. STOCK

CLASSIC/STRAIGHT PREF. STOCK

CONVERTIBLE PREF. STOCK

CONVERTIBLE & PARTICIPATINGPREF. STOCK

COMMON STOCK

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IX. Preferred Stock (Debt Equivalents)

Redeemable and Straight, or Classic

1. Return of capital

2. Interest rate or dividend

3. Premium upon repayment

4. Voting

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X. Preferred Stock (Equity Equivalents)

Convertible and Participating Stock1. Convertible

a. Choice of economic rights – preferred or common

b. Pay $1,000,000 for 20% = convert if company worth more than $5,000,000

2. Participating1. “Cake and eat it, too”

2. Receive $1,000,000 plus 20% of remainder

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Convertible and Participating Stock (Cont’d.)

3. Dividends4. Voting Rights5. Conversion Features6. Redemption

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EXAMPLES

1. Redeemable/Straight or Classic Preferreda. Investment - $1,000,000b. Percentage Ownership – Often 0% as not

participating (can receive participation through warrants for common stock)

c. Liquidation at $50,000,000d. Return - $1,000,000 invested (often plus an

interest rate) – assumes 1x liquidation preference

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Examples (cont’d.)

2. Convertible Preferred Stocka. Investment - $1,000,000

b. Percentage Ownership – 20%

c. Liquidation at $50,000,000

d. Return – a choice: $1,000,000 invested (often plus a dividend rate) or $10,000,000 (assumes 1x liquidation preference)

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Examples (cont’d.)

3. Participating Preferred Stocka. Investment - $1,000,000

b. Percentage Ownership – 20%

c. Liquidation at $50,000,000

d. Return - $10,800,000

e. $1,000,000 invested (often plus a dividend rate) plus 20% of $49,000,000 – “cake and eat it too” security (assumes 1x liquidation preference)

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XI. Other Venture Investment Issues

1. Control1. Board of Directors2. Special Approvals3. Stock Transfer Restriction4. Rights of First Refusal on Future Financings

2. Registration Rights3. Drag Alongs4. Financial Reporting

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XII. Employee Incentives

1. Casha. Salaryb. Bonus

2. Stock Optionsa. Incentiveb. Non-Qualified Stock Optionsc. Vestingd. Pricinge. Exercisef. Tax/Securities Law

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Employee Incentives (cont’d.)

3. Restricted Stocka. Pricingb. Paymentc. Vestingd. Tax/Securities Laws

4. Other Equity Incentives

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Employee Incentives (cont’d.)

5. Founders’ Stocka. Cheap (Penny Shares)

6. Restrictionsa. Rights of First Refusal

b. Rights of Co-Sale

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XIII. Intellectual Property

1. Assignment of Existing Intellectual Property2. Licensing/Acquisition of Third Party Rights3. Invention Assignment Agreements4. Prior Employer’s Rights5. Former Employees6. Demand Letters

a. Generalb. Exit Event

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XIV. Management Issues

1. Board of Directorsa. Powers

b. Membership

c. Nominations

2. Officersa. State Law

b. Powers

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Management Issues (cont’d.)

3. Contractual Rightsa. Limits on

i. Changes to Capital

ii. Changes to Certificate of Incorporation and By-Laws

iii. Mergers & Acquisitions

iv. Incurrence of Indebtedness

v. Revisions to Business Plan

vi. Management Changes

vii. Capital Expenditures

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Management Issues (cont’d.)

4. “Who is the Client” Issues

5. Corporate “Divorces”a. Founder v. Founder

i. Control Issues

ii. Buyouts

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Management Issues (cont’d.)

b. Board v. Managementi. Cause v. Without Cause

ii. Stock Vesting

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XV. Liquidity Events

1. Salea. Merger

i. Receive Stock or Cash from Acquiror

b. Stock Purchasei. Generally Cash

c. Asset Salei. Usually Cashii. Tax Issuesiii. Liability Issues

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Liquidity Events (cont’d.)

d. Considerationsi. Number of Stockholders

ii. Securities Laws

iii. State Corporation Laws

iv. I.P. Rights

v. Licenses

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Liquidity Events (cont’d.)

2. Initial Public Offeringsa. Sale to Publicb. Usually only Issuer Sharesc. Valuation Event for Stockholdersd. Future Source of Liquidity

i. Lock Upsii. Rule 144iii. Registration Rights

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Liquidity Events (cont’d.)

3. Liquidationa. Sell Assetsb. Wind Downc. Pay Employees/Landlord

4. Bankruptcya. Comparatively Rare