Download Deal Terms - MassMEDIC

MassMEDIC
Building Successful MedTech Companies:
Financing Strategies for Entrepreneurs
Creating Deal Velocity:
Deal Terms that Really Matter
John Hession, Partner
McDermott Will & Emery LLP
[email protected]
©2004 McDermott, Will & Emery. All Rights Reserved.
So . . who is McDermott?
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International Law Firm: 10th 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 McDermott, Will & Emery. All Rights Reserved.
Yeah, so …who is Johnny Hession?
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
Former High School Teacher, Former
Sales Rep for Burroughs, Office
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 McDermott, Will & Emery. All Rights Reserved.
Representative Experiences

125 Acquisitions: representing Buyers & Sellers: Silknet Software

175 VC & Angel Financings: representing either companies or VC

100+ Strategic Alliances: representing ALWAYS the small tech

25+ Public Offerings: Silknet, Excel Switching, CVC Products,
($4.2B merger with Kana); Excel Switching ($1.2B sale to Lucent);
i-Prospect.com ($50M, bought by Aegis plc); Eigner ($22M, bought by
Agile); Netlink ($185M, by Cabletron); Mainspring (bought by IBM);
Feanix ($50M earn out to Axon plc); Apama UK (bought by Progress)
investors: Turbine ($15m, Highland & Polaris); Polaris ($16M
investment in Meridio, Northern Ireland); TD Capital ($5m investment
in Contour Semiconductor); Powerspan ($30m, Rockport, Beacon
Energy, First Energy Corp.); Highland ($20M 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, DynaGen, Mortgage.com
©2004 McDermott, Will & Emery. All Rights Reserved.
The Venture Industry, 2007
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More dollars raised in 2003-2005, despite
economic downturn in technology
Fewer firms, but with more $$$ per firm
Larger deal sizes, and higher minimum
investment per company
Liquidity Horizon back to 5-8 years
5

years for IT
7/8 years for biotech
EXTREMELY tough market for start-ups
©2004 McDermott, Will & Emery. All Rights Reserved.
The Venture Industry, 2007

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Return expectations are aggressive: 50+%
IRR for early-stage, 35-45% IRR for first
institutional round, 18-25% IRR for
mezzanine round
The Market is crowded
with early-stage
-companies seeking financing – but
professional and institutional money has
moved up market to later stage deals
Angels eclipse the Venture Capital
investment in seed and early-stage
sectors by 10x order of magnitude
©2004 McDermott, Will & Emery. All Rights Reserved.
The Future = The Past
Median Amount Raised ($ M)
$25
Venture Capital Median Amount Raised By Round Type
$25
$20
$20
$15
$15
$10
$10
$5
$5.2 $5.7 $6.0
$7.7
$9.4 $8.6 $9.6 $10.0
$7.3 $7.8
$5
$6.0 $7.0 $6.6 $6.0 $6.5 $6.6 $6.0 $6.0 $7.0 $6.5
$0
$0
1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03
All Rounds
Source: E&Y / VentureOne
©2004 McDermott, Will & Emery. All Rights Reserved.
Seed Round
First Round
Second Round
Later Stage
Current Market Conditions
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Technology financing markets rebounded
in last two years
Financings have heated up in last year
Competition for first institutional
financing rounds becoming fevered
Anecdotal evidence that valuation &
term skirmishes waged for perceived
“good deals”: complete team & product
with customers, early revenues
©2004 McDermott, Will & Emery. All Rights Reserved.
Current Market Conditions
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Improvement in underlying technology
markets: IT spending is returning,
projected to increase in 2007
Pre-$$ Valuations back to 1997 PreBubble levels – approximately:
 $2.5-$3.0m Seed; $5.5m First;
$13.0m Second Round
Deals are moving faster to completion
 2 to 4 months now typical, cycles
compressing
©2004 McDermott, Will & Emery. All Rights Reserved.
The Valuation Game

Deal Valuation is a function of:
 Amount
raising now and ultimate cost of
capital, rounds of financing
 Valuations on alternative deals, comparable
investments (find it on Venture One)
 Number of other interested VC funds
calling – “The Lemming Phenomenon” and
“Nothing Beats a Good Deal like
Competition”
 Transaction structure and deal terms
improving valuation: participating
preferred, Board composition, control
mechanisms
©2004 McDermott, Will & Emery. All Rights Reserved.
The Valuation Game

Deal Terms Can Improve Valuation:
 Board
Composition and # of seats for VCs
 Cumulative Dividends: compounding,
accruing dividend
 Liquidation Preference: 2x-3x return of
capital, plus Participating Preferred
 Anti-Dilution Adjustments: “ratchet” antidilution versus weighted-average
 Option Pool for future hires: maybe 15-18%
of fully-diluted capitalization
 Organic Change-Covenant Control: veto
rights on sales or other acquisitions, new
financings, incurrence of debt, stock or
options above a permitted threshold
©2004 McDermott, Will & Emery. All Rights Reserved.
Current Market Conditions
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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 McDermott, Will & Emery. All Rights Reserved.
Current Market Conditions
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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 McDermott, Will & Emery. All Rights Reserved.
Current Market Conditions
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Median % ownership by investors
increased in 2006-07: received more
company for less $$$ invested
Median Investor Equity Ownership %:

First Round = 50%

Second Round = 39%

Later Round = 28%
©2004 McDermott, Will & Emery. All Rights Reserved.
Deal Terms & Structuring
Common
Stock
Same
Risk as Founders
Little Structural Flexibility
Preferred Stock
Structural Flexibility
Different Valuation for Management’s Shares
Manipulate IRR
Upside Guarantees, Downside Protection
Convertible Note & Warrants
Protection of Principal
Interest as Current Return, Deduction for Interest
Warrants as Sweetener
©2004 McDermott, Will & Emery. All Rights Reserved.
Preferred Stock Deal Terms
Liquidation
Preferences
Participating
Cumulative
Cash-Out
Dividends
Election on Sale
Anti-Dilution
Class
Protection
Voting/Veto Rights
Board
©2004 McDermott, Will & Emery. All Rights Reserved.
Preferred
Composition
More Deal Terms
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“Play or Pay” - “Play or Lose” Provisions
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Mandatory Redemption
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Registration Rights
Piggy-Back
Demand
Short-Form

S-3 Rights
Preemptive Rights, Rights of First Offer,
Rights of First Refusal
©2004 McDermott, Will & Emery. All Rights Reserved.
Preferred Stock Deal Terms
Basket
(the “Pool”) for Management Shares
Noncompetition,
Nonsolicitation Agreements
Employment/Severance
Agreements for
Founders and Management
Vesting,
Buy-Back of Founders’ Stock
Co-Sale
& Rights of First Refusal on
Management, Founders’ Shares
©2004 McDermott, Will & Emery. All Rights Reserved.
Liquidation Preference
Recoup
Principal
Investor
Receives Priority over Management
Option
to Recoup Principal Amount or Choose
to Convert Preferred
Economic
Effect in Event of Acquisition or Sale
of Company
Issue:
Do Founders Get Liquidation Preferences
Too?
©2004 McDermott, Will & Emery. All Rights Reserved.
Liquidation Preference
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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

most = 2x preference; but some as high as 3x-5x!

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 McDermott, Will & Emery. All Rights Reserved.
Cumulative Dividends
Built-In
Return; Rates Vary from 8%--12%
Dividend
Accumulates Until Paid on an Acquisition,
Redemption, Liquidation or Cash-Out Election Event,
Public Offering?
PIK
Dividends: Payment-in-Kind, Tax Issues abound for
Foreign LPs
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 McDermott, Will & Emery. All Rights Reserved.
Participating Preferred
Investor
Gets $$$ Back & Then Participates in All
Residual Amounts on an “As-Converted” Basis!!! Socalled “PIG Preferred”! THIS IS THE BIG KAHUNA!
Potentially
Disastrous Impact on Founders’ equity if
Sale or Acquisition Does Not Yield a Decent Return
Investor
Recovers the Investment (including dividends)
& Then Plays Again in Upside Gain
Issue:
Resist It! Get an “IRR Hurdle”/ Multiple of
Capital Threshold Such that Investor Forfeits This Right
©2004 McDermott, Will & Emery. All Rights Reserved.
Participating Preference

Participating preferences are the “receding norm”
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many are uncapped (always receive return of
capital), some are capped at 2x-3x or receive asconverted participation
evidence of liquidation preference also paid on
IPO
participation features among series can create
conflicts and lead to anomalous results
Resetting or washing out old preferences is the
biggest challenge
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Participating Preferred is disappearing for “hot”
deals
©2004 McDermott, 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
Ratchet
Formula: If Company Issues 1 Share at Lower
Price, Conversion Rate of Preferred is Reduced to
Lower Price !!!!
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 McDermott, Will & Emery. All Rights Reserved.
Anti-Dilution Provisions
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“Weighted-Average” is still market standard
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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 McDermott, Will & Emery. All Rights Reserved.
“Play or Lose” Provisions
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
Incentive
for Investors to Play in Dilutive
Financings and Support the Company
Ensures
that Investment Syndicates will
Remain United in Support
©2004 McDermott, Will & Emery. All Rights Reserved.
Play-or-Lose Provisions
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Most deals still do not have “Pay-to-Play” or
“Play-or-Lose” provisions
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doubled-edged sword nature is an issue
When used, typical provision calls for
conversion to common, not just loss of antidilution protection
Trigger is no longer pro rata participation; now
set at share of insider investor allocation to
apply to inside rounds
©2004 McDermott, Will & Emery. All Rights Reserved.
Class Voting Rights
Investor
has Ability to Block\Veto Important Corporate
Transactions
Mergers,
Sales of Stock or Assets
Issuances
Grant
of Additional Preferred
of Excessive Options to Employees
Incurrence
Sales
of Debt
or Transfers of Technology
Issue:
Separate Class Voting Rights Should Disappear if
Preferred Holds Less than Certain % of Equity
©2004 McDermott, Will & Emery. All Rights Reserved.
“Drag Along” Rights
“Merger
Extortion Device”: Investor has Ability
to compel a Liquidity event: i.e., sale or
merger
Stated
percentage of Investors (maybe 67% of
a round or all preferred) determine that
Company should be sold
Board
sold
determines that Company should be
Result:
Minority stockholders are “dragged
along” in the sale process, a “Forced March to
the Merger Alter” -- with waiver of appraisal
©2004 McDermott, Will & Emery. All Rights Reserved.
Mandatory Redemption
Investor
Wants Money Back After Time (5-7 years)
Depends
on Stage of Company and Venture Fund
Investing, Business Plan and Profitability Model,
Expectations of Liquidity Events
Redemption
for Dollars Invested, Dollars Plus
Cumulative Dividends, Stated Return, or Fair Market
or Appraised Value
Delinquent
Redemptions ??? Increase in Conversion
Rate for “Blown Redemption” – potentially ruinous to
management
©2004 McDermott, Will & Emery. All Rights Reserved.
Mandatory Redemption
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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 McDermott, Will & Emery. All Rights Reserved.
Failed Redemption
 Penalties
 “Board
for failed redemption:
Takeover” right
 Conversion
of unredeemed portion to
promissory note
 Increase
in conversion rate on preferred
 Complexity
of timing of redemption
with multiple series of preferred
©2004 McDermott, Will & Emery. All Rights Reserved.
Basket For Management Pool
Get
Agreement From Investors: Certain % of
Capitalization Set Aside as Option Pool for Future
Employees or to Reward Existing Talent
Share
Equally Dilution Presented by “Basket” or
Option Pool -- On Pro Rata Basis -- by Investors &
Founders
Pool
or Basket Typically Represents 15%-18%18%-20% of Total Fully-Diluted Capitalization,
Post-Financing – but comes out of pre-money !
©2004 McDermott, Will & Emery. All Rights Reserved.
Non-Competition Agreements
Investors
are Backing People & Ideas -- Want
Assurances Key Employees Will Not Leave to
Form Competitive Venture
Time
Periods for Post-Employment NonCompetition: 1 Year – 18 months (beyond that =
unenforceability risk)
Consideration
Needs to Support a Covenant Not
To Compete
Issues:
Should NonCompete expire if Person is
Terminated Without Cause, or Downsizing?
©2004 McDermott, Will & Emery. All Rights Reserved.
Vesting & Buy-Out Of Founder
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
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 McDermott, Will & Emery. All Rights Reserved.
Board Composition
Investor
Representation Often Tracks $$
Management
Importance
5
Needs Representation too
of Outside Directors critical
Directors Is Often the Magic Number
Follow
Board
Ask
the “Martini Rule” for VCs on
me about the “Martini Rule”
©2004 McDermott, Will & Emery. All Rights Reserved.
VentureOne:
Deal Terms Survey
Fourth Edition
www.mwe.com
© 2004 McDermott Will & Emery
McDermott operates its practice through separate legal entities in each of the countries where it has offices.
Participating Preferred
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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 McDermott, Will & Emery. All Rights Reserved.
Cap on Participating Preferred
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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 2x were most common (55.9% =
2x Cap; 31% = 3x Cap; 13%>4x Cap))
©2004 McDermott, Will & Emery. All Rights Reserved.
Cumulative Dividends
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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 McDermott, Will & Emery. All Rights Reserved.
Cumulative Dividends
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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 McDermott, Will & Emery. All Rights Reserved.
Staged Financings
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
26% of First Round respondents reported
Staged Financing fund raisings
Key Triggers:

Product Development: 30.4%

Set Passage of Time: 21.4%

Specific Customers Landed: 12.5%

Key Managers Hired: 12.5%

Revenue Targets Achieved: 14.3%
©2004 McDermott, Will & Emery. All Rights Reserved.
Company Control

Median Amount of Company Sold:

First Round: 40% (previously 50%),
with median amount raised at $5M
(from $5.3M)

Second Round: 33%

Third/Later Round: 26%
©2004 McDermott, Will & Emery. All Rights Reserved.
Company Control: Founders

Median Founders Ownership
After Round:

First Round: 31.5%

Second Round: 15%

Third/Later Round: 10%
©2004 McDermott, Will & Emery. All Rights Reserved.
Anti-Dilution Protection
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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 McDermott, Will & Emery. All Rights Reserved.
Size of Option Pool

Median Ownership Percentage allocated
to Option Pool = 15%

First Round = 15%

Second Round = 15% !!!

Third/Later Round = 15% !!!

Mean = 14.6% -- Median = 15%

Ranges reported from 11% to 18.8%
©2004 McDermott, Will & Emery. All Rights Reserved.