VENTURE CAPITAL INVESTMENT FOR TECHNOLOGY AND ECOMMERCE COMPANIES

By Scott L. Allen

I. Introduction

A. Venture Capital Raising Process. This article addresses key issues for a techno c

1. Pre-Funding Considerations

2. VC Selection Process

3. Mechanics of the VC Process

4. Terms of the VC Financing

B. Checklist Features.

logy ompany in raising venture capital. These issues are addressed from a practical perspective with the objective of presenting a checklist of important legal and business considerations for the technology company in raising its initial capital from the venture community. The venture capital raising process is addressed in the following stages --

The checklist of practical pointers presented below is from th

1. This is the initial round of VC financing

2. Any capital raised to date has been minimal (and probably from

3. There is minimal (or no) revenue to date

4. A Business Plan (or at least an Executive Summary) has been

5. A broker or investment/merchant banker has not been retained

C. Attachments.

e perspective of a technology company with the following features --

friends and family)

prepared

The attachments include:

1. Attachment 1 - Flowchart of Practical Pointers in the VC Process

2. Attachment 2 - Preparation of the Executive Summary

3. Attachment 3 - Proposed Capital Structure - Rounds 1, 2 and 3

4. Attachment 4 - Venture Capital Investment Termsheets

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5. Attachment 5 - Due Diligence Checklist

Please note that the checklist items presented below are based on experiences in dealing with U.S. and international venture capitalists investing in start-up technology companies. Each transaction may have unique aspects requiring special attention to other issues which are beyond the scope of this article. In particular, there may be unique tax and securities considerations associated with the formation of the legal entity which will require input from the company accountant. The goal of this article is to provide a practical focus on the key issues for a technology company in raising its VC financing.

II. Pre-Funding

A. Pointer 1 - Prepare an Executive Summary - The process of raising venture capital starts with the preparation of an Executive Summary describing the proposed business. The objective of this document is to obtain the interest of prospective VCs and to encourage them to read the entire Business Plan. Consider limiting the length of the Executive Summary to 2-5 pages (the shorter the better). This document should succinctly address the following topics (which are discussed in greater detail at Attachment 2).

1. Introductory paragraph on the business

2. Summary of management team

3. The market and its problem

4. The company's solution

5. Your strategy

6. Description of products and services

7. Revenue stream model

8. Sales and marketing plan

9. Competition

10. Proposed investment and use of proceeds

The first paragraph of the Executive Summary may be the most important. This paragraph should be carefully drafted (and redrafted) to present a compelling reason for the VC to read the Business Plan and consider investment in the company. Remember that VCs receive a constant stream of investment opportunities, and they cannot fully investigate all of them. A well-crafted Executive Summary will present a compelling reason for a VC to investigate further.

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B. Pointer 2 - Prepare the Business Plan - The Executive Summary provides the outline for the full Business Plan. The Business Plan is an expansion of the Summary, but should include additional detail regarding:

1. Size of the market (as supported by market research)

2. Biographical information on the management team

3. Financial forecasts and assumptions

4. Enhanced description of the problem being addressed by the Company and its products/services

5. Enhances description of the company's solution for addressing the problem in the market.

6. Detailed description of products and services (especially focusing on differentiators)

7. Detailed description of the sales and marketing plan

8. Description of target markets and competition

9. Detailed list of risk factors

10. Capital to be raised and detailed use of proceeds

11. Media and press articles regarding the market and the problem being addressed by the company

12. Information regarding possible nominees to the Board and additional management team members (to the extent these individuals consent to having information included in the Business Plan)

Additionally, the Business Plan will need to include a description of the current status of the company in which the investments are proposed to be made by the VC, including:

h current capital structure (shares and options outstanding, size of the Option Plan and reserved shares for future issuance, proposed grants of stock and options to Founders, etc.)

i structure of legal entity (S-corporation, C-corporation, limited liability company, partnership, etc.)

i agreements among Shareholders/Founders

i other agreements (such as with strategic partners)

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i employment agreements with Founders

i proposed strategic investors (such as corporate venture funds or strategic partnerships with key customers/suppliers)

i Any legal disputes or litigation

Note that the VC may require the legal structure of the company to be adjusted to accommodate the proposed form of investment. For example, some venture funds are prohibited from investing in partnerships or limited liability companies, thus requiring that these entities be converted to a C-corporation. Similarly, if the technology company is an S-corporation, the company will be required to convert to a C-corporation to accommodate the venture investment. These issues should be addressed with the company's accountant and tax advisor early in the capital-raising process.

C. Pointer 3 - Select the Management Team - A prerequisite to raising capital involves a commitment from members of the management team. In many cases, this may require prospective managers to make a legal commitment to the company, leaving their existing employer and displaying their commitment to the new venture. In any case, the VC firm will generally require that key members of the management team have signed Non-competition/Non-disclosure Agreements and formally joined the new venture prior to funding of the company. Also, this is the time to identify any “holes” in the management team that need to be filled. In evaluating and selecting the management team, consider the following practical pointers --

1. Are managers prepared to reduce their salaries with the expectation of significant upside in the form of equity appreciation?

2. Is one of the managers capable of serving as Interim Chief Financial Officer (until the company is large enough to retain a full-time CFO)?

3. Is the Founder capable of growing with the business (and does the Founder recognize the possibility that a more experienced manager may need to be hired as the company accelerates its growth)?

4. Do the managers have experience in the budgeting process and operating “hand-to-mouth” during early stages of growth?

5. Are the managers committed to the enormous time commitment required to develop and launch the product/service during the early years of the business?

D. Pointer 4 - Anticipate the Capital Structure -- Now and in the Future - The Founders should plan the capital structure of the company through the multiple rounds of financing. While these plans will likely evolve over time, it is important for the Founders to determine their ultimate expectations as to the return on their investment of capital and sweat equity.

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A common process involves the preparation of several pie charts setting forth the capitalization at each stage of financing up to the major liquidity event (which is usually the initial public offering (IPO) or sale of the business). Starting from this liquidity event (and moving back in time), the Founders should determine the desired value of their stock at the time of an IPO or sale of the business. Then, the Founders can move backwards in time to determine the appropriate capital structure during the earlier rounds of financing. Of course, the actual results of this process may be altered, especially if additional unexpected rounds of financing are required in order to meet the goals in the Business Plan and achieve desired revenues and profitability.

Consider preparing a pie chart of the capital structure for each of the following stages in the life cycle of the technology company --

i company inception

i initial angel round (capital from friends and family)

i VC Round 1

i VC Round 2

i VC Round 3 (if required)

i immediately prior to the IPO

At each of these stages, consider the following “slices” of the pie chart with regard to capitalization of the Company:

i stock/options owned by the Founders

i stock/options owned by other officers

i stock/options to be reserved for key executives

i initial stock issued to angels/friends and family (probably in the form of common stock)

i VC Round 1 investment (probably Series A convertible preferred stock)

i VC Round 2 investment (probably Series B convertible preferred stock)

i VC Round 3 (if necessary) (probably Series C convertible preferred stock)

i shares/options reserved for other officers/employees/consultants

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i options reserved for outside directors

i warrants reserved for strategic investors or debt financing (frequently granted to commercial lenders or strategic partners)

In preparing the pie charts, you will notice that there are two key variables that determine relative value for the shareholders:

i the amount of outside capital raised (which is a function of the capital needed to establish and grow the business)

i valuation of the company (which determines the number of shares issued for the outside capital)

An example of a capitalization structure using this pie chart process is included at Attachment 3.

E. Pointer 5 - Assess Existing Employment Issues and Restrictions - Early in the process of raising capital, the Founders should assess any restrictions placed on them in establishing the new business venture. These restrictions could include:

1. Restrictive covenants in existing Employment Agreements with a current employer (such as non-competition, non-solicitation of customers or non-solicitation of employees).

2. Non-disclosure Agreements with the former employer or other third parties.

3. Forfeiture provisions requiring a Founder to lose options or sell stock back to a former employer as a result of the Founder establishing a competitive venture.

4. Alleged breach of fiduciary duties or duty of loyalty (if the Founder has been planning or operating the competitive business while still employed by the former employer).

5. Alleged breach of duty of good faith (if the Founder was an officer/director of the former employer and has solicited co-workers to join the new competitive venture).

Prior to approaching a venture capitalist, these issues should be carefully reviewed and steps should be taken to minimize legal exposure to the former employer. Additionally, the Founders should carefully review existing agreements with their current employers, especially with regard to vesting and forfeiture of stock and options in their current employer. Failure to address these issues head on in the capital raising process can result in a delay or derailment of the capital raising process.

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F. Pointer 6 - Consider Strategic Members of Your Board of Directors - The Founders should consider possible nominees for their Board of Directors who can provide strategic value to the new business. If the Founders are young and inexperienced, then a well-known Director may add credibility to the new venture’s ability to raise capital. This may be particularly the case where the Board member is from a complimentary business or has strategic contacts in the market being pursued by the start-up venture.

A word of caution is in order. The venture capitalists are investing in the management team and its business concept -- not the outside members of the Board of Directors. While a strong Board can compliment the management team, VCs will be unimpressed by a company which is preoccupied with establishing a “superstar” Board of Directors (or Board of Advisors) to the exclusion of addressing the fundamentals of planning and operating the business. Also, the VCs will place their own representatives on the Board, which will add depth of experience and contacts but also dilute the influence of the Founders. In fact, the Founders may soon find themselves in a minority position on the Board.

III. VC Selection Criteria

A. Pointer 7 - Achieve the Desired Valuation - A technology company will seek the highest valuation in its venture capital financing. In the case of a start-up business, the valuation process is more an art than a science. Traditional means of valuing a business based on discounted cash flow or other financial metrics are generally irrelevant at this stage. Rather, the determination of valuation may be based on subjective, rather than objective, criteria established by a venture firm, which may include some or all of the following:

1. Projected revenue growth

2. Projected time to profitability

3. Anticipated time to a liquidity event (such as an IPO or sale)

4. Strength of the management team and its prior performance in the technology area

5. Comparable companies in the market (and their valuations in IPOs and acquisitions)

6. Anticipated rate of return on the investment

7. Industry/market sector

Since an objective formula does not exist for determining exact valuation, a technology company will need to obtain a preliminary valuation from selected venture capitalists. Keep in mind that VCs generally do not encourage heavy “shopping” of a

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technology deal. Therefore, the VC firms should be carefully selected based on the criteria set forth below.

IV. VC Selection Process

A. Pointer 8 - Understand the Extent of the VC's Control - The Founders of a technology company will often misinterpret their ownership of 51% or more of the company's stock as retaining “control” of the business. While this may be true before a venture investment, it will not be true after. VCs typically invest in preferred stock that gives them a number of control provisions, such as

i a specified number of directors (which could be a majority)

i approval rights over certain significant corporate actions

i covenants to undertake certain actions

i purchase and redemption rights with respect to the company's stock.

The founders of a technology company need to understand the control they will inevitably lose to the VCs and be comfortable with it before going down this path.

B. Pointer 9 - Determine a Pool of Prospective VCs - A technology company should do its homework in selecting a small group (no more than 7-10, and preferably 2-3) VC firms to approach for a possible investment. The entrepreneur should obtain information regarding these firms through their websites, contacts with professional advisors and a review of comparable public companies in which the VC firms have invested. Before contacting any VCs, the entrepreneur should determine the investment criteria used by the venture fund in making investments. These criteria may include:

1. The stage of financing (earlier start-up vs. later stage)

2. The size of an investment (note that many firms have substantially increased their minimum investment and have established $10 million as their floor)

The method of introduction to a VC is also important. Cold calls have a much lower percentage of success than introductions made by mutual contacts.

C. Pointer 10 - Select a VC with Industry Contacts - For a “hot” technology company, a number of VC firms will likely express an interest. The technology company will then need to select the firm with the appropriate industry focus and that can provide an “added value” component to the investment. Among the key questions to be asked by a technology company in selecting a VC are:

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1. Has the firm made similar investments in companies in the same market area?

2. Can the firm provide significant industry contacts (particularly with prospective strategic partners and customers)?

3. Does the VC have strong contacts with executive search firms to enhance the management team of the company?

4. Does the firm actively participate in meetings of the Board (as opposed to simply showing up without having read the Board materials)?

5. Who is the representative from the VC firm to serve on the Board (and is it a partner or associate)?

6. Can the VC firm assist in strategic planning and direction for the company (or does it have contacts with strategic planning firms)?

7. Will the VC agree to co-invest along with other funds?

8. Does the VC have significant contacts with the media, PR firms, and marketing consulting?

9. Does the VC firm have sufficient capital to invest in follow-on rounds?

In the long run, there should be a cultural and personality “fit” of the partner/associate at the venture firm and the Founders. One way to determine this level of compatibility is for the Founders to contact portfolio companies in which the VC firms have made investments and obtain references on the funds.

D. Pointer 11 - Do the VC and Founders agree on the Management Team? - This is a pivotal question to be honestly discussed with the prospective venture investor. There should be a convergence of opinion as to such matters as:

1. The ability of the Founders to serve in the capacities of CEO/President

2. The willingness of the Founders to add new members to the management team (and to delegate or relinquish responsibility)

3. The willingness to hire a CFO within a designated period of time

4. The proposed salaries for members of the management team (keeping in mind the desire of most VC investors to keep salaries at a low or moderate level, with an equity upside based on appreciation of stock and options)

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5. Willingness of the Founders to be diluted by the addition of key members of the management team and additional rounds of investment

6. Acceptance of the fact that a new CEO may be required as the company advances to later rounds of financing

E. Pointer 12 - Are There Benefits to Having Local VC Involvement? - There are benefits to having local VC involvement. These benefits include:

1. Contacts with local media

2. Contacts with local executives and proposed Board members

3. Assistance with local governmental and political leaders

4. Hands-on and personal participation by the VC with critical business issues requiring fact-to-face involvement

V. Mechanics of the VC Process

A. After following the pre-funding steps and selecting a group of prospective VC investors, consider the following action items for proceeding toward a closing of the fund raising process:

1. Pointer 13 - Schedule VC Meetings - Schedule these meetings in close proximity to allow the opportunity to compare VC firms. Make sure the company presentation is well rehearsed and highlights the differentiating features of your business, as set forth in your Executive Summary. Note that most VC firms will refuse to sign Nondisclosure Agreements, so care should be taken in the depth of disclosure provided in the initial meetings.

2. Pointer 14 - Check on VC References - With regard to the “best few” VC funds selected, check on references with executives in their portfolio companies. Confirm the information provided by the venture funds regarding the “added value” they claim to provide to their portfolio companies.

3. Pointer 15 - Obtain a Range of Valuation - For those VC funds interested in the business, encourage them to provide a pre-money valuation range for the company. Even if this valuation range is provided verbally, it allows the Founders to assess the seriousness of the venture fund in moving forward with the investment at an acceptable valuation.

4. Pointer 16 - Select a Lead Investor - From among the interested VC firms, the Founders will need to select a lead firm. This firm may be the VC with the highest valuation and will also be the lead on

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conducting due diligence on the company. Additionally, the lead investor will be instrumental in selecting co-investors from the other interested VC funds. Note that some VC funds prefer to be the sole investor and may object to having other firms involved in the financing group.

5. Pointer 17 - Obtain VC Termsheets - If the Founders have attracted a group of interested VCs, each of the firms should be encouraged to submit Termsheets as to the relevant provisions of the financing and proposed valuation. In the best case, the most desirable VC firms will submit their Termsheets for review and comparison by the Founders. The Founders can then select the desired firm to serve as lead investor and to pull together the financing group.

6. Pointer 18 - Finalize the Termsheet - The relevant provisions of the Termsheet will need to be negotiated. Samples of VC Termsheets are included at Attachment 4.

7. Pointer 19 - Prepare for Due Diligence - The lead venture firm will provide a due diligence checklist (see Attachment 5). The Founders should prepare for the materials to be provided to the VCs and have these materials well organized before the request is made.

8. Pointer 20 - Review Draft Documents - Legal counsel for the VC will provide drafts of the relevant documents for the venture financing. These will include the Stock Purchase Agreement and other documents as referenced in the Termsheets at Attachment 4.

9. Pointer 21 - Close the Transaction and Monitor On-going Compliance with Covenants - After the financing is closed, note that the Founders will need to maintain a checklist of the covenants included in the Stock Purchase Agreement.

VI. Terms of the Financing

Attachment 4 contains several sample termsheets with commentary as to a description of the typical terms, the reasons behind the terms and areas for negotiation.

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ATTACHMENT 1

FLOWCHART OF PRACTICAL POINTERS IN THE VC PROCESS

Pointers Pointer 1. Prepare an Executive Summary Pointer 2. Prepare the Business Plan Pointer 3. Select the Management Team Pointer 4. Anticipate the Capital Structure -- Now and in the Future Pointer 5. Assess Existing Employment Issues and Restrictions Pointer 6. Consider Strategic Members of Your Board of Directors Pointer 7. Achieve the Desired Valuation Pointer 8. Understand the Extent of the VC's Control Pointer 9. Determine a Pool of Prospective VCs Pointer 10. Select a VC with Industry Contacts Pointer 11. Do the VC and Founders agree on the Management Team? Pointer 12. Are There Benefits to Having Local VC Involvement? Pointer 13. Schedule VC Meetings Pointer 14. Check on VC References Pointer 15. Obtain a Range of Valuation Pointer 16. Select a Lead Investor Pointer 17. Obtain VC Termsheets Pointer 18. Finalize the Termsheet Pointer 19. Prepare for Due Diligence Pointer 20. Review Draft Documents Pointer 21. Close the Transaction and Monitor On-going Compliance with Covenants

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ATTACHMENT 2

PREPARATION OF THE EXECUTIVE SUMMARY

In preparing the Executive Summary for your Company, review the following outline. The objective of this document is to obtain the interest of the prospective venture capitalist, angel investor or other potential source of capital. The Executive Summary will be supplemented by the full Business Plan. Please keep in mind that the first paragraph may be the most important, along with information on your management team. Finally, please limit the length of the Executive Summary to 2-5 pages.

Introductory Paragraph - This paragraph should provide a carefully worded description of your business, the problem experienced in the market which you are resolving, your Company's solution, and your business objective.

Management Team - If your management team is experienced and well known in the market, you may want to include biographical information in the second section of the Executive Summary. Otherwise, this section can be included at the end of the document. Please note that biographical information should be included as an attachment to the full Business Plan. The Business Plan will also indicate any management positions which you expect to fill and your timetable for filling them.

The Market and its Problem - This paragraph should address the market in which your Company provides products and services. In particular, define the problem experienced in the market. If possible, include market research data to verify the size of the market and the scope of the problem being addressed by your Company.

Company Solution - After you have described the problem in the market, the next section will address the solution provided by your Company. Emphasize any unique or differentiating features of this solution (for example, if your solution is more responsive in addressing the customer’s needs, is more cost-effective or lower priced, is more easily implemented, etc.). Often, a company's solution will include three or four key bullet points which also highlight the differences between your Company and the competition.

Strategy - This section generally sets forth your strategic business direction, outlining the steps you plan to take to deliver your Company's solution to the market. Again, the strategy may include three to five key strategic elements (such as the establishment of a dealer network, expansion into international markets, strategic alliances with third parties, etc.).

Description of Products and Services - Include a paragraph describing the services and products of the Company, highlighting any distinguishing or differentiating features. This should also include any intellectual property protection for products (especially patents). This section can include a description of research and product development activities and plans.

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Revenue Stream Model - Describe how your solution is going to generate revenue. Discuss whether your model is sales-based, advertising-based, etc. Also, discuss your pricing of products/services and the factors that determine price. This discussion will also be the basis for the assumptions in your financial forecast.

Sales and Marketing - Describe the sales and marketing strategies for the Company. If applicable, indicate the experience of the members of the management team with regard to the sales and marketing plans. Again, highlight any differentiating features of your strategies.

Competition - This section should briefly describe your competitors, as well as ways in which your firm can be differentiated in the competitive environment, including a summary of the competition and their strengths and weaknesses.

Financial Statements and Forecasts - Include a summary of the financial statements for the Company and forecasted financial information. Be careful with your financial forecasts and make sure that appropriate assumptions are included. The financial forecasts can be summarized in a couple of sentences, as opposed to including detailed financial information.

Risk Factors - You may want to consider including a summary of potential risks associated with the business venture. These risk factors do not need to be as detailed as would be included in a prospectus for an IPO, but they should highlight those areas of significant concern.

Attachments - Consider attaching one or more of the following, if applicable

• Biographical information on management team

• Information about the Board of Directors (and possible nominees)

• Press/media information and articles

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ATTACHMENT 3

PROPOSED CAPITAL STRUCTURE -- Rounds 1, 2 and 3

ROUND 1

$10,000,000 Post-Money Valuation

1,000,000 shares outstanding

VC Investment = 300,000 shares at $10 per share ($3,000,000)

VC = 30%

(300,000 Shares)

SR = 15%

(150,000 Shares)

F = 55% (550,000 Shares)

Estimated Value = $5,500,00

Legend

F = Founders VC = Venture Capitalists SR = Shares Reserved for Key Employees and Directors

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ROUND 2

$15,000,000 Post-Money Valuation

1,300,000 Shares Outstanding

Additional VC Investment = 250,000 Shares at $12 per share ($3,000,000)

SR = 15.4%

(200,000 Shares)

VC = 42.3%

(550,000 Shares)

F = 42.3% (550,000 Shares)

Estimated Value = $6,345,000

Legend

F = Founders VC = Venture Capitalists SR = Shares Reserved for Key Employees and Directors

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ROUND 3

$30,000,000 Post-Money Valuation

1,610,624 Shares Outstanding

Additional VC Investment = 260,624 Shares at $19.18 per share ($5,000,000)

F = 34.2% (550,000 Shares)

Estimated Value = $10,260,000

VC = 50.3%

(810,624 Shares)

SR = 15.5%

(250,000 Shares)

Legend

F = Founders VC = Venture Capitalists SR = Shares Reserved for Key Employees and Directors

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ATTACHMENT 4

VENTURE CAPITAL INVESTMENT TERMSHEETS

SERIES A FINANCING – ROUND #1

(with commentary) 1. Company

Generic Software, Inc. (the “Company”)

2. Amount of Investment

$2,000,000

3. Form of Investment

2,000,000 shares of Series A Convertible Preferred Stock, $.01 par value (the “Preferred A”). [VCs almost always invest in preferred stock that is convertible into common stock. This allows the VC to take advantage of the preferred liquidation and other rights customary to preferred stock while the company is private while retaining the right to convert to common stock at the IPO or sale of the company to realize their appreciation.]

4. Use of Proceeds

Software development, patent development and general working capital purposes. [Use of proceeds is typically an important factor for VCs. The VCs want to make sure that their money is used to grow the Company and make their investment more valuable.]

5. Stock Option Plan

10% of the fully diluted shares outstanding post-financing will be reserved for issuance to employees and consultants according to a stock option plan. [VCs know that motivated employees are the key to a Company’s success, so a portion of the capital is almost always set aside for employee/director options. The typical option pool is 10% - 20% of the outstanding stock.]

6. Rights, Preferences, Privileges and Restrictions of Preferred

(1) Dividend Provisions: Dividends will be cumulative and accrue at a 10% annual rate and be payable in-kind, upon liquidation, redemption, merger, consolidation, or conversion of Preferred A. [VCs usually want a minimum fixed return without burdening the Company with periodic payments, and they like the option of getting it in either cash or stock.]

(2) Liquidation Preference: In the event of liquidation, sale, merger, consolidation or winding up of the Company, the holders of Preferred A will be entitled to receive in preference to holders of common stock an amount equal to the purchase price of the shares plus all accrued and unpaid dividends. [If the Company liquidates, the VCs want their money first. A liquidation is usually defined to include a sale of the Company, which impacts the amount of

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proceeds that will remain for the common shareholders. Some preferred stock is structured as “participating preferred” which gives the preferred stock this liquidation preference plus the right to participate in the remaining proceeds as if the preferred stock had been converted into common stock.]

(3) Conversion Price: The total number of shares of common stock into which Preferred A may be converted will be determined by multiplying the number of shares of Preferred A to be so converted by the purchase price and dividing the result by the conversion price. The conversion price initially shall be equal to the purchase price but will be subject to adjustment as provided in paragraph (5) below. [The VCs have the right to convert into common stock at anytime, but they never will unless the Company is sold or goes public.]

(4) Automatic Conversion: Upon the closing of an Initial Public Offering of shares of the Common at a public offering price that is not less than 5 times the per share price of the Preferred A, with net proceeds to the Company of at least $10 million, the Preferred A will automatically convert into common stock at the then applicable conversion price. [The public markets will rarely invest in the IPO of a company with preferred stock. As a result, if the Company goes public, the VCs know that their preferential rights go away, but they want to know that it’s a “real” IPO, that is, an IPO that will result in a liquid market in which they can sell their shares.]

(5) Antidilution Provisions: If the Company issues additional shares at a purchase price less than the applicable conversion price of Preferred A, the conversion price used to determine the number of shares of common stock into which shares of Preferred A may be converted will be reduced on a weighted average formula basis. [If the Company sells cheap stock (i.e. below the price of the preferred stock), the VCs have been diluted and they will want more stock. The key issue here is “weighted average” versus “full” ratchet. A “full” ratchet will reduce the conversion price to the price at which the dilutive shares were issued (without regard to the number of dilutive shares issued). A “weighted-average” ratchet will reduce the conversion price in accordance with a formula that takes into account the price and amount of the dilutive shares. The weighted average ratchet is more favorable to the company and is relatively standard.]

(6) Voting Rights: Except with respect to election of directors and certain protective provisions or as required by law, the Preferred A will vote together with the common stock with the right to that number of votes equal to the number of shares of common stock issuable upon

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conversion of the Preferred A. [The VCs will probably have a minority position, but the protective provisions give them the real power.]

(7) Protective Provisions: For so long as at least 25% of the Preferred A remain unconverted, consent of the holders of at least a majority of the Preferred A will be required for: (i) any sale by the Company of all or substantially all of its assets, (ii) any merger of the Company with another entity, (iii) any liquidation or winding up of the Company; (iv) any amendment of the Company's charter in a manner adverse to this class of stock, (v) the issuance of any equity or debt security senior to or on parity with the Preferred A, or (vi) the payment of any dividend on or the purchase, redemption or other acquisition of any security junior to the Preferred A. [Some of these rights are provided by law, the remainder by negotiating leverage. These approval rights are fairly common. VCs may also seek approval rights over more “business judgment” matters in earlier stage companies.]

(8) Redemption: Holders of at least a majority of the Preferred A may elect to cause the Company to redeem the Preferred A in two equal annual installments commencing on the fifth anniversary of the issuance of the Preferred A at a redemption price equal to the greater of the fair market value or purchase price plus all accrued and unpaid dividends. Upon default in the payment of any required redemption installment, the unpaid balance shall accrue interest at the rate of 15% per annum, payable quarterly in arrears. Default in the payment of any required redemption installment that continues for more than ninety days after notice shall be a voting right event permitting the Preferred A to elect a majority of the Board of Directors during the continuance of such default. [The VCs won’t invest unless they have an exit strategy. If the Company doesn’t have the money to redeem the Preferred A after five years (which is likely), the VCs may use this provision to take over the Board (or more likely threaten to do so) and force a sale or refinancing of the Company. The concept is usually not negotiable, but the term and/or payout schedule may have some flexibility.]

7. Board of Directors

The Company's Board of Directors shall be comprised of two representatives of the Common Shareholders, of which one shall be the CEO; two nominees of the holders of Preferred A, and one mutually agreed upon industry representative who shall not otherwise be affiliated with the Company. The Company will reimburse all non-employee directors for their reasonable expenses to attend Board meetings. [The VCs are your new business partners and they will want Board representation. The VC representatives may be in the minority, but beware of “veto” rights (usually relating to compensation or related party transactions). Also, be aware that VCs

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who invest in later rounds will also have Board seats, which may result in the VCs as a group having control of the Board.]

8. Information Rights

So long as any of the Preferred are outstanding, the Company will deliver to each investor audited annual and unaudited quarterly and monthly financial statements, annual budgets and other information reasonably requested by any investor owning shares of Preferred A, provided that such investor is not employed by or associated with a competitor of the Company. [The VC is already on the Board, so he’ll have access to everything anyway.]

9. Registration Rights

(1) Demand Rights: The holders of a majority of the Preferred A (voting together) may request that the Company file a registration statement under the Securities Act of 1933, as amended, covering the shares of common stock requested to be registered, and the Company will use its best efforts to cause such shares to be so registered. The Company will not be obligated to effect and consummate more than two demand registrations (other than on Form S-3 or any equivalent successor form) under this provision. A registration will not count for this purpose unless it is closed or withdrawn at the request of the Investors (other than as a result of a material adverse change to the Company). The Company shall not be required to effect any registration within one hundred eighty days of the effective date of any other registration statement on Form S-1. [If the Company goes public, the VC will want to sell its stock as soon as possible. Registration is at the Company’s expense, and it isn’t cheap, so the Company will want to limit the number of demand registrations. The Company will also want to protect the rights of its common shareholders to participate in the IPO as well.]

(2) Piggy-Back Registration: The Investors will be entitled to unlimited “piggy-back” registration rights on registrations of the Company, subject to customary underwriter's cutback. [Not as important an issue for the Company, but make sure that the VC can’t keep the founders from participating in the IPO.]

(3) Registration Expenses: The Registration expenses (exclusive of underwriting discounts and commissions but including the fees of one counsel for the selling shareholders) of each of the registrations under paragraphs (1) and (2) above will be borne by the Company. [VCs never want to spend their money, even after the Company goes public.]

10. First Refusal Right for Purchase of New Securities

Until the initial public offering of the Company, or until fewer than 25% of the Preferred A remains outstanding, if the Company proposes to offer any shares for the purpose of financing its business (other than shares issued to employees in the form of stock options, shares issued in the

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acquisition of another company, or shares offered to the public pursuant to an underwritten public offering), the Company will first offer all such shares to the Investors. [If the Company needs a second round of financing, the VC will want the first opportunity at the deal.]

11. Stock Restriction Agreement

The Founders and the Company's key employees will each execute a Stock Restriction Agreement with the Investors and the Company pursuant to which the Company first, and the Investors second, will have a right of refusal with respect to any shares proposed to be sold by such persons. The Stock Restriction Agreement will contain a right of co-sale in favor of the Investors providing that before any such person may sell any of his or her common shares, he or she will give the Investors an opportunity to participate in such sale on a basis proportionate to the amount of securities held by the seller and those held by the Investors. [If the founders find a buyer for their stock, the VC wants the option of either buying the stock itself or selling stock along with them.]

12. Noncompetition, Nonsolicitation and Nondisclosure Agreement

Following the closing, the Company will cause each Founder and key employee to enter into a two-year noncompetition, nonsolicitation and nondisclosure agreement, all such agreements to be in a form reasonably acceptable to the Investors. [VCs usually take this opportunity to make sure the Company is protecting itself the way it should.]

13. The Purchase Agreement

The purchase of the Preferred A will be made pursuant to a Series A Convertible Preferred Stock Purchase Agreement drafted by counsel to the Investors. Such agreement shall contain, among other things, appropriate representations and warranties of the Company and the Founders; covenants of the Company reflecting the provisions set forth herein and other typical covenants; and appropriate conditions of closing. [The key points for negotiation are usually the representations and warranties and indemnification for breaches of the representations and warranties.]

14. Expenses

The Company will pay the Investors' expenses for legal fees. [VCs usually get their legal fees paid by the Company, but insist on one counsel for all VCs and a reasonable cap on fees.]

15. Conditions to Closing

The proposed transaction is subject to satisfactory completion of due diligence by the Investors.

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VENTURE CAPITAL INVESTMENT TERM SHEET

SERIES B FINANCING – ROUND #2

XXX=

(the “Company”)

1. Investment Amount

$3,500,000 Series B Convertible Preferred Stock (the “Securities”), representing 25% ownership on a fully diluted basis (inclusive of the Employee Pool described below and all other options and warrants).

2. Investors Venture Capital Firm (“YYY”) will invest up to $2,000,000 and will work with the company to arrange additional investors suitable to all parties for the remaining $1,500,000.

3. Use of Proceeds The proceeds from the sale of the Series B Preferred will be used for working capital and general corporate purposes.

4. Employee Pool Included in the ownership calculated above, the Company will provide for an incentive stock option plan representing 12% of the post-financing fully-diluted common stock equivalents. All stock options issued under the plan will vest to a schedule agreed by the board and be issued at an exercise price not less than current fair market value. Any increase to the Employee Pool must be approved by the Compensation Committee of the Board of Directors including the approval of the director serving on such committee selected by the holders of the Series B Preferred.

5. Board of Directors The Board of Directors will initially consist of five people. The holders of the Series B Preferred will have the right to elect two directors. The Board of Directors will meet at least six times annually, and preferably will meet monthly. The Company will pay reasonable expenses incurred by directors in attending board meetings.

6. Conversion The holders of the Series B Preferred will have the right to convert the Series B Preferred at any time into common stock of the Company. The initial conversion rate shall be on a one-to-one basis and shall be subject to adjustment and dilution protection.

7. Automatic Conversion Upon the closing of a firmly underwritten public offering of shares of the Company for total offering proceeds to the Company of not less than $15 million at an offering price (prior to underwriters’ commissions and expenses) that is not less than 300% of the conversion price of the Series B Preferred, the Series B Preferred will be automatically

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converted into common stock at the then applicable conversion rate.

8. Preference on Liquidation, Merger or Consolidation

In the event of any liquidation or winding up of the Company, the holders of the Series B Preferred will be entitled to receive the amount paid for the Series B Preferred plus all accrued but unpaid dividends on such shares and a premium of 20% per annum compounded from the date of purchase of the Series B Preferred (the “Preferential Amount”), prior to any distributions made to the holders of common stock. In the event of a merger, consolidation, or other corporate reorganization or sale of control, or any transaction in which a majority of the assets of the Company are sold (other than a merger into a wholly-owned subsidiary), the holders of the Series B Preferred will be entitled to convert or receive in cash or securities in the amount they would have received upon a liquidation or conversion, whichever is greater.

9. Anti-Dilution In the event that the Company issues additional shares of common stock, convertible securities or warrants or grants stock options or issues other common stock equivalents (excluding shares reserved for issuance to officers, employees, directors, consultants or advisors pursuant to stock option or restricted stock purchase plans) at a purchase price less than the applicable conversion price, then the conversion price of the Series B Preferred will be subject to full adjustment to prevent dilution to such purchase price.

10. Adjustments In the event of any stock splits, stock dividends or combinations, an adjustment will be made such that the holders of the Series B Preferred will hold the same relative ownership position after such action as they had immediately prior to such action.

11. Dividends Dividends on each share of the Series B Preferred shall be cumulative and shall accrue on a daily basis at the rate of 6% per annum. No dividends shall be paid on the common stock or any other series of preferred stock so long as any shares of the Series B Preferred remain outstanding. The Company will be precluded from purchasing, redeeming or paying dividends on any capital stock other than the Series B Preferred.

12. Redemption Mandatory redemption upon demand of holders of the Series B Preferred after five years. Such redemption to be one-half of the total of the Series B Preferred in each of the two years following such demand; redemption price to be the greater of the Preferential Amount or fair market value (not discounted for minority interest).

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13. Registration Rights Commencing five years from the closing, the holders of a majority of the Series B Preferred will have the right to demand two registrations of common stock into which the Series B Preferred are convertible and will have unlimited piggyback registration rights. In addition, such holders will be entitled to two demand registrations on Form S-3 per year, so long as such registered offerings are not less than $1,500,000. The Company will bear registration expenses (exclusive of underwriting discounts and commission) of all demand and piggyback registrations. The registration rights may be transferred with an investor’s shares. The investors will agree to a reasonable lock-up upon the Company’s initial public offering, not to exceed 180 days, and subject to management and other investors owning 1% or more of the Company’s shares agreeing to the same lock-up. Senior management will be entitled to piggyback registration rights, subject to customary cutback provisions with priority for primary shares and shares to be sold by holders of the Series B Preferred. The Company will not grant or permit to exist any other registration rights in favor of holders of its capital stock without the consent of the holders of the Series B Preferred.

14. Rights of First Refusal The holders of the Series B Preferred will have a right of first refusal to purchase shares in other equity offerings made by the Company (except for shares issuable pursuant to the Employee Pool). The Company will have the right of first refusal to purchase any shares offered for sale by shareholders. Should the Company not exercise the right in full, said shares must then be offered to holders of the Series B Preferred on a pro rata basis.

15. Restrictive Covenants; Protective Provisions

Consent of a majority of the holders of the Series B Preferred will be required for a number of actions, including any actions which:

(a) Amend the Company’s charter or bylaws;

(b) Alters or changes the rights, preferences or privileges of the Series B Preferred;

(c) Increases or decreases the authorized number of shares of the Series B Preferred stock;

(d) Creates (by reclassification or otherwise) any new class or series of shares having rights, preferences or privileges senior to or on a parity with the Series B Preferred;

(e) Results in the sale of any security at a common-equivalent price less than that paid for the Series B Preferred, other than shares in the Employee Pool;

(f) Results in any merger, other corporate reorganization, sale of control, or any transaction in

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which all or substantially all of the assets of the Company are sold;

(g) Results in a material change in the Company’s line(s) of business;

(h) Enters the Company into material business activities not contemplated in the original business plan presented to the holders of the Series B Preferred;

(i) Results in the Company acquiring the stock, assets or business of any other entity in any form of transaction;

(j) Creates or commits the Company to enter into a joint venture, licensing agreement, or exclusive marketing or other distribution agreement with respect to the Company’s products, other than in the ordinary course of business.

16. Events of Non-Compliance and

Remedies

An event of non-compliance shall occur if (i) the Company breaches in any material respect any of the covenants or any of its obligations to the holders of the Series B Preferred and fails to cure such breach after notice and a reasonable opportunity to cure or (ii) the Company incurs a bankruptcy, receivership, assignment for the benefit of creditors or any unsatisfied judgment in a material amount.

If any event of non-compliance occurs and continues for 90 days, and until such event of non-compliance is cured, the holders of a majority of the Series B Preferred then outstanding shall have the right to elect a majority of the Company’s Board of Directors. The foregoing remedy is not exclusive, and all other legal remedies may be pursued by such shareholders upon the occurrence of an event of non-compliance.

17. Capital Expenditures, Assumption of Debt And Guarantees

A capital budget will be approved by the Board of Directors. Approval of the Board of Directors is required for any capital expenditure beyond that approved in the annual capital budget. Approval of the holders of the Series B Preferred is required for any assumption of debt in excess of a total of $1,000,000 outstanding at any time and any guarantees of debt or other obligations of another entity.

18. Information Requirements All holders of the Series B Preferred or their assigns will receive annual audited and quarterly unaudited financial statements. Sixty days prior to the start of each fiscal year, the Company will provide to such investors a comprehensive operating budget forecasting the Company’s revenues, expenses and cash position on a month to month basis for the upcoming fiscal year.

19. Voting Rights Each share of the Series B Preferred will carry one vote for each share of common stock (including fractions) then issuable upon its conversion. The Series B Preferred will

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vote together with the common stock and not as a separate class, except as specifically provided herein or as otherwise required by law.

20. Purchase Agreements The investment shall be made pursuant to a stock purchase agreement reasonably acceptable to the Company and the Investors, which agreement shall contain, among other things, appropriate representations and warranties and covenants of the Company reflecting the provisions set forth herein and appropriate conditions of closing, including an opinion of counsel for the Company. The purchase agreement, charter provisions and related documents shall be drafted by counsel for the Investors.

21. Management Compensation The Compensation Committee of the Board of Directors will consist of three directors at least one of which will be a representative of the holders of the Series B Preferred and at least one of which will be an outside director. Compensation for senior management will not exceed that which is reasonable and customary.

22. Proprietary and Inventions Agreement

Each officer and other key employee of the Company will enter into an acceptable proprietary information and inventions agreement.

23. Key Person Insurance Prior to closing the Company will obtain key person insurance in the amount of $1,000,000 on the life of the Founder.

24. New Hires A CFO or VP of Finance will be recruited and selected by mutual agreement between the Company and the holders of the Series B Preferred with 180 days of the closing of this financing.

25. Non-Compete Agreement Each officer and other key employee of the Company will enter into an acceptable non-compete agreement for a period of two years after leaving the Company.

26. Stockholders’ Agreement; Co-Sale The holders of the Series B Preferred will have a right of co-sale for any stock sales by any shareholder in excess of 10% of their respective holdings.

27. Transactions with Affiliates Transactions with affiliates require approval of the Board of Directors acting by majority of disinterested directors.

28. No Brokers The Company and each of the Investors represent and warrant that it has incurred no liability for any brokerage fees, agents’ fees, commissions or finders’ fees in connection with this Term Sheet or the consummation of the transactions contemplated hereby.

29. Professional Advisors Corporate counsel, CPA and commercial banker to be mutually agreed upon by the Company and the Preferred Stockholders.

30. Investor’s Counsel AAA or BBB or CCC

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31. Fees and Expenses The Company shall pay reasonable fees and expenses related to the transaction for one legal counsel for the holders of the Series B Preferred. It is anticipated that their fees will not exceed $25,000 (plus reasonable expenses), but such fees may exceed that amount in the event that unanticipated legal issues arise in connection with this transaction. In the event this transaction does not close for any reason, the Company will pay the reasonable fees and expenses of the legal counsel for the proposed holders of the Series B Preferred.

32. Conditions To Closing

Closing is subject to the satisfactory completion by the Investors of all due diligence they deem necessary. The proposed investment is subject to agreement upon final documentation and other customary conditions and any amendments to the terms and rights of the holders of the Series A Preferred Stock, so as not to conflict with the rights and preferences for the Series B Preferred. This term sheet does not represent a legal commitment to consummate the transaction described herein or any other transaction, except that the Company agrees to be bound by the “No Shop” commitment set forth below, and the foregoing agreement with respect to the payment of legal fees and expenses. It is understood and agreed that the Investors may undertake background examinations of key management of the Company as part of the due diligence investigations conducted by the Investors, and that such Investors may utilize such information in connection with their investment decision with respect to this transaction.

33. “No Shop” The Company agrees that for a period of thirty (30) days from the date this term sheet is accepted by both parties and thereafter so long as the Investors continue to conduct due diligence in good faith and/or document the transaction (and the Company has not given written notice to the Investors to discontinue same), neither the Company nor any of its representatives or agents shall directly or indirectly approach, contact or discuss with, or provide any information to, any other investment entity or person concerning the sale by the Company of any debt, equity or assets to any such entity or person, other than as necessary to complete, with the Investor’s participation, the financing contemplated by this document.

This proposal shall remain open until 6:00 p.m. on _________, 2001.

ACCEPTED:

XXX YYY

By: By:

Its: Its:

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ATTACHMENT 5

PRELIMINARY DUE DILIGENCE CHECKLIST

“XXX” (Company) The following is a preliminary list of documents and other information to be provided to “YYY” (VC) for review as part of our due diligence investigation to be conducted in connection with the proposed private placement of Series D Convertible Preferred Stock by “XXX” (the “Company”). To the extent any of the documents or information requested are not applicable, please so indicate. Items may subsequently be added, deleted or modified, as appropriate, as the due diligence review progresses. All requests are for information since the date of incorporation of the Company, unless otherwise noted. In each case, the requested information should also be provided for the Company's subsidiaries, if any. 1. Formation and Qualification to do Business 1.1 Articles of Incorporation and by-laws, including any amendments thereto, of the Company (including any predecessor company). 1.2 A list of each jurisdiction in which the Company is qualified to do business as a foreign corporation, owns or leases real property or is otherwise operating. 2. Corporate Proceedings and Capital Stock 2.1 The minutes of meetings held since the Company's organization of (a) shareholders, (b) Board of Directors and (c) all committees of the Board of Directors. Authorizing resolutions for the proposed private placement. 2.2 A list of all classes of stock of the Company, the number of shares authorized and issued, respectively, in each class, the number of shareholders in each class, the names of the Company's shareholders for each class of stock, the capacities in which shares are held (i.e., individually, as a trustee, as a guardian, administrator, etc.) and the amount of such holdings. 2.3 A list of all holders of options or warrants to purchase securities of the Company setting forth each holder's name, the date of grant of each option or the date on which each warrant was acquired, the title and amount of securities subject to each such option or warrant, and the exercise price. 2.4 A list of subsidiaries and other entities in which the Company has an equity investment. 2.5 Copies of any agreements to which the Company or any of its subsidiaries is a party relating to: a. a commitment to insure or sell securities b. a commitment or option to repurchase securities c. past issuances of securities (debt and equity) d. voting of stock e. registration rights f. rights of first refusal g. preemptive rights h. restrictions on transfer of stock i. warrants.

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2.6 Documents pertaining to any recapitalization, merger or acquisition involving the Company. 3. Litigation, Etc. 3.1 Letters from lawyers to auditors concerning litigation and other legal proceedings for the Company. 3.2 A list of all concluded litigation and other legal proceedings, a list (and status) of all threatened or pending litigation, proceedings, investigations, inquiries or disputes involving the Company and a list of all asserted and threatened claims involving the Company. 3.3 List of any consent decrees, injunctions, writs, orders or the like that currently bind the Company. 4. Government Regulation 4.1 All material communications to and all filings with domestic and foreign governmental agencies relating to the Company (including the Securities and Exchange Commission, state securities agencies, the Internal Revenue Service and any state or foreign taxing authority), including permits and consents. 4.2 A list of all federal, state and foreign agencies which license, regulate, inspect or register the Company and any of its activities. 4.3 Any reports, notices or correspondence relating to any purported violation or infringement by the Company of government regulations, including, but not limited to, the areas of insurance, equal opportunity, occupational safety and health and environmental protection, and copies of all other material correspondence with federal, state or other regulatory agencies. 5. Management and Employees 5.1 A list of all directors, officers and key employees of the Company, their salaries and, if less than full-time, the amount of business time devoted to the Company's business by each. 5.2 Non-competition, confidentiality, non-disclosure, assignment of invention and similar agreements with any entity to which any director, officer, or key employee of the Company is a party (please indicate any employees not covered by such agreements). 5.3 A schedule (and any related agreements) of all material transactions involving the Company and any current or former stockholder, officer, key employee or director of the Company. 5.4 Copies of all employee stock option plans or other stock option or employee bonus or incentive plans. 5.5 Copies of Employment Contracts (other than those set forth above). 5.6 Copies of Employee benefit plans. 5.7 Copies of Contracts with unions, if any. 5.8 List of “Key Person” Insurance Policies.

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6. Consultants 6.1 A list of all consultants of the Company and copies of such consultants' agreements with the Company. 7. Property 7.1 Summary of property owned, if any. 7.2 Copies of mortgages, if any, on property, plant and equipment owned by the Company. 7.3 Copies of deeds, if any, on property, plant and equipment owned by the Company. 7.4 Schedule and copies of leases and related agreements for all property, plant and equipment leased by or to the Company with rental, expiration and renewal terms. 7.5 Appraisal reports, if any, on property, plant and equipment owned by the Company. 7.6 List of Insurance policies on the Company's property. 8. Operational Matters 8.1 Copies of all material contracts of the Company. 8.2 List of all franchisees, franchise locations and Company operated offices. 8.3 Any written business plans of the Company, an explanation of material developments expected to occur during the next 12 months, including any anticipated material acquisition of plant and equipment and the capacity thereof. 8.4 Copies of documents relating to acquisitions of capital stock or assets. 8.5 A list of significant or sole-source suppliers, setting forth annual dollar amounts purchased, with copies of contracts and agreements with such suppliers. 8.6 Forms of franchise agreements and customer agreements used by the Company. 8.7 All records maintained by the Company relating to customer complaints. 9. Financial Data 9.1 Auditors' reports to management and any management responses thereto, and internal memoranda (particularly internal audit or regulatory compliance memoranda) concerning the Company. 9.2 Copies of the Company's financial statements covering the last two years. 9.3 Year-to-date financials. 9.4 Budgets or projections for the Company made on a quarterly, annual or other basis. 9.5 Reports to security holders, if any.

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10. Financial Matters 10.1 Credit agreements, loan agreements and lease agreements. 10.2 Security agreements and mortgages. 10.3 Guarantees of third party obligations. 10.4 Convertible note agreements. 10.5 Copies of any other contracts and agreements with financial institutions. 11. Intellectual Property Matters 11.1 Schedule of all trademark, copyright and patent registrations and related filings. 11.2 List of unregistered trademarks and service marks. 11.3 License and technology agreements. 11.4 All documents, materials and correspondence relating to any clams or disputes with respect to any intellectual property rights of the Company or any of its subsidiaries or any third party. 12. Miscellaneous A copy of any other document that the Company believes is material with respect to its operations.