ARTICLE REPRINT Securities in the Electronic Age Wall StreetLAWYER od hne f aig t across finish making chance thegood it of acceptable terms. otherwisebe unable to secure financing on latedevelopment stage issuer which would lar purposes but with added benefits to the pre-IPOTheconvertible servesbondsimi addingingsorleverage balance a tosheet. capitalwithoutimmediately dilutingearn debt and have been used by issuers to raise and equity of characteristics the blended tool.Traditionally, convertible bondshave financingversatile a as stage center taken has convertible pre-IPO the years, few next the in (“IPO”) offering initial public lucrative a for candidates strong consideredare anddevelopment stagethe leave to preparing are which companies debtissuersto andinvestors alike. Among equity andboth benefits risks) of the(and ple on the corporate menu, offering milbank.com. orafowler@ [email protected] ofthe Contacts: firm. views the reflect necessarily not do and authors the of those are article this in expressed LLP.McCloy views & The Tweed,Hadley Milbank, of Yorkoffice New the in associate senior a is er Jr.Ball, F.H. Andrew James and partner a is Fowl J y B Convertible Bonds Anticipate Issues in Pre-IPO Structuring Provisions to Road to an IPO: Bumps on the In manyinstances,In issueranwhich a has Convertiblebondshave longstabeen a From the EDITOR a m e B . H s a A & . r J , l l D N r e F . F w - - - - CONTINUED ONPAGE 3 nificantly lower rate than would be IPO convertible bond, which will have a sig madebepossible throughpre- atheuseof only may IPO an to momentum get of to financing necessary sustainto the last burst cycle.manyForsuchissuers, obtaining the ty at the worst possible time in prohibitivethe issuer’s and which life put a drain on liquiditheyoftendemand interest rateswhichare rewards,the makefinancingand available, investors are willing to look past the risks continued operation. When to their threaten even cases, extreme in development and, litigationor challenges delaythatcantheir often faceregulatory, product development companiestheindevelopment stage, which providetraditional debt financing to private turecapital investments canbe unwilling to aggressive specializing funds hedge ven in cases, even some In path. challenges its in significant few a faces still IPO an toline

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© 2007 Thomson/West. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered, however it may not necessarily have been prepared by persons licensed to practice law in a particular jurisdiction. The publisher Free Service for Subscribers is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the Online Editions Now Available advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent West Legalworks is pleased to announce that this attorney or other professional. newsletter is now available on the Internet to Subscribers of the print edition. For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, The online version offers additional interactive capabilities Danvers, MA 01923, USA (978) 750-8400; fax (978) that enhance the usefulness of your subscription including 646-8600 or West’s Copyright Services at 610 Opperman Search features for current and archived articles and Drive, Eagan, MN 55123, fax (651)687-7551. Please Links to other information and Westlaw® cases. outline the specific material involved, the number of copies you wish to distribute and the purpose or format To take advantage of this service, of the use. please visit www.glwnewsletters.com/register.asp For subscription information, please contact the publisher to register or call 800.308.1700. at: [email protected]

Editorial Board Alexander C. Gavis Michael P. Jamroz Joseph McLaughlin Vice President & Associate General Counsel Partner, Financial Services Sidley Austin, LLP CHAIRMAN: Fidelity Investments Deloitte & Touche New York, NY John F. Olson Jay B. Gould Stanley Keller William McLucas Gibson, Dunn & Crutcher Pillsbury Winthrop Shaw Pittman LLP Edwards Angell Palmer & Dodge LLP Wilmer Cutler Pickering Hale & Dorr, LLP Washington, DC San Francisco, CA Boston, MA Washington, DC ADVISORY BOARD: Joseph A. Grundfest Cary I. Klaftor Broc Romanek Professor of Law, Stanford Law School Vice President, Legal & Government Affairs, General Counsel, Executive Press, and Editor Brandon Becker and Corporate Secretary TheCorporateCounsel.net Wilmer Cutler Pickering Hale & Dorr, LLP Micalyn S. Harris Intel Corporation Washington, DC VP, General Counsel and Corporate Secretary Joel Michael Schwarz Winpro, Inc. Bruce W. Leppla Attorney, U.S. Government Blake A. Bell Lieff Cabraser Heimann & Bernstein, LLP Simpson Thacher & Bartlett Prof. Thomas Lee Hazen San Francisco, CA Steven W. Stone New York, NY University of North Carolina – Chapel Hill Morgan Lewis LLP Simon M. Lorne Washington, DC Steven E. Bochner Allan Horwich Vice Chairman Chief Wilson Sonsini Goodrich & Rosati Schiff Hardin LLP Legal Officer Laura S. Unger Palo Alto, CA Chicago, IL Millennium Partners, L.P. Former SEC Commissioner and Acting Chairman Edward H. Fleischman Teresa lannaconi Michael D. Mann John C. Wilcox Linklaters Partner, Department of Professional Practice Richards Kibbe & Orbe Senior VP, Head of Corporate Governance New York ,NY KPMG Peat Marwick Washington, DC TIAA-CREF Joel Rothstein Wolfson Banc of America Securities LLP

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 December 2007 n Volume 11 n Issue 12 associated with a conventional bond issued by the The Case of the Missed Milestone same company. Especially in the later development stage, investors are more content to trade interest For many development stage companies, there now for the potentially unlimited equity upside as- are often milestones which, if reached in a timely fashion, will be indicative of a profitable path sociated with the conversion, typically at favorable toward success. Achievement of these goals will rates, of the pre-IPO convertible bond into shares of increase, and in some cases guarantee, the issuer’s a public company down the road. If all goes accord- ability to complete its IPO within the timeline en- ing to plan, the issuer will conduct an IPO within visioned by the original deal structure and value the timeline contemplated by the terms of the bond proposition. Conversely, a failure to reach such and investors will convert at a favorable premium. milestones, while not necessarily evidence of out- There are many significant legal issues impli- right failure, will delay the completion of the IPO cated by pre-IPO convertible bonds, including, and move back investors’ potential exit window. among many others: the risk of integration of Some typical milestones for the pre-IPO com- public and private offerings under the federal se- pany include initial regulatory or licensing ap- curities laws; Section 16 -swing profit and provals, which are followed by achievement of a critical mass of subscribers or a certain size of ownership issues; the scope and substance of customer base, (or for a manufacturer, produc- anti-dilution protections; dealing with the rights tion of a certain number of units of its product.) of investors in previous financing rounds; and last As noted below, counsel should work with - but far from least, the overriding need to ensure ers and others familiar with the fundamentals of that the viability of the IPO is never jeopardized. an issuer’s business plan, since the synergies of the These topics are important, but we wish to fo- relevant factors can also define whether or not a cus here on the mechanisms that counsel to the company’s plan achieves full potential. From the issuer, investors and the placement agent can put investors’ standpoint, the key is to ask what are in place to address the bumps on the road that a the most important steps required for the issuer’s pre-IPO issuer may face. success and what the effect on the issuer would be Because convertible bonds generally, and pre- if they were not achieved. IPO convertible bonds in particular, tend to be In many cases, the importance of including trig- gers for regulatory milestones, as well as what used by companies that are smaller and riskier those milestones are, will be self-evident to inves- than those that can finance their growth with tors and their counsel, especially in a highly regu- straight debt, there is no “one size fits most” pre- lated or specialized industry, or one where the scription for structuring to proactively address company is dependent on new technology or pat- the growing pains which these issuers can face. ents. Nonetheless, when structuring to deal with Nonetheless, certain common patterns emerge. the fallout of a possible missed milestone, counsel Investors often demand and receive protection should be careful to ensure both that the material from potential pitfalls by means of adjustments to alternative outcomes are addressed by the specified interest rates or conversion terms. Common trig- alternatives of the deal terms and that the triggers gers include: failure to meet, or a delay in meet- and associated penalties or adjustments do not ing, development milestones or goals; an inability tie the issuer’s hands unnecessarily. While inves- to acquire necessary patents or secure the rights tors’ counsel can and should insist on appropri- ate adjustments to the interest or conversion rate, to key intellectual property; problems with litiga- care should be taken that the ability of the issuer’s tion; or a loss of key managerial or creative per- management to take remedial action and deal with sonnel. The implications of each of these scenar- regulatory authorities is not compromised or lim- ios on the provisions of the pre-IPO convertible ited by clauses requiring consultation or shared bond are discussed below, with the most detailed decision-making. While such measures may be treatment given to the missed milestone, the most appropriate in limited circumstances, presumably common scenario. investors should have faith that the issuer’s man-

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agement has the capacity to deal with regulatory dress key areas where investors might otherwise challenges as part of their general competence in demand a higher interest premium, or decline to running the business. It is also crucial to provide provide financing if not otherwise compensated if that adjustments or penalties are proportionate the contingency occurred. to the actual importance to the issuer’s prospects A practical example of how the conversion of the milestone, or one step toward the ultimate terms and interest rate of a hypothetical issuer milestone, being considered. In certain industries, might be affected by a missed milestone is illus- for example, the acquisition of one permit may en- trated by the following hypothetical example. sure that other related permits will be forthcoming without difficulty, but counsel should take care to Case Study: Cyclops Optics Systems consult with the business people on both sides of Hypothetical issuer Cyclops Optics Systems the transaction to make sure that the triggers and (“Cyclops”) designs and develops weapon sight- remedies work as planned in the real world. ing systems for military applications. After five [W]hen structuring to deal with the fall- years of work, and several rounds of venture cap- out of a possible missed milestone, coun- ital financing totaling over $300 million, Cyclops sel should be careful to ensure both that has produced two prototype weapon sighting the material alternative outcomes are ad- systems which are designed for use on helicop- dressed by the specified alternatives of the ters. Based on analysis prepared by its investment deal terms and that the triggers and asso- banking advisers, Cyclops has strong prospects to ciated penalties or adjustments do not tie move toward sufficient earnings and capitaliza- the issuer’s hands unnecessarily. tion to justify an IPO within the next two years. There are three main areas where Cyclops must Similarly, once necessary regulatory approval, meet goals to develop: first, on the regulatory patents or licensing approvals have been ob- front, it must win a key patent and obtain gov- tained, the issuer must be able to exploit its inno- ernmental approval to mass produce its weapon vation by either licensing its product or service to sighting systems; second, it must be able to secure others to develop, or moving into the production necessary components in adequate quantities and phase itself. Here, counsel should consider the on a timely basis to move into production; and necessity of triggers to compensate investors for third, it must successfully contract and sell to cus- any delay in achievement of fundamentals such tomers enough of its units to remain viable and as satisfactory productions levels and successful generate a profit as soon as possible. sales, as well as the possible impact of unavail- To address these issues, provisions should be ability of supplies, any of which could affect the added to the conversion adjustments section of issuer’s ability to sustain momentum into the pro- the convertible bond terms which compensate in- duction phase. vestors with a more favorable conversion ratio if When counsel is focusing on how a variety of these milestones are not reached in time. The ad- factors may come together (or, may not come to- justments to the conversion rate may also be ac- gether, as it were) to impact a company’s success, companied by increases in the interest rate which investors may ask why do we need specificity in rise in parallel with the severity of the missed the triggers at all? Investors in a pre-IPO convert- milestone. These interest rate increases may fall ible bond are usually already compensated by an away if the goal is later achieved. increased interest rate or, less commonly, a gen- As a preliminary matter, the mechanics of con- eral ratchet improving the conversion rate of the version adjustments must take into account the convertible bonds, if the IPO is not completed on extent to which there is a quantifiable component schedule. Arguably, this mechanism is designed as to the achievement of a goal as a function of the a “fail safe” to pick up any scenario where success issuer’s . For example, if achieve- eludes the issuer, regardless of the cause. The ad- ment of a given goal will comprise, for sake of justments discussed in this article should be seen argument, roughly 10% of a given issuer’s valu- as supplements to that general mechanism to ad- ation, then a fairly straight forward adjustment

 December 2007 n Volume 11 n Issue 12

may be made to increase the conversion rate by ately be reduced to an amount equal to 10% if the goal is not reached within a specific the product of (x) the Conversion Price in time. In cases where a product or service must be effect immediately prior to such date and certified by government or other regulatory body (y) .75 (seventy-five percent).](Example 1) to meet certain performance goals, it may make sense to match adjustments to reflect the ratio The reduction posits that a delay in this milestone to which achieved results bear to desired results, would reduce the enterprise value by 25%, and such that if a product meets 80% of its desired effects a proportional adjustment in the conver- performance, the conversion rate will be reduced sion price. by 20%. For requirements regarding projected The second scenario is one where the necessary production numbers, sales figures or number of patents are obtained within the right timeframe, contracts, the percent of actual completion as a the issuer moves to the government approval proportion of achieved results may be a useful phase, but the product does not perform to full metric. These proportional adjustments can be specifications. As noted above, the adjustment easier to conceptualize and justify to the company in this event could be tied to the extent to which and investors, as there is a sense of inherent fair- the product performed according to specification, ness if reductions in conversion rate are tied to a such that if it was 85% effective, then the rate proportionate decrease in value or performance would take this proportionately into account. If metrics. Of the three, adjustments tied to a reduc- tied to a reduction in enterprise value, the adjust- tion in overall enterprise value may offer a more ment could be structured as follows: accurate change to the conversion rate and be less punitive for the issuer. [If the Patent Event is reached by DATE 1 For our hypothetical issuer Cyclops, assuming and the Government Approval is obtained the issuer is required to undertake an IPO within on or prior to DATE 2, but the product is two years of the date of issue of the convertible certified only for daytime use and not for bonds (the “Required IPO Date”), the provisions nighttime use, then the Conversion Price in could take the form of a series of increasingly in- effect on such date shall immediately be vestor-favorable adjustments to the conversion reduced to an amount equal to the prod- rate. Since the patent and the governmental ap- uct of (x) the Conversion Price in effect proval process here are being undertaken in par- immediately prior to such date and (y) .85 allel, the interplay between the milestones would (eighty-five percent).](Example 2) be especially important here. The other key fac- tor would be the dates on the original timetable The reduction posits that a delay in this milestone by which these goals would ideally be reached to would reduce the enterprise value by 15%, and keep the issuer on track as originally planned. effects a proportional adjustment in the conver- The first general scenario is one where the nec- sion price. If tied to the relative performance of essary patents are obtained (the “Patent Event”) the product when compared to expected results, within a timeframe that permits the issuer to the adjustment might be more severe for the is- move to the government approval phase, but suer, depending on the measures and the range of the governmental approval (the “Government variance between expected and obtained results. Approval”) does not occur by the contemplated Such a provision would work as follows: date under the original plan. Here the adjustment could be tied directly to the reduction of the en- [If the Patent Event is reached by DATE 1 terprise value as compared to projections if the and the Government Approval is obtained goal had been reached as follows: on or prior to DATE 2, but the product is certified only for daytime use and not for [If the Patent Event is reached by DATE 1, but nighttime use, then the Conversion Price in the Government Approval is not obtained effect on such date shall immediately be on or prior to DATE 2, then the Conversion reduced to an amount equal to the product Price in effect on such date shall immedi- of (x) the Conversion Price in effect imme-

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diately prior to such date and (y) a frac- function without the litigation counterparty being tion, the numerator of which is the number aware of them, since if the litigation counterparty of proposed applications where a daytime- discovers that the outcome of their case also may only sight can be used (“Results”) and the relieve the issuer of a penalty provision, their le- denominator of which is the number of verage over the issuer will be increased. Counsel proposed applications where a dual-capa- should note that documents embodying the terms bility daytime and nighttime sight can be of pre-IPO financings will nearly always constitute used (“Plan”).](Example 3) material contracts which will be required to be filed publicly as exhibits to the issuer’s registration state- The relative complexity of such a provision makes ment in connection with an IPO. Applications for it more suitable when approvals involve perfor- confidential treatment to prevent disclosure will be mance measure that are relatively easy to quan- appropriate for such provisions. However, these tify, such as speed, fuel efficiency or applicability provisions may be deemed material to investors’ to one or more uses. Because this type of provi- decision to purchase shares in the IPO and there- sion may also function more capriciously than an fore confidential treatment may not be permitted. adjustment tied to enterprise value, metrics used In any event, it is likely that litigation would be should be as clearly identified as possible in the resolved prior to commencement of the IPO for drafting phase to prevent disputes later. A simi- marketing reasons. lar mechanic can satisfactorily address deviation Pre-IPO adjustments to address negative results from sales or production projections. in an ongoing litigation would often track Exam- The third scenario, where neither the relevant ple 1 above, and investors would be compensated patents or the required government approvals are by the reduction in value with a favorable reduc- obtained, could typically be addressed by a vari- tion in the conversion rate. One possible way to ant of the first scenario but with a greater reduc- protect investors in the period following the IPO tion of the enterprise value. is by using a weighted average of the trading pric- The attendant increase in interest rate is concep- es -- after the negative litigation outcome (“Nega- tually much simpler, and typically would simply tive Litigation Event”) is disclosed – as the lower call for an incremental accretive increase in inter- end of the adjustment. This would help guaran- est rate upon each missed milestone noted above, tee investors’ conversion optionality is not “out with additional penalty increases if the situation of the money” in the wake of an expected is not remedied subsequently. These additional in- price drop following the negative news disclosure. terest provisions would typically fall away upon Such a provision could work as follows: the attainment of the relevant goal. [Upon the occurrence of Negative Litiga- Litigation Pitfalls: The (Multi) tion Event, the Conversion Price then in ef- Million-Dollar Nightmare fect shall be reduced to an amount equal to the lower of (x) the Conversion Price in Similarly, a pre-IPO issuer may face litigation effect immediately prior to such Negative that can hamper its ability to make use of technol- Litigation Event and (y) the -volume ogies or resources on which its success depends. weighted average of the Weighted Average In essence, the favorable settlement of litigation is Price of the for the 20 Trad- treated as a milestone, and an issuer that cannot ing Days beginning on the firstT rading Day end litigation is penalized by an increase in the following such Negative Litigation Event.] interest rate and/or adjustments to the conversion terms which are favorable to investors. A similar approach can be taken for post-IPO ad- There are certain special considerations involved justments for any material negative event. with structuring triggers around litigation which do not apply so clearly in the context of regula- Loss of Key Executive tory approval. It is important for counsel to design provisions addressing the existence of litigation to Another scenario where investors may require protection is in the event of the loss of certain key

 December 2007 n Volume 11 n Issue 12 managerial or technical employees, on whom the Some Final Thoughts success of the business is perceived to depend. The Although coverage of all the scenarios where adjustment here would track Example 1 above, adjustments or other provisions could be appro- with the variation that (arguably) the adjustment priate is beyond the scope of this article, some should be removed if a suitable replacement for the other considerations are worth noting in brief. In key executive was located. In such a case, inves- appropriate cases, counsel should consider if in tors would presumably have to be provided with addition to interest rate and conversion adjust- some input into the determination as to whether ments, that investors should seek springing board or not the replacement was comparable, perhaps seats, whereby investors may appoint board members only if certain events occur. One such through giving investors one of three votes on a event might be the loss of key personnel discussed panel (with the other two being independent of above. Such springing board seats could be tem- the company). Issuers and their advisers can be porary or permanent depending on the underly- understandably sensitive about the key executive ing issue which gives rise to the right. issue, but if one or more members of the man- Adjustments to interest rates and conversion agement team are really indispensable, there is no terms can often mean the difference between a reason why investors should not be compensated deal getting done on terms that are commercially for any decrease in value associated with their de- viable for the issuer or not done at all. Some atten- tive drafting and close consultation between the parture, regardless of the cause. lawyers and business people can construc- tive, creative solutions that both protect investors Another scenario where investors may re- while allowing the issuer the financing it needs to quire protection is in the event of the loss bring its business plan to full fruition through a of certain key managerial or technical em- successful IPO. ployees, on whom the success of the busi- ness is perceived to depend.