Memorandum: Net Present Value and Apex Investment Partners

MEMORANDUM To Apex Investment Partners: According to my analysis of the Accessline’s proposed term sheet, I do not believe that Apex would serve its own interests, or those of its investing partners, by investing in Accessline according to the terms proposed. By investing at the proposed valuation, according to the proposed control and incentive structure, Apex would be shouldering a disproportionate share of the risk should Accessline fail to meet its performance targets, or require fresh inflows of capital from future investment rounds.

Nor can Accessline take the sort of steps necessary to protect its investment in the case of management failure. Should Apex make a counter-offer, I would suggest the following terms: Valuation: Accessline’s projected revenues in 1999 are $208m. Using the average price/revenue ratio of 3com and Boston Technologies, it seems reasonable to expect an IPO valuation at 3. 67 times revenues, producing gross proceeds of $764m with a present value of $116m (using our 60% discount rate).

Assuming that Accessline meets this revenue target, and that no future funding is required, Apex will take a slight loss on its required rate of return, barring the voluntary distribution of the dividend from the board of directors, on which we are not offered a seat. The present price per share at such an exit would be approximately $7. 84. However, given Accessline’s historical burn rate, it seems unreasonable to expect the $16m investment produced in Series B to last Accessline until 1999.

Assuming Accessline will need another $32m to reach its revenue targets by 1999, Apex takes a much more severe loss relative to its required rate of return. The present price per share at such an exit, assuming the new shares are also offered at $8 per share, would be $6. 18 per share. I therefore suggest using $6 per share as a point for a new valuation of the company, assuming the inclusion/revision of terms as described below. Rights and Preferences Apart from the valuation, other elements of the term sheet must be adjusted to allow Accessline to protect its interests and motivate or replace management in the case of performance failure.

First and foremost, Apex must insist on the right to elect one director to the board. Series A investors already have one seat, and the current voting clauses allow Series A to effectively retain control of decision making by requiring 2/3rds majority for many key decisions. Should future funding rounds be required, those investors may insist on seats on the board. Apex must remove antidilution protection from employee shares, as this removes a significant incentive for employees and management to reduce Accessline’s burn rate.

However, as Series A investors retain a veto over the deal, their shares must be allowed to retain anti-dilution protection. Additionally, we may propose a point at which additional investment rounds (above and beyond $32m of fresh capital) would cause dilution of ESOP shares at an accelerated rate. Dividends should be made cumulative and issuable upon a liquidation event or an IPO. Such dividends may be converted, if the holder desires, to common shares. This will encourage management to seek a quicker exit. Liquidation preference must be strengthened in other ways.

In my opinion, the current arrangement allows management and employees to receive unjustified returns in the case of a liquidation. I suggest a ratio of 1. 5 times the Series B purchase price, applicable to Series A shares, with the remainder to be distributed among Series A, Series B, and common shareholders/ESOP on an as-if-converted basis. In an IPO, Series B shares should auto-convert at a ratio of one-to-one at a target price of $12 until June 30th and $15 after June 30th 1996. After that, the targets must continue to ratchet upwards.

The written consent of 3/4ths of Preferred shareholders could override this requirement while preserving Apex’s ability to veto auto-conversion. This voting ratio should also be employed in the voting clause, since without it Apex lacks any ability to control future funding rounds. Series B must be allowed to redeem all of their shares upon the failure of Accessline to come within 5% of its revenue and income projections for 2 consecutive years. Alternatively, Apex could require that unvested management/ESOP shares be returned to Series A and Series B on a pari passu basis in the case of performance failure.

Alternatively, Accessline could insist on a right to replace management in the case of this eventuality. Given the large number of competitors already present in the market, it is likely that if Accessline’s business fails, it will do so quickly and drastically. Negotiation considerations It is important to note that a counterproposal from Accessline that strengthens or enhances any of these provisions in Apex’ favor in exchange for a higher issue price of the Series B shares should be considered.

However, there are limits to the premium we should pay for enhanced control, and firm limits for how far such control can be reduced. A board member and the voting rules are non-negotiable. The dividend and the autoconversion terms, however, are places in which we can demonstrate flexibility. At this price, with these changes to the term sheet, we are still exposed. Significant competitive, regulatory, or technological changes in the marketplace could quickly destroy Accessline’s profitability.

This is, as it stands, a strong counterproposal that is bound to meet resistance from management and employees, but provided we preserve Series A’s valuation, I believe Series A investors will be inclined to allow us more control and latitude provided the performance requirements for management are strengthened. Since I believe our competitors will also propose lower valuations based on a view of these same numbers, we must act tactfully. Perhaps some sort of parachute can be arranged for senior management in the event of a takeover.