ETRM Enteromedics

PROPOSAL 1—PREFERRED STOCK CONVERSION PROPOSAL

Background

        On May 22, 2017, we completed our acquisition of BarioSurg, Inc., a Delaware corporation ("BarioSurg"), pursuant to the terms of an Agreement and Plan of Merger (the "Merger Agreement"), among EnteroMedics, BarioSurg, Acorn Subsidiary Inc., a Delaware corporation and our wholly owned subsidiary ("Merger Sub"), Acorn Subsidiary Holdings LLC, a Delaware limited liability company and our wholly owned subsidiary ("Sub LLC"), and Dr. Raj Nihalani, solely in his capacity as representative of BarioSurg's stockholders and option holders (collectively, the "equity holders"), pursuant to which, among other things, Merger Sub merged with and into BarioSurg, with BarioSurg surviving as our wholly owned subsidiary (the "Merger"). BarioSurg was subsequently merged with and into Sub LLC, with Sub LLC as the surviving company. The Merger was approved by our Board of Directors.

        BarioSurg developed the Gastric Vest System™, an investigational, minimally-invasive, laparoscopically implanted medical device being studied for weight loss in morbidly obese patients. The device, which wraps around the stomach and emulates the effect of conventional weight loss surgery, is intended to enable gastric volume reduction without permanently changing patient anatomy. We believe that our acquisition of BarioSurg will help us move toward building a comprehensive bariatric and metabolic continuum of care platform to effectively address unmet needs within these areas.

        The aggregate merger consideration we paid for all of the outstanding shares of capital stock and outstanding options of BarioSurg was:

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1,380,684 shares of our common stock, representing 19.99% of our outstanding common stock immediately prior to the Merger;



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1,000,181 shares of our newly created conditional convertible preferred stock, par value $0.01 per share, which shares will convert into 5,000,905 shares of common stock subject to and contingent upon the approval of our stockholders in accordance with the NASDAQ Stock Market Rules; and



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$2 million in cash, less the amount of third party expenses that we paid on behalf of BarioSurg, as set forth in the Merger Agreement.

        At the closing of the Merger, 100,018 shares of conditional convertible preferred stock were deposited with an escrow agent to fund-post closing indemnification obligations of BarioSurg's former equity holders. The issuance of the common stock and conditional convertible preferred stock in connection with the Merger was intended to be exempt from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act") pursuant to Section 4(a)(2) thereof and Regulation D promulgated thereunder, based upon representations and certifications that we obtained from BarioSurg and its equity holders.

        Although stockholder approval was not required for the Merger, under the terms of the Merger Agreement, we agreed to use commercially reasonable efforts to call and hold a meeting of our stockholders to obtain the requisite approval for the conversion of the conditional convertible preferred stock into shares of common stock, as required by the NASDAQ Stock Market Rules, within 120 days after the date of the Merger Agreement (which deadline has subsequently been extended by agreement between the parties) and, if such approval is not obtained at that meeting, to seek to obtain such approval at an annual or special stockholders meeting to be held at least every six months thereafter.

        Therefore, we are seeking stockholder approval for the issuance of 5,000,905 shares of our common stock upon the conversion of 1,000,181 shares of our conditional convertible preferred stock in

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order to comply with Rule 5635 of the NASDAQ Listing Rules and the limitations set forth therein. NASDAQ Listing Rule 5635 requires stockholder approval prior to, among other things:

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the issuance of securities in connection with a transaction other than a public offering involving the sale, issuance or potential issuance by us of our common stock (or securities convertible into or exercisable for common stock) equal to 20% or more of the common stock or 20% or more of the voting power outstanding immediately before the issuance; and



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the issuance of securities when the issuance or potential issuance will result in a change of control of the company. Under the NASDAQ rules, generally a change of control would occur when, as a result of the issuance, an investor or a group would own, or have the right to acquire, 20% or more of the outstanding shares of common stock or voting power and such ownership or voting power would be the largest ownership position.

        You are being asked to approve the issuance of the shares of common stock issuable upon conversion of the conditional convertible preferred stock because:

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the issuance of such shares, when combined with the shares of common stock issued at the closing of the Merger, would exceed 19.99% of the voting power and number of shares of common stock outstanding immediately prior to the Merger; and



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the issuance of such shares, when combined with the shares of common stock issued at the closing of the Merger, may be deemed to result in a change of control of our company under the applicable NASDAQ rules. The transactions contemplated by the Merger Agreement may be deemed to be a change of control of our company because in connection with the Merger (i) Dr. Nihalani will own, or have the right to acquire, approximately 34% of the outstanding shares of our common stock, measured immediately after the Merger, which represents our largest ownership position as of such time, assuming conversion of the conditional convertible preferred stock into common stock, and (ii) pursuant to the voting agreement described below, Dr. Nihalani has agreed to vote his shares of common stock (including shares of common stock that he beneficially owns in his capacity as representative of BarioSurg's equity holders) in accordance with the recommendations of our Board of Directors. Prior to the consummation of the Merger, Dr. Nihalani did not own any shares of our common stock and the members of our Board of Directors owned in the aggregate approximately 3.4% of our outstanding common stock.

        The shares of common stock issued at the closing of the Merger represented approximately 10.4% of the total outstanding shares of common stock immediately following the Merger and approximately 7.1% of the total outstanding shares of common stock as of the record date. Subject to receipt of the required approval of our stockholders, the number of shares of common stock to be issued upon conversion of the shares of conditional convertible preferred stock represents approximately 37.6% of the total outstanding shares of common stock immediately following the Merger and approximately 25.6% of the total outstanding shares of common stock as of the record date, each on an as-converted basis. Collectively, the shares of common stock and conditional convertible preferred stock (assuming conversion of the conditional convertible preferred stock into common stock) issued in connection with the Merger represent approximately 48.0% of our issued and outstanding capital stock immediately following the Merger and approximately 32.6% of our issued and outstanding common stock as of the record date, each on an as-converted basis. Shares of conditional convertible preferred stock are non-voting until the receipt of the required stockholder approval.

Effects of Approving the Conversion

        If our stockholders vote to approve the conversion of 1,000,181 shares of conditional convertible preferred stock into 5,000,905 shares of our common stock, the conversion, and our issuance of

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common stock necessary to effect the conversion, will occur automatically upon the approval by our stockholders and will not require any additional approval by us, our common stockholders, or the holders of the conditional convertible preferred stock. The shares of conditional convertible preferred stock that are converted into shares of common stock will revert to the status of authorized but unissued and undesignated shares of conditional convertible preferred stock. Upon the conversion, in addition to any other holdings they may have, the former holders of the conditional convertible preferred stock in the aggregate would hold approximately 32.6% of our common stock outstanding, based on the number of shares of common stock outstanding on the record date assuming conversion of the conditional convertible preferred stock. In particular, Dr. Nihalani would hold approximately 23.9% of our common stock outstanding based on the number of shares of common stock outstanding on the record date assuming conversion of the conditional convertible preferred stock. The common stock issued in the conversion would dilute the percentage ownership of the holders of common stock currently outstanding, and the resale of these shares could have an adverse effect on the trading price of our common stock. The shares issued to the former BarioSurg equity holders in connection with the Merger were issued in a transaction intended to be exempt from registration under the Securities Act. Therefore, those shares are not currently freely tradeable under the federal securities laws. However, those shares will become tradeable upon the expiration of the holding period under Rule 144 promulgated under the Securities Act, subject to and in accordance with any restrictions set forth in Rule 144.

Effects of Failure to Approve the Conversion

        If our stockholders do not approve the Preferred Stock Conversion Proposal, under the terms of the Merger Agreement, we will be required to continue to seek the requisite stockholder approval for the conversion of the conditional convertible preferred stock into common stock at subsequent annual or special meetings to be held at least every six months until such approval is obtained, which would be time consuming and costly.

        Until we obtain the requisite stockholder approval, the conditional convertible preferred stock will remain outstanding in accordance with its terms. The terms of the conditional convertible preferred stock, which are set forth in the certificate of designation of preferences, rights and limitations of conditional convertible preferred stock filed with the Secretary of State of Delaware (the "certificate of designation"), are briefly summarized below:

        Dividends:     The conditional convertible preferred stock is entitled to receive dividends (on an as-if-converted-to-common stock basis) actually paid on shares of common stock when, as and if such dividends are paid on shares of common stock. No other dividends will be paid on shares of conditional convertible preferred stock. The certificate of designation does not provide for any restriction on the repurchase of the conditional convertible preferred stock by us while there is any arrearage in the payment of dividends on the conditional convertible preferred stock. There are no sinking fund provisions applicable to the conditional convertible preferred stock.

        Voting Rights:     In general, the conditional convertible preferred stock does not have voting rights. However, as long as any shares of conditional convertible preferred stock remain outstanding, the certificate of designation provides that we shall not, without the affirmative vote of holders of a majority of the then-outstanding shares of conditional convertible preferred stock, (a) alter or change adversely the powers, preferences or rights given to the conditional convertible preferred stock or alter or amend the certificate of designation, (b) amend our certificate of incorporation or other charter documents in any manner that adversely affects any rights of the holders of conditional convertible preferred stock, (c) increase the number of authorized shares of conditional convertible preferred stock or (d) enter into any agreement with respect to any of the foregoing.

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        Liquidation:     In the event of a liquidation, the holders of shares of conditional convertible preferred stock are entitled to an amount equal to the par value per share of conditional convertible preferred stock, plus any accrued but unpaid dividends thereon, and to participate on an as-converted-to-common stock basis with holders of the common stock in any distribution of our assets to the holders of common stock. In addition, in the event we consummate a merger or consolidation with or into another person or other reorganization event in which our common shares are converted or exchanged for securities, cash or other property, or we sell, lease, license, assign, transfer, convey or otherwise dispose of all or substantially all of our assets or we or another person acquire 50% or more of our outstanding shares of common stock, then following such event, the holders of the conditional convertible preferred stock will be entitled to receive upon conversion of the conditional convertible preferred stock the same kind and amount of securities, cash or property which the holders would have received had they converted the conditional convertible preferred stock immediately prior to such fundamental transaction. Any successor to us or surviving entity shall assume the obligations under the certificate of designation with respect to the conditional convertible preferred stock.

        Conversion:     Each share of conditional convertible preferred stock will be automatically converted into five shares of common stock at 5:00 p.m. Central time on the date that our stockholders approve the Preferred Stock Conversion Proposal, without any further action by the holder thereof. In no event will the conditional convertible preferred stock convert into shares of common stock prior to the approval by our stockholders of the Preferred Stock Conversion Proposal. Shares of conditional convertible preferred stock converted into common stock will revert to the status of authorized but unissued and undesignated shares of conditional convertible preferred stock. We do not intend to apply for listing of the conditional convertible preferred stock on any securities exchange or other trading system.

Interests of Certain Persons in the Transaction

        On May 22, 2017, in connection with and as a condition to the execution of the Merger Agreement, we entered into a voting agreement and irrevocable proxy with Dr. Raj Nihalani, the founder and Chief Executive Officer of BarioSurg, pursuant to which Dr. Nihalani agreed to vote all shares of our common stock he owns after the Merger, including shares of common stock issued upon conversion of conditional convertible preferred stock, in accordance with the recommendation of our Board of Directors. Dr. Nihalani holds approximately 23.9% of the outstanding common stock as of the record date (assuming conversion of the conditional convertible preferred stock into common stock). Except for certain limited exceptions, including transfers permitted under Rule 144 of the Securities Act, Dr. Nihalani agreed to not transfer any common stock owned, subject any common stock owned to any pledges, liens or other encumbrances or arrangements, or grant any proxies or powers of attorney with respect to any common stock in contravention of the obligations under the voting agreement. The voting agreement will terminate upon the earlier of (i) the date Dr. Nihalani and his affiliates no longer beneficially own at least 5% of our outstanding capital stock or (ii) our written notice to Dr. Nihalani of termination of the voting agreement.

        We also entered into an employment agreement with Dr. Nihalani pursuant to which he serves as our Chief Technology Officer. The employment agreement provides for an annual base salary of $300,000 and a potential cash incentive payment of up to 32% of annual base salary. Dr. Nihalani also entered into an indemnification agreement with us in substantially the same form as our other executive officers. In connection with the Merger Agreement, we entered into a non-competition agreement with Dr. Nihalani pursuant to which Dr. Nihalani agreed, among other things, not to engage in any business activities that are directly related to bariatric surgery medical devices for a period of three-years after the Merger.

        As a result of the voting agreement, each member of our Board of Directors, in his or her capacity as a member of the Board of Directors, may be deemed to be the beneficial owner of, and have shared

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voting power with respect to, the shares owned by Dr. Nihalani. Collectively, our directors and executive officers as a group beneficially own approximately 26.4% of our outstanding common stock as of the record date, including shares they may be deemed to beneficially own as a result of the voting agreement with Dr. Nihalani. As a result of Dr. Nihalani's share ownership and the voting agreement and irrevocable proxy, our Board of Directors and executive officers are able to influence matters requiring stockholder approval, such as the election of directors and approval of significant corporate transactions. The interests of our Board of Directors and executive officers may differ from the interests of our other stockholders. For example, our Board of Directors and executive officers could oppose a third party offer to acquire us that the other stockholders might consider attractive. In such case and in similar situations, our other stockholders may disagree with our Board of Directors and executive officers as to whether the action opposed or supported by our Board of Directors and executive officers is in the best interest of our stockholders.

Vote Required

        The affirmative vote of the holders of a majority of the shares present in person or represented by proxy and entitled to vote on the Preferred Stock Conversion Proposal at the special meeting will be required to approve the Preferred Stock Conversion Proposal. However, the 1,380,684 shares of common stock that were issued to former BarioSurg equity holders in connection with the Merger are not entitled to vote on this proposal.

Board Recommendation

         The Board of Directors unanimously recommends a vote FOR the approval of the Preferred Stock Conversion Proposal.