CONVERTIBLE NOTE, WARRANT AND COMMON STOCK PURCHASE AGREEMENT

Exhibit 10.3

PHOTOWORKS, INC.

CONVERTIBLE NOTE, WARRANT AND

COMMON STOCK PURCHASE AGREEMENT

THIS CONVERTIBLE NOTE, WARRANT AND COMMON STOCK PURCHASE AGREEMENT ( the PURVI1#147; Agreement PURVI1#148;) is made as of the 16th day of February, 2005 (the “ Effective Date ”) by and among PHOTOWORKS, INC., a Washington corporation (the “ Company ”), and Sunra Capital Holdings, Ltd. (the “ Purchaser ” ).

RECITALS

A.         On the terms and subject to the conditions set forth herein, the Company desires to issue and sell, and the Purchaser desires to purchase (i) at the Initial Closing (as defined below), a convertible note in the principal amount set forth opposite the Purchaser’s name on Schedule 1 attached hereto and in substantially the form attached to this Agreement as Exhibit A (the “ Note ”), which shall be convertible on the terms stated therein into Common Stock of the Company, par value $0.01 per share (the “ Common Stock ”), and a warrant to purchase Common Stock of the Company, in substantially the form attached to this Agreement as Exhibit B (the “ Warrant ”) to purchase that number of shares of Common Stock indicated with respect to the Purchaser on Schedule 1 attached hereto and (ii) at the Second Closing (as defined below), that number of shares of Common Stock of the Company (the “ Stock ”) in the range set forth opposite the Purchaser’s name on Schedule 1 attached hereto and a Warrant to purchase that number of shares of Common Stock as determined pursuant to Section 1.2 below. The shares of Common Stock issuable upon exercise of the Warrants shall be hereinafter referred to as the “ Warrant Shares ”. The Note, the Warrants, the Warrant Shares, the Stock and the Common Stock issuable upon conversion of the Note are collectively referred to herein as the “ Securities ”.

B.         Capitalized terms not otherwise defined herein shall have the meanings set forth in the form of Note or Warrant, as applicable.

NOW, THEREFORE, the parties hereby agree as follows:

1.1   The Note and Warrant at the Initial Closing . Subject to the terms of this Agreement, the Purchaser hereby agrees to purchase at the Initial Closing from the Company and the Company agrees to sell and issue to the Purchaser a Note in the principal amount set forth on Schedule 1 opposite the Purchaser’s name against the issuance and delivery by the Company of such Note and a Warrant to purchase that number of shares of Common Stock indicated with respect to the Purchaser on Schedule 1.

1.2   The Stock and Warrant at the Second Closing . Subject to the terms of this Agreement, the Purchaser hereby agrees to purchase at the Second Closing from the Company that number of shares of Stock in the range set forth opposite the Purchaser’s name on Schedule 1 attached hereto at a purchase price of $0.1078 per share and a Warrant to purchase that number of shares of Common Stock equal to (a) 20% of the aggregate purchase price of the Stock

purchased by the Purchaser at the Second Closing divided by (b) $0.21. Notwithstanding the foregoing, the obligations of the Purchaser to purchase the Stock and a Warrant in the Second Closing pursuant to this Section 1.2 may be assigned in whole or in part to an affiliate of Purchaser (a " Sunra Affiliate ") and/or Matinicus, LP or its affiliates (collectively, " Matinicus "). If Matinicus or a Sunra Affiliate participate in the Second Closing, then such additional purchaser shall (i) become a party to this Agreement and any other agreements contemplated hereby, and (ii) have the rights and obligations hereunder and thereunder, by executing and delivering to the Company an additional counterpart signature page to this Agreement and such additional agreements. Any additional purchaser so acquiring shares of Common Stock and Warrants at the Second Closing shall be considered a “ Purchaser ” for purposes of this Agreement, and any Common Stock or Warrants so acquired by such additional purchaser shall be considered “ Stock ” “ Warrants ” or “ Warrant Stock ,” as applicable, for purposes of this Agreement and all other agreements contemplated hereby. Exhibit A will be amended at the Second Closing, as necessary, to list the Purchasers in the Second Closing.

2.1         Initial Closing Date . The initial closing of the purchase and sale of the Note and Warrant pursuant to this Agreement (the “ Initial Closing ” ) shall be held on the Effective Date, or at such other time as the Company and the Purchaser shall agree (the “ Initial Closing Date ” ). The Initial Closing shall take place at the principal executive offices of the Company located at 1260 16th Avenue West, Seattle, WA 98119. In the event there is more than one closing, the term “ Closing ” shall apply to each such closing, unless otherwise specified herein.

2.2         Delivery at Initial Closing. At the Initial Closing, the Company shall deliver to the Purchaser the Note and Warrant to be purchased by the Purchaser against (a) payment of the purchase price therefor by check payable to the Company or by wire transfer to a bank designated by the Company, (b) delivery of counterpart signature pages to this Agreement and the Warrant, and (c) delivery of a validly completed and executed IRS Form W-8 BEN or IRS Form W-9, as applicable, establishing the Purchaser’s exemption from withholding tax, which forms are attached to this Agreement as Exhibit C .

2.3         Second Closing. Within 10 business days of the approval of the Recapitalization Proposal by the Company’s shareholders (the “ Second Closing Date ” ), the purchase and sale of the Stock and Warrant in the amounts set forth on Schedule 1 (the “ Second Closing ”) shall take place at the Company’s principal executive offices or at such other time and place as the Company and the Purchaser shall agree in writing. The Company shall notify the Purchaser as soon as practicable following the annual meeting as to whether the Recapitalization Proposal was approved. The term “ Closing Date ” shall apply to both the Initial Closing Date and Second Closing Date, unless otherwise specified herein. The Company agrees to submit the Recapitalization Proposal to the Company's shareholders on or before May 31, 2005.

2.4         Delivery at Second Closing. At the Second Closing, the Company shall deliver to the Purchaser a certificate representing the Stock and a Warrant for the number of Warrant Shares which that Purchaser is obtaining against payment of the purchase price therefor by check payable to the Company or by wire transfer to a bank designated by the Company.

2.5         Use of Proceeds . The Company shall use the proceeds from the sale of the Note, Stock and Warrants for general corporate purposes.

For purposes of this Agreement the following terms shall have the following meanings:

3.2         “ Intellectual Property ” shall mean patents, patent applications, trademarks, service marks, mask works, trade names, copyrights, trade secrets, information, proprietary rights and processes.  

3.3         “ Incentive Plans ” shall mean collectively the Incentive Stock Option Plan as amended and restated as of April 1, 1996, the 1987 Stock Option Plan, as amended and restated as of April 1, 1996, the 1993 Employee Stock Purchase Plan, as amended and restated as of May 31, 1995, the 1999 Employee Stock Option Plan dated October 20, 1999, the 1999 Stock Incentive Compensation Plan, approved by the Company’s board of directors on November 23, 1999 and as later amended, and the Nonqualified Stock Option Agreement between the Company and Philippe Sanchez dated October 17, 2003.

3.4         “ Material Adverse Event ” shall mean any change, event or effect that is materially adverse to the general affairs, business, operations, assets, condition (financial or otherwise) or results of operations of the Company and its Subsidiaries taken as a whole; provided, however, that the following shall not be taken into account in determining a “Material Adverse Event”: (a) any adverse change, event or effect that is directly attributable to conditions affecting the United States economy generally unless such conditions adversely affect such party in a materially disproportionate manner, and (b) any adverse change, event or effect that is directly attributable to conditions affecting the Company’s industry generally, unless such conditions adversely affect such party in a materially disproportionate manner.  

3.6         “ Post-Recap Investor Rights Agreement ” shall mean the Amended and Restated Investor Rights Agreement attached as Exhibit 3.6 hereto.

3.7         “ Pre-Recap Investor Rights Agreement ” shall mean the Investor Rights Agreement attached as Exhibit 3.7 hereto.

3.8         “ Recapitalization ” shall mean, collectively, (i) the exchange of all outstanding shares of the Company’s Series A Preferred Stock (the “ Series   A Preferred ”) into shares of Common Stock pursuant to the Share Exchange Agreement, (ii) the amendment of all of the Company’s outstanding Series B Subordinated Debentures (the “ Debentures ”) to permit the conversion of all outstanding principal and interest thereon into shares of Common Stock at a conversion price of $0.11 per share, and (iii) the conversion of all Debentures (as so amended) into shares of Common Stock.

3.9         “ Recapitalization Proposal ” shall mean the proxy statement and related documentation and agreements pursuant to which the consent of the Company’s shareholders to is solicited to the following: (a) the Recapitalization, (b) the adoption of the Amendment to the Company's Articles of Incorporation, in the form attached hereto as Exhibit 3.9(b), which provides for, among other things, the adoption of cumulative voting in the Company’s articles of incorporation for the election of members to the Company’s Board of Directors and (c) the adoption of the Company's Restated Bylaws, in the form attached hereto as Exhibit 3.9(c), which provide for, among other things, the elimination of the provisions providing for a staggered Board of Directors.

3.10      “ Schedule of Exceptions ” shall mean the schedule of exceptions to the representations and warranties of the Company in Section 6. The Schedule of Exceptions is attached as Exhibit 3.10 hereto.

3.11      “ Securities Act ” shall mean the Securities Act of 1933, as amended and the rules and regulations of the Commission promulgated thereunder.

3.13      “ Share Exchange Agreement ” shall mean the Share Exchange Agreement between the Company and the holders of the Company's Series A Preferred Stock attached as Exhibit 3.13 hereto.

3.14      “ Subsidiary ” shall mean any corporation, partnership or other entity more than 50% of whose equity interests (measured by virtue of voting rights) in the aggregate is owned by the Company or which is otherwise controlled by or under common control with the Company.  

3.15      “ Transactional Agreements ” shall mean this Agreement, the Post-Recap Rights Agreement, the Pre-Recap Rights Agreement, the Share Exchange Agreement and the Note.

4.1         Purchaser's Closing Conditions at Initial Closing and Second Closing. The Purchaser's obligations to purchase the Note and Stock at a Closing are subject to the fulfillment as of such Closing of the following conditions, any of which the Purchaser may waive in accordance with the terms hereof:

(a) Representations and Warranties True. The Company’s representations and warranties set forth herein in Section 6 below shall be true and correct when made and shall be true and correct in all material respects as of such Closing as if made on and as of such date, except for representations qualified by materiality, which shall be correct in all respects.

(b)                 Compliance with Covenants. The Company shall have performed and complied with all agreements and conditions contained in this Agreement required to be performed or complied with by it prior to or at the Closing.

(c) Qualifications . All authorizations, approvals or permits, if any, of any governmental authority or regulatory body of the United States or of any state that are required in connection with the lawful issuance and sale of the Note and Stock pursuant to this Agreement, including, if applicable the amendment of the Rights Plan, shall be duly obtained and effective as of such Closing, other than notice filings in accordance with state securities law that may be filed post-Closing.

(d)                 Officers Certificate . At the Closing, the President and Chief Executive Officer of the Company shall deliver to the Purchaser a certificate in form and substance satisfactory to Purchaser certifying as to: (i) resolutions of the Company’s Board of Directors authorizing and approving all matters in connection with this Agreement and the transactions contemplated hereby; (ii) the Company’s by-laws in effect as of the Closing; (iii) the Company’s Articles of Incorporation, as amended in full force and effect as of the Closing; (iv) the satisfaction of the conditions set forth in Sections 4.1(a), (b) and (c) above.

(e) Certificate of Existence. The Company shall deliver to the Purchaser at the Closing a long-form Certificate of Existence issued by the Secretary of State, as of a date within five (5) business days of the Closing.

(f)   Opinion of the Company’s Counsel. The Purchaser shall have received from Heller Ehrman White & McAuliffe LLP, legal counsel for the Company, an opinion dated the Initial Closing Date or Second Closing Date, as applicable, in the forms attached as Exhibit 4.1(f) .

4.2         Additional Purchaser's Closing Conditions at Initial Closing. The Purchaser’s obligations to purchase the Note at the Initial Closing are subject to the fulfillment as of the Initial Closing of the following conditions, any of which the Purchaser may waive in accordance with the terms hereof:

(a) Escrow . Prior to the Initial Closing, the Company shall deliver the executed Note to the Purchaser's counsel to be held in escrow pending the Initial Closing.

(b)                 Attorneys Fees . At the Initial Closing, the Company shall pay by wire transfer the reasonable fees and disbursements of counsel to Sunra Capital Holdings, Ltd. up to, but not in excess of, $10,000.

(c)       Rights Agreements . The Company, the Purchaser, Orca Bay Partners, Madrona Venture Group and Matinicus, LP shall have entered into the Post-Recap Rights Agreement and the Pre-Recap Rights Agreement.

(d)       Amendment to Series B Debentures. The holders of the Debentures shall have entered into an amendment to such Debentures in the form attached hereto as Exhibit 4.2(d) (the " Debenture Amendment ").

(e)       Share Exchange Agreement. The Company and the holders of the Company's Series A Preferred Stock shall have entered into the Share Exchange Agreement.

4.3         Additional Purchaser's Closing Conditions at Second Closing. The Purchaser’s obligations to purchase the Stock at the Second Closing are subject to the fulfillment as of the Second Closing of the following conditions, any of which the Purchaser may waive in accordance with the terms hereof:

(a) Approval of Recapitalization Proposal. The Recapitalization Proposal shall have been approved by the shareholders at a shareholders' meeting held no later than May 31, 2005.

(b)                 Escrow . Prior to the Second Closing, the Company shall deliver executed certificates representing the Stock to the Purchaser's counsel to be held in escrow pending the Second Closing.

(c) Articles of Amendment and Restated Bylaws. The Articles of Amendment shall have been filed with the Secretary of State of the State of Washington and shall be in full force and effect on the Second Closing Date and the Board of Directors shall have adopted the Restated Bylaws.

(d)                 No Legal Proceedings. There is no action, proceeding, or, to the Company’s knowledge, investigation pending or threatened, or any basis therefor known to the Company that questions the validity of the Transactional Agreements or the right of the Company to enter into the Transactional Agreements or to consummate the transactions contemplated thereby.

(e)       Conversion of the Series B Debentures. The Debentures shall have converted into Common Stock prior to or simultaneous with the Second Closing in accordance with the terms of the Debenture Amendment.

5.1         Company’s Closing Conditions at Initial Closing and Second Closing. The obligations of the Company under Section 1 of this Agreement are subject to the fulfillment at or before a Closing of each of the following conditions, any of which may be waived in writing by the Company.

(a) Representations and Warranties True. The representations and warranties of the Purchaser contained in Section 7 shall be true in all material respects on and as of the Closing with the same effect as if made on and as of the Closing.

(b) Performance. All covenants, agreements and conditions contained in this Agreement to be performed by the Purchaser on or prior to the Closing shall have been performed or complied with in all material respects.

(c) Payment of Purchase Price. The Purchaser shall have delivered to the Company in accordance with Section 2 the purchase price for the Note and Stock, as applicable, as set forth on Schedule 1 hereto.

5.2         Additional Company’s Closing Conditions at Initial Closing. The obligations of the Company under Section 1 of this Agreement are subject to the fulfillment at or before the Initial Closing of each of the following conditions, any of which may be waived in writing by the Company:

(a)       Rights Agreements . The Company, the Purchaser, Orca Bay Partners, Madrona Venture Group and Matinicus, LP shall have entered into the Post-Recap Rights Agreement and the Pre-Recap Rights Agreement.

(b)       Share Exchange Agreement. The Company and the holders of the Company's Series A Preferred Stock shall have entered into the Share Exchange Agreement.

5.3         Additional Company’s Closing Conditions at Second Closing. The obligations of the Company under Section 1 of this Agreement are subject to the fulfillment at or before the Second Closing of each of the following conditions, any of which may be waived in writing by the Company:

(a) Approval of Recapitalization Proposal. The Recapitalization Proposal shall have been approved by the shareholders.

(b) Articles of Amendment. The Articles of Amendment shall have been filed with the Secretary of State of the State of Washington and shall be in full force and effect on the Second Closing Date.

Except as set forth in the Schedule of Exceptions, the Company hereby represents and warrants to the Purchaser that:

(a) is a corporation duly organized and validly existing under the laws of the State of Washington;

(b)                 has the corporate power and corporate authority to own and operate its properties and to carry on its business as now conducted and as currently proposed to be conducted;

(c) is qualified as a foreign corporation in all jurisdictions in which such qualification is required, other than those jurisdictions in which its failure to so qualify would not constitute a Material Adverse Event; and

(d)                 by-laws and Articles of Incorporation, as amended, both in the form delivered to the Purchaser, are in full force and effect as of the Closing Date.

6.2         Capitalization . Immediately prior to the Initial Closing, the authorized capital of the Company consists of:

(a) Preferred Stock . 2,000,000 shares of Preferred Stock, $0.01 par value, of which 105,000 shares have been designated Series RP Preferred Stock (none of which are outstanding), 15,000 shares have been designated as Series A Preferred Stock of which 15,000 are outstanding, and 36,830 shares have been designated as Series B Preferred Stock (none of which are outstanding).

(b)                 Common Stock . 101,250,000 shares of Common Stock, $0.01 par value, of which 18,451,875 shares are duly and validly issued (including, without limitation, issued in compliance with applicable federal and state securities laws), fully paid, and nonassessable.

(c) Other Securities . As of the Initial Closing Date, the Company will have reserved for issuance: (a) 3,683,000 shares of Common Stock for issuance upon conversion of the Series B Preferred Stock; (b) 3,157,895 shares of Common Stock for issuance upon conversion of the Series A Preferred Stock; (c) 105,000 shares of Series RP Preferred Stock, (d) 912,201 shares of Common Stock for issuance upon exercise of the warrants listed in the Schedule of Exceptions; (e) 4,645,250 shares of Common Stock for issuance under the Company’s Incentive Plans; and (f) 3,809,524 shares of Common Stock for issuance upon exercise of the Warrants. Except for (i) the Warrants, (ii) the conversion privileges of the Series A Preferred Stock, (iii) the conversion privileges of the Series B Preferred Stock, (iv) the Investor Rights Agreement dated February 14, 2000 (the “ Series A Investor Rights Agreement ” ), (v) the Investor Rights Agreement dated April 25, 2001 (the “ Series B Investor Rights Agreement ” ), (vi) the options and other rights granted under the Company’s Incentive Plans listed in the Schedule of Exceptions, and (vii) the preferred share purchase rights issued as a dividend on the Company’s Common Stock pursuant to the Rights Agreement between the Company and ChaseMellon Shareholder Services LLC, as Rights Agent, dated December 16, 1999 attached as Exhibit 6.2 , there are no outstanding rights of first refusal, registration rights, preemptive rights or other securities, rights, warrants, options, conversion privileges, subscriptions, or other instruments or agreements, either directly or indirectly, to purchase or otherwise acquire or issue or convertible into or exercisable for any equity securities of the Company or with any holders of any of the Company’s securities.

6.3         Subsidiaries . The Company does not presently own, have any investment in, or control, directly or indirectly, any Subsidiaries or other entities, other than the following Subsidiaries: Seattle FilmWorks Manufacturing Company, OptiColor, Inc. and PhotoWorks Digital Imaging, Inc. Each of the Subsidiaries:

(a) is duly organized, validly existing and in good standing in the state of its incorporation;

(b)                 has the corporate power and corporate authority to own and operate its properties and to carry on its business as now conducted and as currently proposed to be conducted; and

(c) is qualified as a foreign corporation in all jurisdictions in which such qualification is required, other than those jurisdictions in which its failure to qualify would not constitute a Material Adverse Event.

6.4         Corporate Power . The Company will have on the Closing Date all requisite legal and corporate power and authority to execute and deliver the Transactional Agreements, to issue the Note and the Common Stock issuable upon conversion