CHAPTER 5

QUESTIONS

1. Why do venture capitalists use preferred stock?

Particularly in the most developed markets, such as the United States and Europe,
private equity investors (especially venture capitalists) typically purchase not common
stock but preferred stock.
This security has a liquidation preference over common stock; that is, if the company is
sold or liquidated, the preferred stock gets paid first, ahead of the common stock.
Preferred stock therefore has a face value, which is the amount that the preferred
stockholders receive before the common stock is paid. Generally the face value of
preferred stock in a private equity transaction is the cost basis—the amount that the
investor pays for the stock.

2. If you were an entrepreneur, how would you think of the difference

between a preferred-plus-cheap common structure and a convertible
preferred structure?

I don't think that one is inherently better than the other. It depends on the exact
percentages, terms, and stage of growth of the company. Are you near profitability and
need $X to get over the hump? Are you profitable but need to run faster? Are you a raw
start up and it is a high risk investment for the investor?
First, assess which is more expensive to you based on your assumptions of exit
timing/value.

next, take a look at the structural elements. when talking about redeemable preferred
stock (with no conversion feature) coupled with cheap common versus convertible
preferred. Redeemable preferred, as the name indicates, will have a redemption feature
in lieu of the conversion right. Are you comfortable with this? Are you comfortable
with the timing of the redemption? What happens if you are unable to redeem the
preferred on the redemption date? Is their a cash pay preferred dividend? You could
derail the company diverting cash to dividends and to redemption of the preferred when
it comes due - is the risk worth it?

3. How does the concept of fiduciary duty play into the use of preferred stock?

4. Why is vesting used in venture capital deals? Why do managements agree

to it?

The concept of vesting is simple. It holds that a manager’s stock is not “owned” until
that individual has been with the company for a period of time, or some value accretion
event occurs (e.g., the sale of the company). Typically, vesting is implemented over a
period of time (typically three to five years in the United States; although periods are
shorter on the West Coast than on the East Coast, indicating that vesting reflects activity
in the market) and the stock “vests” (i.e., the manager obtains unqualified ownership of
the shares or options) proportionally over that time. For administrative purposes, stock
vesting usually occurs quarterly, occasionally annually, and sometimes even monthly.
Acceleration of vesting is possible:
- Managers could feel vulnerable after IPOs or acquisitions and want to protect their
investment
- Acceleration aligns incentives of managers and investors

5. Why would Kevin Laracey of eDOCs agree to a transaction that included a

liquidation preference, vesting of the management team’s stock, and the possibility
of his replacement? Why would Charles River Ventures have suggested it?

6. Ever the risk taker, Max has invested in another of Sam’s companies. This time,
he pays $3 million for 30 percent of SpecialStuff (SS). Calculate the payout table
and draw the graphs for Sam and Max in the following situations:

1. All common, $3.5 million offer:

Max receives 30% of valuation: 30%*3.5 mil=1.05 mil (loses on his $3 million
investment)
Sam receives 70% of valuation: 2.45 mil

2. Redeemable preferred with cheap common, $3.5 million offer:

Max receives his initial investment of $3 mil
The rest is split, and Max also gets 30%*0.5 mil=$0.15 mil
Max receives $3.15 mil, and Sam receives $0.35 mil

3. Deal is structured as convertible preferred, and the fund offers $5 mil. At what
price should Max convert?
To convert, 30% of the offer price should equal Max’s investment: 30%*X=$3
mil
Offer price should be at least $9 mil

4. SpecialStuff goes public at a valuation of $20 million, and Max owns

participating convertible preferred:
Max receives his initial investment of $3 mil and 30% of the remaining $17 mil
Max receives=$3 mil + 30%*$17 mil=$8.1 mil

5. OtherStuff, a private company, buys SpecialStuff for $7 million. Max owns

participating convertible preferred:
Max receives his initial investment and 30% of the remaining $4 mil
Max receives=$3 mil + 30%*$4 mil=$4.2 mil

7. Why would an investor even fund a company that would accept a liquidation
preference?

8. Consider that you hold securities in a company that has just accepted an
investment of $10 million with 6 times liquidation at $3 million pre-money. How
would you value this company if you were the “new money”? The previous
investors?
Consider that you hold securities in a company that has just accepted an investment of
$10 million with 6 times liquidation at $3 million pre-money.
Post-money valuation: $13 mil, a new investor owns 333,333 shares at $30, or 77% of a
company
As an old investor, you will not receive any payments until a new investor receives $60
million.

9. SpecialStuff needs another $3 million. Acme, happy with its returns on Sam’s
first company, eagerly agrees to participate, investing $4 million for 20 percent of
the company. Assume the first round was as in question 6 and that Sam and Max
each own convertible preferred stock.
a. How much do Max and Sam now own?
b. Create payout tables for exit values at $4 million, $8 million, $12 million, and
$20 million for each participant assuming pooled seniority
c. . . . with Acme senior to Max and Sam.

1. Acme owns 20%, Max owns 30% of the remaining 80%, or 24%. Sam owns
56% (70% * 80%)
2. If a company is valued at $4 million and assuming pooled seniority, Acme
receives 20% ($0.8 mil), Max receives 24% ($0.96 mil).
If a company is valued at $8 million and assuming pooled seniority, Acme and
Max receive their investments back. Also, Acme receives 20% of the remaining
$1 million, Max receives 24%, and Sam gets 56% of the remaining value ($0.56
mil)
3. If a company is valued at $4 million and Acme’s investment is senior, then
Acme receives his investment back. Max and Sam receive nothing
If a company is valued at $8 million, Acme receives his investment first. Max
receives his investment back too, and the remaining $1 mil is split
proportionally to their shares.

10. How does antidilution make sense?

A term that is similar to a covenant is an antidilution provision. Convertible preferred

stock, as noted earlier, naturally led to the idea that the conversion ratio need not be
fixed. Many convertible preferred stocks contain antidilution provisions that
automatically adjust the conversion price18 down if the company sells stock below the
share price paid by the current investor. The rationale for these provisions is that the
company is presumably selling stock at a lower price (a “down round ”) because of
underperformance. If the stock has an automatic adjustment, the investor is less likely to
oppose or forestall a dilutive financing that will allow the company to raise capital when
most needed (if the company is underperforming) or when the private equity markets
are difficult. Moreover, antidilution provisions reflect the fundamental reality of private
investing— illiquidity. When public stock investors are dissatisfied with the
performance of a company whose stock they own, they simply sell the stock. No such
opportunity exists for the private investor, who must stay invested until a liquidity event
occurs. Antidilution provisions act as a cushion and therefore create an incentive for
investors to take on such risk.
11. Calculate the difference in Max’s ownership in the following scenarios:
SpecialStuff raised its A round at $1.50 per share. Max invested $1.5 million for
one million shares and 30 percent ownership. Now SpecialStuff is raising a B
round, but the market has turned against it and Acme will pay only $1.00 per
share for 1 million shares. (Assume that Max doesn’t participate at all and allows
Acme Ventures to take the whole round.)
a. What if Max has full-ratchet antidilution?
b. Weighted average?
c. If Max participates pro rata to his ownership, how will parts 11a and 11b
change?

1. Assume Max has a full-ratchet antidilusion provision.

Before Acme’s investment, the total number of shares is 3.3 million
($1,000,000/0.3). After Acme’s investment, Max owns 1.5 million shares
($1,500,000/$1). The total number of shares now equals 2,333,333 (Sam’s
share) +1,000,000 (Acme’s) + 1,500,000 (Max’s)=4,833,333. Max’s
ownership=1,500,000/5,833,333=31.1%
2. Assume Max has a weighted average antidilusion provision.
Max’s new stock price is:
($1,500,000*$1.5)+($1,000,000*$1.0)/($1,500,000+$1,000,000)=$1.30
At this price, Max owns $1,500,000/$1.3=1,153,846 shares. The total number
shares after Acme’s investment is 2,333,333 (Sam’s) + 1,000,000 (Acme’s) +
1,153,846 (Max’s)=4,487,179
Max’s ownership=1,153,846/4,487,179=25.7%
3. If Max participates at pro-rata to his ownership, the ownership will remain at
30%

12. If a mezzanine investor has received warrant coverage for 5 percent of a $3

million loan where the equity investors are paying $2.50 per share, how many
shares will she be able to buy and at what price?

If a mezzanine investor has received warrant coverage for 5 percent of a $3 million loan
where the equity investors are paying $2.50 per share, how many shares will she be able
to buy and at what price?
The total exercise price of the warrant is equal to 5 percent of $3 million, or $150,000.
The number of warrants issued is $150,000 divided by $2.5 per share, or 60,000
warrants. The mezzanine investor has a warrant for 60,000 shares exercisable at $2.50
per share.
13. Assume Max and Sam are negotiating their first round in SpecialStuff. Sam is
sure that $3 million is all that will be needed, but Max believes it will take at least
twice that. Max is willing to invest $3 million in this round for ownership
somewhere between 25% and 40%. What do you think the final deal will look like
and why?

If Sam is sure that $3 million is all that is needed in the first round and Max is willing to
invest $3 million, Sam will agree to let Max invest for ownership between 25% and
40%. Later when more money is needed, Sam will negotiate with Max or a third party
for the second round.