Suppose that ROSS is considering a $10M Series A investment in MIC. ROSS proposes to structure the investment as 3M shares of convertible preferred stock (CP). The employees of ROSS have claims on 10M shares of common stock. Following the Series A investment, MIC will have 10M common shares outstanding and would have 7M shares outstanding on conversion of CP. The fees are $20M. Investment Capital is $80M.
The rights of the preferred shareholders when they are to receive a particular amount equal to their capital contribution according to the preference shares they hold, when the company goes into liquidation is referred to as the liquidation preference. When a circumstance forces a venture capital to sell rather than exit during an IPO, for example the collapse of the IPO market, the investors normally will opt for the liquidation preference since they always focus on the greatness of the returns. The sale of a venture capital in this case is taken, according to the charter of the company, as liquidation. The economic impact of the sale on the investors as well as the management and employees is significant when they opt for the liquidation preference. Minimally, the investors are expected to have their funds returned more than what they provided before the employees and the management can share any sales proceeds in the case of a liquidation preference.
Explain the Base-case option pricing assumptions. How do we deal with volatility?
Normally, the liquidation preference is done with several assumptions made during the liquidation processes. The most common is the profit sharing ratio which is done at an 80:20 split. This is after all the liabilities of the investment original to the limited partners with the carried interest for the general partner being 20%. Unless stated otherwise the base case option pricing assumptions are as follows:
For a series A investments a riskless rate of 5% is assumed, with 5 years as the expected years of holding. The volatility percentage is 90%.
Series B experiment period of holding is explained as 4 years. For series C and other subsequent series the expected holding period is adjusted as 3 years.
Of the above assumptions the volatility is the most difficult of the inputs to adjust. In that case it is assumed that for stocks traded publicly the volatility is estimated by analyzing the historic returns. Since this is a method which is not applicable to private companies that are not traded, a technique was put in place by Cochrane in 2005 (Fenny, G et a, 1998). He proposed that a CAPM model which addresses the expected log of returns and the Venture source database is used. The database is used to give estimate parameters for a company typically backed by venture capital. In this method the volatility is annualized at 89% being a standard deviation of returns that are compounded in a continuous manner but in most cases this is normally rounded off to 90% (Metrick, 2007)..
Define what is meant by Redemption Value (RV). Explain the process of Redemption Value per Share (RVPS)
When the investors in a venture capital considers a liquidation preference the preferred stock shareholders are paid a sum of money stated according to the investment contract set up before the company liquidates. Normally, the liquidation preference will be paid at a multiple of the initially paid amount for the shares before conversion. This multiple price is the price to which the preference shares will be paid when converting these shares to common stock. The value of the shares to which the total value of each shareholder will be paid for all his preferred shares is the redemption value. It is considered as the total value to which an investor is paid for him or her to redeem his shares (Metrick, 2007).
The redemption value per share is the value of the preferred divided by the number of common stock that is received from the conversion. It is the total redemption value received from one investor converts during the rounding to the next round of series. The process of getting this value starts by establishing the number of the preferred stock and their total value. Thereafter, the value of the outstanding common shares and their total value is established. The two figures give the value available to repay the converting investor both for the common and the preferred shareholder. The division then gives the redemption value of the preferred stock the common shareholder owes. Its calculation is most helpful in the valuation of the liquidation preference for the preferred shareholder (Metrick, 2007).
References
Metrick, A. (2007). Venture capital and the finance of innovation. Hoboken, NJ: Wiley.
Fenny, G, Nellie L, & Stephen P, (1998), The Private Equity Market: An overview, Financial Markets, Institutions & Instruments 6(4).
