2. Financing Alternatives

2.4. Participating Preferred (With Cap)

The Participating Preferred with a cap that we have considered had the following characteristics:

  • Liquidation preference of 10.0 million
  • Thereafter, the VC participates pro rata on an as-converted basis (40%)
  • The maximum participation is 30.0 million. Given the terms above, this maximum participation is reached at a liquidation value of 60 million.

The corresponding payoff charts were as follows:

  

participating preferred with cap

 

Also for this instrument, we can find a portfolio that exactly replicates the payoffs at maturity. The resulting portfolio is similar to the one before. The two differences are:

  • Liquidation preference stops only at 10 million (so the exercise price of the 0.6 options granted to the entrepreneur is 10.0)
  • There is a cap at a liquidation value of 60 million. The cap implies that the VC gives the remaining 40% of his claims to the entrepreneur. Therefore, from the point of view of the VC, this cap is equivalent to 0.4 call options short with exercise price 60.

  

Replicating Portfolio:

 

Description Variable Value (millions) 
Own the firm S 15.0
Grant the entrepreneur 0.6 call options with X = 10.0 -0.6 × C(X = 10.0) -0.6 × 7.88 = -4.7
Grant the entrepreneur 0.4 call options with X = 60.0 -0.4 × C(X = 60.0) -0.4 × 0.62 =-0.3
Total Portfolio Value 10.0

   

The first option granted to the entrepreneur was valued as follows (remember, the entrepreneur receives 0.6 of these options):

  

black scholes valuation participating preferred cap 1

  

The second option granted to the entrepreneur was valued as follows (remember, the entrepreneur receives 0.4 of these options):

 

participating preferred with cap bs2