Reading: Valuing Financing Alternatives

If the deal is financed with a straight preferred with a liquidation preference of 17.1 million and no convertibility, the payoffs at maturity to the VC and the entrepreneur are as follows (as a function of the liquidation value in year 4):

The question is how to value these payoff patterns.

For the investor, the payoff pattern can be described as follows: He owns the firm (cash flow rights) and grants the entrepreneur to buy the firm from him at a price of 17.1 million. In more technical terms, the VC's claim can therefore be summarized as follows:

• The VC is long the firm (he owns it)
• The VC is short a call option on the firm with exercise price 17.1 million (he grants the entrepreneur the right to buy the firm at that price).

In order to value the financial claim of the VC, we therefore have to value two assets:

• The firm itself
• A call option on the firm with exercise price 17.1 million.

As per our assumptions from before, the value of the firm (post money) is 15 million. Consequently, all we have to do is value the call option on the firm.  Using the Black-Scholes model, we need the following ingredients:

• Current value of the firm (S): 15 million
• Exercise price (X): 17.1 million
• Time to maturity (T-t): 4 years
• Risk-free rate of return (R): 5%
• Volatility of the firm (σ): 40%

We can plug these parameters in the Black-Scholes model, for example using this Excel file. The result is as follows:

As mentioned before, the Excel file "Valuation of Alternative Deal Structures" contains the detailed valuations of all deal structures from this section. 

The numbers imply that the right to buy the firm at 17.1 million currently has a value of 5 million. Because the VC grants this right to the entrepreneur, this reduces the value of his financial claim. Overall, the value of the Straight Preferred is 10 million:

Value Straight Preferred = Firm value - Call value with exercise price 17.1 million 

Value Straight Preferred = S - C(X = 17.1) = 15.0 - 5.0 = 10 million.

Discussion  

This result should not be very surprising. After all, the amount of capital the investor provides is 10 million. We can therefore conclude that a straight preferred with a 17.1 million liquidation preference constitutes a fair deal from the point of view of the investor. Assuming the firm issues 10 million shares of Straight Preferred, the issue price is $1.00.

We have also seen that, from the point of view of the VC, the current value of the equity is 5.00 million (call long). This is consistent with the pre-money valuation shown in the Offering Terms. Given that there are currently 15 million shares of common stock outstanding, the implied stock price is therefore $0.33.