2. Financing Alternatives

2.3. Participating Preferred (Full Participation)

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

  • Liquidation preference of 9.2 million
  • Thereafter, the VC participates pro rata on an as-converted basis (40%)

The corresponding payoff charts were as follows:

  

participating preferred payoffs

 

Also for the Participating Preferred we can find a portfolio that exactly replicates the payoffs at maturity: The VC receives all the proceeds up to a liquidation value of 9.2 million ("Own the firm"). Thereafter, the Entrepreneur receives 60% of the proceeds. Consequently, the VC grants the entrepreneur a call option on 60% of the liquidation value with exercise price 9.2 million.

 

Replicating Portfolio:

 

Description Variable Value (millions) 
Own the firm S 15.0
Grant the entrepreneur 0.6 call option with X = 9.2 -0.6 × C(X = 9.2) -5.0
Total Portfolio Value 10.0

   

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

 

black scholes valuation participating preferred

  

Discussion

From the point of view of the VC, a participating preferred with liquidation preference of 9.2 million and full participation on an as-converted basis thereafter constitutes a "fair" deal. It has the same value as all the other deal alternatives considered before.