Reading: Valuing Financing Alternatives
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2. Financing Alternatives
2.5. Convertible Participating Preferred (With Cap)
Finally, the Convertible Participating Preferred with a cap that we have considered had the following characteristics:
- Liquidation preference of 9.5 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 60.8 million.
- The Preferred can be converted into 40% of common stock. Given the terms above, the conversion value is 75 million.
The corresponding payoff charts were as follows:
The resulting portfolio is similar to the one before. The two differences are:
- The first two "kinks" in the payoff are at 9.5 million and 60.8 million, respectively (instead of 10.0 and 60.0 million)
- The VC receives the right to convert the Preferred in 40% of common stock at a liquidation value of 75 million. This right corresponds to 0.4 call options with exercise price 75.0 million.
These considerations imply the following replicating portfolio for the convertible participating preferred:
| Description | Variable | Value (millions) |
| Own the firm | S | 15.0 |
| Grant the entrepreneur 0.6 call options with X = 9.5 | -0.6 × C(X = 9.5) | -0.6 × 8.15 = -4.9 |
| Grant the entrepreneur 0.4 call options with X = 60.8 | -0.4 × C(X = 60.8) | -0.4 × 0.60 =-0.2 |
| Own 0.4 call options with X = 75.0 | 0.4 × C(X = 75.0) | 0.4 × 0.35 = 0.1 |
| 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):
The second option granted to the entrepreneur was valued as follows (remember, the entrepreneur receives 0.4 of these options):
And the VC's conversion option was valued as follows (remember, the VC has 0.4 of these options):
