Reading: Valuing Financing Alternatives

In the previous sections, we have valued the six different financing alternatives that we have derived in the section Division of Financial Returns. While these financing alternatives have different liquidation preferences, participation rights, and convertibility rights, we have engineered them in a way that they:

• all have the same value (10 million)
• and constitute a fair deal (value = amount invested)

from the point of view of the VC. 

Consequently, from a pure financial point of view (and based on our assumptions), the VC should be indifferent between all 6 financing alternatives.

An important technical takeaway from these considerations is how we can actually value relatively complex financing instruments. The trick, as we have seen, is to build a portfolio with "simple" instruments that generates the exact same payoffs as the financing instrument in questions. If the payoff of this replicating portfolio is identical to the financing instrument in question, so should be the valuation.

From the point of view of deal structuring and negotiation, an important takeaway is the following.

• Liquidation preference, participation rights, and conversion, are not independent deal elements. 
• To maintain the valuation of a deal, we have to find the right balance between these three elements.
• In a negotiation, it will often be fruitless to ask for, say, more liquidation preference, better participation, and better conversion terms, as all these three demands will work against the interest of the counter party. 
• A more realistic outcome will be that if the VC desires more liquidation preference, he will have to forgo some of the participation and conversion rights (and vice versa).
• In order to find the 'right' balance, we need to know the preferences of the parties involved. And we need to be able to value such instruments.