3. The Entrepreneur's Perspective

In the previous section, we have valued the six deal alternatives from the point of view of the VC. The remaining question we have to address is: What about the entrepreneur? Put differently: Is the entrepreneur also indifferent between the 6 deal structures?

 

The answer is 'yes' if the entrepreneur has the same expectations as the VC. The reason is very simple: The pre-money valuation implied in all six deal structures is 5 million:

  • The post money valuation is 15 million, as per our assumptions
  • The VC claims a value of 10 million as per our valuations before
  • Hence, 5 million is left for the entrepreneur.

 

However, as per our original assumptions, the entrepreneur has does not fully agree with the VC. According to her view, the post-money valuation is 30 million instead of 15 million! Therefore, in all the preceding analyses, here subjective assessment of the value of the firm (S) is 30 million instead of 15 million. Therefore, it is not necessarily the case that the six deal structures are equally attractive to the entrepreneur. 

To find out, we have to conduct the necessary valuations. The procedure to find these valuations is equivalent to what we have done before, only that this time, we build the replicating portfolio from the point of view of the entrepreneur, and we assume that the post-money valuation is 30 million.

The following table summarizes the main takeaways of this analysis. For simplicity, we assume that the entrepreneur agrees with the VC's assessment of the risk-free rate of 5% and the volatility of 40%.

  

Deal Structure Replicating Portfolio for Entrepreneur  Valuation of Portfolio Elements (millions) Deal Value to Entrepreneur  
(millions)
33.3% of Common Equity 0.333×30 = 10 10.0
Straight Preferred Call long with X = 17.1 C(X=17.1) = 17.4 17.4
Convertible Preferred

Call long with X = 15.1

0.4 Call short with X = 37.8

C(X=15.1) = 18.6

-0.4×C(X=37.8) = -0.4×8.9 = -3.6

 15.0
Participating Preferred (Full) 0.6 Call long with X = 9.2 0.6×C(X=9.2) = 0.6×22.7 = 13.6 13.6
Participating Preferred (Cap)

0.6 Call long with X = 10.0

0.4 Call long with X = 60.0

0.6×C(X=10) = 0.6×22.0 = 13.2

0.4×C(X=60) = 0.6×4.8= 1.9

 15.1
Convertible Participating Preferred (Cap)

0.6 Call long with X = 9.5

0.4 Call long with X = 60.8

0.4 Call short with X = 75.0

0.6×C(X=9.5) = 0.6×22.4 = 13.4

0.4×C(X=60.8) = 0.6×4.7= 1.9

-0.4×C(X=75) = -0.4×4.7= -1.3

 14.0

 

Based on these considerations, the most valuable deal structure from the point of view of the entrepreneur is the straight preferred (17.1 million), followed by the Participating Preferred (15.1 million) and the Convertible Preferred (15.0 million). The numbers also show that the worst deal for the entrepreneur is Common Stock. 

This result is probably not very surprising. Since the entrepreneur is more optimistic than the VC, she values upside potential comparatively more highly than downside protection. Consequently, the deal structures that award the VC with the lowest upside potential (and, in exchange, the best downside protection) have the highest value from the point of view of the entrepreneur. 

A quick comparison of the deal valuations from the above table with the payoff charts of the six financing instruments (from the point or view of the entrepreneur) confirms this conclusion: If things go well (high liquidation value), the Straight Preferred promises the best payoff for the entrepreneur, followed by the Participating Preferred with Cap and the Convertible Preferred:

 

Entrepreneur's Payoffs

 

Therefore, the entrepreneur should argue for a deal with Straight Preferred. This, in turn, would signal the VC that the entrepreneur is truly optimistic about the venture, as this deal alternative grants her the worst downside protection.