Reference no: EM13197641

VESTING AND FOUNDER REPLACEMENT-BIG PIES AND SMALL SLICES

The three founders initially thought that they would get their 5 million shares immediately, an idea that they seemed to like quite a lot. The disappointment was therefore even larger when they found out the true meaning of the word "vesting." It had little to do with fashion clothes, but instead meant that they would only own their shares over time. Being of a suspicious nature, they wondered what could go wrong.

Krishnuvara was particularly concerned. He was going to be the CEO, and the founders had agreed that as the CEO, he was to receive 2 million shares, whereas Annabella and Bob were to receive 1.5 million shares each. While Annabella and Bob were sure about being able to stay with the company for as long as they wanted, Krishnuvara was concerned that he would be taken out of the company in favor of some gray-haired guy in a suit, or what Sand Hill called a "professional" CEO.

Krishnuvara formulated the following expectations about the company. After two years SpiffyTerm, Inc. would need to raise an additional $2 million. The company would be able to achieve an IPO in four years, with a valuation of $80 million. Investors would require a 60 percent discount rate. This was based on the assumption that he would be the CEO. Grudgingly he also agreed that having a professional CEO would reduce the risk of the new company. In fact, the reduced risk would be reflected in a discount rate of 45 percent for the third and fourth year.

Krishnuvara thought he had to choose between two very different scenarios, one in which he was the CEO throughout, and one in which a new CEO would be brought in. He also thought that in order to remain the CEO throughout, he had to have control over the board of directors. With control, he could resist the pressure to bring in another CEO, and this way he would be able to safely vest all of his stock. Without control, he thought that after two years, Wolf C. Flow would kick him out of the company, personally, and with a grin on his face. According to the term sheet he would own only 1.5 million shares of his 2 million shares after two years. The remaining 0.5 million shares, he suspected, would be put into the option pool, for others to enjoy (like that smooth-talking, gray-haired CEO who would get to sit in his leather chair).

Question a: Assume that the first round will occur at $1 per share for Vulture Venture's $4 million investment. Using all of Krishnuvara's assumptions, calculate his final wealth and the NPV of it, both if he controls and does not control the board. Based only on those numbers, should he prefer to retain control? Also calculate the same numbers for Annabella, Bob, and Vulture Ventures. What control structure would they prefer?

Question b: How does your answer change when you re-price the first round; i.e., if you allow the price of the first round to vary across the two control structures? Comment on your findings, focusing on the issue of getting a smaller slice of a bigger pie.

Question c: Is Krishnuvara correct in his assumption about control and the role of the board?