Reference no: EM133227568

Suppose a VC invests $18 million in a regular Convertible Preferred security issued by firm A at a fully-diluted pre-money valuation on the term sheet of $50 million. The security has a face value of $18 million, a maturity of eight years and pays no interest. Other companies in firm A's industry have an annual volatility of 45%. The annualized risk-free rate over the next eight years is 3.5%. Prior to this security issuance, firm A was an all-equity firm owned completely by the entrepreneur.

1. What is the conversion point for this security? That is, for what firm values in eight years will the VC convert this claim into equity?

2. Draw a general diagram for the Convertible Preferred payoffs in eight years for different future firm values. Also, as a specific example, suppose firm A is sold for $140 million in eight years. What payoff will the VC receive at that time?

3. We will label the true post-money value of the firm today F. Describe the value today of the "debt piece" (all the payoffs below the face value) of the Convertible Preferred. (This will depend on F and a certain option value)

4. Describe the value today of the "upside" (all the payoffs above the face value) of the Convertible Preferred. (This will also depend on F and different option value)

5. If F=$68 million (the term sheet post-money value), then what is the value of the Convertible Preferred today? Do you think the VC believes F=$68 million?