Reference no: EM133205123

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.

A - 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?

B - Please 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?

C - 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)

D - 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)

E- 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?

f) Find the solution for F that gives the Convertible Preferred a value today equal to the price being paid by the VC. (Use Goal Seek)