Reference no: EM13743274

Chariot.com needs $500,000 in venture capital to bring a new Internet messaging service to market. The firm's management has approached Route 128 Ventures, a venture capital firm located in the high-tech start-up mecca known as Route 128 in Boston, Massachusetts, which has expressed an interest in the investment opportunity. Chariot.com's management made the following EBITDA forecasts for the firm spanning the next five years:

Year EBITDA

1 -$175,000

2 75,000

3 300,000

4 650,000

5 1,050,000

Route 128 Ventures believes that the firm will sell for six times EBITDA in the fifth year of its operations, and that the firm will have $1.2 million in debt at that time, including $1 million in interest-bearing debt. Finally, Chariot.com's management anticipates having a $200,000 cash balance in five years.

The venture capitalist is considering three ways of structuring the financing:

1. Straight common stock, where the investor requires an IRR of 45%.

2. Convertible debt paying 10% interest. Given the change from common stock to debt, the investor would lower the required IRR to 35%.

3. Redeemable preferred stock with an 8% dividend rate plus warrants entitling the VC to purchase 40% of the value of the firm's equity for $100,000 in five years. In addition to the share of the firm's equity, the holder of the redeemable preferred shares will receive 8% dividends for each of the next five years, plus the face value of the preferred stack in Year 5.

TERMINOLOGY

A convertible security (debt or preferred stock) is replaced with common stock when it is converted. The principal is not repaid. In contrast, the face value of a security with warrants is repaid, and the investor has the right to receive common stock shares by remitting the warrants.

Redeemable preferred stock is typically straight preferred with no conversion privileges. The preferred always carries a negotiated term to maturity specifying when it must be redeemed by the company (often the sooner of a public offering or five to eight years). The preferred shareholders typically receive a small dividend (sometimes none), plus the face amount of the preferred issue at redemption, plus a share of the value of the firm in the form of common stock or warrants.

a. Based on the offering terms for the first alternative (common stock), what fraction of the firm's shares will it have to give up to get the requisite financing?

b. If the convertible debt alternative is chosen, what fraction of the firm's ownership must be given up?

c. What rate of return will the firm have to pay for the new funds if the redeemable preferred stock alternative is chosen?

d. Which alternative would you prefer if you were the management of Chariot?