SpiffyTerm, Inc. would achieve its goal to go public in four years. Secretly, the founders were also interested in finding out what would happen if their performance would be less than stellar. In this case, they suspected that the structure of preferred equity would become relevant.
The term sheet specified that the Series A investors invest $4 million, and that they have rights to a dividend of $0.08 per share. This accrues annually, but unlike an interest rate there is no compounding. Suppose again that the founders made the following assumption. There will be a second round of finance after two years for $2 million at $2 per share. The Series B investors will receive basically the same term sheet, except that they receive a dividend of $0.16 per share. Series A and B investors also have equal seniority status.
There are several types of preferred equity that are all hybrid securities that behave sometimes like debt and sometimes like equity. SpiffyTerm, Inc.'s term sheet used a particular security that is called "participating preferred equity." In order to understand how this works, it is useful to first consider a simpler instrument, which is "plain preferred equity." For the latter, the investors have a choice in case of liquidation and redemption (including an acquisition, but not an IPO). They can ask to get their investment back, together with the accrued dividend. Or they can choose to convert, in which case they forgo any debt-like claim and hold straight equity. In case of an IPO, conversion is automatic.
Question a: Suppose that all investors hold plain preferred equity. Suppose that the firm is acquired after four years. At the time of the acquisition, calculate the value of the first round investors if they do and don't convert their preferred equity. Then do the same for the second round investors. Consider the following acquisition prices for the firm: $5 million, $10 million, $20 million, $30 million, $49 million, and $51 million.
Hint: You will need to calculate the percentage ownership of the Series A and Series B investors after four years to answer this question. For a first pass you can calculate the value of the securities under the scenario in which both A and B convert, and the scenario in which neither A nor B convert. For a completely accurate answer, however, you also need to consider the cases in which only Series A or only Series B converts.
Question b: At what acquisition price are Series A investors indifferent about converting or not? And at what acquisition price are Series B investors indifferent about converting or not? Be careful that Series A investors may have a different ownership stake after conversion if Series B investors don't convert!
Unfortunately, Vulture Ventures was not asking for plain preferred equity, but for something called "participating preferred equity." This is different from "plain preferred equity" in the following way. Plain preferred equity is essentially either debt or equity. In contrast, participating preferred equity is both debt and equity. With participating preferred equity, the investors first get their money back plus accrued dividends. After that, they participate in any remaining value according to their percentage equity.
There are two additional twists to participating preferred equity. First, there is a cap on the valuation of the company. In the case of SpiffyTerm, Inc., this is $50 million. If the value of the firm goes above this cap, then the participating preferred equity automatically converts to straight equity. Similarly, if the company goes public, there is also an automatic conversion to straight equity.
Question c: Suppose that all investors hold participating preferred equity. Suppose again that the firm is acquired after four years. Calculate the value of the first round and second round investors at that time. Again, consider the following acquisition prices for the firm: $5 million, $10 million, $20 million, $30 million, $49 million and $51 million. Do the investors ever want to convert?
Question d: Suppose that at the time of the acquisition, Wolf C. Flow is bargaining with the acquirer. Does he prefer an acquisition price of $49 million or $51 million? What could the founders of SpiffyTerm, Inc. do to persuade him to change his bargaining stance?