Chapter11.SecurityDesign.21Aug2013.ppt

Chapter11.SecurityDesign.21Aug2013.ppt - Security Design...

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© Cumming & Johan (2013) Forms of VC Finance Security Design Cumming & Johan (2013, Chapter 11) 1
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© Cumming & Johan (2013) Forms of VC Finance Forms of Finance Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Debt 1 st priority in bankruptcy Stipulated interest payments Non-payment of interest can force bankruptcy Preferred Equity 2 nd priority in bankruptcy Stipulated preferred dividend payments Non-payment of dividends cannot force bankruptcy 2
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© Cumming & Johan (2013) Forms of VC Finance Forms of Finance (Con’t) Common Equity Last priority in bankruptcy Dividends may or may not be forthcoming Residual claimants upside potential capital gains! Warrants Option to purchase common equity Like an American call option to purchase the firm (but different because increases # securities when exercised) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 3
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© Cumming & Johan (2013) Forms of VC Finance Forms of Finance (Con’t) Convertible debt Debt + option to convert from debt to common equity Similar to debt + warrants Convertible preferred equity Preferred equity + option to convert from preferred equity to common equity Similar to preferred equity + warrants Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 4
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© Cumming & Johan (2013) Forms of VC Finance 5 Figure 2.1. Payoff Functions $ Value of Entrepreneurial Firm Payoff to Common Equity Payoff to Debt Payoff to Preferred Equity 45 o 45 o 45 o Present Value of Interest + Principal on Debt Present Value of Pre-Specified Preferred Dividends Slope is 45 o for 100% of the common shares (45 o * X/100 for X% of the common shares) 5
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© Cumming & Johan (2013) Forms of VC Finance The Conventional Wisdom “Convertible preferred equity is optimal” No threat of bankruptcy for entrepreneurial firm (contrast to debt & interest payments) Priority for the VC in the event of bankruptcy Upside potential for the VC Entrepreneur would not agree unless truly committed to the venture – mitigates adverse selection problems Provides incentives for the VC to help the firm in bad times (VC a residual claimant in bankruptcy) Pricing of securities is robust to errors in firm valuation Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 6
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© Cumming & Johan (2013) Forms of VC Finance The Conventional Wisdom (Con’t) “Convertible preferred equity is optimal” Mitigates ‘window-dressing’ problems in staged financing arrangements Mitigates ‘risk-shifting’ problems Terms of the contract can be flexible Incentives for the entrepreneur (terms of conversion less favorable for VC the more successful the firm) Incentives for the VC (ensure worth converting the securities) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 7
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