SECURITY STRUCTURE AND ENTERPRISE VALUE ENTREPRENEURIAL FINANCE Leach & Melicher Chapter 11 SECURITY STRUCTURE AND ENTERPRISE VALUE © 2003 South-Western College Publishing

CHAPTER 11 LEARNING OBJECTIVES Describe the types of securities often involved in venture financing Discuss the structural considerations involved in designing venture securities Draw simple diagrams describing the payoffs to calls, puts, and warrants Value a venture as a complete enterprise and relate that value to the value of the securities involved in supporting the enterprise

COMMON STOCK (COMMON EQUITY) Common Stock: the least senior claim on a venture’s asset (residual ownership) Voting rights Right to legal dividends Preemptive rights: right for existing owners to buy sufficient shares to preserve their ownership share

PREFERRED STOCK (PREFERRED EQUITY) Preferred Stock: equity claim senior to common stock providing preference on dividends and liquidation proceeds Dividends as a percent of par Non-cumulative v. cumulative Participating preferred stock: preferred stock with rights to participate in any dividends paid to common stockholders or preferred stock with an investment repayment provision that must be met prior to distribution of returns to common stockholders

PREFERRED STOCK (PREFERRED EQUITY) Paid in kind (PIK) Preferred Stock: preferred stock that has the option of paying preferred dividends by issuing more preferred stock Redemption feature: preferred stock feature permitting venture to redeem (buy back) preferred security

PREFERRED STOCK (PREFERRED EQUITY) Convertible Preferred Stock: preferred stock with option to exchange into common stock Conversion ratio vs. conversion price Down (reset) round: venture round priced below most recent previous price

PREFERRED STOCK (PREFERRED EQUITY)

CONVERTIBLE DEBT Convertible debt: debt that converts into common equity Has bankruptcy rights Has security interests in venture’s assets senior to preferred shareholders’ interests in venture’s assets

OPTIONS Option: right to buy or sell additional shares of stock Call Option: right, not the obligation, to purchase a specified asset at a specified price Put Option: right, not the obligation, to sell a specified asset at a specified price American-Style Option: an option that can be exercised at any time until expiration European-Style Option: an option that can be exercised only at expiration date Bermuda-Style Option: an option that can be exercised only at a specific set of dates

OPTION PAYOFFS Out of the money options: not currently worth exercising At the money options: breakeven current exercise In the money options: profitable current exercise

CALL OPTION PAYOFFS Out of the money options: option to buy at 3, stock only worth 2 At the money options: option to buy at 2, stock worth 2 In the money options: option to buy at 1, stock worth 2

PUT OPTION PAYOFFS Out of the money options: option to sell at 1, stock worth 2 At the money options: option to sell at 2, stock worth 2 In the money options: option to sell at 3, stock worth 2

VALUE RELATIONSHIPS FOR AMERICAN STYLE OPTIONS 1

WARRANTS Warrants: call option issued by a company granting the holder the right to buy a common stock at a specific price for a specific period of time Typically involves new shares

VALUING VENTURES WITH COMPLEX CAPITAL STRUCTURES Enterprise (entity) method: valuation method for the entire financial capital structure including interest-bearing debt Cash flows distilled down to an amount that belongs and must flow to the firm’s investors as a whole, rather than a residual flow to equity

VALUING VENTURES WITH COMPLEX CAPITAL STRUCTURES Enterprise Valuation Cash Flow = EBIT x (1-Enterprise Tax Rate) + Depreciation & Amortization Expense - Change in Net Working Capital (w/o Surplus Cash) - Capital Expenditures

BLACK-SCHOLES OPTION PRICING FORMULA

EXAMPLE WITH ONE WARRANT (ENTITY PER SHARE VARIATION)

EXAMPLE WITH ONE WARRANT (ENTITY PER SHARE VARIATION) Pre-exercise entity value of $1,000 $1,000 divided among 9 shares & 1 warrant Call option worth $39.34 Warrant as optioning 1/10 of 9 calls on entity per existing share ($111.11) Warrant value = 90% of call value (dilution factor=.9) Warrant value =$35.40 (.9 x $39.34) Value per share of existing 9 shares = $107.18 (9 x $111.11 -$35.40)/9 Value same as $111.11 - $35.40/9 =$107.18 Existing shareholder bears 1/9 of warrants burden

EXAMPLE WITH FIVE WARRANTS (ENTITY PER SHARE VARIATION)

EXAMPLE WITH FIVE WARRANTS (ENTITY PER SHARE VARIATION) Pre-exercise entity value of $1,000 $1,000 divided among 9 shares & 5 warrants Call option worth $39.34 Warrant as optioning 1/14 of 9 calls on entity per existing share ($111.11) Warrant value = 73.68% of call value (dilution factor=.7368) Warrant value =$28.99 = (.7368 x $39.34) Value per share of existing 9 shares = $95.01=(9 x $111.11 -5x$28.99)/9 Value =$111.11-(5/9) x $28.99 =$95.01 Existing shareholder bears 1/9 of warrants burden

EXAMPLE WITH FIVE WARRANTS (ENTITY WARRANT VARIATION)

EXAMPLE WITH FIVE WARRANTS (ENTITY WARRANT VARIATION) Entity warrant exercise price : 9x80=720 Dilution factor = .7368 Value of entity option is $354.04 Value of entity warrant is 354.04 x .7368 =260.87 Each warrant worth 1/5 of value of block Single warrant value =$28.99 = (260.87/9) Total equity value is entity value less 5 single warrants, 855.05 (1,000 -5 x 28.99) Equity value per share is total equity value divided by9, or 855.05/9 =

ZERO EXERCISE WARRANTS (ENTITY PER SHARE VARIATION)

ZERO EXERCISE WARRANTS (ENTITY PER SHARE VARIATION) Pre-exercise entity value of $1,000 $1,000 divided among 9 shares & 5 warrants Call option worth $111.11(call=underlying when k=0) Warrant as optioning 1/14 of 9 calls on entity per existing share ($111.11) Warrant value = 73.68% of call value (dilution factor=.7368) Warrant value =$81.87 = (.7368 x $111.11) Value per share of existing 9 shares = $65.63=(9 x $111.11 -5x$81.87)/9 Value =$111.11-(5/9) x $81.87 =$65.63 Existing shareholder bears 1/9 of warrants burden