J. K. Dietrich - FBE 432 – Spring, 2002 Module II: Venture Capital Financing, Options and Warrants Week 6 – September 30 and October 2, 2002

J. K. Dietrich - FBE 432 – Spring, 2002 Lecture Topics u Venture capital financing terms –Different types of venture capital financing u Options and warrants in convertible securities u Pricing options and warrants –Black-Scholes option pricing –Adjusting option prices for warrant pricing

J. K. Dietrich - FBE 432 – Spring, 2002 Venture Capital Terms u Term sheets are standard means of communicating all aspects of a deal (not just venture capital) u Terms on any deal contain a number of aspects and conditions (e.g. maturity, repayment, etc.) u Venture capital terms tend to focus on key issues important to venture capitalists

J. K. Dietrich - FBE 432 – Spring, 2002 Venture Capital Terms u Venture capitalists –Have high risk-adjusted expected returns –Short investment horizons (e.g. 5 years) –Option to influence or exercise control –Exit strategies u Basic terms are amounts invested, the extent of control, factors determining returns under various outcomes, exit alternatives

J. K. Dietrich - FBE 432 – Spring, 2002 Negotiations: Valuation u Pre-money valuation = value placed on business by venture capital firm u Post-money valuation = value of firm after venture capital financing u Valuation can have range under different circumstances, e.g. benchmark performance or milestones and effects entrepreneur’s claim on future firm value

J. K. Dietrich - FBE 432 – Spring, 2002 Negotiations: Share Allocation u Share allocation affects distribution of control and future wealth gains from the firm –Founders’ pool is equity before financing –Employee option pool may be part of founders’ pool or out of capital raised u Allocation of shares to founders and employees is vesting

J. K. Dietrich - FBE 432 – Spring, 2002 Vesting Alternatives u Immediate vesting means taking ownership of some or all shares at once u Pattern of gradual investing can be different: –Cliff meaning large amount at one time –Linear investing means gradual allocation of shares u Example: 50% immediate vesting, remainder over 24 months allocates 50% of share immediately, the remainder 2.083% per month until 100% of commitment is satisfied

J. K. Dietrich - FBE 432 – Spring, 2002 Control Issues u Voting rights of shares u Board membership u Share ownership upon management or employee dismissal or quitting u Reporting and information rights u Antidilution protection u Purchase rights in case of changes u Conversion privileges

J. K. Dietrich - FBE 432 – Spring, 2002 Exit Alternatives for VC u Liquidation alternatives –Assumes cash purchase or merger –Liquidation preference of securities –Optional conversion of securities to common shares u Initial public offering (IPO) –Piggyback registration –S-3 registration

J. K. Dietrich - FBE 432 – Spring, 2002 Options and Warrants u A call option or warrant is the right to buy an asset at a given price before a given date u Convertible securities can be exchanged for other securities (usually common stock) at a given ratio of face value (e.g. 50 shares per $1000 bond) or conversion price (e.g. $20 per share) u Conversion feature is similar to call option or warrant

J. K. Dietrich - FBE 432 – Spring, 2002 Option Pricing u Major theoretical breakthrough in finance in 1973 by Fisher Black and Myron Scholes –Scholes and Robert Merton received a Nobel Prize in economics for their work in option pricing, Black died relatively young\ u Basic argument is that you should not be able to make money with no investment and no risk u Logic is called arbitrage pricing theory (APT)

J. K. Dietrich - FBE 432 – Spring, 2002 Major Assumptions u European call option –Can be relaxed easily in some cases u No dividends –Easy to adjust for dividends u Returns are normally distributed –Can be extended for jump discontinuities u Constant volatility of returns –Stochastic volatility can be incorporated

J. K. Dietrich - FBE 432 – Spring, 2002 Call Options Profits at Maturity 0 Strike Price (X) Profit Asset Value (S) Payoff to Buyer

J. K. Dietrich - FBE 432 – Spring, 2002 Value of Call Options 0 Call Price (C) Asset Value Option Premium Strike Price “Out of the Money” “At the Money” “In the Money”

J. K. Dietrich - FBE 432 – Spring, 2002 Inputs u S t Stock Price at time t u X Exercise Price u T-t Time remaining to maturity u R f Risk-free Rate   Volatility (standard deviation of stock returns, annualized)

J. K. Dietrich - FBE 432 – Spring, 2002 The Black-Scholes formula European Call: where and

J. K. Dietrich - FBE 432 – Spring, 2002 Option prices in the WSJ

J. K. Dietrich - FBE 432 – Spring, 2002 Estimating   u Use historical returns on the stock –Remember to adjust for the time interval to get the annualized return! u Use implied volatility from previous trading prices of the option

J. K. Dietrich - FBE 432 – Spring, 2002 Inputs for this Example: u S t $62.56 u X $60.00 u T-t 72 days u R f 5.09%   45%

J. K. Dietrich - FBE 432 – Spring, 2002 Computation u Using the inputs, you can compute the price of the call using the spreadsheet option.xls u Check the answer:

J. K. Dietrich - FBE 432 – Spring, 2002 Some Fine Points u Notice that the Black-Scholes formula does not depend on the following “intuitive” inputs: –The expected rate of growth of the stock price –Beta –Investors concerns about risk –This is because the option is a combination of a bond and a stock, both of which are currently priced

J. K. Dietrich - FBE 432 – Spring, 2002 Extensions: Dividends u Pricing calls with known dividends is straightforward. The intuition is as follows: –When a stock pays a dividend, the price falls (in theory) by the amount of the dividend. –We need to adjust the stock price for the dividend. Formally, we subtract the present value of the known dividend from the stock price

J. K. Dietrich - FBE 432 – Spring, 2002 Extensions: Pricing Puts u The put-call parity theorem relates the price of a put to the price of a call u The basic formula is:

J. K. Dietrich - FBE 432 – Spring, 2002 Pricing Warrants u Since warrants are issued by the firm, there is an immediate dilution effect upon the exercise of warrants u This means that the warrant is worth less than a comparable call u For most firms, the dilution effect is so small that the call value is a good approximation to true value

J. K. Dietrich - FBE 432 – Spring, 2002 Black-Scholes for Warrants u In venture capital situations, warrant exercise may result in substantial dilution and hence you need to know how to use Black-Scholes in this situation u Suppose that a VC holds warrants for 100,000 shares and that there are 100,000 shares outstanding. If the B-S call value is $3, what is the warrant value?

J. K. Dietrich - FBE 432 – Spring, 2002 The General Formula u Denote by C the Black-Scholes call price, W the warrant price, N the number of shares outstanding and M the number of warrants (the number of shares created when warrants are exercised ). Then:

J. K. Dietrich - FBE 432 – Spring, 2002 Next Week – October 7 and 9 u Next week we will discuss derivatives securities (options, futures, and swaps) and how they are used to hedge risk u These topics are crucial to the Union Carbide Corporation Interest Rate Risk Management case so you should read the case and review recommended chapters u Continue to review your comprehension of topics covered to date (midterm October 16)