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

2. 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

3. 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

4. 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

5. 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

6. 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

7. PREFERRED STOCK (PREFERRED EQUITY)

8. 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

9. 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

10. 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

11. 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

12. 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

13. VALUE RELATIONSHIPS FOR AMERICAN STYLE OPTIONS1

14. 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

15. 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

16. 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

17. BLACK-SCHOLES OPTION PRICING FORMULA

18. EXAMPLE WITH ONE WARRANT (ENTITY PER SHARE VARIATION)

19. 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 = $ (9 x $ $35.40)/9
Value same as $ $35.40/9 =$107.18
Existing shareholder bears 1/9 of warrants burden

20. EXAMPLE WITH FIVE WARRANTS (ENTITY PER SHARE VARIATION)

21. 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 $ x$28.99)/9
Value =$ (5/9) x $28.99 =$95.01
Existing shareholder bears 1/9 of warrants burden

22. EXAMPLE WITH FIVE WARRANTS (ENTITY WARRANT VARIATION)

23. 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 x =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, (1, x 28.99)
Equity value per share is total equity value divided by9, or /9 =

24. ZERO EXERCISE WARRANTS (ENTITY PER SHARE VARIATION)

25. 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 $ x$81.87)/9
Value =$ (5/9) x $81.87 =$65.63
Existing shareholder bears 1/9 of warrants burden