Chapter 14
SECURITY STRUCTURES AND DETERMINING ENTERPRISE VALUES
FOCUS
In this chapter, we discuss important concepts in structuring securities a venture uses to
raise funds. We introduce the notion of primitive securities (like bonds and common
stocks) and consider other more complex securities (like warrants and convertible
preferred) that derive their value from the primitive securities. We introduce the
enterprise valuation method, a straightforward technique for valuing a venture using
complex financial securities.
LEARNING OBJECTIVES
1. Describe the types of securities often involved in venture financing.
2. Discuss the structural considerations involved in designing venture securities.
3. Draw simple diagrams describing the payoffs to calls, puts, and warrants.
4. Value a venture as a complete enterprise and relate that value to the value of the
securities involved in supporting the enterprise.
CHAPTER OUTLINE
14.1 COMMON STOCK OR COMMON EQUITY
14.2 PREFERRED STOCK OP PREFERRED EQUITY
A. Selected Characteristics
B. Convertible Preferreds
C. Conversion Value Protection
D. Conversion Protection Clauses
14.3 CONVERTIBLE DEBT
14.4 WARRANTS AND OPTIONS
14.5 OTHER CONCERNS ABOUT SECURITY DESIGN
14.6 VALUING VENTURES WITH COMPLEX CAPITAL STRUCTURES: THE
ENTERPRISE METHOD
SUMMARY
LEARNING SUPPLEMENT 14A:
Alternative Enterprise Valuation Method
LEARNING SUPPLEMENT 14B:
Application of Black-Scholes Option-Pricing Formula
DISCUSSION QUESTIONS AND ANSWERS
1. What is common stock or common equity? What is the purpose of preemptive rights?
2. What is preferred stock? What is participating preferred stock, and what is meant by
paid in kind (PIK) preferred stock?
Preferred stock: equity claim senior to common stock and providing preference on
3. What are the basic design features for financial securities used in venture investing?
4. Why is the conversion feature in convertible preferred important for venture
investors?
5. What is meant by a (a) full ratchet clause, and (b) down (reset) round?
6. Which is more favorable to the founders, the Market Price Formula (MPF) or the
Conversion Price Formula (CPF)?
7. How does convertible debt differ from convertible preferred stock?
Convertible debt holders have bankruptcy rights that can kick in when coupon
8. What are convertible notes? Why are convertible notes issued, and who typically
issues them?
9. Why are options to buy additional shares of stock used in venture financing? What
are warrants?
10. How do (a) American-style options, (b) European-style options, and (c) Bermudan-
style options differ?
11. How are put and call options similar? How are they different?
12. What are the “factors” that influence the values of American-style options?
13. Why is price protection an issue when convertibles or warrants are used?
14. Why is it important that convertible securities also be callable (redeemable)?
It is important for convertible securities to also be callable because they can “hang”
15. Is the sale of an out-of-the-money warrant a future sale of equity at a favorable price?
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Answers will vary: An enterprise valuation of Fuel3D would typically involve
INTERNET ACTIVITIES
1. Web surfing exercise: Search the web for a direct offering of a convertible preferred
security. Possible search words include “direct public offering” or “small corporate
offering registration” (SCOR). Analyze the conversion and dilution clauses offered
in the security.
Web-researched results will vary due to constant updating of the related web sites.
2. Get a current price for a traded call option on a publicly traded security having
publicly traded options (e.g., http://www.cboe.com). Compare the option price to the
value of exercise (stock price – exercise price) and comment on the difference.
Web-researched results will vary due to constant updating of the related web sites.
EXERCISES/PROBLEMS AND ANSWERS
1. [Preferred Stock Characteristics] A share of a venture’s preferred stock is convertible
into 1.5 shares of its common stock. The dividend on the preferred stock is $.50 per
share.
A. If the firm’s common stock is currently trading at $9.75, what is the conversion
value of a share of the preferred stock?
B. What would be the dividend yield on the preferred stock based on its conversion
value?
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C. What explanation would you give if the venture’s preferred stock currently trades
at $15? What would be the dividend yield?
D. If the venture doubles the number of shares of its common stock that is
outstanding (and cutting its stock price in half) but increases the conversion terms
on its preferred stock to 2.5 shares of common stock, what would be the
conversion value of a share of preferred stock after the new common stock issue?
What would be the dividend yield on the preferred stock based on this new
conversion value?
E. If the venture increased its common stock offering by 50 percent (instead of 100
percent), what common stock conversion ratio would be needed on a share of
preferred stock to keep its conversion value the same as it was before the new
common stock issue?
2. [convertible Preferred Stock Concepts] The CCC (triple C) Venture has issued
convertible preferred stock to its venture investors. Each share of preferred stock is
convertible into .80 shares of common stock and pays an annual cash dividend of
$.25.
A. If each share of preferred stock has a market value of $4.00, what is the minimum
price that a share of the CCC Venture’s common stock should be selling for
(ignore the dividend yield on the preferred stock)?
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B. If a share of the CCC Venture’s common stock is actually trading at $3.00 per
share, what are the implied conversion terms? Given the above actual conversion
terms, explain how the common stock could be trading at $3.00 per share while
the preferred stock is trading at $4.00 per share.
3. [Conversion Price and Market Price Formulas] Calculate the conversion price
formula (CPF) and market price formula (MPF) prices for an offering involving an
existing conversion price of $1, a hypothesized market price of $2, and a new offering
price of $.95 for 1,000 shares with 2,000 shares outstanding prior to the new issue.
Relate the new conversion price to the implied new conversion ratio.
CPF = [(Shares before issue)(Old Conversion Price) + (New Issue Price)(New
Shares)]/(Total shares after issue)
MPF = (Old Conversion Price) x [(Shares before issue) + ((New issue price)(New
shares)/(Share value w/o new))/(Total shares after issue)]
4. [Conversion Price and Market Price Formulas] Show how your answers for Problem
3 would change if the new offering price was $.80 for 1,500 shares. Assume other
things remain the same.
5. [Stock Option Concepts] Draw the payoff diagram for the following options:
A. Call option to buy a venture’s stock at $3
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B. Put option to sell a venture’s stock back to the venture at $15
6. [Stock Option Concepts] Draw the payoff for a portfolio of a share of venture equity
and a short call option to buy that share at $5.
7. [Stock Unit Concepts] Sometimes the combination of a share and a warrant is called
a “stock unit.” What does the payoff diagram look like for such an investment?
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10. [WACC Calculations] Calculate the after-tax WACC for a firm with a 25 percent tax
rate, a 10 percent cost of debt, a 30 percent cost of equity and a target debt-to-value
of .30. Explain how investing to provide the WACC returns keeps the debt and equity
investors happy. (Review Chapter 7)
11. [WACC Concepts] Why is the (1-tax rate) in the WACC? How does the government
pay the tax rebate on interest – through a flow or in the rate? (Review Chapter 7)
12. [WACC Concepts] Given a WACC of 15 percent, a target debt-to-value of .5, a tax rate
of 28 percent and a cost of debt of 10 percent, what is the implied cost of equity?
13. [Enterprise and Equity Value Concepts] Assume a venture has a perpetuity enterprise
value cash flow of $800,000. Cash flows are expected to continue to grow at 8
percent annually and the venture’s WACC is 15 percent.
A. Calculate the venture’s enterprise value.
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B. If the venture has $2,000,000 in interest-bearing debt obligations, what would be
the venture’s equity value?
C. Show how your answers to Parts A and B would change if the perpetuity cash
flow growth rate was only 6 percent and the WACC was 16 percent.
14. [Enterprise and Equity Value Concepts] A venture has a $500,000 bank loan
outstanding, a long-term debt obligation of $900,000, accounts payable of $200,000,
and accounts receivable of $350,000.
A. If the venture’s equity value is $2,450,000, what would be the associated
enterprise value?
B. Assume the venture’s enterprise value has been estimated to be $5,300,000
(ignore any information from Part A). What would be the venture’s equity value?
C. Now assume that the venture has surplus cash of $700,000. Show how your
answers (it at all) would change for Parts A and B.
15. [Enterprise Value Concepts] Why is the market value of currently issued debt
subtracted from the enterprise value (in a debt-and-equity-only firm) to arrive at the
value of equity? Why are future debt issues ignored by the process?
The enterprise value is the value of all of the securities (debt and equity). To get
16. [Enterprise Valuation Method] The Datametrix Corporation has been in operation
for one full year (2016). Financial statements are shown below. Sales are expected
to grow at a 30 percent annual rate for each of the next three years (2017, 2018, and