Valuation of Preferred Investment

The technique for valuing Random Expiration Callable Options (RE Calls) is used to assess the special conditions or options generated by a startup’s financing contract (link).

Here, I will specifically discuss one example and upload the Excel model.

The example examines a format of redeemable preferred (RP) shares, with versions including liquidity preference and additional dividend rights.

The investment is considered with the following data:

• Investment amount: $6 million, with 5,000 new shares issued.
• Redeemable (redeemable) shares portion of the amount: $5 million.
• Number of existing shares owned by the startup owners: 10,000.
• Investment round: First.
• Expected lifespan of the investment: 5 years.
• Post-financing valuation: $18 million (mathematically, this is the result).

Thus, the outcome will be as follows:

We get the following exit scenario:

Sure! Here’s the translation:

So, when a startup goes for an IPO or liquidation, if its value is up to 5 million, the fund takes the entire amount. However, if the valuation exceeds 5 million, you get the 5 million and also participate as a regular investor owning 1/3.

Therefore, the value of such a contract will be calculated by the following formula:

PEV = V – 2/3 C (5)

Where:

• PEV = Partial Exit Valuation
• V = Total Exit Value
• C = Random Expiration Call Option
• (5) = Strike Price = $5 million

Result:

As you can see, the table above includes additional data about the general partner’s share and the investor’s expense: GP% = 10%, and the investor’s LP Cost = $7.5 million. I described how these figures are calculated in the discussion of the VC Method and will not delve into that here (link).

The investment recommendation is negative, meaning the numbers suggest that the investor should not make such an investment. But what happens if we assign a 2X liquidity preference to part of the redeemable shares? Or add an annual dividend of 12%?

The 2X liquidity preference changes the exit diagram and the result:

Additionally, integrating the dividend rights also changes the outcome:

The full calculation model, which includes the options calculator, can be found here:

RP Option Valuation Excel.

P.S.

The RP version of preferred shares is not usually used alone, but understanding this is essential for more practical versions.

Here’s the translation:

“Below is a similar model that pertains to the conversion option, i.e., when preferred stock can be converted into common stock. Three options are also considered here – ordinary, with an additional liquidity preference, and with the obligation to pay dividends:

Convertible Preferred Stock Valuation – Excel”

Source:

Venture Capital & the Finance of Innovation
Andrew Metrick & Ayako Yasuda
Second Edition