Chapter 14: Security Structures and Determining Enterprise Values 184

Chapter 14

SECURITY STRUCTURES AND DETERMINING ENTERPRISE VALUES

DISCUSSION QUESTIONS AND ANSWERS

1. What is common stock or common equity? What is the purpose of preemptive rights?

Common stock: the least senior claim on a venture’s assets (residual ownership)

Pre-emptive rights: the right for existing owners to buy sufficient shares to preserve
their ownership share

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
dividends and liquidation proceeds

Participating preferred stock: preferred stock with rights to participate in any

dividends paid to common stockholders; or, stock with an investment repayment
provision that must be met before distribution of returns to common stockholders

Paid in kind (PIK) preferred stock: preferred stock that has the option of paying
preferred dividends by issuing more preferred stock

3. What are the basic design features for financial securities used in venture investing?

Typically, venture investing securities need to address the type of financial claim
(equity, debt, convertible) and the voting rights assigned. It is common for the
security to have debt-like seniority in promised payments and be convertible in to an
equity claim in successful ventures. There is almost always some claim of equity-like
ownership.

4. Why is the conversion feature in convertible preferred important for venture investors?

The conversion features allows the venture investor to participate in the venture’s
success as reflected in equity appreciation. This is where the majority of return on
investment in a successful venture will come.

5. What is meant by a (a) full ratchet clause, and (b) down (reset) round?

A full ratchet clause provides that existing investors will receive enough post-
185 Chapter 14: Security Structures and Determining Enterprise Values

conversion shares to protect their pre-issue conversion value.

Down (reset) round: venture round priced below most recent previous price

6. Which is more favorable to the founders, the Market Price Formula (MPF) or the
Conversion Price Formula (CPF)?

It depends. However in many cases, the MPF is typically more favorable because it
only adjusts for issues below a certain market price. The CPF adjusts for any issue
below the existing conversion price. When the market price is below the conversion
price, the MPF makes no adjustment as long as the shares are issued at or above the
“market price.” For an example of where the CPF is softer than the MPF (market
price is significantly above conversion price and the offering is priced below both, see
problem 4 below).

7. How does convertible debt differ from convertible preferred stock?

      Convertible debt is debt with the option to exchange it into stock. 

Convertible preferred stock: preferred stock with option to exchange into common
stock

 Convertible debt holders have bankruptcy rights that can kick in when coupon 
payments are missed. These rights are much stronger than those of preferred 
shareholders, who don’t receive a scheduled dividend. Convertible debt holders also 
have a security interest in the venture’s assets that is senior to preferred shareholders’ 
interests. Unlike preferred equity, debt can be structured to provide senior interest in 
specific assets such as inventory or property, plant, and equipment (collateral).

8. What are convertible notes? Why are convertible notes issued, and who typically
issues them?

Convertible notes are debt allowing for conversion into stock at a price set by a 
future financing round.

Convertible notes are issued to allow for a delayed valuation until the time of a future 
financing round.  Ventures needing seed financing are increasingly issuing
convertible notes.

Typically, convertible notes convert into equity securities (frequently convertible 
preferreds) using a formula based on a future round’s price. That formula can include 
 Chapter 14: Security Structures and Determining Enterprise Values 186

maximum valuation “caps” (setting up a minimum number of shares the converted 
note creates) or discounts to the eventual offering price.

9. Why are options to buy additional shares of stock used in venture financing?
What are warrants?

Options to buy additional shares at specified prices are common “sweeteners” or

“equitykickers” use to increase the attractiveness of a securities offering. Options are
also a common component of venture employee incentive compensation.

Warrants: call options issued by a company granting the holder the right to buy
common stock at a specific price for a specific period of time

10. How do (a) American-style options, (b) European-style options, and (c)
Bermudan-style options differ?

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 the expiration date
Bermudan-Style Option: an option that can be exercised only at a specific set of dates

11. How are put and call options similar? How are they different?

Put and call options are similar in that they provide the holder the right to buy (call)
or sell (put) at a specified price. They are different because a call option holder has
the right to buy and gains if the price goes up and a put option holder has the right to
sell and gains if the stock price goes down.

12. What are the “factors” that influence the values of American-style options?

The factors are:

 Underlying Asset
 Exercise (or Strike) Price
 Time to Maturity
 Volatility
 Interest Rate
 Payouts, if any

13. Why is price protection an issue when convertibles or warrants are used?

If an investor has a fixed conversion or exercise price, then new issues at prices below
that fixed price can effectively make the conversion or option less valuable. Price
protection clauses allow for some compensating adjustment in conversion or exercise
prices to allow the investor to retain more of the value when the venture is facing a
down round.

14. Why is it important that convertible securities also be callable (redeemable)?

 187 Chapter 14: Security Structures and Determining Enterprise Values

It is important for convertible securities to also be callable because they can “hang”
otherwise. That is, there may be little incentive to convert them if they can always be
subsequently converted. The unconverted value will be at least as high as the
conversion value. Leaving the security unconverted softens any downside from a
decline in venture value because the security retains its superior claims. Forcing
conversion with a redemption or call feature makes the investor give up this downside
protection in order to continue to participate in venture upside.

15. Is the sale of an out-of-the-money warrant a future sale of equity at a favorable price?

It is not a guaranteed sale at all. It is a contingent “sale” when the venture’s value per
share exceeds the warrant exercise price. However, at that time the company will be
selling the share at less than its value. It is still true that this future contingent sale
may be at more favorable prices than a current sale of the same security.

16. What is the enterprise (entity) method of valuation and how does it differ from the
equity methods of Chapters 10 and 11?

The enterprise method attempts to value the entire firm, value to debt holders and
equity holders, while the equity method attempts to just determine the value to equity
holders.

17. Describe how the enterprise valuation cash flow is determined. That is, identify the
components included in determining the enterprise valuation cash flow.

Enterprise Valuation Cash Flow =

 EBIT x (1 – Enterprise Tax Rate)
 +Depreciation and Amortization Expense
 - Change in Net Working Capital (w/o Surplus Cash)
 - Capital Expenditures

18. What is meant by (a) NOPAT, and (b) EBIAT? How do they compare with each other?

NOPAT is net operating profit after taxes

EBIAT is earnings before interest after taxes

NOPAT and EBIAT will have the same values and are also the same as after-tax EBIT

19. Why is the weighted average cost of capital (WACC) used as the discount rate in the
enterprise method?

The WACC is used in the enterprise method because the enterprise method values
flows to all security holders. The average return that must be achieved to keep this
group of investors happy requires weighting the individual securities’ required return
 Chapter 14: Security Structures and Determining Enterprise Values 188

in proportion to their (market) weight in funding the venture. The resulting overall
average required return is called the Weighted Average Cost of Capital (WACC).

20. How do debt investors get paid in the enterprise method?

The enterprise method values all possible payments to investors and then subtracts the
market value of debt to arrive at the market value of equity. Consequently, debt
holders are paid with a “slice” of the pie allocated directly to them.

21. From the Headlines – Fuel3D: What would you need if you wanted to conduct an 

enterprise valuation for a hypothetical Round D for Fuel3D? Discuss the relationship 
between Fuel3D and MakerBot. How might it affect the terminal value used in the 
enterprise valuation?

Answers will vary: An enterprise valuation of Fuel3D would typically involve

projections of the income statement, balance sheet and statement of cash flows over
an explicit period with a conjecture for the growth and capital structure it will sustain
after that explicit period. Additionally, one would need estimates of the required
returns for equity and debt. With an estimated WACC calculated using the projected
structure and rates, the enterprise valuation can be completed. If the 3D world follows
that of the 2D world, one would expect there to be a variety of scanning software
providers that sell their software to hardware (3D printer) firms like MakerBot to
distribute with their hardware. Acquisition by a hardware firm seems likely in the
resulting shake out.

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?

$9.75(1.5) = $14.625
The convertible preferred stock’s value should be directly related to the common
stock price

B. What would be the dividend yield on the preferred stock based on its conversion
value?

$.50/$14.625 = 3.42%
189 Chapter 14: Security Structures and Determining Enterprise Values

C.What explanation would you give if the venture’s preferred stock currently trades at
$15? What would be the dividend yield?

$15 - $14.625 = $.375

The convertible preferred stock is trading at a premium relative to the current
common stock price. This may reflect a higher dividend yield on the preferred
stock and/or there may be a current price anomaly.

$.50/$15 = 3.33%

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?

$9.75/2 = $4.875 new common stock price

Or, 1.0/2.0 = .50; $9.75(.50) = $4.875
$4.875(2.5) = $12.1875
The preferred stock’s value would decline

$.50/$12.1875 = 4.10%

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?

$9.75/1.5 = $6.50
Or, 1.0/1.5 = $.667; $9.75(.667) = $6.50
$14.625/$6.50 = 2.25
That is, one share of preferred stock would have to be convertible into 2.25 shares
of common stock.

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)?

$4.00/.80 = $5.00
 Chapter 14: Security Structures and Determining Enterprise Values 190

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.

$4.00/$3.00 = 1.3333 implied conversion terms

That is, one share of preferred stock should be convertible into 1.3333 shares of
common stock

Actual conversion value: $3.00(.80) = $2.40 implied value of preferred stock

Even considering the expected $.25 dividend on the preferred stock results in a
value of $2.65 ($2.40 + $.25). Thus, there is an unexplainable current price
anomaly between the preferred stock’s value in terms of its worth in common
stock and its current trading price. Possibly very little trading of one or both of
these securities occurs. Arbitrageurs will soon cause these price differentials to
converge by purchasing the common stock and selling the preferred stock short.

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)

= [(2000)($1.00) + ($0.95)(1000)]/3000 = $2,950/3,000 = $0.9833

MPF = (Old Conversion Price) x [(Shares before issue) + ((New issue price)(New
shares)/(Share value w/o new))/(Total shares after issue)]

= ($1.00)[(2000) + (($0.95)(1000)/($2.00))/3000] = $1.00[$2,475/3,000]

= $0.825

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.

CPF = [(2000)($1.00) + ($0.80)(1500)]/(3500) = $3,200/3,500 = $0.9143

MPF = ($1.00) x [(2000) + (($0.80)(1500)/($2.00))/(3500)] = $1.00[$2,600/3,500]

= $0.7429

5.
13.[Enterprise and Equity Value Concepts] Assume a venture has a perpetuity enterprise
 191 Chapter 14: Security Structures and Determining Enterprise Values

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.

$800,000/(.15 - .08) = $11,428,571.43

B.If the venture has $2,000,000 in interest-bearing debt obligations, what would be
the venture’s equity value?

$11,428,571.43 - $2,000,000 = $9,428,571.43

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.

$800,000/(.16 - .06) = $8,000,000 enterprise value

$8,000,000 - $2,000,000 = $6,000,000 equity value

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?

Enterprise value = $2,450,000 + $500,000 + $900,000 = $3,850,000

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?

Equity value = $5,300,000 - $500,000 - $900,000 = $3,900,000

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.

In each case, the surplus cash would add $700,000 to the value:
Revised Part A: Enterprise value = $3,850,000 + $700,000 = $4,550,000
Revised Part B: Equity value = $3,900,000 + $700,000 = $4,600,000

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?
 Chapter 14: Security Structures and Determining Enterprise Values 192

The enterprise value is the value of all of the securities (debt and equity). To get
what’s left for the market value of equity, we have to subtract the market value of
debt. This type of formulation assumes all future debt offerings are NPV=0. (Debt is
fairly priced and the tax implications of future debt payments are already incorporated
in the discount rate).

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
2019) before settling down to a long-run growth rate of 7 percent annually. The cost
of goods sold is expected to vary with sales. Operating expenses are expected to
grow at 75 percent of the sales growth rate (i.e., be semi-fixed) for the next three
years before again growing at the same rate as sales beginning in 2020. Interest
expense is expected to grow with sales. Depreciation can be forecasted either as a
percentage of sales or as a percentage of net fixed assets (since net fixed assets are
expected to grow at the same rate as sales growth). Individual asset accounts are
expected to grow at the same rate as sales. Accounts payable and accrued liabilities
are also expected to grow with sales.
Because Datametrix is in its start-up life cycle stage, management and venture
investors believe that 35 percent is an appropriate weighted average cost of capital
(WACC) discount rate until the firm reaches its long run or perpetuity growth rate.
At that time it will have survived, recapitalized its capital structure, and will become
a more typical firm in the industry with an estimated WACC of 18 percent. Calculate
Datametrix’s enterprise value as of the end of 2016. Also indicate what the equity
would be worth.

_________________________________
Datametrix Corporation
Income Statement for December 31, 2016
(Thousands of Dollars)
__________________________________
Sales $20,000
Cost of goods sold -10,000
Gross profit 10,000
Operating expenses -7,500
Depreciation -400
EBIT 2,100
Interest -100
EBT 2,000
Taxes (40%) -800
Net income $1,200

______________________________________________________________________________
Datametrix Corporation
Balance Sheet as of December 31, 2016
(Thousands of Dollars)
193 Chapter 14: Security Structures and Determining Enterprise Values

______________________________________________________________________________
Cash $ 1,000 Accounts payable $ 1,500
Accounts receivable 2,000 Accrued liabilities 1,000
Inventories 2,000 Total current liabilities 2,500
Total current assets 5,000 Long-term debt 1,000
Gross fixed assets 5,400 Common stock 5,300
Accumulated depreciation 400 Retained earnings 1,200
Net fixed assets 5,000 Total equity 6,500

Total assets $10,000 Total liabilities & equity $10,000

Solutions:

See spreadsheet solutions presented below.

Market Value of Firm (Enterprise Value) = $13,128,000
Less: Long-Term Debt = $1,000,000
Market Value of Equity = $12,128,000

[Note: While not stated in the problem, the instructor may want to inform students
that there are 1,000,000 shares of common stock outstanding so that market value can
be stated on a per share basis.]

Thus, assuming 1,000,000 shares of stock are outstanding, results in a per share value =
$12.13. and thereafter.