With the advent of accounting (FASB 123R) and income tax (IRC 409A) guidelines regarding the valuation of equity-based compensation, it has become increasingly important for entrepreneurs to become familiar with complex equity securities and the valuation of equity-based compensation such as stock or option grants.
This typically arises in the context of venture capital funding. Providers of early stage institutional funding provide growth capital for emerging companies and therefore, are interested in the return of the their capital (often called liquidation preference) but also participating in the “upside” or increase in equity value of the business, hence achieving a return commensurate with the risk involved.
Two commonly used securities for early stage institutional funding are convertible and participating preferred stock.
- The holders of Convertible Preferred Stock have the option of either receiving their stated liquidation preference OR converting their shares into Common Stock based on an established conversion price. This structure provides “downside” protection for the investor in the form of a priority or preferential distribution of proceeds OR gives them the option of participating pro rata with common stockholders on an as-if converted basis.
As an example, assume the holders of a Convertible Preferred Stock have a liquidation preference of $5 million and it is convertible into 30% of the common equity. Management of the company receives an offer which will result in sale proceeds to equity holders of $15 million. Should the preferred stockholder take their preferential distribution or convert? Using this simple example, the preferred shareholder would not convert, as they would receive a larger share of the sale proceeds ($5 million) under the liquidation preference than if they converted to Common Stock ($4.5 million).
The conversion “trigger point,” the value at which the preferred holder would convert, could be mathematically presented as:
Conversion Trigger Point = $1 plus (Stated Liquidation Preference/ Conversion Percentage).
In this simple example, the conversion trigger point would be approximately $16.67 million and the preferred holder would be entitled to 30% of the liquidation or sale proceeds in excess of this amount.
In future blogs, we will discuss participating preferred stock and additional timely business valuation issues.
For more information, contact Greg Huff at 410-997-6000 or firstname.lastname@example.org