Case 044Deal structuring and pricingWarm up

A growth fund invests Rs 200 crore for 25% of a cloud kitchen company with a 1x non-participating liquidation preference. What does the fund receive at exit equity values of Rs 500, 800 and 1,500 crore, and at what value does converting beat the preference?

The situation

Rasoighar Cloud Kitchens runs delivery-only kitchens for six of its own food brands across four cities. A growth fund invests Rs 200 crore in new preference shares for 25% of the company, a post-money valuation of Rs 800 crore.

The shares carry a 1x non-participating liquidation preferenceA right to be paid a set amount, usually the money invested, out of a sale before ordinary shareholders receive anything.: on a sale, the fund can either take its Rs 200 crore back first, or convert into ordinary shares and take 25% of the proceeds, whichever is larger, but not both. Assume no debt, so exit equity value is the sale price, and no other preference shares.

Your task

Work the fund's proceeds at exit values of Rs 500, 800 and 1,500 crore, find the crossover, and explain what the preference does for each side.

Quick check

At an exit of Rs 500 crore, what does the fund receive?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The fund receives Rs 200 crore at Rs 500 crore, Rs 200 crore at Rs 800 crore, and Rs 375 crore at Rs 1,500 crore; it converts once exit value passes Rs 800 crore. Below that, its Rs 200 crore back beats 25% of the sale; above it, 25% is larger. The crossover is the investment divided by the stake, which is the post-money valuation. The preference protects the downside and costs the founders only when the company sells below the price the fund paid.

Step 1How does a non-participating preference pay out?

Think of lending a friend money for a share in his restaurant on one condition: if it is sold, you get either your money back or your share of the sale, whichever is more. A 1x non-participating preference is exactly that choice: Rs 200 crore back, or 25% of the proceeds, never both. So at every exit value you compute two numbers and take the larger: the preference, capped at the sale price if the sale is smaller than Rs 200 crore, and 25% of the sale.

Step 2What does the fund get at each exit value?

At Rs 500 crore, 25% is Rs 125 crore against a Rs 200 crore preference: the fund takes Rs 200 crore, 40% of the proceeds, and the other shareholders share Rs 300 crore. At Rs 800 crore, 25% is exactly Rs 200 crore, so the two choices are equal. At Rs 1,500 crore, 25% is Rs 375 crore, so the fund converts and the preference no longer matters. Below Rs 200 crore, say a fire sale at Rs 150 crore, the fund takes everything and the founders get nothing.

Exit equity valuePreference25% if convertedFund takesOthers receiveFund's choice
Rs 500 crore200125200300preference
Rs 800 crore200200200600either
Rs 1,500 crore2003753751,125convert
Rs crore. The fund takes its Rs 200 crore preference at Rs 500 crore, is indifferent at Rs 800 crore and converts at Rs 1,500 crore to take Rs 375 crore, so the preference only changes the split when the company sells below the Rs 800 crore post-money value.
What the fund receives against the exit value of the company, Rs crore100200300400004008001,2001,600Exit equity value of Rasoighar, Rs croreplain 25% stake, no preferencepreference: Rs 200 crore back firstshaded: what the preference protects500: 200800: crossover1,500: 375, converts
The fund's proceeds rise with the sale price up to Rs 200 crore, stay flat at Rs 200 crore until the exit value reaches Rs 800 crore, then rise at 25%, so the preference only pays out more than a plain stake below the price the fund invested at.
Step 3Why is the crossover at Rs 800 crore, and what does each side get?
The relationship
Crossover=InvestmentStake=2000.25=800\text{Crossover} = \frac{\text{Investment}}{\text{Stake}} = \frac{200}{0.25} = 800
200the preference, Rs crore
0.25the fund's share on conversion
800exit value above which converting pays more, Rs crore
What it says in wordsConverting beats the preference once a quarter of the sale exceeds the money invested, which happens exactly at the post-money valuation.

The crossover equals the post-money valuation, so a 1x non-participating preference only bites if the company is sold for less than the price the fund paid. For the fund it is downside protection: in a sale at Rs 500 crore it loses nothing instead of losing Rs 75 crore. For the founders it costs nothing in a good outcome and shifts money to the fund in a bad one. A participating preference would be harsher: at Rs 1,500 crore the fund would take Rs 200 crore plus 25% of the remaining Rs 1,300 crore, Rs 525 crore, instead of Rs 375 crore. That is why founders fight participation much harder than they fight a 1x preference.

The limit of the simple version is that real companies raise several rounds, each with its own preference, and the later ones usually rank first. With Rs 600 crore of preferences stacked across three rounds, a Rs 500 crore sale could leave founders and employees with nothing at all, which is why a founder reads the whole preference stack, not just the latest term sheet.

Where candidates lose it

The usual loss is adding the preference and the stake together, Rs 200 crore plus 25%, which is a participating preference. Non-participating means the fund picks one.

The second miss is not seeing that the crossover is the post-money valuation. Candidates solve it by trial and error when it falls straight out of the price of the round.

What the interviewer asks next

  • What is the crossover if the preference is 1.5x?
  • A later investor puts in Rs 300 crore with a senior 1x preference. What does the first fund receive at a Rs 500 crore exit?
  • Why might a fund accept no preference at all in a competitive round?

Company names and figures are illustrative.