Venture Capital puzzles, solved step by step

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  1. 066An investor puts in Rs 30 crore for 25% of a company, with a 1x non-participating liquidation preference. Above what exit value does converting to common shares beat taking the preference?Preferences, payouts and protectionsWarm upSeries A to C VCMulti-stage VC

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    Above what exit does the investor convert?

    Show the worked solution

    Above Rs 120 crore. A non-participating investor chooses the better of two payouts: the Rs 30 crore preference, or 25% of the exit as common. 25% of the exit equals Rs 30 crore at an exit of Rs 120 crore, so below that the investor takes the preference and above it converts. At Rs 100 crore the preference pays Rs 30 crore against Rs 25 crore as common; at Rs 160 crore converting pays Rs 40 crore.

    What exactly is the investor choosing between?

    A shopper with a Rs 300 voucher or a 25% discount uses the voucher on small bills and the discount once the bill passes Rs 1,200. A 1x non-participating preference is the same either-or: the investor takes its money back or its percentage of the exit, never both, so it switches at the exit where the two are equal. Rs 30 crore equals 25% of Rs 120 crore. The non-participatingThe holder takes either its preference or its as-converted share of the proceeds, whichever is larger, but not both. label is what makes it a choice; a participating preference would take the Rs 30 crore and then a share of the rest as well.

    Take the preference until 25% of the exit beats Rs 30 crore0408012016020001020304050Exit value, Rs croreInvestor payout, Rs croreRs 120 crore: indifferenttake the Rs 30 crore preferencepreference beats 25%convert: 25% of exit25% line40
    The investor's payout is flat at Rs 30 crore from a Rs 30 crore exit up to Rs 120 crore, where it meets the 25% line, and above Rs 120 crore converting pays more, so the kink sits exactly at the price the investor paid for the whole company.
    The relationship
    s×V=P  ⇒  V∗=Ps=300.25=120s \times V = P \;\Rightarrow\; V^* = \frac{P}{s} = \frac{30}{0.25} = 120
    sinvestor's stake as converted, 25%
    Ppreference amount, Rs 30 crore at 1x
    V*exit value at which the two payouts are equal
    What it says in wordsThe switch point is the preference divided by the stake, which is also the post-money valuation the investor paid.

    Why is the answer the same as the price the investor paid?

    Rs 30 crore for 25% means the investor valued the company at Rs 120 crore post-money. For a 1x non-participating preference, the conversion point is always the post-money valuation of the round, so the preference only bites in exits below the price the investor came in at. That gives a quick reading of any term sheet: below the round's post-money the investor is protected, above it the investor is just another shareholder. In between Rs 30 and Rs 120 crore, the common holders share whatever is left after the Rs 30 crore comes off the top.

    The limit: this holds with one preferred class. With several classes, each with its own price, the junior classes convert later than their own simple line because senior preferences taken first shrink the pool. And a 2x preference doubles the conversion point to Rs 240 crore, which is why the multiple on a preference matters more to founders than it first appears.

    Where candidates lose it

    The common wrong answer is Rs 30 crore, the exit at which the preference is just covered. At that exit converting would pay only Rs 7.5 crore, so nobody converts there; covering the preference and making conversion pay are different lines.

    The second loss is solving correctly without noticing that Rs 120 crore is the round's post-money. Say it; it shows you can read a cap table at a glance.

    What the interviewer asks next

    • What if the preference were 2x?
    • At a Rs 90 crore exit, what do the common holders receive?
    • How would a participating preference change the investor's payout above Rs 120 crore?