Venture Capital puzzles, solved step by step

The preference is about Rs 73.47 crore, and conversion wins only above an exit of about Rs 293.9 crore. Rs 50 crore compounding at 8% for five years is 50 x 1.08 to the power 5. Converting gives 25% of the exit, which beats Rs 73.47 crore only when the exit exceeds 73.47 divided by 0.25. Without the dividend the break-even would be Rs 200 crore.

How does an unpaid dividend change the preference?

Think of a loan where the interest is not paid each year but added to what you owe, so next year's interest is charged on the bigger amount. A cumulative dividend that accrues instead of being paid works the same way: each year's 8% is added to the preference, and the next year's 8% is charged on the larger figure. After one year the preference is Rs 54 crore, after two Rs 58.32 crore, and after five Rs 73.47 crore, about 47% more than was invested.

What happens between Rs 200 crore and Rs 294 crore?

In that band the investor takes the preference rather than converting, and the founders and common holders feel it. At an exit of Rs 250 crore, a plain 1x preference holder would convert and take Rs 62.5 crore; with the accrued dividend the investor takes Rs 73.47 crore instead, and the extra comes out of the common holders' share. The accrued dividend is a return on the investment that is paid whether or not the company has grown, which is why founders negotiate hard against it or ask for it to be non-cumulative.

Name the assumptions. The answer takes the dividend as forfeited on conversion, which is the usual drafting, and the preference as non-participating. If the dividend were also paid on conversion, the investor would convert at a lower exit; read the actual terms before trusting any break-even.

With B senior, B takes Rs 40 crore and A Rs 5 crore; pari passu, A takes Rs 9 crore and B Rs 36 crore. The preferences add to Rs 50 crore against a Rs 45 crore sale, so someone is short. A senior B is paid in full first and A gets what is left. Pari passu, each recovers 90% of its preference. Common shareholders get nothing either way, and seniority moves Rs 4 crore from A to B.

What do senior and pari passu mean when the money runs short?

Two friends lent Rs 10,000 and Rs 40,000 to a third, who can now repay only Rs 45,000. If the bigger lender was promised first claim, he takes his Rs 40,000 and the other gets Rs 5,000. If they agreed to stand together, they each take 90 paise in the rupee. Seniority decides the order of payment; pari passuLatin for equal step. Claims that rank pari passu are paid at the same time, sharing any shortfall in proportion to the amounts owed. means paying everyone at once in proportion to what each is owed. Both rules give the same answer whenever the sale covers every preference; they only differ in a shortfall like this one.

Would either series rather convert to common?

Check it, because non-participating preferred can always choose to convert. When the total preference exceeds the sale price, converting cannot help either series, because a converted holder still stands behind the other series' preference and shares only what is left. If A converted under B seniority, it would share the Rs 5 crore left with the other common holders, getting less than Rs 5 crore. If B converted under pari passu, it would share the Rs 35 crore left after A's Rs 10 crore, less than its Rs 36 crore. So the stacks above are the answer, whatever the stakes are.

Why does the later investor usually ask for seniority?

The later investor writes the bigger cheque at the higher price, and a down-side sale hurts it most. Seniority protects the Rs 40 crore cheque at the expense of the Rs 10 crore one, so it moves Series A's recovery from 90% to 50%. That is why earlier investors negotiate hard for pari passu when a new round comes in. The limitation of this example is that it is a single sale at a single price; at any exit above Rs 50 crore the ranking stops mattering for the preferences and only the conversion decisions remain.

Above about Rs 250 crore, and Series B sets that line. A non-participating holder converts when its share of the exit beats its preference, so each class's line is preference divided by stake: seed Rs 5 crore over 10% is Rs 50 crore, Series A Rs 20 crore over 20% is Rs 100 crore, Series B Rs 50 crore over 20% is Rs 250 crore. The class that paid the most per percentage point is the last to convert.

Why is the line for each class its preference divided by its stake?

Suppose a friend offers you a choice: your Rs 500 back, or a tenth of whatever the raffle raises. You take the tenth only once the pot is above Rs 5,000. A 1x non-participating preference is exactly that choice, so a class converts once its stake times the exit value beats its money back, and the crossover is preference divided by stake. Preference over stake is also the price the class paid for the whole company, which is why the class that bought at the highest valuation, here Series B at an implied Rs 250 crore, holds out longest.

Why does the question say 'roughly', and do the lower lines move?

The simple division assumes everyone else has converted. Below Rs 250 crore Series B keeps its Rs 50 crore, and that comes out of the pot before the others share it. When a senior class holds its preference, the pool left for everyone else shrinks, so the junior classes need a bigger exit before converting pays. Series A with B holding gets 20/80 of the exit less Rs 50 crore, which beats Rs 20 crore only above Rs 130 crore. Seed, with both A and B holding, needs Rs 100 crore. The top line does not move, because by the time Series B is deciding, everyone below it has already converted.

In the room, give Rs 250 crore and Series B first, then offer the refinement as a check. It shows you understand that preferences interact, which matters when you are the junior investor negotiating behind a large late round.