Venture Capital puzzles, solved step by step

Series B takes its Rs 60 crore preference and Series A converts. Converting would give Series B at most Rs 45 crore, so it takes its money back. That leaves Rs 140 crore for Series A and common, who hold 20% and 60% of the shares; Series A's quarter is Rs 35 crore, beating its Rs 20 crore preference. Common receives Rs 105 crore.

How does a non-participating holder decide?

Think of a refund policy: you can take your money back, or keep the product and its resale value, but not both. A non-participating preferred holder takes the larger of its preference or what its shares are worth as common, never both. Two series holding the same 20% each face very different choices here, because Series B paid Rs 60 crore for its 20% and Series A paid Rs 20 crore. Series B's refund is worth three times as much, while their shares are worth the same.

Why does Series B not convert, whatever Series A does?

Test its best case. If Series A takes its preference, Series B converting would share Rs 180 crore with common, 20 parts of 80, which is Rs 45 crore. If Series A also converts, Series B would get 20% of Rs 200 crore, Rs 40 crore. Both are below Rs 60 crore, so Series B takes its preference however Series A behaves. That settles the order: take B's Rs 60 crore off the top first, then decide A.

Where are the break points if the sale price moves?

Series A converts once a quarter of what is left after Series B exceeds Rs 20 crore, which is any sale above Rs 140 crore. Series B converts only once 20% of the whole sale exceeds Rs 60 crore, above Rs 300 crore. Between Rs 140 crore and Rs 300 crore, the two series that own the same stake are treated differently, and Rs 200 crore sits inside that band. Below Rs 80 crore, pari passu means the two preferences share the proceeds in proportion to Rs 20 crore and Rs 60 crore, one part to three.

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.

About Rs 8.33 crore, roughly 5% of the sale, although they own half the company. The investors compare their Rs 150 crore preference with 40% of Rs 160 crore, Rs 64 crore, and take the preference. That leaves Rs 10 crore for common shareholders. Founders hold 50 of the 60 points of common, so they get five sixths of Rs 10 crore, and employees get Rs 1.67 crore.

Why do founders who own half the company get so little?

If you own half a house with a large loan against it and sell it for slightly more than the loan, the bank is paid first and your half of the small remainder is all you get. A liquidation preference works like that loan: investors are paid their Rs 150 crore before common shareholders see anything, so in a sale close to the preference, ownership percentages barely matter. This is the preference overhangThe total of liquidation preferences ahead of common shareholders. Until a sale exceeds it by a wide margin, common holders receive little, whatever their ownership. founders worry about after raising a lot of money at high valuations.

At what sale price does ownership start to matter again?

Investors convert when 40% of the sale beats Rs 150 crore, which happens above Rs 375 crore. Between Rs 150 crore and Rs 375 crore every extra rupee goes to common, so founders get five sixths of each rupee; above Rs 375 crore everyone shares by ownership and founders get half. At exactly Rs 375 crore the two rules give the same answer: founders take five sixths of Rs 225 crore, Rs 187.5 crore, which is half the sale. That is the price at which the founders' 50% stake finally means 50% of the money.

What does this mean for an investor sitting on the board?

A founder team facing Rs 8 crore from a Rs 160 crore sale has little reason to work for it, and a board that needs the founders to close the deal has a problem. That is why sales near the preference overhang often include a management carve-out, a slice of proceeds set aside for the team ahead of or alongside the preferences. The limits of the clean answer: real stacks have several series with different seniority, and any carve-out, transaction costs or debt come off the top first, which leaves common with even less.

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.

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.

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.

The cap bites at an exit of Rs 220 crore and converting takes over above Rs 300 crore; in between, the investor's payout is stuck at Rs 60 crore. Below Rs 20 crore the investor takes everything. Above it, the investor takes Rs 20 crore plus 20% of the rest until the total reaches 3x, Rs 60 crore. Only when 20% of the whole exit exceeds Rs 60 crore does converting pay more.

What does a capped participating preference mean in plain words?

Picture a relative who lends to your shop on the terms: my money back first, then a fifth of whatever is left, but I will never take more than three times what I put in; if a fifth of the whole shop is ever worth more, I will take that instead. The investor first takes back Rs 20 crore, then shares 20% of the remainder, until the total reaches the cap of 3x, Rs 60 crore. Above the cap, the investor can give up the preference and convert to plain common shares. Here the cap covers the total return, preference included, which is the usual reading; say so before you calculate.

Where exactly do the two kinks sit?

Set each piece equal to the cap. Participation reaches Rs 60 crore when 20 plus 20% of the exit less 20 equals 60, which is an exit of Rs 220 crore; converting beats Rs 60 crore when 20% of the exit exceeds it, above Rs 300 crore. At a Rs 100 crore exit the investor receives Rs 36 crore against Rs 20 crore as plain common; at Rs 400 crore it receives Rs 80 crore, exactly its 20%.

Why does the flat band matter at the negotiating table?

Inside the band the investor gains nothing from a better price, while every extra rupee goes to the common holders. Between Rs 220 crore and Rs 300 crore the investor is indifferent to the price, so a quick, certain sale at the bottom of the band can suit it more than a long push for the top. A founder who knows where the band sits knows when interests diverge, and can plan the board conversation before a buyer appears.

25 lakh shares under full ratchet and about 11.1 lakh under broad-based weighted average. Full ratchet resets the conversion price to the new Rs 40, so the Rs 10 crore converts into 10 crore / 40 = 25 lakh shares. Weighted average resets it to 100 x (100 + 8) / (100 + 20) = Rs 90, so the investor gets 10 crore / 90 = 11.1 lakh. Either way, the extra shares dilute the other holders.

What does anti-dilution protection actually change?

A shop that promises to refund the difference if the price drops within a month is protecting its customer against a later, cheaper sale. Anti-dilution keeps the investor's rupees the same and lowers the price at which they convert into common shares, so the investor ends up with more shares. The investor put in Rs 10 crore at Rs 100. If the conversion price falls to P, it converts into 10 crore / P shares. The whole question is how far P falls, and the two formulas answer differently.

How does each formula set the new price?

Full ratchet is blunt: the conversion price becomes the new round's price, Rs 40, however few shares were sold there. Broad-based weighted average moves the price only in proportion to how much cheap stock was issued relative to the whole company. The Rs 8 crore raised would have bought 8 lakh shares at the old Rs 100; it actually bought 20 lakh. Against a fully diluted base of 1 crore shares, the price moves by 108 over 120, to Rs 90.

Who pays for the extra shares?

Everyone without the protection, mostly the founders and employees. With no protection the investor holds 8.3% after the round; under weighted average 9.2%; under full ratchet 18.5%. Full ratchet hands the investor 15 extra lakh shares against about 1.1 lakh under weighted average, and the other holders' 90 lakh shares fall from 75.0% to 66.7% of the company. That is why broad-based weighted average is the common market term and full ratchet a sign that a company had little negotiating power. New investors in the down round also dislike a ratchet, because it dilutes them too, and often ask for it to be waived as a condition of investing.