Lecture 6

Question 1

What are the Black-Scholes assumptions ?

Answer 1

•	Perfect markets
      o	Open all time
      o	Allow assets trade in any quantity
      o	Not taxes, transactions costs
      o	No arbitrage opportunities
      o	No dividends

• Stock price → Brownian Motion

Question 2

What are Random Expiration Options ?

Answer 2

• Options without known exit time

* Investors do not know ex-ante when exit from PE investment going to take place

Question 3

What do venture capital financing deals frequently use ?

Answer 3

Preferred stock

Question 4

What is the key idea on how to price preferred stock ?

Answer 4

Replicate exit payoff with portfolio of stock + random expiration options with different strike prices
→ Can price options so can find value of preferred stock for VC fund

Question 5

Is the aggregate purchase price the same as $investment ?

Answer 5

Not always because of multiple securities

Question 6

Is the redemption value the same as APP

Answer 6

Not always because of liquidation preferences and dividends

Question 7

What are the two valuation methods ?

Answer 7

• LP valuation equation

* Breakeven valuation

Question 8

What does the partial valuation equation give ?

Answer 8

Risk-adjusted PV of exit proceeds that accrues to VC fund (to LPs and GPs)

Question 9

How much of partial valuation accrues to LP’s ?

Answer 9

Depends on compensation structure of GPs

Question 10

On what depends the compensation of the GPs

Answer 10

Not on performance of individual investment but total fund performance

Question 11

What does the total fund performance imply ?

Answer 11

Need to value every other investment in fund + make joint probability assumptions about performance of every investment in fund

Question 12

What is the idea behind the LP valuation ?

Answer 12

Estimate GP%, fraction of partial valuation that on avg accrues to GPs
GP% = carry% (GVM x investment capital - carry basis)/GVM x investment captial)
Then LP valuation = (1-GP%) x partial valuation

Question 13

What are the steps in the analysis ?

Answer 13

1. Draw exit diagram
2. Find partial valuation equation
3. Find LP valuation equation
4. Evaluate LP valuation equation at estimated total valuation

Question 14

On what depends the value one series holders expect to get by converting their shares ?

Answer 14

On whether other series holders are going to be converting as well

Question 15

How to draw exit diagram without aid of computer ?

Answer 15

1. Use fact payoffs piecewise linear
2. Evaluate payoffs at critical points
   • 0
   • Cummulative redemption points
   • Conversion points for all series
3. Compute slopes

Question 16

What happens if both series A and B own convertible preferred stock ?

Answer 16

Need to know who converts first

Question 17

What is one possible way to know who converts first ?

Answer 17

• Find conversion point for Series A, assuming Series B not convert
• Same for B
• Minimum of two = convert first

Question 18

What happens if there are more Series ?

Answer 18

Need to check combinations of conversion assumptions

Question 19

What is one way to know who converts first if there are more Series ?

Answer 19

Compute redemption value per share (RVPS) for each Series = total redemption value of preferred stock divided by # of common shares received on conversion