Hybrid Security: Convertible Bonds and Convertible Preferred

HybridAs the name suggests, the convertible bonds and convertible preferred (or convertibles, in short) are securities that offer the holder the option of converting them into or exchanging with a predetermined number of common shares in the issuing company. They are hybrid securities that demonstrated the features of both equity and bond. Convertibles are issued by a company (also referred to as borrower) when a lower interest rate or dividend is desired and the issuer is willing to suffer the potential dilution of the investor converting the hybrid into common equity of the issuing company. Also, refer my article Equity: Common Stock, Preferred Stock and Convertible Preferred here.

Historically, the interest rates or dividend rates on convertibles have been lower than that of a similar non-convertible debt. The investor funds the company with the believe that the value of the underlying stock, into which the debt will convert, will grow over a period of time to an amount that exceeds a market rate of return for the instrument. In other words, the investor receives the potential upside of the conversion into common equity while protecting the downside with cash flow from the interest payments and the return of principal amount at maturity. However, if the stock delivers an under performance, the conversion does not make sense and the investor is stuck with a sub-par bond rate.

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Equity: Common Stock, Preferred Stock and Participating Preferred

stockA company’s equity capital is represented by common stock or preferred stock. A company can be capitalized with only common stock, but usually preferred stock is issued along with common stock. Both common and preferred stocks are entitled to receiving dividends, but where both of them are outstanding, preferred stock holders enjoy priority. Let’s understand the concept in detail.

Common Stock

Common stock is a type of equity security that represents an ownership in a company. It can be classified into voting shares and non-voting shares. The holder of a voting stock carries a voting right to elect Directors of the company and to vote company’s fundamental corporate activities (including M&A) and policies. A non-voting stock, on the other hand, has all the financial rights of the common stock, but is devoid of the power to choose directors or veto corporate transactions.

During liquidation, the common shareholders are entitled to receive residual claim on the company’s assets that is, they stand at the last behind all the corporate creditors and preferred shareholders for receiving the payment. When a company is forced into bankruptcy because of its inability to pay its obligations (debts), the common shareholders receive nothing. So, their returns are uncertain, contingent to earnings, company reinvestment, market efficiency and stock sale. Since their investment risk is high, common stockholders enjoy higher returns (with higher capital appreciation) compared to preferred stockholders when the company does well.

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Startup Valuation: Pre-money and Post-money

StartupValuePre-money and post-money are measures of valuing a company. Pre-money valuation refers to the company’s value before the investor makes an investment in the company and post-money valuation refers to the value of the company after the fund is infused into the company. Let’s take an example to understand the concept.

Let’s assume that an Investor agrees to invest $300,000 in a start-up which is valued at $1 million. The following table explains how the ownership changes in both the situation for the same amount of investment. Let’s ignore the option pool for now to keep it simple.

Individual

Pre-Money Valuation Post-Money Valuation

Value

Ownership Value

Ownership

Entrepreneur

1,000,000

77% 700,000

70%

Investor

300,000

23% 300,000

30%

Total

1,300,000

100% 1,000,000 100%

As we can see above, the ownership percentage depends on the value placed on the company – pre-money or post-money. In pre-money valuation, the company is valued at $1 million before the investment. So, after the investor’s funding, the total value of the company increases, thereby decreasing the investor’s share of ownership. In post-money valuation, the company is valued at $1 million after the investment. So, the investor share increases by 7%. This percentage difference looks small, but can reflect millions when the company goes public.

Investors like Venture Capitalists and Angel Investors generally use the pre-money valuation to determine the “ask” – percentage ownership in the company against the funding – and is calculated on a fully diluted basis. Usually, a fund raising company receives a series of funds (Series A, Series B, Series C, etc.) so that investors minimize the risk of their investment. It’s also a way to motivate the Entrepreneur to achieve the agreed upon milestones. The pre-money and post-money concepts apply to each subsequent series of funding.

Determining pre-money and post-money valuation through formula

Post-money valuation = New funding x (post investment shares outstanding /
shares issued for new investment)

Pre-money valuation = Post-money valuation – new funding

For example, Company A owns 100% stake with 1,000 shares. Investor A infuses $1 million capital into the company against 200 shares (20% ownership), the post-money valuation will be:

$1,000,000 x (1,200/200) = $6 million

Pre-money valuation = $6 million – $1 million = $5 million

The same approach to calculation applies to subsequent series of funding as well.

You may also refer my article on Valuation: Asset Approach, Income Approach and Market Approach here.

What’s my blog “Terms Simplified” all about?

According to The Economic Survey, Year 2014–15 witnessed hyper-growth in Technology start-ups and software product landscape with India ranking fourth among the world’s largest start-up hubs with over 3,100 start-ups. Software products and services revenue is estimated to grow @ 12-14 % in the fiscal year 2015–16.

Year 2014 also witnessed the largest ever Venture Capital infusion into the Indian start-up ecosystem. With an increase of 47.7% from the previous year, Venture Capitalists invested $2.1 billion with 1,108 deals. E-commerce, consumer web and payments dominated the funding in the country, whereas technology start-ups formed the spinal cord, playing a vital role in economic growth of India.

I have discovered that most of the young Business Leaders lack the understanding of the terminologies that are prevalent in the VC circle. My blog “Terms Simplified” makes a sincere effort to educate the young Entrepreneurs on the most frequent jargon prevalent the investor community. I’ll add a series of articles in this category over a period of time that focuses on Venture Capital and Terms Sheet. I’d love to hear your thoughts and views regarding my endeavor.

Stay tuned…