Venture Capital And Private Eqiuty Harvard Case Solution & Analysis

PREFERRED STOCK

QUESTION 1:

ANSWER 1:

In a venture capital, the investment made into the company under different modes of investment always seems to be risky and there is always a risk of losing investment, but the only option that could be less risky than other is the convertible preferred stock as by investing in the convertible preferred shares, it gives the investors to avail the opportunity to earn profit.

CONVERTIBLE PREFERRED STOCK

Convertible preferred stock includes an option attached to this type of instrument and this option entitles the holder of preferred stock to exercise the option and convert the preferred stocks into common stock as per the predefined conversion ratio. Meanwhile, the conversion right can be exercised at any time on or before a predefined date. Further, the conversion of preferred stock shares into common stock, usually takes place when a holder of preferred stock requests the issuer company for conversion, however, the conversion can also take place at the discretion of issuing company in which case the conversion would be a forceful conversion. Additionally the value of preferred stock would be based on the current market value of common stock.

RETURNS ON CONVERTIBLE PREFERRED STOCK

Convertible preferred stocks are such instruments that are ranked in priority for the payment of dividend and principle repayment in comparison of common stock, meanwhile, the dividend on preferred stock has to be paid in any case whether the issuing company generates profits or not. However, in case if the issuing corporation does not pay dividend in any period than the corporation has to pay compounded dividends on preferred stock. Furthermore, since the payment of dividend is fixed and is not linked with the performance of issuing company, therefore, the convertible preferred stock does not generate capital gains, hence, the only return that a holder of convertible preferred stock holder enjoys is a fixed amount of dividend payment.

VALUATION OF A CONVERTIBLE PREFERRED STOCK

The valuation of convertible preferred stock is lower than the usual preferred stock value and the reason for this lower value is that since the preferred stock do not carry the equity ownership right in the corporation that entitles the holder a right to the retained earnings of a corporation. Therefore, since the convertible preference stock carries a conversion option for the conversion of preferred stock into common stock, therefore, the value of convertible preferred stock is lower to justify the value of attaching conversion option.

INVESTMENT RISK

Since the convertible preferred stock carry a conversion right to convert the preferred stock into common stock and this feature is suitable for the investors who are interested in investment in low risky instruments. Because the holder of convertible preferred stock will be entitled to repayment of principle in priority of common stockholders, hence the risk is lower in comparison of common stockholders, meanwhile, the convertible preferred stock holder enjoys a fixed dividend on the invested amount. In addition to this, the conversion right enable the holders to exercise the option and convert the convertible preferred stock into common stock only if the company is performing well and is in good financial position.

VOTING RIGHTS

However, since the convertible preferred stock are not entitled to the equity ownership and the dividend payments are also fixed in advance, therefore, the holder of convertible preferred stock is not entitled to any kind of voting right, hence, they do not participate in any kind of voting.

USE OF CONVERTIBLE PREFERRED STOCK

The convertible preferred stock holder is ranked in priority for the for the repayment of principle investment, therefore, they are best suited for raising capital from venture capitalists because they invest in a company when they are in need of finance, hence, a convertible preference stock will allow the venture capitalist either to exercise the right and convert the preference stock into common stock only if the company has started to perform more efficiently and generates a good return for common stock holders or the venture capitalist would not convert the preferred stock into common stock and would continue to receive a fixed dividend.

COMPETITIVE ADVANTAGE OF THE INVESTMENT IN CONVERTIBLE PREFERRED STOCK:

To illustrate that how these stock work and how it benefits the investor the answers given below has been calculated in the Excel sheet:

A company issued 6 million (series A) convertible preferred stock with the face value of $0.50 a share. As these share are the fixed income security that gives the stock holders a priority in two ways over the common stock holders such as:

  • It receives the dividend before it paid to the common stock holders.

It gives the Convertible Preferred Stock holders the priority when company went bankrupt as company must have to pay first these stock holders and afterward if enough amount is available after selling of all the assets of the company than it would be paid off to common stock holders.................

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