Financial Contracting

Firms are competing in

• Labor market
• Product market
• Financial market
Financial Contracting
• Uncertainty
• Information and Incentive
• Adverse selection (hidden information)
• Moral hazard (hidden action)
• Agency problem
• Incomplete contract: hold-up problem (commitment problem)
• Incentive to entrepreneur
References
• Akerlof, George A. (1970). "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism". Quarterly Journal of
Economics. The MIT Press. 84 (3): 488–500Grossman, S. J., & Hart, O. D. (1986). The costs and benefits of ownership: A theory of
vertical and lateral integration. Journal of political economy, 94(4), 691-719.
• Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal
of financial economics, 3(4), 305-360.
• Grossman, S. J., & Hart, O. D. (1986). The costs and benefits of ownership: A theory of vertical and lateral integration. Journal of
political economy, 94(4), 691-719.
• Hart, O., & Moore, J. (1990). Property Rights and the Nature of the Firm. Journal of political economy, 98(6), 1119-1158.
• Aghion, P., & Bolton, P. (1992). An incomplete contracts approach to financial contracting. The review of economic Studies, 59(3),
473-494.
• Hart, O. (2017). Incomplete contracts and control. American Economic Review, 107(7), 1731-52.
• Kaplan, S. N., & Strömberg, P. (2003). Financial contracting theory meets the real world: An empirical analysis of venture capital
contracts. The review of economic studies, 70(2), 281-315.
• Kaplan, S. N., & Strömberg, P. E. (2004). Characteristics, contracts, and actions: Evidence from venture capitalist analyses. The
Journal of Finance, 59(5), 2177-2210.
• Gompers, P. A., Gornall, W., Kaplan, S. N., & Strebulaev, I. A. (2020). How do venture capitalists make decisions?. Journal of
Financial Economics, 135(1), 169-190.
Hybrid Securities

5
Hybrid security
• Convertible Preferred Stock
• Convertible Participating Preferred Stock
• Convertible Preferred Stock with multiple liquidation preference
• Compulsorily convertible preference shares (CCPS)
• Perpetual Non-Cumulative Preference Shares (PNCPS)
• Perpetual Cumulative Preference Shares (PCPS)
• Redeemable Non-Cumulative Preference Shares (RNCPS)
• Redeemable Cumulative Preference Shares (RCPS)
• Convertible alternative reference securities (CARS)
• Secured, Redeemable, Non-Convertible Debentures
• Convertible Bond
• Redeemable preferred stock
• Mezzanine debt
• Warrants
• Mezzanine
• Subordinate debt
• SWORD (stock warrant off-balance-sheet research and development) [biotechnology]

6
Convertible preference shares
• Convertible Preferred Stock
• Convertible Participating Preferred Stock
• Convertible Preferred Stock with multiple liquidation preference

7
8
Start up Dream
• XYZ is a Software startup company with owners’ investment of 1 Crore
• XYZ need to raise INR 2 Crore Immediately
• They hired advisory firm to raise fund
• Four VC funds has shown interest in XYZ and given Term Sheet

9
 Hypothetical Synopsis of Term Sheet of four VC Funds
Alpha Beta Delta Gama
Founder Investment INR 1 Crore INR 1 Crore INR 1 Crore INR 1 Crore
No of Shares 1,000,000 1,000,000 1,000,000 1,000,000
Amount of Investment INR 2 Crore INR 2 Crore INR 2 Crore INR 2 Crore
Convertible Preferred Convertible Participating Preferred Convertible Preferred Stock with
Type of Securities Common Equity
Stock Stock multiple liquidation preference 3X
As decided by
Dividend Noncumulative 7.5% Cumulative 10% Cumulative 10%
BoD
Liquidation Preference X X + Unpaid Divident 3X
Series A share Price + unpaid
Redemption Right None None Series A share Price + unpaid Dividend
Dividend
Antidilution Weighted Average Full Rachet Full Rachet
Stake in Company 40% 35% 30% 25%
No of Share Issued to
666,667 538,462 428,571 333,333
Fund
Compensation
yes Yes None None
Committee
Board Membership 2 out of 5 2 out of 5 1 out of 5 1 out of 5
Voting Rights Pre-Conversion Post Conversion Post Conversion
Conversion Yes Yes Yes
Counsel Expenditure XYZ Fund XYZ Fund 10
 Organizational Structure of Venture Capital Investment
• Harvesting Investment
• Effort and small capital • IPO
• Annual Management fee: 2-3% • Leveraged Buyout
• Carried Interest: 20-30% • Acquisition
• Liquidation
• Screen & Evaluate Business Plan General Partners • Distributing Proceeds
• Conduct Due Diligence • Cash
• Negotiate Deals • Public Shares
• Invest Fund

Investment
Venture Fund Exit
Portfolio Companies

• ~ 99% of capital • Value Creation and Monitoring

• Pension Fund • Board service
Limited Partners
• Life insurance companies • Performance evaluation and review
• Corporate; Individuals • Recruitment management
• Assist with external relationships
• Help arrange additional financing
11
Valuation
• Pre-money Value is the valuation of aa firm immediately before an
injection of capita occurs

𝑃𝑟𝑒 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑂𝑙𝑑 𝑠ℎ𝑎𝑟𝑒𝑠 × 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒

• Post-money value is the valuation of a company including the capital

provided by the current round of financing

𝑃𝑜𝑠𝑡 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑟𝑒𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑚𝑒𝑛𝑡

12
Example
• XYZ is a Software startup company
• Initial Investment by founders of the company was INR 1 Crore

Owners Security Shares Investment Share Price

Owners Common Equity 1,000,000 10,000,000 10

• XYZ need to raise INR 2 Crore immediately

13
Funding option 1
• A VC fund “Alpha” has shown interest to invest INR 2 Crore for a 40%
stake. Discuss the claim of owner and VC after exit.

Owners Security Shares Investment Share Price

Series A Common Equity 666,667 20, 000,000 30

𝑃𝑜𝑠𝑡 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 = 50,000,000

𝑃𝑟𝑒 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 = 30,000,000

14
Common Stock
• Perpetual
• No obligation to pay dividend and repay capital
• Represent ownership right
• Entitled one vote per share and future dividend payments on discretion of BoD
• Not convertible into any other type pf security
• No special rights such as anti-dilution provisions, liquidation
preferences
• Owned by founders, management, and employee

15
Owners Security Shares Investment Share Price

Owners Common Equity 1,000,000 10,000,000 10

Series A Common Equity 666,667 20,000,000 30

Analyze payoff if company were sold for

Company were sold for Owners Series A Investors
INR 1 Crore
INR 2 Crore
INR 4 Crore
INR 5 Crore
INR 10 Crore

16
Funding option 2
• A VC fund “Beta” has shown interest to invest INR 2 Crore for a 40%
stake. Discuss the claim of owner and VC after exit.

Owners Security Shares Investment Share Price

Convertible Preferred
Series A 666,667 20, 000,000 30
stock

𝑃𝑜𝑠𝑡 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 = 50,000,000

𝑃𝑟𝑒 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 = 30,000,000

17
Convertible Preferred Stock
• Convertible preferred stock is a preferred stock that can be converted
into equity at the shareholder’s discretion

18
Owners Security Shares Investment Share Price

Owners Common Equity 1,000,000 10,000,000 10

Convertible Preferred
Series A 666,667 20,000,000 30
stock

Analyze payoff if company were sold for

Company were sold for Owners Series A Investors
INR 1 Crore
INR 2 Crore
INR 4 Crore
INR 5 Crore
INR 10 Crore

19
Funding Option 3

20
Funding option 3
• A VC fund “Beta” has shown interest to invest INR 2 Crore for a 40%
stake. Discuss the claim of owner and VC after exit.

Owners Security Shares Investment Share Price

Participating Preferred
Series A 666,667 20, 000,000 30
stock

𝑃𝑜𝑠𝑡 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 = 50,000,000

𝑃𝑟𝑒 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 = 30,000,000

21
Participating Preferred stock
Participating
Preferred stock

Preferred stock Common stock

Share in remaining
Original investment
proceed

Accrued dividends

22
Participating Preferred
• No Dividend
• If the company were sold for INR 50,000,000
Owners Security Shares Investment Share Price

Owners Common Equity 1,000,000 10,000,000 10

Participating Preferred
Series A 666,667 20,000,000 30
stock

• Proceeds to Series A=20,000,000 + 40% of 30,000,000

• Proceeds to Owners= 50,000,000-32,000,000=18,000,000
23
Owners Security Shares Investment Share Price

Owners Common Equity 1,000,000 10,000,000 10

Participating Preferred
Series A 666,667 20,000,000 30
stock

Analyze payoff if company were sold for

Company were sold for Owners Series A Investors
INR 1 Crore
INR 2 Crore
INR 4 Crore
INR 5 Crore
INR 10 Crore

24
Multiple liquidation preference
• Is a provision that gives preferred stockholder s of a specific round of
financing the right to receive a multiple (e.g., 3X) of their original
investment if the company is sold or liquidated.
• It still allows the investor to convert to common stock if the company
does well.

25
Multiple liquidation preference
• Multiple liquidation preference is 3X
• If the company were sold for INR 50,000,000

Owners Security Shares Investment Share Price

Owners Common 1,000,000 10,000,000 10

Convertible Preferred with
Series A multiple liquidation 666,667 20,000,000 30
preference 3X

• Proceeds to Series A=20,000,000 * 3

• Proceeds to Owners= None
26
Owners Security Shares Investment Share Price

Owners Common Equity 1,000,000 10,000,000 10

Convertible Preferred with

Series A 666,667 20,000,000 30
multiple liquidation preference 3X

Analyze payoff if company were sold for

Company were sold for Owners Series A Investors
INR 1 Crore
INR 2 Crore
INR 4 Crore
INR 5 Crore
INR 10 Crore
INR 15 Crore
INR 25 Crore 27
Anti-Dilution
• Dilution occurs when an investor’s proportionate ownership is
reduced by the issue of new shares.
• Existing investors are primarily concerned with down rounds
Full Ratchets
• If a firm issues stock to a lower price per share than exiting preferred
stock, then the conversion price of the existing preferred stock is
adjusted downward to new lower price

28
 Example
Owners Security Shares Investment Share Price
Owners Common 1,000,000 10,000,000 10
Series A Convertible Preferred 666,667 20,000,000 30
Series B Convertible Preferred 500,000 10,000,000 20

Full Rachet

Owners Security Shares Investment Share Price

Owners Common 1,000,000 10,000,000 10
Series A Convertible Preferred 1,000,000 20,000,000 20
Series B Convertible Preferred 500,000 10,000,000 20

29
Anti-Dilution
• Weighted Average
• Less harsh than full rachet
• If few new shares are issued, the conversion price will not drop too much

𝐴+𝐶
𝑁𝑒𝑤 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑟𝑖𝑐𝑒 = × 𝑂𝑙𝑑 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑟𝑖𝑐𝑒
𝐴+𝐷
𝑊ℎ𝑒𝑟𝑒,

𝐴= 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡ℎ𝑒 𝑑𝑖𝑙𝑢𝑡𝑖𝑣𝑒 𝑖𝑠𝑠𝑢𝑒 (round B)

𝐶 = 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑡ℎ𝑎𝑡 𝑤𝑜𝑢𝑙𝑑 ℎ𝑎𝑣𝑒 𝑏𝑒𝑒𝑛 𝑖𝑠𝑠𝑢𝑒𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑜𝑙𝑑 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑖𝑛 𝑡ℎ𝑒 𝑑𝑖𝑙𝑢𝑡𝑖𝑣𝑒 𝑟𝑜𝑢𝑛𝑑 (round B)

𝐷 = 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑒𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑑𝑖𝑙𝑢𝑡𝑖𝑣𝑒 𝑟𝑜𝑢𝑛𝑑

30
Example
Owners Security Shares Investment Share Price
Owners Common 1,000,000 10,000,000 10
Series A Convertible Preferred 666,667 20,000,000 30
Series B Convertible Preferred 500,000 10,000,000 20

Full Rachet

Owners Security Shares Investment Share Price

Owners Common 1,000,000 10,000,000 10
Series A Convertible Preferred 1,000,000 20,000,000 20
Series B Convertible Preferred 500,000 10,000,000 20

Weighted Average
Owners Security Shares Investment Share Price
Owners Common 1,000,000 10,000,000 10
Series A Convertible Preferred 722,222 20,000,000 27.69
Series B Convertible Preferred 500,000 10,000,000 20
31
Example
Owners Security Shares Investment Share Price
Owners Common 1,000,000 10,000,000 10
Series A Convertible Preferred 666,667 20,000,000 30
Series B Convertible Preferred 1 10 20

Full Rachet

Owners Security Shares Investment Share Price

Owners Common 1,000,000 10,000,000 10
Series A Convertible Preferred 1,000,000 20,000,000 20
Series B Convertible Preferred 1 10 20

Weighted Average
Owners Security Shares Investment Share Price
Owners Common 1,000,000 10,000,000 10
Series A Convertible Preferred 666,667 20,000,000 30
Series B Convertible Preferred 1 10 20
32
Why firms use convertible securities to raise
external capital
• Conversion feature serves as a sweetener to investors
• Benefits issuers through a coupon or dividend rate that is lower than that for
the nonconvertible counterpart
• Conversion provision sets up “delayed equity” to be sold at a price
higher than the current stock price

33
Rationales for Hybrid
• All financial contracting confronts three fundamental problems
• Uncertainty
• Information asymmetries
• Agency cost
• Generally Preferred stocks
• Cheap debt and cheap equity
• Low coupon than straight debt
• Conversion price is higher than current Market Price
• Reduce adverse selection
• Asymmetric information between firm’s insiders and outsiders
• Unlike straight bond and equity, hybrid offers considerable flexibility
• Debt Vs Equity (Cash flow Vs ownership rights)
34
What is "preferred" about
preferred stock?

35
Dividend
• Cash available for distributions during the year must be used to meet
promised payments to preferred shareholders before any common
dividends can be paid.
• Meaningless
• Corporations being financed with venture capital money are rarely able to pay
dividends to their venture capital investors
• To be effective
• Cumulative
• Meaningless because low probability that the portfolio company w ill w ant to pay a common
dividend before convertible preferred stock is converted in an acquisition or automatically in IPO
• To make effective
• Requiring company to pay accumulated preferred dividend before common stockholder receive any
liquidity o their investment
• Incorporate accumulated but unpaid dividend into the liquidation preference and treat
acquisition as liquidation
• Adjust the conversion ratio to reflect accumulated but unpaid dividend

36
Liquidation preference
• Applies during liquidation or acquisition
• Preferred stock has right to get a certain amount before the common stock
gets anything
• Meaningless
• Dominant input in early-stage technology companies is human capital
• Generally they don’t have physical assets; they subcontract capital intensive operation like
manufacturing
• Participating or multiple liquidation
• Redemption Preference
• Allocation of control
• Convertible preferred stock facilitates the separation of control and cash flow right
• More board seats but 25% profit from IPO

37
• Dividend and liquidation preference of convertible preferred stock
• Incentive and signaling
• Make unattractive for low-quality owners and managers

38
Term Sheet Negotiation: Rich Vs King Approach
• Two motivation of start up
• Building wealth (Rich)
• Ready to give up equity, board representation, and voting rights so that they can attract
best resources
• Valuable slice of the economic pie
• Importance of term
• Valuation
• Liquidation preference
• Anti dilution
• Dividend rights
• Maintaining control (King)
• Bootstrap venture and take money from investors who allow to retain control
• Importance of term
• Board composition
39
 Hypothetical Synopsis of Term Sheet of four VC Funds
Alpha Beta Delta Gama
Founder Investment INR 1 Crore INR 1 Crore INR 1 Crore INR 1 Crore
No of Shares 1,000,000 1,000,000 1,000,000 1,000,000
Amount of Investment INR 2 Crore INR 2 Crore INR 2 Crore INR 2 Crore
Convertible Preferred Convertible Participating Preferred Convertible Preferred Stock with
Type of Securities Common Equity
Stock Stock multiple liquidation preference 3X
As decided by
Dividend Noncumulative 7.5% Cumulative 10% Cumulative 10%
BoD
Liquidation Preference X X + Unpaid Divident 3X
Series A share Price + unpaid
Redemption Right None None Series A share Price + unpaid Dividend
Dividend
Antidilution Weighted Average Full Rachet Full Rachet
Stake in Company 40% 35% 30% 25%
No of Share Issued to
666,667 538,462 428,571 333,333
Fund
Compensation
yes Yes None None
Committee
Board Membership 2 out of 5 2 out of 5 1 out of 5 1 out of 5
Voting Rights Pre-Conversion Post Conversion Post Conversion
Conversion Yes Yes Yes
Counsel Expenditure XYZ Fund XYZ Fund 40
Term Sheet Negotiation

41
Term Sheet
• Green Flag
• Simple
• Little downside protection
• Pain vanilla convertible preferred stock
• Yellow Flag
• Milestone
• Complicated terms
• Reg flag
• To many milestone
• Clauses that take control from founders
• Important
• Personal chemistry and reputation of VC fund
• Take advice from lawyers
• Who will be on board is more important than VC firm

42
Term Sheet Negotiation
Gama
Founder Investment INR 1 Crore
No of Shares 1,000,000
Amount of Investment INR 2 Crore
Convertible Preferred Stock with multiple
Type of Securities
liquidation preference 3X

Dividend Cumulative 10%

Liquidation Preference 3X

Redemption Right Series A share Price + unpaid Dividend

Antidilution Full Rachet

Stake in Company 25%

No of Share Issued to Fund 333,333

Compensation Committee None

Board Membership 1 out of 5

Voting Rights Post Conversion
Conversion Yes
Counsel Expenditure Fund
43
One more Example

44
XYZ Ltd.
• XYZ is a Software startup company
• XYZ need to raise INR 5 Crore Immediately
• Two VC fund shown interest—Alpha and Beta
• Both VC funds have given Term Sheet

45
 Alpha VC Fund Beta VC Fund
Amount of Investment INR 5 CR INR 5CR
Type of Securities Convertible Preferred Stock Convertible Participating Preferred Stock
Dividend Noncumulative 7.5% Cumulative 10%
Liquidation Preference 3X 1.5X
Redemption Right None Series A share Price + unpaid Dividend
Antidilution Weighted Average Full Rachet
Pre money valuation 15 CR if sales > 1 CR or 5 CR 10 CR
Counsel Expenditure XYZ Beta
Compensation
Control by Alpha None
Committee
Voting Rights Pre-Conversion Post Conversion
Conversion Yes Yes
Board Membership 2 1
46
Term Sheet Negotiation
Beta VC Fund
Amount of Investment INR 5CR
Type of Securities Convertible Participating Preferred Stock
Dividend Cumulative 10%
Liquidation Preference 1.5X
Redemption Right Series A share Price + unpaid Dividend
Antidilution Full Rachet
Pre money valuation 10 CR
Counsel Expenditure Beta
Compensation
None
Committee
Voting Rights Post Conversion
Conversion Yes
Board Membership 1
47
Other Instrument
• Redeemable preferred stock
• Redeemed for face value at the choice of the investor
• Sometimes called straight preferred
• Gives the investor an exit if IPO or sale is not materialized
• Mezzanine debt
• Low priority than senior debt but high interest rate
• Warrants
• Right to purchase shares at pre-determined price
• Generally issued with preferred stock or bonds.

48