Assume that a VC makes an investment of $ 200 million in a firm's project. This project has 40% probability of being highly successful and 60% probability of having a mediocre outcome. The cash flows for each scenario are projected to be as follows:Highly Successful Scenario: Cash flows of $70 million, $340 million, and $1000 million,
respectively, in year 1, year 2, and year 3. Mediocre Scenario: Cash flows of $50million, $60 million, and $200 million, respectively,
in year 1, year 2, and year 3.
(a) Assume first that the VC takes common stock in the firm in return for its investment. How much of the equity should he demand if his expected rate of return is 40%.
(b) As an alternative to giving the VC common stock, design a combination of a bond and a warrant to be given to the VC that you believe will improve the entrepreneur's incentive to work hard to achieve the "highly successful" scenario. You should give the details of the proposed cash flows to the bond at each date; and the fraction of the firm's equity that the warrant should be convertible into at time 3.
(c) What are the advantages of securities such as a bond and warrant (or a similar security used in practice, namely, convertible preferred shares) being offered to the VC by startup firms (instead of offering common stock to the VC)?