Gorbenko Ventures (GV), a VC fund, is considering a $6 million investment in Newco. GV expects Newco to successfully exit in 5 years. In return for the investment, GV proposes to receive 5 million shares of convertible preferred stock with a 2x liquidation preference. The employees of Newco have claims on 10 million shares of common stock. Hence, following the investment, Newco will have 10 million common shares outstanding and would have 15 million shares outstanding upon conversion of the convertible preferred stock. All parties agree that the annual volatility of Newco’s value is 80%. The annual riskless rate is 2%.

a) (5 points) Draw the payoff diagram of the VC contract.

b) (4 points) Interpret the VC contract in part (a) as a portfolio of options on the start-up value.

c) (8 points) Like the vast majority of VC funds, Gorbenko Ventures is a limited partnership. A general partner raises capital by inviting wealthy limited partners, who on their own have limited ability to identify and advise valuable startups. Limited partners have the power to accept or reject the general partner’s investment choices. The general partner is compensated for his/her skill and efforts via the “carried interest.” Specifically, suppose that the general partner of GV contributes no capital of his/her own to the fund. However, the general partner receives 10% of every dollar of total VC proceeds upon exit, as long as those are below $15 million. Further, the general partner receives 20% of every dollar of total VC proceeds that is above $15 million. For example, if total VC proceeds are $16 million, the general partner receives $1.5 million from first $15 million and $0.2 million from final $1 million of total proceeds. Finally, to make things simple suppose that the general partner receives no salary before exit or at exit. Using your answers to parts (a) and (b), draw the diagram of the payoff that accrues to limited partners only.

d) (4 points) Interpret the payoff to limited partners in part (c) as a portfolio of options on the start-up value.

e) (4 points) Suppose that limited partners choose to accept or reject the general partner’s investment choices based on the NPV criterion. What is the break-even current value V of Newco such that that limited partners are just indifferent between accepting or rejecting the investment given your answers to parts (a)-(d)?