FINA 4603 Sample Midterm 2
You have 1 hour to complete this exam. The total possible score you can achieve is 40 points. You may
use a calculator and a single sheet of A4 paper with notes on both sides. No other materials are allowed.
There are a total of 3 multi-choice questions and 2 longer questions. Make sure to read the questions
carefully and budget your time.
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Multi-choice (9 points)
1. Lonergan Ventures owns a stake in Mackay Corp that has the following exit equation: V0 − C0 (10m) +
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3 C0 (30m ). If the founders of Mackay Corp own 10m shares of common stock and there are no other
stakeholders, which of the following securities does Lonergan Ventures potentially own? (3 points)
(a) 10m shares of convertible preferred (CP) with APP = 10m.
(b) 5m shares of CP with APP = 5m and 2× excess liquidation preference.
(c) Redeemable preferred (RP) with APP = 10m and 5m shares of common stock.
(d) None of the above
2. Which of the following meets the criteria for asset substitution? (3 points)
(a) An investment opportunity with a positive NPV that is not taken by an entrepreneur because it
reduces the value of the entrepreneurs stake in his/her firm
(b) An investment opportunity with a positive NPV that is taken by an entrepreneur because it
increases the value of the entrepreneurs stake in his/her firm
(c) An investment opportunity with a negative NPV that is not taken by an entrepreneur because it
reduces the value of the entrepreneurs stake in his/her firm
(d) An investment opportunity with a negative NPV that is taken by an entrepreneur because it
increases the value of the entrepreneurs stake in his/her firm
3. Shibata Corp currently has two stakeholders; Lonergan Ventures and its founders. Both parties own
common stock (and nothing else), but only Lonergan Ventures stake has anti-dilition protection; a fullratchet clause. The founders are considering a Series B investment by Okat Ventures with a proposed
price per share of PO . Let PL be the price per share previously paid by Lonergan Ventures. Which of
the following statements is true? (3 points)
(a) If PO < PL , Okat Ventures investment will dilute Lonergan Ventures’ stake in Shibata Corp.
However, the dilutive effect would be smaller if Lonergan Ventures’ shares were instead protected a weighted-average anti-dilution protection clause.
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(b) If PO > PL , Okat Ventures investment will dilute Lonergan Ventures’ stake in Shibata Corp.
However, the dilutive effect would be greater if Lonergan Ventures’ shares were instead protected a weighted-average anti-dilution protection clause.
(c) If Okat Ventures investment is smaller than Lonergan Ventures, then Okat Ventures ownership
stake will also be smaller than Lonergan Ventures.
(d) All of the above.
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Venture Capital Incentives (16 points)
Background: Suppose Lonergan Ventures has provided 10m of funding to Davies Corp in exchange for
redeemable preferred shares with liquidation preference equal to 14m. Davies Corp currently has assets
that will be worth 30m in one years time if its new business idea is a success and 6m if its new business idea
is a failure, with each outcome is equally likely. The founders of Davies Corp own common stock. Assume
the discount rate is equal to zero.
2(a). Draw value diagrams for Davies Corp, Lonergan Ventures, and the founders. (2 points)
2(b). What is the value of the investment by Lonergan Ventures and what is the value of the founders
stake in Davies Corp? (2 points)
2(c). Assume the founders make all investment and financing decisions at Davies Corp. Suppose that
the founders are considering obtaining an additional 5m funds from Okat Ventures in order to undertake a
new investment. The new investment will pay 6m regardless of whether Davies Corp’s pre-existing business idea is a success or a failure. Okat Ventures will receive redeemable preferred shares in return for its
investment, and these shares will be junior to the existing redeemable preferred owned by Lonergan Ventures due to existing seniority covenants. What liquidation preference must the founders promise to Okat
Ventures in order to obtain an investment? (1 point)
2(d). What is the value of each stakeholder’s claim on Davies Corp if the new investment goes ahead?
Will the founders be interested in making this investment? Why or why not? What is this phenomena
called? (4 points)
2(e). Now suppose that Lonergan Ventures waives its seniority covenants. Re-solve parts (c) and (d). Will
Lonergan Ventures be willing to waive these covenants? (4 points)
2(f). (Hard) Ignore the assumption in part (e). Instead, suppose the founders offer to rework Lonergan
Ventures compensation structure. They propose Lonergan Ventures waive Lwaive of its liquidation preference so that the gains from the new investment can be shared evenly (50/50) between the two existing
parties. Lonergan Ventures are tough negotiators. They agree to waive the Lwaive proposed by the founders,
but only if they also receive an equity stake f Lonergan which allows them to obtain 75% of the gains from
investment. The founders agree. Solve for Lwaive and f Lonergan . (3 points)
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3
Preferred Shares (15 points)
Background: Consider Schembri Specialists (SS), a startup marketing company which offers creative marketing solutions for small family owned businesses. SS has no debt and the founders of SS own all existing
12m shares of common stock in the firm. After demonstrating some initial success, the founders of SS are
looking for additional investment from various different venture capitalists. They plan to raise 20m which
will increase SS’s valuation to V0 = 60m. Initially, the founders of SS contact Okat Ventures. Okat Ventures
agrees to invest in return for 4m convertible preferred shares (CP) with liqudiation preference equal to 20m.
3(a). What is Okat Ventures’ conversion condition? What is Okat Ventures’ conversion point? (2 points)
3(b). Either (i) draw and label Okat Ventures’ exit diagram (be sure to label all key points on the graph
and slopes) or (ii) provide the functional form that describes Okat Ventures’ exit diagram. (2 points)
3(c). What is Okat Ventures’ exit equation? Okat Ventures anticipates exit will take place in four years,
estimates σ = 0.8, and uses a discount rate of r = 0.025 in its valuation. What is the value of Okat Ventures’
claim? Should Okat Ventures’ invest in SS? (4 points)
Additional Background: Although Okat Ventures has an excellent reputation as a VC firm, the founders
from SS decide to investigate alternative funding sources and thus get in touch with the VC’s at Lonergan
Ventures. Lonergan Ventures agrees to invest 20m, but favours a portfolio made up of 3m shares of common stock and redeemable preferred shares with liquidation preference of 5m.
3(d). Either (i) draw and label Lonergan Ventures’ exit diagram (be sure to label all key points on the
graph and slopes) or (ii) provide the functional form that describes Lonergan Ventures’ exit diagram. (3
points)
3(e). Explain, without calculation, why the founders of SS prefer the terms proposed by Lonergan Ventures to those specified by Okat Ventures? [Hint: Use your answers to (b) and (d)]. (2 points)
3(f). Okat Ventures revises its offer to the founders of SS. Specifically, Okat Ventures suggests the same
terms, except they propose reducing the liquidation preference on their CP to 10m. The founders, however,
still prefer Lonergan Ventures offer, arguing that because it has smaller liquidation preference and a smaller
potential fraction of the SS’s common stock, it is a more “founder friendly” offer. Is the founders’ argument
correct? Explain, without calculation, why or why not? (2 points)
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Appendix
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