articles_tuck mba school dartmouth

8/8/2019 Articles_Tuck MBA School Dartmouth

http://slidepdf.com/reader/full/articlestuck-mba-school-dartmouth 1/18

Bury the Ratchets

With private equity markets grim, venture capitalists are resuscitating a

financing tool from downturns past: the full ratchet.

A full ratchet enables early round investors to preserve the value of their initial

investment in a down round. Essentially, the early ratchet-protected investors

get additional "free" shares so that their effective share price equals the new

lower price. The investors avoid a markdown in the value of their investment.

Even better, they don't look like they were wrong.

But nothing comes for free. With ratchets, the price is paid by the common and

non-protected shareholders, who end up diluted, and by the new investors,

whose ownership percentage is limited by these new shares. Indeed, full

ratchets can turn off potential investors to a deal at a time when a company

needs new money the most.

Though the tough market conditions that ratchets are supposed to protect

against have largely happened already, some investors are now attempting to

insert "retroactive ratchets" in down rounds. At the same time, once-burned

investors are insisting on favorable full ratchets in new deals, when there are

probably some better ways to avoid dilution. This article takes a critical look atratchets and offers alternative term structures that may produce more desirable

outcomes.

How Ratchets Work

Ratchets are a mechanism for adding shares to an earlier investment round

when a new round of financing is done at a lower share price. The most simple

and aggressive form is the full ratchet, which issues sufficient supplemental

shares to investors in an earlier round so that their effective share price equals

the lower share price of the new round.

If, for example, the new round share price is half the price of a previous round, a

full ratchet would give the previous round investors twice the number of their

original shares. This form of anti-dilution protection basically re-prices the earlier

financing round to make a dollar in the earlier round equivalent to a dollar in the

new round in terms of the percentage of outstanding shares bought by the

investments in either round.



New investment money and old money that is ratchet-protected share relative

ownership in direct proportion to their investments, independent of the share

price of the down round, while the common and non-protected shares suffer

dilution as the round price goes down. So, continuing the example of a 50%

reduction in share price, if a new round investor puts in half of the money that

earlier ratchet-protected rounds had already put in, then they would own half

the number of shares of the earlier investors, after their ratchet adjustment. If

the new share price were set very low, approaching zero, then the new investor

could own no more than one third of the shares, even as the common and other

unprotected shares are effectively diluted out of the picture.

Full Ratchet Example

• Founders/Common: 20 shares

• Original investors: 10 shares at $10 per share, $100 investment for 1/3

ownership

• New investors: 50 shares at $1 per share, $50 investment

• Full ratchet effect: Original investors get 90 new shares, for a total of 100

shares (The ratchet entitles the original investors to won as many shares

as their original investment would buy them at the new price. In this case

that's 100 shares, and they already have 10 shares.)

Respective ownership percentages after new round:

With Full

Ratchet

Without Full

Ratchet

Founders/Common 12% 25%

Original Investors 59% 13%

New Investors 29% 63%

The appeal of the full ratchet for the original investor is obvious. The effective

price per share of the original investment is knocked down to the new price of $1

per share. In this example, the original investor's stake in the company also

explodes to a super-majority, which could be useful in influencing the direction

of the company down the road. Without the full ratchet, the original investor

would be holding only 13% of the company after having paid twice what the newinvestor paid to hold 63% of the company.



The tension with the full ratchet is obvious too. From the eyes of a prospective

investor, putting money into a company where the original investor has a full

ratchet looks like a bad deal. Instead of holding a majority interest in the

company, which the changed market circumstances would dictate in the absence

of ratchets, the new investor has half the ownership of the original investor.

Founders and management that holds common shares may also balk at seeing

their stake drop so much. Their option positions may need to be "re-loaded,"

that is, they may need to be given more shares, to keep them incentivized.

The Retroactive Ratchet

Though ratchet protection is generally supposed to be forward looking, ratchets

are increasingly being inserted retroactively as part of new financing rounds.That's because, in cheerier times, few deals leading up to recent financings had

ratchets. Retroactive ratchets, or "get well" provisions, can add insult to a new

outside investor's injury. Not only do the new investor shares get diluted by the

ratchet-generated shares as in the example above, but the rights to the ratchet

shares were not even part of the original investor agreement.

Here's an example. In a case the authors recently saw, a company that had

gotten a strong valuation on a previous round needed new financing to get to

cash breakeven. This down round was to be led by one of the existing investors,

who proposed a retroactive re-pricing of their earlier round by issuing additional

shares to that round, effectively creating a retroactive ratchet. When the

management team went out to try to raise new money, potential investors

protested that they were paying a price for their shares that was twice the

effective price being paid by the earlier round investors.

To make the investment sufficiently attractive to the new outside investors, the

round price for these new investors had to be lowered. But that change furtherdiluted the common shareholders and unprotected preferred shareholders. In

the end, the early investors also had to give up a portion of their retroactive

ratchet shares to soften this impact and further narrow the price differential

between the new outside money and the new funding provided by the earlier

investors.

Alternatives to Full Ratchets

Other ratchet structures are less severe than full ratchets. For most of the '90s,ratchets were typically weighted-average ratchets. This formula re-prices an



earlier round by issuing enough additional shares to that round to bring the

effective price down to the average price of both the new and the previous

round. In other words, the average price is the total investment of both rounds

divided by the number of shares of both rounds, before adjusting for the ratchet

shares.

"Pay to play" provisions are a way to attempt to justify the issuance of ratchet

shares. A ratchet with a "pay to play" provision requires the old investors with

ratchets to participate in the new financing round in order to trigger the issuance

of ratchet shares. (These provisions are also sometimes called "play or pay,"

meaning that if you don't play by investing in the new round, then you pay by

losing your anti-dilution protection.) Typically, the requirement is for investors

with ratchets to invest their pro rata share in the down round. In essence, theyget new shares under the ratchet provision but they have to pay for them.

Finally, investors wanting protection of their ultimate return should consider

liquidation preferences as an alternative to ratchets. Ratchets are a way of

making the average price paid for a position look better in the event the

company turns out to be less successful than anticipated. However, the price at

some interim stage of a company's development becomes immaterial when it

comes time to liquidate the company. At that point liquidation preferences are

the final arbiter of who gets what. Of course, securing excessive multiples in

liquidation preferences will appear no less unsavory to future investors than

ratchets, unless they are also granted similar rights. However, the direct effects

of liquidation preferences on percentage ownership and on share prices don't

emerge until the company is sold, which means less fodder for disagreement in

getting a deal done.

Using Ratchets Appropriately

In sum, ratchets can turn off potential new investors and disgruntle unprotected

shareholders, most importantly management whose continued commitment is

crucial for future success. Early investors still bent on using ratchets despite

these pitfalls should be prepared either for pressure to waive their ratchets

entirely if they are not participating in subsequent rounds, or to reduce the

number of ratcheted shares they insist on receiving.

Do these ratchet woes mean VCs can't protect themselves? To the contrary,

there are ways of doing so that are more "win win." In particular, "pay to play"



provisions and liquidation preferences can lessen the insidious effects of ratchets

while still providing dilution and valuation protection.

Liquidation Preferences: What You May Not Know

Shortly after a recent exit sale, a CEO called his lead venture capital backer to

complain that while he had thought his management team owned 34% of the

company, they had received only 5% of the sale proceeds. "How did we get such

a bum deal?" he asked. The VC patiently explained: liquidation preferences.

Liquidation preferences ensure that in the event of a sale, investors get a certain

return on their money before anyone else gets a cent. This staple financing tool

is a must have for the savvy preferred investor. But management often doesn't

—or doesn't want to—understand the potentially draconian consequences of

preferences.

Those consequences are only getting worse. Recently, liquidation preferences

have become particularly aggressive as burned investors seek to protect

themselves from future disaster. This is not good news for management. Yet,

deals with liquidation preferences can be structured to provide investors with the

protection they seek while keeping management from feeling exploited and

resentful. In this article, we discuss ways to strike that balance.

What are liquidation preferences?

Liquidation preferences provide preferential treatment for preferred shareholders

in the event of a liquidation of the company or a sale of a majority of the

company's stock. Essentially, the investor receives a multiple of his original

investment as the first money out. For example, a $10 million investor with a 2X

liquidation preference would be entitled to receive the first $20 million generated

by a sale.

Because liquidation preferences give the VC a guaranteed return on their

investment of up to 1X or 2X or, as we have seen recently, 5X! (as long as the

sale price matches or exceeds that) they are an attractive way to limit downside

loss. But this protection comes at the expense of common and other preferred

shareholders without liquidation preferences. They're left divvying up a smaller

pie. After the preferences, there may not even be crumbs.



Liquidation preferences come in two shades, participating and non-participating.

With a non-participating liquidation preference, the investor receives the

liquidation multiple, and that is it. An investor with participating liquidation

preferences gets to double-dip, receiving both the multiple of the original

investment plus his or her share of the rest of the proceeds dictated by

ownership percentage once preferred stock is converted to common.

How do liquidation preferences affect valuation?

As with ratchet clauses, liquidation preferences protect preferred shareholders

when a company's value turns out to be less than what everyone ostensibly

expected when the investment was first made. But since liquidation clauses are

only invoked at the terminal point of a company's independent life, not atinterim financings, they receive less attention by company management

considering investor term sheets.

Indeed, sometimes management will be more wooed by a deal with liquidation

preferences because these preferences can make the valuation of a company

upon a financing round look better than it is—or better than the investors really

think it is.

Here's why: The effect of a liquidation preference depends on the liquidation orsale price of the company, an unknown at the time of the financing. In the event

the company is highly valued in the final transaction, the liquidation preference

has little effect on common's share of the proceeds. In a non-participating

situation, the multiple is easily matched by the sizeable value of the investor's

shares. In a participating situation, the multiple may be de minimus given the

whopping total value of the equity.

But if the company is sold at a valuation at or below the liquidation preference

multiple times the post-money valuation of the company at the financing round,

the liquidation preference effectively grants the preferred shareholders a greater

percentage of the company at the time of sale and hence—in hindsight—reduces

the implied valuation at the time of the interim financing. (The preference

multiple times the post-money valuation represents the sale value at which the

non-participating preferred investor would be equally compensated by receiving

the liquidation preference amount or the percentage ownership times the

liquidation value. At any lower valuation, the investor's liquidation preference

would exceed his/her percentage ownership times liquidation value. Hence,



effectively, the investor owns more of the company on liquidation than this

percentage ownership.)

Even more confusing, a financing round is generally quoted in terms of price per

share and the associated valuation is based on that share price. If a financing

has relatively few new shares but an aggressive liquidation preference, the

apparent valuation based on per share value may appear to be a flat or even up

round, while effectively the pre-money value is close to zero and the post-money

value is equal to the new investment!

Say, for example, the venture capitalist invests $10 million with a 4X liquidation

preference for 10% of the company. Presumably the company is worth $100

million. But if the company sells for $40 million, the VC effectively owns 100%because of the liquidation preference. The post-money valuation then is $10

million and pre money is zero.

This ability of liquidation preferences to distort the ex post valuation picture can

be effectively used to an investor's advantage when negotiating around other

anti-dilution provisions from an earlier round of financing. An investor can do an

investment at the previous round's price but secure a substantial liquidation

preference, effectively gaining a larger share of the company at the time of sale,

again, depending on valuation.

How about management?

It all sounds great for investors. But how about management? Top executives

are usually paid substantially through their shares and so focus more on per

share valuation than on nebulous liquidation preferences. But if they later realize

that preferences will wipe their money off the table, they may lose motivation .

Even if managers are savvy about preferences, they might be unconcerned

about them at a financing round when they are feeling optimistic. That

sentiment may change as tough realities set in.

Investors, then, should seek ways to satisfy management's needs while

protecting their own. We offer three such approaches.

First, investors can offer management a transaction bonus. An incentive to sell

the company, this cash bonus aims to make up some for any share of proceeds

foregone to the preferences. The bonus needs to be in cash rather than new



options, because the whole idea is that after the preferences, shares aren't

worth much.

Transaction bonuses are usually done in side agreements, sometimes even

verbally. And that's the problem. The message is usually a "we'll take care of

you." But if the rules of the game aren't clear, management might not be

responsive. Investors won't get the desired enthusiastic response they're

seeking, namely, a company sale.

Second, investors can offer management a slice of their liquidation preference.

If, for example, they've got a 4X multiple on a $10 million investment, they can

offer, say, 5% of their $40 million. Again, such arrangements would be in a side

deal. But these slices can be somewhat self-defeating in that they reduce theprotection of the preference.

Finally, investors can set up a valuation hurdle at which point the preferences

would disappear. This approach aligns management's interests with investors.

The message is: You hit a home run, and our liquidation preferences go away.

How high the hurdle? The higher the valuation hurdle to get the liquidation

preference to disappear, the less of an impact the liquidation preference would

have on preferred's investment return anyway. (IPOs are another story.Investment bankers generally insist that all preferred stock converts to common,

and liquidation preferences go away.)

Let's say a venture capitalist invests $2M for 25% of a company with a 2X

participating liquidation preference that goes away if the company sells for more

than $100M. If the company sells for exactly $100M, assuming no further

dilution after the VC invests, his or her return would be $25 million, or 12.5X

without the liquidation preference. Had the liquidation preference applied, the

investor's return would have been $28 million (4 million + 25% of 96), or 14X.

Clearly the liquidation preference is not generating the bulk of the investor's

return. A $100 million hurdle for management would not inflict too much pain on

the investor.

The problem with hurdles is that if they are structured as a single hurdle, like

$100 million in our example, they might be too narrow to achieve the objective

of motivating and rewarding management. What if the company sells for $95

million? Then management doesn't get the benefit of its efforts even thoughthey substantially, though not entirely, reached the goal. And management



might find itself inclined to pass on market-wise sales that don't satisfy the

internal hurdle.

The way around this problem is a "sliding scale" of hurdles, whereby the

preferences are reduced by greater percentages as the sale price rises.

In sum, there are several ways for investors to incent management while using

liquidation preferences to protect themselves. The key is to address these issues

squarely and clearly at the time of financing. If liquidation preferences actually

have to come into play, it's generally not because things have gone well. And

that's the worst time for more surprises



PRIVATE EQUITY GLOSSARY

“A” round – a financing event whereby angel groups and / or venture capitalists become involved in a

fast growth company that was previously financed by founders and their friends and families.

ˆ

Accredited investor – a person or legal entity, such as a company or trust fund, that meets certain net

worth and income qualifications and is considered to be sufficiently sophisticated to make investment

decisions in private offerings. Regulation D of the Securities Act of 1933 exempts accredited investors

from protection of the Securities Act. The Securities and Exchange Commission has proposed revisions

to the accredited investor qualifying rules, which may or may not result in changes for venture

investors. The current criteria for a natural person are: $1 million net worth or annual income exceeding$200,000 individually or $300,000 with a spouse. Directors, general partners and executive officers of

the issuer are considered to be accredited investors.

ˆ

After-tax operating income — see Net operating income after taxes.

ˆ

Airball – a loan whose value exceeds the value of the collateral.

ˆ

Alternative asset class — a class of investments that includes private equity, real estate, and oil and

gas, but excludes publicly traded securities. Pension plans, college endowments, and other relatively

large institutional investors typically allocate a certain percentage of their investments to alternative

assets with an objective to diversify their portfolios.

ˆ

Alpha – a term derived from statistics and finance theory that is used to describe the return produced

by a fund manager in excess of the return of a benchmark index. Manager returns and benchmark

returns are measured net of the risk-free rate. In addition, manager returns are adjusted for the risk of

the manager’s portfolio relative to the risk of the benchmark index. Alpha is a proxy for manager skill.

ˆ

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html#top%23top


http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_i_o.html#net







http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_i_o.html#net







Angel – a wealthy individual that invests in companies in relatively early stages of development. Usually

angels invest less than $1 million per startup.

ˆ

Anti-dilution – a contract clause that protects an investor from a substantial reduction in percentage

ownership in a company due to the issuance by the company of additional shares to other entities. The

mechanism for making an adjustment that maintains the same percentage ownership is called a Full

Ratchet. The most commonly used adjustment provides partial protection and is called Weighted

Average.

ˆ

“B” round – a financing event whereby investors such as venture capitalists and organized angel

groups are sufficiently interested in a company to provide additional funds after the “A” round of

financing. Subsequent rounds are called “C”, “D” and so on.

ˆ

Balloon payment – a relatively large principal payment due at a specific time as required by a lender.

ˆ

Basis point (“bp”) – one one-hundredth (1/100) of a percentage unit. For example, 50 basis points

equals one half of one percent. Banks quote variable loan rates in terms of an index plus a margin and

the margin is often described in basis points, such as LIBOR plus 400 basis points (or, as the experts

say, “beeps”).

ˆ

Best efforts offering – a commitment by a syndicate of investment banks to use best efforts to ensure

the sale to investors of a company’s offering of securities. In a best efforts offering, the syndicate avoids

any firm commitment for a specific number of shares or bonds.

ˆ

Beta – a measure of volatility of a public stock relative to an index or a composite of all stocks in a

market or geographical region. A beta of more than one indicates the stock has higher volatility than the

index (or composite) and a beta of one indicates volatility equivalent to the index (or composite). For

example, the price of a stock with a beta of 1.5 will change by 1.5% if the index value changes by 1%.


http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_d_h.html#fullratchet


http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_s_z.html#weightedaverageratchet




















Typically, the S&P500 index is used in calculating the beta of a stock.

ˆ

Beta Product – a product that is being tested by potential customers prior to being formally launched

into the marketplace.

ˆ

Blow-out round – see Cram-down round.

ˆ

Blue sky – regulations in individual states regarding the sale of securities and mutual funds. These laws

are intended to protect investors from purposely fraudulent transactions.

ˆ

Board of directors – a group of individuals, typically composed of managers, investors and experts

who have a fiduciary responsibility for the well being and proper guidance of a corporation. The board is

elected by the shareholders.

ˆ

Boat anchor – a person, project or activity that hinders the growth of a company.

ˆ

Book — see Private placement memorandum.

ˆ

Book runner – the lead bank that manages the transaction process for an equity or debt financing,

including documentation, syndication, pricing, allocation and closing.

ˆ

Book value – the book value of a company is the value of the common stock as shown on its balance

sheet. This is defined as total assets minus liabilities minus preferred stock minus intangible assets. The

book value of an asset of a company is typically based on its original cost minus accumulated




http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html#cramdown









http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_p_r.html#privateplacementmemo











http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_p_r.html#privateplacementmemo





depreciation.

ˆ

Bootstrapping – the actions of a startup to minimize expenses and build cash flow, thereby reducing or

eliminating the need for outside investors.

ˆ

Bp – see Basis point.

ˆ

Bridge financing – temporary funding that will eventually be replaced by permanent capital from

equity investors or debt lenders. In venture capital, a bridge is usually a short term note (6 to 12

months) that converts to preferred stock. Typically, the bridge lender has the right to convert the note

to preferred stock at a price that is a 20% to 25% discount from the price of the preferred stock in the

next financing round. See Mezzanine and Wipeout bridge.

ˆ

Broad-based weighted average anti-dilution – A weighted average anti-dilution method adjusts

downward the price per share of the preferred stock of investor A due to the issuance of new preferred

shares to new investor B at a price lower than the price investor A originally received. Investor A’s

preferred stock is repriced to a weighted average of investor A’s price and investor B’s price. A broad-

based anti-dilution method uses all common stock outstanding on a fully diluted basis (including all

convertible securities, warrants and options) in the denominator of the formula for determining the new

weighted average price. See Narrow-based weighted average anti-dilution.

ˆ

Bullet payment – a payment of all principal due at a time specified by a bank or a bond issuer.

ˆ

Burn rate – the rate at which a startup with little or no revenue uses available cash to cover expenses.

Usually expressed on a monthly or weekly basis.

ˆ





http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html#basispoint



http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_i_o.html#mezzanine

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_s_z.html#wipeoutbridge



http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_i_o.html#narrowbased









http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html#basispoint


http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_i_o.html#mezzanine

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_s_z.html#wipeoutbridge


http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_i_o.html#narrowbased






Business Development Company (BDC) – a publicly traded company that invests in private

companies and is required by law to provide meaningful support and assistance to its portfolio

companies.

ˆ

Business plan – a document that describes a new concept for a business opportunity. A business plan

typically includes the following sections: executive summary, market need, solution, technology,

competition, marketing, management, operations, exit strategy, and financials (including cash flow

projections). For most venture capital funds fewer than 10 of every 100 business plans received

eventually receive funding.

ˆ

Buyout – a sector of the private equity industry. Also, the purchase of a controlling interest of a

company by an outside investor (in a leveraged buyout) or a management team (in a management

buyout).

ˆ

Buy-sell agreement – a contract that sets forth the conditions under which a shareholder must first

offer his or her shares for sale to the other shareholders before being allowed to sell to entities outside

the company.

ˆ

C Corporation – an ownership structure that allows any number of individuals or companies to own

shares. A C corporation is a stand-alone legal entity so it offers some protection to its owners, managers

and investors from liability resulting from its actions.

ˆ

Call date – when a bond issuer has the right to retire part or all of a bond issuance at a specific price.

ˆ

Call premium – the premium above par value that an issuer is willing to pay as part of the redemption

of a bond issue prior to maturity.

ˆ
























Call price – the price an issuer agrees to pay to bondholders to redeem all or part of a bond issuance.

ˆ

Call protection – a provision in the terms of a bond specifying the period of time during which the bond

cannot be called by the issuer.

Capital Asset Pricing Model (CAPM) – a method of estimating the cost of equity capital of a

company. The cost of equity capital is equal to the return of a risk-free investment plus a premium that

reflects the risk of the company’s equity.

Capital call – when a private equity fund manager (usually a “general partner” in a partnership)

requests that an investor in the fund (a “limited partner”) provide additional capital. Usually a limited

partner will agree to a maximum investment amount and the general partner will make a series of

capital calls over time to the limited partner as opportunities arise to finance startups and buyouts.

Capital gap – the difficulty faced by some entrepreneurs in trying to raise between $2 million and $5

million. Friends, family and angel investors are typically good sources for financing rounds of less than

$2 million, while many venture capital funds have become so large that they are only interested in

investing amounts greater than $5 million.

Capitalization table – a table showing the owners of a company’s shares and their ownership

percentages as well as the debt holders. It also lists the forms of ownership, such as common stock,

preferred stock, warrants, options, senior debt, and subordinated debt.

Capital gains – a tax classification of investment earnings resulting from the purchase and sale of

assets. Typically, an investor prefers that investment earnings be classified as long term capital gains

(held for a year or longer), which are taxed at a lower rate than ordinary income.

Capital stock – a description of stock that applies when there is only one class of shares. This class is

known as “common stock”.

Capped participating preferred stock – preferred stock whose participating feature is limited so that

an investor cannot receive more than a specified amount. See Participating preferred stock.

Carried interest – the share in the capital gains of a venture capital fund which is allocated to the

General Partner. Typically, a fund must return the capital given to it by limited partners plus any

preferential rate of return before the general partner can share in the profits of the fund. The general

partner will typically receive a 20% carried interest, although some successful firms receive 25%-30%.

Also known as "carry" or "promote."



http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_p_r.html#participatingpreferred


http://mba.tuck.dartmouth.edu/pecenter/resources/glossary



http://mba.tuck.dartmouth.edu/pecenter/resources/glossary



Catch-up – a clause in the agreement between the general partner and the limited partners of a private

equity fund. Once the limited partners have received a certain portion of their expected return, the

general partner can then receive a majority of profits until the previously agreed upon profit split is

reached.

Change of control bonus – a bonus of cash or stock given by private equity investors to members of a

management group if they successfully negotiate a sale of the company for a price greater than a

specified amount.

Clawback – a clause in the agreement between the general partner and the limited partners of a

private equity fund. The clawback gives limited partners the right to reclaim a portion of disbursements

to a general partner for profitable investments based on significant losses from later investments in a

portfolio.

Closing – the conclusion of a financing round whereby all necessary legal documents are signed and

capital has been transferred.

Club deal – the act of investing by two or more entities in the same target company, usually involving a

leveraged buyout transaction.

Co-investment – the direct investment by a limited partner alongside a general partner in a portfolio

company.

Collateral – hard assets of the borrower, such as real estate or equipment, for which a lender has a

legal interest until a loan obligation is fully paid off.

Commitment – an obligation, typically the maximum amount that a limited partner agrees to invest in

a fund. See Capital call.

Common stock – a type of security representing ownership rights in a company. Usually, company

founders, management and employees own common stock while investors own preferred stock. In the

event of a liquidation of the company, the claims of secured and unsecured creditors, bondholders and

preferred stockholders take precedence over common stockholders. See Preferred stock.

Comparable – a publicly traded company with similar characteristics to a private company that is

being valued. For example, a telecommunications equipment manufacturer whose market value is 2

times revenues can be used to estimate the value of a similar and relatively new company with a new

product in the same industry. See Liquidity discount.

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html#capitalcall

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_p_r.html#preferredstock

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_i_o.html#liquiditydiscount

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html#capitalcall

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_p_r.html#preferredstock

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_i_o.html#liquiditydiscount



Control – the authority of an individual or entity that owns more than 50% of equity in a company or

owns the largest block of shares compared to other shareholders.

Consolidation — see Rollup.

Conversion – the right of an investor or lender to force a company to replace the investor’s preferred

shares or the lender’s debt with common shares at a preset conversion ratio. A conversion feature was

first used in railroad bonds in the 1800’s.

Convertible debt – a loan which allows the lender to exchange the debt for common shares in a

company at a preset conversion ratio. Also known as a “convertible note.”

Convertible preferred stock – a type of stock that gives an owner the right to convert to common

shares of stock. Usually, preferred stock has certain rights that common stock doesn’t have, such as

decision-making management control, a promised return on investment (dividend), or senior priority in

receiving proceeds from a sale or liquidation of the company. Typically, convertible preferred stock

automatically converts to common stock if the company makes an initial public offering (IPO).

Convertible preferred is the most common tool for private equity funds to invest in companies.

Convertible security – a security that gives its owner the right to exchange the security for common

shares in a company at a preset conversion ratio. The security is typically preferred stock, warrants or

debt.

Co-sale right – a contractual right of an investor to sell some of the investor’s stock along with the

founder’s or majority shareholder’s stock if either the founder or majority shareholder elects to sell stock

to a third-party. Also known as Tag-along right.

Cost of capital — see Weighted average cost of capital.

Cost of revenue – the expenses generated by the core operations of a company.

Covenant – a legal promise to do or not do a certain thing. For example, in a financing arrangement,

company management may agree to a negative covenant, whereby it promises not to incur additional

debt. The penalties for violation of a covenant may vary from repairing the mistake to losing control of

the company.

Coverage ratio – describes a company’s ability to pay debt from cash flow or profits. Typical measures

are EBITDA/Interest, (EBITDA minus Capital Expenditures)/Interest, and EBIT/Interest.

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_p_r.html#rollup

http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_s_z.html#tagalongright


http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_s_z.html#weightedaveragecost


http://mba.tuck.dartmouth.edu/pecenter/resources/glossary_p_r.html#rollup





Cram down round – a financing event upon which new investors with substantial capital are able to

demand and receive contractual terms that effectively cause the issuance of sufficient new shares by the

startup company to significantly reduce (“dilute”) the ownership percentage of previous investors.

Cumulative dividends – the owner of preferred stock with cumulative dividends has the right to

receive accrued (previously unpaid) dividends in full before dividends are paid to any other classes of

stock.

Current ratio – the ratio of current assets to current liabilities.

articles_tuck mba school dartmouth

Documents