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Metapath Software Case Note

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Metapath Software

OUTLINE
• What happened.
• The broader themes:
– The interplay of terms.
– Options in private equity.

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WHAT HAPPENED (1)
• The Company turned down Cell
Tech:
– Offering 30% of their capitalization indicated that their base business had limited upside.
– Clearly there were ongoing financing risks and liquidity issues.
– The fit was not compelling.

• Cell Tech stock fell $9 –> $3
– After 3 years and several acquisitions, it
rebounded.

WHAT HAPPENED (2)
• Accepted RSC Participating Preferred, later had to raise a $12mm Ser F Rd at $8/shr, had to keep participation.


• Merged with UK based MSI Dec ‘98:
– 65% MSI, 35% Metapath, both private cos.
– Grey area since preferred carried over to merged company.
– Mezzanine investors insisted on participation.

WHAT HAPPENED (3)
• Much rancor between late investors and early investors plus Management:
– Ser E (and Ser F) had defined “liquidation” to include any change of control event.
– Management maintained all rights could be preserved in capitalization post-merger.
– Late stage investors knew company worth more than their ~$24mm liquidation preference, so were willing to vote down deal (votes were by class)–they won.

WHAT HAPPENED (4):
Lessons Learned
• Metapath used too much money:
– Despite continual progress, ran out of
cash.

• Metapath too price focused:
– $4/shr w/ no participation possible?
– $4/shr still a good step up from $1.62.

• RSco and TCV fundamentally different
kind of investor from BVP & Norwest:
– Trading terms for price.
– Good trade when you perform but leaves
no room for error!

THE INTERPLAY OF TERMS:
Trading price for terms

• Trend in price/share often only
outside gauge of company progress.
• Price/share affects employee options
and morale.
• Fancy terms tend to put boundaries
on the downside.
• Term-laden deals often play on
entrepreneur’s optimism (screening?).

THE INTERPLAY OF TERMS:
Liquidation & Participation
• A liquidation triggers participation.
• In the Metapath case, formerly the
board could deem a change of
control a liquidation, but it was not
automatic.
• “Liquidation” was changed to
include change of control in Ser E:
– Implication not picked up by
management, early investors or
company counsel.

THE INTERPLAY OF TERMS:
Voting & Negative Covenants
• Negative Covenants outline what the
company can NOT do without special
vote of preferred (e.g.: merge, sell,
change business, liquidate etc.)
• Preferred previously voted as one
class, or on an “as converted basis”.
• Voting class by class became part of
deal when terms between classes
significantly diverged.

BLACK-SCHOLES LOOKS AT
THE LIMITING CASE
• Assumes continuous time–many
branching points.
• Obtains complex formula as function
of:
– Time to maturity.
– Standard deviation of stock.
– Current stock price.
– Exercise price.
– Risk-free interest rate.

USING THE BLACK-SCHOLES
FORMULA
• Black-Scholes EXCEL calculator.

ILLUSTRATION
• Switch from convertible to
participating preferred is essentially
“re-pricing” the call option of Series E
holders:
– Will begin sharing in equity above $11.75
million, rather than $87.75 million:
• How much is this worth?
• How lower share price should Hardy be
willing to accept to get rid of?
– He had offered $5.50 without instead of $6 with.

BASIC STRUCTURE
• Look at what worth in current setting.
• Look at what worth with higher
exercise price.
• Look at how much lower share price
will equate.

ASSUMPTIONS
• Ten-year option life.
• 30% volatility (guess).
• $11.75 and $87.75 million exercise
prices.
• Assume $87.75 valuation is right.
• Interest rate of 6.21%.
– Assume away complexity of IPO.

CALCULATION
• Value of option with $11.75 strike
price is $81.4 million.
– 13.4% of this is $10.7 million.

• Value of option with $87.75 strike
price is $49.9 million.
– 13.4% of this is $6.7 million.

• The participating feature represents
about $4 million in value!

CALCULATION (2)
• Now look at how much larger share of
the company (lower price) will equate:
– 13.4% * $81.5MM = X * $49.9 MM.
– X = 21.9%.

• Hardy would have been equally well
off giving Series E holders 21.9% of
company without participation:
• Share price of (13.4%/21.9%)*$6=$3.67!

Why do we see these features
Convertible preferred
Participating Convertible Preferred
Liquidation Preferences
Full Ratchet/ Weighted Average
Ratchet
• Registration rights



Challenges for VCs
• Joe Flash and Rex Finance do a deal
Asset

Liabilities and
Shareholders’ Equity

Joe’s Idea ???

0

Asset

Liabilities and
Shareholders’ Equity

Joe’s Idea 1.5 million

Joe 50.05%

Cash

Rex 49.95%

1.5 million

John Terrific Offers $2 million for the
Company – What happens if Rex had taken
Common Stock?

Challenges of Venture Financing
• Critical issues involved in • Responses by VCs
financing young firms
– Active Screening
– Stage financing
– Uncertainty
– Syndication
– Asymmetric
– Use of Stock options/grants
Information
with strict vesting
– Nature of Firm’s assets
requirements
– Conditions of relevant
– Contingent control
financial and product
mechanisms – Covenants and
markets
restrictions
– Strategic composition of
Board of Directors

Securities used by VCs
• Common Stock
• Debt
• Preferred Stock

• Never – why
not?
• Never – why
not?
• Interestingwhy?

VCs response #1– Security
Design
• Redeemable Preferred (RP)
• Convertible Preferred (CP) – Forced
Conversion Clause
• Participating Convertible Preferred
(PCP)

VCs response #2 Vesting
• Vesting – creates “Golden Handcuffs”
for key employees
• Idea being that you have to “Earn”
your share of the company!
• Also keeps the option pool from being
depleted if employees leave

VCs response #3 Covenants
• Covenants
– Positive Covenants
• Example Provide regular information

– Negative Covenants
• Example Sale of assets

– Others
• Mandatory redemption
• Board Seats

How Do VCs Evaluate Potential
Investments?
• How do you evaluate potential venture opportunities?
• How do you evaluate the venture’s prospective business model?
• What due diligence do you conduct?
• What is the process through which funding decisions are made?
• What financial analysis do you perform?
• What role does risk play in your evaluation?
• How do you think about a potential exit
route?

Key Takeaways
• While hard to codify some key patterns are
consistent
• Risk-Reward trade-off
• Market is big factor
– How much pain!
– Who feels the pain!

• Acceptance that mistakes will be made but
with a twist
– Mistake when made the investment
– Mistake when DID NOT make investment

• Intense desire for IPO worthy investment

Cite this Metapath Software Case Note

Metapath Software Case Note. (2017, Jan 31). Retrieved from https://graduateway.com/metapath-software-case-note/

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