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Private Investment Forum - Summer 2012


Raising Equity? - Thinking About the Next Series



Historically, Boards of Directors and Special Committees have faced fairness issues and legal scrutiny in change of control transactions, particularly as it relates to the fiduciary responsibility to all shareholders in a proposed transaction. However, we see an increasing prevalence of actions being raised against fiduciaries involved in venture capital financing transactions. VC funded companies are often burdened with complex capital structures that have numerous minority shareholders and varying levels of preferred equity and liquidation preferences.When these companies seek additional infusions of capital, it can result in a “squeeze out” or “cram down” for the existing shareholder base. This has the potential to trigger significant fiduciary issues for the Boards and Special Committees overseeing the transaction process, especially if there are any interested parties to the transaction holding varying levels of preferred equity involved in the decision making process. In order to provide the necessary defense against potential shareholder claims, fiduciaries need to conduct a process that considers all alternatives available to the company, removes conflicting interested parties from negotiations and board approval, and ensures a post-transaction capital structure that is economically fair to all shareholders.

New Money, More Problems

In many instances, liquidity and time constraints can make companies feel like their back is up against the wall.The pressure to solve the immediate need for capital compels companies to move forward with less than ideal financing partners and agreements that, while they provide the much needed capital infusion, can create a number of unfavorable outcomes; such as, a convoluted capital structure heavily favoring later stage investors; restrictive measures imposed on management; and/or a requirement of adding a new board seat(s) creating a clash of personalities and interests. All of these outcomes create fiduciary risk for Boards and Special Committees overseeing the process and can elicit a wave of claims from shareholders.

Fairness Opinion or Alternatives?

These issues are most common in down round VC financings involving a “cram down” or forced conversion of existing shareholders, but can arise in many other late stage VC and/or growth equity financings. Best practice suggests the retention of a reputable independent financial advisor to represent the Board or Special Committee to issue a supportable, well-documented opinion as to the financial fairness of the transaction to the shareholders.However, some companies are concerned about the costs associated with obtaining a fairness opinion and must look to other avenues. This not only takes up a substantial amount of time and energy from key members of the Board and management, it also does not solve the immediate need for capital.

Navigating Fiduciary Pitfalls for Boards and Special Committees

Though obtaining a fairness opinion is widely considered the gold standard in protecting members of the Board and Special Committee, the following outlines a number of practical steps and protective measures to minimize fiduciary risk and establishes a well-supported process that can withstand the scrutiny of the courts.First, ensure the process and actions of the board are fully documented, including minutes from board meetings and meetings of a Special Committee. Documenting the process is an effective measure that will help shift the burden of proof away from the Board and/or Special Committee. Second, we suggest that the Board or a Special Committee of the Board work with a financial advisor to assess viable options, ensuring that all strategic alternatives were considered and through careful consideration, the optimal solution is selected. Third, it is important that the Board and or Special Committee carefully identifies and removes conflicts of interest at the onset of a transaction that may taint the appearance of fair process and fair dealing. Care should be taken to form a team of independent, non-affiliated individuals to lead the process of selecting a capital structure that is economically fair to all stakeholders.Generally, board members who are also economic stakeholders in the company, should not be involved in the decision making process. Fourth, the company should design an appropriate capital structure that not only supports the proposed transaction but also simplifies the capital structure and positions the company for success in subsequent rounds of financing or future liquidity events. Lastly, and often considered the most cumbersome aspect of the transaction process, align the interests of all the shareholders in order to obtain shareholder approval and facilitate a timely transaction close.

A Case Study on Fiduciary Risk in Venture Capital Financing Transactions

In a recent transaction, Cognient was retained by a Special Committee to render a fairness opinion in conjunction with a proposed financing transaction for a venture capital-backed company. The company, having previously undergone several rounds of financing, had 10 existing layers of preferred equity, all with varying degrees of liquidation preference. The company initially designed a transaction that forced the conversion of all existing classes of preferred equity and common equity, regardless of liquidation preference, into a single class of common stock in the recapitalized company. Given the current value of the company, the initially proposed transaction was not fair from a financial point of view to several classes of shareholders, and therefore Cognient was unable to issue a fairness opinion. However, Cognient worked closely with the Special Committee and its counsel to create a paired-share equity structure that allowed all shareholders to both maintain their level of liquidation preference and their proportionate equity upside potential in the recapitalized company.This was accomplished through the design of one preferred security and one common equity security in combination with an economically appropriate exchange ratio for existing shareholder securities. The revised transaction resulted in full shareholder approval and the company obtained the capital it needed to grow and continue to work towards their goal of an initial public offering.

Valuing the Company’s Equity in Subsequent Rounds of Financing

As seen in the case study above, valuing the various classes of equity can become an onerous task as multiple layers of preferred equity complicate the capital structure. There are four “equity allocation” methodologies that are generally used to allocate value to each class of equity: i) Current Method; ii) Contingent Claims Analysis; iii) Probability Weighted Expected Return Method (“PWERM”); and iv) Back-Solve Method. The Current Method allocates value to each class of equity without regard to the future growth of the equity and is appropriate when a liquidity event is imminent or the company is at such an early stage of development that no material progress has been made to reasonably estimate future earnings or value.The Contingent Claims Analysis can be performed by replicating all equity classes with call and put options on the total enterprise value and is employed when future outcomes can be estimated such as an IPO or M&A transaction, yet the value at these future events cannot be estimated.Option pricing can be implemented by separately pricing the imbedded call and put options using a Black-Scholes or Binomial option pricing model.Contingent claims analysis can also be performed using a Monte Carlo simulation analysis to value each debt and equity security in the capital structure. While the Monte Carlo simulation is the most time consuming analysis to construct, it can also be the most comprehensive and powerful analysis.PWERM is appropriate when management can reasonably estimate the Company’s future outcomes and the value for each scenario can be reasonably estimated. The Back-Solve Method can be used for companies that do not have substantial financial or operating histories. Essentially, this approach uses the most recent round of financing in another equity class as a referenced transaction to “back solve” for the implied equity value. The assumption here is that the most recent round of financing is sold at a market price, which can be constituted as fair value.

About Cognient Group

Cognient Group is a financial advisory,valuation and investment banking firm dedicated to helping clients confidently make informed, strategic decisions about their businesses. If you have any questions about the article or would like to discuss Cognient’s capabilities and experience, please contact Mary Kate Higham at mkhigham@cognient.com or Michael Olson at michael.olson@cognient.com.




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