FINC6025 · Entrepreneurial Finance
Investment Instruments, Contracts, Monitoring & Advice
Week 10 of University of Sydney FINC6025 Entrepreneurial Finance covers the deal-structuring toolkit that aligns incentives and manages agency risk. It works through the holdup problem, convertible preferred stock and its redeem-versus-convert payoff, participating preferred, antidilution provisions, convertible notes and SAFEs, and the economic and control terms of a term sheet, closing with how investors add value through monitoring and advice. The redeem-versus-convert decision and the term-sheet taxonomy are staple short-answer and case items on the final exam.
What this chapter covers
- 01The holdup (cheap-sale) problem: why VCs do not buy common stock; founder/employee vesting as a remedy
- 02Convertible preferred stock (CPS): liquidation preference and the choice of the higher of redeem or as-converted value
- 03Redeem-vs-convert break-even sale value = face value / VC ownership %; the flat-then-sloping payoff shape
- 04Participating convertible preferred (PCP): face value AND participation (the 'double dip'); behaviour in an IPO vs a trade sale
- 05Down rounds and antidilution: full ratchet vs weighted-average (broad-based) conversion-price adjustment
- 06Convertible notes and SAFEs: debt-like early instruments; conversion at the lower of a discount price or a valuation-cap price
- 07Term sheet contents: deal economics, securities, control (voting, board, protective provisions), exit and process terms
- 08Monitoring and value-adding: board seats, governance, human resources and matchmaking; standard 4-year vesting with a 1-year cliff
Convertible preferred: redeem or convert at exit
- +1A CPS holder takes the higher of the liquidation (redemption) value or the as-converted common value. Redeem gives the face 2.0 million; convert gives 40% of the sale value.
- +1Break-even is where face = ownership % x sale value, so sale value = face / ownership % = 2.0 / 0.40 = 5.0 million dollars. Below 5.0 million, redeeming wins; above it, converting wins.
- +1At a 4.0-million sale: convert = 0.40 x 4.0 = 1.6 million < redeem 2.0 million, so Meridian redeems and takes 2.0 million.
- +1At a 7.0-million sale: convert = 0.40 x 7.0 = 2.8 million > redeem 2.0 million, so Meridian converts and takes 2.8 million. The payoff is flat at the 2.0-million face up to the 5.0-million break-even, then slopes upward at the 40% ownership rate.
Key terms
- Holdup (cheap-sale) problem
- After a VC invests common-for-common, the founder gains bargaining power and could threaten to leave or force a cheap sale, expropriating the investor. It is why VCs use preferred stock, convertible notes and founder vesting rather than buying common.
- Convertible preferred stock (CPS)
- Preferred stock with a liquidation preference that the holder may convert into common. The holder takes the higher of the redemption value or the as-converted value; the break-even sale value is face value divided by the ownership percentage.
- Participating convertible preferred (PCP)
- Preferred that, in a sale or liquidation, pays the face value AND then participates in the remaining equity (a 'double dip'), protecting late-round investors against cheap sales. In an IPO it converts to common like ordinary CPS.
- Antidilution provision
- A term that lowers the preferred's conversion price if the company later raises at a lower price, giving the investor more common shares on conversion. Full ratchet resets to the new price (founder bears all the loss); weighted-average shares the loss via new CP = old CP x (A + C)/(A + D).
- Convertible note / SAFE
- Early-stage instruments, legally debt-like (a SAFE is a standardised agreement for future equity), that defer valuation. At the qualifying round they convert at the lower (more favourable) of a discount price, (1 - discount) x round price, or a valuation-cap price.
- Vesting (4-year, 1-year cliff)
- Founder or employee equity is earned over time: nothing vests before the one-year cliff, then a lump vests, and the rest accrues (typically monthly) to year four. It aligns incentives to stay and is a standard remedy for the holdup problem.
Investment Instruments, Contracts, Monitoring & Advice FAQ
Why don't VCs just buy common stock?
Because of the holdup problem. Once a VC has put cash in for common shares, the founder holds the firm's key asset - themselves - and can threaten to walk out or push a cheap sale, leaving the common-holding VC short-changed. Preferred stock (with a liquidation preference), convertible notes, founder and employee vesting, and board control are the tools that protect the investor against this, which is why real venture deals rarely use plain common for the investor.
When does convertible preferred redeem versus convert?
The holder always takes the higher of the two. The break-even sale value is the face (liquidation) value divided by the ownership percentage: below it, the fixed face value is worth more, so the holder redeems; above it, the as-converted equity is worth more, so the holder converts. This gives the flat-then-sloping payoff that protects the downside while keeping the upside - the essence of why the instrument exists.
What is the difference between full-ratchet and weighted-average antidilution?
Both adjust a preferred holder's conversion price down after a lower-priced (down) round so the investor converts into more common. Full ratchet resets the conversion price all the way to the new, lower price, fully protecting the investor and dumping the entire dilution on the founder. Weighted-average uses new CP = old CP x (A + C)/(A + D), which only partially lowers the price so founder and earlier investors share the loss - the more common, founder-friendlier form.
Can AI help me with FINC6025 deal terms?
Yes. Sia can walk the redeem-versus-convert decision, contrast convertible and participating preferred payoffs, drill the antidilution formulas and the convertible-note discount-versus-cap rule, and organise the term sheet into economic, control, exit and process terms for revision. It teaches the method and checks your reasoning; it does not do graded assessment, and the University of Sydney academic-integrity policy applies.
Exam move
Week 10 is dense with instruments, so organise it around one question: what problem does each term solve? Tie preferred stock and vesting to the holdup problem, participating preferred and antidilution to the cheap-sale and down-round risks, and convertible notes/SAFEs to deferring valuation. Drill the two calculations that recur: the CPS break-even (face / ownership %) with its redeem/convert decision, and the convertible-note conversion at the lower of discount and cap prices. For the term sheet, memorise the four buckets - deal economics, securities, control and exit - and be able to slot any named term (liquidation preference, protective provisions, drag-along, pay-to-play) into one. Confirm the exam's coverage on Canvas.
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