The venture capital firm called MIT Ventures is considering a $5M first round investment in Brainiac.com. MIT Ventures proposes to structure the investment as 5M shares of convertible preferred stock. The founders of Brainiac.com, who will continue with the firm, currently hold 10M shares of common stock (including the stock option pool). Thus, following the first investment, Brainiac.com will have 10M common shares outstanding. MIT Ventures estimates that a successful exit would be possible in five years and the company would have an exit multiple of 10x sales at that time. The cost of capital of MIT Ventures is 25%.
Now assume that MIT Ventures considers offering Brainiac.com a shareholder contract. However, before settling on one contract, MIT Ventures is considering two alternative structures for their investment:
Structure I: 5M shares of Convertible Preferred (this is the standard VC contract that we discussed in class);
Structure II: Debt ($5M) + 5M shares of common stock;
Let's assume that MIT Ventures agreed to invest in Brainiac.com using a convertible preferred as in Structure I. However, within one year after the first financing round MIT Ventures finds out that Brainiac.com will need much more capital than initially expected to get to cash flow positive. Therefore, the founders and the VC decide to raise another round of financing for the company.