Question

1. Explain the use of Common Stock, Preferred stock, Convertible Preferred Stock and Participating Preferred Stock in a VC/Start-up financing setting. Describe the advantages and disadvantages of each type of contract by VCs.

2. Banking Questions

(1) Explain the differences between Commercial and Investment banking.

(2) Describe some of the ways in which banks are regulated.  Explain why banks are heavily regulated

(3) Describe the role that these institutions play in the economy.

Answer 1

USE BY VENTURE CAPITALISTS

1.COMMON STOCK -

Common stock tends to come with voting rights. These rights may be proportionate to the entire company, may be limited, or may be worth more than the voting power of other share classes. This is negotiable, and something the entrepreneur needs to consider. In most cases during a funding event, the rights of the common shareholder often become more restricted, or rather, the rights provided to the preferred shareholder become superior. But like everything else, those restrictions are negotiable. Just as the investor will seek to maximize the amount of control they have on their investment, they will appreciate and support the entrepreneur’s efforts to negotiate and win additional rights, IF those wins are tied to company success metrics.

advantage

The main advantage of this type of share structure is that owners get access to the capital markets, while retaining effective control and potentially warding off hostile takeovers.

disadvantage

The disadvantage for investors is lower voting rights and trading volumes in some of these share classes.

2.PREFERRED STOCK -

Venture capitalists prefer preference shares, as they allow venture capitalists to specify certain rights (e.g. preemption rights, anti-dilution provisions, liquidation preferences, conversion on an IPO) which (i) protects their investment (e.g. from dilution in later rounds), and (ii) provides a larger upside in an exit, to compensate for the risk of investing in high-risk, speculative startups, among other things.

These preferences can be at the expense of less preferred shareholders (e.g. founders, employees, angels and earlier investors), so that's something a startup founder should look out for as well.

advantage-

In the event that a company experiences a bankruptcy and subsequent liquidation, preferred shareholders have a higher claim on company assets than common shareholders do. Not surprisingly, preference shares attract conservative investors, who enjoy the comfort of the downside risk protection baked into these investments.

disadvanatge -

The main disadvantage of owning preference shares is that the investors in these vehicles don't enjoy the same voting rights as common shareholders. This means that the company is not beholden to preferred shareholders the way it is to traditional equity shareholders.

3.CONVERTIBLE PREFERRED STOCK -

they prefer Convertible preferred stock because is a type of preferred stock that gives holders the option to convert their preferred shares into a fixed number of common shares after a specified date. It is a hybrid type of security that has features of both debt (from its fixed guaranteed dividend payment) and equity (from its ability to convert into common stock).

advantage-

Benefits are in the form of an absence of a legal obligation to pay the dividend, improves borrowing capacity, saves dilution in control of existing shareholders and no charge on assets.

disadvantage -

The major disadvantage is that it is a costly source of finance and has preferential rights everywhere.

4.PARTICIPATING PREFERRED STOCK -

Participating preferred stock is preferred stock that provides a specific dividend that is paid before any dividends are paid to common stock holders, and that takes precedence over common stock in the event of a liquidation. This form of financing is used by private equity investors and venture capital (VC) firms. Holders of participating preferred stock have the choice between two payoffs: a liquidation preference or an optional conversion. In a liquidation, they first get their money back at the original purchase price, the balance of any proceeds is then shared between common and participating preferred stock as though all convertible stock was converted. In an optional conversion, all shares are converted into common stock. Holders of participating preferred stock will always pick the option with the highest payoff.

advantage-

The additional dividend paid to preferred shareholders is commonly structured to be paid only if the amount of dividends that common shareholders receive exceeds a specified per-share amount

disadvanatge-

Participating preferred stock is not common, but can be issued in response to a hostile takeover bid as part of a poison pill strategy.

2.

(a)

BASIS FOR COMPARISON	INVESTMENT BANK	COMMERCIAL BANK
Meaning	Investment bank refers to a financial institution, that offers services like underwriting of securities, brokerage services and so on.	Commercial bank is a bank that provides services like accepting deposits, lending money, payment on standing order and many more.
Offers	Customer specific service	Standardized service
Associated with	Performance of financial market.	Nation's economic growth and demand for credit
Customer base	Few hundreds only	Millions
Banker to	Individuals, government and corporations.	All citizens
Income	Fees, commissions or profit on trading activities.	Fees and interest income

(b)

Banks are regulated by both state and federal regulators. Virtually all banks are regulated and examined by their deposit insurers, either the Federal Deposit Insurance Corporation (FDIC), which insures most banks, or the National Credit Union, which insures credit unions. Most state banks and all national banks are also members of the Federal Reserve, which oversees and regulates their operation. The Federal Reserve also has some regulatory oversight over nonmember banks.

National banks with a federal charter are also regulated either by the Office of the Controller of the Currency (OCC) or by the Office of Thrift Supervision (OTC). Traditionally, the OCC covered commercial banks and the OTS covered savings banks, but, because most banks are offering the same services, there is little distinction between the two. Hence, banks can choose either regulatory agency by changing their charter, and since these federal agencies collect fees from banks for their oversight, they strive to get more members. This creates a regulatory competition between the OCC and the OTC, where each eases their restrictions to attract more new members. OTC reduced its restrictions so much that during the Great Recession of 2008, IndyMac Bancorp, Washington Mutual, and Downey Savings and Loan Association — all supervised by the OTC — were seized by the federal government; others were taken over by healthier institutions.

State banks are mainly regulated by the states, but the Federal Reserve and the FDIC still have some authority even with state banks, and states also have some authority over national banks. The Supreme Court recently ruled[i] that federal banking regulations do not preempt states from enforcing their own fair-lending laws.

(c)

A financial institution is basically an establishment that conducts financial transactions such as investments, loans and deposits.

There are five main types of financial institutions.

1.Commercial banks

2. Investment Banks

3. Insurance Company

4. Brokerage

5. Investment Company

The primary role of financial institutions is to provide liquidity to the economy and permit a higher level of economic activity than would otherwise be possible.

According to the Brookings Institute, banks accomplish this in three main ways: offering credit, managing markets and pooling risk among consumers.

If you are familiar with GDP, the investment portion is heavily influenced by financial institutions, as they facilitate how much people save and invest in an economy, which is an ingredient for economic growth.

Without financial institutions, people wouldn’t be able to take advantage of rising and falling interest rates and there would be no saving of money, other than the stacks you stuff under your mattress.