1. What are the potential shortfalls of using comparable to value a private company? 2. How...

1. What are the potential shortfalls of using comparable to value a private company?

2. How does the concept of fiduciary duty play into the use of preferred stock?

3. Why is vesting used in venture capital deals? Why do managements agree to it?

Expert Solution

(1): For a private company the potential shortfalls of using comparable for valuation purpose starts with the shortfall that market multiples can diverge strongly from the investment value. Secondly the shortfall for using comparable in case of private company is that in case the overall industry is undervalued (or overvalued in the opposite case) then it will not be possible to know by comparing multiples of listed competitors. This will, in all probability, lead to incorrect valuations of private companies.

(2): The concept of fiduciary duty applies to the use of preferred stock only to the extent that interests of the preferred stock holders overlap with the interests of the common stock holders. It should be noted that a company and its board and management have a fiduciary duty only towards the holders of ‘permanent capital’ (i.e. common stock holders) and so a company has no fiduciary duty to maximize preferred stock holder’s return. In cases of exit preferred stock holders will get benefit of their bargain.

(3): Vesting is used in venture capital deals so as to protect a company from giving up too much equity to a person who spends only a short time with the company. In other words vesting is used in venture capital to ensure that the person to whom the equity is being given works with the company for a long period of time. Managements agree to vesting because of several reasons. First of all it becomes easier for managers to get a new hire to agree to a vesting schedule if you have one in place as founder. Secondly management is safe in cases of disagreements between founders. In case of disagreements between founders a vesting schedule will prevent the partner who has quit to earn large portion of profits as this partners earning would have been limited only on the year or for the term for which they were with the entity.

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