1. Analyze Metapath’s capital structure, in particular the various forms and prices of preferred stock from the previous rounds of financing. How has this capital structure affected the offer from Robertson & Stephens? How would RSC’s participating preferred interact with the other tranches of preferred stock?
Up to the date in issue, Metapath has raised $9m in four rounds of financing, of which two occurred simultaneously in the beginning. The two participating investors, Bessemer and STI, which supplied the initial funds, received redeemable preferred for the total amount of $1.6m, the third and fourth rounds brought in $1m and $7m respectively (in both cases preferred convertible were issued), with the calculated price for common being the same for the first three rounds ($1.05) and higher ($1.62) for the fourth round. In case of non-conversion, the last issue was supposed to be paid out first, then the last but one, finally, the first two issues, on a pro rata basis.
All of the issues had demand registration rights provision, however, the third and the fourth issues, had more leeway in the exercising of the rights (not only on request of 50%+ of all the issues, but also after-IPO or specific date (July 31, 1999), whichever is earlier), thus protecting the interests of the holders. That said, in fact the holders of the two first issues in many respects enjoyed the position of debt holders, with a scheduled payment of principal and dividends.
Given the structure and the fact the managers hadn’t invested from their own pockets, RSC suggested investment in participating convertible preferred shares supposed to protect RSC from possible early sale, which would enrich the management disproportionally and leave RSC abused. Through PCPT, RSC would be able to keep both liquidation preference (with the right to receive the first payment in the amount of invested capital and accrued, not unpaid dividend (8%), before any other security holders receive their part) and equity participation along with other investors (after payment of similar to its own liquidation preference), thus, staying in a highly beneficial position.
2. How do you analyze the RSC offer? In particular, what is the value of the participating preferred feature of the RSC syndicate? What are the risks to the Metapath shareholders if the board accepts the RSC offer? Even though the company has only projected its activity one quarter forward, is it possible to assess the reasonableness of the valuation? (The ten-year treasury rate in September 1997 was 6.21%).
To value the participating feature, first, calculate the options’ values for $11.75% and $87.75 million exercise prices. For calculation, assume: ten-year option price; 40% volatility (corresponding to the middle stock volatility range 20-40%); abovementioned exercise prices ($11.75% and $87.75 million); valuation of $87.75 million is reflective of a true “asset” value; interest rate of 6.21% (as suggested). Apply Black-Scholes model to receive prices of $81.44 and $49.44 million for the two strikes respectively. For $11.75 is 13.4% of post-money $87.75, the price of the issue is $10.91 and $6.62 million respectively; hence, the participation feature’s value is c. $4.29 million. Therefore, the corresponding share of the company, which makes choice irrelevant is $81.44*0.134/$49.44=22%, that is concession of 22% of the company without the participation feature will make Series E holders equally happy, the corresponding price is 0.134/0.22*$6=$3.65 per share.
Acceptance by the board of the RSC’s offer will put Metapath shareholders will add a new senior holder to claim the proceeds, both in case of early liquidation and in case of successful exist. This offer will reduce shareholders’ wealth not only by capital dilution, but also by the absolute amount of investments of Series E holders even in the case of future success. With negative earnings and absence of predictable cash flows, one can do the rough check on the basis of P/Sales ratio (given both companies’ (Metapath and Celltech) similar capital structure, the proxy seems reasonable).
With the last quarterly figures as of June 1997, when numbers were available for both Celltech and Metapath, and considering the market cap of Celltech of approximately 260 million, the valuation of around 130 million could be used, which means the company might be worth more. The projections per se, however, don’t tell the story as the two segments (system sales and services) are expected to demonstrate different dynamics, so further investigation is needed. A cautionary note on Black-Scholes model application should be made:
3. Is the Celltech offer reasonable? How should the Metapath board view the Celltech stock? What are the risks for the Metapath shareholders if the board accepts the Celltech offer? While the Celltech’s offers seems to be more reasonable in terms of price offered, the shareholders may face additional risks, including the risk of Celltech’s stock price.
While possible liquidity within near future (90 days plus other possible restrictions, which is considerably less than its own IPO in 1+ years) as well as lack of dilution appealed to the managers, the fluctuation in the price of Celltech may wipeout the fortune (the stock had only a short history and the view of insiders doesn’t seem to strongly support Celltech). Furthermore, the fit of the Metapath and Celltech’s businesses is questionable, with Metapath potential possibly higher than that of Celltech, which on the other hand may have a limited upside.
4. If you were on the Metapath board, which option would you support?
While the offer of RSC is restrictive in many ways, it is more attractive for a team that will manage to perform. With a set of potential liquidity and financial risk questions, which may arise from Celltech’s financing, Metapath board should not only consider the price, but also other terms (which eventually will incentivize the management in the long-term success and keep its interest in business). With this in mind Metapath board will be better off with the RSC’s proposal, rather than Celltech’s.