Metapath's Future: Financing Options for Growth and IPO

Purpose

In this briefing note, our primary objective is to furnish comprehensive recommendations for Metapath Software Corp. (“Metapath”) regarding the financing offers it received in September 1997. The offers emanate from two distinctive entities: a fund consortium led by Robertson Stephens Omega Fund (“RSC”) and Technology Crossover Ventures (“TCV”), and CellTech Communications (“CellTech”), a wireless technology vendor that recently underwent an Initial Public Offering (IPO).

Executive Summary

Metapath has exhibited commendable progress in its business endeavors, culminating in a revenue of $6.4 million in the September quarter of 1997.

Despite this success, the company aspires to secure an Initial Public Offering (IPO) within the next two years. To fuel this ambition and ensure sustained growth, Metapath is faced with the need to raise additional capital. The crux of this note revolves around the detailed examination of two significant offers received in September 1997.

The first offer comes from the fund consortium led by RSC and TCV, proposing to purchase $11.75 million of Metapath's stock at a $76 million pre-money valuation, denoted as “Series E Preferred.

Get quality help now

Sweet V

Verified writer

Proficient in: Investment

4.9 (984)

“ Ok, let me say I’m extremely satisfy with the result while it was a last minute thing. I really enjoy the effort put in. ”

+84 relevant experts are online

Hire writer

” The instrument under consideration is a participating convertible stock (“PCPT”), functioning akin to convertible preferred stock in the context of a qualified public offering. In the event of a sale, the consortium not only receives the face value of the consideration but also partakes in equity participation.

On the other hand, CellTech extends an offer for Metapath’s shareholders to acquire common stock at the closing value of CellTech, pegged at $115 million.

Statement of the Problems

The challenges associated with the RSC and TCV consortium offer are multifaceted.

Primarily, the proposed stock instrument raises concerns about its potential dilutive impact on the founders in the event of a sale. The liquidity preference embedded in the instrument could potentially diminish the funds available to the other four tranches from prior investments. Moreover, if Metapath goes public, the ownership percentage for tranches C and D is further at risk of dilution after the consortium exercises its liquidity preference.

Turning to CellTech’s offer, the issues encompass not only its liquidity and financing challenges but also the strategic and business fit between CellTech and Metapath.

Analysis

A meticulous comparison of the term sheets from the RSC and TCV consortium against those of CellTech reveals a pronounced dilutive impact of the former’s PCPT upon Metapath's potential exit.

Delving into the intricacies of the term sheet, it stipulates that the Series E investors are entitled to claim their initial investment of $10.75 million, along with any accrued but unpaid dividends. Following this claim, any remaining proceeds are distributed to all common and Series E Preferred shareholders on an as-converted pro-rata basis. This double-dipping mechanism implies that RSC will not only recoup its initial investment of $5 million but will also enjoy the convertible benefits.

Consequently, if a sale occurs before 2000, the profitability for tranches A-D will face negative impacts due to the 'preferred' characteristic in the Series E. Conversely, if the sale transpires after 2000, tranches A and B will be gradually redeemed on an annual basis, leaving tranches C and D more susceptible to the adverse impacts of the preferred characteristic in the Series E stock.

In the scenario of an IPO, tranches C, D, and E are slated to convert to common stock at their negotiated prices, while tranches A and B will be redeemed.

Despite these complexities, the offered price by the RSC and TCV consortium stands at $6, significantly surpassing the values of the initial three rounds of financing (tranches A, B, and C) at $1.05 and the final round (tranche D) at $1.62. It's crucial to recognize that the PCPT instrument was strategically crafted to enable the consortium to mitigate risks in the event of a sale or liquidation, safeguarding founders’ interests and preventing value destruction.

Shifting focus to CellTech’s valuation, which amounts to $115 million, presents an attractive proposition for Metapath, especially considering its revenue run rate of $25.6 million. However, this valuation constitutes approximately 30% of the total capitalization. The willingness of CellTech to allocate such a substantial amount of capital raises questions about whether CellTech genuinely believes in Metapath's contribution to the synergies of the new venture or if there exists asymmetric information hidden from Metapath's management. This potentially signals limitations in CellTech’s underlying business, warranting further investigation if the offer is accepted.

An additional dimension to CellTech’s suitability stems from the analysis of its balance sheet, revealing ongoing liquidity and financing risks. A closer examination illustrates a consistent deterioration in cash and quick ratios from 1995 to 1997, indicative of persistent liquidity pressure. With six consecutive quarters of operating losses, CellTech's unhealthy operating cash flow ratio further compounds its financial challenges.

Doubts emerge regarding CellTech’s alignment with Metapath’s business model, given the stark contrast in their product offerings. While CellTech predominantly deals in hardware-based products installed in the field with cellular base stations, Metapath’s products largely consist of software running on standard server platforms in the wireless switching office. Although there is a potential benefit in leveraging some of CellTech’s engineers for Metapath’s development group, the overall strategic fit remains questionable.

Conclusions

In light of the multifaceted analysis, the recommendation for Metapath is to favor the offer from the RSC and TCV consortium. While CellTech has demonstrated commendable performance post-IPO, coupled with optimistic views from stock analysts, potential issues related to information asymmetry and liquidity risks could jeopardize the post-acquisition value of Metapath. The limited strategic fit raises concerns about constraining Metapath’s growth potential.

Aligning with Metapath’s ambition to progress towards an IPO, the RSC and TCV consortium emerges as a more fitting choice. The interests of tranches A and B are safeguarded through their initial capital structures, while tranches C and D face dilution. However, this strategic move enables Metapath to sustain its growth momentum with limited downside.