Wallsplat Technologies has previously raised $50 million in equity financing but is now facing financial difficulties. It needs to raise additional capital to fund ongoing operations. Three of its existing venture capital investors are willing to invest another $6 million but only at a greatly reduced pre-money valuation of $2 million (down 98% from the last round). The summary outlines two potential capitalization structures for the new round of financing. The first would issue 75 million new shares at $0.08 each to raise $6 million. It would also increase the management option pool to reserve 20% of shares for management. The second approach treats the increased option pool as part of the pre-money valuation, further diluting existing investors.

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FALL 2003 THE JOURNAL OF PRIVATE EQUITY 1
S
ince the Nasdaq meltdown three years
ago, numerous early stage companies
with fundamentally sound products
and management have seen an extraor-
dinary deterioration in their ability to gen-
erate sales and meet their business plans and
financial projections. The result has been con-
tinued negative operating cash flows and the
need to raise additional private capital to fund
operations and product development costs. At
the same time, valuations have declined dra-
matically, and companies that may have been
valued at tens or hundreds of millions of dol-
lars a few years ago may be viewed as having
virtually no equity value today. To remain alive
until the equity markets rebound and capital
spending increases requires the companies to
raise additional equity capital, frequently from
the same group of venture capitalists that
funded the company historically. While these
venture investors may be willing to invest addi-
tional money in the company, the terms and
valuations they are able to negotiate can be
very onerous.
This article will discuss some of the key
terms and conditions that might be encoun-
tered in today’s market. The framework for
this analysis will be Wallsplat Technologies,
Inc., a company which previously raised
$50,000,000 in equity, most recently at a
$125,000,000 post-money valuation.
COMPANY BACKGROUND
Wallsplat Technologies, the company
being restructured, has previously raised three
rounds of equity financing. Its existing capital
structure is shown in Exhibit 1. In the first
round, 3,000,000 shares of Series A Preferred
Stock were issued at a price of $1 per share.
In addition, 3,500,000 shares of common stock
and stock options were issued at nominal prices
to a variety of founders, employees, and friends
and family. The second round involved the
issuance of 3,500,000 shares of Series B Pre-
ferred Stock at a price of $2 per share. Most
recently, the company engaged in a third round
of financing, issuing 8,000,000 shares of Series
C Preferred Stock at a price of $5 per share.
In addition, there is a 7,000,000 share option
pool for management, none of which have
been issued. Each of the classes of preferred
stock are convertible 1 for 1 into common
stock, and carry a liquidation preference equal
to their initial issue price.
As a result, there are 25,000,000 autho-
rized common stock equivalents, 18,000,000
of which are outstanding, and the company
has previously raised $50,000,000 and has liq-
uidation preferences equal to that amount in
place. Since the $40,000,000 of Series C Pre-
ferred owns 32% of the company, the implied
post-money value of the company when that
round was done was $125,000,000. That
number is of historical interest only.
In addition, the company purchased
Restructuring Private Equity
Investments
PETER M. SUSKO
PETER M. SUSKO
is president of Capital
Strategies Group in
Greenbrae, CA.
Psusko@mba.berkeley.edu

2. FinalApprovalCopy
$10,000,000 of equipment financed with an equipment
loan which is secured by a lien on all of the company’s
assets, including its intellectual property. The loan has a
current balance of about $3,500,000, requires a monthly
payment of approximately $325,000, bears interest at
10.50%, and has about 12 months to run. Finally, in antic-
ipation of expanding its business, the company leased
60,000 square feet of prime office and research and devel-
opment space at the top of the market at an annual rent
of $40 per foot, or a monthly rent of $200,000. The lease
has several years left on its term. The current market rent
is $15 per foot, but potential tenants are hard to find since
the market vacancy rate is approaching 40%.
Although the original cost of the company’s hard
assets (excluding the intellectual property) was
$20,000,000, the liquidation value may be as little as
$1,500,000 to $2,500,000. The intellectual property may
have significant value, but is not well documented and
that value can be realized only if the engineering team can
be kept reasonably intact.
Wallsplat’s business hasn’t grown as quickly as had
been originally projected, and the company is now down
to $2,000,000 in cash and has a monthly cash burn rate
of $500,000. The problem confronting the potential
investors is how to structure a deal which keeps manage-
ment engaged in the success of the company, eliminates
or greatly reduces the negative cash flow to a level which
will allow the company to reach cash flow breakeven as
a result of increased revenue, rewards the investors in the
proposed round for committing additional capital and
sticking with the company, and provides suitable incen-
tives for these investors to provide additional capital in
the future if necessary.
Of the four venture capital firms that have previ-
ously backed Wallsplat, three are willing to invest addi-
tional money to keep the company alive, based on the
unique nature of the company’s technology, and the belief
that sales and revenues will grow strongly if the company
can remain in business. Those three firms are willing to
invest an additional $6,000,000 in a new Class D Pre-
ferred Stock to be issued by Wallsplat, but only at a pre-
money valuation of $2,000,000 (a 98% decrease from the
post-money valuation after the last round). The fourth
venture capital firm has decided not to make any further
investment. The three venture firms want to have equal
ownership of the company once the round is completed.
The venture capitalists also decide that management
should receive 20% of the equity in the recapitalized com-
pany, which will be accomplished by increasing the size
of the unallocated option pool to whatever percentage of
the post-financing common stock equivalents is needed
to make the existing outstanding options, plus the new
pool, equal to 20%.1
Providing management with 15%
to 25% of the company is fairly typical, unless the com-
pany has an all-star management team that can demand
a higher share.
OUTLINING THE POST-MONEY
CAPITALIZATION
Since the number of common stock equivalents
(including the 7,000,000 shares of authorized but unis-
sued shares in the management option pool) currently
outstanding is fixed at 25,000,000, and the pre-money
valuation of $2,000,000 has been agreed upon, the cur-
rent per share value is $0.08, which is also the price at
which the new equity will be offered. The $6,000,000 of
new equity will purchase 75,000,000 Series D Preferred
shares convertible 1 for 1 into common stock, so the total
common stock equivalents outstanding before adjusting
the management option pool will be 100,000,000.
To accomplish the goal of reserving 20% of the total
2 RESTRUCTURING PRIVATE EQUITY INVESTMENTS FALL 2003
Series A
Preferred
Shares
Series B
Preferred
Shares
Series C
Preferred
Shares
Price/Share 1.00$ 2.00$ 5.00$
VC # 1 2,000,000 2,000,000$ -$ -$ 2,000,000 2,000,000$ 8.0%
VC # 2 - - 2,500,000 5,000,000 - 2,500,000 5,000,000 10.0%
VC # 3 - - - 2,500,000 12,500,000 2,500,000 12,500,000 10.0%
VC # 4 - - 2,500,000 12,500,000 2,500,000 12,500,000 10.0%
Other owners 3,500,000 1,000,000 1,000,000 1,000,000 2,000,000 3,000,000 15,000,000 8,500,000 18,000,000 34.0%
Mgmt option pool 7,000,000 - - - - - - 7,000,000 - 28.0%
Total 10,500,000 3,000,000 3,000,000$ 3,500,000 7,000,000$ 8,000,000 40,000,000$ 25,000,000 50,000,000$ 100.0%
%
Ownership
Total Total
Shares Invested
Common
stock and
options
Series A
Purchase
Price
Series B
Purchase
Price
Series C
Purchase
Price
E X H I B I T 1
Wallsplat Technologies’ Existing Capital Structure

3. FinalApprovalCopynumber of shares outstanding for management, the
number of shares which must be added to the manage-
ment option pool is 16,250,000, and the total common
share equivalents that will be authorized after the new
money is raised will be 116,250,000.2
Of these, 23,250,000
will be in the management option pool.
Another objective may be to have each of the three
venture investors own an equal, or nearly equal, share of
the fully diluted equity of the company once the new
round is completed. If so, the amount of each firm’s invest-
ment in the Series D Preferred must be adjusted slightly
to reflect the fact that the firms own different amounts of
the existing equity. Ultimately, it’s determined that each
of the three firms will own 23.51% of the equity, and that
VC #1 will invest $2,026,667 while VC #2 and VC #3
will each invest $1,986,667.3
The post Series D capital
structure of the firm given this structure is summarized
in Exhibit 2.
An alternative structure with respect to the man-
agement option pool would be to treat the addition
to the management option pool as part of the pre-
money valuation. While the logic for this position may
not be clear, the effect is: it decreases the per share
price, greatly increases the number of shares to be
issued, and increases the overall ownership of the new
money investors.
For instance, if this approach were to be used with
respect to Wallsplat, the number of shares which must be
added to the management option pool for management
to own 20% of the post-financing equity will be
65,000,000.4
The total number of shares outstanding for
purposes of the pre-money per share calculation will be
90,000,000, and the per share price will be $0.022. There
will be 270,000,000 shares of Series D Preferred issued,
and each of the venture investors will own 25.65% of the
company. The post Series D capital structure of the firm
given this structure is summarized in Exhibit 3.
An advantage of this approach is that it substan-
tially increases the number of shares that must be added
to the management option pool, which can have a strike
price set at current market. If the existing management
options are far out of the money, the ability to issue
more options at current prices may avoid the possibility
of repricing the current options to adequately incen-
tivize management.
FALL 2003 THE JOURNAL OF PRIVATE EQUITY 3
Series D
Preferred
Shares
Series D
Purchase Price
Series E-1
Preferred
Shares
Series E-2
Preferred
Shares
Series E-3
Preferred
Shares
Common Stock
and Options Total Shares % Ownership
Price/Share 0.08$
VC # 1 25,333,333 2,026,667$ 2,000,000 - - - 27,333,333 23.51%
VC # 2 24,833,333 1,986,667 - 993,333 - 1,506,667 27,333,333 23.51%
VC # 3 24,833,333 1,986,667 - - 397,333 2,102,667 27,333,333 23.51%
VC # 4 - - - - - 2,500,000 2,500,000 2.15%
Other owners - 8,500,000 8,500,000 7.31%
Old mgmt pool 7,000,000 7,000,000 6.02%
New mgmt pool - - - - - 16,250,000 16,250,000 13.98%
Total 75,000,000 6,000,000$ 2,000,000 993,333$ 397,333 37,859,333 116,250,000 100.00%
E X H B I T 2
Wallsplat Technologies’ Post Series D Capital Structure
Preferred
Shares
Series D
Purchase Price
Preferred
Shares
Preferred
Shares
Preferred
Shares
Common Stock
and Options Total Shares % Ownership
Price/Share 0.022$
VC # 1 90,333,333 2,007,407$ 2,000,000 - - - 92,333,333 25.65%
VC # 2 89,833,333 1,996,296 - 993,333 - 1,506,667 92,333,333 25.65%
VC # 3 89,833,333 1,996,296 - - 397,333 2,102,667 92,333,333 25.65%
VC # 4 - - - - - 2,500,000 2,500,000 0.69%
Other owners - 8,500,000 8,500,000 2.36%
Old mgmt pool 7,000,000 7,000,000 1.94%
New mgmt pool - - - - - 65,000,000 65,000,000 18.06%
Total 270,000,000 6,000,000$ 2,000,000 993,333$ 397,333 86,609,333 360,000,000 100.00%
E X H I B I T 3
Wallsplat Technologies’ Alternative Post Series D Capital Structure

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LIQUIDATION PREFERENCES FOR THE NEW
EQUITY
While the Series A through C Preferred Stock was
entitled to a liquidation preference just equal to the
amount of capital contributed (a 1× preference), new
equity in today’s market is frequently able to demand
much more favorable terms and first priority liquidation
preferences of as much as 3 times (3×) the amount invested
are not out of the question. The determination of how
much of a multiple is appropriate is a function of the risk
and uncertainty involved in the investment, the level of
desperation the company faces, the potential returns that
may be produced, the need to provide real incentives to
the management team, and the relationship of the new
investors to the existing investors.
If a large amount of new equity is being raised car-
rying a 3× first priority liquidation preference, and the pre-
money value of the company is low (implying that virtually
all of the value of the company is the new money), then
management will need to triple the value of the com-
pany before it receives any participation in the value it is
working to create. Unless management believes strongly
in the future value of the company, this may create the
wrong incentives for management.
PULL-THROUGH OF EXISTING
LIQUIDATION PREFERENCES
The pull-through of existing liquidation preferences
plays two roles. First, it recognizes some of the dollar value
of the existing investors’ early equity contributions and
provides a liquidation preference for some or all of that
value. Second, it can be used as a vehicle for creating an
additional level of liquidation preference for the current
round investors who were also prior round investors vis-
à-vis the current round investors who did not contribute
as much in the earlier rounds.
For instance, a pull-through provision might state
that an amount equal to the lesser of 1) 100% of the cur-
rent round investment, or 2) the equity contributions
made by that investor in earlier rounds, will be pulled
through and create a subordinated liquidation preference.
Consider the effect of this provision on VCs #1, #2, #3,
and #4 as they are shown on Exhibit 2. VC #1 invested
a total of $2,000,000 in the A round, buying 2,000,000
shares at $1 per share. VC #2 previously invested
$5,000,000 in the B round, buying 2,500,000 Series B
shares at $2.00 per share. VCs #3 and #4 each previously
invested $12,500,000 in the C round, but only VC #3 is
investing in the Series D round. As a result of the pull-
through provision, VC #1 receives a $2,000,000 subor-
dinated liquidation preference, VC #2 and VC #3 each
receives a $1,986,667 preference, and VC #4 receives no
preference.
Mechanically, the preference is documented by cre-
ating a new class of subordinated preferred stock which
carries the preference with it but is subordinated to the
liquidation preference given to the new money preferred
stock. Investors receive the right to convert their existing
classes of preferred stock at the original purchase price
for that class of stock and in the reverse order that the
stock was issued. For instance, VC #2 will use the
$1,986,667 preference to convert 993,333 shares of his
Class B Preferred Stock into new Series E-2 Preferred
Stock at a price of $2 per share. The remainder of his old
preferred stock—1,506,667 shares of Class B—converts
into common stock. The Class E-2 Preferred has a $2 per
share liquidation preference, so his total liquidation pref-
erence is $1,986,667. VC #3 will use his preference to
acquire 397,333 shares of Series E-3 Preferred and con-
vert his remaining Series C Preferred into 2,102,667 shares
of common.
On the other hand, VC #1 uses his $2,000,000 pull-
through to convert all of his shares of Class A Preferred
into Class E-1 Preferred at a price of $1 per share. How-
ever, the Class E-1 Preferred has a $1 per share liquida-
tion preference, so his total liquidation preference is also
$2,000,000. VC #4 fares worst of all. Since he is not
investing in the Series D stock, there is no pull-through
for him. All 2,500,000 shares of Series C that he holds con-
vert into 2,500,000 shares of common stock with no liq-
uidation preference.
It’s also possible to create a hurdle which each
investor must attain in order to pull through any of his
existing equity. The purpose of this provision is to dif-
ferentiate the investors who are putting money into the
current round from those that are not participating in the
current round or whose participation is less material, and
cutting those smaller investors out of pull-through treat-
ment altogether. In many instances, this type of provision
is used when a company has a number of small investors
from prior rounds who are not actively involved anymore.
In addition, there is the question of where the
pulled-through liquidation preference stands in the pri-
orities. If $6,000,000 is being raised in the Series D round,
and the first liquidation preference is a 3× return on the
new money, followed by the 1× preference on the Series
4 RESTRUCTURING PRIVATE EQUITY INVESTMENTS FALL 2003

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E-1, E-2, and E-3 Preferred, then the pull-through is
subordinated to $18,000,000 and the company would
need to have a $23,975,000 liquidation value for the pull-
through to be fully paid off. In contrast, if the first liqui-
dation preference is only a 1× return on the new money,
followed by the 1× preference on the Series E-1, E-2,
and E-3 Preferred, then the pull-through is subordinated
to only $6,000,000 and the company would need to have
a $11,975,000 liquidation value for the pull-through to
be fully paid off.
The structure of the liquidation preferences reflects
the uncertainty in the valuation of the company. The
more certain the investors are about the value of the com-
pany, the less need there is to put in a super-preference
for the new money and the more willingness there is to
recognize the value of the existing equity and to give it
a higher priority in the liquidation structure.
Finally, how does the pull-through affect the overall
ownership of the equity? Frequently, not at all. Notice
that any shares of Series A through C Preferred that didn’t
convert into shares of the new E Preferred converted into
common stock instead. If the Series E Preferred is all con-
vertible on a 1 for 1 basis into common stock, the total
number of common stock equivalents held by each
investor doesn’t change.
Since the overall number of common stock equiv-
alents hasn’t changed, the change in the classes of stock
owned will only be relevant if there are particular voting
provisions applicable to the preferred stock as a class which
are affected by the change in relative ownership of the
preferred stock versus the common stock. The relative
rights of each party would have been part of the deal
negotiation, so the preferred stock voting agreement
should address these issues.
RESIDUAL OWNERSHIP
Once the liquidation preferences have been paid in
full, the method of distributing any residual proceeds from
a sale or merger must be determined. The most obvious
method is to distribute these proceeds pro rata among all
the equity holders based on their relative ownership of the
common stock equivalents. For instance, referring back
to Exhibit 2, VC #1 would receive 23.51% of any residual
proceeds, while VC #4 would receive only 2.15%.
Assuming each share of preferred stock is convertible 1
for 1 into common, the result of this allocation scheme
is to lock in the preferred liquidation preferences regard-
less of the liquidation value of the company, since the
preferred holders will never have any incentive to con-
vert to common and give up their preferences.
Alternatively, the residual proceeds might be dis-
tributed only to the holders of common stock or holders
of all stock except for the Series D Preferred Stock on an
as-converted-to-common basis. In this case, a breakeven
valuation point should be reached at which holders of
the new preferred will be better off converting to
common. There are a couple of problems that can arise
in this regard. First, and particularly if the holders of the
new preferred must convert as a class rather than making
individual decisions, the breakeven value at which the
new preferred will want to convert should be approxi-
mately the same for all holders of the new preferred. To
achieve this result, it may be necessary to adjust other
terms of the deal, particularly the multiplier that deter-
mines the amount of existing equity that is being pulled
through, or the order in which the existing preferred
shares are pulled through. For instance, if the residual is
distributed only to holders of common stock, then a pull-
through calculation which applies to the highest priced
shares of existing preferred stock first will result in more
shares being converted to common, and therefore, a
greater participation in the residual on the part of the
existing preferred stock holders.
The second problem that can arise with this struc-
ture occurs if some of the investors in the current round
own a higher percentage of the residual before they con-
vert than they would own after a conversion occurs, and
the decision to convert is made by the class rather than
by each individual holder. This problem can occur if there
is a substantial pre-money value given to the company
(so there is less dilution of the existing equity), and a sig-
nificant portion of the new round is being purchased by
new investors that hold little or none of the common
stock. The result is that the existing investors have no
incentive to convert, and the new investors will not par-
ticipate in the residual value unless they have the right to
convert on their own.
In the case of Wallsplat, by using the pull-through
multiple of 1× rather than some other value (say 1.5×), it
was possible to establish a breakeven value of approxi-
mately $37,100,000 at which all three venture capital
investors would be willing to convert. The other advan-
tage of using this pull-through multiplier is that all the
equity holders, including management, receive approxi-
mately the same proceeds at that valuation, so all stake-
holders interests are well aligned.5
Exhibit 4 summarizes
this calculation.
FALL 2003 THE JOURNAL OF PRIVATE EQUITY 5

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AUTOMATIC CONVERSION IN THE CASE
OF A PUBLIC OFFERING
The liquidation preferences apply only if the com-
pany liquidates, which includes an actual liquidation, a
sale of the assets, or a merger of the company with another
company. If the company engages in an initial public
offering (IPO) instead, it is desirable to force a conver-
sion of the outstanding preferred stock to common stock,
so that the capitalization structure of the company can be
cleaned up in anticipation of the IPO. To ensure that the
holders of the preferred receive the benefit of the liqui-
dation preferences that have been negotiated, the auto-
matic conversion provision will apply only if the IPO
meets certain minimum market value amounts and per
share offering prices, calculated by taking into account
any stock splits or other events which change the per share
price of the stock. These hurdle levels will be set so that
the automatic conversion doesn’t occur unless the com-
pany has a high enough value that the holders of the con-
vertible preferred would have exercised their conversion
option anyway. This eliminates conflicts that might occur
between taking the company public or engaging in a
merger or sale of the assets.
For instance, Wallsplat’s new capitalization has a
breakeven value of approximately $37,100,000, which
equates to about $0.32 per share, or four times the Series
D offering price of $0.08 per share. The automatic con-
version provision might apply to any IPO which values
the company at more than $37,500,000 and a per share
price of at least $0.40 per share (five times the Series D
price). To clean up the capitalization in anticipation of
an IPO, the company might engage in a reverse 1 to 20
stock split, increasing the Series D purchase price to $1.60
per share but decreasing the number of common stock
equivalents from 116,250,000 to 5,812,500. An IPO at a
per share price of $8.00 or more would then cause an
automatic conversion of the existing preferreds into
common stock.
DIVIDENDS
Since start-up companies usually have negative oper-
ating cash flow, and to the extent their cash flow is pos-
itive, they intend to reinvest it to grow the business, the
actual declaration and payment of dividends on either the
common stock or the preferred stock is unlikely to occur.
Consequently, the articles normally provide that divi-
dends do not accrue and that they are payable only when,
as, and if declared by the board of directors.
Notwithstanding this general rule, one way for the
new equity holders to receive an additional return on
their investment and to make that return payable regard-
less of whether the company is sold or goes public is to
provide for a cumulative, perhaps compounding, divi-
dend on one or more classes of the preferred stock. This
is a particularly attractive alternative if the investors believe
that a sale or public offering of the company is not likely
to occur for a number of years, so that the accrued divi-
dend can add significantly to the new investors’ first pri-
ority return. For instance, a 10% annual compound
dividend will produce another 0.46× multiple on the orig-
inal investment after four years.
6 RESTRUCTURING PRIVATE EQUITY INVESTMENTS FALL 2003
Series D
Liquidation
Preference
Series E Pull-
through
Preference Residual Share
Combined
Liquidation
Preference
As Converted
Share of
Proceeds Diffference
Price/Share
VC # 1 6,080,000$ 2,000,000$ 634,701$ 8,714,701$ 8,714,701$ -$
VC # 2 5,960,000 1,986,667 793,377 8,740,043 8,714,701 (25,342)
VC # 3 5,960,000 1,986,667 793,377 8,740,043 8,714,701 (25,342)
VC # 4 - - 793,377 793,377 797,076 3,700
Other owners 2,697,481 2,697,481 2,710,059 12,578
LCP - - -
Warrants - - -
Mgmt - - -
Old mgmt pool 2,221,455 2,221,455 2,231,814 10,359
New mgmt pool 5,156,949 5,156,949 5,180,996 24,047
Total 18,000,000$ 5,973,333$ 13,090,717$ 37,064,050$ 37,064,050$ (0)$
E X H I B I T 4
Wallsplat Technologies’ Comparison of Liquidation Proceeds

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PAY TO PLAY PROVISIONS
The goal of pay to play provisions is to penalize
investors who fail to participate either in the current
financing or in future rounds. The critical considerations
in structuring these provisions are the financings to which
the pay to play provision applies, the height of the hurdle
which must be cleared for an investor to avoid having the
provision apply, and the penalty suffered if the investor
doesn’t clear that hurdle.
The hurdle is usually defined in terms of the
investor’s pro rata share of the current offering. For
instance, the penalty may apply to any investor that fails
to invest 100% of his pro rata share of the current financing
round. The most onerous calculation of pro rata share
would be one which calculates that share based only on
the outstanding common stock equivalents at the time of
the offering. For instance, using Wallsplat’s current capi-
talization, if an investor has 1% of the currently outstanding
common stock equivalents, he would be required to invest
1% of the new equity round, or $60,000.
Less onerous hurdles could be devised by either
defining the pro rata share based on all of the common
stock equivalents, including the unissued option pool, or
by lowering the hurdle rate from 100% to some lesser
percentage. Either approach accomplishes the same objec-
tive, which is to make the hurdle easier to achieve. For
instance, since Wallsplat’s unissued option pool consti-
tutes 28% of its total common stock equivalents, basing
the pro rata share calculation on all of the common stock
equivalents is the same as reducing the hurdle percentage
from 100% to 72%. The reason for having a lower hurdle
may simply reflect the economic reality of the deal; per-
haps one of the lead investors in the current round will
be investing only 75% of its pro rata share because it has
a disproportionately large percentage of the prior rounds,
and the splits among the current round’s lead investors
would cause that investor to fail the 100% hurdle. What-
ever hurdle is set, for fairness purposes each investor must
be offered the opportunity to meet it.6
It would not be
permissible to have a hurdle requiring an investor to put
up 100% of his pro rata amount, and then only offer him
the opportunity to invest up to 50% of his pro rata share.
As far as the financings to which the pay to play
provision will apply, there are several choices. Most
obvious is a failure to invest in the current equity round.
In this case, the only equity to which the penalty can
apply is the existing preferred stock, and the penalty
will be the conversion of that investor’s existing pre-
ferred into common stock. Of course, this penalty has
teeth only if there is some kind of preferential pull-
through of existing preferred equity. If the terms of the
new financing create a liquidation preference for the
existing equity, an investor that fails to make his pro rata
investment will lose his share of the liquidation prefer-
ence. However, if there is no liquidation preference for
the existing equity, the pay to play penalty must be struc-
tured to reduce the number of common stock equiva-
lents the investor will receive.
For instance, if the existing preferred stock will be
converted into common stock at a 1:1 ratio, the existing
preferred stock held by the investors that fail to invest
their pro rata share might convert into half a share of
common stock instead. Alternatively, if the company
intends to do a reverse common stock split as part of the
new equity round, the deal may be structured to provide
that the conversion of the existing preferred stock into
common stock will occur before the reverse split. The
deal might provide that the existing preferred stock owned
by investors who make their pro rata investment will, at
the close of the new equity round, convert share for share
into a new class of preferred stock. This new preferred
stock has no liquidation preference, but is convertible 1:1
into common stock. On the other hand, the existing pre-
ferred stock held by the non-pro rata investors converts
into common stock just before the close, and all common
stock outstanding at the close is then subject to the 1:2
reverse split.
For instance, if two investors both hold 1,000 shares
of Series A Preferred, the investor that makes his pro rata
investment will end up holding 1,000 shares of the new
preferred stock, which is equivalent to owning 1,000
shares of common. The investor that fails to make the pro
rata share investment sees his Series A Preferred convert
into 1,000 shares of common stock just before the close,
which then become 500 shares of common as a result of
the reverse split.
Another instance to which the pay to play provisions
might apply is if the current equity round will be com-
pleted in a series of installments. This would be particu-
larly likely to occur if the company must do a bridge
financing in order to continue operations while it lines up
the investors for the current equity round. To ensure that
investors will make all of their required payments in each
of the closings, a pay to play provision might be used. For
instance, failure to make each of the committed payments
might cause the investor to be treated as if he had failed
to make his pro rata investment in the first place.
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BRIDGE FINANCINGS
Frequently, a company will need to raise a portion
of the money as a bridge financing to continue operations
while it lines up investors for the current round. The
bridge debt converts into the shares of preferred stock
being offered in the current round when that round closes.
Any accrued interest will be converted into additional
shares of the new preferred stock. Because the bridge
investors may be taking the risk that the company won’t
be able to close the proposed new round, and because
they have tremendous leverage over the company when
they are providing the bridge financing, the bridge investors
frequently obtain very favorable terms vis-à-vis any of the
other investors. In particular, they may receive warrants to
purchase additional shares of the current round of financing
at the offering price. The longer the bridge debt is out-
standing, the more warrants they are entitled to.
For instance, assume that Wallsplat had no cash. The
three venture investors agree to lend the company
$1,500,000, accruing interest at 6% per year, convertible
into the Series D Preferred when the round closes, and
earning warrant coverage equal to 5% of the bridge
amount for each month that the bridge is outstanding,
up to a maximum of 15% (three months). Since the
$1,500,000 is part of the $6,000,000 they were going to
invest anyway, the 15% warrant coverage allows them to
purchase another $225,000 of Series D Preferred Stock
at $0.08 a share.
OTHER INTERESTED PARTIES
The equity investors do not want to see their cap-
ital being used primarily to repay the landlord and the
secured lenders. Consequently, some accommodations
will need to be made with each of these parties, in the
form of relief from the cash flow burden they create on
the company. In exchange, the company and the investors
must be willing to give up some equity to obtain that
relief.
The Equipment Lender
Because the equipment lender holds a lien on all of
the company’s property in our example, and therefore is
entitled to a priority position on all of the company’s
assets in a bankruptcy, the equipment lender is in a much
better negotiating position than the landlord.8
However,
the lender would still stand to lose as much as $2,000,000
8 RESTRUCTURING PRIVATE EQUITY INVESTMENTS FALL 2003
For instance, assume that an investor’s pro rata share
is $60,000, and that the current equity round is being
raised in two closes. The investor is obligated to invest
$30,000 at the first close and $30,000 at the second close.
The investor makes the first $30,000 payment, but fails
to make the second one. Not only is his existing preferred
stock converted to common and then subjected to the
1:2 reverse split, but the shares of Series D Preferred Stock
that he acquired at the first close are also converted to
common and subjected to the 1:2 split.
Finally, the pay to play provisions might apply to
the failure to make the pro rata share investment in a
future equity round. This provision could apply to all
future rounds, just to the next round, or just to future
down rounds (rounds in which the per share price is lower
than the current per share price). This type of pay to play
provision might provide that all of the investor’s preferred
stock would convert to common, so that there wouldn’t
be any equity dilution (other than the dilution which
results from failing to participate in the subsequent round)
but there would be a loss of any liquidation preference
associated with the preferred stock.
RATCHET PROVISIONS
A ratchet provision gives the current investors the
right to have their shares partially or fully repriced if a
future round is done at a lower price per share. For
instance, if Wallsplat engages in a future round at a per
share price of less than $0.08, the per share price of the
Series D Preferred Stock will automatically be reduced,
and the number of shares automatically increased, to reflect
that lower price. If a future round is done at $0.06 per
share, and a full ratchet provision is in place, the per share
price of the Series D Preferred Stock would automatically
be reduced to $0.06 per share and the number of shares
of Series D stock outstanding would be increased to
100,000,000.7
Ratchet provisions were more common a few years
ago when the likelihood of a future down round were
perceived to be less and valuations were higher. The reality
is that the new investors will either demand that the ratchet
provision be waived before they put in the new money,
or will value the company lower so that the end result in
terms of ownership interests and liquidation preferences
comes out where it needs to.

9. FinalApprovalCopy
in a bankruptcy, so he must make an evaluation of whether
it’s better to take that loss today or renegotiate the trans-
action. A renegotiation of the transaction would involve
some combination of a conversion of a portion of the
debt to equity, reduced interest rate and payments on
the remaining debt, and additional equity participation
in the form of warrants.
The Landlord
If the company files for bankruptcy, it is likely that
the bankruptcy trustee will reject the lease, in which case
the landlord will have a claim against the company equal
to the greater of one year’s rent on the real property or
15% of the remaining rent due on the lease. However,
because the equipment lender has a blanket lien on all of
the company’s property, and this lien is superior to the
landlord’s claim, there won’t be any assets available to pay
this claim. In addition, in many instances, the landlord
may have taken advantage of the higher property valua-
tions of a few years ago and borrowed significantly against
the property. This will result in the landlord having a very
significant income tax liability if he decides to give the
property back to the lender.9
From the landlord’s per-
spective, he may be better off renegotiating the lease down
to the market rent, even though it will result in negative
cash flow from the property, and taking an equity interest
in the company in the form of preferred stock or warrants.
In this case, because the landlord would not receive any-
thing in a liquidation, it’s likely that the equity interest will
be subordinated to the new money, as well as to the equip-
ment lender’s interest.
STRUCTURING THE INVESTMENT
Taking into account the considerations and require-
ments described above, a deal structure along the fol-
lowing lines might be adopted:10
1. The new money investors will invest a total of
$6,000,000 in exchange for 75,000,000 shares of
Series D Preferred Stock at $0.08 per share.
2. Each new money investor who invests more than 5%
of their existing investment amount will pull through
an amount of existing equity equal to 1× the amount
of their new investment. In reality, only the three lead
investors will benefit from the pull-through.
3. The existing preferred stock will convert, in reverse
order, into shares of new Series E-1 through E-3
Preferred Stock in order to create a class of stock
which will carry the pulled-through liquidation
preference.
4. Any preferred stock not converted into new Series
E Preferred will convert into common stock.
5. The option pool available for future issuance to man-
agement will be increased by 16,250,000 shares, or
13.98% of the fully diluted equity. Combined with
the existing option pool of 6.02%, the total avail-
able to management is now 20%.
6. The Series D Preferred will have a first level liqui-
dation preference of 3×, or $18,000,000.
7. The Series E Preferred will have a second level liq-
uidation preference equal to 1×, or about
$5,975,000.
8. After the two preferences are paid, any residual pro-
ceeds of sale or liquidation will be split pro rata
among the holders of the Series E Preferred and the
Common Stock. At an approximate value of
$37,100,000, the Series D Preferred holders will
want to convert their shares into common.
9. There will be an automatic conversion of all pre-
ferred shares into common stock in the event of an
IPO at a value of $37,500,000 or more and a per
share price at least five times as great as the Series
D Preferred Stock price.
10. A renegotiated lease with the landlord is entered
into, reducing the current monthly rental payment
from $200,000 to $100,000. Similarly, the equip-
ment lender agrees to convert a portion of its debt
to equity, and revises the terms of the remaining debt
to interest-only for a period of time. This reduces the
monthly payments due on the debt from $325,000
to $25,000 during the interest-only period. The
overall effect is a temporary reduction of the com-
pany’s negative cash flow per month from $500,000
to $100,000. Of course, because of the secured posi-
tion of the equipment lender and the additional risk
it is taking on due to the interest-only period, it may
be necessary to agree to a not insubstantial equity
interest in the company for this lender.
The effect of this structure on a distribution of sale
or liquidation proceeds is that up to a value of approxi-
mately $37,100,000, the first $18,000,000 of liquidation
proceeds will be distributed to the Series D investors, fol-
lowed by a distribution of approximately $5,975,000 to
the Series E investors. The next $13,425,000 will be dis-
tributed to the holders of the common stock and the
FALL 2003 THE JOURNAL OF PRIVATE EQUITY 9

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Series E investors. Once a value in excess of $37,100,000
is achieved, the Series D investors will convert their hold-
ings to common stock, and all of the proceeds will be
distributed in accordance with the percentage ownership
interests shown in Exhibit 2.11
CONCLUSION
The extraordinary changes in the capital markets
over the past three years have resulted in equally extraor-
dinary changes in the issues which confront private equity
investors and the deal structures which have arisen to
resolve those issues. In many cases, the management and
technology is already in place, and the potential to realize
significant future profits exists for those willing to invest
the time and money now.
ENDNOTES
1
Note that the strike price of some or all of the options
in the existing pool is almost certainly higher—perhaps much
higher—than the per share price at which the new equity will
be raised. As a result, many of these options are very far out of
the money and either the strike price must be reset, or man-
agement’s true economic share of the company will be much
less than 20%.
2
The formula for this calculation is:
Management pool % × (new option pool + total existing
shares) = new option pool + existing option pool
Or
0.2x(N + 100,000,000) = N + 7,000,000
N = 16,250,000
3
Given the total common stock equivalents of
116,250,000, by subtracting the 34,250,000 shares not owned
by the Series D investors leaves 82,000,000 shares in total to
be owned by the three firms, including the 7,000,000 shares
they already hold. Dividing this number by 3, subtracting the
number of shares already held, and multiplying this number by
the per share price of $0.08 gives the total capital to be invested
by each firm.
4
The formula for this calculation is also somewhat more
complicated. It is:
Existing shares not included in the management pool/
(Ratio of pre-money to post-money value – mgmt pool %) =
(new option pool + existing option pool)/mgmt pool %
5
In this example, it was possible to reach this result quite
easily. More complex capital structures, or greater differences
in existing share ownership, may make this issue much more
difficult to resolve.
6
Similarly, existing investors must usually be offered the
right to invest their pro rata share so that they can maintain
their existing percentage ownership.
7
The formula for calculating the additional shares resulting
from the ratchet is:
[R × (original per share price – new round per share
price) × original number of shares]/new round per share price
where R is the percentage ratchet (full ratchet equals 100%).
8
If the equipment lender was secured only by the equip-
ment financed, rather than by all of the assets of the company,
his position would be significantly less attractive.
9
For instance, assume that the landlord bought the prop-
erty for $5,000,000 ten years ago, and has taken $1,000,000 in
depreciation deductions, so that his tax basis is $4,000,000.
Four years ago, he borrowed $7,500,000 on a non-recourse
interest-only basis against the property. In a foreclosure, the
landlord would have a $3,500,000 gain for tax purposes,
resulting in a tax liability of $1,000,000 or more.
Since most real estate loans are non-recourse, it is unlikely
that the landlord would be obligated to pay the lender any
money but could simply give the property to the lender in a
foreclosure proceeding. Only if the landlord had guaranteed
some portion of the loan would he have an obligation to make
a cash payment to the lender.
10
To simplify the example, the deals struck with the
equipment lender and the real estate landlord are not included.
11
This ignores the effect that the existence of the strike
price will have on the holders of the options. In fact, the man-
agement options will almost certainly contain a net exercise
provision, allowing management to exercise without making
a cash payment. This reduces the effective number of options,
which reduces the breakeven amount at which the Series D
holders will find it economic to convert.
To order reprints of this article, please contact Ajani Malik at
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10 RESTRUCTURING PRIVATE EQUITY INVESTMENTS FALL 2003