314 ENTREPRENEURSHIPnario receives 83 percent of the rewards and assumes 83 percent of the risk. However,
the venture capitalist will desire a different deal structure and, owing to the Golden Rule
(whoever has the gold makes the rule), will be able to bargain for it. The investor will
negotiate for preferred stock with a fixed dividend and some liquidation preference. The
sophisticated investor will probably want the preferred stock to be cumulative as well,
meaning that any missed dividend payments accumulate and must be paid before any
dividends on common stock are declared. The bottom half of Table 8.4 shows how pre-
ferred stock changes the risk/reward ratio in favor of the investors.
In this scenario, the investors receive their expected $415 cash flow dividend re-
gardless of whether the actual cash flow is $450 or $550. In the bad year, the investors
receive 93 percent of the cash flow; in the good year, 73 percent. All the risk of a bad
year (and extra reward for the good year) is borne by the entrepreneurs. The standard
deviation of the investors’ returns is zero because there is no variation. Because they hold
preferred stock instead of common stock, the investors bear no risk—except, of course,
the risk of bankruptcy, which accounts for the 40 percent discount rate.
Investors want preferred stock for two reasons in addition to their desire to minimize
risk. First, by enabling the entrepreneurs to achieve maximal gain in the good years, the
investors provide incentives for the entrepreneurs to work both hard and smart. Second,
the entrepreneurs will not present rosier forecasts than they themselves believe in. Why?
Because they know they will not achieve the cash flows necessary for them to realize any
of the profits of the business. In essence, they will be working for the investors without
hope of personal gain. This process is known as “smoking them out.”TABLE 8.4 Sharing the Risk
Share of total stock
Annual cash received: bad scenario
Annual cash received: good scenario
Expected annual cash received
PV of cash received (incl. TV)
Net PV (incl. investment)
Standard deviation of PV (and of NPV)Share of total stock
Annual cash received: bad scenario
Annual cash received: good scenario
Expected annual cash received
PV of cash received (incl. TV)
Net PV (incl. investment)
Standard deviation of PV (and of NPV)17%
$77 (17%)
94 (17%)
85 (17%)
204 (17%)
204
18 1717%
$35 ( 7)%
135 (27%)
85 (17%)
204 (17%)
204100%
$450
550
500
1,204
204
102100%
$450
550
500
1,204
204
102Common Stock (Proportional Sharing) Venture Capitalist Entrepreneur TotalPreferred Stock Venture Capitalist Entrepreneur TotalSOURCE: From “Aspects of Financial Contracting,” Journal of Applied Corporate Finance, 1988: 25–36. Reprinted by permis-
sion of Stern Stewart Co., New York, NY.83%
$ 373 (83%)
456 (83%)
415 (83%)
1,000 (83%)
0
85 (83%)83%
$ 415 (93%)
415 (73%)
415 (83%)
1,000 (83%
0
0 (0%) 102 (100%)