The Effects of Call Options on Exit Strategies in Private Equity Shareholder Agreements

Abstract

Private equity financing is a primary source of funding for new ventures. However, forfeiting ownership and control may deter entrepreneurs. We show how recapitalizations are viable exit strategies allowing founders to maintain control. In a recapitalization, the private equity interest is repurchased with proceeds from a company debt offering. This can be modeled as an option and is in-the-money when firm valuation is sufficient to meet the investor’s return requirement. We model the option with: a theoretical model of residual cash flows and break-even growth rates; a discrete probability model; and a Monte Carlo simulation with continuous normal and trapezoidal distributions. Growth rates are a major factor in option exercise and we illustrate how only modest rates are necessary for a company to satisfy relatively high private equity investor return requirements. This suggests perceived barriers to this important source of capital may be lower than commonly thought by startup companies.

Keywords: Private Equity, exit strategies, call options, option valuation

JEL Classification: G11, G13, G14