Chapter 9 Sources of long-term finance: equity

1. Chapter 9Sources of long-term finance: equity

2. Learning objectives Outline the characteristics of ordinary shares. Explain the advantages and disadvantages of equity as a source of finance. Outline the main sources of private equity in the Australian market. Identify the information that must be disclosed when issuing securities. Outline the process of floating a public company. Discuss alternative explanations for the underpricing of initial public offerings.

3. Learning objectives Outline evidence on the long-term performance of companies that are floated. Explain how companies raise capital through rights issues, placements, share purchase plans and share options. Outline the different types of employee share plans. Outline the advantages of internal funds as a source of finance. Outline the effects of bonus issues, share splits and share consolidations.

4. Chapter contents Introduction The characteristics of ordinary shares Private equity Information disclosure Floating a public company Subsequent issues of ordinary shares Employee share plans Internal funds Managing a company’s equity structure

5. Characteristics of ordinary shares Ordinary shares represent an ownership interest in a business and provide the holder with voting rights. Holders have a residual claim to the profits of the business through dividends. In the event of failure, the holder has a claim to the residual value of the assets after claims of all other entitled parties are met. Shareholders are more likely than debt holders to lose their investment if the company fails. To compensate for this risk, shareholders expect a return that is greater than that received by lending.

6. Characteristics of ordinary shares Fully and partly paid shares When fully paid new shares are created, they will have a stated issue price, which may be paid in full at issue. Alternatively, shares may be issued for part payment, with the balance paid in subsequent instalments, often referred to as calls. This are called ‘partly paid’ or ‘contributing’ shares. The size and timing of calls may be specified at the outset or determined at some date after issue.

7. Characteristics of ordinary shares Instalment receipts: marketable securities for which only part of the issue price has been paid. The balance of an instalment receipt is payable in a final instalment on or before a specified date. A well-known example is the Australian government’s sale of Telstra shares. Main differences from partly paid shares are: timing and size of instalments are specified up front instalments are payable to vendor of shares rather than issuing company holders of instalment receipts are entitled to the same dividends as ordinary shareholders.

8. Characteristics of ordinary shares Limited liability: Shareholders’ liability is limited to any amount unpaid on the shares they hold. No liability (NL) companies: Restricted to operating in the mining industry. Holders have no liability for company’s debts. Partly paid shares are not obliged to pay calls made by the company, though shares are forfeited if calls are not paid.

9. Characteristics of ordinary shares Rights of shareholders: entitled to a proportional share of any dividend declared right to exert a degree of control over management through the use of voting rights attached to ordinary shares. Includes the right to elect the Board of Directors shareholders have the right to sell their shares.

10. Equity as a source of finance Advantages: dividends are discretionary no maturity date the higher the proportion of capital structure made up by equity, the lower the cost of debt. Disadvantages: issuing more shares can dilute existing shareholders’ ownership and control returns to shareholders can be subject to double taxation (non-residents) transaction costs of issuing shares (including prospectus).

11. Private equity Securities issued to investors that are not publicly traded. This includes family members and friends, but a more formal source is a private equity fund. Two types: venture capital—funding for smaller, higher risk companies with the potential for strong growth acquisition of a public company by a group of investors who wish to ‘privatise’ it.

12. Private equity Four categories of private equity financing: start-up: new companies, funds to develop products expansion: additional funds required to manufacture and sell products commercially turnaround: assisting a company in financial difficulty MBO: where a business is purchased by its management team with the assistance of a private equity partner or fund. The market is illiquid—investors must hold investment for 5–10 years.

13. Private equity There are three information problems with new ventures: information gap: information is incomplete and uncertain information asymmetry: either party, the entrepreneur or investor, may have more information than the other information leakage: idea may be stolen by potential investors.

14. Private equity New ventures are typically financed in stages to overcome uncertainty and information asymmetry problems. The entrepreneur may require confidentiality agreements with potential investors in order to prevent them from stealing the idea. Venture capitalists usually do not sign such agreements. Instead, they focus on establishing and protecting a reputation for honesty and integrity.

15. Sources of finance for new ventures Stages of a venture include: R&D phase start-up phase, equipment and personnel assembled rapid growth, if product is successful slower growth, followed by maturity and possible decline. Different sources of finance are appropriate at different stages. Personal savings, personal loans and home mortgages are the most likely sources at R&D stage. Business angel may enter the R&D stage if these other sources are exhausted.

16. Finance from business angels Business angels—investors in the early stages of new ventures. Bring useful expertise as well as funds to a new venture. Attempt to help develop a project to a point where outside finance from private equity funds and other financial institutions can be attracted. Investment horizon is medium to long term (5–10 years).

17. Finance from private equity funds The Australian Bureau of Statistics (ABS) estimates $17.4b was committed to private equity market at 30 June 2009. As at June 2009, 275 private equity funds operated in Australia by 180 fund managers, investing in 1089 companies. According to ABS, these 180 managers reviewed 5,670 potential investments in 2008–09, of which only 126 have been successful. Investments range from $500000 to $20m over 3–7 years.

18. Finance from private equity funds Private equity funds look for projects with high growth prospects. To obtain private equity, companies require a well-structured and convincing business plan. Private equity fund managers usually require a seat on the board of the company. These managers specialise in new, fast-growing companies. They can offer specialised expertise to help the venture succeed.

19. Information disclosure Corporations Act 2001 has provisions that protect investors in public companies by disclosure of information requirements. Specific requirements apply to offers of securities. Typically requires the provision of a disclosure document with details of the issuer and securities being offered.

20. Offers of unlisted securities Offers of unlisted securities include IPOs of shares and offers of new classes of securities by listed companies. Securities do not have an obvious market price and information can help determine the appropriate price. Offer cannot proceed until disclosure document has been lodged with ASIC. Prospectus: most comprehensive disclosure document contains details of the issue, capital sought, price, use of funds, etc.

21. Offers of unlisted securities non-financial information on issuer—description of business and reports from directors and/or industry experts risks associated with business and expensive disclosure documents to prepare financial information on issuer—most recent and audited financial statements contributors to prospectus are liable for prosecution by investors over losses resulting from misstatements in, or omissions from, disclosure documents. Offer Information Statements (OIS): An OIS may be used instead of a prospectus in smaller capital raisings cases. Total raisings must be < $5m. OIS is less costly to prepare, less information to disclose.

22. Offers of listed securities Disclosure requirements for offers of listed securities are less onerous. Listed entity is subject to continual disclosure requirements. Much of the relevant information is publicly available anyway. Market provides a guide on price.

23. Offers that do not need disclosure Various offerings may not require a disclosure document: small-scale offerings rights issues offers to sophisticated investors offers to executive officers and associates offers to existing security holders. These exemptions assume that participants have relevant skills or information to judge the merits of an offer.

24. Floating a public company A float is the term given to the company’s first invitation for the public to subscribe for shares—an initial public offering (IPO). For a stock exchange listing, the company needs to satisfy the listing requirements of the exchange. A prospectus is required—a legal document that provides details of the company and the terms of the issue of shares. Companies unable to meet ASX listing requirements may list on Bendigo or Newcastle Stock Exchanges.

25. Public vs private ownership A company undertaking a float may be a new company or an existing private company. Two reasons for a private company to float: better access to capital markets allows private owners to cash in on the success of their business (creates a market for otherwise non-traded shares). Costs of going public include loss of control, listing fees, shareholder servicing costs, and information disclosure requirements.

26. Pricing a new issue Difficult if there is no historic earnings record. Consider P/E ratios of existing companies in the same industry to give an idea of value. Fixed price approach. Book building—competitive bidding where investors such as institutions nominate quantities they would purchase at different prices. A book-building approach is less likely to generate abnormal returns to investors.

27. Underwriting and managing a new issue Service provided by a stockbroker or investment bank. For a fee, the underwriter contracts to purchase all shares for which applications have not been received by the closing date of the issue. If a book-building process is used to issue shares, there is no need for underwriting, but an institution needs to manage the issue. Underwriter can limit exposure by sub-underwriting.

28. Selling a new issue If a stockbroker is an underwriter or lead manager, he/she will usually act as selling agent for the issue. Promotion reduces the need to purchase underwritten shares and will generate brokerage fees. Even without underwriting, a broker is engaged to assist in the distribution of shares. Brokerage depends on size of issue, but usually ranges between 1% and 2% of funds raised.

29. Costs of floating a company Costs fall into three main categories: ASX listing fees, prospectus costs (legal, accounting, expert opinions and printing and distribution) underwriters’ fees and brokers’ commissions (generally 4-7% of funds raised) shares sold in an IPO are usually underpriced—on average, there is an immediate abnormal return to IPOs.

30. Costs of floating a company Possible reasons for underpricing: Winner’s curse—bidders who ‘win’ are likely to be those who most overestimate the value of the assets. Potential investors will attempt to judge the interest of others and will only buy if they think IPO will be popular. Underpricing provides benefits gain from greater liquidity. Underpricing leaves a good taste with investors, raising the price at which subsequent share issues by the company can be sold. Underpricing reduces the risk of being sued by investors.

31. Costs of floating a company Long-term performance of IPOs (LTPIPOs): Several studies have found that shares of newly listed companies tend to under-perform during the first few years after listing. Researchers have used two approaches to tackle LTPIPOs: Compare post-listing returns on IPO companies to one or more market indices, without risk adjustment. Compare IPOs companies’ return with a control sample of other listed companies matched on the basis of one or more characteristics such as size and industry. In summary, there is mixed empirical evidence of LTPIPOs, and the ‘new issues puzzle’ still remains controversial.

32. Subsequent ordinary share issues: These include: rights issues placements (private issues) contributing shares and installment receipts share purchase plans share options.

33. Rights issues An issue of new shares to existing shareholders in proportion to their current shareholding. Requires a prospectus. If the right is exercisable only by the existing shareholders, the issue is non-renounceable. If the right can be sold the issue is renounceable.

34. Rights issues subscription price—must pay price to obtain new shares ex-rights date—the date on which a share begins trading ex-rights cum-rights—when shares are traded cum-rights, the buyer is entitled to participate in the forthcoming rights issue.

35. Valuation of rights The ex-rights price should fall by the value of the right attached to each share. The theoretical value of a right (R) is given by: N is the number of shares an investor must hold to have the right to purchase one new share. S is the subscription price per share. M is the market price of the share cum rights.

36. Valuation of rights The theoretical value of a share ex-rights (X) is given by:

37. Valuation of rights Theoretically, a rights issue has no value to shareholders. However, the announcement can have an impact on shareholders’ wealth. The information content is typically negative. Rights issues are seen as containing bad news about expected future cash flows.

38. Rights issue regulation Since 2007 issuers can proceed with a rights issue without a prospectus providing they: lodge with the ASX a ‘rights issue cleansing notice’ send shareholders a note outlining the reasons for the rights issue and a timetable. The rights issue cleansing notice must comply with the Corporations Act.

39. Rights issues One disadvantage with traditional renounceable rights issues is that they take a minimum of 23 business days to be completed. The ASX often grants rule waivers to allow companies to make non-traditional or ‘accelerated’ rights issues. The structures used for these include: Accelerated Non-Renounceable Entitlement Offer (or ‘Jumbo’) structures Accelerated Renounceable Entitlement Offers (AREO) Simultaneous Accelerated Renounceable Entitlement Offers (SAREO).

40. Private issues (placements) directly place equity with chosen investors rather than the public do not generally require a disclosure document result in dilution of the proportion of the company owned by non-participating investors. can be underwritten and can be a very inexpensive way of accessing equity. A book build is a popular mechanism for private placement.

41. Contributing shares and instalment receipts Contributing (partly paid) shares: shares on which only part of the issue price has been paid the issuing company can call up the unpaid part (reserve capital) of the issue price in one or more instalments. Instalment receipts marketable securities for which only part of the issue price has been paid issued when existing fully paid shares are offered to the public, with the sale price to be paid in two instalments.

42. Contributing shares and instalment receipts Instalment receipts differ from partly issued shares due to the following factors: Timing of instalment is specified at the time of original sale rather than being at the discretion of directors. Instalments are payable to the vendor of the shares rather than the issuing company. Holders of instalment receipts are entitled to the same dividends as holders of fully paid shares rather than a partial dividend.

43. Share purchase plans ASX-listed companies can raise limited funds from existing shareholders through share purchase plans. Prospectus not required as long as they comply with ASIC Regulatory Guide125. Limit of $15,000 from each shareholder p.a. Attractive to shareholders because shares are issued at a discount to market price, and there are no brokerage fees.

44. Share options Share options give the holder the right, but not the obligation, to purchase an ordinary share at a stated price at a future date. Exercise of the option will depend on the exercise price relative to the market price of the share around the exercise date.

45. Share options Company options may be issued free with the underlying share or sold at a price set by the issuing company: to employees as a sweetener to an equity issue as a sweetener to a private debt issue. Company options often restrict the holder from exercising the option for a certain period after it has been granted.

46. Choosing between equity-raising methods Companies generally prefer placements to rights issues—bias for placements up to regulatory limits. Advantages of placements include speed (days rather than weeks) and lower transaction costs. Shares can also be placed with ‘friendly’ shareholders. Rights issues are seen as equitable to existing shareholders.

47. Choosing between equity-raising methods Combination issues: When the amount of funds is sought is above the placement ceiling, a company may make a placement in combination with other equity raising such as a rights issue. Different features of combination issues: Issue price is determined by book build, which is then used to determine share prices for the second component of the issue. There may be three aspects: a placement, an institutional entitlement offer, and a retail entitlement offer.

48. Employee share plans Companies raise significant funds through employee share plans. Primary purpose of such plans is to motivate senior managers and other employees by giving them an ownership interest in the company. Types of employee share plans: Fully-paid share plans partly-paid share plans option plans employee share trusts replicator plans.

49. Internal funds Internal equity financing refers to the positive net cash flows generated by a company—funds from operations. A recent RBA report defined as cash profit less payments to supplies, employees, and tax. Using internal funds has advantages: does not affect the control of the company does not attract transaction costs. Management can influence the level of internal funds through dividend policy. They may offer a dividend reinvestment plan.

50. Dividend reinvestment plans Advantages Avoids relatively high transaction costs if shareholders used cash dividends to acquire additional shares. Shares often issued at a discount to current market price. Disadvantages Reinvestment of dividends could be dysfunctional if company has few prospects for future profitable investments, and/or if cash position is quite healthy. By increasing the company’s equity base, a DRP dilutes key indicators such as EPS.