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Raising Capital. Chapter 20. Key Concepts and Skills. Understand the venture capital market and its role in financing new businesses Understand how securities are sold to the public and the role of investment bankers Understand initial public offerings and the costs of going public
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Raising Capital Chapter 20
Key Concepts and Skills • Understand the venture capital market and its role in financing new businesses • Understand how securities are sold to the public and the role of investment bankers • Understand initial public offerings and the costs of going public • Understand the process of secondary offerings and the impact of dilution
20.1 Early-Stage Financing and Venture Capital • Start-up companies • Banks are generally not interested in making loans to start-up companies with no assets • Angel investors • Venture capital
Venture Capitalists (VCs) • Financial intermediaries that are typically set up as limited partnerships • Play an active role in overseeing, advising, and monitoring companies in which they invest • Generally do not want to own the investment forever
Stages of Financing • Seed-Money Stage • Start-Up • First-Round Financing • Second-Round Financing • Third-Round Financing • Fourth-Round Financing
Facts about Venture Capitalists (VCs) • Although there is a large venture capital market, the truth is that access to venture capital is very limited. • Venture capital is that it is quite expensive. • Venture capital investments are strongly influenced by economic conditions.
20.2 The Public Issue • The Basic Procedure • Management gets the approval of the Board. • The firm prepares and files a registration statement with the SEC. • The SEC studies the registration statement during the waiting period. • The firm prepares and files an amended registration statement with the SEC. • If everything is copasetic with the SEC, a price is set and a full-fledged selling effort gets underway.
The Process of a Public Offering • Steps in Public Offering Time • 1. Pre-underwriting conferences Several months • 2. Registration statements 20-day waiting period • 3. Pricing the issue Usually on the 20th day • 4. Public offering and sale After the 20th day • 5. Market stabilization 30 days after offering
20.3 Alternative Issue Methods • There are two kinds of public issues: • The general cash offer • The rights offer • Almost all debt is sold in general cash offerings. • Public equity issue • IPO • SEO
20.4 The Cash Offer • There are three methods for issuing securities for cash: • Firm Commitment • Best Efforts • Dutch Auction
Firm Commitment Underwriting • The issuing firm sells the entire issue to the underwriting syndicate. • The syndicate then resells the issue to the public. • The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold. • The syndicate bears the risk of not being able to sell the entire issue for more than the cost. • This is the most common type of underwriting in the United States.
Best Efforts Underwriting • Underwriter must make their “best effort” to sell the securities at an agreed-upon offering price. • The company bears the risk of the issue not being sold. • The offer may be pulled if there is not enough interest at the offer price. The company does not get the capital, and they have still incurred substantial flotation costs. • This type of underwriting is not as common as it used to be.
Dutch Auction Underwriting • Underwriter accepts a series of bids that include number of shares and price per share. • The price that everyone pays is the highest price that will result in all shares being sold. • There is an incentive to bid high to make sure you get in on the auction but knowing that you will probably pay a lower price than you bid. • The Treasury has used Dutch auctions for years. • Google was the first large Dutch auction IPO.
Investment Banks • Also called underwriters • Perform critical functions: • Help determine type of security, method of sale, and offering price • Sell the securities • Typically using a syndicate to limit risk • For compensation – the spread • Stabilize IPO prices in the aftermarket
Investment Banks • There are two methods for selecting an underwriter • Competitive: the issuing firm sells its securities to the underwriter with the highest bid. • Negotiated: the issuing firm works with one underwriter.
IPO Underpricing • May be difficult to price an IPO because there is not a current market price available. • Private companies tend to have more asymmetric information than companies that are already publicly traded. • Underwriters want to ensure that, on average, their clients earn a good return on IPOs. • Underpricing causes the issuer to “leave money on the table.”
20.5 The Announcement of New Equity and the Value of the Firm • The market value of existing equity drops on the announcement of a new issue of common stock. • Reasons include • Managerial Information Since the managers are the insiders, perhaps they are selling new stock because they think it is overpriced. • Debt Capacity If the market infers that the managers are issuing new equity to reduce their debt-equity ratio due to the specter of financial distress, the stock price will fall. • Issue Costs
20.6 The Cost of New Issues • Gross spread, or underwriting discount • Other direct expenses • Indirect expenses • Abnormal returns • Underpricing • Green Shoe Option
20.7 Rights • If a preemptive right is contained in the firm’s articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders. • This allows shareholders to maintain their percentage ownership if they so desire. • An issue of common stock to existing stockholders is called a rights offering. • Each shareholder is issued an option to buy a specified number of new shares from the firm at a specified price within a specified time, after which the rights expire. • Subscription price is the price that existing shareholders are allowed to pay for a share of stock.
Mechanics of Rights Offerings • The management of the firm must decide: • The exercise price (the price existing shareholders must pay for new shares). • How many rights will be required to purchase one new share of stock. • These rights have value: • Shareholders can either exercise their rights or sell their rights.
Rights Offering • National Power wants to raise $5 million in new equity. With a subscription price of $10, it will issue 500,000 new shares.
Rights Offering • National Power wants to raise $5 million in new equity. With a subscription price of $10, it will issue 500,000 new shares.
Rights Offering Example • Popular Delusions, Inc. is proposing a rights offering. There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new shares issued at a $20 subscription price. • What is the new market value of the firm? • What is the ex-rights price? • What is the value of a right?
What is the new market value of the firm? There are 200,000 outstanding shares at $25 each. There will be 10,000 new shares issued at a $20 subscription price.
$5,200,000 210,000 shares What Is the Ex-Rights Price? • There are 110,000 outstanding shares of a firm with a market value of $5,200,000. • Thus the value of an ex-rights share is: = $24.7619
What Is the Ex-Rights Price? • Thus, the value of a right is: • $0.2381 = $25 – $24.7619
20.8 The Rights Puzzle • The vast majority of new issues in the U.S. are underwritten, even though rights offerings are much cheaper. • A few explanations: • Underwriters increase the stock price. There is not much evidence for this, but it sounds good. • The underwriter provides a form of insurance to the issuing firm in a firm-commitment underwriting. • Underwriters “certify” the price to the market. • The proceeds from underwriting may be available sooner than the proceeds from a rights offering.
20.9 Dilution • Dilution is a loss in value for existing shareholders: • Percentage ownership – shares sold to the general public without a rights offering • Market value – firm accepts negative NPV projects • Earnings per share – may decline even with positive NPV projects (at least in short run) • Book value– occurs when market-to-book value is less than one
20.10 Shelf Registration • Permits a corporation to register an offering that it reasonably expects to sell within the next two years. • Not all companies are allowed shelf registration. • Qualifications include: • The firm must be rated investment grade. • They cannot have recently defaulted on debt. • The market capitalization must be > $150 m. • No recent SEC violations.
20.11 Issuing Long-Term Debt • Public issuance follows the same general process as stocks • Direct financing • Term loans • Private placements • Direct financing may have more restrictive covenants and higher rates, but is less costly to issue and easier to negotiate.
Summary • What is venture capital, and what types of firms receive it? • What are some of the important services provided by underwriters? • What type of underwriting is the most common in the United States, and how does it work? • What is IPO underpricing, and why might it persist? • What are some of the costs associated with issuing securities? • What is a rights offering, and how do you value a right? • What is shelf registration? • What are the advantages of direct financing as opposed to public issuance of long-term debt?
