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Raising Capital

Chapter Fifteen. Raising Capital. 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

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  1. Chapter Fifteen Raising Capital

  2. 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

  3. Chapter Outline • The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital • The Public Issue • The Basic Procedure for a New Issue • The Cash Offer • The Decision to Go Public • New Equity Sales and the Value of the Firm • The Cost of Issuing Securities • Rights • Dilution • Issuing Long-Term Debt

  4. Venture Capital 15.1 • Private financing for relatively new businesses in exchange for stock • Usually entails some hands-on guidance • The ultimate goal is usually to take the company public and the VC will benefit from the capital raised in the IPO • Many VC firms are formed from a group of investors that pool capital and then have partners in the firm decide which companies will receive financing • Some large corporations have a VC division

  5. Choosing a Venture Capitalist • Look for financial strength • Choose a VC that has a management style that is compatible with your own • Obtain and check references • What contacts does the VC have? • What is the exit strategy?

  6. The Public Issue 15.2 • Public issue – the creation and sale of securities that are intended to be traded on public markets • All companies listed on the TSX come under the Ontario Securities Commission’s jurisdiction • All securities traded on the TSX Venture Exchange come under the jurisdiction of the Alberta Securities Commission

  7. Alberta Securities Commission • The Alberta Securities Commission (ASC) is the industry-funded organization responsible for overseeing the capital market in Alberta. The Commission administers the Alberta Securities Act, the Securities Regulation and Alberta Securities Commission Rules. • This legislation is designed to ensure that Alberta’s capital market operates fairly and efficiently for participants, and that investors have timely, accurate information on which to base investment decisions. It also ensures that those who sell securities in Alberta are registered and that they conduct themselves according to applicable laws and professional standards. • In addition to regulating Alberta’s capital market, the ASC oversees the activities of the TSX Venture Exchange (formerly the Canadian Venture Exchange or CDNX) and the Investment Dealers Association of Canada (IDA). • Source: http://www.albertasecurities.com

  8. Selling Securities to the Public 15.3 • Management must obtain permission from the Board of Directors • Firm must prepare and distribute copies of a preliminary prospectus (red herring) to the Securities Commissions in the jurisdictions where they want to sell the shares • The Securities Commissions study the preliminary prospectus and notify the company of any deficiencies (usually takes a minimum of 2 weeks) • When the prospectus is approved by the Securities Commissions, the price is set and the securities dealers can begin selling the new issue

  9. Underwriters 15.4 • Services provided by underwriters • Formulate method used to issue securities • Price the securities • Sell the securities • Price stabilization by lead underwriter • Syndicate – group of underwriters that market the securities and share the risk associated with selling the issue • Spread – difference between what the syndicate pays the company and what the security sells for in the market

  10. Firm Commitment Underwriting • Also called a “bought deal” • Issuer sells entire issue to 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 • Most common type of underwriting in Canada

  11. 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. In this situation, the company does not get the capital and they have still incurred substantial flotation costs

  12. Overallotment Option • Overallotment Option / Green Shoe provision • Allows syndicate to purchase an additional 15% of the issue from the issuer • Allows the issue to be oversubscribed • Provides some protection for the lead underwriter as they perform their price stabilization function

  13. IPO Underpricing 15.5 • Initial Public Offering – IPO • May be difficult to price an IPO because there isn’t a current market price available • Additional asymmetric information associated with companies going public • Underwriters want to ensure that their clients earn a good return on IPOs on average • Underpricing causes the issuer to “leave money on the table”

  14. Table 15.3 – What Determines Subscription Prices?

  15. Table 15.4 – Initial Aftermarket Performance

  16. Figure 15.1 – Average Initial Returns for SEC-Registered IPO’s: 1960 to 1998

  17. New Equity Issues and Price • Stock prices tend to decline when new equity is issued • Possible explanations for this phenomenon • Managerial information and signaling • Debt usage and signaling • Issue costs • Since the drop in price can be significant and much of the drop may be attributable to negative signals, it is important for management to understand the signals that are being sent and try to reduce the effect when possible

  18. The Cost of Issuing Securities 15.7 • Spread • Other direct expenses – legal fees, filing fees, etc. • Indirect expenses – opportunity costs, i.e., management time spent working on issue • Abnormal returns – price drop on existing stock • Underpricing – below market issue price on IPOs • Overallotment (Green Shoe) option – cost of additional shares that the syndicate can purchase after the issue has gone to market

  19. Rights Offerings: Basic Concepts 15.8 • More correct name is the Pre-emptive Right • A Rights Offer is an issue of new common stock offered to existing shareholders • A Rights Offer allows current shareholders avoid the dilution that occurs with a new stock issue, since they are able to purchase a pro rata share of the new issue • One “Right” is given for each common stock owned. The Right will: • Specify number of shares that can be purchased • Specify purchase price • Specify time frame • Rights usually trade on the same exchange as the company’s stock

  20. The Value of a Right • The price specified in a rights offering is generally less than the current market price • The share price will adjust based on the number of new shares issued • The value of the right is the difference between the old share price and the “new” share price

  21. Rights Offering Example • Suppose a company wants to raise $10 million. The subscription price is $20 and the current stock price is $25. The firm currently has 5,000,000 shares outstanding. • How many shares have to be issued? • How many rights will it take to purchase one share? • What is the value of a right?

  22. Rights Offering Example continued Where: M0 = Value of the Common, rights-on S = Subscription price N = Number of rights for one new share

  23. More on Rights Offerings • Ex-rights – the price of the stock will drop by the value of the right on the day that the stock no longer carries the “right” • Standby underwriting – underwriter agrees to buy any shares that are not purchased through the rights offering • Stockholders can either exercise their rights or sell them – they are not hurt by the rights offering either way • Rights offerings have lower issue costs than other methods of selling new equity • Until the early 1980’s, rights offerings were the most popular method of raising new equity in Canada • Bought deals have replaced rights offers as the prevalent form of equity issue

  24. Dilution 15.9 • Dilution is a loss in value for existing shareholders • Percentage ownership – if the firm sells new shares, the old shareholder’s proportionate ownership goes down, if they don’t buy an equal percentage of the new shares offered. • Example: Jill currently owns 5,000 shares in a firm with 50,000 shares outstanding. She thus owns 10% of the firm. The firm then sells another 50,000 shares. If Jill does not purchase any of the new shares, her ownership falls to 5%.

  25. Dilution • Market value – dilution (a drop in market price per share) occurs when the firm accepts negative NPV projects, thereby destroying shareholder wealth. • Book value and EPS – both the book value per share and the Earnings per Share (EPS) will drop when new common stock is issued when the market-to-book ratio is less than one

  26. Types of Long-term Debt 15.10 • Bonds – long-term debt • May be sold through a public offering or a private placement • Private issues • Term loans • Direct business loans from commercial banks, insurance companies, etc. • Maturities usually in the range of 1 – 5 years, although may be much longer • Term loans are usually amortized over the life of the loan • Private placements • Similar to term loans with longer maturity • Easier to renegotiate than public issues • Lower costs than public issues

  27. Quick Quiz • What is venture capital and what types of firms receive it? • What are some of the important services provided by underwriters? • 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 are some of the characteristics of private placement debt?

  28. Summary 15.11 • Venture capital is first-stage financing • Costs of issuing securities can be quite large. • Bought deals are far more prevalent for large issues than regular underwriting • Direct and indirect costs of going public can be substantial • In Canada, the bought deal is cheaper and dominates the new issue market

  29. Some Useful Links to More Information • The links section on the Alberta Securities Commission site provides access to lots of great resources. To access the Alberta Securities Commission, go to www.albertasecurities.com. From there, you can find links to each of the following. • Provincial Securities Regulators:Canadian Securities Administrators (CSA)National Cease Trade Order DatabaseAlberta Securities Commission (ASC)British Columbia Securities Commission (BCSC)Autorité Des Marchés Financiers (AMF)Manitoba Securities CommissionNew Brunswick Securities CommissionSecurities Commission of Newfoundland and LabradorNova Scotia Securities CommissionOntario Securities Commission (OSC)Saskatchewan Financial Services CommissionSecurities Office, Prince Edward Island

  30. Access to information SEDI (System for Electronic Disclosure by Insiders)SEDAR (System for Electronic Document Analysis and Retrieval) • Other Industry Regulators:Investment Dealers Association of CanadaMutual Fund Dealers Association of CanadaMarket Regulation Services Inc. (RS Inc.)Institute of Chartered Accountants of Alberta (ICAA)Joint Forum of Financial Market Regulators • Other Law Enforcement Agencies & Gov't:Government of AlbertaRoyal Canadian Mounted PoliceCalgary Police ServiceEdmonton Police ServiceReport Economic Crime Online (RECOL)

  31. Canadian Stock Exchanges:TSX ExchangeTSX Venture ExchangeMontreal Exchange • Industry Resources:Alberta Capital Market Foundation (ACMF)Canadian Investor Protection Fund (CIPF)Canadian Securities Institute (CSI)Investment Funds Institute of Canada (IFIC)Investor Learning Centre of Canada (ILC)Omudsman for Banking Services and InvestmentsFinancial Services OmbudsnetworkFinancial Consumer Agency of Canada • International Securities & Regulatory Organizations:Securities & Exchange Commission (SEC)International Organization of Securities Commissions (IOSCO)North American Securities Administrators Association (NASAA)

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