Chapter 14 Raising Equity Capital

Chapter 14 Outline 14.1 Equity Financing for Private Companies 14.2 Taking Your Firm Public: The Initial Public Offering 14.3 IPO Puzzles 14.4 Raising Additional Capital: The Seasoned Equity Offering

Learning Objectives Contrast the different ways to raise equity capital for a private company Understand the process of taking a company public Gain insight into puzzles associated with initial public offerings Explain how to raise additional equity capital once the company is public

14.1 Equity Financing for Private Companies Sources of Funding: – A private company can seek funding from several potential sources: Angel Investors Venture Capital Firms Institutional Investors Corporate Investors

14.1 Equity Financing for Private Companies Angel Investors: – Individual investors who buy equity in small private firms – The first round of outside private equity financing is often obtained from angels

14.1 Equity Financing for Private Companies Venture Capital Firms: – Specialize in raising money to invest in the private equity of young firms – In return, venture capitalists often demand a great deal of control of the company

Figure 14.1 Most Active U.S. Venture Capital Firms in 2012 (by Number of Deals Completed

Figure 14.2 Venture Capital Funding in the United States

14.1 Equity Financing for Private Companies Institutional Investors: – Pension funds, insurance companies, endowments, and foundations May invest directly May invest indirectly by becoming limited partners in venture capital firms

14.1 Equity Financing for Private Companies Corporate Investors: – Many established corporations purchase equity in younger, private companies corporate strategic objectives desire for investment returns – Also called corporate partner, strategic partner, strategic investor

14.1 Equity Financing for Private Companies Securities and Valuation – When a company decides to sell equity to outside investors for the first time, it is typical to issue preferred stock rather than common stock to raise capital It is called convertible preferred stock if the owner can convert it into common stock at a future date

Example 14.1 Funding and Ownership Problem: You founded your own firm two years ago. You initially contributed $100,000 of your money and, in return received 1,500,000 shares of stock. Since then, you have sold an additional 500,000 shares to angel investors. You are now considering raising even more capital from a venture capitalist (VC). This VC would invest $6 million and would receive 3 million newly issued shares. What is the post-money valuation? Assuming that this is the VC’s first investment in your company, what percentage of the firm will she end up owning? What percentage will you own? What is the value of your shares?

Example 14.1 Funding and Ownership Solution: Plan: After this funding round, there will be a total of 5,000,000 shares outstanding: Your shares 1,500,000 Angel investors’ shares500,000 Newly issued shares3,000,000 Total5,000,000

Example 14.1 Funding and Ownership Plan (cont’d): The VC is paying $6,000,000/3,000,000=$2/share. The post-money valuation will be the total number of shares multiplied by the price paid by the VC. The percentage of the firm owned by the VC is her shares divided by the total number of shares. Your percentage will be your shares divided by the total shares and the value of your shares will be the number of shares you own multiplied by the price the VC paid.

Example 14.1 Funding and Ownership Execute: There are 5,000,000 shares and the VC paid $2 per share. Therefore, the post-money valuation would be 5,000,000($2) = $10 million. Because she is buying 3,000,000 shares, and there will be 5,000,000 total shares outstanding after the funding round, the VC will end up owning 3,000,000/5,000,000=60% of the firm. You will own 1,500,000/5,000,000=30% of the firm, and the post-money valuation of your shares is 1,500,000($2) = $3,000,000.

Example 14.1 Funding and Ownership Evaluate: Funding your firm with new equity capital, be it from an angel or venture capitalist, involves a tradeoff—you must give-up part of the ownership of the firm in return for the money you need to grow. The higher is the price you can negotiate per share, the smaller is the percentage of your firm you have to give up for a given amount of capital.

14.1 Equity Financing for Private Companies Exiting an Investment in a Private Company Acquisition Public Offering

14.2 Taking Your Firm Public: The Initial Public Offering The process of selling stock to the public for the first time is called an initial public offering (IPO)

Table 14.1 Largest Global IPOs

14.2 Taking Your Firm Public: The Initial Public Offering Advantages and Disadvantages of Going Public – Advantages: Greater liquidity Better access to capital – Disadvantages: Equity holders more dispersed Must satisfy requirements of public companies

14.2 Taking Your Firm Public: The Initial Public Offering IPOs include both Primary and Secondary offerings Underwriters and the Syndicate – Underwriter: an investment banking firm that manages the offering and designs its structure Lead Underwriter – Syndicate: other underwriters that help market and sell the issue

Table 14.2 International IPO Underwriter Ranking Report for 2012

14.2 Taking Your Firm Public: The Initial Public Offering SEC Filings – Registration Statement preliminary prospectus or red herring – Final Prospectus

Figure 14.3 The Cover Page of RealNetworks’ IPO Prospectus

14.2 Taking Your Firm Public: The Initial Public Offering Valuation – Underwriters work with the company to come up with a price Estimate the future cash flows and compute the present value Use market multiples approach – Road Show – Book Building

Example 14.2 Valuing an IPO Using Comparables Problem: Wagner, Inc., is a private company that designs, manufactures, and distributes branded consumer products. During the most recent fiscal year, Wagner had revenues of $325 million and earnings of $15 million. Wagner has filed a registration statement with the SEC for its IPO.

Example 14.2 Valuing an IPO Using Comparables Problem (cont'd): Before the stock is offered, Wagner’s investment bankers would like to estimate the value of the company using comparable companies. The investment bankers have assembled the following information based on data for other companies in the same industry that have recently gone public. In each case, the ratios are based on the IPO price.

Example 14.2 Valuing an IPO Using Comparables Problem (cont'd) After the IPO, Wagner will have 20 million shares outstanding. Estimate the IPO price for Wagner using the price/earnings ratio and the price/revenues ratio.

Example 14.2 Valuing an IPO Using Comparables Solution: Plan: If the IPO price of Wagner is based on a price/earnings ratio that is similar to those for recent IPOs, then this ratio will equal the average of recent deals. Thus, to compute the IPO price based on the P/E ratio, we will first take the average P/E ratio from the comparison group and multiply it by Wagner’s total earnings. This will give us a total value of equity for Wagner. To get the per share IPO price, we need to divide the total equity value by the number of shares outstanding after the IPO (20 million). The approach will be the same for the price-to-revenues ratio.

Example 14.2 Valuing an IPO Using Comparables Execute: The average P/E ratio for recent deals is Given earnings of $15 million, we estimate the total market value of Wagner’s stock to be ($15 million)(21.2) = $318 million. With 20 million shares outstanding, the price per share should be $318 million / 20 million = $ Similarly, if Wagner’s IPO price implies a price/revenues ratio equal to the recent average of 0.9, then using its revenues of $325 million, the total market value of Wagner will be ($325 million)(0.9) = $292.5 million, or ($292.5/20)= $14.63/share

Example 14.2 Valuing an IPO Using Comparables Evaluate: As we found in Chapter 10, using multiples for valuation always produces a range of estimates—you should not expect to get the same value from different ratios. Based on these estimates, the underwriters will probably establish an initial price range for Wagner stock of $13 to $17 per share to take on the road show.

14.2 Taking Your Firm Public: The Initial Public Offering Pricing the Deal and Managing Risk – Firm Commitment IPO: the underwriter guarantees that it will sell all of the stock at the offer price Spread Lockup – Over-allotment allocation, or greenshoe provision: allows the underwriter to issue more stock, amounting to 15% of the original offer size, at the IPO offer price

14.2 Taking Your Firm Public: The Initial Public Offering Other IPO Types – Best-Efforts Basis: the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price – Auction IPO: The company or its investment bankers auction off the shares, allowing the market to determine the price of the stock

Table 14.3 Bids Received to Purchase Shares in a Hypothetical Auction IPO

Figure 14.4 Aggregating the Shares Sought in the Hypothetical Auction IPO

Example 14.3 Auction IPO Pricing Problem: Fleming Educational Software, Inc., is selling 500,000 shares of stock in an auction IPO. At the end of the bidding period, Fleming’s investment bank has received the following bids: What will the offer price of the shares be?

Example 14.3 Auction IPO Pricing Solution: Plan: First, we must compute the total number of shares demanded at or above any given price. Then, we pick the lowest price that will allow us to sell the full issue (500,000 shares).

Example 14.3 Auction IPO Pricing Execute: Convert the table of bids into a table of cumulative demand:

Example 14.3 Auction IPO Pricing Execute (cont'd): For example, the company has received bids for a total of 125,000 shares at $7.75 per share or higher (25, ,000 = 125,000). Fleming is offering a total of 500,000 shares. The winning auction price would be $7.00 per share, because investors have placed orders for a total of 500,000 shares at a price of $7.00 or higher. All investors who placed bids of at least this price will be able to buy the stock for $7.00 per share, even if their initial bid was higher.

Example 14.3 Auction IPO Pricing Execute (cont'd): In this example, the cumulative demand at the winning price exactly equals the supply. If total demand at this price were greater than supply, all auction participants who bid prices higher than the winning price would receive their full bid (at the winning price). Shares would be awarded on a pro rata basis to bidders who bid exactly the winning price.

Example 14.3 Auction IPO Pricing Evaluate: Although the auction IPO does not provide the certainty of the firm commitment, it has the advantage of using the market to determine the offer price. It also reduces the underwriter’s role, and consequently, fees.

Table 14.4 Summary of IPO Methods

14.3 IPO Puzzles Four IPO puzzles: – Underpricing of IPOs – “Hot” and “Cold” IPO markets – High underwriting costs – Poor long-run performance of IPOs

14.3 IPO Puzzles Underpriced IPOs – On average, between 1980 and 2012, the price in the U.S. aftermarket was 18% higher at the end of the first day of trading Who wins and who loses because of underpricing?

Figure 14.5 International Comparison of First-Day IPO Returns

14.3 IPO Puzzles “Hot” and “Cold” IPO Markets – It appears that the number of IPOs is not solely driven by the demand for capital – Sometimes firms and investors seem to favor IPOs; at other times firms appear to rely on alternative sources of capital

Figure 14.6 Cyclicality of Initial Public Offerings in the United States, ( )

14.3 IPO Puzzles High Cost of Issuing an IPO – In the U.S., the discount below the issue price at which the underwriter purchases the shares from the issuing firm is 7% of the issue price – This fee is large, especially considering the additional cost to the firm associated with underpricing

Figure 14.7 Relative Costs of Issuing Securities

14.3 IPO Puzzles Poor Post-IPO Long-Run Stock Performance – Newly listed firms appear to perform relatively poorly over the following three to five years after their IPOs – That underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place

14.4 Raising Additional Capital: The Seasoned Equity Offering A firm’s need for outside capital rarely ends at the IPO – Seasoned Equity Offering (SEO): firms return to the equity markets and offer new shares for sale

14.4 Raising Additional Capital: The Seasoned Equity Offering SEO Process – When a firm issues stock using an SEO, it follows many of the same steps as for an IPO – Main difference is that the price-setting process is not necessary Tombstones

Figure 14.8 Tombstone Advertisement for a RealNetworks SEO

14.4 Raising Additional Capital: The Seasoned Equity Offering Two kinds of seasoned equity offerings: – Cash offer – Rights offer

Example 14.4 Raising Money with Rights Offers Problem: You are the CFO of a company that has a market capitalization of $1 billion. The firm has 100 million shares outstanding, so the shares are trading at $10 per share. You need to raise $200 million and have announced a rights issue. Each existing shareholder is sent one right for every share he or she owns. You have not decided how many rights you will require to purchase a share of new stock. You will require either four rights to purchase one share at a price of $8 per share, or five rights to purchase two new shares at a price of $5 per share. Which approach will raise more money?

Example 14.4 Raising Money with Rights Offers Solution: Plan: In order to know how much money will be raised, we need to compute how many total shares would be purchased if everyone exercises their rights. Then we can multiply it by the price per share to calculate the total amount raised.

Example 14.4 Raising Money with Rights Offers Execute: There are 100 million shares, each with one right attached. In the first case, 4 rights will be needed to purchase a new share, so 100 million / 4 = 25 million new shares will be purchased. At a price of $8 per share, that would raise $8 x 25 million = $200 million.

Example 14.4 Raising Money with Rights Offers Execute (cont’d): In the second case, for every 5 rights, 2 new shares can be purchased, so there will be 2 x (100 million / 5) = 40 million new shares. At a price of $5 per share, that would also raise $200 million. If all shareholders exercise their rights, both approaches will raise the same amount of money.

Example 14.4 Raising Money with Rights Offers Evaluate: In both cases, the value of the firm after the issue is $1.2 billion. In the first case, there are 125 million shares outstanding after the issue, so the price per share after the issue is $1.2 billion / 125 million = $9.60. This price exceeds the issue price of $8, so the shareholders will exercise their rights. Because exercising will yield a profit of ($9.60 – $8.00)/4 = $0.40 per right, the total value per share to each shareholder is $ = $10.00.

14.4 Raising Additional Capital: The Seasoned Equity Offering Researchers have found that, on average, the market greets the news of an SEO with a price decline (about 1.5%) – Often the value lost can be a significant fraction of the new money raised – Adverse selection (the lemons problem)

Figure 14.9 Price Reaction to an SEO Announcement

14.4 Raising Additional Capital: The Seasoned Equity Offering SEO Costs – In addition to the price drop when the SEO is announced, the firm must pay direct costs as well. Underwriting fees amount to 5% of the proceeds of the issue