Raising Equity Capital Chapter 13 Raising Equity Capital

13.1 Equity Financing for Private Companies Chapter 13 Outline 13.1 Equity Financing for Private Companies 13.2 Taking Your Firm Public: The Initial Public Offering 13.3 IPO Puzzles 13.4 Raising Additional Capital: The Seasoned Equity Offering Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Understand the process of taking a company public 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.1 Equity Financing for Private Companies Entrepreneurs usually need capital from outside sources In this section, we examine: the sources that can provide a private company with capital the effect of the infusion of outside capital on the control of the company Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.1 Equity 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.1 Equity 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.1 Equity for Private Companies Venture Capital Firms: Specialize in raising money to invest in the private equity of young firms During 2007, venture capital firms invested $29.4 billion in 3,811 venture capital deals, for an average investment of about $7.7 million per deal In return, venture capitalists often demand a great deal of control of the company Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Figure 13.1 Most Active U.S. Venture Capital Firms in 2006 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Figure 13.2 Venture Capital Funding in the United States What was the spike in 2000? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.1 Equity for Private Companies Institutional Investors: pension funds, insurance companies, endowments, and foundations may invest directly in private firms, or may invest indirectly by becoming limited partners in venture capital firms Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.1 Equity for Private Companies Corporate Investors: Many established corporations purchase equity in younger, private companies Corporations might invest for corporate strategic objectives in addition to the desire for  investment returns Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.1 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1 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). Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1 Funding and Ownership Problem (cont’d): …This VC would invest $6 million and would receive 3,000,000 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? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1 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’ shares 500,000 Newly issued shares 3,000,000 Total 5,000,000 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1a Funding and Ownership Problem: You founded a drug discovery company 5 years ago. You initially contributed $50,000 of your money and, in return received 500,000 shares of stock. You have also sold 500,000 shares to angel investors to bring the drugs through animal studies. You now need more funding from VCs to clear the drugs through clinical trials… Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1a Funding and Ownership Problem (cont’d): …The VC would invest $100 million and would receive 100,000,000 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? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1a Funding and Ownership Solution: Plan: After this funding round, there will be a total of 101,000,000 shares outstanding: Your shares 500,000 Angel investors’ shares 500,000 Newly issued shares 100,000,000 Total 101,000,000 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1a Funding and Ownership Plan (cont’d): The VC is paying $100,000,000/100,000,000=$1/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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1a Funding and Ownership Execute: There are 101,000,000 shares and the VC paid $1 per share. Therefore, the post-money valuation would be 101,000,000($1) = $101 million. Because she is buying 100,000,000 shares, and there will be 101,000,000 total shares outstanding after the funding round, the VC will end up owning 100,000,000/101,000,000=99% of the firm. You will own 100,000/101,000,000=0.0009% of the firm, and the post-money valuation of your shares is 100,000($1) = $100,000. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.1a Funding and Ownership Evaluate: Funding your firm with new equity capital involves a tradeoff—you must give-up part (or basically all, in this case) of the ownership of the firm in return for the money you need to grow. Pharmaceuticals require a huge investment of money and it may have been a better option to sell the rights to your drug to a large pharmaceutical company. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.1 Equity Financing for Private Companies Exiting an Investment in a Private Company Exit Strategy Acquisition Public Offering Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 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) In this section we look at the mechanics of IPOs in two cases—the traditional set-up and recent innovations. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Table 13.1 Largest Global Equity Issues Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 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 IPOs include both Primary and Secondary offerings Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 Taking Your Firm Public: The Initial Public Offering 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Table 13.2 International IPO Underwriter Ranking Report for 2007 The major U.S. investment and commercial banks dominate the underwriting business. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Figure 13.3 The Cover Page of RealNetworks’ IPO Prospectus

13.2 Taking Your Firm Public: The Initial Public Offering SEC Filings Registration Statement preliminary prospectus or red herring Final Prospectus Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 Taking Your Firm Public: The Initial Public Offering Valuation Underwriters work with the company to come up with a price that they believe is a reasonable valuation for the firm Two ways: estimate the future cash flows compute the present value Road Show Book Building Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2 Valuing an IPO Using Comparables Execute: The average P/E ratio for recent deals is 21.2. 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 = $15.90. 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2 Valuing an IPO Using Comparables Evaluate: As we found in Chapter 9, 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2a Valuing an IPO Using Comparables Problem: Gen Probe, Inc. is a medical diagnostics company that designs and manufactures tests for HIV. During the most recent fiscal year, Gen Probe had revenues of $150 million and earnings of $10 million. Gen Probe has filed a registration statement with the SEC for its IPO. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2a Valuing an IPO Using Comparables Problem (cont'd): Before the stock is offered, Gen Probe’s investment bankers try to estimate the value of the company. They gather information by comparing Gen Probe to other medical diagnostic companies that have offered an IPO. The ratios are based on the IPO price. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2a Valuing an IPO Using Comparables Problem (cont'd) After the IPO, Gen Probe will have 10 million shares outstanding. Estimate the IPO price for Gen Probe using the price/earnings ratio and the price/revenues ratio. Company Price/Earnings Price/Revenues Bayer/Versant 14.2 1.3 Roche Diagnostics, Inc. 18.2 0.8 Beckdon Dickinson, Inc. 28.3 0.7 3rd Wave Technologies 12.5 0.5 Average 18.3 0.825 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2a Valuing an IPO Using Comparables Solution: Plan: If the IPO price of Gen Probe 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 Gen Probe total earnings. This will give us a total value of equity for Gen Probe. To get the per share IPO price, we need to divide the total equity value by the number of shares outstanding after the IPO (10 million). The approach will be the same for the price-to-revenues ratio. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2a Valuing an IPO Using Comparables Execute: The average P/E ratio for recent deals is 18.3. Given earnings of $10 million, we estimate the total market value of Gen Probe’s stock will be ($10 million)(18.3) = $183 million. With 10 million shares outstanding, the price per share should be $183 million / 10 million = $18.30. Similarly, if Gen Probe’s IPO price implies a price/revenues ratio equal to the recent average of 0.825, then using its revenues of $150 million, the total market value of Gen Probe will be ($150 million)(0.825) = $123.8 million, or (123.8/10)=$12.38/share Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.2a Valuing an IPO Using Comparables Evaluate: As we found in Chapter 9, 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 Gen Probe stock of $10 to $15 per share to take on the road show. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 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 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Table 13.3 Bids Received to Purchase Shares in a Hypothetical Auction IPO (in ‘000) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Figure 13.4 Aggregating the Shares Sought in the Hypothetical Auction IPO Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3 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? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3 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). Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3 Auction IPO Pricing Execute: Convert the table of bids into a table of cumulative demand: Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3 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 + 100,000 = 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3 Auction IPO Pricing Evaluate: While 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3a Auction IPO Pricing Problem: Stryker Endoscopy, Inc., is selling 700,000 shares of stock in an auction IPO. At the end of the bidding period, Stryker Endoscopy’s investment bank has received the following bids: What will the offer price of the shares be? Price ($) Number of Shares Bid 9.00 125,000 8.75 150,000 8.50 75,000 8.25 100,000 8.00 7.75 7.50 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3a 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 (700,000 shares). Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3a Auction IPO Pricing Execute: Convert the table of bids into a table of cumulative demand: Price ($) Number of Shares Bid 9.00 125,000 8.75 275,000 8.50 350,000 8.25 450,000 8.00 600,000 7.75 700,000 7.50 825,000 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3a Auction IPO Pricing Execute (cont'd): Stryker Endoscopy is offering a total of 700,000 shares. The winning auction price would be $7.75 per share, because investors have placed orders for a total of 700,000 shares at a price of $7.75 or higher. All investors who placed bids of at least this price will be able to buy the stock for $7.75 per share, even if their initial bid was higher. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3a 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.3a Auction IPO Pricing Evaluate: While 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 Taking Your Firm Public: The Initial Public Offering Google’s IPO On April 29, 2004, Google, Inc., announced plans to go public. Breaking with tradition, Google startled Wall Street by declaring its intention to rely heavily on the auction IPO mechanism for distributing its shares. Google had been profitable since 2001, so, according to Google executives, access to capital was not the only motive to go public. The company also wanted to provide employees and private equity investors with liquidity. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 Taking Your Firm Public: The Initial Public Offering Google’s IPO (cont'd) …One of the major attractions of the auction mechanism was the possibility of allocating shares to more individual investors. Google also hoped to set an accurate offer price by letting market bidders set the IPO price. After the Internet stock market boom, there were many lawsuits related to the way underwriters allocated shares. Google hoped to avoid the allocation scandals by letting the auction allocate shares. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.2 Taking Your Firm Public: The Initial Public Offering Google’s IPO (cont'd) …Investors who wanted to bid opened a brokerage account with one of the deal’s underwriters and then placed their bids with the brokerage house. Google and its underwriters identified the highest bid that allowed the company to sell all of the shares being offered. They also had the flexibility to choose to offer shares at a lower price. On August 18, 2004, Google sold 19.6 million shares at $85 per share. The $1.67 billion raised was easily the largest auction IPO ever. Google stock (ticker: GOOG) opened trading on the Nasdaq market the next day at $100 per share. Although the Google IPO sometimes stumbled along the way, it represents the most significant example of the use of the auction mechanism as an alternative to the traditional IPO mechanism. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Table 13.4 Summary of IPO Methods Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.3 IPO Puzzles Four characteristics of IPOs puzzle financial economists, and all are relevant to the financial manager: On average, IPOs appear to be underpriced: The price at the end of trading on the first day is often substantially  higher than the IPO price. The number of IPOs is highly cyclical. When times are good, the market is flooded with IPOs; when times are bad, the number of IPOs dries up. The costs of the IPO are very high, and it is unclear why firms willingly incur such high costs. The long-run performance of a newly public company (three to five years from the date of issue) is poor. That is, on average, a three- to five-year buy and hold strategy appears to be a bad investment. We will now examine each of these puzzles that financial economists seek to understand. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.3 IPO Puzzles Underpriced IPOs On average, between 1960 and 2003, the price in the U.S. aftermarket was 18.3% higher at the end of the first day of trading Who wins and who loses because of underpricing? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

“Hot” and “Cold” IPO Markets 13.3 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Figure 13.6 Cyclicality of Initial Public Offerings in the United States, (1975–2006 ) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

High Cost of Issuing an IPO 13.3 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Figure 13.7 Relative Costs of Issuing Securities

Poor Post-IPO Long-Run Stock Performance 13.3 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 Possibly 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.4 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.4 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. The main difference is that a market price for the stock already exists, so the price-setting process is not necessary. Tombstones Copyright © 2009 Pearson Prentice Hall. All rights reserved. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-75

13.4 Raising Additional Capital: The Seasoned Equity Offering Two kinds of seasoned equity offerings exist: Cash offer: the firm offers the  new shares to investors at large.   Rights offer: the firm offers the new shares only to existing shareholders Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.4 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.4 Raising Money with Rights Offers Problem (cont'd): 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? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.4 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.4 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. 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.4 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 $9.60 + 0.40 = $10.00. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Example 13.4 Raising Money with Rights Offers Evaluate (cont'd): In the second case, the number of shares outstanding will grow to 140 million, resulting in a post-issue stock price of $1.2 billion / 140 million shares = $8.57 per share (also higher than the issue price). Again, the shareholders will exercise their rights, and receive a total value per share of $8.57 + 2($8.57 - $5.00)/5 = $10.00. Thus, in both cases the same amount of money is raised and shareholders are equally well off. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.4 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 due to the price decline can be a significant fraction of the new money raised Lemon Principle Copyright © 2009 Pearson Prentice Hall. All rights reserved.

13.4 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter Quiz What are the main sources of funding for private companies to raise outside equity capital? What is a venture capital firm? What services does the underwriter provide in a traditional IPO? Explain the mechanics of an auction IPO. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter Quiz List and discuss four characteristics about IPOs that are puzzling. For each of the characteristics, identify its relevance to financial managers. What is the difference between a cash offer and a rights offer for a seasoned equity offering? What is the average stock price reaction to an SEO? Copyright © 2009 Pearson Prentice Hall. All rights reserved.