Chapter 14 Raising Equity 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

Chapter Outline The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital Selling Securities to the Public: The Basic Procedure Alternative Issue Methods Underwriting IPOs and Underpricing New Equity Sales and the Value of the Firm The Cost of Issuing Securities Issuing Long-Term Debt Shelf Registration

Venture Capital 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 See the instructors manual for more information on some of the groups that provide capital for VC operations. One group that students may be particularly interested in is discussed in an article in the May 16, 2000 special issue of Inc. magazine. The article discusses a venture capital firm that received the majority of its financing from professional athletes (pp. 63 – 65). www: Click on the web surfer icon to go to the PriceWaterhouseCoopers web site. The site provides information on venture capital deals each quarter.

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? Financial strength – you want to have the option to obtain additional financing Style – do you want a hands-on or hands-off VC? Contacts – will the VC provide you with additional business contacts that can help your business succeed Exit strategy – VC’s are not long term investors – what are the provisions for the VC getting out of the business? www: Click on the web surfer icon to go to a web site that allows entrepreneur’s to search for capital and VC’s to search for prospective investments. Video Note: “Going Public” shows what must be done to take a company public – a common exit strategy for many VC’s.

Selling Securities to the Public Management must obtain permission from the Board of Directors Firm must file a registration statement with the SEC SEC examines the registration during a 20-day waiting period A preliminary prospectus, called a red herring, is distributed during the waiting period If there are problems the company is allowed to amend the registration and the waiting period starts over Securities may not be sold during the waiting period The price is determined on the effective date of the registration Registration statements don’t have to be filed if the loan will mature in less than nine months or the issue involves less than $5 million The SEC makes no statement about the financial strength of the firm, it just indicates that the registration is in order

Table 15.1 Securities are sold directly to the purchaser who, at least until recently, generally could not resell securities for at least two years. Direct placement Private Company can elect to award the underwriting contract through a public auction instead of negotiation. Competitive firm cash offer Qualifying companies can authorize all the shares they expect to sell over a two-year period and sell them when needed. Shelf cash offer Nontraditional cash offer Like the direct rights offer, this contains a privileged subscription arrangement with existing shareholders. The net proceeds are guaranteed by the underwriters. Standby rights offer Company offers the new stock directly to its existing shareholders. Direct rights offer Privileged subscription Company has investment bankers sell as many of the new shares as possible at the agreed upon price. There is no guarantee concerning how much cash will be raised. Best efforts cash offer Company negotiates an agreement with an investment banker to underwriters and distribute the new stocks. A specified number of shares are bought by underwriters and sold at a higher price. Firm commitment cash offer Public Traditional negotiated Cash offer Definition Type Method

Underwriters Services provided by underwriters Formulate method used to issue securities Price the securities Sell the securities Price stabilization by lead underwriter Syndicate – group of investment bankers 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 Price stabilization is an important component of the lead underwriter’s job for IPOs. For more information, see “Stabilization Activities by Underwriters After Initial Public Offerings” by Aggarwal in the June 2000 issue of The Journal of Finance. Spread – the typical spread for IPOs between $20 and $80 million is 7%. For more information, see “The Seven Percent Solution” by Chen and Ritter in the June 2000 issue of The Journal of Finance

Firm Commitment Underwriting 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 the United States This is a good place to review the difference between primary and secondary market transactions. Technically, the sale to the syndicate is the primary market transaction and the sale to the public is the secondary market transaction. Note that the cost of the issue includes the price paid to the issuing company plus the expenses of selling the issue

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 and the company does not get the capital and they have still incurred substantial flotation costs Not as common as it used to be

Green Shoes and Lockups 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 Lockup agreements Restriction on insiders that prevents them from selling their shares of an IPO for a specified time period The lockup period is commonly 180 days The stock price tends to drop when the lockup period expires due to market anticipation of additional shares hitting the street

IPO Underpricing 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”

Figure 15.2 Percentage average first-day returns Year 120 100 80 60 40 1960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 120 100 80 60 40 20 -20 -40 Year

Figure 15.3 Number of offerings Year 130+ 120 110 100 90 80 70 60 50 1960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 Year 10 20 30 40 50 60 70 80 90 100 110 120 130+ Number of offerings

New Equity Issues and Price Stock prices tend to decline when new equity is issued Possible explanations for this phenomenon Signaling and managerial information Signaling and debt usage 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 Signaling and managerial information – managers may choose to sell new shares of stock when they believe the current stock price is high (they can issue fewer shares at a higher price) Signaling and debt usage – issuing equity may send signal that management believes the company currently has too much debt Issuing securities is very expensive and the decrease in price may be partial compensation for the cost of the issue

Issuance Costs 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 Green Shoe option – cost of additional shares that the syndicate can purchase after the issue has gone to market

Prob 15-2: Equity Issuance Lambert Corp needs to raise $42 million to finance its expansion into new markets. The company will sell new shares of equity in a general cash offering to raise the funds. The offer price to the public is $75 per share, & the underwriters charge an 8% spread. How many shares need to be sold? A: 608,696 shares

Prob 15-2, part B: Equity Issuance From the previous problem, if SEC filing fees & associated administrative expenses of the offering are $500,000, how many shares need to be sold now? A: 615,942 shares

Types of Long-term Debt Bonds – public issue of long-term debt Private issues Term loans Direct business loans from commercial banks, insurance companies, etc. Maturities 1 – 5 years Repayable during life of the loan Private placements Similar to term loans with longer maturity Easier to renegotiate than public issues Lower costs than public issues

Shelf Registration Permits a corporation to register a large issue with the SEC and sell it in small portions Reduces the flotation costs of registration Allows the company more flexibility to raise money quickly Requirements Company must be rated investment grade Cannot have defaulted on debt within last three years Market value of stock must be greater than $150 million No violations of the Securities Act of 1934 in the last three years

Chapter 14 Quick Quiz 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 are some of the characteristics of private placement debt? What is shelf registration? In question three – I am going for firm commitment.