16 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

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 Underwriters IPOs and Underpricing New Equity Sales and the Value of the Firm The Cost of Issuing Securities Rights Dilution 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 company should have an “exit” strategy Sell the company – VC benefits from proceeds from sale Take the company public – VC benefits from 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 16.1 - I

Table 16.1 - II

Public Vs. Private Financing for Companies Publicly financed company: when shares of a company are offered to the public anyone can buy shares of the stock Privately financed company: privately owned or held by an individual or family securities are sold directly to insurance companies, pension funds and others, not available to the general public additional funds may be raised by private placement

Advantages of Public Financing Advantages of being public: greater availability of funds (easier to grow and raise money) prestige higher liquidity for shareholders enables a firm to engage in merger activities more readily

Disadvantages of Public Financing Disadvantages of being public: company information must be made available to the public Accumulating and disclosing information is expensive in terms of dollars and time Short-term pressure from security analysts and investors high costs of going public (expensive)

Advantages and Disadvantages of Private Placement Used more for debt than equity issues. Advantages: Eliminates the lengthy, expensive registration process with the Securities commissions. Greater flexibility in negotiating terms of issue. Costs of issue are less. Disadvantage: Usually higher interest cost on a privately placed debt instrument.

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 initially 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

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

Green Shoes and Lockups Green Shoe provision Allows the syndicate to purchase an additional 15% of the issue from the issuer Allows the issue to be oversubscribed Provides some protection for the underwriters 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 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”

Figure 16.2

Figure 16.3

Work the Web Example How have recent IPOs done? Click on the web surfer to go to the Hoovers and follow the “IPO Central” link Look at the IPO Scorecard and Money Left on the Table to see how much underpricing there has been in recent issues What other information can you find on IPOs at this site?

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 a signal that management believes the company currently has too much debt Issuing securities, especially stock, is very expensive and the decrease in price may be partial compensation for the cost of the issue

Factors be considered by the dealer in pricing the security Experience of the firm in the market. Financial position of the issuing firm. Expected earnings and dividends. P/E multiples of firms in the same industry. Anticipated public demand.

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

Distribution process for an investment deal Maxwell Corporation Managing investment dealer Underwriting or banking syndicate Selected dealers or sellers group Brokers Public Issues 250,000 additional shares of stock 15 investment dealers (including Wood Gundy) CIBC Wood Gundy

Underwriting Spread The spread is the difference in the price of a security to the public and the amount paid to the issuing firm and represents the compensation for those participating in the distribution Spread = Public Price - Issue Price It is shared by all the participants Usually, the larger the dollar value of an issue, the smaller the spread Spread on common stocks is greater than spread on bonds A corporate will also incur other flotation costs such as printing and legal expenses in raising funds

Allocation of underwriting spread Managing investment dealer Other syndicate members Selected dealer group Broker Public Price received $20.00 if sold to selling group $20.50 if sold to public $20.20 if sold through broker $20.50 to public Price paid ($) $19.3725 $19.60 $20.00 $20.20 $20.50

Rights Offerings: Basic Concepts Issue of common stock offered to existing shareholders Allows current shareholders to avoid the dilution that can occur with a new stock issue “Rights” are given to the shareholders Specify number of shares that can be purchased Specify purchase price Specify time frame Rights may be traded OTC or on an exchange

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

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? Shares issued = 10,000,000/20 = 500,000 Rights to buy one share = 5,000,000/500,000 = 10 Total investment = 10*25 + 20 = 270 Price per share = 270 / 11 = 24.55 Value of a right = 25 – 24.55 = .45 Buy 10 rights = .45*10 = 4.50 + 20 = 24.50 difference due to rounding

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 Book value and EPS – occurs when market-to-book value is less than one

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

Go private Go private are usually small companies that are seeking to avoid large auditing and reporting expenses. Larger firms have been going private to avoid the pressure of pleasing analysts in the short term. Two basic ways to go private. The public firm can be purchased by a private firm. The company can repurchase all publicly traded shares from the shareholders.

Leveraged Buyout Leveraged Buyout (LBO): management or some external group borrows the needed cash to repurchase all the shares of the company resulting in a great deal of debt when a company “goes private”

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 is a rights offering and how do you value a right? What are some of the characteristics of private placement debt? What is shelf registration? In question three – I am going for firm commitment.

16 End of Chapter