1. Chapter 15
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
Understand how rights are issued to existing shareholders and how the rights are valued
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3. 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 Costs of Issuing Securities
Rights
Dilution
Issuing Long-Term Debt
Shelf Registration
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4. Venture Capital
Private financing for relatively new businesses in exchange for equity
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
www: Click on the web surfer icon to go to the PriceWaterhouseCoopers web site. The site provides information on venture capital deals each quarter.
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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?
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 – VCs 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 entrepreneurs to search for capital and VCs 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 VCs.
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6. Selling Securities to the Public
Management must obtain permission from the Board of Directors
Firm must file a registration statement with the SEC
The 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 simply indicates that the registration is in order
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7. Crowd Funding
On April 5, 2012, the JOBS Act was signed into law. A provision of this act allowed companies to raise money through crowdfunding, which is the practice of raising small amounts of capital from a large number of people, typically via the Internet.
Crowdfunding was first used to underwrite the U.S. tour of British rock band Marillion.
Learn more about crowdfunding at the National Crowdfunding Association website:
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8. Table 15.1 – The Methods of Issuing New Securities
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9. Table 15.1 – The Methods of Issuing New Securities, CTD
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10. Underwriters Formulate method used to issue securities
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. A recent example that may interest students is the Facebook IPO.
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. For penny stock IPOs, the spread is typically 10%; see “Penny Stock IPOs” by Bradley, Cooney, Dolvin and Jordan in the Spring 2006 issue of Financial Management.
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11. 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.
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12. 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 case, the company does not get the capital, and they have still incurred substantial flotation costs
Not as common as it previously was
Real-World Tip: “Corporate America is turning more fickle in choosing finance partners on Wall Street …[m]ore companies are ditching the Wall Street underwriters they had selected for initial public offerings and picking different investment banks when it comes time to complete follow-on stock sales.” So read the opening lines of an article in the December 19, 1996 issue of The Wall Street Journal. But why is this occurring? According to the article, the phenomenon is attributable in part to the fact that many offerings quickly rise above the offering price, leading issuers to feel that their shares were underpriced (and that they left millions of dollars “on the table” as a result).
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13. 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
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14. 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
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15. IPO Underpricing
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”
Lecture Tip: More recent evidence (see “Underpricing, Overhang, and the Cost of Going Public to Preexisting Shareholders” by Dolvin and Jordan in the 2007 issue of Journal of Business Finance and Accounting) suggests that underpricing has little impact on owners, as very few preexisting shares are sold in IPOs.
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16. Figure 15.2
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17. Figure 15.3
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18. 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.
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19. 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
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20. 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
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21. 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
Lecture Tip: You may wish to link the stock behavior associated with the ex rights date to that of the ex dividend date. Point out that a time line could be drawn that applies to stocks trading ex rights as well as stocks trading ex dividend. Both dividend and rights declarations involve setting an ex date, which is two days before the record date. In both situations, the share price reacts on the ex date to reflect the value of the right or dividend that would not be received if the shares were purchased after the ex date.
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22. Example: Rights Offering
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 must 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* = 270
Price per share = 270 / 11 = 24.55
Value of a right = 25 – = .45
Buy 10 rights = .45*10 = = share price (difference is due to rounding)
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23. 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
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24. 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 but with longer maturity
Easier to renegotiate than public issues
Lower costs than public issues
Although, coupons may be higher.
Real-World Tip: Corporate issuers continued to exploit the relatively low level of long-term interest rates in 1996 and In December 1996, IBM issued 100-year bonds with a face value of $850 million. As evidence of the low required return, note that the yield on these bonds is only one-tenth of one percent higher than on similar 30-year IBM bonds. In all, approximately
$3.6 billion worth of 100-year bonds were issued between November 1995 and December Previous “century bond” issuers include Walt Disney Company, Coca-Cola and Yale University.
Real-World Tip: An interesting article on private placements appeared in the third quarter 1997 issue of the Dallas Federal Reserve Bank’s Economic Review. Stephen Prowse, an economist with the Dallas Fed, described the structure of the private placement market, calling private placements “a significant source of funds for U.S. corporations.” He noted that, on average, private placements tend to be “larger than bank loans and smaller than public bonds.” In a similar fashion, the maturity of privately placed debt tends to be longer than that of bank debt but shorter than that of publicly placed debt. Finally, he noted that borrowers in the private placement market tend to fall between those who rely on bank loans and those who rely on public debt, in terms of firm size.
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25. Shelf Registration
Permits a corporation to register a large issue with the SEC and sell it in small portions over a two-year period
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
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26. 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?
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27. Ethics Issues
Brokers have been known to sell securities based on sales scripts that have little to do with the information provided in the prospectus. Also, investors often make investment decisions before receiving (or reading) the prospectus. Who is at greater fault in this case?
Traditionally, IPO share allocations have been reserved for the underwriting syndicates’ best customers. What ethical implications exist.
There are also legal implications for allocating shares. In July, 2004, Piper Jaffray was fined $2.4 million for selling shares of “hot” IPOs to the executives of firms that they have either recently done business with or with whom they were trying to gain business.
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28. Comprehensive Problem
A company wants to raise $20 million.
The subscription price is $40, and the current stock price is $50.
The firm currently has 5,000,000 shares outstanding.
How many shares must be issued?
How many rights will it take to purchase one share?
What is the value of a right?
Shares issued = $20,000,000/40 = 500,000
Rights to buy one share = 5,000,000/500,000 = 10
Total investment = 10* = 540
Price per share = 540 / 11 = 49.09
Value of a right = 50 – = .91
Buy 10 rights = .91*10 = subscription price = 49.10, which equals the share price (difference is due to rounding)
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29. Chapter 15
End of Chapter
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