1. © Prentice Hall, 2000 1 Chapter 13 How Companies Raise Long-Term Capital Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

2. © Prentice Hall, 2000 2 Learning Objectives è Describe how venture capitalists assist entrepreneurs in financing new businesses. è Discuss the functions performed by an investment banker in helping a firm wanting to raise funds in the financial markets. è Describe how the financial markets respond to new security offerings. è Discuss the regulatory requirements that must be met before bringing a new security issue to market.

3. © Prentice Hall, 2000 3 Learning Objectives (Cont.) è Explain the mechanics of a rights offering and indicate when it may be superior to a public offering as a way of selling new common stock. è Calculate the value of a right. è Discuss the advantages and dis- advantages of raising funds through a private placement rather than through a public offering.

4. © Prentice Hall, 2000 4 Venture Capitalists Venture capitalists are investors who take an equity position in new businesses. These investment are often high-risk propositions promising enormous returns if the venture survives. Venture capitalists make their money by cashing in their holdings when the company goes public.

5. © Prentice Hall, 2000 5 Rad Neato Enterprises: First-Stage Financing Balance Sheet (Market Values) Cash from venture $ 500,000 Equity from first-$ 500,000 capitalstage financing Growth option on$1,000,000Equity held by$1,000,000 Boomboard marketfounders Total Assets$1,500,000Total Equity$1,500,000

6. © Prentice Hall, 2000 6 Limiting Downside Risks è Staged financing è Limit founder’s compensation è Assist in management of the company

7. © Prentice Hall, 2000 7 Rad Neato Enterprises: Second-Stage Financing Balance Sheet (Market Values) Cash from venture $1,000,000 Equity from second-$1,000,000 capitalstage financing Other tangible assets$ 500,000Equity from first-$1,250,000 stage financing Growth option on$3,250,000Equity held by$2,500,000 Boomboard marketfounders Total Assets$4,750,000Total Equity$4,750,000

8. © Prentice Hall, 2000 8 Market Response to New Security Offerings The market response to new security offerings of all kinds is either negative or neutral. Market reaction is more negative for common stock issues than to preferred stock or debt offerings. Convertible of- ferings show a more negative reaction than straight-debt issues.

9. © Prentice Hall, 2000 9 Information Symmetry Hypothesis Used to explain market response to new security offerings, the information symmetry hypothesis relies on the fact that managers, as insiders, have better information about a firm’s prospects than outside investors. Management would (presumably) exploit this informational asymmetry by issuing “overpriced” securities.

10. © Prentice Hall, 2000 10 Information Asymmetries and the Financing Pecking Order The creditability problem associated with information asymmetries helps explain the strong corporate preference for internal versus external funding. It also explains why firms that must raise external capital issue securities in ascending order of risk: first debt, then hybrid securities, then external equity as a last resort. This set of preferences is known as a financing pecking order.

11. © Prentice Hall, 2000 11 Competitive Bids versus Negotiated Offerings In making a public offering, a firm must select an investment banker on either a competitive bid basis or a negotiated basis. èNegotiated Offering: Firm works with a particular investment banker to work out the features and characteristics of the offering. èCompetitive Bid: Firm decides on the details of the offering and then asks a number of investment bankers for bids.

12. © Prentice Hall, 2000 12 Functions of Investment Bankers è Advice and council èTerms and characteristics of the issue èPricing the issue è Underwriting èFirm commitment èBest efforts è Marketing the issue

13. © Prentice Hall, 2000 13 Securities Registration Process è Register the issue with the SEC. èRegistration Statement èProspectus è SEC approves or disapproves the registration statement. è Firm may issue a preliminary prospectus while waiting for approval. è Upon approval, a final prospectus to the public is issued.

14. © Prentice Hall, 2000 14 SEC Approval and Issue Quality In passing on the registration statement, the SEC is not certifying the quality of the issue. It is only making sure that there is full disclosure of relevant facts.

15. © Prentice Hall, 2000 15 Flotation Costs on Public Offerings è Cost of readying the issue for market èAdministrative, legal, and accounting expenses in preparing the registration statement èPrinting and mailing costs è Underwriting fees

16. © Prentice Hall, 2000 16 Shelf Registration Under Rule 415, companies can file a single registration statement outlining their long- term financing plans over a two-year period. èFirm can sell securities at any time by taking them “off the shelf.” èThis gives qualifying firms flexibility in issuing securities. èThis reduces the flotation costs on small transactions.

17. © Prentice Hall, 2000 17 Rights Offering Instead of selling a new issue through a public offering,some firms will first offer the securities to their shareholders on a privileged-subscription basis. These rights offerings are mandatory in those firms where shareholders have a preemptive right.

18. © Prentice Hall, 2000 18 Mechanics of a Rights Offering è Rights offering must be registered with the SEC è Shareholders receive one right for each share of common they own è Rights are like options; shareholders can èExercise them èSell them èLet them expire unexercised

19. © Prentice Hall, 2000 19 Rights Offering - An Example Suppose a share of stock is currently selling rights-on for $50; the subscription price is $45 and it takes four rights to subscribe to one share. What’s the value of a right?

20. © Prentice Hall, 2000 20 Right Offering - An Example The value of a right is R = (P-S)/(N+1) Where R is the value of one right, P is the rights on price, S is the subscription price, and N is the number of shares required for one new share. The value of the right is: R = ($50 - $45)/(4+1) = $1

21. © Prentice Hall, 2000 21 Rights Offering versus Public Offering è Advantages of Rights Offering èWith a low enough subscription price, the cost of underwriting can be eliminated. èFirm can tap a market that already exists. èCurrent shareholders can retain their present ownership proportion. è Disadvantages of Rights Offering èMore costly to complete than a public offering èDoes not broaden the shareholder base

22. © Prentice Hall, 2000 22 Private Placements è Direct sale of securities to a limited number of institutional investors è Exempt from SEC registration è SEC Rule 144A allows institutional investors to trade private placements among themselves

23. © Prentice Hall, 2000 23 Advantages of Private Placements è Avoids lengthy and costly SEC registration process è Speed of placement è Minimizes disclosure of strategically sensitive information è Can be tailored to meet the needs of borrowers and lenders è Easier to negotiate terms relative to a public offering

24. © Prentice Hall, 2000 24 Disadvantages of Private Placements è Private investors typically require tighter and more restrictive loan covenants. è Investors typically demand higher yields.