0. 16
Raising Capital

1. 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

2. 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

3. 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.

4. 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.

5. 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

6. Table I

7. Table II

8. 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

9. 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

10. 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)

11. 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.

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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”

18. Figure 16.2

19. Figure 16.3

20. 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?

21. 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

22. 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.

23. 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

24. 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

25. 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

26. 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
$20.50 to public
Price paid ($) $
$19.60
$20.00
$20.20
$20.50

27. 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

28. 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

29. 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* = 270
Price per share = 270 / 11 = 24.55
Value of a right = 25 – = .45
Buy 10 rights = .45*10 = = difference due to rounding

30. 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

31. 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

32. 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

33. 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.

34. 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”

35. 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.

36. 16
End of Chapter