Chapter
Fifteen
Raising Capital
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
15.1
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
15.2
Chapter Outline
 The Financing Life Cycle of a Firm: Early-Stage
Financing and Venture Capital
 The Public Issue
 The Basic Procedure for a New Issue
 The Cash Offer
 The Decision to Go Public
 New Equity Sales and the Value of the Firm
 The Cost of Issuing Securities
 Rights
 Dilution
 Issuing Long-Term Debt
15.3
Venture Capital 15.1
 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
15.4
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?
15.5
The Public Issue 15.2
 Public issue – the creation and sale of
securities that are intended to be traded on
public markets
 All companies listed on the TSX come under
the Ontario Securities Commission’s
jurisdiction
 All securities traded on the TSX Venture
Exchange come under the jurisdiction of the
Alberta Securities Commission
15.6
Alberta Securities Commission
 The Alberta Securities Commission (ASC) is the industryfunded organization responsible for overseeing the capital
market in Alberta. The Commission administers the Alberta
Securities Act, the Securities Regulation and Alberta
Securities Commission Rules.
 This legislation is designed to ensure that Alberta’s capital
market operates fairly and efficiently for participants, and that
investors have timely, accurate information on which to base
investment decisions. It also ensures that those who sell
securities in Alberta are registered and that they conduct
themselves according to applicable laws and professional
standards.
 In addition to regulating Alberta’s capital market, the ASC
oversees the activities of the TSX Venture Exchange (formerly
the Canadian Venture Exchange or CDNX) and the Investment
Dealers Association of Canada (IDA).
 Source: http://www.albertasecurities.com
15.7
Selling Securities to the Public 15.3
 Management must obtain permission from the Board
of Directors
 Firm must prepare and distribute copies of a
preliminary prospectus (red herring) to the Securities
Commissions in the jurisdictions where they want to
sell the shares
 The Securities Commissions study the preliminary
prospectus and notify the company of any
deficiencies (usually takes a minimum of 2 weeks)
 When the prospectus is approved by the Securities
Commissions, the price is set and the securities
dealers can begin selling the new issue
15.8
Underwriters 15.4
 Services provided by underwriters




Formulate method used to issue securities
Price the securities
Sell the securities
Price stabilization by lead underwriter
 Syndicate – group of underwriters 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
15.9
Firm Commitment Underwriting




Also called a “bought deal”
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 Canada
15.10
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 situation, the
company does not get the capital and they have still
incurred substantial flotation costs
15.11
Overallotment Option
 Overallotment Option / 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
15.12
IPO Underpricing 15.5
 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”
15.13
Table 15.3 – What Determines Subscription Prices?
15.14
Table 15.4 – Initial Aftermarket Performance
15.15
Figure 15.1 – Average Initial Returns for SECRegistered IPO’s: 1960 to 1998
15.16
New Equity Issues and Price
 Stock prices tend to decline when new equity is
issued
 Possible explanations for this phenomenon
 Managerial information and signaling
 Debt usage and signaling
 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
15.17
The Cost of Issuing Securities 15.7
 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
 Overallotment (Green Shoe) option – cost of
additional shares that the syndicate can purchase after
the issue has gone to market
15.18
Rights Offerings: Basic Concepts 15.8
 More correct name is the Pre-emptive Right
 A Rights Offer is an issue of new common stock
offered to existing shareholders
 A Rights Offer allows current shareholders avoid the
dilution that occurs with a new stock issue, since they
are able to purchase a pro rata share of the new issue
 One “Right” is given for each common stock owned.
The Right will:
 Specify number of shares that can be purchased
 Specify purchase price
 Specify time frame
 Rights usually trade on the same exchange as the
company’s stock
15.19
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
15.20
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?
15.21
Rights Offering Example continued
Funds to be raised
Subscripti on Price
10,000,000

20
 500,000
Number of new shares to be issued 
# of Old Shares Outstandin g
# of New Shares to be Issued
5,000,000

500,000
 10
Number of rights to purchase one new share 
M0  S
N 1
25  20

10  1
 $0.45
Value of a right 
Where: M0 = Value of the Common, rights-on
S = Subscription price
N = Number of rights for one new share
15.22
More on Rights Offerings
 Ex-rights – the price of the stock will drop by the value of the
right on the day that the stock no longer carries the “right”
 Standby underwriting – underwriter agrees to buy any shares
that are not purchased through the rights offering
 Stockholders can either exercise their rights or sell them –
they are not hurt by the rights offering either way
 Rights offerings have lower issue costs than other methods of
selling new equity
 Until the early 1980’s, rights offerings were the most popular
method of raising new equity in Canada
 Bought deals have replaced rights offers as the prevalent form
of equity issue
15.23
Dilution 15.9
 Dilution is a loss in value for existing shareholders
 Percentage ownership – if the firm sells new shares, the
old shareholder’s proportionate ownership goes down, if
they don’t buy an equal percentage of the new shares
offered.
 Example: Jill currently owns 5,000 shares in a firm with
50,000 shares outstanding. She thus owns 10% of the firm.
The firm then sells another 50,000 shares. If Jill does not
purchase any of the new shares, her ownership falls to 5%.
15.24
Dilution
 Market value – dilution (a drop in market price per share)
occurs when the firm accepts negative NPV projects,
thereby destroying shareholder wealth.
 Book value and EPS – both the book value per share and
the Earnings per Share (EPS) will drop when new common
stock is issued when the market-to-book ratio is less than
one
15.25
Types of Long-term Debt 15.10
 Bonds – long-term debt
 May be sold through a public offering or a private placement
 Private issues
 Term loans
 Direct business loans from commercial banks, insurance
companies, etc.
 Maturities usually in the range of 1 – 5 years, although may be
much longer
 Term loans are usually amortized over the life of the loan
 Private placements
 Similar to term loans with longer maturity
 Easier to renegotiate than public issues
 Lower costs than public issues
15.26
Quick Quiz
 What is venture capital and what types of firms receive
it?
 What are some of the important services provided by
underwriters?
 What 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?
15.27
Summary 15.11
 Venture capital is first-stage financing
 Costs of issuing securities can be quite large.
 Bought deals are far more prevalent for large issues than
regular underwriting
 Direct and indirect costs of going public can be substantial
 In Canada, the bought deal is cheaper and dominates the new
issue market
15.28
Some Useful Links to More Information

The links section on the Alberta Securities Commission site provides access to lots
of great resources. To access the Alberta Securities Commission, go to
www.albertasecurities.com.
From there, you can find links to each of the following.

Provincial Securities Regulators:
Canadian Securities Administrators (CSA)
National Cease Trade Order Database
Alberta Securities Commission (ASC)
British Columbia Securities Commission (BCSC)
Autorité Des Marchés Financiers (AMF)
Manitoba Securities Commission
New Brunswick Securities Commission
Securities Commission of Newfoundland and Labrador
Nova Scotia Securities Commission
Ontario Securities Commission (OSC)
Saskatchewan Financial Services Commission
Securities Office, Prince Edward Island
15.29
 Access to information
SEDI (System for Electronic Disclosure by Insiders)
SEDAR (System for Electronic Document Analysis and Retrieval)
 Other Industry Regulators:
Investment Dealers Association of Canada
Mutual Fund Dealers Association of Canada
Market Regulation Services Inc. (RS Inc.)
Institute of Chartered Accountants of Alberta (ICAA)
Joint Forum of Financial Market Regulators
 Other Law Enforcement Agencies & Gov't:
Government of Alberta
Royal Canadian Mounted Police
Calgary Police Service
Edmonton Police Service
Report Economic Crime Online (RECOL)
15.30
 Canadian Stock Exchanges:
TSX Exchange
TSX Venture Exchange
Montreal Exchange
 Industry Resources:
Alberta Capital Market Foundation (ACMF)
Canadian Investor Protection Fund (CIPF)
Canadian Securities Institute (CSI)
Investment Funds Institute of Canada (IFIC)
Investor Learning Centre of Canada (ILC)
Omudsman for Banking Services and Investments
Financial Services Ombudsnetwork
Financial Consumer Agency of Canada
 International Securities & Regulatory Organizations:
Securities & Exchange Commission (SEC)
International Organization of Securities Commissions (IOSCO)
North American Securities Administrators Association (NASAA)