Chapter 14 Lecture –
Raising Capital
15-1
14-1
Learning Objectives
After studying this chapter, you should be able to:
LO1 Explain the venture capital market and its role in the
financing of new, high-risk ventures.
LO2 Describe how securities are sold to the public and the
role of investment banks in the process.
LO3 Explain initial public offerings and identify some of the
costs of going public.
14-2
Venture Capital
“Private Equity”



Private financing for new, high risk businesses in
exchange for stock
 Individual investors
 Venture capital firms
Usually involves active participation by VC
Ultimate goal: take company public; the VC will
benefit from the capital raised in the IPO

Hard to find

Expensive
14-3
Venture Capital Stage Financing




Funding provided in several stages
Contingent upon specified goals at each stage
First stage
 “Ground floor” or “Seed money”
 Fund prototype and manufacturing plan
Second Stage
 “Mezzanine” financing
 Begin manufacturing, marketing & distribution
Choosing a Venture Capitalist





Financial strength
Compatible management style
Obtain and check references
Contacts
Exit strategy
14-4
Selling Securities to the Public
1.
2.
3.
4.
5.
6.
Management obtains permission from the Board
of Directors
Firm files a registration statement with the SEC
SEC examines the registration during a 20-day
waiting period
Securities may not be sold during the waiting
period
A preliminary prospectus, called a red herring, is
distributed during the waiting period
- If problems, the company amends the
registration, and the waiting period starts over
Price per share determined on the effective date
of the registration and the selling effort begins
14-5
Issue Methods

Public Issue






Registration with SEC required
General cash offer = offered to general public
Rights offer = offered only to current
shareholders
IPO = Initial Public Offering = Unseasoned new
issue
SEO = Seasoned Equity Offering
Private Issue


Sold to fewer than 35 investors
SEC registration not required
14-6
Methods of Issuing New Securities
14-7
Underwriters

Underwriting services:






Formulate method to issue securities
Price the securities
Sell the securities
Price stabilization by lead underwriter in the
aftermarket
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 in the market
14-8
Tombstone
• Investment banks
in syndicate
divided into
brackets
• Firms listed
alphabetically
within each
bracket
• “Pecking order”
• Higher bracket =
greater prestige
http://usequities.nyx.com/ipo-center/recent-ipo
• Underwriting
success built on
reputation
http://www.renaissancecapital.com/ipohome/press/ipofilings.aspx
14-9
Firm Commitment Underwriting





Issuer sells entire issue to underwriting syndicate
Syndicate resells issue to the public
Underwriter makes money on the spread between
the price paid to the issuer and the price received
from investors when the stock is sold
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
14-10
Best Efforts Underwriting



Underwriter makes “best effort” to sell the
securities at an agreed-upon offering price
Issuing company bears the risk of the
issue not being sold
Offer may be pulled if not enough interest
at the offer price


Company does not get the capital and they
have still incurred substantial flotation costs
Not as common as it used to be
14-11
Dutch or Uniform Price Auction
Buyers:
•Bid a price and number of shares
Seller:
•Work down the list of bidders
•Determine the highest price at which they can sell the
desired number of shares
• All successful bidders pay the same price per share.
• Encourages aggressive bidding
14-12
Dutch or Uniform Price Auction Example
The company wants to sell 1,500 shares of stock.
Bidder
A
B
C
D
E
Quantity
500
400
250
350
200
Bid
$20
18
16
15
12
The firm will sell 1,500 shares at $15 per share.
Bidders A, B, C, and D will get shares.
Bidder
A
B
C
D
E
Quantity
500
400
250
350
200
Bid
$20
18
16
15
12
Σ Qty
500
900
1,150
1,500
1,700
14-13
Green Shoe Provision





“Overallotment Option”
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
In all IPO and SEO offerings but not in ordinary debt offerings
Lockup Agreements



Not legally required but common
Restricts insiders from selling IPO shares for a specified time
period
 Common lockup period = 180 days
Stock price tends to drop when the lockup period expires due
to market anticipation of additional shares hitting the Street
14-14
IPO Underpricing




IPO pricing = very difficult
 No current market price available
Dutch Auctions designed to eliminate first
day IPO price “pop”
Underpricing causes the issuer to “leave
money on the table”
Degree of underpricing varies over time
14-15
The Partial Adjustment Phenomenon


During SEC registration, a company will
set a “file price range”
Just before the IPO, the final price is
determined


The final price can be below, inside, or above
the file price range
Historically, IPOs with a final price above
the file range have been far more
underpriced than those with a final price
below or inside the file range
14-16
IPO Underpricing Reasons


Underwriters want offerings to sell out
 Reputation for successful IPOs is critical
 Underpricing = insurance for
underwriters
 Oversubscription & allotment
 “Winner’s Curse”
Smaller, riskier IPOs underprice to attract
investors
14-17
Seasoned Equity Offerings


Stock prices tend to decline when new equity is
issued
Signaling explanations:



Equity overvalued: If management believes
equity is overvalued, they would choose to
issue stock shares
Debt usage: Issuing stock may indicate firm has
too much debt and can not issue more debt
Issue costs

Issue costs for equity – direct and indirect - are
significantly more than for debt
14-18
The Cost of Issuing Securities
14-19
The Cost of Issuing Securities



Average total direct costs ≈ 10.4%
 Largest direct cost, gross spread average ≈ 7.2%
 Direct costs very large, especially for issues < $10
million (25.22%)
Underpricing cost ≈ 19.3%
Patterns:
 Substantial economies of scale
 Costs of selling debt < issuing equity
 IPO costs > SEO costs
 Straight bonds < Convertible bonds
14-20
IPO Cost – Example



The Faulk Co. has just gone public under a firm commitment
agreement. Faulk received $32 for each of the 4.1 million
shares sold. The initial offering price was $34.40 per share,
and the stock rose to $41 per share in the first few minutes
of trading. Faulk paid $905,000 in legal and other direct
costs and $250,000 in indirect costs. What was the flotation
cost as a percentage of funds raised?
The net amount raised is the number of shares offered
times the price received by the company, minus the costs
associated with the offer, so:
Net amount raised = (4,100,000 shares)($32) – 905,000 –
250,000 = $130,045,000
14-21
IPO Cost – Example




Next, we can calculate the direct costs. Part of the
direct costs are given in the problem, but the
company also had to pay the underwriters. The stock
was offered at $34.40 per share, and the company
received $32 per share. The difference, which is the
underwriters’ spread, is also a direct cost.
Total direct costs = $905,000
+ ($34.40 – 32)(4,100,000 shares) = $10,745,000
We are given part of the indirect costs, but the
underpricing is another indirect cost.
Total indirect costs = $250,000
+ ($41 – 34.40)(4,100,000 shares) = $27,310,000
14-22
IPO Cost – Example




Total costs = $10,745,000 + 27,310,000 =
$38,055,000
The flotation costs as a percentage of the amount
raised is the total cost divided by the amount
raised, or:
Flotation cost percentage =
$38,055,000 / $130,045,000
Flotation cost percentage = .2926, or 29.26%
14-23
Types of Long-term Debt


Bonds – public issue of long-term debt
Private issues

Term loans




Private placements



Direct business loans from commercial banks,
insurance companies, etc.
Maturities 1 – 5 years
Repayable during the life of the loan
Similar to term loans with longer maturity
Easier to renegotiate than public issues
Lower costs than public issues

No SEC registration
14-24
Shelf Registration


SEC Rule 415
Permits firm to register a large issue with the SEC and sell it
in small portions

Reduces flotation costs

Allows 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
preceding three years
14-25
What Agencies Regulate
Securities Markets?




The Securities and Exchange Commission (SEC) regulates:
 Interstate public offerings.
 National stock exchanges.
 Trading by corporate insiders.
 The corporate proxy process.
The Federal Reserve Board controls margin requirements.
States control the issuance of securities within their
boundaries.
The securities industry, through the exchanges and the
National Association of Securities Dealers (NASD), takes
actions to ensure the integrity and credibility of the trading
26
system.
What about Qatar?
14-26
How are Start-up Firms
Unusually Financed?



Founder’s resources
Angels
Venture capital funds



Most capital in fund is provided by institutional
investors
Managers of fund are called venture capitalists
Venture capitalists (VCs) sit on boards of
companies they fund
14-27
Differentiate Between a Private
Placement and a Public Offering



In a private placement, such as to angels or VCs, securities
are sold to a few investors rather than to the public at large.
In a public offering, securities are offered to the public and
must be registered with SEC.
Privately placed stock is not registered, so sales must be to
“accredited” (high net worth) investors.
 Send out “offering memorandum” with 20-30 pages of
data and information, prepared by securities lawyers.
 Buyers certify that they meet net worth/income
requirements and they will not sell to unqualified
investors.
14-28
Why Would a Company Consider
Going Public?

Advantages of going public
 Current stockholders can diversify.
 Liquidity is increased.
 Easier to raise capital in the future.
 Going public establishes firm value.
 Makes it more feasible to use stock as
employee incentives.
 Increases customer recognition.
14-29
Disadvantages of Going Public






Must file numerous reports.
Operating data must be disclosed.
Officers must disclose holdings.
Special “deals” to insiders will be more
difficult to undertake.
A small new issue may not be actively
traded, so market-determined price may not
reflect true value.
Managing investor relations is timeconsuming.
14-30
What are the Steps of an IPO?





Select investment banker
 Reputation and experience in this industry
 Existing mix of institutional and retail (i.e.,
individual) clients
 Support in the post-IPO secondary market
 Reputation of analyst covering the stock
File registration document (S-1) with SEC
Choose price range for preliminary (or “red
herring”) prospectus
Go on roadshow
Set final offer price in final prospectus
14-31
Would Companies Going Public Use a
Negotiated Deal or a Competitive Bid?

A negotiated deal.


The competitive bid process is only
feasible for large issues by major firms.
Even here, the use of bids is rare for equity
issues.
It would cost investment bankers too
much to learn enough about the company
to make an intelligent bid.
14-32
What Would the Sale be on an
Underwritten or Best Efforts Basis?



Most offerings are underwritten.
In very small, risky deals, the
investment banker may insist on a
best efforts basis.
On an underwritten deal, the price is
not set until
 Investor interest is assessed.
 Oral commitments are obtained.
14-33
How an IPO Would be Priced





Since the firm is going public, there is no established
price.
Banker and company project the company’s future
earnings and free cash flows
The banker would examine market data on similar
companies.
Price set to place the firm’s P/E and M/B ratios in
line with publicly traded firms in the same industry
having similar risk and growth prospects.
On the basis of all relevant factors, the investment
banker would determine a ballpark price, and
specify a range (such as $10 to $12) in the
preliminary prospectus.
14-34
What is a Roadshow?



Senior management team, investment banker, and
lawyer visit potential institutional investors
Usually travel to ten to twenty cities in a two-week
period, making three to five presentations each day.
Management can’t say anything that is not in
prospectus, because company is in “quiet period.”
What is “Book Building?”



Investment banker asks investors to indicate how
many shares they plan to buy, and records this in a
“book”.
Investment banker hopes for oversubscribed issue.
Based on demand, investment banker sets final offer
price on evening before IPO.
14-35
What are Typical First-day Returns?








For 75% of IPOs, price goes up on first day.
Average first-day return is 14.1%.
About 10% of IPOs have first-day returns greater
than 30%.
For some companies, the first-day return is well
over 100%.
There is an inherent conflict of interest, because
the banker has an incentive to set a low price:
 to make brokerage customers happy.
 to make it easy to sell the issue.
Firm would like price to be high.
Note that original owners generally sell only a small
part of their stock, so if price increases, they
benefit.
Later offerings easier if first goes well
14-36
What are the Long-term Returns to
Investors in IPOs?


Two-year return following IPO is lower than for
comparable non-IPO firms.
On average, the IPO offer price is too low, and the
first-day run-up is too high.
14-37
What are the Direct Costs of an IPO?


Underwriter usually charges a 7% spread between offer price
and proceeds to issuer.
Direct costs to lawyers, printers, accountants, etc. can be over
$400,000.
What are the Indirect costs of an IPO?
Money left on the table
(End of price on first day - Offer price) x Num
If firm issues 7 million shares at $10, what
are net proceeds if spread is 7%?
Gross proceeds = 7 x $10 million
= $70 million
Underwriting fee = 7% x $70 million
= $4.9 million
Net proceeds
= $70 - $4.9
14-38
If firm issues 7 million shares at $10,
what are net proceeds if spread is 7%?
Gross proceeds
= 7 x $10 million
= $70 million
Underwriting fee = 7% x $70 million
= $4.9 million
Net proceeds
= $70 - $4.9
= $65.1 million
14-39
What are equity carve-outs?


A special IPO in which a parent company creates a
new public company by selling stock in a subsidiary
to outside investors.
Parent usually retains controlling interest in new
public company.
What is a rights offering?



A rights offering occurs when current shareholders
get the first right to buy new shares.
Shareholders can either exercise the right and buy
new shares, or sell the right
40 to someone else.
Wealth of shareholders doesn’t change whether
they exercise right or sell it.
14-40
What is meant by going private?



Going private is the reverse of going public.
Typically, the firm’s managers team up with
a small group of outside investors and
purchase all of the publicly held shares of
the firm.
The new equity holders usually use a large
amount of debt financing, so such
transactions are called leveraged buyouts
(LBOs).
41
14-41
Real world IPOs
42
14-42
Advantages of going private



Gives managers greater incentives and more
flexibility in running the company.
Removes pressure to report high earnings in the
short run.
After several years as a private firm, owners
typically go public again. Firm is presumably
operating more efficiently and sells for more.
Disadvantages of going private


Firms that have recently gone private are normally
leveraged to the hilt, so it’s
43difficult to raise new
capital.
A difficult period that normally could be weathered
might bankrupt the company.
14-43
firm exercise a bond call
provision?




If interest rates have fallen since the bond was
issued, the firm can replace the current issue with a
new, lower coupon rate bond.
However, there are costs involved in refunding a
bond issue. For example,
 The call premium.
 Flotation costs on the new issue.
The NPV of refunding compares the interest savings
benefit with the costs of the refunding. A positive
NPV indicates that refunding today would increase
the value of the firm.
44
However, it interest rates are expected to fall
further, it may be better to delay refunding until
some time in the future.
14-44
Managing debt risk with project
financing



Project financings are used to finance a specific
large capital project.
Sponsors provide the equity capital, while the rest
of the project’s capital is supplied by lenders and/or
lessors.
Interest is paid from project’s cash flows, and
borrowers don’t have recourse.
45
14-45
Managing debt risk with
securitization


Securitization is the process whereby financial
instruments that were previously illiquid are
converted to a form that creates greater liquidity.
Examples are bonds backed by mortgages, auto
loans, credit card loans (asset-backed), and so on.
46
14-46