1. Equity financing for private companies
Nature of Long Term Financing:

the institutional setting for raising capital;

the nature of equity,

debt and other instruments.
The initial capital that is required to start a business is usually provided by the entrepreneur herself and her immediate
family. Growth almost always requires additional outside capital. Infusion of outside capital affects the control of the
company.
Potential sources:
1) Angel investor is a high-net-worth individual who provides financial backing for small startups or
entrepreneurs, typically in exchange for ownership equity in the company.
In recent years the role of angel investors has changed, allowing start-ups to rely on angel financing for much longer into
their life cycle. There are two reasons for this change:
-
The number of angel investors has grown enormously, and within the angel community, angel groups have
formed. An angel group is a group of angel investors who pool their money and decide as a group which
investments to fund. The Angel Capital Association lists over 400 angel groups on its Web site and estimates that
the typical angel group had 42 members and invested an average of $2.42 million in 9.8 deals per year in 2015. In
addition, it estimates that there are over 300,000 individuals making angel investments in any given year.
- The cost of setting up a business has dropped dramatically. Twenty years ago a new company would have to
make relatively large capital investments in servers, databases, and other back office technologies. Today, almost
all of these functions can be outsourced, allowing individuals to start and grow their businesses with much less
capital.
The typical size of an angel investment ranges from several hundred thousand dollars for individual investors to a few
million dollars for angel groups.
Angel financing often occurs at such an early stage in the business that it is difficult to assess a value for the firm. Angel
investors often circumvent this problem by holding either a convertible note or a SAFE (simple agreement for future
equity) rather than equity.
- these securities are convertible into equity when the company finances with equity for the first time.
- their terms allow angel investors to convert the value of their initial investment plus any accrued interest into equity
at a discount (often 20%) to the price paid by new investors.
- structuring the deal in this way allows angels and entrepreneurs to agree on terms without agreeing on a value for
the firm, instead postponing the valuation decision until the firm is more mature and becomes attractive to venture
capitalists.
2) Crowdfunding - individuals, charities, and businesses (including start-ups) can raise money from the public to
support a project, campaign, or person (Financial Conduct Authority). Investment levels can be minute, in some cases
less than $100.
How crowdfunding works?
Crowdfunding usually occurs on a website platform that allows businesses or individuals to raise money and investors
to provide that money. The business or individual often explains their project in a pitch (с целью) to attract loans or
investment from as many people as possible.
Crowdfunding in the UK. Equity crowdfunding - regulated in the UK by the Financial Services and Markets Act
2000 even before the “crowdfunding” term was coined.
FCA regulates equity and loan-based crowdfunding (peer-to-peer lending). Donation and reward-based
crowdfunding platforms are spared from the regulation as they don’t offer equity stakes or returns.
Alternative Crowdfunding Models According to the FCA
FCA Crowdfunding
Definition
Category
Peer-to-Peer Business
Loan-based Crowdfunding
Secured and unsecured debt-based transactions
Lending
between individuals/institutions and businesses with
trading history; most of which are SMEs.
Peer-to-Peer Business
Loan-based Crowdfunding
Property-based debt transactions between individuals
Lending (Real Estate)
/institutions and businesses with trading history; most of
which are SMEs.
Peer-to-Peer Consumer
Loan-based Crowdfunding
Debt-based transactions between individuals/institutions
Lending
to an individual; most are unsecured personal loans
Business sell their invoices or receivables to a pool of
Invoice trading
Loan-based Crowdfunding
primarily high net worth individuals or institutional
investors.
Equity-based Crowdunding Investment-based
Sale of registered securities, by mostly early stage firms,
Crowdunding
to both retail, sophisticated and institutional investors.
Equity-based Crowdunding Investment-based
Direct investment into property by individuals, usually
(Real Estate)
Crowdunding
through the sale of a registered security in a special
purpose vehicle (SPV).
Debt-based securities
Investment-based
Individuals purchased debt-based securities (typically
Crowdunding
a bond or debenture) at a fixed interest rate. Lenders
receive full repayment plus interest paid in maturity.
Reward-based
Pre-payment or RewardDonors have an expectation that fund recipients will
Crowdunding
based Crowdunding
provide a tangible but non-financial rewards or product in
exchange to their contribution. This model falls outside of
FCA purview.
Donation-based
Donation-based
Non-investment model in which no legally binding
Crowdunding
Crowdunding
financial obligation is incurred by fund recipients to
donors; no financial or material returns are expected by
the donor. This model falls outside of FCA purview.
Model Name
Benefits of crowdfunding
• A useful way for organizations or individuals to access finance that banks or other lenders are not prepared to offer, or
only offer at a high cost.
• Consumers may also find it rewarding to be involved in a business or project as it develops, or to support a local
initiative or other individuals.
• Crowdfunding platforms may offer higher returns than those available from other financial products, however, there are
usually greater risks.
Risks of crowdfunding
• Different platforms and loans carry different levels of risk.
• FCA recommends seeking out more information about high-risk investments and the important questions to ask before
you invest.
Investment-based crowdfunding
• Due to the potential for losses, FCA regards (рассматривает) investment-based crowdfunding as a high-risk investment
activity.
• It is very likely that investors will lose all their money.
• Most investments are in shares or debt securities in start-up companies and will often result in a 100% loss of capital as
most start-up businesses fail.
• Investors will not be repaid and/or dividends will not be paid if the company they invest in fails or there is a fraud.
• If investors hold shares in a business or project, it is unlikely that income in the form of dividends will be paid.
• The value of their investment may be diluted if more shares are issued, and this is likely as many start-up businesses
undergo multiple rounds of funding.
• Investors should be prepared to wait for a return on their investment, as even successful start-up businesses tend to take
time to generate income.
• If firms do handle clients’ money without FCA’s permission or authorization, there will be no protection for investors in
place.
• This is a particular risk if a platform fails and becomes insolvent.
• Most platforms do not have a way investors can cash in their investment (a secondary market).
FCA: How investors should protect themselves?
Before investing, investors must understand:
• What due diligence has been performed (the checks made on the business or person looking for funding)?
• The level of risk (and that investors are happy with this level of risk).
• The value for money offered by an investment (after charges, taxes, and allowance for defaults (на невыполнение
обязательств)).
• Investors should only invest money they can afford to lose.
FCA’s view on crowdfunding:
• Given the typical risks involved, under our (FCA) regulations, firms are only allowed to promote crowdfunding offers to
certain investors.
• These include experienced or sophisticated investors, or ordinary investors who confirm that they will not invest more
than 10% of their net investable assets.
Crowdfunding in the U.S.
• Historically, in the U.S., the SEC (Securities and Exchange Commission) has enforced strict rules that only allowed
“qualified investors” (investors with a high net worth) to invest in private equity issues. These rules effectively barred
U.S. crowdfunding sites from offering equity to investors. As a result, companies like Kickstarter and Indiegogo offered
investors other payoffs, such as the products the company would ultimately produce. However, in 2012, the landscape
changed dramatically when Congress passed the JOBS Act that exempted crowdfunding from the historical restrictions
on private equity investments. The act allowed equity investment by non-qualified individuals so long as the
crowdfunding sites did not charge a commission for the transaction. In the wake of this act (Вслед за этим поступком),
several equity-based platforms, such as AngelList, emerged that charged fees based on the performance of the
investment.
• In 2015, the SEC released Regulation Crowdfunding, which outlined more specific rules for firms and investors. For
example, in any year, companies may raise no more than $5 million through crowdfunding, and individuals whose
annual income or net worth is less than $107,000 can invest no more than $2,200, or up to 5% of their annual income or
net worth (whichever is less) in crowdfunding-based equity.
For the European Union
The Regulation (EU) 2020/1503 on European crowdfunding service providers for business aims to establish common rules
for providing crowdfunding services, authorizing and supervising service providers, and ensuring transparent marketing
practices. Key points include the necessity for providers to be officially authorized, act in the best interests of clients, and
avoid conflicts of interest. They must also conduct due diligence on project owners, handle complaints transparently, and
adhere to prudential safeguards. National authorities are responsible for vetting (для проверки), authorizing, and monitoring
providers, as well as cooperating with the European Securities and Markets Authority (ESMA). Additionally, measures
are in place to ensure investor protection, including fair information disclosure, default rate reporting, and a reflection period
for non-professional investors.
The regulation excludes personal crowdfunding and campaigns over €5 million, which fall under different regulations.
Moreover, it establishes technical standards and procedures for compliance through implementing and delegated (həvalə
edilmiş) acts. The regulation has been in effect since 10 November 2021, aiming to facilitate cross-border crowdfunding
while enhancing investor protection. It forms part of the EU's efforts to enable crowdfunding platforms to offer services
across national borders under a single regime, enhancing access to finance for small investors and businesses, particularly
start-ups, while providing better protection and guarantees for investors.
3) Although the pool of capital available from angel financing continues to grow, most firms’ financing needs eventually
reach the point of tapping into larger funding sources, such as venture capital.
A venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of
young firms.
Two practical examples will be discussed in the workshop 1 (question number 2 and 3).
Typically, institutional investors, such as pension funds, are the limited partners. The general partners run the
venture capital firm; they are called venture capitalists. Venture capital firms offer limited partners a number of
advantages over investing directly in startups themselves.
• Venture firms invest in many start-ups, so limited partners benefit from this diversification.
• Benefit from the expertise of the general partners.
• However, these advantages come at a cost - GP charges substantial fees to run the firm.
• An annual management fee of about 1.5% - 2.5% of the fund’s committed capital.
• GP also takes a share of any positive return the fund generates in a fee referred to as carried interest.
• Most firms charge 20%, but some take up to 30% of any profits as carried interest.
The table lists the 12 most active U.S. venture capital firms in 2021, based on the number of deals completed.
In return, venture capitalists often demand a great deal of control. Evidence suggests that venture capitalists typically
control about one-third of the seats on a startup’s board of directors and often represent the single largest voting block
(P. Gompers and J. Lerner, The Venture Capital Cycle (MIT Press, 1999)).
 The importance of the venture capital sector has grown enormously in the last 50 years. As Figure 23.1 shows,
growth in the sector increased in the 1990s and peaked at the height of the Internet boom. Although the size of the
industry decreased substantially in the 2000s, it has since recovered to the level it was in the late 1990s.
• In 2020, venture capital-backed start-ups in the U.S. raised over $133 billion in 6305 separate deals, for an average
investment of about $21.1 million per deal.
What are the consequences of such control?
• Although entrepreneurs generally view this control as a necessary cost of obtaining venture capital, it is an important
benefit of accepting venture financing.
• Venture capitalists use their control to protect their investments; therefore, they may perform a key nurturing and
monitoring role for the firm.
• For example, Professors Bernstein, Giroud, and Townsend found that when a direct flight between the location of the
key venture capitalist and the firm is introduced, making it easier to do this nurturing, the firm does better.
4) A private equity firm is organized like a venture capital firm but invests in the equity of existing privately held firms
rather than start-up companies.
• They initiate their investment by finding a publicly traded firm and purchasing the outstanding equity, thereby taking
the company private in a leveraged buyout (LBO) transaction. (LBO выкуп с использованием заемных средств)
• In most cases, private equity firms use debt and equity to finance purchases.
• Private equity firms share venture capital firms’ advantages and charge similar fees.
• One key difference between private equity and venture capital is the magnitude invested. (величина вложенных
средств)
• For example, the Figure shows that the total LBO transaction volume in 2021 (the peak of the private equity market)
was over $1 trillion, with an average deal size of over $1 billion.
Global LBO Volume and Number of Deals
Global leveraged buyout (выкуп) volume as measured by dollar volume and number of deals. Private equity activity
surged (резко возросла) during the 2006–2007 period, reflected in record volume, deal size, and number of deals.
While the dollar volume declined dramatically during the global financial crisis in 2008–2009, it has recovered and
reached a new record in 2021.
The Table lists the top 10 private equity funds in 2021 based on the total
investment capital each firm raised over the last five years.
5) Institutional investors (mutual and pension funds, insurance companies, endowments, and foundations) manage large
quantities of money.
• They are major investors in many different types of assets, so, not surprisingly, they are also active investors in private
companies.
• Institutional investors may invest directly in private firms or indirectly by becoming limited partners in venture capital
or private equity firms.
• Mutual funds directly invested over $8 billion in start-ups in 2015, and 39% of venture-backed IPOs in 2016 received
mutual fund financing before going public (S. Kwon, M. Lowry, and Y. Qian, “Mutual Fund Investments in Private
Firms,” Journal of Financial Economics 136 (2020): 407–433).
6) Corporate Investors.
Many established corporations purchase equity in younger, private companies. Google Ventures and Intel Capital are
two well-known examples of “venture capital” arms of existing corporations. A corporation that invests in private
companies is known by different names, including corporate (or strategic) investor/partner. Most of the other types
of investors in private firms that we have considered so far are primarily interested in the financial return that they will
earn on their investments. Corporate investors, by contrast, might invest for corporate strategic objectives in addition
to the desire for investment returns. For example, in May 2009, automaker Daimler invested $50 million for a 10%
equity stake in electric car maker Tesla as part of a strategic collaboration on the development of lithium-ion battery
systems, electric drive systems, and individual vehicle projects.
Venture Capital: Funding and Ownership Features
When a company founder decides to sell equity to outside investors for the first time, it is common practice for private
companies to issue preferred stock rather than common stock to raise capital.
Preferred stock issued by mature companies usually has preferential dividend, liquidation, and sometimes special
voting rights relative to common shareholders. While the preferred stock issued by young companies typically does
not pay regular cash dividends, it usually gives the owner the option to convert it into common stock, and so is
called convertible preferred stock. If the company runs into financial difficulties, the preferred stockholders have a
senior claim on the assets of the firm relative to any common stockholders (who are often the employees of the firm).
If things go well, then these investors will convert their preferred stock and receive all the rights and benefits of
common stockholders.
Each time the firm raises money is referred to as a funding round, and each round will have its own set of securities
with special terms and provisions. After a potential initial “seed round,” it is common to name the securities
alphabetically, starting with Series A, Series B, etc.
For example, RealNetworks, which was founded by Robert Glaser in 1993, was initially funded with an investment of
approximately $1 million by Glaser. As of April 1995, Glaser’s $1 million initial investment in RealNetworks
represented 13,713,439 shares of Series A preferred stock, implying an initial purchase price of about $0.07 per share.
RealNetworks needed more capital, and management decided to raise this money by selling equity in the form of
convertible preferred stock.
The company’s first round of outside equity funding was Series B preferred stock. RealNetworks sold 2,686,567
shares of Series B preferred stock at $0.67 per share in April 1995. After this funding round, the distribution of
ownership was as follows:
The Series B preferred shares were new shares of stock being sold by RealNetworks. At the price the new shares were
sold for, Glaser’s shares were worth $9.2 million and represented 83.6% of the outstanding shares.
The value of the prior shares outstanding at the price in the funding round ($9.2 million in this example) is called the
pre-money valuation.
The value of the whole firm (old plus new shares) at the funding round price ($11.0 million) is known as the postmoney valuation.
The difference between the pre- and post-money valuation is the amount invested. In other words,
Post-money Valuation = Pre-money Valuation + Amount Invested
(23.1)
In addition, the fractional ownership held by the new investors is equal to
Percentage Ownership = Amount Invested / Post-money Valuation
(23.2)
Dilution of ownership with successive fundings:
Ownership (%) = (pre-money valuation/post-money valuation) × previous round ownership share.
Your ownership:
After series A funding: (9.2/9.2) = 100%
After series B funding: (9.2/11) × 1.00 = 0.836 = 83.6%
Series B investor ownership:
After series B funding: (1.8/11) = 0.164 = 16.4%
Over the next few years, RealNetworks raised three more rounds of outside equity in addition to the Series B funding
round. Note the increase in the amount of capital raised as the company matured:
In each case, investors bought preferred stock in the private company. These investors were very similar to the profile
of typical investors in private firms that we described earlier.
 Angel investors purchased the Series B stock.
 The investors in Series C and D stock were primarily venture capital funds.
 Microsoft purchased the Series E stock as a corporate investor.
Example 1.):
Your Startup has raised capital as follows:
Solution: a) How much did you raise in each round?
Solution: b) Assuming no other securities were issued, what fraction of the firm’s shares were held by yourself after
each round?
Funding Series
Seed
Seed A
Seed B
Seed C
Your share
100%
75%
49.43%
35%
Firm value
12 million
16 million
44 million
170 million
Solution: c) What is the distribution of ownership across each security after the Series C financing?
For Series C investors: the total monetary value of their investment = $170 – $120 = $50 million.
Hence, their ownership is = amount invested (the total monetary value of their investment )/post-money valuation = (170120)/170 = 29.41%. So, the value remaining is 170 – 50 = $120 million.
For Series B investors: fraction of share after series B round = (44-29)/44 = 15/44 = 34.09%.
Their share of the remaining monetary value = 34.09% × $120 = $40.91. Hence, their share after Series C funding =
$40.91/$170 = 24.06%. So, the remaining value is 120 – 40.91 = $79.09 million.
For Series A investors: fraction of shares after Series A round = $4/$16 = 25.00%.
Their share of the remaining monetary value = 25% × $79.09 = $19.77. Hence, their share after Series C funding =
$19.77/$170 = 11.63%. So, the value remaining is 79.09 – 19.77 = $59.52 million.
For common shareholders (you): your share after Series C funding = $59.52. Hence, your share after Series C funding =
$59.52/$170 ≈ 35.00%
Investor types
Series C
Series B
Series A
You
Total monetary value
($)
170 - 120 = 50
120 * 15/44 = 40.91
79.09 * 4/16 = 19.77
59.32
Distribution of ownership across each
security after the Series C financing
Remaining value ($)
50/170 = 0.2941= 29.41%
15/44 × 120/170 = 0.3409 × 0.7058 = 24.06%
4/16 ×29/44 × 120/170 = 11.63%
100 – (29.41 + 24.06 + 11.63) ≈ 35%
170 - 50 = 120
120 – 40.91 = 79.09
79.09 – 19.77 = 59.32
Solution: d) If your firm is ultimately sold for $700 million, what multiple of money did each series earn? What will you
receive in $
terms and multiple of money? (Assume all preferred shares convert to common.)
Investor types
Series C
Series B
Series A
You
Multiples of money each series earns
29.41% × $700 = $205.87, i.e., 205.87/50 = 2.12X
24.06% × $700 = $ 168.42, i.e., 168.42/15 = 11.23X
11.63% × $700 = $ 81.41, i.e., 81.41/ 4 = 20.35X
35.00% × $700 = $ 245.00, i.e., 245/12 = 20.42X
Example 2.) Funding and Ownership
You founded your firm two years ago. Initially, you contributed $100,000 of your money and, in return, received
1,500,000 shares of stock. Since then, you have sold an additional 500,000 shares to angel investors. You are now
considering raising even more capital from a venture capitalist. The venture capitalist has agreed to invest $6 million with
a post-money valuation of $10 million for the firm.
a. Assuming this is the venture capitalist’s first investment in your company, what percentage of the firm will she own?
b. What percentage will you own?
c. What is the value of your shares?
Solution:
a. Because the VC will invest $6 million out of the $10 million post-money valuation, her ownership percentage is
6/10 = 0.6 = 60%
b. Post-money Valuation = Pre-money Valuation + Amount Invested
$10 m = Pre-money Valuation + $6m
Pre-money Valuation = $10 m - $6m = $4m
Total pre-money shares outstanding = 2 million (Your 1.5 m and 0.5m Angle investor).
Price per share =
$4 million
= $𝟐 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
2 million shares
Total number of shares outstanding post − money valuation =
$10 million
= 𝟓 𝐦𝐢𝐥𝐥𝐢𝐨𝐧
$2
Thus, the VC will receive 3 million shares (60% of 5m) for her investment. You will own
1 500 000
5 000 000
= 𝟑𝟎% 𝐨𝐟 𝐭𝐡𝐞 𝐟𝐢𝐫𝐦
c. The post-transaction valuation of your shares is $3 million ($2 * 1.5 m).
Venture Capital: Financing Terms
Outside investors generally receive convertible preferred stock. When things go well these securities will ultimately
convert to common stock and so all investors are treated equally. But when they don’t, these securities generally give
preference to outside investors. Here are some typical features these securities have:
Liquidation Preference. The liquidation preference specifies a minimum amount that must be paid to these security
holders—before any payments to common stockholders— in the event of a liquidation, sale, or merger of the company. It
is typically set to between 1 (1x) and 3 times (3x) the value of the initial investment.
Seniority. It is not uncommon for investors in later rounds to demand seniority over investors in earlier rounds, to ensure
that they are repaid first. When later round investors accept securities with equal priority, they are said to be pari passu.
Example: If Series B investors have 3x liquidity preference and seniority over Series A investors (1x liquidity
preference), then after liquidation, Series B investors must be first paid 3 times their initial investments. Only after this,
do Series A investors receive their liquidity preference for the remaining value, based on their ownership percentage.
Participation Rights. Holders of convertible shares without participation rights must choose between demanding their
liquidation preference or converting their shares to common stock and forfeiting their liquidation preference and other
rights. Participation rights allow the investors to “double dip” and receive both their liquidation preference and any
payments to common shareholders as though they had converted their shares. Often, these participation rights are capped
once the investor receives 2–3 times their initial investment (when there is no cap, the securities are referred to as fully
participating).
Anti-Dilution Protection. If things are not going well and the firm raises new funding at a lower price than in a prior
round, it is referred to as a “down round.” Anti-dilution protection lowers the price at which investors in earlier rounds
can convert their shares to common, effectively increasing their ownership percentage in a down round at the expense of
founders and employees.
Board Membership. New investors may also negotiate the right to appoint one or more members to the board of
directors of the firm as a way of securing control rights.
All of these provisions are negotiable, and so the actual terms in each funding round will depend on the relative
bargaining power between the firm and the new investors at the time.
For example, in a selection of Silicon Valley start-ups in 2021, new investors obtained seniority about 24% of the time in
up rounds, but more than 50% of the time in down rounds.
Similarly, while only about 20% of funding rounds gave investors participation rights, 40% received them in down
rounds.
Finally, over 95% of deals include anti-dilution protection, though the exact form of protection varies.
Because of these protections, prior to conversion, preferred shares are generally worth more than the firm’s common
stock and the true value of each series may differ.
Example 1.): Liquidation Preference and VC Payouts
Suppose that in addition to common shares, your firm raised $6 million in Series A financing with a 1x liquidation
preference, no participation rights, and a $20 million post-money valuation, and $10 million in Series B financing with a
3x liquidation preference, no participation rights, and a $40 million post-money valuation, with Series B senior to Series
A.
If you sell the firm after the Series B financing, what should be the minimum sale price before the common shareholders
receive anything?
What is the minimum sale price for all investors to convert their shares?
Solution
Series B has a liquidation preference of 3 × 10 = $30 million,
Series A has a liquidation preference of 1 × 6 = $6 million.
Therefore, for a sale price of $30 million or less, only Series B will be paid, and any additional amount up to $36 million
will be paid to Series A. Common shareholders will receive nothing unless the share price (value) exceeds $36 million.
• Because the Series B investors will receive up to 3x their investment from their liquidation preference, they will not be
willing to convert their shares to common stock (and forfeit their liquidation preference).
• Unless the value of the firm has at least tripled from the time of their investment or a sale price of 3 × 40 = $120
million.
• At that price, because Series B investors own 10/40, i.e., 25% of the firm, they will first receive 0.25 × 120 = $30
million as common shareholders and are just willing to convert.
• The remaining value of 120 – 30 = $90 million now needs to be distributed among the Series A and common
shareholders.
• The share of Series A is 6/20 = 30%. Thus, they receive 0.3 × 90 = $27 million, and the rest ($63 million) goes to the
common shareholders.
Example 2.): Liquidation Preference and VC Payouts
Assume that in addition to common shares, your firm raised $10 million in Series A financing with a 2x liquidation
preference, no participation rights, and a $25 million post-money valuation.
What is the minimum sale price such that the Series A investors will convert their shares?
Solution
• Because the Series A investors will receive up to 2x their investment from their liquidation preference, they will not be
willing to convert their shares to common stock (and forfeit their liquidation preference).
• Unless the firm’s value has at least doubled from the time of their investment or a sale price of 2 × 25 = $50 million.
• At that price, because Series A investors own 10/25 of the firm, they will first receive 10/25 × 50 = $20 million as
common shareholders and are just willing to convert.
• The remaining value of 50 – 20 = $30 million now needs to be distributed among the common shareholders.
The life cycle of a typical successful Start-up
This chart illustrates the life cycle of a typical successful start-up firm from its first launch to its exit as a public firm via
an initial public offering. The chart shows changes in the firm valuation as well as changes in the distribution of
ownership through each funding round.
• Note, the number of such firms begins in their thousands but only a few (4 in our case) survive at the exit point
• Our representative firm begins with an idea and two cofounders, who raise $500,000 from an angel investor in exchange
for 20% of the company in six months (0.5 year).
• Six months (year 1) later they have a first prototype and receive $2 million in VC seed funding with a pre-money
valuation of $6 million. As part of this round, they create an employee option pool with 15% of the shares, which they can
use to attract new employees and fill out their executive team.
• Within a year (year 2) they have their first customer and raise $6 million in a Series A round for a post-money value of
$18 million.
• At this point the founders each hold 16% of the firm’s shares and are sharing control with their VC backers
(спонсорами).
• As the product continues to gain traction and the company grows, it raise $15 million, then $25 million, and finally $50
million in three funding rounds over the next 4 years, watching its valuation grow from $18 million to $200 million.
• With each round, they top up their employee option pool to 10% so they can retain and recruit top talent.
• After 9 years, the company has established itself as a market leader, is consistently profitable, and undertakes an IPO in
which it raises $200 million with an opening market cap (с начальной рыночной капитализацией) of $2.2 billion. At
this point, the founders hold 5.5% of the company and their shares are each valued at $121 million.
• While the figure illustrates a “typical” path of a successful firm, it is important to remember that not all start-ups
succeed.
• The top of the chart shows an estimate of the proportion of firms at each stage: VCs will hear thousands of pitches
before selecting 100 for seed funding.
• Of those, only 56 survive to raise a follow-up Series A round, and the pool continues to shrink leaving only 4 of the
original 100 to go public.
• So, while in this example the Series A investors earned 11.4% × $2.2 billion = $250 million or nearly 42 times (250/6)
their initial investment, their expected multiple of money must take into account that only a small proportion of their
investments ever have a successful exit.
• In this case, if we assume they do not recover anything on their unsuccessful investments (4 successful out of 56), their
expected money multiple would only be 4/56 × 42 = 3x, corresponding to 31/7 − 1 = 17% expected annual return over
their 7-year investment.
Issues with Startup valuation
• When a new valuation round occurs, it is common in the popular press to quote the post-money valuation as the “current
value” of the company.
• Recall that the post-money valuation is calculated as the share price in the round times the total number of shares
outstanding assuming all preferred shareholders convert their shares.
• But although the post-money valuation for a private firm is a similar calculation to the market capitalization of a public
company, there is an important difference:
• While most shareholders of a public company hold the same securities, that is typically not the case for startups, where
the terms in each funding round can differ substantially.
• As a result, the post-money value can be misleading.
Example: Issues with Startup valuation
A start-up whose prior funding round closed at $3 per share with a postmoney value of $300 million (and so has 100
million shares outstanding).
They are now looking to raise $100 million to expand their operations. Suppose investors are willing to pay $8.50 per
share if the series has a 1x liquidation preference and equal priority, but will pay $10 per share if the series has a 3x
liquidation preference and is senior.
Thus, depending on the terms, the post-money value will be either $950 million [($100/$8.5 + 100) * $8.5] or $1.1 billion
[($100/$10)+100)*$10]; some firms might choose the latter in order to enjoy the publicity of achieving so-called unicorn
status (start-ups with valuations over $1 billion, without being listed on the stock market).
Obviously, the true value of the company does not depend on the specific liquidation rights of its investors.
In reality, the higher post-money valuation achieved by providing better terms to the new investors is artificial:
While the new shares are worth $10 per share, the old shares, which have inferior liquidation rights, are worth less.
These terms can also create a serious conflict of interest - if in the future the firm were to receive an acquisition offer for
$400 million, the new investors would receive a 300% return (having priority for their liquidation preference of $300
million), while earlier investors would split the remaining $100 million, and founders and employees would likely receive
little or nothing.
In a 2017 study, W.Gornall and I.Strebulaev estimate that reported unicorn (start-ups with valuations over $1 billion)
valuations are exaggerated by more than 50% on average (“Squaring Venture Capital Valuations with Reality,” Journal of
Financial Economics 135 (2020): 120–143).
2. Important Theoretical Concepts in Corporate Finance
• Information Asymmetry (IA)
Two issues created by IA
• Adverse Selection
• Moral Hazard
Information asymmetry is a key idea in corporate finance, deeply rooted in the study of how information affects
economic decisions.
Asymmetric information—a situation that arises when one party’s insufficient knowledge about the other party involved
in a transaction makes it impossible to make accurate decisions when conducting the transaction. It is an important aspect
of financial markets.
Financial intermediaries, including banks and other lending institutions, exist in part due to the inherent information
asymmetry that characterizes many financial market interactions. These intermediaries serve a crucial role in mitigating the
effects of information inequality by engaging in activities that balance the informational disparities. They perform due
diligence, assess credit risk, and engage in monitoring that individual investors may not have the resources or expertise to
undertake.
The existence and persistence of information asymmetry within financial markets can lead to two fundamental problems:
adverse selection and moral hazard.
Adverse selection occurs prior to a transaction when one party exploits their informational advantage, potentially leading to
a selection of inferior investment opportunities.
For example: Adverse selection in financial markets occurs when the potential borrowers (in the case of bonds/loans),
issuers (in the case of equity), or those looking for insurance, who are the most likely to produce an undesirable
(adverse) outcome. The bad credit risks, funding for private benefits, excessive risktaking—are the ones who most
actively seek out a loan/investments/insurance and are thus most likely to be selected.
Moral hazard may arise post-transaction if the party with more information takes actions that could negatively affect the
other party, knowing that the risk is not equally shared due to the information gap.
For example: Moral hazard in financial markets is the risk (hazard) that the borrower/issuer might engage in undesirable
(immoral) activities from the lender’s/investor’s point of view because they make it less likely that the loan will be paid
back or investors may be duped. Because moral hazard lowers the probability that the loan (funds) will be repaid
(prudently used), lenders (investors) may decide that they would rather not make a loan/investment.
The problems created by adverse selection and moral hazard are significant impediments to well-functioning financial
markets.
Information asymmetry between firms and investors
Why issue securities?
1. Finance projects: initial financing, reinvestments, and expansions.
2. Risk sharing: a risk-averse entrepreneur wants to diversify her portfolio by selling some of her shares in the firm.
3. Liquidity reasons: an entrepreneur or venture capitalist may want to cash in to move on to other projects, or a bank
may want to securitize loans to increase its loan able funds.
In all three cases, the issuance is motivated by gains from trade between the issuer and potential investors.
4. A fourth motivation, though, is unrelated to gains from trade: the issuer may want to push overvalued assets to
investors.
The firm may:
• Place equity privately with a small group of investors.
• Conduct an initial public offering or a seasoned offering.
When issuing (buying) new claims, the firm (its investors) should be preoccupied with two types of informational
asymmetries: between the issuer and the investors and among investors
Let’s discuss asymmetric information between insiders and investors and the associated lemon problem.
The lemons problem is an issue of information asymmetry between the buyer and seller of an investment or product. The
name comes from calling a defective used car a "lemon." The possibility of adverse selection means that only used cars left
on the market will ultimately be lemons.
Asymmetric information between insiders and investors
Investors have imperfect knowledge of:
▪ the firm’s prospects;
▪ the value of assets in place;
▪ the value of pledged collateral (залогового обеспечения);
▪ the issuer’s potential private benefit, or
▪ any other firm characteristics that affect the profitability of the investment.
Accordingly, investors are concerned that they might purchase overvalued claims.
• As noted earlier, a standard theme of information economics is that gains (to both parties) from trade are often left
unexploited in markets plagued (страдающих) by adverse selection.
• Akerlof (1970) - how markets for used wares may shrink or disappear when sellers are better informed about their
quality than buyers.
• The application of this general idea to credit markets is that the issuer may raise less funds or raise funds less often when
the capital market has limited access to information about the firm.
Implication of Adverse Selection problem:
▪ Market breakdown: potential issuers may refrain (отказаться) altogether from going to the capital market or limit their
recourse to that market.
▪ Cross-subsidization: good issuers are forced to issue low-priced equity or dilute their equity stake by the suspicion of
low-quality issues.
Since, in an environment plagued by adverse selection, good issuers are unable to separate themselves from bad ones, the
phenomenon of adverse selection in the financial markets delivers a rich set of empirical predictions, such as:
First, adverse selection can account for the negative stock price reaction of equity offerings.
▪ This negative stock price reaction is not an obvious phenomenon. After all, investors may learn from an
announcement of a seasoned security offering that the firm enjoys new and attractive investment opportunities.
▪ Thus, the investors’ concern that the issue is motivated by the desire to depart with overvalued assets can rationalize
the negative stock price reaction.
▪ A good issuer who knows that investors undervalue assets in place is reluctant to issue shares under terms that would
be too favorable to investors.
▪ The issuer may then prefer to forgo (отказаться) a profitable investment opportunity (and possibly remain private in
the process).
▪ Share issues are then a bad signal about firm profitability.
▪ It can further be shown that the stock price reaction is less negative in good times, i.e., during booms.
A similar reasoning applies to share buybacks (in 2004, companies announced plans to repurchase $230 billion of their
stocks) - positive stock price reaction.
As Dobbs and Rehm (2005) note, a share repurchase conveys several signals:
a. management’s intention is not to engage in a wasteful acquisition or capital expenditure
b. management’s confidence that the company will not need the cash to cover future expenditures and
c. the absence of new investment opportunities.
Despite the third signal, financial markets generally applaud firms’ moves to buy shares back.
Second, the analysis provides some foundation for the pecking-order hypothesis.
• Myers (1984) and Myers and Majluf (1984) hypothesize that, relative to resorting (прибегая к помощи) to ‘external
finance’ (bonds, convertibles, or equity), firms prefer to use ‘internal finance’ (initial equity, retained earnings) to
finance their investments.
• If internal finance is an insufficient source of funds and external finance is required, firms first issue debt, the safest
security, hybrid securities such as convertibles, and finally, equity as a last resort.
• The idea is that neither internal finance nor default-free debt suffers from the informational asymmetries and the
cross-subsidization traditionally associated with external finance.
• If these do not suffice (достаточно) to meet the firm’s financing needs, the firm will still strive to issue low
information-intensity claims, that is, claims whose valuation is the least affected by the information asymmetry.
• The pecking-order hypothesis has received substantial empirical support.
• The primary source of financing for mature firms is retention, and outside finance is mainly debt finance since
seasoned equity issues are relatively rare.
• Another stylized fact corroborating (подтверждающий) the pecking-order hypothesis is the absence of stock price
reaction upon the announcement of a debt issue, in sharp contrast with the decline for a seasoned equity issue.
However, in practice things are more complicated than the interesting pecking order hypothesis suggests.
• First, while entrepreneurial equity accumulated from previous projects is indeed free from asymmetric information
problems, retained earnings are, in practice, endogenous (derived internally); in particular, the management of a firm
may need to convince its shareholders not to distribute large dividends and to keep cash for reinvestments.
• Whether shareholders are willing to go along with the management’s recommendation depends, among other things,
on their belief about the relative profitability of reinjecting cash into the firm. So, “internal finance” is not totally free
of informational problems.
Second, what constitutes low-information-intensity financing depends on the type of information that is privy
(тайный) to the issuer. Thus, one cannot always equate low-information-intensity financing with debt financing.
Third, other forces than asymmetric information may introduce departures from Myers and Majluf’s pecking-order
hypothesis and generate alternative pecking orders. For example,
▪ cash-poor firms’ viability concerns seriously limit their demand for debt finance.
▪ entrepreneurs’ and large investors’ exit strategies require issuing equity or, more generally, “information-intensive”
claims.
▪ small, high-growth firms do not behave according to the pecking-order hypothesis, even though these firms are
fraught with asymmetric information.
But Myers and Majluf’s pecking-order hypothesis remains a good starting point for the analysis.
Finally, the adverse selection implications provide a simple rationale for market timing - equity issues are more
frequent after the firm’s stock price or the stock market rises.
The idea is that in such circumstances, the concerns about adverse selection may be dwarfed by the fundamentals,
enabling issuers to raise equity. Thus, adverse selection becomes less relevant during booms.
Dealing with Adverse Selection: Signalling
The second theme borrowed from information economics is that the informed side of a market is likely to introduce or
accept distortions in contracting to signal attributes that are attractive to the uninformed side of the market (Spence
1974; Rothschild and Stiglitz 1976; Wilson 1977).
Good borrowers/issuers use various dissipative (рассеивать) signals to reassure investors and obtain good financing
conditions or financing at all. These signals include:
• Costly collateral pledging (дорогостоящий залог);
• Underpricing in IPO and certification by underwriters;
• Suboptimal risk-sharing;
• Short-term finance, and
• Hiring of a monitor, etc.
Initial Public Offering (IPO)/Unseasoned Issue.
Exiting an Investment in a Private Company
Exit Strategy: how investors eventually realize the return on their investment.
• In July 1997, the post-money valuation of the existing preferred stock of Real Networks was $8.99 per share.
• However, because Real Networks was still a private company, investors could not liquidate their investments by
selling their stock in the public stock markets.
• Investors exit in two main ways: through an acquisition or through a public offering.
Public Issue:
• First Time: IPO or unseasoned issue.
• Subsequent Issue: A seasoned issue refers to a new issue of shares for a company already listed on a stock exchange.
A seasoned issue of ordinary shares will typically be through a rights issue.
The motives collectively drive companies to consider going public through an IPO (Initial Public Offering) include:
- Raising Capital: To raise funds for business expansion, debt reduction, or other corporate purposes through the sale of
shares to the public;
- Liquidity for Existing Shareholders: Allowing existing shareholders, such as founders and early investors, to sell their
shares, thereby providing liquidity.
- Brand Visibility and Prestige: Enhancing the company's visibility and reputation by becoming a publicly traded entity,
which can attract customers, partners, and employees.
- Currency for Acquisitions: Using publicly traded shares as a means of currency for future acquisitions, enabling the
company to pursue mergers and acquisitions.
- Employee Incentives: Providing stock-based incentives to employees, which can help in attracting and retaining talent.
- Exit Strategy for Private Equity: Providing an exit opportunity for private equity investors and other early investors in
the company.
An important motive for an IPO is to raise cash, but this is by no means the only objective for going public. Commonly
cited reasons are that an IPO allows the firm to use its shares for future acquisitions and establishes a market price for the
shares. Raising equity capital for the company comes fairly low on the list of motives.
General process for European public equity issues
Stages in public offering
1. Preparatory period
Time relative to
issue date
6 months before
2. Prospectus draft
3. Listing announcement
4. Blackout period
3 months before
2 months before
1 months before
5. Pathfinder prospectus
14 days before
6. Pricing date
3 days before
7. Issue date
0 day
Activities
Advisor appointed: listing eligibility established, due diligence starts,
prospectus prepared.
Advisors submit first draft of prospectus to regulator
Company announces intention to list, draft prospectus published
Research by connected brokers is published; no more connected
research permitted after this period
Pathfinder prospectus issued with indicative issue price range,
underwriters appointed and begin selling, pre-underwriting
conferences held by company directors
Issue price set and shares are allocated to subscribers, final
prospectus published, price stabilization begins.
Shares starts trading
The main steps involved in making an initial public stock offering in the United States.
1. About one year before the company expects to go public, it appoints the managing underwriter (bookrunner) and
co-managers(s). The underwriting syndicate is formed.
2. The arrangement with the underwriters includes agreement on the spread (typically 7% for medium-sized IPOs)
and on the greenshoe option (typically allowing the underwriters to increase the number of shares bought by
15%).
3. About three months before issue date, the company files a registration statement with SEC. A preliminary
prospectus (red herring) is issued, and a preliminary price range is proposed.
4. A roadshow is arranged to market the issue to potential investors. The managing underwriter builds a book of
potential demands and, if appropriate, sets a new preliminary price range.
5. As soon as the SEC approves the registration statement, the company and underwriters agree on the issue price.
6. The following day, the underwriters allot stock (typically with averallotment), and trading starts.
7. The underwriters cover any short position by buying stock in the market ot by exercising their greenshoe option.
8. After the 40-day quiet period, the underwriters are permitted to make forward-looking statements about the
company and recommendations to buy the stock.
Alternative Issue Methods
• Public issue: traded on a stock exchange and the firm is required to register the issue with the stock exchange on which
it is listed.
• Private placement: issue is sold to only a few institutions. No registration with any stock exchange is needed.
• All IPOs are cash offers because, if the firm’s existing shareholders wanted to buy the shares, the firm would not need
to sell them publicly.
• IPO activity is positively related to the performance of stock markets, and this has been reflected in the slew (во
множестве) of new issues in Europe and the USA over the past few years.
Role of investment banks: Deals with the sale of securities, facilitate mergers and other corporate reorganizations, act as
brokers to both individual and institutional clients, and trade for their own accounts.
For corporate issuers, the investment banking function includes:
• Formulating the method used to issue new securities.
• Pricing the new securities.
• Selling the new securities.
Methods of issuing new securities
Method
Type
Definition
Public
Traditional negotiated
cash offer
Firm commitment
cash offer
The company negotiates an agreement with a bank to underwriter and
distribute the new shares. A specified number of shares are bought by
underwriters and sold at a higher price.
Company has underwriters sell as many of the new shares as possible at
the agreed-upon price. There is no guarantee concerning how much cash
will be raised. Some best efforts offerings do not use an underwriter.
Company has underwriters auction shares to determine the highest offer
price obtainable for a given number of shares to be sold.
Company offers the new equity direct to its existing shareholders.
Best effort cash
offer
Privileged
Subscription
Non-traditional cash
offer
Private
Dutch auction
cash offer
Pre-emptive right
issue
Standby rights
issue
Shelf cash offer
Competitive firm
cash offer
Direct placement
Like the pre-emptive rights issue, this contains a privileged subscription
arrangement with existing shareholders. The net proceeds are guaranteed
by the underwriters.
Qualifying companies can authorize all the shares they expect to sell
over a specified period and sell them when needed.
Company can elect to award the underwriting contract through a public
auction instead of negotiation.
Securities are sold direct to purchaser.
1. Firm commitment
• The bank (or a group of banks) buys the securities for less than the offering price and accepts the risk of not
being able to sell them. Thus, the banker underwrites the securities in a firm commitment.
• Risk minimization – forming an underwriting group (syndicate) for risk-sharing and to coordinate the selling
effort.
• The lead manager/s manages the issue and others sell the issue to their clients.
• Spread or discount: The difference between the underwriter’s buying price and the offering price.
• The underwriter may also get noncash compensation in the form of warrants or equity in addition to the spread.
Risk to the underwriter
• Firm commitment underwriting is a purchase–sale arrangement, and the syndicate’s fee is the spread.
• The issuer receives the full amount of the proceeds less the spread, and all the risk is transferred to the
underwriter.
• If the underwriter cannot sell all the shares at the agreed-upon offering price, it may need to lower the price on
the unsold shares.
• However, because the offering price usually is not set until the underwriters have investigated how receptive the
market is to the issue, this risk is usually minimal.
• This is particularly true with seasoned new issues because the price of the new issue can be based on prior
trades in the security.
Example of risk to underwriter
• The most notorious loss in the industry happened when the British government privatized British Petroleum.
• In a highly unusual deal, the company was taken public gradually.
• The British government sold its final stake in British Petroleum at the time of the October 1987 stock market
crash.
• The offer price was set just before the crash, but the offering occurred after the crash.
• At the end of the first day’s trading, the underwriters were facing a loss of $1.29 billion.
• The price then fell even further, until the Kuwaiti Investment Office stepped in and purchased a large stake in
the company.
2. Best Efforts
The underwriter bears risk with a firm commitment because it buys the entire issue. Conversely, the syndicate
avoids this risk under a best-efforts offering because it does not purchase the shares. Instead, it merely acts as an
agent, receiving a commission for each share sold. The syndicate is legally bound to use its best efforts and if the
issue cannot be sold at the offering price, it is usually withdrawn. This form of underwriting has become
relatively rare. For smaller IPOs, the underwriter commonly accepts the deal on a best efforts IPO basis.
(Dutch) Auction Pricing
Problem:
Fleming Education Software, Inc., is selling 500000 shares of the stocks in auction IPO. At the end of bidding
period, Fleming’s investment banks has received the following bids:
Price ($)
8.00
7.75
7.50
7.25
7.00
6.75
6.50
Number of
Shares Bid
25000
100000
75000
150000
150000
275000
125000
What will the offer price of the shares be?
Solution:
First, we compute the total number of shares demanded at or above any given price:
Price ($)
8.00
7.75
7.50
7.25
7.00
6.75
6.50
Number of
Shares Bid
25000
125000
200000
350000
500000
775000
900000
Fleming is offering a total of 500,000 shares. The winning auction price would be $7 per share, because investors
have placed orders for a total of 500,000 shares at a price of $7 or higher. All investors who placed bids of at least
this price will be able to buy the stock for $7 per share, even if their initial bid was higher.
In this example, the cumulative demand at the winning price exactly equals the supply. If total demand at this
price were greater than the supply, all auction participants who bid prices higher than the winning price would
receive their full bid (at the winning price). Shares would be awarded on a pro-rata basis to bidders who bid
exactly the winning price. Alternatively, in some case, if the demand is greater then all bidders get on a pro-rata
basis. E.g., if the total demand here is 625,000 then each investor gets 500,000/625,00 i.e. 80% of the bid number
at $7.00
Online Auction IPO: Open IPO
• In the late 1990s, the investment banking firm of WR Hambrecht and Company attempted to change the IPO
process by selling new issues directly to the public using an online auction IPO mechanism called Open IPO.
• Rather than setting the price itself in the traditional way, Hambrecht lets the market determine the price of the
stock by auctioning off the company.
• Investors place bids over a set period of time. An auction IPO then sets the highest price such that the number of
bids at or above that price equals the number of offered shares.
• All winning bidders pay this price, even if their bid was higher.
• The first Open IPO was the $11.55 million IPO for Ravenswood Winery, completed in 1999.
Other examples of Auction IPO
In 2004, Google went public using the auction mechanism, generating substantial interest in this alternative.
In May 2005, Morningstar raised $140 million in its IPO using a Hambrecht OpenIPO auction. But although the
auction IPO mechanism seems to represent a viable alternative to traditional IPO procedures, few companies have
used the strict auction method.
Today, a hybrid auction approach has become more popular. In a hybrid auction, investors bid as before, but the
listing company retains control to set the final price somewhat below the market clearing price, as well as
determine how the shares are allocated to the winning bidders. This hybrid method was used in 2020 by both
Airbnb and Doordash.
3. Book-building (particularly in the U.S)
Once an initial price range is established, the underwriters try to determine what the market thinks of the
valuation. They begin by arranging a road show, in which senior management and the lead underwriters travel
around the country (and sometimes worldwide). The purpose is to promote the company and explain the rationale
for the offer price to the underwriters’ largest customers - mainly institutional investors such as mutual funds and
pension funds. At the end of the road show, customers inform the underwriters of their interest by telling them
how many shares they may want to purchase. Although these commitments are nonbinding, the underwriters’
customers value their long-term relationships with the underwriters, so they rarely go back on their word. The
underwriters then add up the total demand and adjust the price until the issue is unlikely to fail. This process for
coming up with the offer price based on customers’ expressions of interest is called book-building.
The book-building process provides an early indication of demand for the IPO. If demand appears to be weak in
the target price range, the firm may choose to withdraw from the IPO process. In practice, about 20% of IPOs are
withdrawn, and only some of the firms that do withdraw ultimately go public.
Market support and greenshoe provision
In most offerings, the principal underwriter is permitted to buy shares if the market price falls below the offering
price. The purpose is to support the market and stabilize the price from temporary downward pressure.
Isn’t this a risk to the underwriter? Yes, and that’s why they agree to what is called the Greenshoe provision.
Greenshoe provision - gives the members of the underwriting group the option to purchase additional shares at
the offering price. Greenshoe options usually last for about 30 days and involve no more than a percentage
(usually less than 15 percent) of the newly issued shares. The greenshoe option is a benefit to the underwriting
syndicate and a cost to the issuer. If the market price of the new issue goes above the offering price within 30
days, the underwriters can buy shares from the issuer and immediately resell the shares to the public. If the issue
is not a success and the price falls, the underwriter exercises its greenshoe to minimize loss for supporting the
price.
Example of greenshoe allotment
Suppose an issuer specifies 3 million shares at £12.50 per share. The greenshoe provision allows for the issue of
an additional 450,000 shares at £12.50 per share. The underwriters short-sell the greenshoe allotment option. If
the issue is a success and its price rises, the underwriter exercises the greenshoe option (gain), covering its short
position (loss). If the issue is not a success and its price falls, the underwriter covers the short position (gain) by
repurchasing the greenshoe allotment of 450,000 shares (loss) in the aftermarket, thereby supporting the price.
Four characteristics of IPOs that puzzle financial economists and
are relevant for the financial manager:
1. On average, IPOs appear to be underpriced: The price at the end of trading on the first day is often
substantially higher than IPO price.
2. The number of issues is highly cyclical: When times are good, the market are flooded with new issues; when
times are bad, the number of issues dries up.
3. The cost of an IPO are very high, and it is unclear why willingly incur them.
4. The long-run performance of a newly public company (three to five years from the date of issue) is poor. That
is, on average a three to five year.
Puzzle 1: What is underpricing of an IPO?
• Sometimes, the underwriters misjudge dramatically. For example, in 2020, Airbnb went public with the sale of
51.3 million shares at $68 each. As soon as trading opened, dealers were flooded with orders to buy the stock, 70
million shares were traded, and the stock closed for $144.71, a gain of 113% for those offered the stock in the
IPO. The Airbnb issue was somewhat unusual. However, researchers find that, on average, investors who buy at
the issue price realize very high returns over the following days.
What explains underpricing?
During the 1999-2000 dotcom bubble, average underpricing reached as high as 65%, a remarkable rate of return for just
one day. Several theories help explain why IPO underpricing occurs, and in practice, they all carry some degree of truth.
1. Winner’s curse
Suppose that you successfully bid for a painting at an art auction. Should you be pleased? You now own the
painting, presumably (предположительно) what you wanted, but everybody else at the auction apparently thought
that the painting was worth less than you did. In other words, your success suggests that you may have overpaid.
This problem is known as the winner’s curse.
Unless bidders recognize this in their bids, the successful buyer will, on average, overpay. If bidders know the
danger, they are likely to adjust their bids correspondingly. The same problem arises when you apply for a new
issue of securities. For example, suppose that you decide to apply for every new issue of common stock. You will
find that you have no difficulty getting stock in the issues no one else wants.
But, when the issue is attractive, the underwriters will not have enough stock, and you will receive less stock than
you wanted. The result is that your money-making strategy may become a loser. If you are smart, you will play the
game only if there is substantial underpricing on average. Here, then, we have a possible rationale for the
underpricing of new issues. Uninformed investors who cannot distinguish which issues are attractive or not are
exposed to the winner’s curse. Companies and their underwriters know this and must underprice on average to
attract uninformed investors.
Winner’s curse in IPO: Example
If you, an average uninformed investor, ask for allocations, you will likely be stuck disproportionately with shares
in the hard-to-sell offerings. For example, if half the offerings earn +10% and are oversubscribed by a factor of 2,
and half the offerings earn −10% and are undersubscribed, it would be 0% on average, but you would most likely
receive an allocation of only half as many shares in the +10% offering as in the −10% offer, so his average rate of
return would be
Consequently, if shares, on average, earn a 0% rate of return, average investors should not participate as the return is
expected to be negative. To keep average investors in the market, underwriters must underprice their IPOs.
IPO Investors and the Winner’s Curse
Thompson will guarantee a piece of every IPO it is involved in. Suppose you are a customer. On each deal, you
must commit to buying 2000 shares. If the shares are available, you get them. If the deal is oversubscribed, your
allocation of shares is rationed in proportion to the oversubscription. Your market research shows that typically 80%
of the time, Thompson’s deals are oversubscribed 16 to 1 (there are 16 orders for every 1 order that can be filled),
and this excess demand leads to a price increase on the first day of 20.
However, 20% of the time, Thompson’s deals are not oversubscribed, and while Thompson supports the price in the
market (by not exercising the greenshoe provision and instead buying back shares), on average, the price tends to
decline by 5% on the first day. Based on these statistics, what is the average underpricing of a Thompson IPO?
What is your average return as an investor?
Solution:
First, note that the average first day return for the Thompson Brothers deals is large:
0.8*20%+0.2*(-5%)=15%
If Thompson had one IPO per month, after a year you would earn an annual return of
1.1512 − 1 = 435%
In reality you cannot earn this return. For successful IPO you will earn a 20% return, but you will only receive
2000/16 = 125 shares. Assuming an Average IPO price of $15 per share, your profit is
$15/share x (125 shares) x (20% return) = $375
For unsuccessful IPOs you will receive your full allocation of 2000 shares. Because these stocks tend to fall by 5%,
your profit is
$15 / share x (125 shares) x (- 5% return) = - $1500
Because 80% of Thompson’s IPOs are successful, your average profit is therefore
0.8*$375 + 0.20*(-$1500) = $0
That is, on average you are just breaking even! As this example shows, even though the average IPO may be
profitable, because you receive a higher allocation of the less successful IPOs, your average return may be much
lower. Also, if Thompson’s average underpricing were less than 15%, uninformed investors would lose money and
be unwilling to participate in its IPOs.
2. Underpricing: Means of creating demand
Many investment bankers and institutional investors argue that underpricing is in the interests of the issuing firm.
They say that a low offering price on an IPO raises the price when it is subsequently traded in the market and
enhances the firm’s ability to raise further capital.
3. Underwriters protecting themselves
Many argue that such underpricing is largely in the interests of the underwriters, who want to reduce the risk that
they will be left with unwanted stock and also to court popularity by allotting stock to favored clients.
4. Behavioral psychology argument
Think back to our example of Airbnb. If the company had sold 513 million shares at the market price of $144 rather
than $68, it would have raised an additional $7.2 billion. This is called the money left on the table. The cost of the
underpricing to Airbnb co-founders was about 43% of this figure, or just over $3 billion. So why weren’t they and
other shareholders hopping mad? Loughran and Ritter suggest that the explanation lies in behavioral psychology
and argue that the cost of underpricing may be outweighed in shareholders’ minds by the happy surprise of finding
that they are wealthier than they thought.
Puzzle 2: Cyclicality and Recent Trends
The figure shows the number and dollar volume of IPOs by year from 1975 to 2021.
• The number of IPOs peaked in 1999– 2000, while the dollar volume of IPOs peaked in 2021.
• In 2000, the volume of IPOs was unprecedented by historical standards; yet, within a year or two, the volume of IPOs
decreased significantly. This cyclicality by itself is not particularly surprising.
• We would expect there to be a greater need for capital in times with more growth opportunities than in times with fewer
growth opportunities.
Puzzle 3: Cost of an IPO
• A typical spread - that is, the discount below the issue price at which the underwriter purchases the shares from the
issuing firm - is 7% of the issue price.
• By most standards, this fee is large, especially considering the additional cost to the firm associated with underpricing.
• As Figure in the next slide shows, compared to other security issues, the total cost of issuing stock for the first time is
substantially larger than the costs for other securities.
Almost every IPO between $20 and $80 million the spread has been exactly 7%. Since it is difficult to believe that there
are no scale economies, this clustering at 7% is a puzzle.
• Even more puzzling is the seeming lack of sensitivity of fees to issue size. Although a large issue requires additional
effort, one would not expect the increased effort to be rewarded as lucratively. For example, Professors Hsuan-Chi Chen
and Jay Ritter found that almost all issues ranging in size from $20 million to $80 million paid fees of about 7%. It is
difficult to understand how a $20 million issue can be profitably done for “only” $1.4 million, while an $80 million
issue requires paying fees of $5.6 million.
• No researcher has provided a satisfactory answer to this puzzle.
• Chen and Ritter argue for implicit collusion by the underwriters, but in response to their paper, Robert Hansen finds no
evidence of any such collusion. He shows that there is low underwriting industry concentration, that there have been
significant new entrants in the IPO-underwriting market, and that a 7% spread is less profitable than normal investment
banking activities. One possible explanation is that by attempting to undercut its rivals, an underwriter may risk
signaling that it is not the same quality as its higher-priced competitors, making firms less likely to select that
underwriter.
• Professor Craig Dunbar examined this hypothesis. He found that underwriters charging slightly lower fees appear to
enjoy a greater market share, but those charging significantly lower fees have smaller market shares.
• Indeed, in support of the idea that the quality of the underwriter is important, underwriters that charge very high fees
gain market share.
Puzzle 4: Long-Run Underperformance
• The shares of IPOs generally perform very well immediately following the public offering.
• It is perhaps surprising that Professor Jay Ritter found that newly listed firms subsequently appear to perform
relatively poorly over the following three to five years after their IPOs.
• In follow-up studies, Professors Alon Brav, Christopher Geczy, and Paul Gompers found that IPOs between 1975 and
1992 underperformed by an average of 44% relative to the S&P 500 over the subsequent five years.
• Jay Ritter and Ivo Welch found that IPOs between 1980 and 2001 underperformed the market by an average of 23.4%
during the subsequent three years.
• However, Professors Hendrik Bessembinder and Feng Zhang have cast doubt on interpreting this evidence.
• They argue that the underperformance disappears when compared to firms with similar characteristics.
• In other words, the performance difference is due to the characteristics of the firms that choose to undergo an IPO
rather than the IPO itself.
IPO Example:
Your firm has 8 million shares outstanding and are about to issue 10 million new shares in an IPO. Along with the
underwriter you have set the IPO price at $15 per share, and the underwriting spread is 6%. You consider the IPO to be
a success, and the share price rose to $35 on the first day of trading. Determine:
i.
The amount you raised during the IPO.
ii.
The amount you paid as an underwriting spread.
iii.
The market value of your firm after the IPO.
iv.
Suppose that the post-IPO value of your firm is its fair market value. Suppose you could have issued shares
directly to investors at their fair market value in a perfect market with no underwriting spread and no
underpricing. In such a scenario, if you raise the same amount of funds that you would have with the investment
banker handling the underwriting, what would be the share price?
Solution:
i.
ii.
iii.
iv.
You are issuing 10 million shares at $15 per share. Your gross funds raised is $150 million. However, the
underwriter takes a 6% underwriting spread or 6% × $150 million = $9 million. Thus, your net raised is $150
- $9 = $141 million for your firm.
The underwriting spread is 6% × $150 million = $9 million.
Post IPO, you will have 10 million + 8 million = 18 million shares outstanding. Each of these shares is worth
$35 per share, and thus, the total market value of your firm = 18 million × $35 = $630 million.
If you go with the investment banker, you have 10 million + 8 million = 18 million shares outstanding after
the IPO. Each of these shares is worth $35 per share for a total market value of 18 million × $35 = $630
million. Also, if you use the underwriter, you issue 10 million shares at $15 per share for $150 million.
However, the underwriter takes the 6% underwriting spread or 6% × $150 million = $9 million, leaving only $141
million for your firm. Now, we can solve for the number of new shares issued and the price per share using this
information. The market value of your firm after the IPO and the total capital raised give you the following two
equations and two unknowns:
Without an underwriter and underpricing but the same market value of $630 mil: MV = (8 mil. exist. shares + N new
shares) × new stock price (P) = (8 mil + N)P = $630 mil. – Eq 1.
Raise the same amount of funds you would have with the investment banker handling but with the new share price. N
new shares × new stock price (P) = NP = $141 mil. → N = $141 mil./P - Eq 2.
Now we substitute N = $141 mil./P into Eq 1. giving us:
(8 mil. + $141 mil./P)P = $630 mil. → 8,000,000P + $141 mil. = $630 mil. → 8,000,000P = $489 mil. → P = $61.125
N new shares = $141/P = 141/61.125 = 2.30 million