Chapter 16
RAISING CAPITAL
SLIDES
16.1
16.2
16.3
16.4
16.5
16.6
16.7
16.8
16.9
16.10
16.11
16.12
16.13
16.14
16.15
16.16
16.17
16.18
16.19
16.20
16.21
16.22
16.23
16.24
16.25
Key Concepts and Skills
Chapter Outline
Venture Capital
Choosing a Venture Capitalist
Selling Securities to the Public
Table 16.1 - I
Table 16.1 - II
Underwriters
Firm Commitment Underwriting
Best Efforts Underwriting
Green Shoes and Lockups
IPO Underpricing
Figure 16.2
Figure 16.3
Work the Web Example
New Equity Issues and Price
Issuance Costs
Rights Offerings: Basic Concepts
The Value of a Right
Rights Offering Example
More on Rights Offerings
Dilution
Types of Long-term Debt
Shelf Registration
Quick Quiz
CHAPTER WEB SITES
Section
16.1
16.2
16.3
16.4
16.5
16.10
Web Address
www.vfinance.com
www.dealflow.com
www.globaltechnoscan.com
www.pwcmoneytree.com
cbs.marketwatch.com
www.ipo.com
www.ipohome.com
www.hoovers.com
www.ml.com
www.bloomberg.com
www.dallasfed.org/htm/pubs/er.html
A-208 CHAPTER 16
CHAPTER ORGANIZATION
16.1
The Financing Life Cycle of a Firm: Early Stage Financing and Venture Capital
Venture Capital
Some Venture Capital Realities
Choosing a Venture Capitalist
16.2
Selling Securities to the Public: The Basic Procedure
16.3
Alternative Issue Methods
16.4
Underwriters
Choosing an Underwriter
Types of Underwriting
The Aftermarket
The Green Shoe Provision
Lockup Agreements
16.5
IPOs and Underpricing
Underpricing: The 1999-2000 Experience
Evidence on Underpricing
Why Does Underpricing Exist?
16.6
New Equity Sales and The Value of the Firm
16.7
The Costs of Issuing Securities
The Costs of Selling Stock to the Public
The Costs of Going Public: The Case of Multicom
16.8
Rights
The Mechanics of a Rights Offering
Number of Rights Needed to Purchase a Share
The Value of a Right
Ex Rights
The Underwriting Arrangements
Rights Offers: The Case of Time-Warner
Effects on Shareholders
The Rights Offering Puzzle
16.9
Dilution
Dilution of Proportionate Ownership
Dilution of Value: Book versus Market Values
16.10 Issuing Long-Term Debt
CHAPTER 16 A-209
16.11 Shelf Registration
16.12 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
Slide 16.1
Slide 16.2
Key Concepts and Skills
Chapter Outline
16.1. The Financing Life Cycle of a Firm: Early-Stage Financing and Venture
Capital
A.
Venture Capital
Venture capital – financing for new, often high-risk businesses
First-stage financing – early financing used to get the firm off the
ground
Second-stage financing – subsequent financing to begin operations
and manufacturing
Slide 16.3 Venture Capital Click on the web surfer icon to go to the PWC
Money Tree report.
Real-World Tip, page 526: In a Forbes article, Guy Kawaski,
business author and CEO of Garage.com, a start-up capital firm,
identified four factors that investors should consider.
“Factor number one: the idea … ask who would use the
product. The best answer is that you already use it. The second
best answer is that you would use it if it existed.” He also suggests
that the business model should be coherent and that development
of the firm can be broken into stages.
“Factor number two: the source of the referral. The best
source of investment opportunities is people who have experience
picking from a constant flow of new deals.”
“Factor number three: the quality of the entrepreneur. You
want to invest in people who run at a high-megahertz rate … and
who are adaptable.”
“Factor number four: the existence of organizations that
would be natural partners and allies … today’s partner is
tomorrow’s acquirer. It’s nice to have an exit ramp.”
Real World Tip, page 526: Information on venture capital is much
more readily available than it has been in the past. The
introduction of publications such as Red Herring and Wired has
provided substantial information on high-tech firms that have not
A-210 CHAPTER 16
yet gone public. Red Herring regularly profiles firms in columns
with titles such as “IPO Candidates” (private companies projected
to go public within the next six months).
The Internet is a bountiful source of information on venture
capital and high-tech startups. In December 2001, entering the
keywords “venture capital” into the AltaVista search engine
resulted in 1,189,228 hits, up from 528,706 in October 2000!
Real-World Tip, page 527: Various groups supply venture capital.
An article in the May 16, 2000 issue of Inc. magazine discusses
Champion Ventures, a venture capital firm based in California.
It’s first fund was for $40 million and included investors such as
Barry Bonds, Wayne Gretzky, Joe Montana, Dan Marino and
others.
Corporations are also getting into the venture capital game,
although they often refer to it as “strategic investment.” One such
company is Intel, who formed its venture capital program, “Intel
Capital,” in the early 1990s. It was originally designed to provide
funding for companies that would complement its product line and
capacity. It now invests in a wide range of companies including
Internet companies and companies that are trying to expand
bandwidth for users.
Real World Tip, page 527: PriceWaterhouseCoopers Money Tree
Report provides information about VC funding on a quarterly
basis. Go to www.pwcmoneytree.com to investigate current VC
activity by quantity, sector and region (the hot link on Slide16.3
will help).
B.
Some Venture Capital Realities
Even with the explosion in VC funds, access to venture capital is
still limited and expensive, particularly when you consider that
VCs often take large equity stakes in the new firm and may exert
substantial pressure on management to do things the way the VC
wants. On the other hand, small, risky firms might never be able to
get off the ground without venture capitalists, which would deprive
society of much of the innovation we have enjoyed in recent years.
C.
Choosing a Venture Capitalist
A list of important considerations when choosing a VC is provided
below:
CHAPTER 16 A-211
-Financial strength – you want to make sure the VC will be
able to provide additional financing when necessary.
-Style – since VCs often take an active role in advising
management, you want to make sure that your management
style is compatible with the VCs style.
-References – you need to obtain and check references. Has the
VC been successful in other ventures and how have they
handled adversity.
-Contacts – ideally your VC will have contacts that will be
useful in your business.
-Exit strategy – VCs are not long-term investors. How does the
VC anticipate getting their investment back from the business?
Slide 16.4 Choosing a Venture Capitalist Click on the web surfer to go to
www.dealflow.com.
16.2.
Selling Securities to the Public: The Basic Procedure
Process for issuing securities:
-Obtain approval from the Board of Directors
-File registration statement with SEC
-SEC requires a 20-day waiting period
Company distributes a preliminary prospectus called a red
herring
Cannot sell securities during waiting period
-The price is set when the registration becomes effective and the
securities can be sold
Tombstones – large advertisements used by underwriters to let
investors know that new securities are coming to market
Slide 16.5 Selling Securities to the Public
Real-World Tip, page 528: The June 2000 issue of Red Herring
provides a summary of the IPO process in “The Anatomy of an
IPO” (p. 392). It provides a look at how a company goes public
starting with choosing the underwriter all the way through the first
day of trading. The process is a hectic one with a lot of paperwork
and marketing.
Video Note: “Going Public” shows what must be done to take a company public. This is
a common exit strategy for VCs.
A-212 CHAPTER 16
16.3.
Alternative Issue Methods
-General cash offer – securities offered for sale to the general
public on a cash basis
-Rights offer – public issue in which securities are first offered to
existing shareholders on a pro rata basis
-Initial Public Offering (IPO) – a company’s first equity issue
made available to the public
-Seasoned equity offering – a new equity issue of securities by a
company that has previously issued securities to the public
Slide 16.6
Slide 16.7
16.4.
Table 16.1 – I
Table 16.1 - II
Underwriters
Underwriters are investment firms that act as intermediaries between the
issuer and the public. Some of the services provided by underwriters include:
-Type of security to issue
-Method used to issue the securities
-Pricing of the securities
-Selling the securities
-In the case of an IPO, stabilizing the price in the aftermarket
Syndicates – a group of underwriters that work together to market the
securities and share the risk, managed by a lead underwriter
Spread – the difference between the underwriter’s buying price and the
offering price; it is the underwriter’s main source of compensation and for
IPO’s in the range of $20 to $80 million the spread is typically 7%
Lecture Tip, page 531: The underwriter’s spread is defined as the difference
between price and the price at which the underwriter purchases the securities
from the issuing firm. In a study of utility stock issues by Bhagat and Frost,
published in the Journal of Financial Economics in 1986, average spreads
were found to be lower for competitive issues (3.1%) than for negotiated
issues (3.9%); however, negotiated offerings are still more common.
Chen and Ritter in the June 2000 issue of The Journal of Finance looked at
spreads for IPOs. They found that the spread for over 90% of the issues in the
$20 to $80 million range was 7%, which is above a competitive price.
However, they suggest that this persists because issuing companies are more
concerned about the reputation of the underwriter and view a lower price as a
signal of lower quality.
Slide 16.8
Underwriters
CHAPTER 16 A-213
A.
Choosing an Underwriter
Competitive offer basis – taking the underwriter that bids the most
for the securities
Negotiated offer basis – the more common (and expensive) method
Real-World Tip, page 532: “Corporate America is turning more
fickle in choosing finance partners on Wall Street …[m]ore
companies are ditching the Wall Street underwriters they had
selected for initial public offerings and picking different investment
banks when it comes time to complete follow-on stock sales.” So
read the opening lines of an article in the December 19, 1996 issue
of The Wall Street Journal. But why is this occurring? According
to the article, the phenomenon is attributable in part to the fact
that many recent offerings have quickly risen above the offering
price, leading issuers to feel that their shares were underpriced
(and that they left millions of dollars “on the table” as a result).
B.
Types of Underwriting
Firm commitment underwriting – the underwriting syndicate
purchases the shares from the issuing company and then sells them
to the public. The syndicate’s profit comes from the spread
between the prices and it bears the risk that the actual spread
earned will not be as high as anticipated (or may not even cover
costs). This is the most common type of underwriting
Slide 16.9 Firm Commitment Underwriting
Slide 16.10 Best Efforts Underwriting
Best efforts underwriting – the underwriters are legally bound to
maker their “best effort” to sell the securities at the offer price, but
do not actually purchase the securities from the issuing firm. In this
case, the issuing firm bears the risk of the market being unwilling
to buy at the offer price.
C.
The Aftermarket
Trading period after a new issue is initially sold to the public. The
syndicate, and in particular the lead underwriter, stabilizes the
price by purchasing shares when the price falls below the offer
price. Most IPO’s are overalloted (more shares were sold than
actually existed), so the lead underwriter has a built in short
position. If the price falls, then the short is covered by buying
A-214 CHAPTER 16
shares in the market to support the price. If the price rises, then the
short is covered by exercising the Green Shoe option. For more
information, see Aggarwal, 2000, “Stabilization Activities by
Underwriters After Initial Public Offerings,” The Journal of
Finance, June 2000, pp. 1075 – 1103 and Ellis, Michaely and
O’Hara, 2000, “When the Underwriter Is the Market Maker: An
Examination of Trading in the IPO Aftermarket,” The Journal of
Finance, June 2000, pp. 1039 – 1074.
Ethics Note, page 533: The regulatory process attempts to ensure
that investors receive enough information to make informed
decisions; this is the role of the prospectus. However, this is not
always the case. Brokers have been known to sell securities based
on sales scripts that have little to do with the information provided
in the prospectus. Also, investors often make investment decisions
before receiving (or reading) the prospectus. While the behavior of
the brokers is hardly ethical, it reinforces the point that you should
take what the broker says with a grain of salt and always read the
prospectus before making a purchase decision.
D.
The Green Shoe Provision
The Green Shoe provision allows the underwriters to purchase
additional shares (up to 15% of the issue) at the original price up to
30 days after the initial sale. This provision is used primarily when
an offering goes well and the underwriters need to cover their short
positions created by overallotment of the issue. See the references
provided above for more information.
Slide 16.11 Green Shoes and Lockups
E.
Lockup Agreements
The lockup agreement prevents insiders from selling their shares
for some period after the IPO, usually 180 days. The stock price
often drops right before the lockup period expires in anticipation of
a large number of shares flooding the market (excess supply causes
the price to drop).
16.5.
IPOs and Underpricing
A.
Underpricing: The 1999 - 2000 Experience
Slide 16.12 IPO Underpricing
CHAPTER 16 A-215
B.
Evidence on Underpricing
The underpricing (see a large increase above the offer price the
first day of trading) of IPOs is very common. Empirical evidence
suggests that it has gotten worse in recent years. As Table 15.2
points out the average underpricing has been higher from 1990 to
1999 than any other period in the study; and in 1999 the average
issue was underpriced by almost 70%!
Real-World Tip, page 534: An article in the Red Herring
supplemental issue “Going Public 2000” discusses the issue of
IPO underpricing. The title of the article is “Leaving Money on the
Table, Why banks are pricing IPOs so far below what the public
market seems willing to pay.” It illustrates that underpricing is not
just an academic issue. As the article says, “The difference …
between the offer price and the first-day close could have gone to
the issuing company rather than to the chosen few investors lucky
enough to be given IPO shares to flip for a big one-day take.”
The author points out that a more accurate measure of “money
left on the table” might be the difference between the offer price
and the opening price. In 1999, five IPO’s left over $1 billion on
the table using this measurement. When you consider that the
underwriters generally earn a 7% spread based on the offer price,
they are losing a substantial chunk of money in these transactions
as well.
The author argues that the wild swings are at least partially due
to the unpredictability of online traders. He uses the example of
Andover.net to illustrate his point. The shares of Andover.net were
sold at a Dutch auction that was open to all investors large or
small. Each investor tendered a secret bid. The winning bids were
tallied and all winners paid the lowest accepted price.
Theoretically, there should not have been a price jump because all
investors who were interested could place a bid. If they were
willing to pay enough, they would receive the stock. The Dutch
auction led to an offer price of $18 per share, but it opened trading
at $48 and closed at $63.38.
The other main argument that the author gives is that the
underwriter does not want to face a lawsuit for overpricing an
issue. His final comment about “leaving money on the table” puts
a different light on the whole process: “Everybody wins. The
issuer gets its money and the publicity that comes from a huge
first-trade gain, and the initial investors get a fat profit. As for the
bank, it earns its fees, keeps its customers happy, and, perhaps
most importantly, steers clear of the lawyers.”
A-216 CHAPTER 16
Slide 16.13 Figure 16.2
Slide 16.14 Figure 16.3
Slide 16.15 Work the Web Example
C.
Why Does Underpricing Exist?
Ethics Note, page 540: Traditionally, IPOs have been reserved for
the syndicates’ best customers, but given the explosion of interest
in IPOs in recent years, more opportunities are available for the
average investor. One such example is the Dutch auctions that
have been used to some success by W. R. Hambrecht, a relatively
new investment banker. Be careful, however, if a broker tells you
that you can “buy IPOs” from them. It is doubtful you can buy the
IPO at the offer price; more than likely you will be buying it in the
aftermarket at whatever price is then available.
Real-World Tip, page 541: How good is the long-run performance
of IPO firms? Not overwhelmingly good. In addition to the
growing academic research, there is a good bit of institutional
research suggesting that holding on to IPO stocks is a risky
proposition. Consider the following table compiled by Prudential
Securities: Percentage of IPO Companies reporting financial
losses after:
Year
% of Companies
1
32%
2
37%
3
38%
4
42%
5
44%
16.6.
New Equity Sales and the Value of the Firm
Slide 16.16 New Equity Issues and Price
Stock prices tend to decline when a company announces a
seasoned equity offering. Why? A lot of the decline may be due to
the asymmetric information contained by management and the
signals that the choice to issue equity send to the market.
-Managerial information concerning value of the stock –
expectation that managers will issue equity only when they believe
the current price is too high
CHAPTER 16 A-217
-Debt usage – expectation that a firm will issue debt as long as it
can afford to (allows stockholders to benefit more from good
projects), consequently a stock issue indicates that management
believes that the firm is too highly leveraged
-Issue costs – equity is more expensive to issue than debt from a
straight flotation cost perspective
16.7.
The Costs of Issuing Securities
A.
The Costs of Selling Stocks to the Public
The cost of issuing securities can be broken down into the
following main categories:
-Spread
-Other direct expenses – filing fees, legal fees, etc.
-Indirect expenses – opportunity costs, such as management
time spent working on the issue
-Abnormal returns – seasoned stock issue, the reduction in
price when the announcement is made
-Underpricing – IPOs
-Green Shoe option – additional allotment of shares sold at
offer price
Other conclusions:
-There are substantial economies of scale
-Best efforts cost more (may be why firm commitment is the
standard)
-The cost of underpricing may be greater than the direct
issuance costs
-An IPO is more expensive than a seasoned offering
Slide 16.17 Issuance Costs
B.
The Costs of Going Public: The Case of Multicom
This section describes a real IPO and the attendant costs. The
important conclusion is that, while $7.15 million was raised by
selling shares, the issuing firm received only $6.6 million.
Additionally, the firm had to pay $145,000 to the underwriters to
defray expenses incurred.
A-218 CHAPTER 16
16.8.
Rights
Privileged subscription – issue of common stock offered to
existing stockholders. Offer terms are evidenced by warrants or
rights. Rights are often traded on exchanges or over the counter.
A.
The Mechanics of a Rights Offering
Early stages are the same as for a general cash offer, i.e., obtain
approval from directors, file a registration statement, etc. The
difference is in the sale of the securities. Current shareholders get
rights to buy new shares. They can subscribe (buy) the entitled
shares, sell the rights or do nothing.
Slide 16.18 Rights Offerings: Basic Concepts
B.
Number of Rights Needed to Purchase as Share
Number of new shares = funds to be raised / subscription price
Shareholders get one right for each share already owned. The
number of rights needed to buy a new share is:
Number of rights needed to buy a share = # old shares / # new
shares
Example: Suppose a firm with 200,000 shares outstanding wants to
raise $1 million through a rights offering. Each current shareholder
gets one right per share held. The following table illustrates how
the subscription price, number of new shares to be issued, and the
number of rights needed to buy a share are related, ignoring
flotation costs.
Subscription Price
$25
$20
$10
$5
C.
# of new shares
40,000
50,000
100,000
200,000
# of rights required
5
4
2
1
The Value of a Right
Slide 16.19 The Value of a Right
A right has value if the subscription price is below the share price.
How much a right is worth depends on how many rights it takes to
buy a share and the difference between the stock price and the
CHAPTER 16 A-219
subscription price. If it takes N rights to buy one share, the value of
one right is equal to
(initial stock price – subscription price) / (N + 1)
Slide 16.20 Rights Offering Example
D.
Ex Rights
When a privileged subscription is used, the firm sets a holder-ofrecord date. The stock sells rights-on, or cum rights, until two
business days before the holder-of-record date. After that, the stock
sells without the rights or ex rights.
ex rights price = (1 / (N+1))(N*initial stock price + subscription
price)
Example: Suppose the above firm decides on a subscription price
of $20, with 50,000 shares to be issued. Assume the shares
outstanding currently sell for $35. Using the valuation formula and
letting N = 4, a right is worth (35 – 20)/(4+1) = $3. The expected
ex rights price is (1/5)(4*35 + 20) = $32
Lecture Tip, page 550: You may wish to link the stock behavior
associated with the ex rights date to that of the ex dividend date.
Point out that a time line could be drawn that applies to stocks
trading ex rights as well as stocks trading ex dividend. Both
dividend and rights declarations involve setting an ex date, which
is two days before the record date. In both situations, the share
price reacts on the ex date to reflect the value of the right or
dividend that would not be received if the shares were purchased
after the ex date.
E.
The Underwriting Arrangements
Standby underwriting – firm makes a rights offering and the
underwriter makes a commitment to “take up” (purchase) an
unsubscribed shares. In return, the underwriter receives a standby
fee. In addition, shareholders are usually given oversubscription
privileges, the right to purchase unsubscribed shares at the
subscription price.
F.
Rights Offers: The Case of Time Warner
Slide 16.21 More on Rights Offerings
A-220 CHAPTER 16
Time Warner’s rights offering was somewhat unusual. As
originally proposed, the subscription price would vary, dependent
upon the percentage of the issue actually sold. This feature was
later dropped. As is typical of most rights offerings, only 2 percent
of the rights were neither exercised nor sold. However,
oversubscription rights were used to absorb the unsold stock. The
underwriters’ total compensation was approximately 4 percent of
the issue for management services, standby commitments, and
other services.
G.
Effects on Shareholders
Absent taxes and transaction costs, shareholder wealth is not
differentially affected whether they exercise or sell their rights.
Nor does it matter what subscription price the firm sets as long as
it is below the market price.
H.
The Rights Offerings Puzzle
Although there is evidence that rights offers are cheaper than
general cash offers, they are relatively infrequent in the US
Arguments for underwritten offerings include:
1. Underwriters get higher prices (this is dubious, given
underpricing).
2. Underwriters insure against a failed offering (also dubious).
3. Offering proceeds are available sooner (questionable).
4. Advice from underwriters is valuable.
16.9.
Dilution
Dilution of percentage ownership
Dilution of market value
Dilution of book value and EPS
Slide 16.22 Dilution
A.
Dilution of Proportionate Ownership
This occurs when the firm sells stock through a general cash offer
and new stock is sold to persons who previously weren’t
stockholders. For many large, publicly held firms this simply isn’t
an issue, the stockholders being many and varied to begin with.
For some firms with a few large stockholders it may be of concern.
CHAPTER 16 A-221
B.
Dilution of Value: Book versus Market Values
A stock’s market value will fall if the NPV of the finance project is
negative and rise if the NPV is positive. Whenever a stock’s book
value is greater than its market value, selling new stock will result
in accounting dilution.
16.10. Issuing Long-term Debt
Slide 16.23 Types of Long-Term Debt
The process for issuing long-term debt is similar to issuing stock
except the registration statement must include the bond indenture.
Much of the corporate debt is privately placed. Term loans are
direct business loans with one to five years’ maturity, usually
amortized. Private placements are similar to term loans, except
longer term. Commercial banks, insurance companies and other
intermediaries often grant both types of loans.
Differences between private placements and public issues:
-No SEC registration is required for a private placement
-Direct placements may have more restrictive covenants
-Private placements are easier to renegotiate if necessary
-Issuance costs are generally lower on private placements,
although the coupon rate is generally higher
It is much cheaper to issue debt than equity.
Real-World Tip, page 557: Corporate issues continued to exploit
the relatively low level of long-term interest rates in 1996 and
1997. In December 1996, IBM issued 100-year bonds with a face
value of $850 million. As evidence of the low required return, note
that the yield on these bonds is only one-tenth of one percent
higher than on similar 30-year IBM bonds. In all, approximately
$3.6 billion worth of 100-year bonds were issued between
November 1995 and December 1996. Previous “century bond”
issuers include Walt Disney Company, Coca-Cola and Yale
University.
Real-World Tip, page 557: An interesting article on private
placements appeared in the third quarter 1997 issue of the Dallas
Federal Reserve Bank’s Economic Review. An electronic version is
available at http://www.dallasfed.org/htm/pubs/er.html. Stephen
Prowse, an economist with the Dallas Fed, describes the structure
A-222 CHAPTER 16
of the private placement market, calling private placements “a
significant source of funds for U.S. corporations.” He notes that,
on average, private placements tend to be “larger than bank loans
and smaller than public bonds.” In a similar fashion, the maturity
of privately placed debt tends to be longer than that of bank debt
but shorter than that of publicly placed debt. Finally, he notes that
borrowers in the private placement market tend to fall between
those who rely on bank loans and those who rely on public debt, in
terms of firm size.
International Debt, page 557: The globalization of the financial
markets is nowhere more evident than in the rise in popularity of
large issues by foreign corporations and governments. In
December 1993, Argentina issued $1 billion of “global bonds.”
(Global bonds are offered simultaneously in all of the world’s
major financial markets. First issued by the World Bank in 1989,
they are often, but not always, denominated in U.S. dollars.)
Investor demand was so strong that the size of the issue was raised
from $750 million to $1 billion, even though these were considered
junk bonds at issuance. Furthermore, a Wall Street Journal story
on the Argentina issue states that it is “only the latest in a stream
of global-bond offerings that have flooded the world’s markets this
year.”
16.11. Shelf Registration
Shelf registration – SEC Rule 415 allows a company to register all
securities that it expects to issue within the next two years in one
registration statement. The firm can then issue the securities in
smaller increments, as funds are needed during the two-year
period. Both debt and equity can be registered using Rule 415.
Qualifications:
-Securities must be investment grade
-No debt defaults in the last three years
-Market value of stock must be greater than $150 million
-No violations of the Securities Act of 1934 within the last
three years
Slide 16.24 Shelf Registration
16.12. Summary and Conclusions
Slide 16.25 Quick Quiz