Transcript Chapter 13

Chapter 14
Raising Equity Capital
Chapter 14 Outline
14.1 Equity Financing for Private Companies
14.2 Taking Your Firm Public: The Initial Public Offering
14.3 IPO Puzzles
14.4 Raising Additional Capital: The Seasoned Equity
Offering
Learning Objectives




Contrast the different ways to raise equity capital
for a private company
Understand the process of taking a company public
Gain insight into puzzles associated with initial public
offerings
Explain how to raise additional equity capital once
the company is public
14.1 Equity Financing for Private
Companies

Sources of Funding:
A
private company can seek funding from several
potential sources:
 Angel
Investors
 Venture Capital Firms
 Institutional Investors
 Corporate Investors
14.1 Equity Financing for Private
Companies

Angel Investors:
 Individual
investors who buy equity in small private firms
 The first round of outside private equity financing is
often obtained from angels
14.1 Equity Financing for Private
Companies

Venture Capital Firms:
 Specialize
in raising money to invest in the private equity
of young firms
 In return, venture capitalists often demand a great deal
of control of the company
Figure 14.1 Most Active U.S. Venture Capital Firms in
2009 (by Number of Deals Completed
Figure 14.2 Venture Capital Funding in
the United States
14.1 Equity Financing for Private
Companies

Institutional Investors:
 Pension
funds, insurance companies, endowments, and
foundations
 May
invest directly
 May invest indirectly by becoming limited partners in venture
capital firms
14.1 Equity Financing for Private
Companies

Corporate Investors:
 Many
established corporations purchase equity in
younger, private companies
 corporate
strategic objectives
 desire for investment returns
14.1 Equity Financing for Private
Companies

Securities and Valuation
 When
a company decides to sell equity to outside
investors for the first time, it is typical to issue preferred
stock rather than common stock to raise capital
 It
is called convertible preferred stock if the owner can
convert it into common stock at a future date
Example 14.1 Funding and Ownership
Problem:

You founded your own firm two years ago. You initially 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
(VC).
Example 14.1 Funding and Ownership
Problem (cont’d):

This VC would invest $6 million and would receive 3 million newly issued
shares. What is the post-money valuation? Assuming that this is the VC’s first
investment in your company, what percentage of the firm will she end up
owning? What percentage will you own? What is the value of your shares?
Example 14.1 Funding and Ownership
Solution:
Plan:

After this funding round, there will be a total of 5,000,000 shares
outstanding:
Your shares
1,500,000
Angel investors’ shares
500,000
Newly issued shares
Total
3,000,000
5,000,000
Example 14.1 Funding and Ownership
Plan (cont’d):




The VC is paying $6,000,000/3,000,000=$2/share.
The post-money valuation will be the total number of shares
multiplied by the price paid by the VC.
The percentage of the firm owned by the VC is her shares
divided by the total number of shares.
Your percentage will be your shares divided by the total shares
and the value of your shares will be the number of shares you
own multiplied by the price the VC paid.
Example 14.1 Funding and Ownership
Execute:



There are 5,000,000 shares and the VC paid $2 per share.
Therefore, the post-money valuation would be 5,000,000($2) =
$10 million.
Because she is buying 3,000,000 shares, and there will be
5,000,000 total shares outstanding after the funding round, the
VC will end up owning 3,000,000/5,000,000=60% of the firm.
You will own 1,500,000/5,000,000=30% of the firm, and the
post-money valuation of your shares is 1,500,000($2) =
$3,000,000.
Example 14.1 Funding and Ownership
Evaluate:


Funding your firm with new equity capital, be it from an angel or venture
capitalist, involves a tradeoff—you must give-up part of the ownership of
the firm in return for the money you need to grow.
The higher is the price you can negotiate per share, the smaller is the
percentage of your firm you have to give up for a given amount of capital.
14.1 Equity Financing for Private
Companies

Exiting an Investment in a Private Company
 Acquisition
 Public
Offering
14.2 Taking Your Firm Public: The Initial
Public Offering

The process of selling stock to the public for the first
time is called an initial public offering (IPO)
Table 14.1 Largest Global
Equity Issues, 2009
14.2 Taking Your Firm Public: The Initial
Public Offering

Advantages and Disadvantages of Going Public
 Advantages:
 Greater
liquidity
 Better access to capital
By going public, companies given their private equity
investors the ability to diversify. In addition, public companies
typically have access to much larger amounts of capital
through the public markets, both in the initial public offering
and in subsequent offerings.
14.2 Taking Your Firm Public: The Initial
Public Offering
 Disadvantages:
 Equity
holders more dispersed
 Must satisfy requirements of public companies
When investors sell their stake and thereby diversify their
holdings, the equity holders of the corporation become more
widely dispersed. Thus undermines investor’s ability to monitor
the management and thus represents a loss of control.
Furthermore, once a company goes public, it must satisfy all
of the requirements of public companies. In general, these
standards were designed to provide better protection for
investors. However, compliance with the new standards is
costly and time-consuming for public companies.
14.2 Taking Your Firm Public: The Initial
Public Offering


IPOs include both Primary and Secondary offerings
At an IPO, a firm offers a large block of shares for sale to the public
for the first time. The share that are sold in the IPO may either by new
shares that raise new capital, known as primary offering, or existing
shares that are sold by current shareholders, known as a secondary
offering.
Underwriters and the Syndicate
After deciding to go public, managers of the company work with an
underwriter, an investment banking firm that manages the security
issuance and design its structure.

Underwriter: an investment banking firm that manages the offering and
designs its structure


Lead Underwriter
Syndicate: other underwriters that help market and sell the issue
Table 14.2 International IPO
Underwriter Ranking Report for 2007
14.2 Taking Your Firm Public: The Initial
Public Offering

Valuation
 Underwriters
work with the company to come up with a
price
 Estimate
the future cash flows and compute the present value
 Use market multiples approach
 Road
Show
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
promoting the company and explaining their rational for the
offer price to the underwriter’s largest customers.
14.2 Taking Your Firm Public: The Initial
Public Offering

Valuation
 Underwriters
work with the company to come up with a
price
 Estimate
the future cash flows and compute the present value
 Use market multiples approach
 Road
Show
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
promoting the company and explaining their rational for the
offer price to the underwriter’s largest customers.
14.2 Taking Your Firm Public: The Initial
Public Offering

Valuation
 Book
Building(詢價圈購)
At the end of the road show, customers inform the
underwriters of their interest by telling the underwriters
how many shares they may want to purchase. This
process for coming up with the offer price based on
customer’s expression of interest is called book building.
14.2 Taking Your Firm Public: The Initial
Public Offering

Pricing the Deal and Managing Risk
 Firm
Commitment IPO: the underwriter guarantees that it
will sell all of the stock at the
offer price
 Over-allotment allocation, or Greenshoe provision:
allows the underwriter to issue more stock, amounting to
15% of the original offer size, at the IPO offer price
14.2 Taking Your Firm Public: The Initial
Public Offering

Other IPO Types
 Best-Efforts
Basis: the underwriter does not guarantee
that the stock will be sold, but instead tries to sell the
stock for the best possible price
 Auction IPO: The company or its investment bankers
auction off the shares, allowing the market to determine
the price of the stock
Table 14.4 Summary of IPO Methods
14.3 IPO Puzzles

Four IPO puzzles:

Underpricing of IPOs


“Hot” and “Cold” IPO markets


The number of IPOs is highly cyclical. When times are good, the market
is flooded with IPOs; when times are bad, the number of IPOs fries up.
High underwriting costs


On average, IPO appear to be underpriced: The price at the end of
trading on the first day is often substantially higher than the IPO price.
The transaction costs of the IPO are very high, and it is unclear why
firms willingly incur such high costs.
Poor long-run performance of IPOs

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 buy and hold strategy appears to be a bad investment.
14.3 IPO Puzzles

Underpriced IPOs
 On
average, between 1960 and 2003, the price in the
U.S. aftermarket was 18.3% higher at the end of the
first day of trading
 As id evident in Figure 14.5, the one-day average return
for IPOs has historically been very large around the
world. Note that although underpricing is a persistent
and global phenomenon, it is generally smaller in more
developed capital markets.
 Who
wins and who loses because of underpricing?
Investors vs pre-IPO shareholders
Figure 14.5
International
Comparison
of First-Day
IPO Returns
14.3 IPO Puzzles

“Hot” and “Cold” IPO Markets
 It
appears that the number of IPOs is not solely driven
by the demand for capital.
 Sometimes firms and investors seem to favor IPOs; at
other times firms appear to rely on alternative sources
of capital
14.3 IPO Puzzles

“Hot” and “Cold” IPO Markets

Figure 14.6 shows the number of IPOs by year from 1980 to
2009. As the figure makes clear, the dollar volume of IPOs
grew significantly in the early 1990s, reaching a peak in
1996. An even more important feature of the data is that the
trends related to the number of issues are cyclical. Sometimes,
as in 1996, the volume of IPOs is unprecedented by historical
standards, yet within a year or two the volume of IPOs may
decrease 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.
Figure 14.6 Cyclicality of Initial Public Offerings in the
United States, (1980-2009)
14.3 IPO Puzzles

High Cost of Issuing an IPO
 In
the U.S., the discount below the issue price at which the
underwriter purchases the shares from the issuing firm is
7% of the issue price.
 This fee is large, especially considering the additional
cost to the firm associated with underpricing.
Figure 14.7 Relative Costs of Issuing
Securities
14.3 IPO Puzzles

Poor Post-IPO Long-Run Stock Performance
 Newly
listed firms appear to perform relatively poorly
over the following three to five years after their IPOs
 That underperformance might not result from the issue of
equity itself, but rather from the conditions that
motivated the equity issuance in the first place
14.4 Raising Additional Capital: The
Seasoned Equity Offering

A firm’s need for outside capital rarely ends at the
IPO
 Seasoned
Equity Offering (SEO): firms return to the
equity markets and offer new shares for sale
14.4 Raising Additional Capital: The
Seasoned Equity Offering

SEO Process
 When
a firm issues stock using an SEO, it follows many
of the same steps as for an IPO.
 Main difference is that the price-setting process is not
necessary.
 Tombstones
Historically, underwriters would advertise the sale of stock
(both IPOs and SEOs) by taking out newspaper
advertisements.
Figure 14.8
Tombstone
Advertisement
for a
RealNetworks
SEO
14.4 Raising Additional Capital: The
Seasoned Equity Offering

Two kinds of seasoned equity offerings:
 Cash
offer
the firm’s offers the new shares to investors at large.
 Rights offer
the firm’s offers the new shares only to existing
shareholders.
14.4 Raising Additional Capital: The
Seasoned Equity Offering


SEO Price Reaction
Researchers have found that, on average, the market
greets the news of an SEO with a price decline
(about 1.5%)
 Often
the value lost can be a significant fraction of the
new money raised
 Adverse selection (the lemons problem)
14.4 Raising Additional Capital: The
Seasoned Equity Offering

SEO Costs
 In
addition to the price drop when the SEO is announced,
the firm must pay direct costs as well. Underwriting fees
amount to 5% of the proceeds of the issue