Chapter 20 Raising Capital Copyright 2015 by the

Key Concepts and Skills o Understand the venture capital market and its role in financing new businesses o Understand how securities are sold to the public and the role of investment bankers o Understand initial public offerings and the costs of going public o Understand the process of secondary offerings and the impact of dilution 20 -1

Chapter Outline 20. 1 20. 2 20. 3 20. 4 20. 5 20. 6 20. 7 20. 8 20. 9 20. 10 20. 11 Early-Stage Financing and Venture Capital The Public Issue Alternative Issue Methods The Cash Offer The Announcement of New Equity and the Value of the Firm The Cost of New Issues Rights The Rights Puzzle Dilution Shelf Registration Issuing Long-Term Debt 20 -2

Venture Capitalists (VCs) o o o Financial intermediaries that are typically set up as limited partnerships Play an active role in overseeing, advising, and monitoring companies in which they invest Generally do not want to own the investment forever 20 -3

Stages of Financing 1. 2. 3. 4. 5. 6. Seed-Money Stage Start-Up First-Round Financing Second-Round Financing Third-Round Financing Fourth-Round Financing 20 -4

20. 2 The Public Issue o The Basic Procedure In The U. S. Management gets the approval of the Board. n The firm prepares and files a registration statement with the SEC. n The SEC studies the registration statement during the waiting period. n The firm prepares and files an amended registration statement with the SEC. n If everything is satisfactory with the SEC, a price is set and a full-fledged selling effort gets underway. n 20 -5

The Process of a Public Offering Steps in Public Offering Time 1. Pre-underwriting conferences Several months 2. Registration statements 20 -day waiting period 3. Pricing the issue Usually on the 20 th day 4. Public offering and sale After the 20 th day 5. Market stabilization 30 days after offering 20 -6

An Example of a Tombstone 20 -7

20. 3 Alternative Issue Methods o There are two kinds of public issues: The general cash offer n The rights offer n o Almost all debt is sold in general cash offerings. 20 -8

Table 20. 1 - I 20 -9

Table 20. 1 - II 20 -10

20. 4 The Cash Offer o There are three methods for issuing securities for cash: Firm Commitment n Best Efforts n Dutch Auction n o There are two methods for selecting an underwriter Competitive n Negotiated n 20 -11

Firm Commitment Underwriting o o o The issuing firm sells the entire issue to the underwriting syndicate. The syndicate then resells the issue to the public. The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold. The syndicate bears the risk of not being able to sell the entire issue for more than the cost. This is the most common type of underwriting in the United States. 20 -12

Best Efforts Underwriting o o Underwriter must make their “best effort” to sell the securities at an agreed-upon offering price. The company bears the risk of the issue not being sold. The offer may be pulled if there is not enough interest at the offer price. The company does not get the capital, and they have still incurred substantial flotation costs. This type of underwriting is not as common as it used to be. 20 -13

Dutch Auction Underwriting o o o Underwriter accepts a series of bids that include number of shares and price per share. The price that everyone pays is the highest price that will result in all shares being sold. There is an incentive to bid high to make sure you get in on the auction but knowing that you will probably pay a lower price than you bid. The Treasury has used Dutch auctions for years. Google was the first large Dutch auction IPO. 20 -14

Investment Banks Also called underwriters o Perform critical functions: o n n Help determine type of security, method of sale, and offering price Sell the securities o o n Typically using a syndicate to limit risk For compensation – the spread Stabilize IPO prices in the aftermarket 20 -15

IPO Underpricing May be difficult to price an IPO because there is not a current market price available. o Private companies tend to have more asymmetric information than companies that are already publicly traded. o Underwriters want to ensure that, on average, their clients earn a good return on IPOs. o Underpricing causes the issuer to “leave money on the table. ” o 20 -16

IPO Underpricing In Asia And Various Countries 20 -17

20. 5 The Announcement of New Equity and the Value of the Firm o o The market value of existing equity drops on the announcement of a new issue of common stock. Reasons include n Managerial Information Since the managers are the insiders, perhaps they are selling new stock because they think it is overpriced. n Debt Capacity If the market infers that the managers are issuing new equity to reduce their debt-equity ratio due to the specter of financial distress, the stock price will fall. n Issue Costs 20 -18

20. 6 The Cost of New Issues 1. 2. 3. 4. 5. 6. Gross spread, or underwriting discount Other direct expenses Indirect expenses Abnormal returns Underpricing Green Shoe Option 20 -19

The Costs of Equity Public Offerings Proceeds (in millions) 2 - 9. 99 10 - 19. 99 20 - 39. 99 40 - 59. 99 60 - 79. 99 80 - 99. 99 100 - 199. 99 200 - 499. 99 500 and up Direct Costs SEOs IPOs 35. 11% 25. 22% 13. 86% 14. 69% 9. 54% 14. 03% 13. 96% 9. 77% 6. 85% 8. 94% 6. 72% 8. 55% 5. 23% 7. 96% 4. 94% 6. 84% 3. 37% 5. 50% Underpricing IPOs 20. 42% 10. 33% 17. 03% 28. 26% 28. 36% 32. 92% 21. 55% 6. 19% 6. 64%` 20 -20

20. 7 Rights o If a preemptive right is contained in the firm’s articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders. o This allows shareholders to maintain their percentage ownership if they so desire. 20 -21

Mechanics of Rights Offerings o The management of the firm must decide: The exercise price (the price existing shareholders must pay for new shares). n How many rights will be required to purchase one new share of stock. n o These n rights have value: Shareholders can either exercise their rights or sell their rights. 20 -22

Rights Offering Example o Popular Delusions, Inc. is proposing a rights offering. There are 200, 000 shares outstanding trading at $25 each. There will be 10, 000 new shares issued at a $20 subscription price. o What is the new market value of the firm? o What is the ex-rights price? o What is the value of a right? 20 -23

What is the new market value of the firm? There are 200, 000 outstanding shares at $25 each. There will be 10, 000 new shares issued at a $20 subscription price. 20 -24

What Is the Ex-Rights Price? o There are 210, 000 outstanding shares of a firm with a market value of $5, 200, 000. o Thus the value of an ex-rights share is: $5, 200, 000 = $24. 7619 210, 000 shares o And, the value of a right is: $0. 2381 = $25 – $24. 7619 20 -25

Alternative Way to Compute the Ex. Rights Price and Value of a Right o o o 10, 000 new shares will be issued for 200, 000 outstanding shares, or this is a 1 for 20 rights issue Hence we have: 20 shares @ $25 = $500 plus 1 share @ $20 = $20 equals 21 shares with value of $520 so price of 1 share ex-rights $520/21 = $24. 7619 Value of 1 right = $25 - $24. 7619 = $0. 2381 20 -26

20. 8 The Rights Puzzle o o The vast majority of new issues in the U. S. are underwritten, even though rights offerings are much cheaper. A few explanations: n n Underwriters increase the stock price. There is not much evidence for this, but it sounds good. The underwriter provides a form of insurance to the issuing firm in a firm-commitment underwriting. Underwriters “certify” the price to the market. The proceeds from underwriting may be available sooner than the proceeds from a rights offering. 20 -27

20. 9 Dilution o Dilution is a loss in value for existing shareholders: n n Percentage ownership – shares sold to the general public without a rights offering Market value – firm accepts negative NPV projects Earnings per share – may decline even with positive NPV projects (at least in short run) Book value– occurs when market-to-book value is less than one 20 -28

20. 10 Shelf Registration Permits a corporation to register an offering that it reasonably expects to sell within the next two years. o Not all companies are allowed shelf registration. o Qualifications include: o The firm must be rated investment grade. n They cannot have recently defaulted on debt. n The market capitalization must be > $150 m. n No recent SEC violations. n 20 -29

20. 11 Issuing Long-Term Debt o Public issuance follows the same general process as stocks o Direct financing n n Term loans Private placements o Direct financing may have more restrictive covenants and higher rates, but is less costly to issue and easier to negotiate. 20 -30

Quick Quiz o o o o What is venture capital, and what types of firms receive it? What are some of the important services provided by underwriters? What type of underwriting is the most common in the United States, and how does it work? What is IPO underpricing, and why might it persist? What are some of the costs associated with issuing securities? What is a rights offering, and how do you value a right? What is shelf registration? What are the advantages of direct financing as opposed to public issuance of long-term debt? 20 -31