Ch. 15: Raising Capital
Early-Stage Financing and Venture Capital
- Private financing for new businesses in exchange for equity.
- May be individuals (angels)
- May be pooled (private equity) funds
- Usually entails some hands-on guidance.
- Funding usually comes in stages.
- ``Seed money’’ or ground floor financing
- Mezzanine financing
- VC companies usually have an exit strategy.
- Sell the company
- Take the company public
Types of Public Equity Issues
- General cash offer: an issue of securities offered for sale to the general public
- Initial public offering: a company’s first equity issue made available to the public
- Seasoned equity offering: a company’s subsequent equity issues
- Rights Offering
- A public issue of securities in which securities are first offered to existing shareholders
- Helps with dilution problem
- Uncommon in US
- An investment firm that serves as an intermediary between the issuing company and investors
- Underwriters perform the following services:
- Formulate the method used to issue the securities.
- Price the new securities.
- Sell the new securities.
- Provide price stabilization.
- Typically, the underwriter will buy the shares at less than the offer price. This gross spread serves as the underwriter’s compensation.
- A group of underwriters is called a syndicate.
- Types of underwriting
- Firm Commitment: the underwriter buys the entire issue
- Best Efforts: underwriter can return unsold shares
- Dutch Auction
- offer price is set based on competitive bidding by investors
- price paid is the highest price that will result in all shares being sold
- Additional Terms
- Green shoe provision: allows for oversubscription (underwriter can purchase an additional 15% of the issue)
- Lockup agreement: specifies how long insiders must wait after an IPO before they can sell their shares
- See Figure 15.2.
- Money left on the table
- Potential explanations for underpricing:
- Much of the apparent underpricing is attributable to smaller, more speculative issues.
- Winner’s curse: Suppose there are two investors, Joe Average and Ms. Smarts. Ms. Smarts avoids overpriced issues and heavily invests in underpriced issues. Joe Average puts in a bid for all IPOs. As a result, he gets more of the duds and fewer of the underpriced shares. To keep Joe bidding, firms underprice new shares.
- Legal liability
Seasoned Equity Offerings
- Stock prices tend to decline following the announcement of a new equity issue.
- Managerial information: issuing equity is cheapest when the firm is overvalued
- Debt usage: If the new projects are good, why make them available to new shareholders?
- Issue costs: Indirect costs of selling securities (e.g., management time)
- Dilution is a loss in value for existing shareholders.
- Percentage ownership: shares sold to the general public without a rights offering
- Market value: firm uses new capital on negative NPV projects
- Book value and EPS: occurs when market-to-book ratio is less than one