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

Underwriters

• 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

IPO Underpricing

• 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.
• Why?
  • 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

• 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