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Chapter 20
Raising Capital
SLIDES
CHAPTER ORGANIZATION
20.1 Early-Stage Financing and Venture Capital
Venture Capital
Stages of Financing
Some Venture Capital Realities
Venture Capital Investments and Economic Conditions
20.2 The Public Issue
20.1 Key Concepts and Skills
20.2 Chapter Outline
20.3 Venture Capitalists (VCs)
20.4 Stages of Financing
20.5 The Public Issue
20.6 The Process of a Public Offering
20.7 An Example of a Tombstone
20.8 Alternative Issue Methods
20.9 Table 20.1 - I
20.10 Table 20.1 - II
20.11 The Cash Offer
20.12 Firm Commitment Underwriting
20.13 Best Efforts Underwriting
20.14 Dutch Auction Underwriting
20.15 Investment Banks
20.16 IPO Underpricing
20.17 The Announcement of New Equity and the Value of the Firm
20.18 The Cost of New Issues
20.19 The Costs of Equity Public Offerings
20.20 Rights
20.21 Mechanics of Rights Offerings
20.22 Rights Offering Example
20.23 What is the new market value of the firm?
20.24 What Is the Ex-Rights Price?
20.25 What Is the Ex-Rights Price?
20.26 The Rights Puzzle
20.27 Dilution
20.28 Shelf Registration
20.29 Issuing Long-Term Debt
20.30 Quick Quiz
20.3 Alternative Issue Methods
20.4 The Cash Offer
Investment Banks
The Offering Price
Underpricing: A Possible Explanation
20.5 The Announcement of New Equity and the Value of the Firm
20.6 The Cost of New Issues
The Costs of Going Public: A Case Study
20.7 Rights
The Mechanics of a Rights Offering
Subscription Price
Number of Rights Needed to Purchase a Share
Effect of Rights Offering on Price of Stock
Effects on Shareholders
The Underwriting Arrangements
20.8 The Rights Puzzle
20.9 Dilution
Dilution of Proportionate Ownership
Stock Price Dilution
Book Value
Earnings Per Share
Conclusion
20.10 Shelf Registration
20.11 Issuing Long-Term Debt
ANNOTATED CHAPTER OUTLINE
Slide 20.1 Key Concepts and Skills
Slide 20.2 Chapter Outline
1. Early-Stage Financing and Venture Capital
Angel investors provide early stage funding. This may include family and
friends, but a more well-known group of financiers is venture capitalists.
One distinguishing characteristic is that venture capitalists invest not just
their own money, but that which they manage for others as well.
Lecture Tip: Entrepreneur Magazine has a series of “How to…” articles
on its web site and one particularly relevant set deals with “How to Raise
Money.” The site lists 18 financing sources
(www.entrepreneur.com/howto/raisemoney) and provides additional
information on each one including: what it is; what type of business it is
appropriate for; what it is best used for; the cost and the level of funds
typically available; the ease of acquiring the funds; and the steps to follow
to receive the financing.
The 18 different sources discussed are:
-Start-up financing – Initial infusion of money from a wide variety of
sources including selling assets, borrowing against your house, borrowing
against insurance, friends and family, etc.; any business
-Equipment leasing – Lender purchases and leases equipment to
business; any business at any stage of development
-Community Development Financial Institutions (CDFIs) – Loans to
businesses in areas that need economic development; start-up to
established firms
-Microloans – Small loans developed by the Small Business
Administration (SBA); primarily for working capital financing for small
companies
-Asset-Based Loans – Made through commercial finance companies
collateralized by assets such as receivables or inventory; rapidly growing,
undercapitalized companies
-Bank-Term Loans – Commercial loan; established small businesses
-SBA-Guaranteed Loans – Term loans up to 10 years with a guarantee
of as much as 80% by the Small Business Administration; established
small businesses that can repay loans through cash flows
-Private Loan Guarantees – Guarantee of payment for early-stage
company; early stage companies that will reach profitability within a year
-504 Loans – Long-term, fixed rate financing for fixed assets made
through Certified Development Companies; businesses that meet the SBA
size guidelines
-Royalty Financing – Advance against future sales; established
companies or emerging companies with high gross and net margins
-Federal Government Venture Capital – Small Business Investment
Companies licensed by the Small Business Administration; established to
early-stage companies that can repay a loan
-Angel Investors – Venture capital from individual investors; early-
stage or established companies that are willing to surrender some control
-Business Incubators – House several businesses in one location and
provide contacts, reduced rent and shared services to resident companies;
pre-revenue to early-stage companies
-401(k) Financing – Use money invested in 401K to start a new
business; any company at any stage of development
-Direct Public Offering – Sale of shares to individual investors; best
for established companies with strong tie to customers and community
-Reverse Merger – Private company purchases publicly traded, but
inactive company; minimum sales level of $20 million with no immediate
capital need
-Initial Public Offering – Sale of equity to the public for the first
time; start-up to established companies that can demonstrate significant
future growth potential
-Institutional Venture Capital - Professionally managed funds that have
money to invest in high growth firms; for high growth companies
expecting to reach at least $25 million in sales within five years
The web site provides a substantial amount of additional information
on each type of financing and is an excellent resource.
A. Venture Capital
Slide 20.3 Venture Capitalists (VCs)
Venture Capitalists (VCs) have three particularly important characteristics:
1. VCs are financial intermediaries that raise funds from outside
investors. They are typically formed as limited partnerships.
2. VCs play an active role in overseeing, advising and monitoring
the companies in which they invest.
3. VCs generally do not want to own the investment forever.
Given that VCs wish to exit, they must choose companies they believe can
grow to a sufficient level that will allow for this.
Lecture Tip: 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
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 June 2015, entering the keywords “venture capital”
into the Google search engine resulted in approximately 46 million hits,
up from 24 million hits in May 2009 and 7 million hits in November 2004!
Lecture Tip: 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. Its 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.
Lecture Tip: PriceWaterhouseCoopers’ Money Tree Report provides
information about venture capital (VC) funding on a quarterly basis. Go
to www.pwcmoneytree.com to investigate current VC activity by quantity,
sector and region.
B. Stages of Financing
Capital is typically provided in stages to limit the risk the Venture
Capitalist takes on.
Slide 20.4 Stages of Financing
The six general stages include:
Seed-Money Stage: Small amount of money to prove a concept or develop
a product
Start-Up: Funds are likely to pay for marketing and product refinement
First-Round Financing: Additional money to begin sales and
manufacturing
Second-Round Financing: Funds earmarked for working capital for a firm
that is currently selling its product but still losing money
Third-Round Financing: Financing for a firm that is at least breaking even
and contemplating expansion; a.k.a. mezzanine financing
Fourth-Round Financing: Financing for a firm that is likely to go public
within 6 months; a.k.a. bridge financing
C. Some Venture Capital Realities
The VC market is large, but the reality is that access to the market is
limited since VCs typically rely on an internal network to source deals.
Further, if you do get a VC deal, be prepared to give up a large piece
(commonly over 50 percent) of the firm.
D. Venture Capital Investments and Economic Conditions
The number of VC deals is strongly correlated to economic conditions.
2. The Public Issue
Slide 20.5 The Public Issue
Slide 20.6 The Process of a Public Offering
The Basic Procedure for a New Issue:
-Obtain approval from the Board of Directors
-File registration statement with the 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
-Advertise the offering using a tombstone.
Tombstones – large advertisements used by underwriters to let
investors know that new securities are coming to market
Slide 20.7 An Example of a Tombstone
Lecture Tip: 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.
A relatively new way to raise equity capital is through crowdfunding.
Currently, firms can issue up to $1 million in securities in a 12-month
period, and investors can invest upt to $100,000 per 12-month period.
3. Alternative Issue Methods
Slide 20.8 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 20.9 Table 20.1 – I
Slide 20.10 Table 20.1 - II
4. The Cash Offer
Slide 20.11 The Cash Offer
There are three methods for issuing securities: firm commitment, best
efforts, and Dutch auction.
Slide 20.12 Firm Commitment 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.
Given the risk of being stuck with unsold shares, the underwriter will
typically conduct a “road show” to market the offering prior to the actual
offer date. This is part of the process of “bookbuilding.”
Slide 20.13 Best Efforts Underwriting
Best efforts underwriting – the underwriters are legally bound to make
their “best effort” to sell the securities at the offer price, but they 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.
Slide 20.14 Dutch Auction Underwriting
Dutch auction underwriting – the underwriter does not set the offer price.
Instead, a series of bids is solicited from potential investors, and the price
that is paid by everyone is the price that will result in all shares being sold.
The incentive is to bid high to guarantee that you get in on the offer price,
knowing that you will only pay the lowest accepted price. But, the risk is
that everyone bids high.
The U.S. Treasury has sold bills, bonds, and notes using the Dutch auction
process for many years. Google is the highest profile Dutch auction IPO to
date.
A. Investment Banks
Slide 20.15 Investment Banks
Investment Banks (or Underwriters) are investment firms that act as
intermediaries between the issuer and the public. Some of the services
provided by underwriters include:
-Help in determining the type of security to issue
-Help in determining the 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
To choose an underwriter, two alternative methods exist:
Competitive offer basis – taking the underwriter that bids the most
for the securities
Negotiated offer basis – the more common (and expensive)
method
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. For
IPO’s in the range of $20 to $80 million the spread is typically 7%.
Lecture Tip: The underwriter’s spread is defined as the difference between
the offer 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. In the Spring 2006
issue of Financial Management Bradley, Cooney, Dolvin and Jordan find
that penny stock offerings have a spread that is almost always 10%, which
may be a result of the higher risk for these types of offerings.
The quiet period is a period of time around the IPO when company
employees and the underwriters must limit communications with the
public to “ordinary announcements and other purely factual matters.” This
is done to prevent too much hype in the hope of increasing demand for the
stock.
B. The Offering Price
