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Chapter 15
Raising Capital
LEARNING OBJECTIVES (Slide 15-2)
1. Describe the life cycle of a business.
2. Understand the different sources of capital available to a start-up business and to a growing
business.
3. Explain the funding available to a stable or mature business.
4. Explain how companies sell bonds in a capital market.
5. Explain how companies sell stocks in a capital market.
6. Examine some special forms of financing: commercial paper and banker’s acceptance.
7. Describe the options and regulations for closing a business.
IN A NUTSHELL…
This chapter is about how entrepreneurs and firms go about raising funds for growth and
development. As a firm progresses through the various phases of its business cycle, its needs,
focus, and conditions change requiring it to use different sources of capital. Firms typically sell
bonds and stock to raise capital, and so the author explains the process followed by issuing
companies. Besides bonds and stock, firms also borrow short-term funds by issuing commercial
paper and bankers’ acceptances. The chapter closes with a discussion of the options and
regulations that come into play when a firm decides to cease operations and close permanently.
LECTURE OUTLINE
15.1 The Business Life Cycle (Slide 15-3)
A firm typically goes through five stages in its life cycle: start-up, growth, maturity, decline, and
closing.
Each stage presents unique problems, opportunities, and funding requirements.
Business life cycles vary considerably. Some firms go through the early stages fairly rapidly and
then settle into maturity for a long time, while others skip to the closing stage in a few years.
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The U.S. Census Bureau’s Business Information Tracking System estimates that roughly 60% of
businesses that employ others besides the owners will close within their first six years.
The life cycle approach is a useful way to discuss financing opportunities and sources for
businesses.
15.2 Borrowing for a Start-up
and Growing Business (Slides 15-4 to 15-12)
Five sources of capital can generally be used to start and grow a business:
1. Personal funds
2. Borrowed funds from family and friends
5. Angel financing or venture capital
Personal funds and family loans, although limited in scope, are often good starting points
for most entrepreneurs and sole proprietorships.
After all, if you can’t convince your family and friends that you have a good business idea, how
can you convince a stranger?
Commercial bank loans constitute the first source that people often seek after they have run
out of friends and in-laws to ask.
Start-ups are rarely directly funded by commercial banks.
Commercial bank loans through the Small Business Association (SBA) are available to
qualified small business applicants via a variety of loan programs, the most common of which is
Loan proceeds can be used for working capital and fixed assets, with repayment schedules
extending up to twenty-five years.
These loans are delivered through commercial lenders and guaranteed by the SBA.
The interest rates tend to be quite competitive but the major advantage of this program accrues
to the banks since the loans are backed by the SBA.
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Angel financing and venture capital is generally sought by entrepreneurs and businesses
that would not qualify for commercial bank or SBA-backed financing.
Angel investors are wealthy individuals and groups that are interested in providing initial funding
for high-risk ideas. They typically have very short loan investment horizons (less than ten years)
and upside limits of about $2 million.
Venture capitalist firms or funds are also willing to fund high-risk projects but have longer time
horizons and higher funding limits. They generally provide the funding in stages.
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Example 1: Expected rate of return for a venture capitalist
The Quick Start Funding Group is looking to fund only those projects that have the potential to
return $10 million dollars for every $1 million that they have invested within a five-year period.
Calculate the firm’s expected rate of return on its investment.
15.3 Borrowing for a Stable and
Mature Business: Taking Out Bank Loans (Slides 15-13 to 15-19)
Commercial banks provide much of the short-term financing required for the operating needs of
a business via straight loans, discount loans, and lines of credit with or without compensating
balances.
Straight loans represent the simplest of all types of bank loans and are offered with a quoted
APR and preset payment amounts and intervals.
Example 2: Calculating payments and EAR of a straight loan
The Timken Company wants to borrow $2,000,000 from its local bank. The bank quotes them a
rate of 8.25% (APR) on a five-year loan with payments due monthly. How much will their
monthly payment be and what is their EAR?
Discount loans are offered to firms with the interest amount being already subtracted at the
start.
The difference between the amount the firm can use and the amount that has to be paid back at
the end is the bank’s interest or discount earned.
The loan amount is the amount due at maturity.
Example 3: Discount loan
Let’s say that a firm needs $2,000,000 to fund the operations of its new expansion. It
approaches a commercial bank, which offers it a discount loan at 9.5% per year that will have to
be paid back in full in one payment at the end of twelve months. How much will the face value
of the loan have to be set at and what rate of interest is the company effectively paying?
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Letters of Credit or Lines of Credit are preapproved borrowing amounts that work much like
credit cards. The company can borrow money at a preset rate from bank at any time without
seeking additional approval of the loan each time it needs funds.
The bank, however, is compensated based on the outstanding balance of the loan. The
compensation can be a fixed interest rate but often is a floating interest rate tied to a
benchmark interest rate.
This borrowing style has changing balances and changing interest rates, so it is difficult to state
the effective rate on the loan.
Compensating balance loans work like lines of credit except that a portion of the loan is not
available to the borrower, even though interest is paid on the full face value of the loan. For
example, if a firm takes a loan of $100,000 at a rate of 7.5% per year and a compensating
balance requirement of 15%, it will be able to use only $85,000 and be charge $7,500 in interest
for the year. The effective rate of interest will therefore be:
15.4 Borrowing for a Stable and
Mature Business: Selling Bonds (Slides 15-20 to 15-25)
Corporate bonds represent a major source of long-term financing for established companies.
Bonds are typically sold in $1,000 units, and publicly auctioned or privately placed. The public
issue of bonds is regulated by the SEC and typically involves the following five steps
1. The company selects an investment bank to help design and market the bond. An
investment bank is an agent that works with the firm to meet all the listing requirements of
the bond issue, the design of the bond terms, the marketing of the bond, and the auction of
the bond.
3. The bond is rated by an agency such as Standard & Poor’s or Moody’s to help potential
buyers determine an appropriate price for the bond.
5. An auction is conducted to sell the bond.
Two key documents that are required during the bond issuance process include the prospectus
and the indenture agreement.
The prospectus contains much of the information filed in the registration and is used to inform
potential buyers about the bond.
The indenture agreement is the formal contract for the bond between the issuing company and
the eventual buyer. It includes vital information about the bond, such as the coupon rate,
payment schedule, maturity date, and par value as well as other restrictive covenants, i.e.,
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provisions that restrict the activities of the issuing firm to increase the safety of the bond in the
eyes of potential buyers.
Firms that issue coupon bonds have to make periodic coupon payments and a large lump sum
payment at maturity.
Sinking funds or reserve accounts are often set up by bond issuers to put away funds every year
so as to have the necessary funds available to retire the bond when it matures.
Example 4: Bond proceeds
The Golden Corral Corporation is in the process of issuing a thirty-year, 8% coupon (paid
semiannually) AA1-rated corporate bond with $1,000 par value. If by the time the bonds receive
SEC clearance, the market yield on this bond goes to 8.35%, and the company sells 3,000 of
these bonds with the help of an investment banker who charges them a commission rate of 3%
on the proceeds, what will the total proceeds be for the issuing company, and what is the cost
of these bonds to the firm in terms of the cost of capital? What are the firm’s future cash
obligations?
15.5 Borrowing for a Stable and
Mature Business: Selling Stock (Slides 15-26 to 15-37)
The other major source of capital for a firm to avail of its common stock or equity.
Equity holders get voting rights as part owners and share in the residual profits of the firm.
Stocks are sold as initial public offerings (IPOs) when the firm first goes public and seasoned
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Investment banks partner with issuing firms in exchange for compensation that can be set up on
a best-efforts basis or on a fixed-commitment basis.
Under a best-efforts arrangement, the investment bank pledges to use its best efforts to sell all
the authorized shares and takes a cut on each individual share sold, but it provides no guarantee
as to how many shares will be sold. The more shares sold, the higher the payoff to the
investment bank.
Under a fixed-commitment arrangement, also known as an underwriting arrangement, the
investment banker guarantees a fixed amount of proceeds to the issuer. The investment banker
makes up/keeps the difference between the actual selling price and the guaranteed price.
Example 5: Best efforts versus fixed commitment underwriting
The Wed Link, Inc. wants to raise capital by issuing common stock. They contact a few
investment bankers and the one with the best offer has presented them with two options:
1) A fixed commitment offer of $8,500,000
2) A best efforts arrangement in which the investment banker will receive $1.50 per share for
every share of stock sold up to $1,500,000 for the 1,000,000 shares to be offered to the
public at $11 per share.
a) If 100% of the shares are sold, what are Wed Link’s proceeds? What is the payment to
the investment banking firm under each method of issuing securities?
b) What if 85% of the shares are sold? At what percentage of shares sold are the proceeds
to you the same under the two compensation arrangements?
c) At what percentage is the payment to the investment banking firm the same?
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b) If 85% of the shares are sold, i.e., 850,000 shares at $11 per share, the proceeds are as
follows:
1) With the firm commitment arrangement, the issuer gets $8,500,000
The investment banker gets $9,350,000 – $8,500,000 = $$850,000
2) With the best efforts arrangement, the issuer gets ($11 – $1.50) * 850,000 ➔
$8,075,000
The investment banker gets $1.5*850,000➔$1,275,000
➔So if the issue is only 85% sold, the issuer is better off with a firm commitment offer while
the investment banker would be better off with the best efforts arrangement.
c) Firm commitment offer = best effort $ per share sold
$8,500,000 = $9.50*1,000,000 * X% ➔ X% = $8,500,000/$9,500,000 ➔89.47%
So, if 89.47% of the shares are sold, the payment to the investment banking firm will be the
same under either arrangement.
Registration, Prospectus, and Tombstone: All new issues of shares have to be registered
with the SEC prior to being sold in the capital markets.
Once an application is filed, the approval process could take anywhere from twenty to forty days
(cool-off period). During the waiting period, the issuer can circulate a preliminary prospectus
(red herring) informing potential investors of the issue. No commitments can be obtained from
buyers until after SEC approval. If information is missing, the SEC issues a comment letter,
requiring corrections and a new application to be filed. Once re-filed, the cool-off period starts
again.
During the waiting period, the issuer and investment bank place large advertisements
(tombstone ads) in newspapers and magazines, containing the name of the issuer, some details
about the issue, and a list of participating investment banks.
There are two exceptions to the usual SEC registration process requirement:
The Marketing Process: Road Show: This stage involves taking the issue on the road to
attract interest among potential investors. This process usually last about two weeks and
enables the investment banker to get a feel for what the price should be set at. After a
successful road show and marketing campaign, a price is set and the issue proceeds forward to
be auctioned off in the primary capital market.
The auction: takes place on a single trading day, during which time buyers submit their bids at
preset prices. If over-subscribed, the bids are filled on a pro-rata basis until all the shares are
sold.
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15.6 Other Borrowing Options for a Mature
Business (Slides 15-38 to 15-41)
Commercial paper and bankers’ acceptances are two other popular financing options used by
mature businesses.
Commercial paper is a discounted note sold by a company directly to an investor with both
principal and interest repaid within 270 days just like a treasury bill. These issues typically have a
face value of $100,000, putting them out of the reach of most small investors. It is generally
assumed institutions and sophisticated investors purchase commercial paper. The reason firms
issue commercial paper over other forms of borrowing is that they can get lower rates than
through commercial banks, and because they mature within 270 days, they qualify for short-
form registration with the SEC.
Example 6:
The Large-Scale Industrial Corporation, a large well-established company, is about to issue
$6,000,000 worth of commercial paper. The paper has a maturity of nine months (270 days) and
commands a price worth 97.5% of par value in the market. The paper will be sold with a face or
par value of $100,000. How many commercial papers will be sold? What is the cost of this
borrowing to the firm?
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It typically involves an importing firm having its invoice guaranteed (accepted) by a bank and
sent over to the exporter as assurance of payment in the next few months (typically 60–90
days). The exporter turns in the banker’s acceptance to his bank in exchange for a reduced
payment and in return the bank in the exporting country takes title to the exported goods until
payment is received. The importing firm is able to finance its purchases and releases funds as
inventory is liquidated.
15.7 The Final Phase: Closing the Business (Slides 15-42 to 15-46)
Sometimes, successful solvent firms decide to cease operations, in which case they sell off their
assets, pay off all outstanding debts and expenses, and distribute the residual value to the
stockholders.
When firms are unsuccessful, they may decide to cease operations, declare bankruptcy, and
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Straight Liquidation: Chapter 7 of the Federal Bankruptcy Reform Act (1978) deals with the
process that has to be followed when a firm decides to close its business and liquidate its assets.
Once a firm files for Chapter 7, the bankruptcy court judge appoints a trustee to oversee the
process of liquidation, the order of which is as follows:
Note that common stockholders are last on the list and typically get little to nothing of the
proceeds from the sale of the remaining assets.
Reorganization: Chapter 11 is what some firms file for if their managers feel that there is a
chance that they could restructure the firm and be worth more alive than dead. In a typical
reorganization the process is as follows:
First, a petition for Chapter 11 is filed by either the company or by a creditor, and a bankruptcy
court judge either accepts or denies the petition.
If accepted, a date is set by the judge for all claimants to show proof of their claims and for the
firm to establish who exactly the claimants are.
A reorganization plan is presented to the court and must be approved by a majority of the
members of a claimant class.
If the claimants cannot agree on the reorganization plan, the judge may issue a ruling on all or
parts of a plan and thus “decree” the reorganization plan.
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Old debt may be restructured in terms of both maturity and rates.
The plan itself holds off claimants while the company tries to reorganize and come out of
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Questions
1. What are the five stages of a business life cycle? Do all companies go through all five
stages?
2. According to the U.S. Census Bureau’s Business Information Tracking System, what is the
failure rate of companies over the first six years?
3. What is the function of the Small Business Administration in regard to business loans?
Who receives the guaranty on the loans?
4. What is the difference between an angel investor and a venture capitalist? What event do
these investors want to see happen? Why?
5. What is a letter of credit or line of credit? How does it work?
6. What is the role of an investment bank in selling bonds?
7. What is the role of an investment bank in selling stock?
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ANSWER
2. Venture capital required rate of return. Red Devil Investors has a success rate of one
project for every four funded. Red Devil has an average loan period of two years and
requires a portfolio return of 25%. If you borrow from Red Devil, what is your annual cost of
capital?
ANSWER
3. Straight bank loan. Left Bank has a standing rate of 8% (APR) for all bank loans, and requires
monthly payments. What is a monthly payment if a loan is for (a) $100,000 for five years, (b)
$250,000 for ten years, or (c) $1,000,000 for twenty-five years? What is the effective annual
rate of each of these loans?
ANSWER
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Keys N I/Y PV PMT FV
CPT $3,033.19
For $1,000,000 over twenty-five years
Mode: P/Y = 12, C/Y = 12
Input 300 8.0 –1,000,000 0
Keys N I/Y PV PMT FV
CPT $7,718.16
The EAR for all three loans is:
EAR = (1 + 0.08/12)12 – 1 = 8.299%
