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CHAPTER 20: RAISING CAPITAL—EQUITY

Topics:

• 20.1 Background

• 20.7 Venture Capital

• 20.2-20.5 Initial Public Offerings

• 20.6 Rights Offerings

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Background

• The procedures for selling debt and equity securities are basically the same—we will focus only on equity here

• Securities market regulation in Canada is handled by provincial commissions (in the U.S. this is handled by the federal SEC) – all firms listed on the TSX are under the jurisdiction of the

Ontario Securities Commission (OSC)

– other provinces have similar laws and regulatory agencies

• Regulators want to protect investors against fraud, promote efficient flow of information about securities, and the smooth functioning of securities markets

• Regulation is coordinated by the Canadian Securities Administration

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Firm Life Cycle and Financing

Private debt & equity -Bank debt -Private placements of debt and equity -VC

Startup Growth Maturity

Firm

sales

Firm Life Cycle & Financing

- Insider financing- Angel Financing- VC

Mostly public finance (traded bonds and equity)

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How do firms secure financing? A Pecking Order Theory

• Internally generated funds

• External funds– Venture capital

– Private placement (bank debt/private placement)

– Public issue (traded bonds and traded equity)• Cash offerings: Issues sold to all interested investors

• Rights offerings: to existing S/H on a pro-rated basis

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20.7 Financing in the Early Stages Of the Firm’s Life Cycle

• Private equity market – “Angel” Finance (informal market for direct equity finance

provided by high net worth individuals.)

– Venture capital• A venture capitalist is a very active financial intermediary,

providing financing to relatively new and small businesses.

• VCs also participate in strategic planning and operational decisions.

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How VC’s Raise Funds

• “General Partners” put up about 2% of the funds and do all of the work; “limited partners” put up the other 98%:– Public pension funds

– Corporate pension funds

– Endowments and foundations

• Funds are typically set up to last about 10 years. Many proven VC’s manage multiple funds simultaneously. Investors may not liquidate early and may not freely sell their LP shares.

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How VC’s Invest

• VC’s “stage” their investment. Sometimes as many as nine stages. (staged financing)– ‘Seed’ (zero-stage) - prototype

– Early stage - production

– Later stage – growth.

• Key: only invest ‘big’ money when odds are good; exit bad investments early. High risk.

• Most VC’s focus on particular industries and on particular stages.– http://www.techcapital.com/: “Waterloo Technology Startup

Network”

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How VC’s Make Money

• VC’s profit by liquidating successful investments through either:– Sale back to management, to a buyout firm or to a large

corporation

– Issuance of an IPO. The IPO serves to liquidate the VC investment AND raise new funds.

• After repaying the initial investments, general partners keep 20% of the profits.

• General partners also take a fee of 2.5% ‘carried interest’ every year.

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The Typical VC Investment

• VC’s take preferred equity (like a debt-equity hybrid). The salient features of a VC contract are:– Converts to equity at the time of the IPO

– The entrepreneur may be removed from control by the VC at any time.

– VC’s demand that the majority of the entrepreneur’s wealth be invested in the entity; entrepreneurs typically get very small salaries.

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20.1 -20.5 Public equity

1. Definition

• Public equity is available to firms with larger needs for capital.

• The first issue of public equity is called an IPO:– Primary offering (offer for subscription, shares outstanding

____________)

– Secondary offering (offer for sale, shares outstanding ___________ )

• Later issues are called ‘seasoned’ equity offerings (SEOs)

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2. Typical Procedure for an IPO

• Board / shareholder meeting’s approval

• Preliminary prospectus – sent to securities commissions (OSC for firms listed on the TSE and SEC

for U.S. firms) and investors - no information on price yet (“red herring” prospectus)

• Revise prospectus to meet securities commission’s approval /Final prospectus – price determined with a price “window”/ marketing effort commences

• Road show, where informal ‘orders’ are taken

• Price setting. – 3-way bargain between issuer, investment bank and major purchasers.

• Trading begins. – Rule of thumb: Underwriter keeps 7% of proceeds (“underwriter spread”).

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3. Underwriting

• an underwriter is an investment bank that buys an issue of a security from a firm and resells it to the public

Types of underwriting

• Regular – Form Investment bank syndicate, who purchases securities from issuing

firm and resells them to public

– ‘Out clause’

• Firm commitment– Similar to regular with no ‘out-clause’ – highest price risk

• Best efforts– Does not guarantee any particular amount to issuing firm

• Which procedure will result in the highest offer price

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A tombstone

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4. Investment bankers’ roles

• Provide advice

• Pricing

• Marketing and Underwriting

• Stabilization– In the selling period:

• while the issue is being sold to the public, the syndicate agrees not to sell securities for less than the offering price

• the lead underwriter is allowed to buy shares if the market price drops to stabilize the price from downward pressure

• if the issue remains unsold after a period (e.g. 30 days), the syndicate dissolves and members can sell their shares for whatever price they can get

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5. Costs

• direct costs (underwriting spread, accounting, legal fees, overallotment (Greenshoe) option)– Spread: the difference between the underwriters’ buying price

and the offering price

• indirect costs – underpricing

– public scrutiny

– lose privacy - competitors also have access to information

– restrictions on management’s decision making abilities

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Average Expenses on IPOs

69.1812.0511.00Issues All

36.107.535.72up and 500

10.115.706.53499.99-200

78.127.167.06199.99-100

14.148.917.9199.99-80

35.1611.318.279.99-60

95.1713.658.7259.99-40

18.1812.489.739.99-20

15.189.6511.6319.99-10

16.2516.3616.969.99-2

(%) Costs

Total

(%)Return

DayFirst Avg

(%)

Spread

($mil)

Issues of Value

Source: 1990-1994. Jay Ritter et. Al (1996), Journal of Financial Research, “The Cost of Raising Capital”

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6. Salient Features of IPO Aftermarket

• Underpricing– Average underpricing for Canadian IPOs: (1971-1999) 6.3%

(Jay Ritter)

• IPO Long-run Performance is poor

• IPO Cycles: hot market vs. cold market

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Why are IPOs underpriced?• winner’s curse

– Almost everywhere in the world, investors who buy at the open price make excess returns. But… it is almost impossible to buy at the open price. One explanation is the winner’s curse.

Informed investors “Good issues” underpricing

Uninformed investors Every issue ?

• underwriters’ incentives and risk aversion– minimize risk of issue failing– avoid potential lawsuits if shares subsequently do poorly

• quality signal (issue seasoned equity later at a higher price) • key investors may be able to influence the offering price set by

the underwriter

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IPO “Scandals”

“What Should be Changed in the IPO Market?”, Jay Ritter, April 2003

 

• Spinning: – Allocating hot IPOs to the personal brokerage accounts of top executives

in return for company business

• Laddering: – Requiring the purchase of additional shares in the aftermarket in return for

participation in IPOs

• Analyst conflicts of interest: – Giving “buy” recommendations in return for underwriting and M&A

business

• Commission business in return for IPOs: – Underwriters allocated IPOs primarily to investors that generated a lot of

commissions on other trades

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7. Canadian features

• POP System (Prompt Offering Prospectus)

– the POP system allows large firms to file annual and semi-annual statements with the OSC whether or not they are issuing securities in a given year, and then to use a shorter prospectus so as to speed up seasoned issues

• similar to a U.S. system called shelf registration• Multi-Jurisdictional Disclosure System (MJDS): U.S. and Canada

– Large companies may issue securities in both countries while complying with home country regulatory approval

– Bought deals

• like firm-commitment underwriting where the underwriter has pre-sold the entire issue to large institutional investors

– Usually use POP – deals executed quickly

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20.4 Subsequent equity financing

• Seasoned equity offerings (SEOs) - average price drops by about 3%

• we might expect the price to rise, since the firm could be needing financing to take advantage of new investment opportunities

• Why does the price drop?• insider information

• signal regarding not using debt

• Insufficient earnings

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Case: Google IPO

Initial Public Offering Details

IPO Date: 19-Aug-04

First Trade: 11:56 am ET at $100.01

Price: $85.00

Method: Modified Dutch Auction

Lead Underwriters: Morgan Stanley, Credit Suisse First Boston

Stock Symbol: GOOG

Exchange: NASDAQ

No. of Shares Offered: 19,605,052

Value of Offering: $1.67 billion

Initial Market Cap: $23.1 billion

Total Initial Shares Outstanding:

271.2 million

(33.6 mil. class A, 237.6 mil. class B)

Allocation Percentage: 74.2% of bidded shares

Initial SEC Filings: Form S-1 Prelim. Prospectus (amend. 8/18)

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Google

Price

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IPO Underpricng :18%

9/14/05: SEO of 14.2 m shares at $295, 2.7% below closing price of $303.

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20.6 Rights Offerings

• 1. Definition– New issue offered to existing shareholders

– Shareholders receive one right for each share owned; rights give the shareholders the option to buy newly issued shares for a subscription price before a specified date

– Shareholders can exercise their rights, let it expire or sell the rights - usually rights do not expire unexercised; shareholders usually receive an oversubscription option allowing them to buy unsubscribed shares for the subscription price

– Typically use standby underwriting where underwriter makes firm commitment to buy unsubscribed part of the issue, receives standby fee in return

• In Canada, rights were popular before POP was introduced (now bought deals are popular)

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Example

• A firm currently has 10 million shares, which are selling for $15 per share. The firm wants to raise $50 million from a new equity issue. Suppose the subscription price is set at $10 per share. (1) How many rights are required to purchase one share?

(2) What is the value of a right?

(3) What will the price per share be after the rights offer?

(4) Does the subscription price matter?

Solution:

(1) Number of new shares =

Number of rights needed to buy a share =

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Example cont’d: A to (2) & (3)

a. Number of shares 10

Share Price (M0) 15

Value of current holding 150

b. Terms of Offer

Subscription price (S) 10

Number of rights issued 10

Number of rights for a share (N)

c. After offer

Number of shares 10+5 = 15

Value of Holdings $150 + $50 = $200

(3) Share price (Me)

(2) Value of one right (R0) (Old price – New price)

The Formula: R0 = (M0-S)/(N+1)

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Example cont’d: A to (4) Suppose instead S=$5?• Number of new shares = • Number of rights needed to buy a share =

R0 = (M0-S)/(N+1) =

  S = $10, R0 = 5/3 S = $5, R0 = 5

If exercise rights:

number of shares 10+5 = 15 10+10 = 20

Value 15*10 + 50 = 200 15*10+ 10* 5 = 200

If not exercise:

sell rights

   

share value    

 total  150  150

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• Assigned Problems # 20.1, 3, 4, 5, 9, 10, 11, 13, 14