Pages 198-210

How Firms Raise Capital

To raise money, a firm can borrow, sell equity, or both.

15.1 BOOTSTRAPPING How New Businesses Get Started

Most businesses are started by an entrepreneur Entrepreneurs regularly leave large companies to start businesses (often

using technology developed by these firms) Entrepreneur often holds an informal, low-budget discussion with people he

trusts and usually talk about issues related to technology, manufacturing, personnel, marketing, and finance

Initial Funding of the Firm

Bootstrapping – the process by which many entrepreneurs raise “seed” money to obtain other resources necessary to start their business

The initial seed money usually comes from the entrepreneur or other founders

Other cash comes from personal savings, the sale of assets (such as cars and boats), borrowing against the family home, loans from family members and friends, and loans obtained through credit cards

Entrepreneurs usually work regular full-time jobs until the business gets started

At this stage, banks or venture capitalists are not normally willing to fund the business

Seed money is usually spent on developing a prototype of the product or service and a business plan

The deliverables at this stage are whatever it takes to satisfy investors that the new business concept can become a viable business and deserves their financial support

15.2 VENTURE CAPITAL

- The bootstrapping period usually lasts no more than one or two years; usually have developed a prototype and business plan already – critical time

- Venture capitalists – individuals or firms that help new businesses get started and provide much of their early-stage financing; individuals or firms that invest by purchasing equity in new businesses and often provide entrepreneurs with business advice

o Typically pool money from various sources to invest in new businesses:

Financial and insurance firms Private and public pension funds

Wealthy individuals and families Corporate investments not associate with employee pensions Endowments and foundations

- Angels (angel investors) – wealthy individuals who invest their own money in emerging businesses/ventures at the very early stages in small deals

The Venture Capital Industry

Venture capital industry emerged in the late 1960s with the formation of the first venture capital limited partnership

Today, the venture capital industry consists of several thousand professionals at about one thousand venture capital firms (most in California and Massachusetts)

Modern venture capital firms tend to specialize in a specific line of business, such as hospitality, food manufacturing, or medical devices

A significant number focus on high-technology investments Why Venture Capital Funding is Different

Venture capital is important because entrepreneurs have only limited access to traditional sources of funding.

Why traditional sources of funding do not work for new or emerging businesses:

1. The high degree of risk involved – most new businesses fail so most suppliers of capital (banks, pension funds, insurance companies) do not want to make these high-risk investments

2. Types of productive assets – new firms whose primary assets are often intangible (patents, trade secrets) find it difficult to secure financing from traditional lending sources

3. Informational asymmetry problems – information asymmetry arises when one party to a transaction has knowledge that the other party does not. An entrepreneur knows more about his company’s prospects than a lender does. Most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs so they don’t want to invest in these firms

For these reasons, many investors find it difficult to participate directly in the venture capital market. Instead they invest in venture capital funds that specialize in identifying attractive investments in new businesses, managing those investments and selling (exiting) them at the appropriate time

The Venture Capital Funding Cycle

Starting a New Business – The Tuscan Pizzeria

Developing a high-end pizzeria with an Italian ambiance and feel from the interior design, ingredients, wood oven, etc.

The Business Plan

Business plan describes what you want the business to become, why consumers will find your pizzerias attractive (the value proposition), how you are going to accomplish your objected, and what resources you will need

Send business plan to a regional venture capital firm Venture capital firms receive many unsolicited business plans, but respond

to very few First-Stage Financing

After a number of meetings with you and your management team, the venture capital firm agrees to fund the project – but only in stages and for less than the full amount you requested

Will give you give you some money but you have to come up with the rest on your own

How Venture Capitalists Reduce Their Risk Staged Funding

Each stage gives the venture capitalist an opportunity to reassess the management team and the firm’s financial performance

If the performance does not meet expectations, the venture capitalists can bail out and cut their losses, or if they still have confidence in the project, they can help management make some midcourse corrections so that the project can proceed

Companies typically go through 3-7 funding stages – each stage passed is a vote of confidence for that project

The latter stages of financing sometimes called mezzanine financing because the investors did not get in on the ground floor

In the pizzeria example: the first/seed-stage is for funding the prototype, make it operational, and test the concept’s viability in the marketplace. In the later stages of financing will fund more new restaurants

The venture capitalists’ investments give them an equity interest in the company. Usually this is in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalist

Preferred stock ensures that the venture capitalists have the most senior claim among the stockholders if the firm fails, while the conversion feature enables the venture capitalist to share in the gains if the business is successful

Personal Investment Venture capitalists often require the entrepreneur to make a substantial

personal investment in the business confirming that you are confident in the business and highly motivated to make it succeed

Syndication It is common practice to seed- and early-stage venture capital investments Syndication occurs when the originating venture capitalist sells a percentage

of a deal to other venture capitalists Reduces risk:

o Increases the diversification of the originating venture capitalist’s investment portfolio

o The willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision

In-Depth Knowledge The venture capitalist’s in-depth knowledge of the industry and technology

also reduces risk The Exit Strategy

Venture capitalists are not long-term investors in the companies they back

They stay with a new firm until it is successful with usually take 3-7 years then they exit by selling their equity position

Every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process

Usually includes: timing, the method of exit, and what price is acceptable 3 ways in which venture capital firms exit venture-backed companies: selling

to a strategic buyer in the private market, selling to a financial buyer, and offering stock to the public

most exit though strategic and financial sales rather than public sales Strategic Buyer

The strategic buyer is looking to create value through synergies between the acquisition and the firm’s existing productive assets

Financial Buyer This type of sale occurs when a financial group – often a private equity

(leveraged buyout) firm – buys the new firm with the intention of holding it for a period of time, usually 3-5 years, and then selling it for a higher price

Financial buyer not expecting to gain from operating or marketing synergies The firm operates independently and the buyer focuses on creating value by

improving operations. If firm is performing poorly, the buyer will bring in new management

Initial Public Offering (IPO) To obtain the highest price possible in the IPO, a venture capitalist will not

typically sell all of the shares he or she holds at the time of the IPO o Selling everything would send a bad signal to investors

Once firm’s shares are publicly traded, he can sell the remaining shares in the public market

Venture Capitalists Provide More Than Financing

One of the most important roles of venture capitalists is to provide advice to entrepreneurs

At the early stages of a business’ operations, the people managing often have technical skills but not the skills necessary to successfully manage growth

The extent of the venture capitalists’ involvement in the management of the firm depends on the experience and depth of the management team

Venture capitalists may want a seat on the board of directors Want an agreement that gives them unrestricted access to information about

the firm’s operations and financial performance and the right to attend and observe any board meeting

Insist on a mechanism giving them authority to assume control of the firm if the firm’s performance is poor, as well as the authority to hire a new management team if necessary

The Cost of Venture Capital Funding

The cost of venture capital funding is very high but the high rates of return earned by venture capitalists are not unreasonable

For every 10 businesses backed by venture capitalists, only 1 or 2 will succeed – the winners have to cover the losses on the businesses that fail

If a business is successful, the venture capitalists have made a substantial contribution to creating value for the other owners

15.3 INITIAL PUBLIC OFFERING

- If a business is really successful, it will outgrow the ability of private sources of equity

- It will need more money for investments in plant and equipment, working capital, and research and development (R&D) than these sources of capital will provide

- One way to raise larger sums of cash or to facilitate the exit of a venture capitalist is through an initial public offering (IPO) of the company’s common stock

- And IPO is a company’s first sale of common stock in the public market - A seasoned public offering is a sale of securities (either stocks or bonds) by

a firm that already has similar publicly traded securities outstanding - Public offering means that the securities being sold are registered with the

Securities and Exchange Commission so it can be legally sold to the public at large

o Only these can be sold to the public Advantages and Disadvantages of Going Public

The decision to go public depends on an assessment of the advantages and disadvantages of going public

Advantages of Going Public

The amount of equity capital that can be raised in the public equity markets is typically larger than the amount that can be raised through private sources

Millions of investors in public stock markets and easier to reach them After an IPO, additional equity capital can usually be raised through follow-

on seasoned public offerings at low cost – public markets are highly liquid and investors are willing to pay higher prices for more liquid shares of public firms than for illiquid shares of private firms

Going public can enable an entrepreneur to fund a growing business without giving up control – only needs to sell what is needed to raise the necessary funds

Once public, there’s an active secondary market where stockholders can buy and sell its shares

Motivate and attract top management talent Disadvantages of Going Public

The high cost of the IPO itself – because stock is not seasoned

A seasoned stock allows investors to observe how many shares trade on a regular basis and the prices. The stock sold in IPO is less well known and its value is more uncertain. Investors less comfortable buying a stock sold in an IPO and won’t pay as high for it as for a similar seasoned stock

The costs of complying with ongoing SEC disclosure requirements. Once a firm goes public it must meet a myriad of filing and other requirements by the SEC – the costs are high for smaller firms

The requirement that firms provide the public with detailed financial statements puts the firm at a competitive disadvantage

The SEC’s requirement of quarterly earnings estimates and financial statements encourages managers to focus on short-term profits

Investment Banking Services

To complete an IPO, a firm needs the services of investment bankers who are experts in bringing new securities to the market

Investment bankers provide: origination (giving the firm financial advice and getting the issue ready to sell), underwriting (the risk part of investment banking), and distribution (reselling the securities to the public)

Origination

The investment banker helps the firm determine whether it is ready for an IPO

Determining whether the management team, the firm’s historical financial performance, and the firm’s expected future performance are strong enough to merit serious consideration by sophisticated investors

How much money the firm needs to raise and how many shares must be sold Once decision to sell stock is made, board of directors must approve all

security sales, stockholder approval is required if the number of shares of stock is to be increased

The first step is to file a registration statement with the SEC Preliminary prospectus – contains detailed information about the type of

business activities of the firm and its financial condition, a description of the management team and their experiences, a competitive analysis of the industry, a range within which the issuer expects the initial offering price for the stock to fall, the number of shares that the firms plans to sell, and explanation of how the proceeds from the IPO will be used, and a detailed discussion of the risks associated with the investment opportunity

o Allows investors to make intelligent decision about investing in a security issue and the risks associated with it

No sales can be made from this document Underwriting Firm-Commitment Underwriting

Firm-commitment underwriting – the investment banker guarantees the issuer a fixed amount of money from the stock sale

The investment banker buys the stock at a fixed price and then resells it to the public

Risk: the resale price may be lower than the price the underwriter pays – price risk

Underwriter’s spread – the investment banker’s compensation The spread is the difference between the investment banker’s purchase price

and the offer price The spread covers the investment banker’s expenses, compensation for

bearing risk, and profit Best-Effort Underwriting

Best-effort underwriting - the investment banking firm makes no guarantee to sell the securities at a particular price, promises only to make it’s best effort

Compensation is based on the number of shares sold Underwriting Syndicates

To share the underwriting risk and to sell a new security issue more efficiently, underwriters may combine to form a group called underwriting syndicates

Each member is responsible for selling some of the securities being issued Entitles each underwriter to receive a portion of the underwriting fee as well

as a proportionate allocation of the securities to sell to its own customers May enlist other investment banking firms in a selling group which assists in

the sale of the securities – receive commission and bear no risks Determining the Offer Price

One step is to consider the value of the firm’s expected future cash flows The investment bankers will consider the stock price implied by multiples of

total firm value to EBITDA or stock price to earnings per share for similar firms that are already public

Investment banker will conduct a road show where management makes presentations about the firm and its prospects to potential investors

o Generates interest in the offerings and helps the investment banker determine the number of shares that investors are likely to purchase at different prices

Due Diligence Meeting

Purpose of meeting is list, gather, and authenticate matters such as articles on incorporation, by-laws, patents, important contracts, and corporate minutes

Investment bankers have a final opportunity to ask management questions about the firm’s financial integrity, intended use of the proceeds, and any other issues related to the pending security sales

Investment bankers hold these meetings to protect their reputations and to reduce the risk of investor’s lawsuits in the even the investment goes bad after

Distribution

Pricing call – the final offer price Typically takes place after the market has closed for the day The lead underwriter (book runner) makes its recommendation about the

appropriate price, and the management decide whether the price is acceptable

If acceptable, issuer files an amendment to the registration statement with the SEC which contains the terms of the offering and the final prospectus

Once registered, can be sold to investors The First Day of Trading

Syndicate’s primary concern is to sell the securities as quickly as possible at the offer price

If not sold within a few days, the underwriting syndicate disbands and members sell the securities at whatever price they can get

The Closing

At the closing, the issuing firm delivers the security certificates to the underwriter and the underwriter delivers the payment for the securities, net of the underwriting fee, to the issuer

Usually takes place on the 3rd business day after the trading has started

Pages 211-224

Dividends, Stock Repurchases, and Payout Policy

- Stock repurchase programs are commonly used to distribute excess cash to stockholders – can also be accomplished by dividends

17.1 DIVIDENDS

- Any time value is distributed to a firm’s stockholders, the amount of equity capital invested in the firm is reduced

- Payout policy – a firm’s overall policy regarding distributions of value to stockholders

- Dividend – something of value that is distributed to a firm’s stockholders on a pro-rata basis – in proportion to the percentage of the firm’s shares that they own

- When a firm distributes value through a dividend, it reduces the value of the stockholder’s claims against the firm

Types of Dividends

Regular cash dividend – a cash dividend that is paid on a regular basis. Generally paid quarterly

Stock market investors view a dividend reduction negatively Extra dividend – a dividend that is generally paid at the same time as

regular cash dividend to distribute additional value Special dividend – a one-time payment to stockholders that is normally

used to distribute a large amount of value o Normally used to distribute unusually large amounts of cash

Liquidating dividend – the final dividend that is paid to stockholders when a firm is liquidating

o In the U.S. the proceeds from the sale of a company’s assets are first used to pay all wages owed to employees and the company’s obligation to suppliers, lenders, the various taxing authorities, and any other party that has a claim on those assets

Only after these obligations are done can the company pay a liquidating dividend to the stockholder

Distribution of value to stockholders can also take the form of discounts on the company’s products, free samples, etc.

The Dividend Payment Process

- For public companies:

The Board Vote

Process begins with a vote by a company’s board of directors to pay a dividend. The board must approve any distribution of value to stockholders

The Public Announcement

After the vote, the company announce it will pay the dividend Declaration date/announcement date – the date on which this

announcement is made o Typically includes the amount of value that stockholders will receive

for each share of stock that they own, as well as the other dates associated with the dividend payment process

The price of a firm’s stock often changes when a dividend is announced because the public announcement sends a signal to the market about what management thinks the future performance of the firm will be and if the signal differs from what the investors expected, they will adjust the prices

The Ex-Dividend Date

Ex-dividend date – the first date on which the stock will trade without rights to the dividend

o Investor who buys shares before the date will receive the dividend; on or after the date won’t

Cum dividend – with dividend; ex dividend – on or after the date Stock prices drop on the ex-dividend date but this drop is smaller than the

full amount of the dividend because it will be taxed The Record Date

Record date – the date by which an investor must be a stockholder of record in order to receive a dividend

Typically follows the ex-dividend date by two business days The Payable Date

Payable date – when the stockholders of record actually receive the date; the date on which the company pays a dividend

Typically a couple weeks after the record date The Dividend Payment Process at Private Companies The board members know the identities of the stockholders when they vote to authorize a dividend. It is easy to inform all the stockholders of the decision to pay a dividend, and is easy to actually pay it. There is no public announcement, and no need for an ex-dividend date. The record date and payable date can be any day on or after the day that the board approves the dividend. 17.2 STOCK REPURCHASES - Stock repurchase – the purchase of stock by a company from its stockholder; an alternative way for the company to distribute value to the stockholders How Stock Repurchases Differ From Dividends

They do not represent a pro-rata distribution of value to the stockholders because not all stockholders participate

When a company repurchases its own shares, it removes them from circulation

o Reduces the number of shares of stock held by investors o Can change the ownership of the firm o Can increase or decrease the fraction of shares owned by the major

stockholders so it changes their control over the company Taxed differently. The total value of dividends is normally taxed. In contrast,

when a stockholder sells shares back to the company, the stockholder is taxed only on the profit from the sale

Accounted for differently on the balance sheet. When a company pays a cash dividend, the cash account on the assets side and the retained earnings account on the liabilities and stockholder’s equity side of the balance sheet are reduced. When a company uses cash to repurchase stock, the cash account on the assets side is reduced, while the treasury stock account on the liabilities and stockholder’s equity side is increased

How Stock is Repurchased Companies repurchase stocks in three ways

Can purchase shares in the market – open-market repurchases o Government restricts how much you can repurchase so it could take

months to distribute a large amount of cash using this way Tender offer – an open offer by a company to purchase shares

o Use this when company wants to distribute large amount of cash at one time

o Fixed price – management announces the price that will be paid for the shares and the max number of shares that will be repurchased. Interested stockholders then tender their shares by letting management know how many shares they are willing to sell. If number exceeds announced max, the max number of shares are repurchased

o Dutch auction – firm announces the number of shares that it would like to repurchase and asks the stockholders how many shares they would sell at a series of prices

Targeted stock repurchase – a stock repurchase that targets a specific stockholder

o Typically used to buy blocks of shares from large stockholders o Managers may be able to negotiate a per-share price that is below

current market price o Less chance that the shares will go to an unfriendly investor

17.4 STOCK DIVIDENDS AND STOCK SPLITS Stock Dividends

Stock dividend – a distribution of new shares to existing stockholders in proportion to the percentage of shares that they own (pro rata); the value of the assets in a company does not change with a stock dividend

Stock Splits Stock split – a pro-rata distribution of new shares to existing stockholders

that is not associated with any change in the assets held by the firm; stock splits involve larger increases in the number of shares than stock dividends

A division of each share into more than one share In a stock-split, stockholders frequently receive one additional share for each

share they already own – two-for-one stock split o Can involve larger ratios

Occur infrequently Nothing substantial changes

Reasons for Stock Dividends and Stock Splits

More expensive for investors to purchase odd lots, which consist of less than 100 shares, than round lots, which are multiples of 100 shares.

Odd lots are less liquid than round lots because more investors want to buy round lots

Stock dividends and splits offer ways to bring the price of the stock down to the appropriate trading range

Stock splits send a positive signal to investors about management’s outlook for the future = higher stock price

Reverse stock splits – the number of shares owned by each stockholder is reduced

17.5 SETTING A DIVIDEND PAYOUT What Managers Tell Us

1. Firms tend to have long-term target payout ratios 2. Dividend changes follow shifts in long-term sustainable earnings 3. Managers focus more on dividend changes than on the level (dollar amount)

of the dividend 4. Managers are reluctant to make dividend changes that might have to be

reversed