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© Natalya Brown 2008
Raising Capital
Raising Capital
© Natalya Brown 2009
Early StagesVenture Capital
Initial Public Offering*Primary
Secondary
After the IPORights Issue
General Cash OffersPrivate Placement
*Note that some large companies continue to prosper as independent private businesses (i.e. the company remains closely held).
© Natalya Brown 2009
Overview
• Early Stages: Venture Capital
• Initial Public Offering (IPO)
• The Role of the Underwriter
• Pricing the Issue
• After the IPO: Rights Issue, General Cash Offer and Private Placement of Securities
© Natalya Brown 2009
Venture Capital
• Venture capital is money invested to finance a new firm.
• Venture capitalists are investors who are prepared to back an untried company in return for a share of the profits.
• Venture capitalists specialize in providing new equity capital to help firms grow from start-up until they are ready to “go public”.
• An angel investor is a wealthy individual who invests in early-stage ventures.
• Most venture capital financing is done in stages to keep the firm on a short leash and force it to prove, at several crucial points, that it is worthy of additional investment.• Venture capitalists know that the success of a
business depends on the efforts its owner-managers put in.
• Typically, restrictions are placed on the management and venture capitalists advance the funding to the firm in stages, rather than all upfront.
• This transfers risk from venture capitalists to management
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The Initial Public Offering
• An initial public offering (IPO) is the first sale of shares to the public.
• This sale is usually managed by an underwriting firm or a group of underwriting firms. These are firms that buy an issue of securities from a company and resell it to the public.
• For large issues, a group of underwriters called a syndicate is formed with the principal underwriter being called the lead manager.
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• An IPO is called a primary offering when new shares are sold.
• An IPO is called a secondary offering when the company’s founders and the venture capitalist cash in some of their grains by selling shares.
• IPOs commonly consist of both primary and secondary offerings.
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The Role of the Underwriter
• Underwriters have three specific roles:– Underwriters provide advice to the issuing
firm, as they help to price and market the issue.
– Buying a new issue from the company– Reselling issue to investors
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–Firm Commitment: Underwriters buy new shares from the issuer and then resell them to the public at a higher price, thereby making a spread.
–Underwriter’s spread: Difference between public offer price and price paid by underwriter.
–In risky cases, an underwriter may prefer a best efforts deal. • Here the underwriter agrees, for a commission, to
sell as much of the issue as possible, but does not guarantee to sell the entire issue.
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Prospectus Requirement
• In Canada, a firm going public must provide potential investors with a prospectus.
• A prospectus is a formal summary that provides information on an issue of securities.
• One of the key functions of a prospectus is to warn investors about the risks involved in investment in the firm.
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Pricing the Issue
• The issuing company and the underwriters must set a price for the new securities they are about to offer.
• This is done using: – Discounted cash flow calculations.– An analysis of the price-earnings ratios of the
shares of the firm’s principal competitors.– Underwriters may arrange a “roadshow”
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Underpricing
• The issuing company wants to get the highest possible price for its shares.
• The underwriter is more cautious since they might be left with unsold securities if the issue is perceived to be expensive.
• As a result, underwriters typically try to underprice the IPO.
• Usually measured by calculating the percentage difference between the offer price of the share and its closing price after the first day of trading.
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Degree of Underpricing
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Cost of IPO
Flotation costs – cost of a new issue• Direct costs
– Preparation of registration statement and prospectus– Legal and administrative fees– Underwriter’s fees– Underwriting Spread
• Indirect costs– Underpricing of the issue
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Exercise 1
• Page One Paper Company decides to public with underwriters requiring a total of 16 million shares for $40 each. The underwriters sell them to the public at an offering price of $44.
• Page One and its shareholders will pay $6 million in legal and administrative fees.
• By the end of the first day’s trading Page One’s stock price rises to $60.
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• The underwriter’s spread = $44 - $40 = $4
• Underpricing = $60 - $44 = $16
• Cost of Page One’s IPO:Underwriting Spread: 16 million x $4 = $64 million
Legal, administrative and other = $6 million
Total Direct Expenses = $70 million
Cost of underpricing: 16 million x $16 = $256 million
Total cost of IPO = $326 million
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Listing on the Stock Market
• When a firm decides on an IPO of its shares, it must also decide where its newly issued shares should be traded.– Stock exchanges are organized facilities with a
centralized physical location.
– OTC markets exist in cyber-space and consist of a network of dealers who trade with each other electronically.
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Winner’s Curse
• When an issue is underpriced, the high demand for it means that investors will only be able to get a small share of it.
• However when an issue is overpriced, demand is low enough that investors are able to get a large proportion of it.
• Your ability to purchase an allotment of shares may signal that the stock is overpriced.
© Natalya Brown 2009
After the IPO
• Seasoned Offering: Sale of securities by a firm that is already publicly traded.
• Rights Issue: an issue of securities which is offered only to existing shareholders.
• General Cash Offer: Sale of securities open to all investors by an already public company.
• Shelf Registration: A procedure that allows firms to file one registration statement for several issues of the same security.
• Private Placement: Sale of securities to a limited number of investors without a public offering.
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Rights Issue
• In a rights issue, the company offers its shareholders the right to buy additional shares at a subscription price, which is significantly below the market value of the shares.
• By directly offering new shares to its shareholders, a company saves on issuing and underwriting expenses.
• A rights issue allows shareholders to retain their proportional shareholding and thus their voting position on the company’s major business decisions.
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Value of a Right
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Market Value of Subscription
share, ex rights PriceValue of one right =
number of rights required
to purchasea share
Exercise 2
• ABC Corp currently has 9 million shares outstanding. The market price is $15 per share. ABC decides to raise additional funds via a 1 for 3 rights offer at $12 per share. If we assume 100% subscription, what is the value of each right?
Current Market Value = 9 mil $15 = $135 mil Total Shares = 9 mil + 3 mil = 12 mil Amount of new funds = 3 mil $12 = $36 mil New Share Price = (135 + 36) / 12 = $14.25 per share Value of a Right = Rights-on price – Ex-rights price
= 15 - 14.25 = $0.75
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Private Placements
• A private placement is the sale of securities to a limited number of investors without a public offering.
• Private placements avoid many of the costs associated with a public offering and are less expensive to arrange.
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• Advantages:– The issue can be custom tailored.– It is much easier to change the terms of the
contract when only a few investors are involved.
• Disadvantage:– Investors cannot easily resell the security.
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LECTURE 3: CAPITAL STRUCTURE POLICY
Next
© Natalya Brown 2009