04/22/23 Financing a Business 1

Raising Capital: Financing a Business

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Topics1. Basic Concepts2. Commercial Bank- Short Term3. Commercial Bank- Long Term4. Non Bank Financing5. Early Stage Financing6. Going Public7. Other

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1. Basic Concepts Primary vs. Secondary Market I. Bank vs. C. Bank Efficient Markets

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Investors

Financial Markets

Firms

Stocks and BondsMoney Bob Sue

Primary Market

Secondary Market

securities

money

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How to Create Value through Financing

1. Fool Investors Empirical evidence suggests that it is hard to fool investors

consistently.

2. Reduce Costs or Increase Subsidies Certain forms of financing have tax advantages or carry other

subsidies. Some ways of raising capital are cheaper than others.

3. Create a New Security Sometimes a firm can find a previously-unsatisfied clientele

and issue new securities at favorable prices. In the long-run, this value creation is relatively small,

however.

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2. Commercial Bank – Short Term Short term loans Compensation Collateral and protection Letter of credit (LC) Reverse repurchase agreement (REPO)

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Commercial Bank –Short Term Loans

Single payment loans Installment loans Discount loans Credit lines or bank facility Repayment on demand

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Commercial Bank –Compensation

Commitment fee (1/2 %) Compensating balances (10% in checking) Interest rate

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Commercial Bank –Collateral and Protection

Unsecured Collateralized (financial strength with

escape) Asset-based loans (value of the assets) Key executive insurance (payable to bank) Personal guarantees

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Commercial Bank –Letter of Credit (LC)

Guarantee by bank Importing and exporting

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Commercial Bank –Reverse Repurchase Agreement (REPO)

Sell T-Bill for $998 Agree to buy back the T-Bill for $1000 in 10

days

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3. Commercial Bank – Longer Term Loans

Term loans Periodic repayment or interest w/ balloon Collateral (fixed assets)

Lease financing Mortgage financing

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4. Non-Bank Short-Term Financing Account payable (implicit cost) Commercial finance companies (risky asset backed, factoring, leases) Factoring (credit cards) Commercial paper (rated, 3-months, unsecured IOU from prestigious firm,

$25,000 minimum) Direct or finance paper (GE Capital Corporation or GMAC) Indirect or dealer paper (through I. bank)

Small business administration Guarantees to repay up to 90% of loan Paper work! But new micro loans

Grants (i.e. Small Business Innovation Development Act) All federal agencies with R&D budgets must spend some on small tech

business

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Stages of Financing1. Seed-Money Stage:

Small amount of money to prove a concept or develop a product.2. Start-Up

Funds are likely to pay for marketing and product refinement.3. First-Round Financing

Additional money to begin sales and manufacturing.4. Second-Round Financing

Funds earmarked for working capital for a firm that is currently selling its product but still losing money.

5. Third-Round Financing Financing for a firm that is at least breaking even and contemplating

expansion; a.k.a. mezzanine financing.6. Fourth-Round Financing

Financing for a firm that is likely to go public within 6 months; a.k.a. bridge financing.

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5. Early Stage Financing Bootstrapping Early equity

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Bootstrapping (few resources) Entrepreneur resources (Gates and Allen in

a cheap apartment) Few employees (subcontract, temps,…) Lease, share, or barter OPM (i.e. suppliers)

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Early Equity Personal resources(savings, cards, parents, friends

and family)

Private investors Angels Private placement Venture capital Strategic alliances Small Business Investment Company (SBIC)

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Angels $20 – 750K Referral Former entrepreneurs, wealthy individuals Faster than VC’s Demand less control than VC’s Invest smaller amounts than VC’s

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Private Placement SEC Regulation A (under $1.5 mill. New, no audit, less

reporting) SEC Regulation D

Rule 504 ($1 mill./yr. To any number, sophisticated or not) Rule 505 ($5 mill./yr. To 35 accredited investors) Rule 506 (unlimited amount to accredited and relations, but no

general solicitation) Small Corporate Offering Registration, Form SCOR U-7

(question and answer)

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Venture Capital The limited partnership is the dominant form of

intermediation in this market. There are four types of suppliers of venture capital:

Old-line wealthy families. Private partnerships and corporations. Large industrial or financial corporations have established

venture-capital subsidiaries. Individuals, typically with incomes in excess of $100,000 and net

worth over $1,000,000. Often these “angels” have substantial business experience and are able to tolerate high risks.

Demand convertible preferred stock Demand control

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Strategic Alliances Companies invest in other companies for strategic

reasons (i.e., leverage technology). Fast deals, good valuations What if your product allows Adobe to increase the

price of its products by $5? What if your product allows Sprint’s fiber optic

cables to carry 10% more volume? Offer validation, introductions, promotions…

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Small Business Investment Company (SBIC) VC investment companies licensed by the

SBA.

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6. Going Public (IPO vs. SEO) Approval from board Pick investment bank and pre-underwriting conference Prepare and file registration statement with SEC

20-day waiting period, letter of comment, 20 more days Road show, built a book, preliminary prospectus or red herring,

syndicate registrar and transfer agent (but no selling) Pricing (file amendment), final prospectus, purchase, tombstone Resale After market, stabilization, and lockup Green shoe provision or over allotment option

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Pick Investment Bank and Pre-Underwriting Conference Debt, equity, or hybrid Competitive bid or negotiated offer Public or private Firm commitment or best efforts Cash offer or rights offer Shelf registration, SEC Rule 415 Exchange (NYSE, AMSE, Nasdaq)

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Issuing New Securities

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Allocation of Underwriting Spread

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Public vs Private Placement of Bonds

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Costs Spread (7%) Other direct expenses (filing fees, legal fees, printing,

mailing, registrar and transfer agent) Indirect expenses (management time, accountants time) Abnormal returns (seasoned issue price drop of around

3%) Underpricing (why are so many content to sell assets for

85% of value?) Green shoe option

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The Costs of Public Offerings Proceeds Direct Costs Underpricing(in millions) SEOs IPOs IPOs

2 - 9.99 13.28% 16.96% 16.36%10 - 19.99 8.72% 11.63% 9.65%20 - 39.99 6.93% 9.70% 12.48%40 - 59.99 5.87% 8.72% 13.65%60 - 79.99 5.18% 8.20% 11.31%80 - 99.99 4.73% 7.91% 8.91%

100 - 199.99 4.22% 7.06% 7.16%200 - 499.99 3.47% 6.53% 5.70%

500 and up 3.15% 5.72% 7.53%

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An Example of a Tombstone Advertisement

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Average First-Day Returns by Month for SEC-Registered IPOs: 1960-2005

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7. Other ADR and GDR Euromarket Swaps Convertibles Warrants Junk Bond Securitization