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Equity financing - Faculty of A

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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




                                           1
                          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
                                                                     2
                       Firm Life Cycle and Financing

                                       Firm Life Cycle & Financing




                             Private debt &
                             equity
Firm sales




                               -Bank debt
             -Insider           -Private
             financing       placements of debt
             - Angel         and equity
             Financing          -VC                             Mostly public finance
             - VC                                               (traded bonds and equity)




             Startup             Growth                         Maturity

                                                                                            3
              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




                                                                  4
           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.




                                                                        5
                  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.




                                                               6
                      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‖


                                                                 7
                  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.



                                                                  8
                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.




                                                                  9
                   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)



                                                                     10
               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‖).

                                                                                  11
                            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
                                                                              12
A tombstone




              13
                 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
                                                                             14
                              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



                                                                     15
              Average Expenses on IPOs
Value of Issues Spread         Avg First Day          Total
    ($mil)      (%)              Return (%)       Costs (%)
         2 - 9.99     16.96              16.36         25.16
      10 - 19.99      11.63               9.65         18.15
      20 - 39.99         9.7             12.48         18.18
      40 - 59.99       8.72              13.65         17.95
      60 - 79.99         8.2             11.31         16.35
      80 - 99.99       7.91                8.91        14.14
   100 - 199.99        7.06               7.16         12.78
   200 - 499.99        6.53               5.70         11.10
     500 and up        5.72                7.53        10.36
      All Issues      11.00              12.05         18.69

Source: 1990-1994. Jay Ritter et. Al (1996), Journal of Financial
Research, ―The Cost of Raising Capital‖
                                                                    16
        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




                                                                17
                 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
                                                                              18
                             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

                                                                                     19
                      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


                                                                           20
              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




                                                               21
                               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
                                                                       271.2 million
Total Initial Shares Outstanding:             (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)
                                                                                   22
                                                                    Google
                                                                                 Price

500
450
400
350
300
250
                                                                                                     9/14/05: SEO of 14.2 m
200
                                                                                                     shares at $295, 2.7%
150
                                                                                                     below closing price of
100                                                                                                  $303.
50                         IPO Underpricng :18%
 0
      8/19/2004




                                            2/19/2005


                                                        4/19/2005


                                                                     6/19/2005


                                                                                   8/19/2005




                                                                                                                         2/19/2006


                                                                                                                                     4/19/2006


                                                                                                                                                 6/19/2006


                                                                                                                                                             8/19/2006
                  10/19/2004


                               12/19/2004




                                                                                               10/19/2005


                                                                                                            12/19/2005


                                                                                                                                                                         23
                       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)

                                                                                   24
                            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 =
                                                                  25
                         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)
                                                                          26
                         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


                                                                            27
•   Assigned Problems # 20.1, 3, 4, 5, 9, 10, 11, 13, 14




                                                           28

				
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