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BCOR 2200 Chapter 15

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					 Chapter 15
Raising Capital

                  1
Chapter Overview
We know how to choose projects:
• Calculate the NPV
   – NPV = S CFt/(1 + R)t
      • CFs: Incremental CFs, opportunity costs, no sunk
        costs…
      • Discount rate (WACC): The investors’ required
        return
   – Positive NPV, do it
      • It’s a good use of the investors money
   – Negative NPV, don’t do it
     • Project does not earning enough to cover the risk
• We know how to choose the mix of financing:
   – Choose D/E to minimize WACC
   – Consider Taxes and the Cost of Financial Distress           2
                           But how does the firm get the money? 
Chapter Overview
• How does a firm get the money for new
  projects?

1. It could Retain Earnings
   – Wait until it earns enough from existing operations to
     pay for new projects

2. It could raise capital by Selling Securities
  – Sell stocks or bonds to finance new projects



      What is the process of issuing securities? 

                                                          3
Chapter Overview
We’ll consider 3 stages of a business:
1. A new small firm that needs money to start up
   – Called Venture Capital
   – Private securities that are not allowed to be sold to the public

2. A (somewhat) proven business that needs money to
   expand
   – Raising money from the public market
   – Called an Initial Public Offering (IPO)
   – Sell stock to the public

3. An existing public company that wants to:
   – Expand: Sell debt and/or equity to finance the expansion.
   – Restructure its Balance Sheet: Sell debt and buy equity (or the
     opposite)
   – Issue new debt to payoff expiring debt

                                                                        4
Key Concepts and Skills
• Understand the Venture Capital market and its
  role in financing new businesses

• Understand how securities are sold to the public
  – The role of Investment Bankers


• Understand Initial Public Offerings
  – And the costs of “going public”


• Understand Secondary offerings
                                                     5
Outline:
• The Financing Life Cycle of a Firm
  – Early-Stage Financing and Venture Capital
• Selling Securities to the Public: The Basic
  Procedure
• Alternative Issue Methods
• Underwriters
• IPOs and Underpricing
• New Equity Sales and the Value of the Firm
• The Cost of Issuing Securities
• Issuing Long-Term Debt
• Shelf Registration
                                                6
15.1 Venture Capital
• You have an idea for a product
   – But you don’t have any money to build more than one
   – Also, you don’t really know anything about management, HR,
     supply chain, production methods, marketing, patents, dealing
     with customers…
• You try banks, but they aren’t interested in giving you
  money
   – Too much risk.
   – Also you have no assets (collateral)
• So go to a Venture Capital firm
   –   Firms that specializing in evaluating your idea (and you)
   –   Funding your initial operations
   –   Often provide general business advise
   –   So you can get a working product and a working company



                                                                     7
Venture Capital
• The Goal:
  – Once you have a working product and company
  – And can demonstrate the growth potential of the
    product and company
  – Sell the company to the public (IPO)

• For how much?
                   Value = S CFt/(1 + R)t

  – The discounted present value of the expected future
    cash flows
     • So really E(CFt)
  – If you keep 50% of the company, you only get ½
                                                          8
Venture Capital
• Many VC firms are formed
  – From a group of investors
  – Who pool capital and
  – Then have partners in the firm decide which
    companies will receive financing

• Some large corporations have a VC
  division


                                                  9
15.2 Selling Securities to the Public
• Management must obtain permission from the Board of
  Directors
• Firm must file a registration statement with the SEC
• SEC examines the registration during a 20-day waiting
  period
   – A preliminary prospectus, called a red herring, is
     distributed during the waiting period
   – The “red herring” contains proposed or blank values
     which will be filled in the day of the offering
   – If there are problems, then the company may amend
     the registration and the waiting period starts over
• Securities may not be sold during the waiting period
• The price is determined on the effective date of the
  registration


                                                           10
Selling Securities to the Public
• Securities sold by an Investment Bank
   – Process is called “underwriting”
• Investment banks provide:
   – Expertise in choosing debt/equity mix
   – Valuation of the company
       • Pricing the securities
   – Guidance through the underwriting process
   – SEC and other filings
   – A commitment to create a secondary market for the security
       • Why is that important?
   – Due Diligence in investigating the companies claims
   – Customers to buy the securities
       • Called subscribers

                                                                  11
Large Investment Banks
•   Bank of America (Bank of America Merrill Lynch)
•   Barclays (Barclays Capital)
•   Citigroup (Citi Institutional Clients Group)
•   Credit Suisse
•   Deutsche Bank
•   Goldman Sachs
•   JPMorgan Chase (J.P. Morgan Investment Bank)
•   Morgan Stanley
•   UBS (UBS Investment Bank)
•   Lehman Brothers
•   Bear Stearns & Co. Inc.
These companies also provide services in addition to underwriting:
•   Brokerage – Facilitate customers’ stock trades
•   Investment management (or advising)
•   Commercial banking
•   Securities analysis…

• Colorado Investment Banks
     • Provide underwriting (and usually VC) services to small, local
       companies                                                        12
Public Offerings Types
• Firm Commitment:
    – The I-bank agrees to pay a set price for the issue
    – Sells it to the public for what ever it can get
• Best Efforts:
    – The I-bank sells the issue to the public for what ever it can get
      and keeps a percentage

• Under which type of offering is the I-bank:
    – Acting as a dealer? Acting as a broker?
    – Incurring more risk? Incurring less risk?
• The Underwriting Spread
    – Difference between what the market pays and the company gets
• Underwriting Syndicates
    – Group of I-banks that each market a piece of the issue
    – Share the risk of the underwriting



                                                                          13
Public Announcement (Tombstone)




                                  14
Public Announcement (Tombstone)




                                  15
Public Announcement (Tombstone)




                                  16
Public Offerings Terminology
• Lockup agreements
  – Restriction on insiders that prevents them from selling
    their shares of an IPO for a specified time period
  – The lockup period is commonly 180 days
  – The stock price tends to drop when the lockup period
    expires due to market anticipation of additional shares
    hitting the street
• The IPO Quite Period
  – Begins when IPO the registration statement is filed
  – Ends 25 calendar days after the IPO has been priced
  – Company can only release factual information (not
    opinions)
  – Underwriter can’t release opinions and estimates
                                                         17
Public Offerings Terminology
• Green Shoe provision
  – Allows syndicate to purchase an additional 15% of the
    issue from the issuer
  – Allows the issue to be oversubscribed
  – Provides some protection for the lead underwriter as
    they perform their price stabilization function
• Lockup agreements
  – Restriction on insiders that prevents them from selling
    their shares of an IPO for a specified time period
  – The lockup period is commonly 180 days
  – The stock price tends to drop when the lockup period
    expires due to market anticipation of additional shares
    hitting the street

                                                         18
Private Placements
• I-banks often facilitate the private placement of a
  security issue
• Privately placed securities:
   – Do not require SEC registration
   – But then can’t be sold to the public
   – Are often sold to large investment pools
      • Insurance companies, endowments, private equity firms…
   – Are often special classes of securities




                                                                 19
Debt Underwriting
• Bonds – public issue of long-term debt
• Private issues
  – Term loans
     • Direct business loans from commercial banks,
       insurance companies, etc.
     • Maturities 1 – 5 years
     • Repayable during life of the loan
  – Private placements
     • Similar to term loans with longer maturity
  – Easier to renegotiate than public issues
  – Lower costs than public issue

                                                      20
Shelf Registration of Debt
• Permits a corporation to register a large issue
  with the SEC and sell it in small portions
• Reduces the flotation costs of registration
• Allows the company more flexibility to raise
  money quickly
• Requirements
  – Company must be rated investment grade
  – Cannot have defaulted on debt within last three
    years
  – Market value of stock must be greater than $150
    million
  – No violations of the Securities Act of 1934 in the
    last three years

                                                         21
IPO Underpricing
Assume a stock “goes public” at $10 (the IPO price = $10)
• By the end of the day the price is $20
• Therefore the IPO was underpriced
Here’s the idea:
• Your company (according to the I-bank) is worth $2m
   – You sell ½ of it through an IPO for $1m
       • 100,000 shares x $10 per share = $1m
   – But right after the buyers pay $10 per share, it goes to $20 per share
• So how much should you have received for the ½ you sold?
   – 100,000 x $20 per share = $2m
   – So the total company was really worth $4m (not $2m)
• What happened to the extra $2m?
   – You still own ½ the company so that ½ is now an extra $1m
       • So your share is now worth $2m
   – The other extra $1m went to the people that paid the IPO price of $10
   – Their shares are now worth $20
   – How did they get so lucky?

                                                                              22
IPO Underpricing
So the IPO price was $10 but at the end of the day is $20
• Subscribers made $1m that should have gone to the
  owner
• Why did this happen?
   – It may be difficult to price an IPO because there isn’t a
     current market price available
   – Underwriters want to ensure that their subscription
     clients earn a good return on IPOs for taking the risk
     on an unproven company
   – If the price is too high, all the shares won’t be sold
       • Called Undersubscrition
       • Undersubscrition is such a bad signal, it must be avoided by
   – But these don’t explain the degree of observed
     underpricing
• So what does explain the degree of underpricing?
   – Kick-backs to the Subscribers
   – In exchange for large fees, good customers were steer to
                                                                   23
     underpriced IPOs

				
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