AFC 3140 – Advanced Corporate Finance

Equity Finance and Initial Public Offerings

(Lecture Notes)

How do firms

raise capital for

investment? Two

principle methods

are considered.

The first is

through raising venture capital. The

second involves raising capital through an

initial public offering (IPO’s). Some

anomalies in IPO’s are considered from the

perspective of the efficient market

hypothesis. Although many anomalies can

be explained, some questions remain

unanswered.

The Characteristics of Ordinary Shares

• Ordinary shares represent an ownership interest in

a business.

• The holder has a claim to the profits of the

business (through dividends). In the event of

failure, the holder has a claim to the residual value

of the assets after claims of all other entitled

parties are met.

• Due to this residual claim, shareholders are more

likely to lose their investment if the company fails

(shareholders are said to provide the company’s

risk capital).

• To compensate for this risk, shareholders expect a

return that is greater than that received by

lending.

The Characteristics of Ordinary Shares

• Limited liability:

– Protects shareholders' liability to meet a

company’s debts. The liability is limited to

the value of the shares (shares cannot have

a negative value).

• Rights of shareholders:

– Entitled to proportional share of any

dividend declared.

– Right to exert a degree of control over

management through use of voting rights

attached to ordinary shares — (typically

need at least 50% of shares to execute

rights).

– Shareholders have the right to sell their

shares.

Advantages and Disadvantages of Equity as a

Source of Finance

• Advantages

– Dividends are discretionary.

– No maturity date.

– The higher the proportion of capital

structure made up by equity, the lower the

cost of debt.

• Disadvantages

– Issuing more shares can dilute existing

shareholders’ ownership and control.

– Returns to shareholders can be subject to

double taxation (non-residents).

– Transaction costs of issuing shares.

Private Equity

• What is private equity?

– Securities issued to investors that are not

publicly traded. This includes family

members and friends, but a more formal

source is a private equity fund.

– Private equity or venture capital — not only

for new ventures.

• Four categories of private equity financing:

– Start-up: new companies, funds to develop

products.

– Expansion: additional funds required to

manufacture and sell products

commercially.

– Turnaround: assist a company in financial

difficulty.

– Management Buy Out (MBO): where a

business is purchased by its management

team with the assistance of a private equity

partner or fund.

Sources of Finance for New Ventures

• Sources include bank loans, private equities and

IPO funds.

• Stages of a venture include:

– R&D phase.

– Start-up phase, equipment and personnel

assembled.

– Rapid growth, if product is successful.

– Slower growth, followed by maturity and

possible decline.

• Different sources of finance are appropriate at

different stages.

• Personal savings, personal loans and home

mortgages are the most likely sources at R&D

stage.

• Business angel may enter the R&D stage if

these other sources are exhausted.

Equity Financing for Private Companies

The initial capital that is required to start a business

is usually provided by the entrepreneur and their

immediate family. Often, a private company must

seek outside sources that can provide additional

capital for growth.

Angel Investors and Business Angels - Investors who

buy equity in small private firms. Finding angels is

typically difficult. The term 'business angel' was

used in the theatre when financial backers invested

in a theatrical production and contributed their

skills and contacts to enhance the success of the

show. The same term was used centuries ago by

traders searching the world for merchants. Business

Angels began investing in a wide range of

commercial ventures. They are often retired and

invest their business skills as well as their capital

into new and developing enterprises.

Sources of Funding

Venture Capital Firm

A limited partnership that specializes in raising

money to invest in the private equity of young firms.

For centuries, people have developed ways of pooling

their money to undertake risky ventures. The East

India Company was an early example, and the

fictional voyage of the Pequod in Moby Dick was

illustrative of the high-risk, high-return whaling

ventures of the nineteenth century. Venture capital

is simply a modern variation on a long-established

practice of pooling money to finance risky ventures.

Often the limited partner is a corporate entity such

as a superannuation fund. Both Google and

Starbucks were initially funded by venture capital

firms.

Sources of Funding

A Venture Capitalist is one of the general partners

who work for and run a venture capital firm.

Venture capital firms offer limited partners

advantages over investing directly in start-ups

themselves as angel investors.

Limited partners are more diversified, they spread

their investments amongst a number of risky

projects.

Frees management time to focus on the business,

not financing the business.

They also benefit from the expertise of the

general partners.

Often finance a project so that it can be sold as an

IPO some years down the track (at a considerable

profit – they hope!!).

Venture Capital Around the World

Based on the available data, Australia’s venture

capital intensity appears to be around the median

for OECD countries. At June 2006, the ABS

estimates around $11 billion had been committed to

venture capital and later stage private equity funds.

Venture Capital

The mix of venture capital activity that is conducted

domestically will be influenced by Australia’s

industry structure. Only around 20 per cent of

venture capital in Australia is in the high-technology

sectors of health and biotechnology,

communications, and information technology.

In contrast, almost 90 per cent of venture capital

activity in the US occurs in these sectors. Australia’s

lower venture capital intensity may be due to

relatively smaller high-technology sectors. Another

possible explanation for Australia’s level of venture

capital activity is that the scale and geographical

dispersion of economic activity in Australia place a

natural constraint on the development of a large

venture-capital-financed, high-technology sector.

(e.g. compared to California’s ‘Silicon Valley’)

Sources of Funding

The advantages funding from a venture capitalist

comes at a cost.

General partners usually charge substantial fees.

• Most firms charge 20% of any positive return they

make.

• They also generally charge an annual management

fee of about 2% of the fund’s committed capital.

(this may also amount to a large proportion of the

profit).

Sources of Funding

Institutional investors such as superannuation

funds, insurance companies, endowments, and

foundations are active investors in private

companies. Institutional investors may invest

directly in private firms or they may invest indirectly

by becoming limited partners in venture capital

firms.

Corporate Investor - A corporation that invests in

private companies. Also known as Corporate

Partner, Strategic Partner, and Strategic Investor.

Corporate investors might invest for corporate

strategic objectives, in addition to the financial

returns. Reasons may include obtaining rights to

new ideas or expanding into a related area of

business.

What are investors looking for?

• Looking for projects with high growth prospects.

• Private equity investments are relatively risky —

higher rates of return are typically required.

• To obtain private equity, require a well-

structured and convincing business plan.

• Private equity fund managers usually require a

seat on the board of the company.

• These managers specialise in new, fast-growing

companies. They can offer specialised expertise

to help the venture succeed.

Sources of Funding

Corporate Investor - A corporation that invests in

private companies. Also known as Corporate

Partner, Strategic Partner, and Strategic Investor.

While most other types of investors in private firms

are primarily interested in the financial returns of

their investments, corporate investors might invest

for corporate strategic objectives, in addition to the

financial returns. Reasons may include obtaining

rights to new ideas or expanding into a related area

of business.

Outside Investors

Preferred Stock

Preferred stock is issued by mature

companies and usually has a preferential

dividend and seniority in any liquidation

and sometimes special voting rights.

Preferred stock issued by young companies

has seniority in any liquidation but typically

does not pay regular cash dividends and

often contains a right to convert to common

stock.

Convertible Preferred Stock - Preferred stock that

gives the owner an option to convert it into common

stock on some future date.

Outside Investors

Definitions

Pre-Money Valuation

At the issuance of new equity, the value of

the firm’s prior shares outstanding at the

price in the funding round.

Post-Money Valuation

At the issue of new equity, the value of the

whole firm (old plus new shares) at the price

the new equity sold at.

Exit Strategy

It details how investors will eventually

realize the return from their investment.

Outside Investors

Example

Assume:

• You founded your own firm two years ago.

• You initially contributed $50,000 of your

money and in return received 1,000,000

shares of stock.

• Since then, you have sold an additional

750,000 shares to angel investors.

• You are now considering raising even more

capital from a venture capitalist.

• The venture capitalist will invest $2 million

and will receive 2,000,000 newly issued

shares.

Outside Investors

Questions

What is the post-money valuation?

Assuming that this is the venture capitalist’s

first investment in your company, what

percentage of the firm will he end up

owning?

What percentage will you own?

What is the value of your shares?

Outside Investors

Solution

Your shares 1,000,000 26.67%

Angel Investors’ Shares 750,000 20.00%

Venture capitalist’s shares 2,000,000 53.33%

Total shares outstanding 3,750,000 100.00%

The venture capitalist is paying $1 per share. Thus,

the post-money valuation is $3,750,000

You will own 26.67% of the firm and the post-money

valuation of your shares is $1,000,000.

Initial Public Offerings

A privately owned company may wish to list on the

stock exchange so that it can:

(a) raise extra capital through equity rather than

debt,

(b) create liquidity for the existing shareholders.

Thus a company may initiate an ‘Initial Public

Offering of Shares’ (IPO). Direct costs of ‘floating’ a

company include:

Stock exchange listing fees

Prospectus costs

Underwriting fees

Commissions

Initial Public Offerings

Indirect costs of floating include:

IPO’s are typically underpriced

IPO’s force management to share information

with shareholders and regulators and potentially

competitors

Management may be pressured from investors

and interest groups

There may be indirect benefits to existing

shareholders in the form of:

Listing may provide monitoring and information

to management

The listed company may enjoy greater credibility

with customers, employees and suppliers.

Offers of Unlisted Securities

On 1 Feb, 2010 the following firms were listed on the

Australian Stock Exchange (ASX) as an IPO.

Company Proposed ASX

code * Proposed listing date/time

Altus Renewables Limited AWR 09 February 10#

Australian Governance Masters Index

Fund Limited

AQF 10 February 10#

Careers MultiList Limited CGR 04 February 10#

CBio Limited CBZ To be advised

Doray Minerals Limited DRM To be advised

Hunnu Coal Limited HUN 12 February 10#

Kimberley Metals Limited KBL To be advised

Matrix Gold Limited MXD 12 March 10#

Mobilarm Limited MBO To be advised

NT Resources Limited NTR 01:00PM - Monday, February 1

2010##

Olympus Pacific Minerals Inc OYM 29 January 10#

Q Copper Australia Limited QCU 15 February 10#

Scandinavian Resources Limited SCR To be advised

Shree Minerals Limited SHH To be advised

Wild Acre Metals Limited WAC 05 March 10#

Xiaoxiao Education Limited XXL To be advised

The Prospectus

IPO’s cannot proceed until disclosure document has

been lodged with the Australian Securities and

Investment Commission (ASIC).

• Prospectus:

– Most comprehensive disclosure document.

– Contains details of the issue, capital sought,

price, use of funds, etc.

– Non-financial information on issuer —

description of business and reports from

directors and/or industry experts.

– Risks associated with business and

expensive disclosure documents to prepare.

– Financial information on issuer — most

recent and audited financial statements.

– Contributors to prospectus are liable for

prosecution by investors over losses

resulting from misstatements in, or

omissions from, disclosure documents.

Underwriting and Managing a New Issue

• Underwriting is a service provided by a

stockbroker or investment bank.

• For a fee, the underwriter contracts to purchase

all shares for which applications have not been

received by the closing date of the issue.

• Having Institutional investors initially bid for the

shares is referred to as book building.

• If book building process is used to issue shares,

there is no need for underwriting, but an

institution needs to manage the issue.

• Underwriter can limit exposure by sub-

underwriting (to insurance companies, banks,

superannuation funds).

Initial Public Offerings

However there does exist some market anomalies

(violations of the EMH) in regard to IPO’s. These

include:

(a) Consistent underpricing of IPO’s (average first

day returns of 10%-15%)

(b) Cycles in the extent of underpricing

(c) Long run underperformance by IPO’s after

listing.

Selling a New Issue

• If a stockbroker is an underwriter or lead

manager, he/she will usually act as selling agent

for the issue.

• Promotion reduces the need to purchase

underwritten shares and will generate brokerage

fees.

• Even without underwriting, a broker is engaged

to assist in the distribution of shares.

• Brokerage depends on size of issue, but usually

ranges between 1% and 2% of funds raised.

Evidence on the pricing of IPO’s.

Country Sample

Size

Time

Period

Average

Initial

Return (%)

Australia 266 1976-89 11.9

France 187 1983-92 4.2

Korea 347 1980-90 78.1

Singapore 128 1973-92 31.4

UK 2,133 1959-90 12.0

USA 10,626 1960-92 15.3

Explanations for the underpricing of IPO’s

Under pricing of IPO’s are a violation of the EMH.

Explanations for this anomaly include:

(a) The Winners Curse Hypothesis – It is

assumed all potential investors are of two

types; completely informed investors (who

know the future price of the stock), and

completely uninformed investors. Informed

investors only invest in IPO’s which are

underpriced whilst uninformed investors

invest in all IPO’s. Since uninformed investors

know that on average they are subscribing to

the less lucrative IPO’s, they demand that on

average IPO’s should be underpriced.

Explanations for the underpricing of IPO’s

(b) Dynamic Information Acquisition – Investment

bankers underprice IPO’s to induce regular

investors to reveal information during the pre-

selling period. As information accumulates for

the investment banker, the offer price may be

readjusted.

(c) Information Cascades – It is assumed

potential investors wait to see if others invest

in an IPO. If some investors do indeed invest,

then a ‘cascade’ of investors will subscribe to

the IPO. Hence an issuer may underprice an

IPO to initiate a cascade.

Hot Issue Markets

The number of new listings on the ASX from 1991 to

1997 were:

1991 1992 1993 1994 1995 1996 1997

23 176 104 120 45 75 87

It appears that there are periods of time when far

more listings are offered to the market than at other

times. Furthermore these high listing periods cluster

together. Periods when relatively many IPO’s occur

are referred to as ‘Hot issue markets’.

A similar pattern exists for US markets.

Hot Issue Markets

Number of IPO’s and Average Initial Returns for US

markets.

1960 1970 1980 1990

Number of IPO’s per month

Average initial return per month

Hot Issue Markets

The years 1,999 and 2,000 saw a huge market

‘bubble’ related to information technology and

internet stocks.

Hot Issue Markets

IT share prices peaked in March 2000 at almost

eight times their end 1998 level and fell sharply

thereafter, reverting to their end 1998 level by end

2002.

Hot Issue Markets

Explanations for the existence of hot issue markets

include:

(a) Changes in Firm Risk – It is hypothesised that

their exist periods which are far more risky to

launch an IPO so the IPO is underpriced to a

greater extent to compensate for this risk.

(b) Positive Feedback – Because there is positive

autocorrelation in the initial returns of IPO’s,

investors bid up the price of an IPO as a self

fulfilling prophesy.

(c) Windows of Opportunity – Markets may go

through periods when IPO’s can be sold for

relatively higher value (as proxied by for

example a high market to book value). Issuers

may time the launch of IPO’s to correspond to

these periods of high investor optimism.

Hot Issue Markets

Empirical research suggests that none of the above

explanations fully explain the existence of hot issue

markets. Some researchers suggest that to date the

existence of hot issue markets has simply defied

rational explanation.

Long Run Underperformance

The third IPO anomaly is the poor price performance

of IPO’s in the long run.

For example, during the period 1975-1984, IPO’s

traded on the NYSE had an average return of 34.5%

after 3 years. However, all other companies averaged

a return of 61.9% after 3 years. That is, IPO’s

underperformed in the long run relative to other

stocks.

While IPO’s underperformed as a group, the

underperformance was far more pronounced for

young companies relative to older more established

firms.

Long Run Underperformance

Other evidence suggests that established firms

launched in non-hot issue periods do not

underperform at all relative to the whole market.

Two explanations of long run underperformance

have been proposed:

(a) Excessive Optimism – It is proposed that

buyers of IPO’s are excessively optimistic

about the value of the share, particularly

during periods of high volatility. As time goes

by, the ‘true’ value of the share will be found

by the market as share information is

released.

Long Run Underperformance

(b) Impresarios – Just as rock concert & boxing

promoters ‘talk up’ the event, so do investment

bankers in regard to IPO’s. If this hypothesis is

correct, then the long run underperformance

of IPO’s should be negatively related to short

run under pricing.

Empirical evidence is consistent with both of the

above explanations.