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© Natalya Brown 2008

Raising Capital

Raising Capital


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).


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


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


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.


• 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.


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


–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.


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.


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”


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.


Degree of Underpricing


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


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.


• 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


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.


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.


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.


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.


Value of a Right


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


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.


• 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.


LECTURE 3: CAPITAL STRUCTURE POLICY

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