2Chapter 14 Outline 14.1 Equity Financing for Private Companies 14.2 Taking Your Firm Public: The Initial Public Offering14.3 IPO Puzzles14.4 Raising Additional Capital: The Seasoned Equity Offering
3Learning ObjectivesContrast the different ways to raise equity capital for a private companyUnderstand the process of taking a company publicGain insight into puzzles associated with initial public offeringsExplain how to raise additional equity capital once the company is public
414.1 Equity Financing for Private Companies Sources of Funding:A private company can seek funding from several potential sources:Angel InvestorsVenture Capital FirmsInstitutional InvestorsCorporate Investors
514.1 Equity Financing for Private Companies Angel Investors:Individual investors who buy equity in small private firmsThe first round of outside private equity financing is often obtained from angels
614.1 Equity Financing for Private Companies Venture Capital Firms:Specialize in raising money to invest in the private equity of young firmsIn return, venture capitalists often demand a great deal of control of the company
7Figure 14.1 Most Active U.S. Venture Capital Firms in 2009 (by Number of Deals Completed
8Figure 14.2 Venture Capital Funding in the United States
914.1 Equity Financing for Private Companies Institutional Investors:Pension funds, insurance companies, endowments, and foundationsMay invest directlyMay invest indirectly by becoming limited partners in venture capital firms
1014.1 Equity Financing for Private Companies Corporate Investors:Many established corporations purchase equity in younger, private companiescorporate strategic objectivesdesire for investment returns
1114.1 Equity Financing for Private Companies Securities and ValuationWhen a company decides to sell equity to outside investors for the first time, it is typical to issue preferred stock rather than common stock to raise capitalIt is called convertible preferred stock if the owner can convert it into common stock at a future date
12Example 14.1 Funding and Ownership Problem:You founded your own firm two years ago. You initially contributed $100,000 of your money and, in return received 1,500,000 shares of stock. Since then, you have sold an additional 500,000 shares to angel investors. You are now considering raising even more capital from a venture capitalist (VC).
13Example 14.1 Funding and Ownership Problem (cont’d):This VC would invest $6 million and would receive 3 million newly issued shares. What is the post-money valuation? Assuming that this is the VC’s first investment in your company, what percentage of the firm will she end up owning? What percentage will you own? What is the value of your shares?
14Example 14.1 Funding and Ownership Solution:Plan:After this funding round, there will be a total of 5,000,000 shares outstanding:Your shares ,500,000Angel investors’ shares ,000Newly issued shares ,000,000Total ,000,000
15Example 14.1 Funding and Ownership Plan (cont’d):The VC is paying $6,000,000/3,000,000=$2/share.The post-money valuation will be the total number of shares multiplied by the price paid by the VC.The percentage of the firm owned by the VC is her shares divided by the total number of shares.Your percentage will be your shares divided by the total shares and the value of your shares will be the number of shares you own multiplied by the price the VC paid.
16Example 14.1 Funding and Ownership Execute:There are 5,000,000 shares and the VC paid $2 per share. Therefore, the post-money valuation would be 5,000,000($2) = $10 million.Because she is buying 3,000,000 shares, and there will be 5,000,000 total shares outstanding after the funding round, the VC will end up owning 3,000,000/5,000,000=60% of the firm.You will own 1,500,000/5,000,000=30% of the firm, and the post-money valuation of your shares is 1,500,000($2) = $3,000,000.
17Example 14.1 Funding and Ownership Evaluate:Funding your firm with new equity capital, be it from an angel or venture capitalist, involves a tradeoff—you must give-up part of the ownership of the firm in return for the money you need to grow.The higher is the price you can negotiate per share, the smaller is the percentage of your firm you have to give up for a given amount of capital.
1814.1 Equity Financing for Private Companies Exiting an Investment in a Private CompanyAcquisitionPublic Offering
1914.2 Taking Your Firm Public: The Initial Public Offering The process of selling stock to the public for the first time is called an initial public offering (IPO)
2114.2 Taking Your Firm Public: The Initial Public Offering Advantages and Disadvantages of Going Public Advantages:Greater liquidityBetter access to capitalBy going public, companies given their private equity investors the ability to diversify. In addition, public companies typically have access to much larger amounts of capital through the public markets, both in the initial public offering and in subsequent offerings.
2214.2 Taking Your Firm Public: The Initial Public Offering Disadvantages:Equity holders more dispersedMust satisfy requirements of public companiesWhen investors sell their stake and thereby diversify their holdings, the equity holders of the corporation become more widely dispersed. Thus undermines investor’s ability to monitor the management and thus represents a loss of control. Furthermore, once a company goes public, it must satisfy all of the requirements of public companies. In general, these standards were designed to provide better protection for investors. However, compliance with the new standards is costly and time-consuming for public companies.
2314.2 Taking Your Firm Public: The Initial Public Offering IPOs include both Primary and Secondary offeringsAt an IPO, a firm offers a large block of shares for sale to the public for the first time. The share that are sold in the IPO may either by new shares that raise new capital, known as primary offering, or existing shares that are sold by current shareholders, known as a secondary offering.Underwriters and the SyndicateAfter deciding to go public, managers of the company work with an underwriter, an investment banking firm that manages the security issuance and design its structure.Underwriter: an investment banking firm that manages the offering and designs its structureLead UnderwriterSyndicate: other underwriters that help market and sell the issue
24Table 14.2 International IPO Underwriter Ranking Report for 2007
2514.2 Taking Your Firm Public: The Initial Public Offering ValuationUnderwriters work with the company to come up with a priceEstimate the future cash flows and compute the present valueUse market multiples approachRoad ShowOnce an initial price range is established, the underwriters try to determine what the market thinks of the valuation. They begin by arranging a road show, in which senior management and the lead underwriters travel around the country promoting the company and explaining their rational for the offer price to the underwriter’s largest customers.
2614.2 Taking Your Firm Public: The Initial Public Offering ValuationUnderwriters work with the company to come up with a priceEstimate the future cash flows and compute the present valueUse market multiples approachRoad ShowOnce an initial price range is established, the underwriters try to determine what the market thinks of the valuation. They begin by arranging a road show, in which senior management and the lead underwriters travel around the country promoting the company and explaining their rational for the offer price to the underwriter’s largest customers.
2714.2 Taking Your Firm Public: The Initial Public Offering ValuationBook Building(詢價圈購)At the end of the road show, customers inform the underwriters of their interest by telling the underwriters how many shares they may want to purchase. This process for coming up with the offer price based on customer’s expression of interest is called book building.
2814.2 Taking Your Firm Public: The Initial Public Offering Pricing the Deal and Managing RiskFirm Commitment IPO: the underwriter guarantees that it will sell all of the stock at the offer priceOver-allotment allocation, or Greenshoe provision: allows the underwriter to issue more stock, amounting to 15% of the original offer size, at the IPO offer price
2914.2 Taking Your Firm Public: The Initial Public Offering Other IPO Types Best-Efforts Basis: the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible priceAuction IPO: The company or its investment bankers auction off the shares, allowing the market to determine the price of the stock
3114.3 IPO Puzzles Four IPO puzzles: Underpricing of IPOs On average, IPO appear to be underpriced: The price at the end of trading on the first day is often substantially higher than the IPO price.“Hot” and “Cold” IPO marketsThe number of IPOs is highly cyclical. When times are good, the market is flooded with IPOs; when times are bad, the number of IPOs fries up.High underwriting costsThe transaction costs of the IPO are very high, and it is unclear why firms willingly incur such high costs.Poor long-run performance of IPOsThe long-run performance of a newly public company( three to five years from the date of issue) is poor. That is, on average, a three- to five-year buy and hold strategy appears to be a bad investment.
3214.3 IPO Puzzles Underpriced IPOs On average, between 1960 and 2003, the price in the U.S. aftermarket was 18.3% higher at the end of the first day of tradingAs id evident in Figure 14.5, the one-day average return for IPOs has historically been very large around the world. Note that although underpricing is a persistent and global phenomenon, it is generally smaller in more developed capital markets.Who wins and who loses because of underpricing?Investors vs pre-IPO shareholders
33Figure 14.5 International Comparison of First-Day IPO Returns
3414.3 IPO Puzzles “Hot” and “Cold” IPO Markets It appears that the number of IPOs is not solely driven by the demand for capital.Sometimes firms and investors seem to favor IPOs; at other times firms appear to rely on alternative sources of capital
3514.3 IPO Puzzles “Hot” and “Cold” IPO Markets Figure 14.6 shows the number of IPOs by year from 1980 to As the figure makes clear, the dollar volume of IPOs grew significantly in the early 1990s, reaching a peak in An even more important feature of the data is that the trends related to the number of issues are cyclical. Sometimes, as in 1996, the volume of IPOs is unprecedented by historical standards, yet within a year or two the volume of IPOs may decrease significantly. This cyclicality by itself is not particularly surprising. We would expect there to be a greater need for capital in times with more growth opportunities than in times with fewer growth opportunities.
36Figure 14.6 Cyclicality of Initial Public Offerings in the United States, (1980-2009)
3714.3 IPO Puzzles High Cost of Issuing an IPO In the U.S., the discount below the issue price at which the underwriter purchases the shares from the issuing firm is 7% of the issue price.This fee is large, especially considering the additional cost to the firm associated with underpricing.
38Figure 14.7 Relative Costs of Issuing Securities
3914.3 IPO Puzzles Poor Post-IPO Long-Run Stock Performance Newly listed firms appear to perform relatively poorly over the following three to five years after their IPOsThat underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place
4014.4 Raising Additional Capital: The Seasoned Equity Offering A firm’s need for outside capital rarely ends at the IPOSeasoned Equity Offering (SEO): firms return to the equity markets and offer new shares for sale
4114.4 Raising Additional Capital: The Seasoned Equity Offering SEO ProcessWhen a firm issues stock using an SEO, it follows many of the same steps as for an IPO.Main difference is that the price-setting process is not necessary.TombstonesHistorically, underwriters would advertise the sale of stock (both IPOs and SEOs) by taking out newspaper advertisements.
42Figure 14.8 Tombstone Advertisement for a RealNetworks SEO
4314.4 Raising Additional Capital: The Seasoned Equity Offering Two kinds of seasoned equity offerings:Cash offerthe firm’s offers the new shares to investors at large.Rights offerthe firm’s offers the new shares only to existing shareholders.
4414.4 Raising Additional Capital: The Seasoned Equity Offering SEO Price ReactionResearchers have found that, on average, the market greets the news of an SEO with a price decline (about 1.5%)Often the value lost can be a significant fraction of the new money raisedAdverse selection (the lemons problem)
4514.4 Raising Additional Capital: The Seasoned Equity Offering SEO CostsIn addition to the price drop when the SEO is announced, the firm must pay direct costs as well. Underwriting fees amount to 5% of the proceeds of the issue