1. Financing Process
11/03/05

2. Financing
Internal Financing – funds raised from cash flows of existing assets
External Financing – funds raised from outside the company (VC, debt, equity, etc.)

3. Internal vs. External Financing
Firms may prefer internal financing because
External financing is difficult to raise
External financing may result in loss of control
Raising external capital tends to be expensive
Projects funded by internal financing must meet same hurdle rates
Internal financing is limited

4. A Life Cycle View of Financing Choices

5. Process of raising capital
Private firm expansion
From private to public firm: The IPO
Choices for a public firm

6. VC process Provoke equity investors’ interest
There is an imbalance between the number of small firms that desire VC investment and the number of VCs
Firms need to distinguish themselves from others to obtain VC funding
Type of business
Dot.com in the 90s, bio-tech firms this decade
Successful management

7. VC process
Perform valuation and return assessment (Venture capital method)
Estimate earnings in the year the company is expected to go public
Obtain a P/E multiple for public firms in the same industry
Exit or Terminal Value = P/E multiple * forecasted earnings
Discount this terminal value at the VC’s target rate of return
Discounted Terminal Value = Estimated exit value
(1 + target return)n

8. VC process Structure the deal
Determine the proportion of firm value that VC will get in return for investment
Ownership Proportion = Capital Provided
Disc. Exit Value
VC will establish constraints on how the managers run the firm

9. VC process Participate in post-deal management Exit
VCs provide managerial experience and contacts for additional fund raising efforts
Exit
VCs generate a return on their investment by exiting the investment.
They can do so through
An initial public offering
Selling the business to another firm
Withdrawing firm cash flows and liquidating the firm

10. VC process Stages of Venture Capital Investments
Seed financing is capital provided at the “idea” stage.
Start-up financing is capital used in product development.
First-stage financing is capital provided to initiate manufacturing and sales.
Second-stage financing is for initial expansion.
Third-stage financing allows for major expansion.
Mezzanine financing prepares the company to go public.

11. Going public vs. staying private
The benefits of going public are:
Firms can access financial markets and tap into a much larger source of capital
Owners can cash in on their investments
The costs of going public are:
Loss of control
Information disclosure requirements
Exchange listing requirements

12. Initial Public Offering (IPO) process
Most public offerings are made with the assistance of investment bankers (IBs) which are financial intermediaries that specialize in selling new securities and advising firms with regard to major financial transactions.

13. IPO process The role of the investment banker
Origination - design of a security contract that is acceptable to the market;
prepare the state and federal Securities and Exchange Commission (SEC) registration statements and a summary prospectus,
Underwriting-the risk-bearing function in which the IB buys the securities at a given price and turns to the market to sell them.
Syndicates are formed to reduce the inventory risk.
Sales and distribution-selling quickly reduces inventory risk. Firm members of the syndicate and a wider selling group distribute the securities over a wide retail and institutional area.

14. IPO process

15. IPO process
IPO costs
Legal and administrative costs (up to 6% of the issue)
Underwriting commission (between 3 and 10%)
Underpricing of issue
Represents the first day returns generated by the firm, calculated as
Closing Price – Offer price
Offer price
Issues are underpriced to
Provide investors with a “good taste” about the investment banker and firm
Compensate investors for the information asymmetry between firm and investor

16. IPO process Valuing the company and setting issue details
Investment banker and firm need to determine
Value of company
Valuation is typically done using P/E multiples
Size of the issue
Value per share
Offering price per share
This will tend to be below the value per share, i.e., the offer will be underpriced

17. IPO process Determining the offer price
The investment banker will gauge the level of interest from institutional investors for the issue by conducting road shows. This is referred to as building the book.
After the offer price and issue details are set, and the SEC has approved the registration, the firm places a tombstone advertisement in newspapers, that outlines the details of the issue and the investment bankers involved

18. IPO process
Waiting period – The period between the submission of the registration to the SEC and the SEC’s approval. It is during this time that the company releases the red herring
Quiet period – a period after the registration is approved until approximately a month after the issue where the company cannot comment on the earnings, prospects for the company
Lock-up period – a period of usually 6 months following the issue date in which the insiders of the company cannot sell their shares

19. Choices for a publicly traded firm
General subscription
Private placements
Rights offerings

20. General subscription
Although for IPOs the underwriting agreement almost always involves a firm guarantee from the underwriter to purchase all of the issue, in secondary offerings, the underwriting agreement may be a best efforts guarantee where the underwriter sells as much of the issue as he can
SEOs tend to have lower underwriting commissions because of IB competition.
The issuing price of an SEO tends to be set slightly lower than the current market price

21. Private placement Securities are sold directly to one or few investors
Saves on time and cost (no registration requirements, marketing needs)
Tends to be less common with corporate equity issues. Private placement is used more in corporate bond issues

22. Rights offerings
Existing investors are provided the right to purchase additional shares in proportion to their current holdings at a price (subscription price) below current market price (rights-on price)
Each existing share is provided one right.
The number of rights required to purchase a share in the rights offering is then determined by the number of shares outstanding and the additional shares to be issued in the rights offering.
rights required to purchase one share = # of original shares
# of shares issued in RO

23. Rights offerings
Because investors can purchase shares at a lower price, the rights have value:
Value of the right = rights-on price – subscription price
n + 1
where n = number of rights required for each new share
Because additional shares are issued at a price below market price, the market price will drop after the rights offering to the ex-rights price
ex-rights price = New value of equity
New number of shares
The value (or price) of the right can also be calculated as:
rights-on price – ex-rights price

24. Rights offerings Costs are lower because of No dilution of ownership
Lower underwriting commissions – rights offerings tend to be fully subscribed
Marketing and distribution costs are significantly lower
No dilution of ownership
No transfer of wealth