Raising Equity Capital Chapter 14 Raising Equity Capital

Outline 1. Equity Financing for Private Companies 2. Taking Your Firm Public: The Initial Public Offering 3. IPO Puzzles 4. Raising Additional Capital: The Seasoned Equity Offering Contrast the different ways to raise equity capital for a private company Understand the process of taking a company public Gain insight into puzzles associated with initial public offerings Explain how to raise additional equity capital once the company is public

Google - History On August 1998: The first funding for Google was a $100,000 contribution from Andy Bechtolsheim, co-founder of Sun Microsystems, given to a corporation which did not yet exist. On June 7, 1999: Equity funding totaling $25 million was given by rival venture capital firms Kleiner Perkins Caufield & Byers and Sequoia Capital. In January 2004, Google hired investment bankers, Morgan Stanley and Goldman Sachs Group to arrange the IPO. Google's IPO took place on August 19, 2004. A total of 19,605,052 shares were offered at a price of $85 per share. Of that, 14,142,135 were floated by Google and 5,462,917 by selling stockholders. The sale raised US$1.67 billion, and gave Google a market capitalization of more than $23 billion. The vast majority of Google's 271 million shares remained under Google's control. Many of Google's employees became instant paper millionaires.

GOOGLE IPO

Types of U.S. Firms There are four different types of firms in the United States. As (a) and (b) show, although the majority of U.S. firms are sole proprietorships, they generate only a small fraction of total revenue, in contrast to corporations. Source: www.bizstats.com

Financing Options: Young, Start-Ups vs. Matured Firms Venture Capital, Angel Investors Private Equity Bank Loans Other Personal Sources Matured Firms Public Bonds Stock Offerings All others including what young, start-ups can have

Equity financing for private companies

14.1 Equity Financing for Private Companies Sources of Funding: A private company can seek funding from several potential sources: Angel Investors Venture Capital Firms Institutional Investors Corporate Investors

14.1 Equity Financing for Private Companies Angel Investors: Individual investors who buy equity in small private firms The first round of outside private equity financing or seed money is often obtained from angels Often, angel investors are entrepreneur's family and friends. Often, angel investor is one-time investor. Example: Jeff Bezos from Amazon.com

14.1 Equity Financing for Private Companies Venture Capital Firms: Specialize in raising money to invest in the private equity of young firms In return, venture capitalists often demand a great deal of control of the company Example: Uber Said to Plan Another $1 Billion in Fund-Raising in 2015 (Source: New York Times)

14.1 Equity Financing for Private Companies Venture Capital Firms: Example: “AustinVentures” Austin Ventures (“AV”) has worked with talented entrepreneurs to build valuable companies for over 30 years. With $3.9 billion of capital raised, AV is one of the most established venture capital firms in the nation. AV invests in early stage and middle market companies, and its strategy is to partner with talented executives and entrepreneurs to build industry-leading companies predominantly in Texas. (from http://www.austinventures.com)

Figure 14.1 Most Active U.S. Venture Capital Firms in 2012, 2009 (by Number of Deals Completed

Figure 14.2 Venture Capital Funding in the United States

14.1 Equity Financing for Private Companies Institutional Investors: Pension funds, insurance companies, hedge funds, mutual funds, endowments, and foundations May invest directly May invest indirectly by becoming limited partners in venture capital firms http://www.institutionalinvestor.com/ Source: PensioinsInvestments

14.1 Equity Financing for Private Companies

14.1 Equity Financing for Private Companies Corporate Investors: Many established corporations purchase equity in younger, private companies corporate strategic objectives desire for investment returns

14.1 Equity Financing for Private Companies Securities and Valuation When 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 capital It is called convertible preferred stock if the owner can convert it into common stock at a future date

Example 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). 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?

Example 14.1 Funding and Ownership Solution: Plan: After this funding round, there will be a total of 5,000,000 shares outstanding: Your shares 1,500,000 Angel investors’ shares 500,000 Newly issued shares 3,000,000 Total 5,000,000 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.

Example 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. 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.

14.1 Equity Financing for Private Companies Exiting an Investment in a Private Company “Cash out” investment Acquisition, mergers Public Offering: The process of selling stock to the public for the first time is called an initial public offering (IPO) Private equity investors are willing to take on more risk than banks and other traditional sources of capital and are often the only source of funds for start-ups and companies that require restructuring. These investors include wealthy individuals, institutional funds and sovereign wealth funds. They generally invest in businesses that offer higher-than-average returns on investment. They usually plan to exit their investments after realizing a reasonable return and to provide the portfolio companies with additional liquidity and new strategic direction. Merger Mergers are a common exit strategy. For example, a portfolio company that has had some success in developing a product or turning around its operations could be an attractive merger or takeover candidate. Mergers offer private equity investors a way to exchange their shares for shares in the acquiring company, cash or a combination of cash and shares. Mergers also benefit the portfolio companies by providing them access to new capital, more customers and better distribution channels. The disadvantages include loss of control, turnover of key people and the risk that the integration of the merged entities will not go smoothly. Initial Public Offering Initial public offerings involve listing shares on one or more regulated stock exchanges. IPOs require careful planning, including building relationships with market participants, filing the necessary documents and preparing detailed financial reports and forecasts. If an IPO is successful, private equity investors could cash their shares at a substantial profit. Public companies have access to a large investor base for raising capital and can use publicly traded shares as currency for acquisitions. The risk of an IPO is that insufficient investor demand could mean a lower offering price and a lower return on investment for the private equity investors. Sale Private equity investors could also sell their shares to willing buyers. This exit option does not require a portfolio company to list its shares or merge with another company. The sale could be to a strategic investor, such as a competitor or a supplier, or to a financial investor, such as another private equity investor or a mutual fund. The private equity investor could negotiate with a single buyer or with several bidders. The advantages of this exit option include speed, liquidity and control. The disadvantage is that the management of the portfolio companies could resist transferring control to another investor, especially to an existing or potential competitor. However, this resistance may not exist if the private equity investors negotiate a management buyout with the founders and management of the portfolio company. Other Options Other exit options include restructuring, special dividends and redemption rights. Restructuring could involve shutting down unprofitable units, downsizing staff and making managerial changes to reduce operating expenses and increase cash flow. Restructuring could precede a sale, IPO or merger. Private equity investors may also be able to negotiate partial or complete exits by demanding portfolio companies to redeem their shares for cash or issue special dividends.

Table 14.1 Largest Global IPOs

Initial public offerings

Facebook IPO

14.2 Taking Your Firm Public: The Initial Public Offering Advantages and Disadvantages of Going Public  Advantages: Greater liquidity Better access to capital (e.g., SEO, M&As) Disadvantages: Equity holders more dispersed Must satisfy SEC requirements of public companies

14.2 Taking Your Firm Public: The Initial Public Offering IPOs include both Primary and Secondary offerings Underwriters and the Syndicate Underwriter: an investment banking firm that manages the offering and designs its structure Lead Underwriter Syndicate: other underwriters that help market and sell the issue

Table 14.2 International IPO Underwriter Ranking Report for 2007

Table 14.2 International IPO Underwriter Ranking Report for 2012

14.2 Taking Your Firm Public: The Initial Public Offering SEC Filings Registration Statement preliminary prospectus or red herring Final Prospectus

Figure 14.3 The Cover Page of RealNetworks’ IPO Prospectus

14.2 Taking Your Firm Public: The Initial Public Offering Valuation Underwriters work with the company to come up with a price Estimate the future cash flows and compute the present value Use market multiples approach Road Show Book Building

Example 14.2 Valuing an IPO Using Comparables Problem: Wagner, Inc., is a private company that designs, manufactures, and distributes branded consumer products. During the most recent fiscal year, Wagner had revenues of $325 million and earnings of $15 million. Wagner has filed a registration statement with the SEC for its IPO. Before the stock is offered, Wagner’s investment bankers would like to estimate the value of the company using comparable companies. The investment bankers have assembled the following information based on data for other companies in the same industry that have recently gone public. In each case, the ratios are based on the IPO price.

Example 14.2 Valuing an IPO Using Comparables Problem (cont'd) After the IPO, Wagner will have 20 million shares outstanding. Estimate the IPO price for Wagner using the price/earnings ratio and the price/revenues ratio.

Example 14.2 Valuing an IPO Using Comparables Solution: Plan: If the IPO price of Wagner is based on a price/earnings ratio that is similar to those for recent IPOs, then this ratio will equal the average of recent deals. Thus, to compute the IPO price based on the P/E ratio, we will first take the average P/E ratio from the comparison group and multiply it by Wagner’s total earnings. This will give us a total value of equity for Wagner. To get the per share IPO price, we need to divide the total equity value by the number of shares outstanding after the IPO (20 million). The approach will be the same for the price-to-revenues ratio.

Example 14.2 Valuing an IPO Using Comparables Execute: The average P/E ratio for recent deals is 21.2. Given earnings of $15 million, we estimate the total market value of Wagner’s stock to be ($15 million)(21.2) = $318 million. With 20 million shares outstanding, the price per share should be $318 million / 20 million = $15.90. Similarly, if Wagner’s IPO price implies a price/revenues ratio equal to the recent average of 0.9, then using its revenues of $325 million, the total market value of Wagner will be ($325 million)(0.9) = $292.5 million, or ($292.5/20)= $14.63/share Evaluate: As we found in Chapter 10, using multiples for valuation always produces a range of estimates—you should not expect to get the same value from different ratios. Based on these estimates, the underwriters will probably establish an initial price range for Wagner stock of $13 to $17 per share to take on the road show.

14.2 Taking Your Firm Public: The Initial Public Offering Pricing the Deal and Managing Risk Firm Commitment IPO: the underwriter guarantees that it will sell all of the stock at the offer price Over-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

14.2 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 price Auction IPO: The company or its investment bankers auction off the shares, allowing the market to determine the price of  the stock

Table 14.3 Bids Received to Purchase Shares in a Hypothetical Auction IPO

Figure 14.4 Aggregating the Shares Sought in the Hypothetical Auction IPO

Example 14.3 Auction IPO Pricing Problem: Fleming Educational Software, Inc., is selling 500,000 shares of stock in an auction IPO. At the end of the bidding period, Fleming’s investment bank has received the following bids: What will the offer price of the shares be?

Example 14.3 Auction IPO Pricing Solution: First, we must compute the total number of shares demanded at or above any given price. Then, we pick the lowest price that will allow us to sell the full issue (500,000 shares). Convert the table of bids into a table of cumulative demand: For example, the company has received bids for a total of 125,000 shares at $7.75 per share or higher (25,000 + 100,000 = 125,000).

Example 14.3 Auction IPO Pricing (cont'd): Fleming is offering a total of 500,000 shares. The winning auction price would be $7.00 per share, because investors have placed orders for a total of 500,000 shares at a price of $7.00 or higher. All investors who placed bids of at least this price will be able to buy the stock for $7.00 per share, even if their initial bid was higher. In this example, the cumulative demand at the winning price exactly equals the supply. If total demand at this price were greater than supply, all auction participants who bid prices higher than the winning price would receive their full bid (at the winning price). Shares would be awarded on a pro rata basis to bidders who bid exactly the winning price. While the auction IPO does not provide the certainty of the firm commitment, it has the advantage of using the market to determine the offer price. It also reduces the underwriter’s role, and consequently, fees.

Table 14.4 Summary of IPO Methods

14.3 IPO Puzzles Four IPO puzzles: Underpricing of IPOs “Hot” and “Cold” IPO markets High underwriting costs Poor long-run performance of IPOs

14.3 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 trading Who wins and who loses because of underpricing? LinkedIn case IPO price = $45 per share Offering = 7.84 million shares First day return = 90%+

LinkedIn Case

Figure 14.5 International Comparison of First-Day IPO Returns

Figure 14.5 International Comparison of First-Day IPO Returns

Annual IPO Data, 1999–2008 One Extreme Case: VA Linux, the IPO Offering Price at $30 and closed on the first day of trading at $239.25, a 698% one-day return!

14.3 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

Figure 14.6 Cyclicality of Initial Public Offerings in the United States, (1975-2011)

14.3 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.

Underwriter Spread Source: IPO Prospectus

Figure 14.7 Relative Costs of Issuing Securities

14.3 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 IPOs That underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place

Seasoned equity offerings

14.4 Raising Additional Capital: The Seasoned Equity Offering A firm’s need for outside capital rarely ends at the IPO Seasoned Equity Offering (SEO): firms return to the equity markets and offer new shares for sale SEO Process When 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. Tombstones

Figure 14.8 Tombstone Advertisement for a RealNetworks SEO

14.4 Raising Additional Capital: The Seasoned Equity Offering Two kinds of seasoned equity offerings: Cash offer Rights offer

Example 14.4 Raising Money with Rights Offers Problem: You are the CFO of a company that has a market capitalization of $1 billion. The firm has 100 million shares outstanding, so the shares are trading at $10 per share. You need to raise $200 million and have announced a rights issue. Each existing shareholder is sent one right for every share he or she owns. You have not decided how many rights you will require to purchase a share of new stock. You will require either four rights to purchase one share at a price of $8 per share, or five rights to purchase two new shares at a price of $5 per share. Which approach will raise more money?

Example 14.4 Raising Money with Rights Offers Solution: Plan: In order to know how much money will be raised, we need to compute how many total shares would be purchased if everyone exercises their rights. Then we can multiply it by the price per share to calculate the total amount raised. Execute: There are 100 million shares, each with one right attached. In the first case, 4 rights will be needed to purchase a new share, so 100 million / 4 = 25 million new shares will be purchased. At a price of $8 per share, that would raise $8 x 25 million = $200 million. In the second case, for every 5 rights, 2 new shares can be purchased, so there will be 2 x (100 million / 5) = 40 million new shares. At a price of $5 per share, that would also raise $200 million. If all shareholders exercise their rights, both approaches will raise the same amount of money.

Example 14.4 Raising Money with Rights Offers Evaluate: In both cases, the value of the firm after the issue is $1.2 billion. In the first case, there are 125 million shares outstanding after the issue, so the price per share after the issue is $1.2 billion / 125 million = $9.60. This price exceeds the issue price of $8, so the shareholders will exercise their rights. Because exercising will yield a profit of ($9.60 – $8.00)/4 = $0.40 per right, the total value per share to each shareholder is $9.60 + 0.40 = $10.00. In the second case, the number of shares outstanding will grow to 140 million, resulting in a post-issue stock price of $1.2 billion / 140 million shares = $8.57 per share (also higher than the issue price). Again, the shareholders will exercise their rights, and receive a total value per share of $8.57 + 2($8.57 - $5.00)/5 = $10.00. Thus, in both cases the same amount of money is raised and shareholders are equally well off.

14.4 Raising Additional Capital: The Seasoned Equity Offering Researchers 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 raised Adverse selection (the lemons problem) SEO Costs In 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

Chapter Quiz What are the main sources of funding for private companies to raise outside equity capital? What is a venture capital firm? What services does the underwriter provide in a traditional IPO? Explain the mechanics of an auction IPO. List and discuss four characteristics about IPOs that are puzzling. For each of the characteristics, identify its relevance to financial managers. What is the difference between a cash offer and a rights offer for a seasoned equity offering? What is the typical stock price reaction to an SEO?