Raising Long Term Capital Lecture 4 Prepared by Alhaj Nuhu Abdulrahman1

All companies obtain additional capital at various stages of their growth. They do so by borrowing (debt financing), selling additional shares (equity financing) or both. However where and how a company raises capital depends very much on its size, its life cycle stage, and its growth prospects. The financing life cycle of a firm: Early stage financing and Venture Capital Most young entrepreneurs about to set up a company to put their product ideas into fruition are constraint by lack of take-off capital. Because of this constraint, faced by start-ups the venture capital market emerged in advance economies to fill in the gab. 2Prepared by Alhaj Nuhu Abdulrahman CHAPTER 4: RAISING LONG-TERM CAPITAL

Raising long-term capital Early stage financing and Venture Capital Venture Capital Venture capital is a term generally referred to equity financing for start-ups, often high-risk ventures (businesses). Those who provide such financing are called venture capitalists, and are either wealthy individuals or venture capital firms that specialize in pooling funds from various sources and investing them in promising start-up. Sources of funds for the venture capital firms include wealthy individuals, institutional investors such as pension funds, insurance companies, and large corporations. 3Prepared by Alhaj Nuhu Abdulrahman

Early stage financing and Venture Capital To reduce risk venture capitalists generally provide financing in stages. As a result of the stage by stage financing, venture capital firm tend to specialize in different stages. Those who specialize in the very early stage called “angel capitalists” provide the “seed capital” or ground floor financing. Those that specialize in the later stages after the success of the first, provide what is called “mezzanine” level financing, where mezzanine level refers to the level just above the ground floor. At each stage a venture capitalist becomes a part-owner of the venture. In addition to providing financing, venture capitalists generally participate in running the firm. This is especially necessary when the firm’s founders have little or no experience in running a company. 4Prepared by Alhaj Nuhu Abdulrahman

Early stage financing and Venture Capital In addition the venture capitalist influences appointment into key management positions. Venture capitalists are generally not long-term or permanent investors, they often eventually “cash out” when the goals have been achieved, by selling their part equity-holding through either private placement or public offering. Either way investment banks are often involved in the process. American examples of success stories of venture capital financing include Microsoft, Apple Computers, Google and Federal Express (Fedex). 5Prepared by Alhaj Nuhu Abdulrahman

Early stage financing and Venture Capital Choosing a Venture Capitalist When set to choose a venture capitalist the entrepreneur should consider the following five key points about the target venture capitalist.  Financial strength  Style of involvement  Reference successes  Ability to establish contact with key stakeholders (e.g. customers and suppliers) for the entrepreneur  Exit strategy Having successfully nurtured a company to a certain level of maturity the venture capitalist cashes-out through either of the following exist strategies; Public offer : The venture capitalist may decide to exit the company by availing its stake to the general public through public offer. 6Prepared by Alhaj Nuhu Abdulrahman

Once a firm decides to go public, the first task is choosing and appointing underwriter(s). Underwriters are investment banks that act as financial midwives to a new issue of securities (shares or bonds). They usually help in:  Formulating the strategy for issuing the security  Pricing the new securities  May buying and sell the securities 7Prepared by Alhaj Nuhu Abdulrahman Basic procedure for going public

The investment bank evaluates the company’s financial conditions and future prospects to determine the appropriate price for the security. Having determined the type of security to issue, the amount and issuing price, the investment bank along with the issuing company prepares and files a Registration Statement with the Securities and Exchange Commission (SEC) for approval. The registration statement contains information about the company’s financial history, current condition, management, industry it belongs, details of existing line of business, what the funds will be used for and risk of the securities as well as plans for the future. Having got the approval of SEC, the investment bank then arranges for the listing of the shares on a stock exchange. Relevant portions of the registration statement are then reproduced into another document called Prospectus which is the one widely circulated to prospective investor public. 8Prepared by Alhaj Nuhu Abdulrahman

Basic procedure for going public Types of Underwriting Securities There are basically two types of underwriting securities: 1. Firm commitment underwriting The company sells the entire securities to the investment bank (underwriter) at a reduced price and they resell to the general public at the determined offering price. The difference is the spread which is the basic compensation to the underwriter. The issuing firm receives the full amount from the underwriter, and all the associated risk of the issue is assumed by the underwriter. As a strategy to reduce risk and to help sell the issue the chosen investment bank invites other investment banks to form an underwriting syndicate for the issue. Commitment underwriting is the most prevalent worldwide. 9Prepared by Alhaj Nuhu Abdulrahman

Basic procedure for going public 2. Best efforts underwriting In this strategy the investment bank agrees to use “best efforts” to sell the securities on commission basis. Dutch auction underwriting An unknown alternative to the two basic underwriting methods is the Dutch auction underwriting, also known as uniform price auction. With this underwriting method, the underwriter does not set a fixed offering price for the shares. Instead it conducts an auction in which investors bid for shares, from which the offer price is determined. This approach to selling security is relatively new in equity primary market and not widely used, but very much common in the bond markets. In 2004 the Google Company used the approach to public. 10Prepared by Alhaj Nuhu Abdulrahman

Basic procedure for going public Private placement Shares are sold to few investors rather than the public as a whole. The advantage of the private placement is that the security does not need to be registered with the SEC as long as certain restrictive requirements are satisfied. While investment banks are not required for a private placement, they are necessarily engaged to offer advice to the issuing firm on the appropriate terms and help to identify potential purchasers. Private placements are however more common for the sale of bonds than for stocks. And the usual buyers are Institutional investors like; Insurance companies, Pension Funds, Mutual Funds and Investment firms. 11Prepared by Alhaj Nuhu Abdulrahman

Basic procedure for going public IPOs and under-pricing Determining the appropriate price of a new security is the most difficult thing an underwriter does for an initial public offering. Managers of the firm expect the highest possible price for their stock, but the underwriters are cautious of under subscription if investors perceive the issue price to be high. As a result, underwriters typically under-price initial offerings to patronage and serve as insurance for the investment banks (the underwriters) The benefits of going public The major benefits of going public to are: Better ability to raise large long-term capital Better ability of shareholders to dispose off their shares It allows venture capitalists to cash out easily Establishing market value for the firm 12Prepared by Alhaj Nuhu Abdulrahman

Basic procedure for going public Advertisement announcing a public offering Whether initial public offering or seasoned offering Tombstone advertisements, are used by underwriters to inform the general investor public. Tombstone advertisement contains the name of the issuing firm, the form of issue, and list of investment banks (underwriters) involved in the issue. The cost of issuing securities Issuing securities to the public is a costly exercise, and the costs of different methods are important determinants of which is used. The costs associated with issuing securities are called floatation costs. 13Prepared by Alhaj Nuhu Abdulrahman

Basic procedure for going public Cost of issuing shares The basic costs associated with issuing shares are; Gross spread: Direct fees paid by the company to the underwriter(s) (i.e.difference between the price the company receives and the offer price) Other direct expenses: filing fees, legal fees etc Indirect expenses: The cost of management time spent working on the new issue. Issuing long-term debt security (bonds) Issuing debt security also requires preparation and filing of registration statement with SEC and preparation of prospectus. The registration statement must however indicate an indenture (covenant or agreement). Bond issues are either directly privately issued or publicly issued. There are two types of direct private debt issue- term loans and private placement. 14Prepared by Alhaj Nuhu Abdulrahman

Basic procedure for going public Term loans are direct business loans that have maturity periods of between one year and five years. Lenders include commercial banks, insurance companies and pension funds. Private placements are also direct loans, but their maturity periods are longer – five to twenty years. Differences between direct private debt issues and public issues A direct long-term debt avoids the cost of registration with SEC Private placement often contain more restrictive covenants Term loans and private placement permit renegotiation in the event of default. It is impossible to do same with public issue because many holders are usually involved. 15Prepared by Alhaj Nuhu Abdulrahman

Basic procedure for going public While institutional investors like insurance companies and pension funds dominate the private-placement segment of the bond market, Commercial banks dominate the term-loan segment. Floatation costs of distributing bonds are lower in private placement than in public issue. The interest rates on term loans and private placement are often higher than those on public issues An important fact is that the floatation costs of debt are much less than those for equity. 16Prepared by Alhaj Nuhu Abdulrahman