Chapter 15 RAISING CAPITAL

Key Concepts and Skills Understand the venture capital market and its role in financing new businesses Understand how securities are sold to the public and the role of investment bankers Understand initial public offerings and the costs of going public Understand how rights are issued to existing shareholders and how the rights are valued Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-2

Chapter Outline The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital Selling Securities to the Public: The Basic Procedure Alternative Issue Methods Underwriters IPOs and Underpricing New Equity Sales and the Value of the Firm The Costs of Issuing Securities Rights Dilution Issuing Long-Term Debt Shelf Registration Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-3

Venture Capital Private financing for relatively new businesses in exchange for equity Usually entails some hands-on guidance The company should have an “exit” strategy Sell the company – VC benefits from proceeds from sale Take the company public – VC benefits from IPO Many VC firms are formed from a group of investors that pool capital and then have partners in the firm decide which companies will receive financing Some large corporations have a VC division www: Click on the web surfer icon to go to the PriceWaterhouseCoopers web site. The site provides information on venture capital deals each quarter. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-4

Choosing a Venture Capitalist Look for financial strength Choose a VC that has a management style that is compatible with your own Obtain and check references What contacts does the VC have? What is the exit strategy? Financial strength – you want to have the option to obtain additional financing Style – do you want a hands-on or hands-off VC? Contacts – will the VC provide you with additional business contacts that can help your business succeed? Exit strategy – VCs are not long term investors – what are the provisions for the VC getting out of the business? www: Click on the web surfer icon to go to a web site that allows entrepreneurs to search for capital and VCs to search for prospective investments. Video Note: “Going Public” shows what must be done to take a company public – a common exit strategy for many VCs. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-5

Selling Securities to the Public Management must obtain permission from the Board of Directors Firm must file a registration statement with the SEC The SEC examines the registration during a 20-day waiting period A preliminary prospectus, called a red herring, is distributed during the waiting period If there are problems, the company is allowed to amend the registration and the waiting period starts over Securities may not be sold during the waiting period The price is determined on the effective date of the registration Registration statements don’t have to be filed if the loan will mature in less than nine months or the issue involves less than $5 million The SEC makes no statement about the financial strength of the firm, it simply indicates that the registration is in order Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-6

Crowd Funding On April 5, 2012, the JOBS Act was signed into law. A provision of this act allowed companies to raise money through crowdfunding, which is the practice of raising small amounts of capital from a large number of people, typically via the Internet. Crowdfunding was first used to underwrite the U.S. tour of British rock band Marillion. Learn more about crowdfunding at the National Crowdfunding Association website: Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Table 15.1 – The Methods of Issuing New Securities Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-8

Table 15.1 – The Methods of Issuing New Securities, CTD Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-9

Underwriters Formulate method used to issue securities Services provided by underwriters Formulate method used to issue securities Price the securities Sell the securities Price stabilization by lead underwriter Syndicate – group of investment bankers that market the securities and share the risk associated with selling the issue Spread – difference between what the syndicate pays the company and what the security sells for initially in the market Price stabilization is an important component of the lead underwriter’s job for IPOs. For more information, see “Stabilization Activities by Underwriters After Initial Public Offerings” by Aggarwal in the June 2000 issue of The Journal of Finance. A recent example that may interest students is the Facebook IPO. Spread – the typical spread for IPOs between $20 and $80 million is 7%. For more information, see “The Seven Percent Solution” by Chen and Ritter in the June 2000 issue of The Journal of Finance. For penny stock IPOs, the spread is typically 10%; see “Penny Stock IPOs” by Bradley, Cooney, Dolvin and Jordan in the Spring 2006 issue of Financial Management. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-10

Firm Commitment Underwriting Issuer sells entire issue to underwriting syndicate The syndicate then resells the issue to the public The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold The syndicate bears the risk of not being able to sell the entire issue for more than the cost Most common type of underwriting in the United States This is a good place to review the difference between primary and secondary market transactions. Technically, the sale to the syndicate is the primary market transaction, and the sale to the public is the secondary market transaction. Note that the cost of the issue includes the price paid to the issuing company plus the expenses of selling the issue. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-11

Best Efforts Underwriting Underwriter must make their “best effort” to sell the securities at an agreed-upon offering price The company bears the risk of the issue not being sold The offer may be pulled if there is not enough interest at the offer price. In this case, the company does not get the capital, and they have still incurred substantial flotation costs Not as common as it previously was Real-World Tip: “Corporate America is turning more fickle in choosing finance partners on Wall Street …[m]ore companies are ditching the Wall Street underwriters they had selected for initial public offerings and picking different investment banks when it comes time to complete follow-on stock sales.” So read the opening lines of an article in the December 19, 1996 issue of The Wall Street Journal. But why is this occurring? According to the article, the phenomenon is attributable in part to the fact that many offerings quickly rise above the offering price, leading issuers to feel that their shares were underpriced (and that they left millions of dollars “on the table” as a result). Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-12

Dutch Auction Underwriting Underwriter accepts a series of bids that include number of shares and price per share The price that everyone pays is the highest price that will result in all shares being sold There is an incentive to bid high to make sure you get in on the auction but knowing that you will probably pay a lower price than you bid The Treasury has used Dutch auctions for years Google was the first large Dutch auction IPO Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-13

Green Shoes and Lockups Green Shoe provision Allows the syndicate to purchase an additional 15% of the issue from the issuer Allows the issue to be oversubscribed Provides some protection for the underwriters as they perform their price stabilization function Lockup agreements Restriction on insiders that prevents them from selling their shares of an IPO for a specified time period The lockup period is commonly 180 days The stock price tends to drop when the lockup period expires due to market anticipation of additional shares hitting the street Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-14

IPO Underpricing May be difficult to price an IPO because there isn’t a current market price available Private companies tend to have more asymmetric information than companies that are already publicly traded Underwriters want to ensure that, on average, their clients earn a good return on IPOs Underpricing causes the issuer to “leave money on the table” Lecture Tip: More recent evidence (see “Underpricing, Overhang, and the Cost of Going Public to Preexisting Shareholders” by Dolvin and Jordan in the 2007 issue of Journal of Business Finance and Accounting) suggests that underpricing has little impact on owners, as very few preexisting shares are sold in IPOs. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-15

Figure 15.2 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-16

Figure 15.3 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-17

New Equity Issues and Price Stock prices tend to decline when new equity is issued Possible explanations for this phenomenon Signaling and managerial information Signaling and debt usage Issue costs Since the drop in price can be significant and much of the drop may be attributable to negative signals, it is important for management to understand the signals that are being sent and try to reduce the effect when possible Signaling and managerial information – managers may choose to sell new shares of stock when they believe the current stock price is high (they can issue fewer shares at a higher price) Signaling and debt usage – issuing equity may send a signal that management believes the company currently has too much debt Issuing securities, especially stock, is very expensive, and the decrease in price may be partial compensation for the cost of the issue. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-18

Issuance Costs Spread Other direct expenses – legal fees, filing fees, etc. Indirect expenses – opportunity costs, i.e., management time spent working on issue Abnormal returns – price drop on existing stock Underpricing – below market issue price on IPOs Green Shoe option – cost of additional shares that the syndicate can purchase after the issue has gone to market Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-19

Rights Offerings: Basic Concepts Issue of common stock offered to existing shareholders Allows current shareholders to avoid the dilution that can occur with a new stock issue “Rights” are given to the shareholders Specify number of shares that can be purchased Specify purchase price Specify time frame Rights may be traded OTC or on an exchange Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-20

The Value of a Right The price specified in a rights offering is generally less than the current market price The share price will adjust based on the number of new shares issued The value of the right is the difference between the old share price and the “new” share price Lecture Tip: You may wish to link the stock behavior associated with the ex rights date to that of the ex dividend date. Point out that a time line could be drawn that applies to stocks trading ex rights as well as stocks trading ex dividend. Both dividend and rights declarations involve setting an ex date, which is two days before the record date. In both situations, the share price reacts on the ex date to reflect the value of the right or dividend that would not be received if the shares were purchased after the ex date. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-21

Example: Rights Offering Suppose a company wants to raise $10 million. The subscription price is $20, and the current stock price is $25. The firm currently has 5,000,000 shares outstanding. How many shares must be issued? How many rights will it take to purchase one share? What is the value of a right? Shares issued = 10,000,000/20 = 500,000 Rights to buy one share = 5,000,000/500,000 = 10 Total investment = 10*25 + 20 = 270 Price per share = 270 / 11 = 24.55 Value of a right = 25 – 24.55 = .45 Buy 10 rights = .45*10 = 4.50 + 20 = 24.50 share price (difference is due to rounding) Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-22

Dilution Dilution is a loss in value for existing shareholders Percentage ownership – shares sold to the general public without a rights offering Market value – firm accepts negative NPV projects Book value and EPS – occurs when market-to-book value is less than one Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-23

Types of Long-Term Debt Bonds – public issue of long-term debt Private issues Term loans Direct business loans from commercial banks, insurance companies, etc. Maturities 1 – 5 years Repayable during life of the loan Private placements Similar to term loans but with longer maturity Easier to renegotiate than public issues Lower costs than public issues Although, coupons may be higher. Real-World Tip: Corporate issuers continued to exploit the relatively low level of long-term interest rates in 1996 and 1997. In December 1996, IBM issued 100-year bonds with a face value of $850 million. As evidence of the low required return, note that the yield on these bonds is only one-tenth of one percent higher than on similar 30-year IBM bonds. In all, approximately $3.6 billion worth of 100-year bonds were issued between November 1995 and December 1996. Previous “century bond” issuers include Walt Disney Company, Coca-Cola and Yale University. Real-World Tip: An interesting article on private placements appeared in the third quarter 1997 issue of the Dallas Federal Reserve Bank’s Economic Review. Stephen Prowse, an economist with the Dallas Fed, described the structure of the private placement market, calling private placements “a significant source of funds for U.S. corporations.” He noted that, on average, private placements tend to be “larger than bank loans and smaller than public bonds.” In a similar fashion, the maturity of privately placed debt tends to be longer than that of bank debt but shorter than that of publicly placed debt. Finally, he noted that borrowers in the private placement market tend to fall between those who rely on bank loans and those who rely on public debt, in terms of firm size. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-24

Shelf Registration Permits a corporation to register a large issue with the SEC and sell it in small portions over a two-year period Reduces the flotation costs of registration Allows the company more flexibility to raise money quickly Requirements Company must be rated investment grade Cannot have defaulted on debt within last three years Market value of stock must be greater than $150 million No violations of the Securities Act of 1934 in the last three years Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-25

Quick Quiz What is venture capital, and what types of firms receive it? What are some of the important services provided by underwriters? What type of underwriting is the most common in the United States, and how does it work? What is IPO underpricing, and why might it persist? What are some of the costs associated with issuing securities? What is a rights offering, and how do you value a right? What are some of the characteristics of private placement debt? What is shelf registration? Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-26

Ethics Issues Brokers have been known to sell securities based on sales scripts that have little to do with the information provided in the prospectus. Also, investors often make investment decisions before receiving (or reading) the prospectus. Who is at greater fault in this case? Traditionally, IPO share allocations have been reserved for the underwriting syndicates’ best customers. What ethical implications exist. There are also legal implications for allocating shares. In July, 2004, Piper Jaffray was fined $2.4 million for selling shares of “hot” IPOs to the executives of firms that they have either recently done business with or with whom they were trying to gain business. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-27

Comprehensive Problem A company wants to raise $20 million. The subscription price is $40, and the current stock price is $50. The firm currently has 5,000,000 shares outstanding. How many shares must be issued? How many rights will it take to purchase one share? What is the value of a right? Shares issued = $20,000,000/40 = 500,000 Rights to buy one share = 5,000,000/500,000 = 10 Total investment = 10*50 + 40 = 540 Price per share = 540 / 11 = 49.09 Value of a right = 50 – 49.09 = .91 Buy 10 rights = .91*10 = 9.10 + 40 subscription price = 49.10, which equals the share price (difference is due to rounding) Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-28

Chapter 15 End of Chapter Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 15-29