2 FinancingInternal Financing – funds raised from cash flows of existing assetsExternal Financing – funds raised from outside the company (VC, debt, equity, etc.)
3 Internal vs. External Financing Firms may prefer internal financing becauseExternal financing is difficult to raiseExternal financing may result in loss of controlRaising external capital tends to be expensiveProjects funded by internal financing must meet same hurdle ratesInternal financing is limited
5 Process of raising capital Private firm expansionFrom private to public firm: The IPOChoices 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 VCsFirms need to distinguish themselves from others to obtain VC fundingType of businessDot.com in the 90s, bio-tech firms this decadeSuccessful management
7 VC processPerform valuation and return assessment (Venture capital method)Estimate earnings in the year the company is expected to go publicObtain a P/E multiple for public firms in the same industryExit or Terminal Value = P/E multiple * forecasted earningsDiscount this terminal value at the VC’s target rate of returnDiscounted 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 investmentOwnership Proportion = Capital ProvidedDisc. Exit ValueVC 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 effortsExitVCs generate a return on their investment by exiting the investment.They can do so throughAn initial public offeringSelling the business to another firmWithdrawing 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 capitalOwners can cash in on their investmentsThe costs of going public are:Loss of controlInformation disclosure requirementsExchange 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.
15 IPO processIPO costsLegal and administrative costs (up to 6% of the issue)Underwriting commission (between 3 and 10%)Underpricing of issueRepresents the first day returns generated by the firm, calculated asClosing Price – Offer priceOffer priceIssues are underpriced toProvide investors with a “good taste” about the investment banker and firmCompensate 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 determineValue of companyValuation is typically done using P/E multiplesSize of the issueValue per shareOffering price per shareThis 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 processWaiting 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 herringQuiet 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 companyLock-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 subscriptionPrivate placementsRights offerings
20 General subscriptionAlthough 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 canSEOs 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 offeringsExisting 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 offeringsBecause investors can purchase shares at a lower price, the rights have value:Value of the right = rights-on price – subscription pricen + 1where n = number of rights required for each new shareBecause additional shares are issued at a price below market price, the market price will drop after the rights offering to the ex-rights priceex-rights price = New value of equityNew number of sharesThe 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 subscribedMarketing and distribution costs are significantly lowerNo dilution of ownershipNo transfer of wealth