1. Raising Equity Capital
Chapter 23
Raising Equity Capital

2. Chapter Outline 23.1 Equity Financing for Private Companies
23.2 The Initial Public Offering
23.3 The Seasoned Equity Offering

3. Learning Objectives
Describe four ways in which a private company can raise outside capital.
Discuss the effects of a company founder selling stock to an outsider.
Identify the two main exit strategies used by equity investors in private companies.
Define an initial public offering, and discuss their advantages and disadvantages.
Distinguish between primary and secondary offerings in an IPO.
Describe typical methods by which stock may be sold during an IPO; discuss risks for parties involved in each method.

4. Learning Objectives (cont'd)
Evaluate the role of the underwriter in an IPO.
Describe the IPO process, including the methods underwriters use to value a company before its IPO.
Identify ways in which underwriters can mitigate risk during an IPO.
List and discuss four puzzles associated with IPOs.
Define a seasoned equity offering, describe two ways in which they are brought to market, and identify the stock price reaction to the announcement of a seasoned equity offering.

5. 23.1 Equity Financing for Private Companies
The initial capital that is required to start a business is usually provided by the entrepreneur and their immediate family.
Often, a private company must seek outside sources that can provide additional capital for growth.
It is important to understand how the infusion of outside capital will affect the control of the company.

6. Sources of Funding Angel Investors
Individual Investors who buy equity in small private firms
Finding angels is typically difficult.

7. Sources of Funding (cont'd)
Venture Capital Firm
A limited partnership that specializes in raising money to invest in the private equity of young firms
Venture Capitalists
One of the general partners who work for and run a venture capital firm

8. Sources of Funding (cont'd)
Venture capital firms offer limited partners advantages over investing directly in start-ups themselves as angel investors.
Limited partners are more diversified.
They also benefit from the expertise of the general partners.

9. Sources of Funding (cont'd)
The advantages come at a cost.
General partners usually charge substantial fees.
Most firms charge 20% of any positive return they make.
They also generally charge an annual management fee of about 2% of the fund’s committed capital.

10. Table 23.1 Most Active U.S. Venture Capital Firms in 2007 (by number of deals completed)

11. Figure 23.1 Venture Capital Funding in the United States
Source: PricewaterhouseCoopers MoneyTree Report (

12. Sources of Funding (cont'd)
Private Equity Firms
Organized very much like a venture capital firm, but it invests in the equity of existing privately held firms rather than start-up companies.
Private equity firms initiate their investment by finding a publicly traded firm and purchasing the outstanding equity, thereby taking the company private in a transaction called a leveraged buyout (LBO). In most cases, the private equity firms use debt as well as equity to finance the purchase.

13. Figure 23.2 Total U.S. LBO Volume and Number of Deals
Source: Standard & Poors Leveraged Buyout Review (Volume data not available for the single deal in Q1 ‘09)

14. Table 23.2 Top 10 Private Equity Funds in 2009

15. Sources of Funding (cont'd)
Institutional Investors
Institutional investors such as pension funds, insurance companies, endowments, and foundations are active investors in private companies
Institutional investors may invest directly in private firms or they may invest indirectly by becoming limited partners in venture capital firms.

16. Sources of Funding (cont'd)
Corporate Investor
A corporation that invests in private companies
Also known as Corporate Partner, Strategic Partner, and Strategic Investor
While most other types of investors in private firms are primarily interested in the financial returns of their investments, corporate investors might invest for corporate strategic objectives, in addition to the financial returns.

17. Outside Investors Preferred Stock
Preferred stock issued by mature companies usually has a preferential dividend and seniority in any liquidation and sometimes special voting rights.
Preferred stock issued by young companies has seniority in any liquidation but typically does not pay regular cash dividends and often contains a right to convert to common stock.

18. Outside Investors (cont'd)
Convertible Preferred Stock
Preferred stock that gives the owner an option to convert it into common stock on some future date

19. Outside Investors (cont'd)
RealNetworks, which was founded by Robert Glaser in 1993, was initially funded with an investment of approximately $1 million by Glaser.
As of April 1995, Glaser’s $1 million initial investment in RealNetworks represented 13,713,439 shares of Series A preferred stock, implying an initial purchase price of about $0.07 per share.

20. Outside Investors (cont'd)
RealNetworks needed additional capital and management decided to raise this money by selling equity in the form of convertible preferred stock.
The company’s first round of outside equity funding was Series B preferred stock. RealNetworks sold 2,686,567 shares of Series B preferred stock at $0.67 per share in April After this funding round the distribution of ownership was: (next slide)

21. Outside Investors (cont'd)

22. Outside Investors (cont'd)
The Series B preferred shares were new shares of stock being sold by RealNetworks. At the price the new shares were sold for, Glaser’s shares were worth $9.2 million and represented 83.6% of the outstanding shares.

23. Outside Investors (cont'd)
Pre-Money Valuation
At the issuance of new equity, the value of the firm’s prior shares outstanding at the price in the funding round
$9.2 million in the RealNetworks example
Post-Money Valuation
At the issue of new equity, the value of the whole firm (old plus new shares) at the price the new equity sold at
$11.0 million in the RealNetworks example

24. Outside Investors (cont'd)
Over the next few years, RealNetworks raised three more rounds of outside equity in addition to the Series B funding round.

25. Exiting an Investment in a Private Company
Exit Strategy
It details how investors will eventually realize the return from their investment.
In July 1997, the post-money valuation of existing preferred stock was $8.99 per share.
However, because RealNetworks was still a private company, investors could not liquidate their investment by selling their stock in the public stock markets.

26. Textbook Example 23.1

27. Textbook Example 23.1 (cont'd)

28. Alternative Example 23.1 Problem Assume:
You founded your own firm two years ago.
You initially contributed $50,000 of your money and in return received 1,000,000 shares of stock.
Since then, you have sold an additional 750,000 shares to angel investors.
You are now considering raising even more capital from a venture capitalist. 28

29. Alternative Example 23.1 Problem Assume:
The venture capitalist would invest $2 million and would receive 2,000,000 newly issued shares. 29

30. Alternative Example 23.1 Problem What is the post-money valuation?
Assuming that this is the venture capitalist’s first investment in your company, what percentage of the firm will he end up owning?
What percentage will you own?
What is the value of your shares? 30

31. Alternative Example 23.1 Solution
The venture capitalist is paying $1 per share.
Thus, the post-money valuation is $3,750,000
You will own 26.67% of the firm and the post- money valuation of your shares is $1,000,000.
Your shares
1,000,000
26.67%
Angel Investors’ Shares
750,000
20.00%
Venture capitalist’s shares
2,000,000
53.33%
Total shares outstanding
3,750,000
100.00% 31

32. 23.2 The Initial Public Offering
Initial Public Offering (IPO)
The process of selling stock to the public for the first time

33. Advantages and Disadvantages of Going Public
Greater liquidity
Private equity investors get the ability to diversify.
Better access to capital
Public companies typically have access to much larger amounts of capital through the public markets.

34. Advantages and Disadvantages of Going Public (cont'd)
The equity holders become more widely dispersed.
This makes it difficult to monitor management.
The firm must satisfy all of the requirements of public companies.
SEC filings, Sarbanes-Oxley, etc.

35. Table 23.3 Largest Global Equity Issues, 2008

36. Types of Offerings Underwriter
An investment banking firm that manages a security issuance and designs its structure

37. Types of Offerings (cont'd)
Primary and Secondary Offerings
Primary Offering
New shares available in a public offering that raise new capital
Secondary Offering
Shares sold by existing shareholders in an equity offering

38. Types of Offerings (cont'd)
Best-Efforts, Firm Commitment and Auction IPOs
Best-Efforts Basis
For smaller IPOs, a situation in which the underwriter does not guarantee that the stock will be sold, but instead tries to sell the sock for the best possible price
Often such deals have an all-or-none clause: either all of the shares are sold on the IPO or the deal is called off.

39. Types of Offerings (cont'd)
Best-Efforts, Firm Commitment and Auction IPOs
Firm Commitment
An agreement between an underwriter and an issuing firm in which the underwriter guarantees that it will sell all of the stock at the offer price

40. Types of Offerings (cont'd)
Best-Efforts, Firm Commitment and Auction IPOs
Auction IPO
A method of selling new issues directly to the public
Rather than setting a price itself and then allocating shares to buyers, the underwriter in an auction IPO takes bids from investors and then sets the price that clears the market.

41. Textbook Example 23.2

42. Textbook Example 23.2 (cont'd)

43. Alternative Example 23.2 Problem
Ashton, Inc., is selling 900,000 shares of stock in an auction IPO.
At the end of the bidding period, Ashton’s investment bank has received the following bids.
Price ($)
Number of Shares Bid
$10.00
175,000
$9.75
200,000
$9.50
275,000
$9.25
$9.00
300,000 43

44. Alternative Example 23.2 Problem (continued)
What will the offer price of the shares be? 44

45. Alternative Example 23.2 Solution Price ($) Number of Shares Bid
$10.00
175,000
$9.75
375,000
$9.50
650,000
$9.25
925,000
$9.00
1,225,000
Solution
The winning auction price would be $9.25. 45

46. The Mechanics of an IPO Underwriters and the Syndicate
Lead Underwriter
The primary investment banking firm responsible for managing a security issuance
Syndicate
A group of underwriters who jointly underwrite and distribute a security issuance

47. Table 23. 4 Global IPO Offerings by U. S
Table Global IPO Offerings by U.S. Issuers, Ranked by 2008 Proceeds

48. The Mechanics of an IPO (cont'd)
SEC Filings
Registration Statement
A legal document that provides financial and other information about a company to investors prior to a security issuance
Preliminary Prospectus (Red Herring)
Part of the registration statement prepared by a company prior to an IPO that is circulated to investors before the stock is offered

49. The Mechanics of an IPO (cont'd)
SEC Filings
Final Prospectus
Part of the final registration statement prepared by a company prior to an IPO that contains all the details of the offering, including the number of shares offered and the offer price

50. Figure 23.3 The Cover Page of RealNetworks’ IPO Prospectus
Source: Courtesy RealNetworks, Inc.

51. The Mechanics of an IPO (cont'd)
Valuation
There are two ways to value a company.
Compute the present value of the estimated future cash flows.
Estimate the value by examining comparables (recent IPOs).

52. Textbook Example 23.3

53. Textbook Example 23.3 (cont'd)

54. Alternative Example 23.3 Problem
RAXHouse is a private company considering going public. RAXHouse has assets of $585 million and liabilities of $415 million. The firm’s cash flow from operations was $137 million for the previous year. After the IPO, RAXHouse will have 118 million shares outstanding.
The industry average cash flow per share multiple is 3.0 and the average book value per share is 2.3.
Based on these multiples, estimate the IPO price for RAXHouse.

55. Alternative Example 23.3 Solution
RAXHouse’s book value of equity is the difference between the value of the assets ($585 million) and the value of the liabilities ($415 million), or $170 million. With 118 million shares outstanding, book value per share is $170 million/118 million shares = $1.44/share. Given the industry average of 2.3, the estimated IPO price would be $1.44 × 2.3 = $3.31 per share.
The firm’s cash flow from operations was $137 million, thus cash flow per share is $137 million/118 million shares = $1.16 per share. Given the industry average multiple of 3.0, the estimated IPO price would be $1.16 × 3.0 = $3.48.

56. The Mechanics of an IPO (cont'd)
Valuation
Road Show
During an IPO, when a company’s senior management and its underwriters travel around promoting the company and explaining their rationale for an offer price to the underwriters’ largest customers, mainly institutional investors such as mutual funds and pension funds

57. The Mechanics of an IPO (cont'd)
Valuation
Book Building
A process used by underwriters for coming up with an offer price based on customers’ expressions of interest

58. The Mechanics of an IPO (cont'd)
Pricing the Deal and Managing Risk
Spread
The fee a company pays to its underwriters that is a percentage of the issue price of a share of stock
For RealNetworks, the final offer price was $12.50 per share and the company paid the underwriters a spread of $0.875 per share, exactly 7% of the issue price.
Since this was a firm commitment deal, the underwriters bought the stock from RealNetworks for $ per share and then resold it to their customers for $12.50 per share.
$12.50 – $0.875 = $11.625

59. The Mechanics of an IPO (cont'd)
Pricing the Deal and Managing Risk
When an underwriter provides a firm commitment, it is potentially exposing itself to the risk that the banking firm might have to sell the shares at less than the offer price and take a loss.
However, research shows that 75% of IPOs experience an increase in share price on the first day (only 9% experience a decrease).

60. The Mechanics of an IPO (cont'd)
Pricing the Deal and Managing Risk
Over-Allotment Allocation (Greenshoe Provision)
In an IPO, an option that allows the underwriter to issue more stock, usually amounting to 15% of the original offer size, at the IPO offer price

61. The Mechanics of an IPO (cont'd)
Pricing the Deal and Managing Risk
RealNetworks IPO had a greenshoe provision.
The prospectus specified that 3 million shares would be offered at $12.50 per share. In addition, the greenshoe provision allowed for the issue of an additional 450,000 shares at $12.50 per share.

62. The Mechanics of an IPO (cont'd)
Pricing the Deal and Managing Risk
Underwriters initially market both the initial allotment and the allotment in the greenshoe provision by short selling the greenshoe allotment.
If the issue is a success, the underwriter exercises the greenshoe option, thereby covering its short position.
If the issue is not a success, the underwriter covers the short position by repurchasing the greenshoe allotment in the aftermarket, thereby supporting the price.

63. The Mechanics of an IPO (cont'd)
Pricing the Deal and Managing Risk
Lockup
A restriction that prevents existing shareholders from selling their shares for some period, usually 180 days, after an IPO

64. IPO Puzzles Underpricing
Generally, underwriters set the issue price so that the average first-day return is positive.
As mentioned previously, research has found that 75% of first-day returns are positive.
The average first day return in the United States is 18.3%.

65. IPO Puzzles (cont'd) Underpricing
The underwriters benefit from the underpricing as it allows them to manage their risk.
The pre-IPO shareholders bear the cost of underpricing. In effect, these owners are selling stock in their firm for less than they could get in the aftermarket.

66. Figure 23.4 International Comparison of First Day IPO Returns
Source: Adapted courtesy of Jay Ritter (

67. IPO Puzzles (cont'd) Underpricing
Although IPO returns are attractive, all investors cannot earn these returns.
When an IPO goes well, the demand for the stock exceeds the supply. Thus the allocation of shares for each investor is rationed.
When an IPO does not go well, demand at the issue price is weak, so all initial orders are filled completely.
Thus, the typical investor will have their investment in “good” IPOs rationed while fully investing in “bad” IPOs.

68. IPO Puzzles (cont'd) Underpricing Winner’s Curse
Refers to a situation in competitive bidding when the high bidder, by virtue of being the high bidder, has very likely overestimated the value of the item being bid on
You “win” (get all the shares you requested) when demand for the shares by others is low, and the IPO is more likely to perform poorly.

69. Textbook Example 23.4

70. Textbook Example 23.4 (cont'd)

71. Cyclicality The number of issues is highly cyclical.
When times are good, the market is flooded with new issues; when times are bad, the number of issues dries up.

72. Figure 23.5 Cyclicality of Initial Public Offerings in the United States
Source: Adapted courtesy of Jay R. Ritter from “Some Factoids About the 2008 IPO Market” (

73. Costs of an IPO A typical spread is 7% of the issue price.
By most standards this fee is large, especially considering the additional cost to the firm associated with underpricing.
It is puzzling that there seems to be a lack of sensitivity of fees to issue size.
One possible explanation is that by charging lower fees, an underwriter may risk signaling that it is not the same quality as its higher-priced competitors.

74. Figure 23.6 Relative Costs of Issuing Securities
Source: Adapted from I. Lee, S. Lochhead, J. Ritter, and Q. Zhao, “The Costs of Raising Capital,” Journal of Financial Research 19(1) (1996): 59–74.

75. Long-Run Underperformance
Although shares of IPOs generally perform very well immediately following the public offering, it has been shown that newly listed firms subsequently appear to perform relatively poorly over the following three to five years after their IPOs.

76. 23.3 The Seasoned Equity Offering
Seasoned Equity Offering (SEO)
When a public company offers new shares for sale
Public firms use SEOs to raise additional equity.
When a firm issues stock using an SEO, it follows many of the same steps as for an IPO.
The main difference is that a market price for the stock already exists, so the price-setting process is not necessary.

77. The Mechanics of an SEO Primary Shares Secondary Shares Tombstones
New shares issued by a company in an equity offering
Secondary Shares
Shares sold by existing shareholders in an equity offering
Tombstones
A newspaper advertisement in which an underwriter advertises a security issuance

78. The Mechanics of an SEO (cont'd)
There are two types of seasoned equity offerings.
Cash Offer
A type of SEO in which a firm offers the new shares to investors at large
Rights Offer
A type of SEO in which a firm offers the new shares only to existing shareholders
Rights offers protect existing shareholders from underpricing.

79. Textbook Example 23.5

80. Textbook Example 23.5 (cont'd)

81. Price Reaction
Researchers have found that, on average, the market greets the news of an SEO with a price decline.
This is consistent with the adverse selection discussed in Chapter 16.

82. Figure 23.7 Post-SEO Performance
Source: Adapted from A. Brav, C. Geczy, and P. Gompers, “Is the Abnormal Return Following Equity Issuances Anomalous,” Journal of Financial Economics 56 (2000): 209–249, Figure 3.

83. Issuance Costs
Although not as costly as IPOs, seasoned offerings are still expensive.
Underwriting fees amount to 5% of the proceeds of the issue.
Rights offers have lower costs than cash offers.

84. Chapter Quiz
What are the main sources of funding for private companies to raise outside equity?
What is a venture capital firm?
What are some of the advantages and disadvantages of going public?
List and discuss four IPO “puzzles.”
What is the difference between a cash offer and a rights offer for a seasoned equity offering?