Chapter 19

RAISING CAPITAL

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19-1

KEY CONCEPTS AND SKILLS

Describe the venture capital market and its role
in financing new businesses
Articulate how securities are sold to the public,
and the role of investment bankers
Explain initial public offerings, and the costs of
going public

19-2

CHAPTER OUTLINE
19.1
19.2

Early-Stage Financing and Venture Capital

Selling Securities to the Public: The Basic
Procedure
19.3 Alternative Issue Methods
19.4 Underwriters
19.5 IPOs and Underpricing
19.6 What CFOs Say about the IPO Process
19.7 SEOs and the Value of the Firm
19.8 The Cost of Issuing Securities
19.9 Rights
19.10 Dilution
19.11 Issuing Long-Term Debt
19.12 Shelf Registration
19-3

19.1 THE FINANCING LIFECYCLE OF A

FIRM: VENTURE CAPITAL
Private financing for new, high risk
businesses in exchange for stock
Individual investors
Venture capital firms

Usually involves active participation by

VC
Ultimate goal: take company public;
the VC will benefit from the capital
raised in the IPO
Hard to find
Expensive
19-4

VENTURE CAPITAL STAGE FINANCING

Funding provided in several stages
Contingent upon specified goals at each stage
First stage
Ground floor or Seed money
Fund prototype and manufacturing plan

Second Stage
Mezzanine financing
Begin manufacturing, marketing & distribution

19-5

19.2 SELLING SECURITIES TO THE

PUBLIC
1. Management obtains permission from
the Board of Directors
2. Firm files a registration statement
with the SEC
3. SEC examines the registration during
a 20-day waiting period
4. Securities may not be sold during the
waiting period

19-6

SELLING SECURITIES TO THE PUBLIC

(CONT.)
5. A preliminary prospectus, called a red
herring, is distributed during the waiting
period

If problems, the company amends

the registration, and the waiting period
starts over
6. Price per share determined on the
effective date of the registration and the
selling effort begins

19-7

TOMBSTONE
FIGURE 19.4

Investment banks in
syndicate divided into
brackets
Firms listed alphabetically
within each bracket
Pecking order
Higher bracket =
greater prestige
Underwriting success
built on reputation
19-8

19.3 ALTERNATIVE ISSUE METHODS

Public Issue
Registration with SEC required
General cash offer = offered to general public
Rights offer = offered only to current
shareholders
IPO = Initial Public Offering = Unseasoned new
issue
SEO = Seasoned Equity Offering

Private Issue
Sold to fewer than 35 investors
SEC registration not required
19-9

METHODS OF ISSUING NEW

SECURITIES
TABLE 19.1

19-10

19.4 UNDERWRITERS
Underwriting services:

Formulate method to issue securities

Price the securities
Sell the securities
Price stabilization by lead underwriter in
the aftermarket

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 in the market
19-11

FIRM COMMITMENT UNDERWRITING

Issuer sells entire issue to underwriting
syndicate
Syndicate resells issue to the public
Underwriter makes money on the spread
between the price paid to the issuer and the
price received from investors when the stock is
sold
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

19-12

BEST EFFORTS UNDERWRITING

Underwriter makes best effort to sell the
securities at an agreed-upon offering price
Issuing company bears the risk of the
issue not being sold
Offer may be pulled if not enough interest
at the offer price
Company does not get the capital and they
have still incurred substantial flotation costs

Not as common as it used to be

19-13

DUTCH OR UNIFORM PRICE AUCTION

Buyers:
Bid a price and number of shares
Seller:
Work down the list of bidders
Determine the highest price at which they
can sell the desired number of
shares
All successful bidders pay the same price
per share.
Encourages aggressive bidding
19-14

DUTCH OR UNIFORM PRICE AUCTION

EXAMPLE
The company wants to sell 1,500 shares of stock.

The firm will sell 1,500 shares at $15 per share.

Bidders A, B, C, and D will get shares.

19-15

GREEN SHOE PROVISION

Overallotment Option
Allows syndicate to purchase an
additional 15% of the issue from the
issuer
Allows the issue to be oversubscribed
Provides some protection for the lead
underwriter as they perform their
price stabilization function
In all IPO and SEO offerings but not
in ordinary debt offerings

19-16

LOCKUP AGREEMENTS
Not legally required but common
Restricts insiders from selling IPO shares for a
specified time period
Common lockup period = 180 days

Stock price tends to drop when the lockup

period expires due to market anticipation of
additional shares hitting the Street

19-17

19.5 IPOS AND UNDERPRICING

IPO pricing = very difficult

No current market price available

Dutch Auctions designed to

eliminate first day IPO price
pop
Underpricing causes the issuer
to leave money on the table
Degree of underpricing varies
over time
19-18

IPO UNDERPRICING REASONS

Underwriters want offerings to sell out

Reputation for successful IPOs is critical

Underpricing = insurance for underwriters
Oversubscription & allotment
Winners Curse

Smaller, riskier IPOs underprice to attract

investors

19-19

19.6 WHAT CFOS SAY ABOUT THE

UNDERWRITING PROCESS
Most Common Motivations for IPO:

Create Public Shares for Use in Acquisitions

Establish Market Value of the Firm
Enhance Reputation of Firm
Diversify Ownership and Owner Wealth

Most Common Reasons for Underpricing:

Compensate Investors for IPO Risk

Increase Post-Issue Trading Volume
Curry Favor with Institutional Investors
Increase Publicity on Opening Day
19-20

19.7 SEOS AND THE VALUE OF THE

FIRM
Stock prices tend to decline when new
equity is issued
Managerial Information: If management
believes equity is overvalued, they would choose
to issue stock shares. Usually benefits current
shareholders but new shareholders anticipate
the superior information and bid down the price
of the stock over time.
Debt usage: Issuing stock may indicate firm has
too much debt and can not issue more debt

Issue costs
Issue costs for equity direct and indirect - are
significantly more than for debt
19-21

19.8 THE COST OF ISSUING

SECURITIES
Total direct costs 10.4%
Direct costs very large, especially for issues < $10
million (25.22%)

Underpricing cost 19.3%

Average spread = 7%
Patterns:

Substantial economies of scale

Costs of selling debt < issuing equity
IPO costs > SEO costs
Straight bonds < Convertible bonds

19-22

19.8 THE COST OF ISSUING

SECURITIES

19-23

19.9 RIGHTS
A rights offering is an issue of new common
stock to existing shareholders
Shareholders are issued options to purchase
specified number of shares at a fixed price
and specified period of time
Rights (sometime called warrants) are often
traded on exchanges and OTC.
Efficient market theory dictates that there is
no long term price advantage to acquiring
shares via rights versus the open market.

19-24

RIGHTS (CONT.)
Shareholders can exercise their rights or sell
them
In either case, the shareholders neither win or lose

If investors do not exercise or sell their

rights, undersubscription can occur.
In such a case, underwriters will often take up the
undersubscribed portion of the offering in exchange
for a standby fee

Most US new equity issues are sold without

rights. Paradoxically, issuance costs would
likely be less with rights.
19-25

19.10 DILUTION
Dilution is a loss in existing shareholder value
caused by issuance of more stock
Three types of dilution are extant:
Dilution of percentage ownership
Dilution of market value
Dilution of Book Value and EPS

Dilution of percentage ownership can be

overcome with rights.
Dilution of value is not a result of expanded
financing; it typically results from less than
optimal use of the financing
19-26

19.11 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 the life of the loan

Private placements
Similar to term loans with longer maturity

Easier to renegotiate than public issues

Lower costs than public issues
No SEC registration
19-27

19.12 SHELF REGISTRATION

SEC Rule 415
Permits firm to register a large issue with the
SEC and sell it in small portions
Reduces flotation costs
Allows company more flexibility to raise money
quickly

19-28

19.12 SHELF REGISTRATION

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 preceding three years
19-29

QUICK QUIZ
1. What is venture capital and
what types of firms receive it?
2. What are some of the important
services provided by
underwriters?
3. What type of underwriting is the
most common in the United
States and how does it work?
19-30

QUICK QUIZ
4. What is IPO underpricing and
why might it persist?
5. What are some of the costs
associated with issuing
securities?
6. What are some of the
characteristics of private
placement debt?
7. What is shelf registration?
19-31