Part 1 - ch.23 Raising Equity Capital
23.1 Equity Financing for Private Companies
23.2 The Initial Public Offering
23.3 IPO Puzzles
23.4 The Seasoned Equity Offering
The initial capital that is required to start a business is usually provided by the entrepreneur.
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.
Sources of funding: Angel Investors
Venture Capital Firm
A limited partnership that specializes in raising money to invest in the private equity of young firms.
One of the general partners who work for and run a venture capital firm.
VC firms offer limited partners advantages over investing directly in start-ups themselves as angel investors.
Private Equity Firms
Ex. Blackrock funds, Vanguard funds.
Venture capital investing
When a company founder decides to sell equity to outside investors for the first time, it is common practice for private companies to issue preferred stock rather than common stock to raise capital.
Convertible Preferred Stock
Preferred stock that gives the owner an option to convert it into common stock on some future date.
Each time the firm raises money is referred to as a funding round, and each round will have its own set of securities with special terms and provisions.
After a potential initial “seed round,” it is common to name the securities alphabetically, starting with Series A, Series B, etc
Only then, the company has a market value.
Over the next few years, Real Networks raised three more rounds of outside equity in addition to the Series B funding round
Initial Public Offering (IPO)
The process of selling stock to the public for the first time.
It allows greater liquidity, and better access to capital at the cost of more external monitoring and more demand for transparency.
Primary Offering: New shares available in a public offering that raise new capital
Secondary Offering: Shares sold by existing shareholders in an equity offering
An investment banking firm that manages a security issuance and designs its structure.
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.
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. Most common.
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.
Solution: The winning auction price would be 9.25.
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.
Registration Statement: A legal document that provides financial and other information about a company to investors prior to a security issuance. Company managers work closely with the underwriters to prepare this registration statement.
Preliminary Prospectus: Part of the registration statement prepared by a company prior to an IPO that is circulated to investors before the stock is offered.
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. This document is created only after carefull revision.
Valuation: There are two ways to value a company: a) Compute the present value of the estimated future cash flows, or B) Estimate the value by examining comparables (recent IPOs).
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.
Book Building: A process used by underwriters for coming up with an offer price based on customers’ expressions of interest. The book-building process provides an early indication of demand for the IPO. If demand appears to be weak in the target price range, the firm may choose to withdraw from the IPO process.
Spread: The fee a company pays to its underwriters that is a percentage of the issue price of a share of stock.
Over-allotment allocation (greenshoe provision): In an IPO, an option that allows the underwriter to issue more stock, usually amounting to some % of the original offer size, at the IPO offer price.
Lockup: A restriction that prevents existing shareholders from selling their shares for some period, usually 180 days, after an IPO.
On average, IPOs appear to be underpriced: The price at the end of trading on the first day is often substantially higher than the IPO price.
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.
The costs of an IPO are very high, and it is unclear why firms willingly incur them (source: Berk & DeMarzo).
The long-run performance of a newly public company (three to five years from the date of issue) is poor. That is, on average, a three- to five-year buy and hold strategy appears to be a bad investment.
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.
Cyclicality and Recent Trends
Costs of an IPO
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.
Seasoned Equity Offering (SEO)
Primary Shares: New shares issued by a company in an equity offering.
Secondary Shares: Shares sold by existing shareholders in an equity offering.
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.