CHAPTER 23 Raising Equity Capital
Private Equity Firms:
a) Invest in the equity of existing privately held firms rather than start-up companies. I
b) Initiate their investment by finding a publicly traded firm and purchasing outstanding equity,
thereby taking company private in transaction called leveraged buyout
c) Share advantages of venture capital firms, and also charge similar fees. One key difference
between private equity and venture capital is the magnitude invested.
Institutional Investors
a) Pension funds, insurance companies, endowments and foundations manage large quantities of
money. They are major investors in many different types of assets, so they are also active
investors in private companies.
b) May invest in private firms, or they may invest indirectly by becoming limited partners in
venture capital or private equity firms
Corporate investors
a) Corporation that invests in private companies is called many different names, including
corporate investor, corporate partner, strategic partner, and strategic investor
b) Corporate investors, by contrast, might invest for corporate strategic objectives in addition to
the desire for investment returns
Outside Investors
Preferred stock issued by mature companies such as banks usually has a preferential dividend and
seniority in any liquidation and sometimes special voting rights
Conversely, preferred stock issued by young companies typically doesn’t pay regular cash dividends
However, this preferred stock usually gives the owner an option to convert it into common stock on
some future date, so it is often called convertible preferred stock
Value of prior shares outstanding at the price in the funding round is called the pre-money
valuation. Value of the whole firm at the funding round price is known as the post-money valuation
Exiting an Investment in a Private Company
Important consideration for investors in private companies is their exit strategy – how they will
eventually realize the return from their investment
Investors exit in 2 main ways: through an acquisition or through a public offering
Often, large corporations purchase successful start-up companies. The acquiring company purchase
the outstanding stock of the private company, allowing all investors to cash out
Alternative way to provide liquidity to its investors is for the company to become a publicly traded
company
,1. 23.2 the Initial Public Offering
Process of selling stock to the public for the first time
Adv/Disadv of Going Public
Greater liquidity and better access to capital. By going public, companies give their private equity
investors the ability to diversify
Public companies typically have access to much larger amounts of capital through the public
markets, both in initial public offering and in subsequent offerings
Major disadvantage: when investors diversify their holdings, the equity holders of corporation
become more widely dispersed. This lack of ownership concentration undermines investors’ ability
to monitor the company’s management, and investors may discount the price they are willing to pay
to reflect loss of control
Several high-profile corporate scandals during the early part of the 21st century prompted tougher
regulations designed to address corporate abuses
Types of Offering
After deciding to go public, managers of the company work with an underwriter, an investment
banking firm that manages the offering and design its structure
Choices include the type of shares to be sold and the mechanism the financial advisor will use to sell
the stock
Primary and Secondary Offerings: At an IPO, a firm offers a large block of shares for sale to public
for the first time. Shares that are sold in IPO may either be new shares that raise new capital, known
as primary offering, or existing shares that are sold by current shareholders, known as secondary
offering
Best-efforts, Firm Commitment, and Auction IPOs: for smaller IPOs, underwriter commonly accepts
deal on a best-effort IPO basis. Underwriter doesn’t guarantee that the stock will be sold, but
instead tries to sell stock for the best possible price. Underwriter and an issuing firm agree to a firm
committee IPO, in which the underwriter guarantees that it will sell all of the stock at the offer
price. Underwriter purchases entire issue and then resells it at the offer price. If the entire issue
doesn’t sell out, underwriter is on the hook: the remaining shares must be sold at a lower price and
the underwriter must take a loss
In recent years, the investment banking firm of WR Hambrecht and Company has attempted to
change the IPO process by selling new issues directly to the public using an online auction IPO
mechanism called OpenIPO
The Mechanisms of an IPO
Underwriters and the Syndicate: Many IPOs, especially larger offerings, are managed by group of
underwriters. Lead underwriter is primary banking firm responsible for managing the deal. Lead
, underwriter provides most of the advice and arranges for a group of other underwriters, called the
syndicate, to help market and sell the issue. Underwriters market the IPO, and they help the
company with all the necessary filings. They actively participate in determining the offer price
SEC Filings:
a) SEC requires that companies prepare registration statement, a legal document that provides
financial and other information about the company to investors, prior to an IPO.
b) Part of the registration statement, called the preliminary prospectus or red herring, circulates to
investors before the stock is offered.
c) SEC reviews the registration statement to make sure that the company has disclosed all of the
information necessary for investors to decide whether to purchase the stock. Company prepares
the final registration statement and final prospectus containing all the details of the IPO,
including the number of shares offered and the offer price
Valuation
a) Before the offer price is set, the underwriters work closely with company to come up with a price
range that they believe provides a reasonable valuation for the firm
b) There are 2 ways to value company: estimate the future cash flows and compute present value, or
estimate the value by examining comparable companies. However, when these techniques give
different answers, they often rely on comparable based on recent IPOs
c) Once an initial price range is established, underwriters try to determine what the market thinks of
the valuation
d) They begin by arranging road show, in which senior management and the lead underwriters travel
around the country promoting company and explaining their rationale for the offer price to the
underwriter’s largest customers – mainly institutional investors such as mutual funds and pension
funds
e) At the end of the road show, customers inform underwriters of their interest by telling underwriters
how many shares they may want to purchase
f) Underwriters’ customers value their long-term relationships with underwriters, so they rarely go
back on their word
g) Underwriters then add up the total demand and adjust price until it is unlikely that the issue will fail
h) This process for coming up with the offer price based on customers’ expressions of interest is called
book building.
i) Because no offer price is set in an auction IPO, book building is not as important in that venue as it is
in traditional IPOs
Pricing the Deal and Managing Risk
a) Company agreed to pay the underwriters a fee, called an underwriting spread
b) Underwriters appear to use the info they acquire during the book-building stage to
internationally underprice the IPO, thereby reducing their exposure to losses. Once the issue
price is set, underwriters may invoke another mechanism to protect themselves against a loss –
over-allotment allocation, or greenhouse provision
c) Once the IPO process is complete, the company’s shares trade publicly on an exchange. The lead
underwriter usually makes a market in the stock and assigns an analyst to cover it. The
