Chapter 15 How corporations issue securities
Venture capital
Zero-stage investment = financing through savings, personal bank loans and 3F
Business plan = A confidential document describing the proposed product, its potential market, the underlying
technology, and the resources (time, money, employees, plant and equipment) required for success.
Signalling = Indicating what one thinks of an investment/plan/idea
Further-stage financing = External finance, for instance from banks/stocks/and so on.
Mezzanine financing = a hybrid of debt and equity financing that gives the lender the right to convert the debt to an
equity interest in the company in case of default.
The success of a new business depends critically on the effort put in by the managers. Therefore, venture capital firms
try to structure a deal so that management has a strong incentive to work hard. Venture capitalists rarely give a young
company up front all the money it will need. At each stage they give enough to reach the next major checkpoint.
The venture capital market
Money from 3F (family, friends and fools)
Angel investors = Wealthy individuals that invest in small firms in return for equity in the firm
Specialist venture-capital firms = Firms that pool funds from a variety of investors, seek out fledging
companies to invest in, and work with these companies as they try to grow.
Corporate ventures = Provide equity capital to new innovative companies
Crowdfunding = Raise money from small investors via the web
Most venture capital funds are organized as limited private partnerships with a fixed life of about 10 years. Pension
funds and other investors are the limited partners. The management company, which is the general partner, is
responsible for making and overseeing the investments.
Carried interest = A fixed fee and a share of the profits for the general partner, as a compensation for overseeing the
investment.
Private equity investing = When venture capital partnerships are combined with similar partnerships that provide
funds for companies in distress or that buy out whole companies or divisions of public companies and then take them
private.
Venture capital firms
Active investors
Specialize in young high-tech firms that are difficult to evaluate, they monitor these closely
Provide ongoing advice to the firms that they invest in
Play a major role in recruiting senior management
The judgment and contacts can be valuable to a business in its early years and can help the firm to bring its
product more quickly to market
Two ways to cash in in investments:
1. Once the business has established a track record, it can be sold out to a larger firm
2. However, many entrepreneurs prefer to remain the boss. Thus, the company can go public and provide
original backers an opportunity to “cash out”, selling their stock and leaving the original entrepreneurs in
control.
For every 10 first-stage venture capital investments, only 2 or 3 may survive as successful businesses. 2 rules:
1. Don’t shy away from uncertainty; accept a low probability of success
2. Cut your losses; identify losers early and if you can’t fix the problem throw no good money after bad.
The Initial Public Offering
Primary IPO = new shares are sold to raise additional cash for the company
Secondary IPO = existing shareholders decide to cash in by selling part of their holdings
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, Motives for IPO Drawback of IPO
1. To create public shares for use in future acquisitions Shares may be sold for less than their true worth
2. To establish a market price/value for our firm Longer-term costs to operating as public company
3. To enhance the reputation of our company Pressure on managers to report increase in profits
4. To broaden the base of ownership Red tape involved in running a public company
5. To allow one or more principals to diversify personal
holdings
6. To minimize cost of capital
7. To allow venture capitalists to cash out
8. To attract analysts’ attention
9. Company has run out of private equity
10. Debt is becoming too expensive
Sarbanes Oxley Act (SOX) = sought to prevent a repeat of corporate scandals that brought about the collapse of Enron
and WoldCom; increased reporting, increased willingness to remain private.
Jumpstart Our Business Startups (JOBS) act = eased some of the regulation for small companies that were enacted in
SOX, created due to concerns about the number of private companies increasing more than the public companies.
Steps in arranging an IPO
1. Select the underwriters to serve 3 roles
a. Provide procedural and financial advice
b. Buy the issue
c. Resell the issue to the public
2. The underwriter then forms a syndicate of underwriters to buy the entire issue and resell it to the public.
3. Register at the Securities and Exchange Commission (SEC) and provide a prospectus.
Prospectus includes valuable firm information: the offering, proceeds, dividend policy, management,
compensation, stockholders, underwriting, agreements, legal matters, e.d.
The sale of stock
While awaiting the SEC registration, the company and underwriters have begun to firm up the issue price.
1. Look at price-earnings ratio of principal competitors
2. Trial and error discounted-cash-flow calculations
3. Road show to talk to potential investors and indicate how many shares can be sold for what price
4. Build a book of potential orders based on the road show
5. After clearance from SEC, the issue price is fixed
Higher issue price prosperous sign
6. Green shoe option for underwriters: buy an additional % of shares from the company to sell
7. After IPO, mandatory “quiet period” of 40 days
8. After 40 days, underwriters’ research reports are published on the company
The underwriters
When underwriters buy the stock to offer it to the public, they take the risk that the issue might flop and that they
might be left with unwanted stock.
Best-efforts basis = when underwriters promise to sell as much of the issue as possible, but cannot guarantee to sell
the entire amount often handled with risky stock
Companies get to make only one IPO, but underwriters are in the business all the time. Wise underwriters realize that
their reputation is on the line and will not handle an issue unless they believe the facts have been presented fairly to
investors.
Spinning = Allocating stock in popular new issues to managers of their important corporate clients.
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, Cost of a new issue
Underwriters receive payment in the form of a spread.
Spread = underwriters are allowed to buy the shares for less than the offering price at which the shares were sold to
investors.
Since many of the costs incurred by underwriters are fixed, it is expected that the percentage spread would decline
with issue size. In addition to the underwriting fee, there are substantial administrative costs:
Preparation of the registration statement and prospectus involved management, legal counsel, and
accountants, as well as the underwriters and their advisers.
The firm had to pay fees for registering in the new securities, printing and mailing costs, etc.
Underpricing of IPOs
Underpricing = When the offering price is less than the true value of the issued securities.
How underpricing makes sense:
Investors and bankers argue that a low offering price on an IPO raises the price when it is subsequently traded
in the market and enhances the firm’s ability to raise further capital.
Winner’s curse = The highest bidder in an auction is most likely to have overestimated the object’s value and,
unless bidders recognize this in their bids, the buyer will overpay. You will find that you have no difficulty in
getting stock in the issues that no one wants, but when the issue is attractive, underwriters will not have
enough stock to go around and you receive less stock than you wanted. The result is that your money-making
strategy may turn out to be a loser.
Skeptics point out that underpricing is largely in the interest of the underwriters, who want to reduce the risk that they
will be left with unwanted stock and to court popularity by allotting stock to favored clients.
Hot new issue-periods
Some observers believe that hot new-issue periods arise because investors are prone to periods of excessive optimism
and would-be issuers time their IPOs to coincide with these periods. Other observers stress the fact that a fall in the
cost of capital or an improvement in the economic outlook may mean that several new or dormant projects suddenly
become profitable. At such times, many entrepreneurs rush to raise new cash to invest in these projects.
Overall, the initial reaction to new issues is overenthusiastic. When IPO stocks are compared with those of similar
companies, much of the return shortfall disappears. long-run IPO performance
Alternative issue procedures for IPOs
Bookbuilding method = Underwriter builds a book of likely orders and uses this information to set issue price
Like an auction: buyers indicate how many shares they are prepared to buy, but the indications are not binding and
are used only as a guide to fix the issue price.
Advantage: it allows underwriters to give preference to those investors whose bid are most helpful in setting the
price, it offers them a reward in the shape of underpricing
Issue procedures:
Bookbuilding method
Underwriter builds a book of likely orders and uses this information to set issue price
Open auction
Investors are invited to submit their bids (how many, what price). Securities are sold to the highest bidder
Discriminatory auction
Every winner is required to pay the price that he/she bid
Uniform-price auction
Every bidder is required to pay the price of the lowest winning bidder.
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