14.1 The financing life cycle of a firm: early-stage financing and venture capital
Entrepreneurial start-ups search for capital on the private equity and venture capital market. Venture
capital is financing for new, often high-risk ventures.
The private equity firm
Can be divided into venture equity and non-venture equity markets. A large part of the non-venture
market is made up of firms in financial distress, because they aren’t able to issue public equity, and can’t
use traditional forms of debt such as bank loans.
Suppliers of venture capital
There are at least four types of suppliers of venture capital. (1) A few old-line, wealthy families. (2) A
number of private partnerships and corporations. They may raise capital from institutional investors, or
individuals might provide the funds. (3) Large industrial or financial corporations have established
venture capital subsidiaries. (4) Participants in an informal venture capital market.
Venture capital firms employ various screening procedures to prevent inappropriate funding.
Stages of financing
There are six stages in private equity financing:
1.Seed money. A small amount of financing needed to prove a concept or develop a product.
2.Start-up. Financing for firms that started within the past year. Funds are likely to pay for marketing and
product development expenditures.
3.Later stage capital. Additional money to begin sales and manufacturing after a firm has spent it start-
up funds.
4.Growth capital. Funds earmarked for a firm to enable it to reach its potential and achieve successful
growth.
5.Replacement capital. Financing for a company to buy out other investors in the firm.
6.Buyout financing. Money provided for managers and outside investors to acquire a fully functioning
firm.
Majority of investments is in growth capital.
Some venture capital realities
Access to venture capital is very limited. Venture capitalists heavily rely on informal networks of lawyers,
accountants, bankers and other venture capitalists to help identify potential investments.
Venture capital is incredibly expensive. Venture capitalists demand 40 percent or more of the equity in
the company, and frequently hold voting preference shares. Also, seats on the company’s board may be
demanded.
If a start-up succeeds, the big pay-off comes when the company is sold to another company or goes
public.
14.2 Selling securities to the public: the basic procedure
When considering the steps involved in a public issue of securities, it is important to remember that each
country has its own specific regulations and traditions, although the EU has a comprehensive directive
that covers all member countries. See table 14.1, page 400.
,14.3 Alternative issue methods
A security can be sold as public of private issue. Publics issues should be registered on the stock
exchange it plans to list on. If the issue is to be sold to a small number of investors, it may be carried out
privately. There are two kinds of public issue: a general cash offer and a rights offering. Cash offers are
for the general public and rights issue are initially offered only to existing owners. The first public equity
issue that is made by a company is referred to as an initial public offering, and IPO, or an unseasoned
new issue. All initial public offerings are cash offers. A seasoned equity offering is a new issue for a
company with securities that have been previously issued. Can be made by using a cash or rights offer.
Methods of issuing new securities are shown in table 14.2, page 401.
14.4 Underwriters
Underwriters are usually involved in public issues of securities. They perform services such as:
formulating the method used to issue the securities, pricing the new securities, and selling the new
securities. Typically, underwriters take the risk if the securities won’t sell, because they buy the securities
for less than the offering price. A syndicate is a group of underwriters to share risk and help selling the
issue. The difference between the underwriter’s buying price and the offering price is called the gross
spread, or underwriting discount.
Choosing an underwriter
A firm can offer its securities to the highest bidding underwriter on a competitive offer basis, or it can
negotiate directly with an underwriter on a negotiated offer basis.
Types of underwriting
Three basic types of underwriting are involved in a cash offer:
1.Firm commitment underwriting. The issuer sells the entire issue to the underwriters, who then attempt
to resell it. The issuer receives the agreed-upon amount of money, and all the risk associated with selling
the issue is transferred to the underwriter. The risk is usually minimal, because the underwriters have
investigated how receptive the market is to the issue.
2.Best efforts underwriting. The underwriter is legally bound to use ‘best efforts’ to sell the securities at
the agreed-upon offering price. The underwriter doesn’t guarantee any amount of money to the issuer.
3.Dutch auction underwriting(uniform price auction). The underwriter doesn’t set a fixed price for the
shares to be sold. The underwriter conducts an auction in which investors bid for shares. See page 402-
403 for an example.
The aftermarket
The period after a new issue is initially sold to the public is referred to as the aftermarket. During this
time, securities are generally not sold for less than the offering price.
The green shoe provision(overallotment option)
Many underwriting contracts contain this, which gives the members of the underwriting group the
option to purchase additional shares from the issuer at the offering price. All IPOs and SEOs include this,
but ordinary debt offerings don’t. Green Shoe options last for 30 days and involve 15 percent of the
newly issued shares. If demand for the issue is weak, the underwriters buy the needed shares in the
open market, thereby helping to support the price of the issue in the aftermarket.
,Lock-up agreements
Almost all underwriting contracts contain this. It specifies how long insiders must wait after an IPO
before they can sell some or all of their equity(most of the time 180 days). It ensures that insiders
maintain a significant economic interest in the company going public.
The quiet period
It means that all communications with the public must be limited to ordinary announcements and other
purely factual matters. The logic is that all relevant information should be contained in the prospectus,
and an important result of this requirement is that the underwriter’s analysts are prohibited from
making recommendations to investors.
14.5 IPOs and underpricing
If the offering price is too high, the issue may be unsuccessful and be withdraws. If the price is too low,
existing shareholders experience an opportunity loss. Unseasoned new equity issues are generally
offered below their true market price.
Why does underpricing exist?
There are various explanations, but there is lack of agreement among researchers about it. Underpricing
seems to be attributable to smaller, highly speculative issues. Also, underpricing tends to be higher for
firms with few to no sales in the previous year. These firms tend to be young firms, and they could be
very risky, which means that they should be underpriced.
Relatively few IPO buyers will get the high initial returns observed in IPOs, and many will lose money.
IPOs have positive returns on average, but a significant fraction of them drops price.
The winner’s curse takes place when an average investor gets the entire allocation of shares, this may be
because those who know better avoid the issue. Underwriters can counteract the winner’s curse and
attract the average investor is by underpricing new issues(on average) so that the average investor still
makes a profit. Another reason for underpricing is that it is a kind of insurance for the underwriters. A
final reason for underpricing is that, before the offer price is established, underwriters talk to big
institutional investors to gauge the level of interest in the equity, and to gather opinions about a suitable
price. Underpricing is a way that the bank can reward these investors for truthfully revealing what they
think the equity is worth and the number of shares they would like to buy.
14.6 New equity sales and the value of the firm
Share prices tend to decline following the announcement of a new equity issue, although they tend to
not change much following a debt announcement. Plausible reasons for this strange result:
1.Managerial information. If management has superior information about the market value of the firm, it
will attempt new shares of equity when the firm is overvalued. New shareholders anticipate on this, and
discount it in lower market prices at the new issue date.
2.Debt usage. A company issuing new equity may reveal that the company has too much debt of too
little liquidity.
3.Issue costs. There are substantial costs associated with selling securities.
,14.7 The costs of issuing securities
Issuing securities to the public isn’t free. These costs associated with floating a new issue are generically
called flotation costs.
The costs of selling stock to the public
1.Gross spread. Consists of direct fees paid by the issuer to the underwriting syndicate, the difference
between the price the issuer receives and the offer price.
2.Other direct expenses. Direct costs, which aren’t part of the compensation to underwriters.
3.Indirect expenses. Aren’t reported on the prospectus, and include the costs of management time spent
working on the new issue.
4.Abnormal returns. In a seasoned issue of equity, the price of the existing shares drop on average by 3
percent on the announcement of the issue. This drop is called abnormal returns.
5.Underpricing. Losses which arise from selling the equity below value.
6.Green shoe option. Gives underwriters the right to buy additional shares at the offer price to cover
overallotments.
Research on issue costs provide a number of insights: (1) with the possible exception of straight debt
offerings, there are substantial economies of scale. Underwriters spreads are smaller on larger issues,
and other direct costs fall sharply as a percentage of the amount raised. (2) Costs associated with selling
debt are substantially less than the costs of selling equity. (3) IPOs have higher expenses than SEOs, but
the difference isn’t as great as might originally be guessed. (4) Straight bonds are cheaper to float than
convertible bonds.
14.8 Rights
If a pre-emptive right is contained in the firm’s articles of incorporation, the firm must first offer any new
issue of equity to existing shareholders. An issue of equity offered to existing shareholders is called a
rights issue, rights offering or a privileged subscription. Each shareholder is issued rights to buy a
specified number of new shares from the firm at a specified price within a specified time, after which the
rights expire. The terms of the rights offering are evidenced by certificated known as share warrants or
rights. Rights issues are cheaper than cash offers. It can be done without an underwriter, while that
seems impossible for cash offers.
The mechanics of a rights issue
Read 410-414.
The underwriting agreements
In standby underwriting the issuer makes a rights issue, and the underwriter makes a firm commitment
to ‘take up’ the unsubscribed portion of the issue. The underwriter gets a standby fee and additional
amounts based on the securities taken up. It protects the firm against undersubscription, which can
occur if investors throw away rights or if bad news causes the market price of the equity to fall below the
subscription price. Shareholders are usually given an oversubscription privilege, which enables them to
purchase unsubscribed shares at the subscription price.
, 14.9 Dilution
Dilution refers to a loss in existing shareholders’ value. There are several kinds:
1.Dilution of proportionate ownership.
2.Dilution of market value.
3.Dilution of book value and earnings per share.
Dilution of proportionate ownership
Can arise when a firm sells shares to the general public. It can be avoided by shareholders when using a
right issue.
Dilution of value: book versus market values
Read 415-416.
14.10 Issuing long-term debt
The registration statement for a public issue of bonds is different from the one for equities. For bonds,
the registration statement must indicate an indenture. Another important difference is that more than
50 percent of all debt is issued privately. There are two basic forms of direct private long-term financing:
term loans and private placement. Term loans are direct business loans with maturities between one
and five years. Most term loans are repayable during the life of the loan. Private placement are similar to
term loans except that the maturity is longer.
The important differences between direct private long-term financing and public issues of debt are:
1.A direct long-term loan avoids the cost of stock exchange registration.
2.Direct placement is likely to have more restrictive covenants.
3.It is easier to renegotiate a term loan or a private placement in the event of a default. It is harder to
renegotiate a public issue, because hundreds of holders are usually involved.
4.Life insurance companies and pension funds dominate the private placement segment of the bond
market. Banks are significant participants in the term loan market.
5.The costs of distributing bonds are lower in the private market.
6.The interest rates on term loans and private placements are usually higher than those on an equivalent
public issue.
7.Flotation costs associated with selling debt are much less than the comparable costs associated with
selling equity.
14.11 Bank loans
There are two types of bank loans: lines of credit and loan commitments. A line of credit is an
arrangement between a bank and a firm, typically for short term loan, wherby the bank authorizes the
maximum loans amount, but not the interest rate, when setting up the line of credit. A loan commitment
is an arrangement that requires the bank to lend up to a maximum pre-specified loan amount at a pre-
specified interest rate. It is in place and available at the firm’s request as long as the firm meets the
requirements established. There are two types of loan commitment: (1) revolver, in which funds flow
back and forth between the bank and the firm without any predetermined schedule. (2) non-revolving, in
which the firm can’t pay down the loan and then subsequently increase the amount of borrowing.
