© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

Raising Capital

Chapter

Fifteen

15.2 Chapter Outline

The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital

The Public Issue The Basic Procedure for a New Issue The Cash Offer The Decision to Go Public New Equity Sales and the Value of the Firm The Cost of Issuing Securities Rights Dilution Issuing Long-Term Debt

15.3 Venture Capital 15.1

Private financing for relatively new businesses in exchange for stock

Usually entails some hands-on guidance The ultimate goal is usually to take the company

public and the venture capitalists will benefit from the capital raised in the IPO

Many venture capital firms are formed from a group of investors that pool capital and then have partners in the firm decide which companies will receive financing

Some large corporations have a venture capital division

15.4 Choosing a Venture Capitalist

Look for financial strength (resources and financial reserves for additional financing stages)

Choose a VC that has a management style that is compatible with your own (involved in day-to-day operations or monthly reports)

Obtain and check references (have the venture capitalists been successful with other firms?)

What contacts does the VC have? (contacts with potential important customers and suppliers)

What is the exit strategy? (under what circumstances will venture capitalists “cash-out” of the business?)

15.5 The Public Issue 15.2

Public issue – the creation and sale of securities that are intended to be traded on public markets

All companies listed on the TSX come under the Ontario Securities Commission’s (OSC) jurisdiction

The Canadian Securities Administration (CSA) coordinates across provinces.

15.6 Alberta Securities Commission

The Alberta Securities Commission (ASC) is the industry-funded organization responsible for overseeing the capital market in Alberta. The Commission administers the Alberta Securities Act, the Securities Regulation and Alberta Securities Commission Rules.

This legislation is designed to ensure that:- Alberta’s capital market operates fairly and efficiently for

participants- that investors have timely, accurate information on which to

base investment decisions- those who sell securities in Alberta are registered and that

they conduct themselves according to applicable laws and professional standards.

15.7 Selling Securities to the Public 15.3

Management must obtain permission from the Board of Directors

Firm must prepare and distribute copies of a preliminary prospectus (red herring) to the Securities Commissions in the jurisdictions where they want to sell the shares

Prospectus: is a legal document describing details of the issuing corporation and the proposed offering to potential investors

15.8 Selling Securities to the Public (cont.)

The Securities Commissions study the preliminary prospectus and notify the company of any deficiencies (usually takes a minimum of 2 weeks)

When the prospectus is approved by the Securities Commissions, the price is set and the securities dealers can begin selling the new issue

15.9 Underwriters 15.4

Services provided by underwriters Formulate method used to issue securities Price the securities Sell the securities

Syndicate – group of underwriters 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

15.10 Firm Commitment Underwriting

Also called a “bought deal” Issuer sells entire issue to underwriting syndicate The syndicate then resells the issue to the public The underwriter makes money on the spread between

the price paid to the issuer and the price received from investors when the stock is sold

The syndicate bears the risk of not being able to sell the entire issue for more than the cost

Most common type of underwriting in Canada

15.11 Best Efforts Underwriting

Underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer without financial resposibility

Underwriter must make their “best effort” to sell the securities at an agreed-upon offering price

The company bears the risk of the issue not being sold

The offer may be pulled if there is not enough interest at the offer price. In this situation, the company does not get the capital and they have still incurred substantial flotation costs

15.12 Overallotment Option

Overallotment Option / Green Shoe provision Allows syndicate to purchase an additional 15% of the

issue from the issuer Allows the issue to be oversubscribed and covers

excess demand The overallotment option is a benefit to the

underwriting syndicate and a cost to the issuer

15.13 IPO Underpricing 15.5

Initial Public Offering – IPO May be difficult to price an IPO because there

isn’t a current market price available Additional asymmetric information associated

with companies going public Underwriters want to ensure that their clients

earn a good return on IPOs on average Underpricing causes the issuer to “leave

money on the table” (i.e., reduces the proceeds received by the original owners)

15.14 Why does underpricing exist?

Much of the apparent underpricing is attributable to the smaller, more highly speculative (i.e., very risky investments) issues. Thus, these issues must be significantly underpriced in order to attract investors.

When the price is too low, the issue is often oversubscribed. This, means investors cannot buy all the shares they want, and the underwriters allocate the shares among investors.

15.15 New Equity Issues and Price

Stock prices tend to decline when new equity is issued

Possible explanations for this phenomenon Managerial information and signaling (e.g. issue

new stock when the firm’s stock is overvalued)

Debt usage and signaling (issue new stock because the firm has too much debt or not enough liquidity)

Issue costs (e.g. flotation costs)

15.16 New Equity Issues and Price (cont.)

Since the drop in price can be significant and much of the drop may be attributable to negative signals, it is important for management to understand the signals that are being sent and try to reduce the effect when possible

15.17 The Cost of Issuing Securities 15.7

Spread – the difference between the price the issuer receives and the offer price

Other direct expenses – legal fees, filing fees, etc. Indirect expenses – opportunity costs, i.e.,

management time spent working on issue Abnormal returns – price drop on existing stock (3%)

Underpricing – below market issue price on IPOs Overallotment (Green Shoe) option – cost of

additional shares that the underwriter can purchase at the offer price after the issue has gone to market

15.18 Rights Offerings: Basic Concepts 15.8

More correct name is the Pre-emptive Right A Rights Offeing is an issue of new common stock

offered to existing shareholders A Rights Offer allows current shareholders avoid the

dilution that occurs with a new stock issue, since they are able to purchase a pro rata share of the new issue

One “Right” is given for each common stock owned. The Right will: Specify number of shares that can be purchased Specify purchase price Specify time frame

Rights usually trade on the same exchange as the company’s stock

15.19 Dilution 15.9

Dilution is a loss in value for existing shareholders Percentage ownership – if the firm sells new shares, the

old shareholder’s proportionate ownership goes down, if they don’t buy an equal percentage of the new shares offered.

Example: Jill currently owns 5,000 shares in a firm with 50,000 shares outstanding. She thus owns 10% of the firm. The firm then sells another 50,000 shares. If Jill does not purchase any of the new shares, her ownership falls to 5%.

15.20 Dilution

Market value – dilution (a drop in market price per share) occurs when the firm accepts negative NPV projects, thereby destroying shareholder wealth.

Book value and EPS – both the book value per share and the Earnings per Share (EPS) will drop when new common stock is issued (since you divide by the # of outstanding stocks)

15.21 Types of Long-term Debt 15.10

Bonds – long-term debt May be sold through a public offering or a private placement

Private issues Term loans

Direct business loans from commercial banks, insurance companies, etc.

Maturities usually in the range of 1 – 5 years, although may be much longer

Term loans are usually repayable during the life of the loan Interest rate may be either fixed or floating rate

Syndicated loan Loans made by a group (or syndicate) of banks and other

institutional investors Each bank has a separate loan agreement with the borrower A syndicated loan may be publicly traded

15.22 Types of Long-term Debt (cont.)

Private placements Similar to term loans with longer maturity Easier to renegotiate than public issues Lower costs than public issues (since it does not require a full

prospectus)