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Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Key Concepts and Skills

Understand:• The venture capital market and its role in

financing new businesses

• How securities are sold to the public, and the role of investment bankers

• Initial public offerings, and the costs of going public

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Chapter Outline15.1 The Financing Life Cycle of a Firm: Early-

Stage Financing and Venture Capital15.2 Selling Securities to the Public: The Basic

Procedure15.3 Alternative Issue Methods15.4 Underwriters15.5 IPOs and Underpricing15.6 New Equity Sales and the Value of the

Firm15.7 The Cost of Issuing Securities15.8 Issuing Long-Term Debt15.9 Shelf Registration

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Venture Capital“Private Equity”

• Private financing for new, high risk businesses in exchange for stock– Individual investors– Venture capital firms

• Usually involves active participation by VC• Ultimate goal: take company public; the VC

will benefit from the capital raised in the IPO• Hard to find• Expensive

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Venture Capital Stage Financing

• Funding provided in several stages• Contingent upon specified goals at each

stage• First stage

– “Ground floor” or “Seed money”– Fund prototype and manufacturing plan

• Second Stage– “Mezzanine” financing– Begin manufacturing, marketing & distribution

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Choosing a Venture Capitalist

• Financial strength

• Compatible management style

• Obtain and check references

• Contacts

• Exit strategy

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Selling Securities to the Public

1. Management obtains permission from the Board of Directors

2. Firm files a registration statement with the SEC

3. SEC examines the registration during a 20-day waiting period

4. Securities may not be sold during the waiting period

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Selling Securities to the Public

5. A preliminary prospectus, called a red herring, is distributed during the waiting period - If problems, the company amends the

registration, and the waiting period starts over

6. Price per share determined on the effective date of the registration and the selling effort begins

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Issue Methods

• Public Issue– Registration with SEC required– General cash offer = offered to general public– Rights offer = offered only to current shareholders– IPO = Initial Public Offering = Unseasoned new issue– SEO = Seasoned Equity Offering

• Private Issue– Sold to fewer than 35 investors– SEC registration not required

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Methods of Issuing New SecuritiesTable 15.1

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Underwriters• Underwriting services:

– Formulate method to issue securities– Price the securities– Sell the securities– Price stabilization by lead underwriter in the

aftermarket• Syndicate = group of investment bankers 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

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TombstoneFigure 15.1

• Investment banks in syndicate divided into brackets

•Firms listed alphabetically within each bracket

•“Pecking order”

•Higher bracket = greater prestige

•Underwriting success built on reputation

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Firm Commitment Underwriting

• Issuer sells entire issue to underwriting syndicate

• Syndicate resells issue to the public

• Underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold

• Syndicate bears the risk of not being able to sell the entire issue for more than the cost

• Most common type of underwriting in the United States

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Best Efforts Underwriting

• Underwriter makes “best effort” to sell the securities at an agreed-upon offering price

• Issuing company bears the risk of the issue not being sold

• Offer may be pulled if not enough interest at the offer price

– Company does not get the capital and they have still incurred substantial flotation costs

• Not as common as it used to be

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Dutch or Uniform Price AuctionBuyers:

•Bid a price and number of sharesSeller:

•Work down the list of bidders•Determine the highest price at which they can sell the desired number of shares

•All successful bidders pay the same price per share.•Encourages aggressive bidding

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Dutch or Uniform Price Auction Example

The company wants to sell 1,500 shares of stock.

The firm will sell 1,500 shares at $15 per share.

Bidders A, B, C, and D will get shares.

Bidder Quantity BidA 500 $20B 400 18C 250 16D 350 15E 200 12

Bidder Quantity Bid Σ QtyA 500 $20 500B 400 18 900C 250 16 1,150D 350 15 1,500E 200 12 1,700

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Green Shoe Provision

• “Overallotment Option”

• Allows syndicate to purchase an additional 15% of the issue from the issuer

• Allows the issue to be oversubscribed

• Provides some protection for the lead underwriter as they perform their price stabilization function

• In all IPO and SEO offerings but not in ordinary debt offerings

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Lockup Agreements

• Not legally required but common

• Restricts insiders from selling IPO shares for a specified time period– Common lockup period = 180 days

• Stock price tends to drop when the lockup period expires due to market anticipation of additional shares hitting the Street

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IPO Underpricing

• IPO pricing = very difficult– No current market price available

• Dutch Auctions designed to eliminate first day IPO price “pop”

• Underpricing causes the issuer to “leave money on the table”

• Degree of underpricing varies over time

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IPO Underpricing Reasons

• Underwriters want offerings to sell out– Reputation for successful IPOs is critical– Underpricing = insurance for underwriters– Oversubscription & allotment – “Winner’s Curse”

• Smaller, riskier IPOs underprice to attract investors

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Example: Work the Web• How have recent IPOs performed?

• Click on the Web surfer to go to Hoovers.com’s “IPO Central”– Use the “IPO Calendar” to determine how

many companies went public during the last week

– Use “IPO Performance” to determine how companies that went public three months ago have performed. What about six months ago?

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Seasoned Equity Offerings

• Stock prices tend to decline when new equity is issued

• Signaling explanations:

– Equity overvalued: If management believes equity is overvalued, they would choose to issue stock shares

– Debt usage: Issuing stock may indicate firm has too much debt and can not issue more debt

• Issue costs

– Issue costs for equity – direct and indirect - are significantly more than for debt

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The Cost of Issuing Securities

INSERT TABLE FROM PAGE 486 (middle of the page)

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The Cost of Issuing Securities

• Total direct costs ≈ 10.4%– Direct costs very large, especially for issues

< $10 million (25.22%)

• Underpricing cost ≈ 19.3%• Average spread = 7%• Patterns:

– Substantial economies of scale– Costs of selling debt < issuing equity– IPO costs > SEO costs– Straight bonds < Convertible bonds

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Types of Long-term Debt• Bonds – public issue of long-term debt• Private issues

– Term loans• Direct business loans from commercial banks,

insurance companies, etc.

• Maturities 1 – 5 years

• Repayable during the life of the loan

– Private placements• Similar to term loans with longer maturity

– Easier to renegotiate than public issues– Lower costs than public issues

• No SEC registration Return to Quick Quiz

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Shelf Registration

• SEC Rule 415

• Permits firm to register a large issue with the SEC and sell it in small portions

• Reduces flotation costs

• Allows company more flexibility to raise money quickly

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Shelf Registration

• Requirements– Company must be rated investment

grade– Cannot have defaulted on debt within

last three years– Market value of stock must be greater

than $150 million– No violations of the Securities Act of

1934 in the preceding three years

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Quick Quiz

1. What is venture capital and what types of firms receive it? (Slide 15.4)

2. What are some of the important services provided by underwriters?

(Slide 15.11)

3. What type of underwriting is the most common in the United States and how does it work? (Slide 15.13)

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Quick Quiz

4. What is IPO underpricing and why might it persist? (Slide 15.19 and 15.20)

5. What are some of the costs associated with issuing securities? (Slide 15.23)

6. What are some of the characteristics of private placement debt? (Slide 15.25)

7. What is shelf registration? (Slide 15.26)

Chapter 15

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