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  1. 1. Sources of Capital Brealey and Myers Chapter 14, 15
  2. 2. Financial Growth Cycle
    • Opaque Assets
    • Insider Finance
    • Angel Finance
    • Venture Capital
    • Tangible Assets
    • Private Debt
      • Bank Debt
      • Private Placements
    • Public finance (traded bonds and traded equity) is available only to the largest firms.
  3. 3. Small Businesses
    • Generally must use insider finance while developing a product or business concept, and when most assets are intangible.
    • Angel finance possible when a formal business plan is in place.
    • Bank and finance company debt is generally not available until balance sheet has substantial tangible business assets.
  4. 4. Angel Finance
    • A very informal market for direct equity finance provided by high net worth individuals.
    • Typically provide $50,000 - $1,000,000.
    • Angels are very local, and sometimes operate as investment groups.Often connected by a lawyer or accountant.
  5. 5. Venture Capital Finance
    • A venture capitalist is a very active financial intermediary.
      • Most are limited partnerships
      • A few are subsidiaries of financial institutions.
    • Venture capitalists not only provide financing, but also participate in strategic planning and operational decisions.
  6. 6. How VCs Raise Funds
    • General Partners put up about 2% of the funds and do all of the work; limited partners put up the other 98%:
      • Public pension funds
      • Corporate pension funds
      • Endowments and foundations
    • Funds are typically set up to last about 10 years.Many proven VCs manage multiple funds simultaneously.Investors may not liquidate early and may not freely sell their LP shares.
  7. 7. How VCs Invest
    • VCs stage their investment.Sometimes as many as nine stages.
      • Seed (zero-stage) - prototype
      • Early stage - production
      • Later stage growth.
    • Key:only invest big money when odds are good; exit bad investments early.
    • Most VCs focus on particular industries and on particular stages.
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  8. 8. How VCs Make Money
    • VCs profit by liquidating successful investments through either:
      • Sale back to management, to a buyout firm or to a large corporation
      • Issuance of an IPO.The IPO serves to liquidate the VC investment AND raise new funds.
    • After repaying the initial investments, general partners keep 20% of the profits.
    • General partners also take a fee of 2.5% carried interest every year.
  9. 9. A note on VC returns
    • How would we find expected returns on VC investment, from a limited partners perspective?
      • CAPM?No.This is infeasible due to the limited information private equity returns.(i.e. what did private equity return on Mar 12, 1994?)
    • How would we find expected returns that VCs demand? (From a GPs perspective)
      • CAPM?No.Partners are not diversified, and so we cannot use the CAPM.
  10. 10. A note on VC returns
    • The end result is that we dont know how much private equity is expected to return going forward, and we dont know how much itshouldreturn.
      • Asset allocation problem for pensions, endowments, etc. is a serious problem.
  11. 11. The Typical VC Investment
    • VCs take preferred equity (like a debt-equity hybrid).The salient features of a VC contract are:
      • Converts to equity at the time of the IPO
      • The entrepreneur may be removed from control by the VC at any time.
      • VCs demand that the majority of the entrepreneurs wealth be invested in the entity; entrepreneurs typically get very small salaries.
  12. 12. Private Debt
    • Banks, and finance companies are the largest providers of private debt.
    • Brealey and Myers: typically serve firms whose debt needs are less than $100 million.
      • Truth:Small size is a sufficient condition for bank debt, not a necessary one!
    • Typically serve firms whose assets are tangible.Provide constant monitoring; lending often based on collateral.
  13. 13. Private Placements
    • Some firms with larger needs for debt ($100 - $150 million) use the private placement market.Typically, these loans are placed with insurance companies.
      • Collateral and restrictive covenants are not as important as in the bank loan market.
      • Must be a better-grade borrower due to insurers desire for AAA ratings on policies.
      • An intermediate step between bank loan market and public bond market?
  14. 14. Public Debt
    • May be senior or subordinated, may be fixed or floating, may be convertible or straight, may be puttable, etc.
  15. 15. Public Equity
    • Public equity is available to firms with larger needs for capital.
    • The first issue of public equity is called an IPO:
      • Primary offering
      • Secondary offering
    • Later issues are called seasoned equity offerings (SEOs)
  16. 16.
    • Market customs and regulations for IPOs differ around the world.
    • In the US:
      • Registration
      • Prospectus, with a price window
      • Road show, where informal orders are taken
      • Price setting.3-way bargain between issuer, investment bank and major purchasers.
      • Trading begins.Underwriter keeps 7% of proceeds.
  17. 17. Salient Features of IPO Aftermarket
    • Underpricing
    • Overallotment Option (The Greenshoe)
    • Price Support
    • IPO Lockups
      • Why its done
      • What happens at expiration
    • IPO Long-run Performance is poor
    • IPO Cycles
  18. 18. Why are IPOs underpriced?
    • Almost everywhere in the world, investors who buy at the open price make excess returns.But it is almost impossible to buy at the open price. One explanation is thewinners curse .
    • The average value of a Matisse painting is $X.
    • You have no private information about the value of a particular Matisse painting up for sale.
    • The sale is sealed-bid, first price.What do you bid?
  19. 19. Initial Public Offerings
    • Average Expenses on IPOs
  20. 21. Can we avoid underpricing?
    • By selling securities which are not equity-like?
      • Probably not.
    • By selling securities through an auction mechanism?
      • WR Hambrecht Open IPO
      • Treasury Auctions
      • Used with apparently good results in France, Chile, Israel, Japan.
  21. 22. Another Puzzle (for SEOs)
    • Rights Issue- Issue of securities offered only to current stockholders.
    • This would avoid underpricing as well.
    • Why not use it to avoid underpricing for small (e.g. private) firms?
    • For public firms?
  22. 23. Patterns of Corporate Financing