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- 1. Sources of Capital Brealey and Myers Chapter 14, 15
- 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. 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. 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. 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. 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. 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.
- http:// www.vistavc.com /
- 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. 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. 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. 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. 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. 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. Public Debt
- May be senior or subordinated, may be fixed or floating, may be convertible or straight, may be puttable, etc.
- 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)
- Market customs and regulations for IPOs differ around the world.
- In the US:
- 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. Salient Features of IPO Aftermarket
- Overallotment Option (The Greenshoe)
- Price Support
- IPO Lockups
- Why its done
- What happens at expiration
- IPO Long-run Performance is poor
- IPO Cycles
- 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. Initial Public Offerings
- Average Expenses on IPOs
- 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.
- 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?
- 23. Patterns of Corporate Financing
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