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

Raising Capital

Chapter

Fifteen

15.2 Key Concepts and Skills

Understand the venture capital market and its role in financing new businesses

Understand how securities are sold to the public and the role of investment bankers

Understand initial public offerings and the costs of going public

15.3 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

15.4 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 VC will benefit from the capital raised in the IPO

Many VC 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 VC division

15.5 Choosing a Venture Capitalist

Look for financial strength Choose a VC that has a management style that

is compatible with your own Obtain and check references What contacts does the VC have? What is the exit strategy?

15.6 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 jurisdiction

All securities traded on the TSX Venture Exchange come under the jurisdiction of the Alberta Securities Commission

15.7 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, and that investors have timely, accurate information on which to base investment decisions. It also ensures that those who sell securities in Alberta are registered and that they conduct themselves according to applicable laws and professional standards.

In addition to regulating Alberta’s capital market, the ASC oversees the activities of the TSX Venture Exchange (formerly the Canadian Venture Exchange or CDNX) and the Investment Dealers Association of Canada (IDA).

Source: http://www.albertasecurities.com

15.8 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

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 Price stabilization by lead underwriter

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 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 Provides some protection for the lead underwriter as

they perform their price stabilization function

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”

15.14 Table 15.3 – What Determines Subscription Prices?

15.15 Table 15.4 – Initial Aftermarket Performance

15.16 Figure 15.1 – Average Initial Returns for SEC-Registered IPO’s: 1960 to 1998

15.17 New Equity Issues and Price

Stock prices tend to decline when new equity is issued

Possible explanations for this phenomenon Managerial information and signaling Debt usage and signaling Issue costs

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

15.18 The Cost of Issuing Securities 15.7

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

additional shares that the syndicate can purchase after the issue has gone to market

15.19 Rights Offerings: Basic Concepts 15.8

More correct name is the Pre-emptive Right A Rights Offer 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

15.20 The Value of a Right

The price specified in a rights offering is generally less than the current market price

The share price will adjust based on the number of new shares issued

The value of the right is the difference between the old share price and the “new” share price

15.21 Rights Offering Example

Suppose a company wants to raise $10 million. The subscription price is $20 and the current stock price is $25. The firm currently has 5,000,000 shares outstanding. How many shares have to be issued? How many rights will it take to purchase one share? What is the value of a right?

15.22 Rights Offering Example continued

000,50020

000,000,10

Priceon Subscripti

raised be toFundsissued be toshares new ofNumber

10

000,500

000,000,5Issued be toShares New of #

gOutstandin Shares Old of #share new one purchase torights ofNumber

45.0$110

20251

Mright a of Value 0

N

SWhere: M0 = Value of the Common, rights-on

S = Subscription price

N = Number of rights for one new share

15.23 More on Rights Offerings

Ex-rights – the price of the stock will drop by the value of the right on the day that the stock no longer carries the “right”

Standby underwriting – underwriter agrees to buy any shares that are not purchased through the rights offering

Stockholders can either exercise their rights or sell them – they are not hurt by the rights offering either way

Rights offerings have lower issue costs than other methods of selling new equity

Until the early 1980’s, rights offerings were the most popular method of raising new equity in Canada

Bought deals have replaced rights offers as the prevalent form of equity issue

15.24 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%.

15.25 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 when the market-to-book ratio is less than one

15.26 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 amortized over 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

15.27 Quick Quiz

What is venture capital and what types of firms receive it?

What are some of the important services provided by underwriters?

What is IPO underpricing and why might it persist? What are some of the costs associated with issuing

securities? What is a rights offering and how do you value a right? What are some of the characteristics of private placement

debt?

15.28 Summary 15.11

Venture capital is first-stage financing Costs of issuing securities can be quite large. Bought deals are far more prevalent for large issues than

regular underwriting Direct and indirect costs of going public can be substantial In Canada, the bought deal is cheaper and dominates the new

issue market

15.29 Some Useful Links to More Information

The links section on the Alberta Securities Commission site provides access to lots of great resources. To access the Alberta Securities Commission, go to www.albertasecurities.com. From there, you can find links to each of the following.

Provincial Securities Regulators:Canadian Securities Administrators (CSA)  National Cease Trade Order Database

Alberta Securities Commission (ASC)British Columbia Securities Commission (BCSC)Autorité Des Marchés Financiers (AMF)Manitoba Securities CommissionNew Brunswick Securities CommissionSecurities Commission of Newfoundland and LabradorNova Scotia Securities CommissionOntario Securities Commission (OSC)Saskatchewan Financial Services CommissionSecurities Office, Prince Edward Island

15.30

Access to informationSEDI (System for Electronic Disclosure by Insiders)SEDAR (System for Electronic Document Analysis and Retrieval)

Other Industry Regulators:Investment Dealers Association of CanadaMutual Fund Dealers Association of CanadaMarket Regulation Services Inc. (RS Inc.)Institute of Chartered Accountants of Alberta (ICAA)Joint Forum of Financial Market Regulators

Other Law Enforcement Agencies & Gov't:Government of AlbertaRoyal Canadian Mounted PoliceCalgary Police ServiceEdmonton Police ServiceReport Economic Crime Online (RECOL)

15.31

Canadian Stock Exchanges:TSX ExchangeTSX Venture ExchangeMontreal Exchange

Industry Resources:Alberta Capital Market Foundation (ACMF) Canadian Investor Protection Fund (CIPF) Canadian Securities Institute (CSI) Investment Funds Institute of Canada (IFIC) Investor Learning Centre of Canada (ILC) Omudsman for Banking Services and InvestmentsFinancial Services OmbudsnetworkFinancial Consumer Agency of Canada

International Securities & Regulatory Organizations:Securities & Exchange Commission (SEC)International Organization of Securities Commissions (IOSCO)  North American Securities Administrators Association (NASAA)