AFC 3140 – Advanced Corporate Finance Equity Finance and Initial Public Offerings (Lecture Notes) How do firms raise capital for investment? Two principle methods are considered. The first is through raising venture capital. The second involves raising capital through an initial public offering (IPO’s). Some anomalies in IPO’s are considered from the perspective of the efficient market hypothesis. Although many anomalies can be explained, some questions remain unanswered.
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AFC 3140 – Advanced Corporate Finance
Equity Finance and Initial Public Offerings
(Lecture Notes)
How do firms
raise capital for
investment? Two
principle methods
are considered.
The first is
through raising venture capital. The
second involves raising capital through an
initial public offering (IPO’s). Some
anomalies in IPO’s are considered from the
perspective of the efficient market
hypothesis. Although many anomalies can
be explained, some questions remain
unanswered.
The Characteristics of Ordinary Shares
• Ordinary shares represent an ownership interest in
a business.
• The holder has a claim to the profits of the
business (through dividends). In the event of
failure, the holder has a claim to the residual value
of the assets after claims of all other entitled
parties are met.
• Due to this residual claim, shareholders are more
likely to lose their investment if the company fails
(shareholders are said to provide the company’s
risk capital).
• To compensate for this risk, shareholders expect a
return that is greater than that received by
lending.
The Characteristics of Ordinary Shares
• Limited liability:
– Protects shareholders' liability to meet a
company’s debts. The liability is limited to
the value of the shares (shares cannot have
a negative value).
• Rights of shareholders:
– Entitled to proportional share of any
dividend declared.
– Right to exert a degree of control over
management through use of voting rights
attached to ordinary shares — (typically
need at least 50% of shares to execute
rights).
– Shareholders have the right to sell their
shares.
Advantages and Disadvantages of Equity as a
Source of Finance
• Advantages
– Dividends are discretionary.
– No maturity date.
– The higher the proportion of capital
structure made up by equity, the lower the
cost of debt.
• Disadvantages
– Issuing more shares can dilute existing
shareholders’ ownership and control.
– Returns to shareholders can be subject to
double taxation (non-residents).
– Transaction costs of issuing shares.
Private Equity
• What is private equity?
– Securities issued to investors that are not
publicly traded. This includes family
members and friends, but a more formal
source is a private equity fund.
– Private equity or venture capital — not only
for new ventures.
• Four categories of private equity financing:
– Start-up: new companies, funds to develop
products.
– Expansion: additional funds required to
manufacture and sell products
commercially.
– Turnaround: assist a company in financial
difficulty.
– Management Buy Out (MBO): where a
business is purchased by its management
team with the assistance of a private equity
partner or fund.
Sources of Finance for New Ventures
• Sources include bank loans, private equities and
IPO funds.
• Stages of a venture include:
– R&D phase.
– Start-up phase, equipment and personnel
assembled.
– Rapid growth, if product is successful.
– Slower growth, followed by maturity and
possible decline.
• Different sources of finance are appropriate at
different stages.
• Personal savings, personal loans and home
mortgages are the most likely sources at R&D
stage.
• Business angel may enter the R&D stage if
these other sources are exhausted.
Equity Financing for Private Companies
The initial capital that is required to start a business
is usually provided by the entrepreneur and their
immediate family. Often, a private company must
seek outside sources that can provide additional
capital for growth.
Angel Investors and Business Angels - Investors who
buy equity in small private firms. Finding angels is
typically difficult. The term 'business angel' was
used in the theatre when financial backers invested
in a theatrical production and contributed their
skills and contacts to enhance the success of the
show. The same term was used centuries ago by
traders searching the world for merchants. Business
Angels began investing in a wide range of
commercial ventures. They are often retired and
invest their business skills as well as their capital
into new and developing enterprises.
Sources of Funding
Venture Capital Firm
A limited partnership that specializes in raising
money to invest in the private equity of young firms.
For centuries, people have developed ways of pooling
their money to undertake risky ventures. The East
India Company was an early example, and the
fictional voyage of the Pequod in Moby Dick was
illustrative of the high-risk, high-return whaling
ventures of the nineteenth century. Venture capital
is simply a modern variation on a long-established
practice of pooling money to finance risky ventures.
Often the limited partner is a corporate entity such
as a superannuation fund. Both Google and
Starbucks were initially funded by venture capital
firms.
Sources of Funding
A Venture Capitalist is one of the general partners
who work for and run a venture capital firm.
Venture capital firms offer limited partners
advantages over investing directly in start-ups
themselves as angel investors.
Limited partners are more diversified, they spread
their investments amongst a number of risky
projects.
Frees management time to focus on the business,
not financing the business.
They also benefit from the expertise of the
general partners.
Often finance a project so that it can be sold as an
IPO some years down the track (at a considerable
profit – they hope!!).
Venture Capital Around the World
Based on the available data, Australia’s venture
capital intensity appears to be around the median
for OECD countries. At June 2006, the ABS
estimates around $11 billion had been committed to
venture capital and later stage private equity funds.
Venture Capital
The mix of venture capital activity that is conducted
domestically will be influenced by Australia’s
industry structure. Only around 20 per cent of
venture capital in Australia is in the high-technology
sectors of health and biotechnology,
communications, and information technology.
In contrast, almost 90 per cent of venture capital
activity in the US occurs in these sectors. Australia’s
lower venture capital intensity may be due to
relatively smaller high-technology sectors. Another
possible explanation for Australia’s level of venture
capital activity is that the scale and geographical
dispersion of economic activity in Australia place a
natural constraint on the development of a large
venture-capital-financed, high-technology sector.
(e.g. compared to California’s ‘Silicon Valley’)
Sources of Funding
The advantages funding from a venture capitalist
comes at a cost.
General partners usually charge substantial fees.
• Most firms charge 20% of any positive return they
make.
• They also generally charge an annual management
fee of about 2% of the fund’s committed capital.
(this may also amount to a large proportion of the
profit).
Sources of Funding
Institutional investors such as superannuation
funds, insurance companies, endowments, and
foundations are active investors in private
companies. Institutional investors may invest
directly in private firms or they may invest indirectly
by becoming limited partners in venture capital
firms.
Corporate Investor - A corporation that invests in
private companies. Also known as Corporate
Partner, Strategic Partner, and Strategic Investor.
Corporate investors might invest for corporate
strategic objectives, in addition to the financial
returns. Reasons may include obtaining rights to
new ideas or expanding into a related area of
business.
What are investors looking for?
• Looking for projects with high growth prospects.
• Private equity investments are relatively risky —
higher rates of return are typically required.
• To obtain private equity, require a well-
structured and convincing business plan.
• Private equity fund managers usually require a
seat on the board of the company.
• These managers specialise in new, fast-growing
companies. They can offer specialised expertise
to help the venture succeed.
Sources of Funding
Corporate Investor - A corporation that invests in
private companies. Also known as Corporate
Partner, Strategic Partner, and Strategic Investor.
While most other types of investors in private firms
are primarily interested in the financial returns of
their investments, corporate investors might invest
for corporate strategic objectives, in addition to the
financial returns. Reasons may include obtaining
rights to new ideas or expanding into a related area
of business.
Outside Investors
Preferred Stock
Preferred stock is issued by mature
companies and usually has a preferential
dividend and seniority in any liquidation
and sometimes special voting rights.
Preferred stock issued by young companies
has seniority in any liquidation but typically
does not pay regular cash dividends and
often contains a right to convert to common
stock.
Convertible Preferred Stock - Preferred stock that
gives the owner an option to convert it into common
stock on some future date.
Outside Investors
Definitions
Pre-Money Valuation
At the issuance of new equity, the value of
the firm’s prior shares outstanding at the
price in the funding round.
Post-Money Valuation
At the issue of new equity, the value of the
whole firm (old plus new shares) at the price
the new equity sold at.
Exit Strategy
It details how investors will eventually
realize the return from their investment.
Outside Investors
Example
Assume:
• You founded your own firm two years ago.
• You initially contributed $50,000 of your
money and in return received 1,000,000
shares of stock.
• Since then, you have sold an additional
750,000 shares to angel investors.
• You are now considering raising even more
capital from a venture capitalist.
• The venture capitalist will invest $2 million
and will receive 2,000,000 newly issued
shares.
Outside Investors
Questions
What is the post-money valuation?
Assuming that this is the venture capitalist’s
first investment in your company, what
percentage of the firm will he end up
owning?
What percentage will you own?
What is the value of your shares?
Outside Investors
Solution
Your shares 1,000,000 26.67%
Angel Investors’ Shares 750,000 20.00%
Venture capitalist’s shares 2,000,000 53.33%
Total shares outstanding 3,750,000 100.00%
The venture capitalist is paying $1 per share. Thus,
the post-money valuation is $3,750,000
You will own 26.67% of the firm and the post-money
valuation of your shares is $1,000,000.
Initial Public Offerings
A privately owned company may wish to list on the
stock exchange so that it can:
(a) raise extra capital through equity rather than
debt,
(b) create liquidity for the existing shareholders.
Thus a company may initiate an ‘Initial Public
Offering of Shares’ (IPO). Direct costs of ‘floating’ a
company include:
Stock exchange listing fees
Prospectus costs
Underwriting fees
Commissions
Initial Public Offerings
Indirect costs of floating include:
IPO’s are typically underpriced
IPO’s force management to share information
with shareholders and regulators and potentially
competitors
Management may be pressured from investors
and interest groups
There may be indirect benefits to existing
shareholders in the form of:
Listing may provide monitoring and information
to management
The listed company may enjoy greater credibility
with customers, employees and suppliers.
Offers of Unlisted Securities
On 1 Feb, 2010 the following firms were listed on the
Australian Stock Exchange (ASX) as an IPO.
Company Proposed ASX
code * Proposed listing date/time
Altus Renewables Limited AWR 09 February 10#
Australian Governance Masters Index
Fund Limited
AQF 10 February 10#
Careers MultiList Limited CGR 04 February 10#
CBio Limited CBZ To be advised
Doray Minerals Limited DRM To be advised
Hunnu Coal Limited HUN 12 February 10#
Kimberley Metals Limited KBL To be advised
Matrix Gold Limited MXD 12 March 10#
Mobilarm Limited MBO To be advised
NT Resources Limited NTR 01:00PM - Monday, February 1