Lecture 5 How Corporations Raise Venture Capital and Issue Securities

15-15-11

Lecture 5How Corporations Raise Venture

Capital and Issue Securities

Young firms often require venture capital to finance growth.

The issuance of securities is a complex process that the successful financier must comprehend.

15-15-22

Company Growth

Venture Capital provides entrepreneurs with financing to grow their firms.

Firms issue securities to further finance their growth.

15-15-33

Obtaining Venture Capital Steps to obtaining venture funding:

1. Prepare a business plan.

• Business Plan – A description of a firm’s products, market, production methods, and resources needed for success.

• Staged Financing – Venture capital is rarely disbursed in one large lump sum payment, but instead is paid to the firm in stages. Each stage is usually just enough to guide the firm towards its next major checkpoint.

1. Receive first-stage financing.

2. Receive subsequent staged financing.

15-15-44

Venture Capital Ownership: Example

Suppose a Venture Capital firm offers to purchase 1 million of your firm’s shares for $1 each, which will give them 50% ownership in the firm. What value are they placing on your firm?

$1,000,000Value of the Firm = $2,000,000.50

15-15-55

Types of Venture Investors

Angel Investors• Investors who finance companies in their earliest stages of

growth

Corporate Venturers• Corporations that offer venture assistance to finance young,

promising companies.

Private Equity Investing• Investors who offer funds to finance firms that do not trade on

public stock exchanges such as the NYSE or NASDAQ.

15-15-66

Venture Capital Management

Venture Capitalist are not passive investors.

What do they provide beyond financing?

15-15-77

The Initial Public OfferingWhen a firm requires more capital than private investors can provide, it can choose to go public through an Initial Public

Offering, or IPO.

Primary Offering– when new shares are sold to raise additional cash for

the company Secondary Offering

– when the company’s founders and venture capitalists cash in on some of their gains by selling shares.

Does a secondary offering provide additional capital to the firm?

15-15-88

Benefits of Going Public Ability to raise new capital

Stock price provides performance measure

Information more widely available

15-15-99

Benefits of Going Public

Diversified sources of finance

Reduced borrowing costs

15-15-1010

Arranging Public IssuesSteps to issue a new public security:

1. SEC Registration

• Prospectus—a formal summary that provides information on an issue of securities

2. Select Underwriter / Undertake Roadshow

3. Set final issue price for public

•The roadshow attempts to gauge the interest that potential investors would have in purchasing the new securities.

•If enough public interest, the underwriters issue shares to the public. Typically underwriters underprice shares upon issue.

• Underpricing – Issuing securities at an offering price set below the true value of the security.

15-15-1111

IPO Flowchart

InvestorsFirmUnderwriter

1

2

4

3

51. Underwriter provides advice to firm2. Underwriter pays firm for a number of shares3. Firm provides shares to underwriter to be resold4. Underwriter offers shares to investors5. Investors purchase shares from underwriter

15-15-1212

Underwriter Spread

Assume the issuing company incurs $1 million in expenses to sell 3 million shares at $40 each to an underwriter; the underwriter sells

the shares at $43 each. What is the spread for this deal?

Spread - the difference between the public offer price and the price paid by underwriter

15-15-1313

Underwriting Arrangements

Firm Commitment:Underwriters buy the securities from the firm and then resell them to the public.

Best Efforts Commitment:Underwriters agree to sell as much of the issue as possible but do not guarantee the

sale of the entire issue.

15-15-1414

Underwriting Arrangements: Capital To Firm

How much will a firm receive in net funding from a firm commitment underwriting of 250,000 shares priced to the public at $40 if a 10%

underwriting spread has been added to the price paid by the underwriter? Additionally, the firm pays $600,000 in legal fees.

15-15-1515

Underpricing of an IPO

Example: Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day’s trading, the issuing company’s stock price had risen to $70. What is the total cost of underpricing?

Cost of Underpricing:

Underpricing: Issuing securities at an offering price set below the true value of the security.

15-15-1616

Flotation Costs

Flotation Costs: The costs incurred when a firm issues new securities to the public.

What are some of the specific costs incurred when a firm issues new securities?

15-15-1717

Types of OfferingsAfter the IPO, successful firms may issue additional equity or debt.

Seasoned Offering:– Sale of securities by a firm that is already publicly traded.

Rights IssueIssue of securities offered only to current stockholders.

General Cash OfferSale of securities open to all investors by an already-public company.

15-15-1818

Rights Issue: ExampleAn investor exercises his right to buy one additional share at $20 for every five shares held. How much should each share be worth after the rights issue if they previously sold for $50 each?

Pre-Rights Issue:

Post-Rights Issue:+

15-15-1919

General Cash Offer and Shelf Registration

Benefits of Shelf Registration:1. Security issuance without excessive costs2. Security issuance on very short notice3. Timed issuance to capitalize on favorable market

conditions4. Additional underwriter competition

Shelf Registration: A procedure that allows firms to file one registration statement for several issues of the same security.

15-15-2020

Private PlacementsIn order to avoid registering with the SEC, a

company can issue a security privately.

Private Placement: The sale of securities to a limited number of investors without a public offering

15-15-2121

Private Placements-Advantages

Do not have to register with SEC

Private placements cost less than public issues

Contracts can be customized for each investor

15-15-2222

Private Placements-Disadvantages

Difficult for investors to resell security

Lenders often require higher return to compensate for higher risk.

• Private placements typically yield .5% higher than public issues