Finance 7311

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Finance 7311

• Lecture 4
• Long-Term Financing

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Outline

• Equity issues - general
• Dilution
• Typical funding sources
• Initial Public Offerings
• Rights Offerings
• Long-Term Debt
• Long-Run performance of SEOs IPOs

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Why Issue Stock?

• ADVANTAGES
• Firm Not Committed to Fixed Payout
• Increases Collateral for B/H
• May Create Reserve of Borrowing Power
• May Move to Optimal Capital Structure

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Why Issue Stock? cont.

• DISADVANTAGES
• Give up Some Control
• Flotation Costs are Higher for Equity than Debt
  (3.5 - 13 v. 1 - 4 Direct Costs)
• Dividends not deductible
• DILUTION ??

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DILUTION

• Dilution of What?
• Ownership (Control)
• Earnings Per Share
• Value
• Control may be important we will focus on the
  latter two

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DILUTION EXAMPLE

• Suppose we have a firm with the following
• 5,000,000 earnings forever
• Re 10
• 1,000,000 shares currently O/S

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DILUTION EXAMPLE

• Thus, we know that
• Value 5,000,000 / .10 50,000,000
• Value per share 50mm/1mm 50
• EPS 5.00

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Dilution Example

• Assume a Firm wants to finance a new project
• Project cost 5,000,000
• Same risk as firm
• Generates 400,000 earnings, forever

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Dilution Example

• Assume the firm sells 100,000 shares _at_ 50 per
  share
• Raises 5,000,000
• Shares O/S 1,100,000
• Earnings 5,400,000

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Dilution Example

• Consider effect on EPS Value
• EPS 5,400,000 1,100,000 4.91 lt 5
• Value 5,400,000 10 54,000,000
• 54,000,000 1,100,000 49.09 / share
• Is there Dilution?
• YES!
• Why??

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Dilution Example

• Consider NPV of project
• Cost 5,000,000
• PV Inflows 400,000 10 4,000,000
• NPV (1,000,000)
• (1,000,000) 1,100,000 (0.91)/share
• 0.91 loss on all shares

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Dilution Example

• Source of 0.91 loss
• (1) Loss of 1.00 on project, per existing S/H
• (2) New S/H pay too much
• 1.00 x 100,000 100,000 1,100,000 0.09
  overpayment, for all shares
• (1.00) 0.09 (0.91)
• Will new S/H pay 50 for something shortly to be
  worth 49.00? No!

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DILUTION SUMMARY

• NO DILUTION UNLESS
• NEGATIVE NPV PROJECT
• NEW S/H UNDERPAY
• COMBINATION OF BOTH

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Financing Development

• One Classification Scheme
• Seed
• Startup
• Growth
• Late Growth
• Harvest

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Sources of Seed Capital

• Entrepreneur
• Friends and family
• Angels
• Strategic partners

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Sources of Startup Capital

• Venture investment clubs
• Economic development agencies
• Asset-based lenders
• SBA loans

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Sources of Growth Capital

• Commercial lenders
• Suppliers Customers
• Private placements
• Venture capitalists
• Small business investment companies

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Sources of Late Growth Capital

• Investment bankers
• Private equity funds
• Institutional investors
• Venture Capital funds

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Sources of Harvest Capital

• Initial public offerings
• Mergers and acquisitions
• Public debt

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Capital Source by Stage
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Venture Capital

• Value added financing
• VC financed firms more professional
• Human resource policies
• Marketing VP
• Quicker to replace founder with outside CEO
• Reputation of VC important
• Contacts
• Exit Strategy
• Going public
• Merger/Acquisition

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Actual Returns to Investors

• IRR () Angels () VC ()
• Negative 39.8 64.2
• 0-24 23.8 7.1
• 25-49 12.7 7.1
• 50-99 13.3 9.5
• 100 10.2 12.0

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Target Multipliers

• The targeted rates of return on individuals deals
  have to be higher so that the portfolio can net
  acceptable returns. As a general rule investors
  target the following annual IRRs
• Years to Exit Development Stage Rate of
  Return Multiplier
• 6 Seed 66 21X
• 5 Start-up 60 10.5X
• 4 First Stage 53 5.5X
• 3 Second Stage 47 3.2X
• 2 Mezzanine 41 2.0X
• 1 Mezzanine Pre-exit 35 1.35X

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Initial Public Offerings (IPOs)

• Previously Private Company sells shares in public
  market for first time
• Why Go Public?
• Stockholder diversification - allows original
  owners to diversify
• Establishes a value for shares - shares more
  liquid easier to raise capital

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IPOs, cont.

• Disadvantages
• Control - give up some control to outsiders
• Disclosure requirements
• Accounting / Reporting to SEC, S/Hs
• Disclose valuable company information, such as
  profitability

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How Does a Firm Go Public?

• Determine how much to raise?
• Business plan pro-formas
• Line up investment banker
• Negotiated v. competitive bid
• Reputation Expertise and pricing
• Best efforts v. firm commitment
• File Registration statement w/ SEC

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IPOs, cont.

• Determine OFFERING PRICE
• Usually done night before
• IB issues RED HERRING
• Overallotment agreement (Green Shoe)
• Costs
• Commissions (5.2 to 9.0)
• Acct. legal expenses (.51 - 7.9)
• Underpricing (18.3) 1960-2003

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Underpricing

• Closing Price - Offering Price
• Dilution of existing shares
• Ex Akamai Technologies
• Offering Price 26
• Closed at 145
• Left over 1 billion on the table
• Underpricing has been significant on avg.

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IPO Underpricing

• Ljungqvist Wilhelm 2002 ? report average
  underpricing of 36 for nearly 2,200 firms that
  went public from 1996 2000
• Loughran Ritter ? market value/sales mulitple
  of 1.82 for 1986 1995 v. 7.53 for 1996 - 2000

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Reasons for Underpricing

• Short-run phenomenon
• Risk - not all are underpriced
• ADVERSE SELECTION
• Informed v. Uninformed investors
• Uninformed
• Receive bad shares
• Do not receive good shares
• Must expect to be rewarded, on avg.

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IB Aftermarket Support

• IB will typically oversell the issue
• Interestingly, hot issues are less oversold
• IB effectively takes a short position in amount
  of shares gt shares in offering
• 15 over-allotment option (green shoe)
• If mkt price lt offering price, acquire shares in
  market
• If mkt price gt offering price, exercise OA

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IPOs and Windows of Opportunity

• Recall from capital structure lectures that
  Windows of opportunity theory says management
  attempts to time issues
• Empirical studies of IPOs indicate that
  management does not

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Rights Offering

• Gives Existing S/H the Right to Buy X number of
  new shares for each Y shares currently owned
• Example
• Right to buy 1 additional share for each 5 shares
  currently owned
• Ex-rights rights on value of right

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Rights Offering Issues

• Price per share of new stock?
• How many shares have to be sold?
• How many shares will each s/h be allowed to buy?
• Effect of offering on per-share value of existing
  stock?

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Number of Rights

• Funds to be raised/Subscription Price Number of
  New Shares
• Ex 5,000,000 to be raised 10 Sub P
• gt 500,000 new shares
• Rights Old Shares/New Shares
• Ex 1,000,000 Old shares gt 2 rights
• Sub Price 20 gt How many Rights?

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Value of a Right

• Suppose Initially
• Current Price 20
• Hold 2 shares Value of Holding 40
• Offer 2 rights 10 buy another share
• After Offer
• Number of shares 3
• Value of holding 40 10 50
• Share price 50/3 16.67
• Value of right 20 - 16.67 3.33

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Rights Offerings, issues

• Setting the Rights Price
• IF ALL exercise, price does not matter
• S/H incentives
• Price too high
• Standby arrangement - IB, for a fee, agrees to
  buy up unused rights

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Long-Term Debt

• Mortgage Bond - secured
• Debenture - unsecured
• Junk Bonds - below investment grade
• Convertible - convertible into equity
• Callable - may be redeemed early by company
• Puttable - may be sold back to company

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Long-Term Debt, cont.

• Bond Covenants - legal restrictions on management
  behavior
• Positive - things the company must do
• Maintain certain ratios
• Maintain insurance
• Negative - things the company may not do
• restriction on dividends
• restriction on investment

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Long-Term Debt, other

• Agency Problems
• Debt may help solve
• Debt instills discipline
• Takes cash out of management hands
• Incentive to invest in risky projects
• Terms
• Rate Maturity other provisions

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Long-Run Performance

• Seasoned Equity Offerings
• High returns in year before issuing
• Five year Average Returns
• -3 to -5 relative to non-issuing firms
  controlling for size/type
• Reason
• 1) Perhaps firm less risky lower leverage
• 2) Managers investors are systematically too
  optimistic about the prospects of issuing firms

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Long-run Performance

• Initial Public Offerings
• Excluding first day return
• Size Matched
• Underperform 3 per year next five years
• Style matched
• No evidence of underperformance