Raising equity capital

1

• Raising equity capital
• (see chapter 23 in Berk and Demarzo
• The Mechanics of Raising Equity
  Capital)

2
Equity Financing for Private Companies

• Sources of Funding (Institutional Investors)
• Angel Investors
• Venture Capital Firms
• Private Equity
• Corporate Investors

3
Venture Capital Funding in the United States
Panel (a) indicates the total number of venture
capital deals by year. Panel (b) shows the total
dollar amount of venture capital
investment. Source Venture Economics.
4
Angel investors

• An angel investor is an affluent individual who
  provides capital for a business start-up
• Angels provide capital (few hundred thousand to
  few millions) and expertize
• A small but increasing number of angel investors
  organize themselves into angel groups or angel
  networks to share research and pool their capital
• Angel investments bear extremely high risk, and
  thus require a very high return on investment,
  sometimes 10 or more their original investment
  within 5 years
• Defined exit strategy, such as plans for an
  initial public offerings or a sale

5
Venture capital

• Investment in start-ups with high growth
  opportunities
• Organized as investment partnerships, with VC as
  general partners and the investors as limited
  partners
• The bring capital (millions to ten of millions),
  technical and managerial expertise
• Actively involved in the management of the
  company
• First venture capital founded in 1946
• Exit strategy IPO or sale, usually after 3-7
  years
• For performance and more information see the
  National Venture Capital Association web site

6
Private equity

• Investment partnerships with a structure similar
  to venture capital
• Leveraged buyout refers to a strategy of making
  equity investments as part of a transaction in
  which a company, business unit or business assets
  is acquired from the current shareholders
  typically with the use of financial leverage. The
  companies involved in these transactions are
  typically more mature and generate operating cash
  flows.
• Growth capital refers to equity investments,
  most often minority investments, in more mature
  companies that are looking for capital to expand
  or restructure operations, enter new markets or
  finance a major acquisition without a change of
  control of the business.

7
Example 23.1 Funding and Ownership
8
Alternative Example 23.1

• Problem
• What is the post-money valuation?
• Assuming that this is the venture capitalists
  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?

9
Example 23.1 Funding and Ownership
10
Advantages and Disadvantages of Going Public

• IPO (Initial Public Offering) the process of
  selling stock to the public for the first time
• Advantages
• - Greater liquidity
• Private equity investors get the ability to
  diversify.
• Better access to capital
• Public companies typically have access to much
  larger amounts of capital through the public
  markets.
• Disadvantages
• The equity holders become more widely dispersed.
• This makes it difficult to monitor management.
• The firm must satisfy all of the requirements of
  public companies.
• SEC filings, Sarbanes-Oxley, etc.

11
Types of Offerings

• Primary and Secondary Offerings
• Primary Offering
• New shares available in a public offering that
  raise new capital
• Secondary Offering
• Shares sold by existing shareholders in an equity
  offering

12

• Best-Efforts basis
• For smaller IPOs, a situation in which the
  underwriter does not guarantee that the stock
  will be sold, but instead tries to sell the sock
  for the best possible price
• Often such deals have an all-or-none clause
  either all of the shares are sold on the IPO or
  the deal is called off

• Firm Commitment
• An agreement between an underwriter and an
  issuing firm in which the underwriter guarantees
  that it will sell all of the stock at the offer
  price

• Auction IPOs
• Rather than setting a price itself and then
  allocating shares to buyers, the underwriter in
  an auction IPO takes bids from investors and then
  sets the price that clears the market.

13

• Underwriters and the Syndicate
• Lead Underwriter The primary investment banking
  firm responsible for managing a security issuance
• Syndicate A group of underwriters who jointly
  underwrite and distribute a security issuance

• SEC Filings
• Registration Statement A legal document that
  provides financial and other information about a
  company to investors prior to a security
  issuance
• Preliminary Prospectus (Red Herring)Part of the
  registration statement prepared by a company
  prior to an IPO that is circulated to investors
  before the stock is offered

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The Cover Page of RealNetworks IPO Prospectus
15

• Valuation of the IPO
• There are two ways to value a company.
• Compute the present value of the estimated future
  cash flows.
• Estimate the value by examining comparables
  (recent IPOs).

16
Example 23.3
17
Example 23.3 (cont'd)
18

• Pricing the Deal and Managing Risk
• Spread
• The fee a company pays to its underwriters that
  is a percentage of the issue price of a share of
  stock
• For RealNetworks, the final offer price was
  12.50 per share and the company paid the
  underwriters a spread of 0.875 per share,
  exactly 7 of the issue price.
• Since this was a firm commitment deal, the
  underwriters bought the stock from RealNetworks
  for 11.625 per share and then resold it to their
  customers for 12.50 per share.
• 12.50 0.875 11.625

19
IPO Puzzle

• Underpricing
• Generally, underwriters set the issue price so
  that the average first-day return is positive.
• As mentioned previously, research has found that
  75 of first-day returns are positive.
• The average first day return in the United States
  is 18.3
• The underwriters benefit from the underpricing as
  it allows them to manage their risk.
• The pre-IPO shareholders bear the cost of
  underpricing. In effect, these owners are selling
  stock in their firm for less than they could get
  in the aftermarket.

20
International Comparison of First Day IPO Returns
21
Long-Run Underperformance

• Although shares of IPOs generally perform very
  well immediately following the public offering,
  it has been shown that newly listed firms
  subsequently appear to perform relatively poorly
  over the following three to five years after
  their IPOs.

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Learning Objectives

• Discuss what is and the role of Angel capital
• Discuss what is and the role of Venture capital
• Discuss what is and the role of Private Equity
• Discuss the best efforts, firm commitment and
  auction mechanisms to go public
• Define an initial public offering, and discuss
  their advantages and disadvantages.
• Discuss the IPO first day performance and longer
  term performance
• Terminology slides 11, 13, 18