Topics Covered Chapter 15 Raising Capital Konan Chan Financial Management, Fall 2018 Venture capital Equity offering procedure Alternative issue methods Underwriters IPO underpricing Costs of issuing securities Rights Shelf registration Financial Management Konan Chan 2 Venture Capital Private financing for new, high risk businesses in exchange for stock Usually involves active participation by VC Ultimate goal: take company public; the VC will benefit from the capital raised in the IPO Hard to find Expensive (cash flow and control) Some Famous VC Deals VC Firms / Funds Portfolio Firm Investment Exit Sequoia Capital Cisco Systems $2.5M for 30% in 1987 Kleiner Perkins Caufield & Byers VIII Kleiner Perkins Caufield & Byers IX A Sequoia Capital VIII IPO (1990) stake at $68M 27x Amazon.com $8M in 1996 Worth $60M in 1997 IPO, far more later (up to 55x) Google $12.5M each in 1999 (became 21M shares for KPCB and 24M for Sequoia) IPO (2004), around $4B each, 320x multiple Accel Partners IX Facebook $12.7M for 15% in 2005 15% of $50B =$7.5B, 590x multiple Financial Management Konan Chan 3 Financial Management Konan Chan 4
Most Active U.S. VCs, 2015 Financial Management Konan 5 Chan 5 Financial Management Konan Chan 6 Venture Capital Stage Financing Funding provided in several stages Contingent upon specified goals at each stage First stage Ground floor or Seed money Fund prototype and manufacturing plan Second Stage Mezzanine financing Begin manufacturing, marketing & distribution 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? Financial Management Konan Chan 7 Financial Management Konan Chan 8
Equity Offerings Initial public offerings (IPOs) First offering of stock to the general public Seasoned equity offerings (SEOs) New issue for firms that are already listed Also called follow-on offerings Equity Offering Schedule Approval from the board of directors File a registration statement with the SEC SEC examines the registration in a 20-day waiting period, during which equities cannot be sold A preliminary prospectus, called a red herring, is distributed during the waiting period If any problems, the firm amends the registration and the waiting period starts over The price is determined on the effective date of the registration Financial Management Konan Chan 9 Financial Management Konan Chan 10 Alternative Issue Methods Cash offer Securities are sold to general public Rights offer Securities are first sold to existing shareholders IPOs are cash offers Crowdfunding On April 5, 2012, the JOBS Act was signed into law. A provision of this act allowed companies to raise money through crowdfunding, which is the practice of raising small amounts of capital from a large number of people, typically via the Internet. Crowdfunding was first used to underwrite the U.S. tour of British rock band Marillion in 1997. Financial Management Konan Chan 11 Financial Management Konan Chan 12
Underwriting Offerings Underwriter Buy securities from the firm and resells them to the public Lead underwriter, co-lead, and syndicate Spread: diff between offer price and price paid by underwriter Firm commitment, best efforts, dutch auction Promised payment to issuer No commitment Price is set by auction Negotiated vs. competitive bids issuer negotiates with investment bankers issuer structures the offering and secures bids Financial Management Konan Chan 13 Financial Management Konan Chan 14 Underwriter Ranking Green Shoes Option and Lockups Green Shoe provision Allows the syndicate to buy an additional 15% of issues from issuers Allows issues (both IPOs and SEOs) to be oversubscribed Underwriters may use these extra shares to stablize price Lockup agreements Insiders are not allowed to sell shares of an IPO for a specified time period The lockup period is commonly 180 days The stock price tends to drop when the lockup period expires due to market anticipation of larger supply Quiet period Financial Management Konan Chan 15 Expires on 40th calendar day after an IPO No comments or reports on the IPO prior to quiet period expiration Financial Management Konan Chan 16
When lockup expires IPO Underpricing Source: Laura Field and Gordon Hanka, 2001, The expiration of IPO share lockups Financial Management Konan Chan 17 Financial Management Konan Chan 18 IPO Underpricing IPO Underpricing Financial Management Konan Chan 19 Financial Management Konan Chan 20
IPO Wave IPO and Internet Bubble Source: Prof. Jay Ritter, University of Florida Financial Management Konan Chan 21 Financial Management Konan Chan 22 IPO and Firm Size Source: Prof. Jay Ritter, University of Florida Financial Management Konan Chan 23 IPO Underpricing Underpricing Offering price set below the true value of the security Positive initial returns Winner s curse If an issue is underpriced, everyone wants to get some shares, so you will get less shares For overpriced shares, since others investors do not want, you will get most shares You are more likely to be allocated overpriced shares Uninformed investors like you will suffer loss on average So, IPOs need to be underpriced to encourage participation of uninformed investors; but your average return maybe zero Financial Management Konan Chan 24
Reasons of IPO Underpricing Compensation for taking risks Information asymmetry / Signaling Winner s curse Leave a good taste Information acquisition Lawsuit avoidance Financial Management Konan Chan 25 New Equity Issues (SEOs) Stock prices tend to drop when SEOs are issued Possible explanations for this phenomenon Overpriced stock and signaling (insider information) Too much leverage 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 Financial Management Konan Chan 26 Issuance Costs Relative Issue Cost 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 Green Shoe option cost of additional shares that the syndicate can purchase after the issue has gone to market Financial Management Konan Chan 27 Financial Management Konan Chan 28
Rights Offerings: Basic Concepts Issue of common stock offered to existing shareholders Allows current shareholders to avoid the dilution that can occur with a new stock issue Rights are given to the shareholders Specify number of shares that can be purchased Specify purchase price Specify time frame Rights may be traded OTC or on an exchange 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 Financial Management Konan Chan 29 Financial Management Konan Chan 30 Rights Offering Example Example Stock price: $20 Number of shares outstanding: 1 million Plan to raise $5 million by rights offering Scenarios Subscription Number of Number of rights to price new shares buy a new share $20 250,000 4 10 500,000 2 5 1,000,000 1 Financial Management Konan Chan 31 How Rights Affect Prices? 1-for-2 at $10 1-for-1 at $5 Initial # of shares 2 2 Initial value 20*2=$40 $40 Post-offer # of shares 2+1=3 2+2=4 Post-offer value 40+10=$50 $50 Post-offer stock price 50/3=$16.67 50/4=$12.5 Before the rights offerings, the stock is actually a bundle, which includes both a stock and a right. Stock price = actual value of stock + right value Rights-on price: $20 (stock price before offerings) Ex-right price: (price after offerings) Financial Management Konan Chan 32
Rights on vs. Ex-rights How to Compute Rights Value? Value of a right 1-for-2 at $10 1-for-1 at $5 Old price - new price 20-16.67=$3.33 20-12.5=$7.5 (16.67-10)/2=$3.33 (12.5-5)/1=$7.5 (20-10)/3=$3.33 (20-5)/2=$7.5 Ex-right price: $16.7 (1-for-2), $12.5 (1-for-1) Financial Management Konan Chan 33 Financial Management Konan Chan 34 Dilution Dilution is a loss in value for existing shareholders Percentage ownership shares sold to the general public without a rights offering Market value firm accepts negative NPV projects Financial Management Konan Chan 35 Types of Long-term Debt Public bonds public issue of long-term debt Private issues Term loans Direct business loans from commercial banks, insurance companies, etc. Maturities 1 5 years Repayable during life of the loan Private placements Similar to term loans with longer maturity Easier to renegotiate than public issues Lower costs than public issues Financial Management Konan Chan 36
Shelf Registration Permits a corporation to register a large issue with the SEC and sell it in small portions Reduces the flotation costs of registration Allows the firm more flexibility to raise money quickly Requirements Company must be rated investment grade Cannot have defaulted on debt within last three years Market stock value must be greater than $150 million No violations of the Securities Act of 1934 in the last three years Financial Management Konan Chan 37 HSBC Rights Issue (1) HSBC raised 12.5 billion ($18.5 billion) through a rights issue, with current investors taking up 96.6% of new issues, the largest ever in the U.K. HSBC didn t seek government aid in financial crisis. Net profit decreased 70% in 2008, because of souring consumer loans in the US and write-downs on trading assets. Cut dividend and U.S. consumer-lending operation "This underlines our determination that HSBC should maintain its signature financial strength which has served us so well over HSBC's long history," Chairman said. Financial Management Konan Chan 38 HSBC Rights Issue (2) Investors subscribed to the rights issue at a 40% discount to the shares' closing price of 434.50 pence on April 3, where price dropped by 5.34%. The five-for-12 shares offer was underwritten by Goldman Sachs, JPMorgan, HSBC and three other co-bookrunners. Ethics Issues Brokers have been known to sell securities based on sales scripts that have little to do with the information provided in the prospectus. Also, investors often make investment decisions before receiving (or reading) the prospectus. Who is at greater fault in this case? Traditionally, IPO share allocations have been reserved for the underwriting syndicates best customers. What ethical implications exist. Financial Management Konan Chan 39 Financial Management Konan Chan 40