LECTURE 1: RAISING CAPITAL- EQUITY 1. FINANCING POLICY Sources of funds: 1. Internal funds i.e. Retained earnings, cash 2. External funds Debt i.e. Borrowing Equity i.e. Issuing new shares Hybrids Pecking Order financing scheme: Most public firms tend to finance their projects first with retained earnings, then with debt, and only finally with equity (as a last resort) This is due to information asymmetry. Suppose that managers have more information about the firm than outside investors. Managers prefer to issue equity when equity is overvalued. Equity issues signal to investors that equity is overvalued. Stock prices decline at equity issue announcement. Therefore, managers avoid issuing equity. 2. RAISING EQUITY CAPITAL Different options to raise equity: Unlisted firms (private company) Private equity financing (Issue private shares to certain investors) Initial Public Offering (IPO) Angel finance Venture Capital Listing shares for the first time. Private company will become public. An exit strategy for existing shareholders of private company. Listed firms (public company) Private placement Rights issue Dividend reinvestment plan To small group of investors To existing shareholders To existing shareholders Offered to reinvest dividend to apply for new shares 1
Angel finance: Informal market for direct equity finance provided by a small number of high net worth individuals Private equity Public equity Venture Capital: Venture capitalist is an active financial intermediary, providing financing to early stage (typically after the seed funding round) and high potential start-up companies mainly in high tech industries. It organizes and manages funds mostly raised from limited partners (such as pension funds and endowments/foundations) and do all of the work as general partners Funds are typically set up to last about 5 to 7 years Typically staggered financing; significant control over company decisions Initial Public Offerings (IPO): the process by which a firm sells equity to the public for the first time Primary offering: company issues new shares to general public Secondary offering: Existing shareholders sell their existing shares to the general public Seasoned Equity Offerings (SEOs): The sale of shares in an already publicly traded company. [Issuing more shares] Alternative types of SEOS include general offers, placements, rights issues and dividend reinvestment plans 3. INITIAL PUBLIC OFFERINGS Advantages of going public Access to additional capital Allow venture capitalist to cash out [they can sell shares through IPO] Current stockholders can diversify Liquidity is increased [shares can be rapidly sold with little impact on stock price] Establishes firm value [to see how the firm is performing] Makes it more feasible to use stock as employee incentives Increases customer recognition [enhance reputation] Create public shares for use in future acquisitions [Companies acquire many businesses to grow. When they do that, they need to pay target shareholders to buy their shares of the target company. Using cash is risky as it cannot be withdrawn, but if the acquiring firm gives out shares to target shareholders, then the target shareholders can hold the share of the combined company. It is a more convenient way to pay target shareholders to make the acquisition deal. If the acquisition firm is private, they cannot pay target shareholders shares because shareholders cannot easily sell the shares ] Minimizes cost of capital Disadvantages of going public IPO creates substantial fees [Legal, accounting, investment banking fees are often 10% of funds raised in the offering] Greater degree of disclosure of scrutiny Dilution of control of existing owners Special deals to insiders will be more difficult to undertake Managing investor relations is time-consuming [Corporate managers need to satisfy shareholders] Procedure for an IPO: 1. Appointment of an underwriter & other advisers 2. Undertakes the due diligence process and prepare the preliminary prospectus 2
3. Institutional marketing program commences 4. Exposure period: lodge the final prospectus with the ASIC and lodge listing application with ASX 5. Marketing and offer period 6. Offer closes, shares allocated, trading commences Underwriters: Investment banks that act as intermediaries between a company selling securities and the investing public. Mandatory for IPOs but not SEOs They manage the issue of securities on behalf of the issuing firm, performing a range of services including: o formulating the method used to issue the securities and marketing the issue o pricing the new securities o selling the new securities Two contracts they can make with the issuing firm: o Firm commitment contract: Underwriter promises the issuing firm to buy all leftover unsold shares after they sell the shares to investors (Underwriters bear under-subscription risk). This is so that the issuing firm can raise all the money it planned to raise. o Best effort contract: Underwriter makes the best effort to sell shares, if the minimum amount of shares is not sold through the IPO, then the IPO is withdrawn and the issuing firm will not go public. Sometimes, different underwriters form an underwriting group (syndicate) to help the issuing firm together to minimize under-subscription risk Valuing IPOs- Preliminary Valuation: No established price because firm is going public for the first time Two common valuation method: DCF analysis and comparable firms analysis On the basis of all relevant factors, the underwriter/investment banker would specify a range in the preliminary prospectus Procedure: 1. Fixed pricing- traditional method (common in Australia) Price is set by company, prospectus sent out and offers are received. Once price is set, it cannot be changed. There is a large time gap between the setting of the price (step 1) and the closing of offers (step 6). During this period, the company will be subject to market movement, hence high risk of undersubscription because if price set is high but market goes down, people won t buy. 2. Book-building (common in US) Underwriters ask institutional investors to indicate quantities they would purchase at what price, and records this in a book. They continue to do so before the listing date. They determine the price the evening before trading starts so there is a smaller time gap between the setting of the price (step 1) and the closing of offers (step 6) hence, lower under-subscription risk (reducing price uncertainty), but there are significant costs and possible investment banking (underwriter) conflicts. 3. Open auction (a Dutch auction) Investors are invited to submit their bids, and the securities are then sold to successful bidders. Costs of IPOs: Direct costs Underwriters receive payment in the form of a spread (the difference between the underwriters buying price and the Indirect costs Underpricing: Issuing securities at an offering price et below the actual 3
offering price). i.e. Underwriters paid by being able to purchase IPO shares at a price lower than the IPO offering price. Usually the underwriting spread on a new issue amounts to 7% of the proceeds to the issuer. Direct administrative costs to management, lawyers and accountants as well as fees for registering the new securities, etc. Can be over 1% of the proceeds to the issuer market value of the security (captured by first day closing price) First day closing price offer price Underpricing (%) = Offer price e.g. LinkedIn s IPO offer price =$ 45, but its first day closing = $94.25, which is about 110% first day return The economic consequence of underpricing is significant for the original owners of the firm: Money left on the table= (first-day closing price offer price) x No. of shares If the company had been able to predict the market price, they would have been able to raise a different amount of capital Explanations of Underpricing: 1. Winner s curse (information asymmetry) Investors have different information about the fair value of the shares. While uninformed investors subscribe to every IPO, informed investors only buy underpriced shares. There will be a higher amount of excess demand when there is more underpricing. Investors will be allocated only a fraction of the most desirable new issues whilst they will be allocated most of the least desirable new issues. Hence, uninformed investors will face a winner s curse because if they get all of the shares which they ask for, it is because the informed investors don t want the shares. Therefore, share must be offered at a discount to hold uninformed investors in the market because none of the investors group have enough money to absorb the initial public offering. 2. Investment Banking (Underwriter) Conflicts Investment banks (underwriter) arrange for underpricing as a way to benefit themselves and their other clients 3. Litigation insurance Liability on the issuer and underwriter for material misstatements and omissions made in connection with the IPO. So they intend to underprice the IPO to avoid potential lawsuits if shares subsequently do poorly. 4. Signaling Leaving a good-taste with investors provide a mechanism to signal the quality of the issue. This makes it easier to subsequently raise funds at higher prices in 2 nd round offers. Reasons for long-run underperformance: Clientele effects: only optimistic investors buy into an IPO, but their optimism will disappear as more information about the firm is released Window of opportunity: management times the issue (taking advantage of high demand for IPOs by the markethot markets). A decline in demand for IPOs (cold market) after hot markets are generally correlated with a reduction in equity prices after IPOs 4. SEASONED EQUITY OFFERINGS Types of SEOs: 1. General offers is offered to the public (Not discussed) 4
2. Rights issue or dividend reinvestment plan is offered to existing shareholders 3. Private placement is offered to financial institutions Determinants of Choice of Methods: Costs Time to implement Transfer of votes/wealth i.e. dilution (from old to new shareholders) Private placements: An issue of new shares to a limited number of investors (usually financial institutions) After the new issue, the share price drops from $10 to $9.909 Advantages of private placements Quicker to complete ( few weeks) Lower issue costs ( no need for underwriting normally) Do not generally require a prospectus Disadvantages of private placements Shares issued at a discount transfer of wealth from existing shareholders to new investors Dilute control (votes) of existing shareholders Rights issues: A new share issue offered to existing shareholders at a fixed subscription price Shareholders receive an entitlement to new shares at a fixed proportion of the number of shares already held (on a pro-rata basis) Shareholders can: 1) Exercise the rights 2) Let the rights expire 3) Sell the rights (on the ASX) if the issue is renounceable Subscription price is usually at 10-30% discount to the share price at the time the issue is announced. Usually takes 2-3 months to complete Notations: Subscription price (S) Pro-rata entitlement (1:N) M is the market price of the share cum-rights X is the theoretical price of the share ex-rights R is the value of the right Trading cum rights and ex rights 5
Example: A company already has 10 million shares outstanding with a current market price of $3.50 per share. The company wishes to raise $5 million for a new investment. The company makes a 1-for-5 rights issue with a subscription price of $2.50 per share. What is the theoretical ex-rights price X? (What should the value of the price be once it begins trading ex-rights?) By owning N shares at the price of M just before the ex-rights date, we can buy another share at price S On the ex-rights date, we will now have N+1 shares and the weighted average share price is then X = N N + 1 M + 1 N + 1 S = 5 6 3.50 + 1 2.50 = $3.33 6 What is the value of a single right R? (How much would the market pay for the right to purchase one additional share at the subscription price?) Value of the right (R)= Theoretical price per share after issue subscription price = $3.33-$2.50=$0.83 Or N(M S) R = N + 1 5(3.50 2.50) = = $0.83 6 Suppose an investor had 5 shares in the company prior to the rights issue, assuming that she exercise her right to subscribe for the new shares: Before After 5 @ $3.50=$17.50 6@3.33=$20 Cash=$2.50 Total wealth= $20 Total wealth=$20 Ownership= 5/10M Ownership=6/12M 6