Chapter 15 - Raising Capital PDF

Preview

Summary

Chapter 15 - Raising Capital 575 - 609The Financing Life Cycle of a Firm: Early-Stage Financing and Venture CapitalVenture Capital ● Financing for new, often high-risk ventures ● Angels are usually individual investors and tend to specialize in smaller deals ● Private equity is often used to label t...

Description

Chapter 15 - Raising Capital 575 - 609 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital Venture Capital ● Financing for new, often high-risk ventures ● Angels are usually individual investors and tend to specialize in smaller deals ● Private equity is often used to label the rapidly growing area of equity financing for nonpublic companies ● Financing is usually provided in stages from venture capitalists ○ At each stage, enough money is invested to reach the next milestone or planning stage ■ Ex. building a prototype or a manufacturing plan ○ Some specialize in different stages, such as very early “seed money” or ground floor financing ○ Financing in the later stages might come from venture capitalists specializing in mezzanine level financing, referring to the level above the ground floor ○ Also help run the firm at times, providing experience and expertise Some Venture Capital Realities ● Access to venture capital is limited, as the proposals vastly outnumber the supply ● Personal contacts are essential ● Also very expensive, they will take near 40% equity in the company ● Usually they will get on the BOD and also hold preferred stock and other powers Choosing a Venture Capitalist ● 1) Financial strength is important: the venture capitalist needs to have resources and financial reserves for additional financing stages. Does not mean that bigger is better because of the next point… ● 2) style is important. Some wish to be involved very much and some not as much, depending on the firm to see what is better. A large firm may be less flexible and bureaucratic than a smaller one ● 3) References are important. Have they been successful? How have they dealt with situations that haven’t worked out ● 4) Contacts are important. Good if they can provide contacts to help with financing, managing, and introductions to important figures along with specialization ● 5) Exit strategy is important. They’re not long-term, usually around 10 years. How will they cash out Conclusion ● If startups succeed, the payoff comes when they are sold or go public

The Public Issue ● Creation and sale of securities to be traded on public markets ● Rules and regulations for these are enforced by provincial securities commissions ○ Goal is to promote the efficient flow of info about securities to the markets ● All companies on TSX are under jurisdiction of OSC ○ Securities Act sets provincial regulations for all new securities issues, OSC administers act ● Canadian Securities Administration (CSA) coordinates across provinces ○ They try to streamline securities regulations ● OSC rules seek to ensure that investors receive all material info on new issues in the form of a registration statement and prospectus ● OSC also regulates the trading of securities to ensure adequate flow of information ○ One company had 4 executives guilty of fraudulently overstating the company’s assets and revenues to investors ● OSC also gathers and publishes insider reports filed by major shareholders and directors ● They also oversee training and supervision of investment dealers, it also works with Investment Industry Regulatory Organization of Canada (IIROC) to monitor the dealers’ positions The Basic Procedure for a New Issue ● Steps to issue securities to the public: ○ 1) Management must first get approval from the BOD (sometimes number of authorized shares much be increased which requires a vote of shareholders) ○ 2) Firm must distribute a copy of a preliminary prospectus to the OSC and potential investors. Contains some of the info, and is also called the red herring. OSC studies the preliminary prospectus and notifies the company if any changes are required ○ 3) Once revised, final prospectus meets with the OSC’s approval and a price is determine and selling starts ● Tombstone advertisements are placed during and after waiting periods ○ Contains the name of company whose securities are involved and has info about the issue, and it lists the dealers (underwriters) involved with selling it ● Dealers are divided into groups called brackets on the tombstone and prospectus ○ The higher the bracket the greater the underwriter’s prestige ○ Their prestige is more important for the first public equity issue (IPO) ○ IPOs with prestigious underwriters perform better ■ Likely because investors believe that prestigious underwriters shun questionable IPOs Securities Regulation ● OSC’s short-form prospectus distribution (SFPD) is designed to reduce repetitive filing requirements for large companies ○ Allows certain issuers prompt access to capital markets without long-form preliminary and final prospectus before a distribution

● ●

SFPD system is accessible to reporting issuers who have made public distributions and who are subject to continuous disclosure requirements Securities regulators introduced a multi-jurisdictional disclosure system (MJDS) where large issuers in the two countries are allowed to issue securities in both countries under disclosure documents satisfactory to regulators in the home country ○ Simplified filing requirements for large Canadian companies ○ Many candian companies are cross-listed on NYSE or NASDAQ ■ Cross-listing is the practice of listing a firm’s share for trading on other exchanges, usually in foreign countries ■ Advantages of listing in the US includes greater liquidity, lower trading costs, greater visibility, and greater investor protection under the Sarbanes-Oxley on corporate governance ● BUT, has higher accounting and compliance costs ● Undecided if US listing adds shareholder value

Exempt Securities and Crowdfunding ● When certain criteria is met, securities can be exempt from the prospectus requirements ○ Called exempt securities ○ Issuance and resale of these take place in an exempt market ○ These markets facilitate trades of securities like equity, debts, etc ○ Provides security issuers the benefit of cost=effective and efficient financing by selling securities directly to high net worth investors ■ Usually theft are more sophisticated and do not require the protection of a prospectus ○ Can face greater risk when investing in this market ○ This market provides more than $100 billion in gross capital flow per year ● Crowdfunding is the practice of raising small amounts of capital from a large group of people, usually on the internet ○ Maximum amount an issuer can raise using this exception is $1.5 million, with a maximum of $2500 from any one investor (or $25,000 from qualified investors) ○ Called the MI 45-108 for the Multilateral Instrument Crowdfunding Exemption to facilitate online capital raising activities by startups Alternative Issue Methods ● For equity sales there are two kinds of public issues: a general cash offer and a rights offer ○ With a cash offer, securities are offered to the public ○ With a rights offer, securities are initially offered only to existing owners ■ Rare in NA but common in other countries ○ Focus is on cash offers for this chapter ● First public equity issue is an IPO, or an unseasoned new issue ○ Occurs when a company decides to go public ○ All are cash offers

●

A seasoned equity offering (SEO) is a new issue for a company with securities that have previously been issued ○ Can be made with a cash offer or a rights offer

The Cash Offer ● Underwriters are involved and is the main business of investment banks, they perform the following for corporate issuers: ○ Formulating the method used to issue the securities ○ Pricing the new securities ○ Selling the new securities ● They buy it for less than the offering price and accepts risk of not being able to sell them ● Group of underwriters is called a syndicate or a banking group to share risk and help sell the issue ○ In this, one or more managers arrange the offering and are designated the lead manager ■ This manager has responsibility of packing and executing the deal, the other underwriters serve primarily to distribute hte issue ● Difference between the underwriter’s buying and offering price is called the spread or discount ● Firms often have long-lasting relationships with underwriters ● With growth in popularity of bought deal (an investment bank commits to buy the entire offering from the issuing company, competition among underwriters has increased Types of Underwriting - 2 kinds

●

●

Regular underwriting: the banking group of underwriters buys the securities from the issuing firm and resells them to the publ;ic for the purchase price plus an underwriting spread ○ Includes a market out clause that gives the banking group the option to decline the issue if the price drops dramatically, and in this case, the deal is usually withdrawn ○ Issue may be repriced or re offered at a later date ○ Firm commitment underwriting is like regular underwriting without the market out clause Best efforts Underwriting: underwriter is legally bound to use its best efforts to sell the securities at the agreed-on offering price, beyond this, the underwriter does not guarantee any particular amount of money to the issuer ○ More common with IPOs and with smaller companies

Bought Deal ● Issuer sells entire issue to one investment dealer or to a group attempting to resell it ● Investment dealer assumes all price risk ● Usually markets the issue to a few large institutional investors ● Issuers in bought deals are large, well-known firms qualifying for the use of SFPD to speed up the OSC filings ○ Deals are usually done swiftly ● Most popular form of underwriting ● Smaller offer price discounts and smaller underwriting fees, implying superior pricing and thus higher quality offerings Dutch Auction Underwriting ● Underwriter does not set a fixed price for the shares to be sold, but conducts an auction where investors bid for shares ● Offer price is determined based on the submitted bids ● Also known as uniform price auction ● Was used by Google ● Not widely used in IPOs but common for bonds ● Can also be used for repurchase of shares by a corporation Example: R Company wants to sell 400 share ot the public

● ● ● ●

A is willing to buy 100 shares at $16 each, etc A through D get the shares but E does not All winning bidders will pay $12 ○ Reason for the name uniform price auction At the $12 offer price, there are actually bids for 600 shares which exceeds the 400 shares they wish to sell ○ 400/600 = 0.67 and allocate bidders that percentage of their bids ○ Bidders A through D would each receive 67% of the share they bid for at a price of $12 per share

The Selling Period ● While issue is being sold, underwriting group agrees not to sell securities for less than offering price until the syndicate dissolves ● Principal underwriter is permitted to buy share if the market price falls below the offering price ● Purpose would be to support the market and stabilize the price from temporary downward pressure ● If issue remains unsold after a time, members can leave the group and sell their shares at whatever price the market allows The Over Allotment Option or green Shoe Provision ● Gives members of the underwriting group the option to purchase additional shares at the offering price less fees and commissions ○ Done to cover excess demand and oversubscriptions ● Has a short maturity and is limited to 15% of the original number of shares issued ● Benefit to the underwriting syndicate and cost to the issuer ○ If market price of a new issue rises immediately, the over allotment options allows the underwriters to buy additional shares form the issuer and immediately resell them to the public for a profit Example: Facebook went public and sold around 420 million shares at $38 per share ● Underwriters could use provision and raise another $18.4 billion

●

They sold 15% more shares than their initial allocation and left them short of around 63 million shares ○ If there would have been an increase in price, they would have used the provision and went to facebook and bought the shares at $38 to cover their short position ○ Share price fell and they did not use the green shoe option, but they had to cover their short position so they bought the 63 million shares in the aftermarket at or around the issue price to stabilize the IPO price

Lockup Agreements ● Specify how long insiders must wait after an IPO before they can sell their stock ● Usually around 180 days to ensure they maintain a significant economic interest in the company going public ● Also important since sometimes the share locked up exceed the outstanding ones in the public ○ So if all these were to flood the market, the price would drop dramatically ● Companies backed by venture capital are likely to experience a loss in value on the lockup expiration day The Quiet Periods ● For 10 calendar days following an IPO or 3 calendar days following a seasoned offering, both OSC and SEC require the issuing firm limit all communications with the public to ordinary announcements and other factual matters ● All material information should be contained in the prospectus ● An important result is that the underwriters’ analysts are prohibited from making recommendations to investors ○ When this period ends, the managing underwriters typically public research reports, usually accompanied by a favourable buy recommendation ● Also observed during the period between the issue of a receipt for a preliminary prospectus and the issue of a receipt for the final prospectus ● Google had an issue with this where a co-founder had an interview in Playboy just before an IPO, almost causing a postponement of the IPO

Investment Dealers ● They provide advice, market the securities, provide a guarantee of the amount an issue will raise (with a bought deal) ● To determine the price of an issue they usually meet with potential buyers like large institutions like mutual funds ○ They do presentations in cities and pitch the stock ○ Potential buyers provide info on the price they would pay and how many ● Bookbuilding: the process of soliciting info about buyers and the precise and quantities they would demand ○ Even despite this, underwriters frequently get the price wrong

IPOs and Underpricing ● Very difficult to determine the correct offering price for an IPO ○ If too high, it may be unsuccessful and have to be withdrawn ○ If too low, the shareholders will experience an opportunity loss when the issuer sells new shares for less than they are worth ● Underpricing is common and helps new shareholders earn a higher return on the share they buy ○ BUT the existing shareholders of the issuing firm are not helped by underpricing, as they miss out on a significant portion when the price rises ● One company called eToys underpriced their IPO by $57 per share, missing out on half a billion dollars, and leading to going bankrupt within 2 years IPO Underpricing: The 1999-2000 Experience ● In this time, 900 companies went public, and the average first-day return was about 65% ● Dollar amount raised in 2000 of $66 billion was a record ● Underpricing was so bad in 1999 that companies left another $36 billion on the table due to underpricing ● In 1999, WWE and Marktha Stewart went public ○ Stewart gained 98% on the first day and WWE only 48% Evidence on Underpricing

● ●

Underpricing can be dramatic Periods of severe underpricing are followed by periods of little underpricing ○ Ex. in 1960 the average US IPO was underpriced by 21.2%, in the 70s the average underpricing was 7.1%

● ● ●

Number changes much throughout time Pronounced cycles in booth degree of underpricing and the number of IPOs *** increases in the number of new offerings tend to follow periods of significant underpricing by roughly six months ○ Occurs due to companies deciding to go public when they perceive the market is highly receptive to new issues

● ● ● ●

Degree of underpricing averaged 16.8% overall Overpriced only five of the 56 years In 1999, 486 issues were underpriced by 69.7% In 07 and 08, market conditions made it hard for issuers seeking financing in the capital market

●

Canadian IPO Market closed 2017 with a strong fourth quarter ($1.7 billion raised from 13 new issues ○ Yield proceeds of $5.1 billion

Why Does Underpricing Exist? ● Average figures we have examined tend to obscure the fact that much of the apparent underpricing is attributable to the smaller, more speculative issues found in the following table which shows the extent of underpricing for IPOs over the period from 1980 to 2016

●

●

● ●

Underpricing tends to be higher for firms with little to no sales in the previous year ○ Tends to be younger firms and riskier ones ○ Must be underpriced to attract investors Relatively few IPO buyers will get the initial high average returns observed in IPOs, many will lose money ○ A fraction have price drops When the price is too low, the issue is often “oversubscribed” which means investors will not be able to buy all the shares they want Average investor finds it hard to get shares in a successful offering as there isn’t usually enough to go around

Example: Two investors, Smith, a knowledgeable investor who thinks a share is underpriced, and Jones, an average investor, knows only that prices usually rise one month after an IPO so he buys 1000 shares of every IPO ● But Smith invests all her money in its IPO and when the issue is oversubscribed, the underwriters have to allocate shares between them so Jones doesn’t get to buy as many ● Smith also knows that Blue Sky IPO is overpriced so she avoids it and Jones ends up with 1000 shares CONCLUSION: Jones gets fewer shares when knowledgeable investors swarm to buy an underpriced issue and gets all he wants when the smart money avoids the issue

This is an example of Winner’s curse ● When the average investor wins and gets the entire allocation. It may be because those who knew better avoided it ● Underwriters try to counteract this curse and attract the average investor by underpricing new issues so the average investor still makes a profit Underpricing is also a type of insurance for the investment banks ● Can be sued if they consistently overpriced securities and underpricing thus guarantees customers will come out ahead Final reason for underpricing is that before the offer price is established, investment banks talk to big institutional investors to gauge interest in the stock ● Underpricing is a way the bank can reward these investors for truthfully revealing what they think the stock is worth and the number of shares they’d buy New Equity Sales and the Value of the Firm ● Stock prices tend to decline following the announcement of a new equity issue, and rise following a debt announcement, reasons may include: ○ 1) Managerial Information. If management has superior information about the market value of a firm, it may know when it is overvalued. If it does, it attempts to issue new shares of stock when the market value exceeds the correct value, benefiting existing shareholders. But potential new shareholders are not stupid and they anticipate this superior information and discount it in lower market prices at the new issue date ○ 2) Debt usage. Issuing new equity may reveal a company has too much debt or too little liquidity. Equity issue is a bad signal to the market, after all, if the new projects are favourable, why should the firm let new shareholders in on them. Issuing new debt is sometimes viewed positively as it signal’s management’s confidence in the company’s ability to handle the debt obligation ○ 3) Issue costs. Selling securities can be expensive Underpriced IPOs happen all around the world ● Countries with developed capital markets have more moderate underpricing than in emerging markets

Costs of Issuing Securities ● Flotation costs related to equity sales ● Costs of selling stock fall into 6 categories: ○ 1) The Spread ○ 2) Other direct Expenses ○ 3) Indirect Expenses ○ 4) Abnormal returns ○ 5) Underpricing ○ 6) Over Allotment Option

●

●

The direct costs can be very large, particularly for sm...