Applied Corporate Finance

Week 6
Raising
Equity Capital

References:
Berk and DeMarzo Ch. 23
 Lecture Outline
• Equity Financing for Private Companies
• Initial Public Offerings
• Seasoned Equity Offerings
Equity Financing for Private Companies

• The initial capital that is required to start a

business is usually provided by the
entrepreneur and their immediate family.
• Often, a private company must seek outside
sources that can provide additional capital for
growth.
– how will the infusion of outside capital affect the
control of the company?
 Angel Investors

• Individual Investors who buy equity in small

private firms
• Can organize themselves into angel groups or
networks to share research and pool their
capital, as well as to provide advice to their
portfolio companies eg Sydney Angels, Sydney
Seed Fund
• Crowdfunding regulation
• How to be an angel investor
 Venture Capital (VC)
• A limited partnership that specializes in raising money
to invest in the private equity of young firms.
• VC firm manages funds that have a fixed-life
investment that is typically 10 years plus some number
of extensions.
• Fund is managed by general partners (venture
capitalists)
• Investors such as pension funds, universities, insurance
companies, foundations, endowments, and high-net-
worth individuals invest in the fund as limited partners
(LPs).
• Advantages :
– LPs are more diversified.
– Benefit from the expertise of the general partners.
• Cost : General partners usually charge substantial fees.
– Most firms charge 20% of any positive return they make.
– Also generally charge an annual management fee of about
2% of the fund’s committed capital.
• VCs often demand a great deal of control.
– Seats in the boardroom.
– Significant voting power.
• VC and PE explained
• Start up financing in Australia very low
– Accounts for only 0.009% of GDP compared to
0.3% and 0.055% for Israel and US (OECD, 2014).
• AVCAL overview
Funds under No. of active No. of portfolio Investment in
management fund managers companies held FY2015
A$2.2b 26 270 $224m

• VC fundraising increased in FY2015 from

$126m to $368m
Venture Capital Funding in the US
• To VC or not to VC
 Private Equity
• Organized very much like a venture capital firm, but
invest in established businesses with growth potential
rather than start-up companies.
• Later stage and buyout investing
• Typically finance their acquisitions through a
combination of equity and debt.
• Leveraged buyout (LBO)
– purchasing the outstanding equity of publicly traded firm and
take the company private
– Re-organise, add value and exit by selling the company
• Largest LBOs ever
• But is high risk/leverage and markets can
change
– TXU
– Channel 9
• Australia
• PE fundraising rose to $2.7b in FY2015 from
$933m

Funds under No. of active No. of Investment in

management fund portfolio FY2014
managers companies
held
$23b 45 294 $3.3b
• When a company decides to sell equity to
outside investors for the first time, is common
practice (in US) to issue preferred stock rather
than common stock to raise capital.
• Preferred stock issued by young companies has
seniority in any liquidation but typically does
not pay regular cash dividends and often
contains a right to convert to common stock.
• Convertible Preferred Stock : Preferred stock
that gives the owner an option to convert it into
common stock on some future date
 Example
• You founded your own firm two years ago.
• You initially contributed $50,000 of your money
and in return received 1,000,000 shares of stock.
• Since then, you have sold an additional 750,000
shares to angel investors.
• You are now considering raising even more
capital from a venture capitalist.
• The venture capitalist would invest $2 million and
would receive 2,000,000 newly issued shares
• What is the post-money valuation?
• Assuming that this is the venture capitalist’s
first investment in your company, what
percentage of the firm will they end up
owning?
• What percentage will you own?
• What is the value of your shares?
 Your shares 1,000,000 26.67%
Angel Investors’ Shares 750,000 20.00%

Venture capitalist’s shares 2,000,000 53.33%

Total shares outstanding 3,750,000 100.00%

• Based on the price paid by the VC, your share

price is $1 per share.
• Thus, the post-money valuation is $3,750,000
• VC’s ownership is 53.33%
• Your ownership is 26.67%
• Your shares are worth $1 million
 Initial Public Offering (IPO)
• Is the first issue of shares to the general public made
by a firm seeking listing on the stock exchange.
• Benefits of a public raising of capital:
– Gives access to a wider pool of equity investors
– May liberate the firm from relying on debt as the primary
source of financing
• Benefits of listing:
– Secures liquidity
– Establishes a market value for the company (pricing)
– Exit mechanism for investors in the private firm
– Facilitates raising of further equity capital
– Public profile
• Costs of a public raising of capital:
• High floatation costs
– Direct – legal, auditing and underwriting
– Indirect – management time/effort
• Dilution of ownership
• Costs of listing:
– Onerous disclosure requirements
– Loss of privacy
– Loss of control (susceptible to hostile takeovers)
• IPOs include both primary offerings 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.
• Underwriter: an investment banking firm that
manages a security issuance and designs its
structure.
 Types of Offerings
• In Australia, the traditional method of an IPO is to set
a fixed offer price before marketing the shares.
• Investment banks have increasingly used bookbuilds
to handle large IPOs
– The underwriter collects bids from investors at various
prices, between the floor price and the cap price.
– Bids can be revised by the bidder before the book closes.
– Final issue price is not determined until the end of the
process when the book has closed.
 – After the close of the book building period, underwriter
evaluates the collected bids on the basis of certain
evaluation criteria and sets the final issue price.
– Underwriter has complete control over the price and
allocation of shares.
– Over-Allotment Allocation: an option that allows the
underwriter to issue more stock, usually amounting to 15%
of the original offer size, at the IPO offer price.
• Auction IPO
– 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.
– More transparent than bookbuild
 Example
• Aston Inc. is selling 900,000 shares of stock in an
auction IPO.
• At the end of the bidding period, Aston’s investment
bank has received the following bids.
• What will the offer price be?
Price ($) Number of Shares Bid Cumulative Demand
$10.00 175,000 175,000
$9.75 200,000 375,000
$9.50 275,000 650,000
$9.25 275,000 925,000
$9.00 300,000 1,225,000
 Valuation
• 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).
 Example
• RAXHouse is a private company considering going
public.
– Assets of $585 million and liabilities of $415 million.
– The firm’s cash flow from operations was $137 million for
the previous year.
– After the IPO, RAXHouse will have 118 million shares
outstanding.
• The industry average cash flow per share multiple is
3.0 and the average book value per share is 2.3.
• Estimate the IPO price for RAXHouse.
• Book value of equity = value of the assets – liabilities = $585-
$415 million = $170 million.
• 118 million shares outstanding, book value per share is $170
million/118 million shares = $1.44/share.
• Given the industry average of 2.3, the estimated IPO price
would be $1.44 × 2.3 = $3.31 per share.
• The firm’s cash flow from operations was $137 million,
• Cash flow per share is $137 million/118 million shares = $1.16
per share.
• Given the industry average multiple of 3.0, the estimated IPO
price would be $1.16 × 3.0 = $3.48.
• Road Show
– During an IPO, the company’s senior management and
underwriters travel around promoting the company and
explaining their rationale for an offer price to the underwriters’
largest customers, mainly institutional investors such as mutual
funds and pension funds
• Lockup
– A restriction that prevents existing shareholders from selling
their shares for some period, usually 180 days in the US, after
an IPO
– Generally is 1 year in Australia for VCs, 2 years for related
parties unless firm meets the ASX profits test (unless ASX
decides otherwise)
 IPO Puzzles : Underpricing
• Generally, underwriters set the issue price so
that the average first-day return is positive.
• On the first day of listing, issues tend to
reveal underpricing
– That is, the closing price on the first day of trading
is higher than the subscription price

• Level of Underpricing = First Day Closing Price -Issue Price

Issue Price
• The level of underpricing is about 17-18% in US
and UK over 80’s to mid 90s
• Underpricing was the greatest during the
internet bubble:
– 99-00: initial day return = 65%
• Has returned to pre bubble levels
• Research has found that 75% of first-day returns
are positive.
International Comparison of First Day
IPO Returns
• Why do firms leave so much money on the table?
• The underwriters benefit from the underpricing
as it allows them to manage their risk.
• The pre-IPO shareholders bear the cost of
underpricing.
– owners are selling stock in their firm for less than they
could get in the aftermarket.
• Although IPO returns are attractive, all
investors cannot earn these returns.
‒ When an IPO goes well, the demand for the stock
exceeds the supply. Thus the allocation of shares for
each investor is rationed.
‒ When an IPO does not go well, demand at the issue
price is weak, so all initial orders are filled completely.
‒ Thus, the typical investor will have their investment in “good”
IPOs rationed while fully investing in “bad” IPOs.
• Winner’s Curse
– Situation in competitive bidding when the high
bidder, by virtue of being the high bidder, has very
likely overestimated the value of the item being
bid on
• You “win” (get all the shares you requested) when
demand for the shares by others is low, and the IPO is
more likely to perform poorly.
• Agency problems during the late 90s bubble :
• Dotcon; Wall St fix
• With underpricing, underwriters can benefit from:
• Quid pro quo arrangements
– Underpriced IPOs allocated to investors in return for future
commissions from other trades
• Spinning
– Underpriced IPOs allocated to the personal brokerage
accounts of top executives in return for company business
• Laddering
– Requiring the purchase of additional shares in the
aftermarket in return for IPO allocation
• Underwriters were able to underprice significantly
because:
– Analyst coverage was very important in this new market
(analysts almost invariably gave “buy” recommendations)
– Issuers experienced unexpected increases in demand for
their IPO
• – Nasdaq index increased by 256% in 17 months during the period
 Cyclicality
• The number of issues is highly cyclical- hot markets, returns
lead volume
• In 1980-2000, an average of 310 firms went public every
year, In 2001-2015, an average of 111 firms went public
every year
• Number of Offerings (bars) and Average First-
day Returns (black) on US IPOs, 1980-2015
Source: Jay Ritter, University of Florida.

800 80

700 70

600 60

Average First-day Returns

500 50
Number of IPOs

400 40

300 30

200 20

100 10

0 0
 IPO underwriter cost
• A typical spread is 7% of the issue price.
– By most standards this fee is large, especially
considering the additional cost to the firm
associated with underpricing.
– It is puzzling that there seems to be a lack of
sensitivity of fees to issue size.
• Possible explanation : by charging lower fees, an
underwriter may risk signaling that it is not the same
quality as its higher-priced competitors.
 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.
 Seasoned Equity Offerings (SEO)
• When a public company offers new shares for
sale to raise additional equity
• Market price for the stock already exists, so
the price-setting process is not necessary.
• 3 main methods :
– Public issue
– Rights issue
– Private placement
 Public Issue
• Members of the public are invited to subscribe to
the issue
– Requires a prospectus
• Public issues are generally only used for IPOs in
Australia
• Is most common method in US and Japan for
raising seasoned capital
 Rights issue
• Most common method in Australia, Asia and
Europe
• Existing shareholders are given the option of
purchasing the new equity on a pro-rata basis
ie in proportion to their holdings
• no dilution in the proportional shareholding of
each shareholder provided that each
shareholder subscribes to his/her full
entitlement.
• The option/right may be tradeable/sold
• renounceable issue
– The rights are listed on the stock exchange and can
either be taken up by the shareholder or traded
• non renounceable
– the rights cannot be traded and the only person
eligible to take up the right is the registered
shareholder on the ex-rights day.
• Ex rights day
– Date on which share begins trading ex rights. After
this date a share does not have the attached right to
purchase new shares
• In Australia, the issue price is set at
announcement of the issue
• In US price set just prior to the issue opening
or rights trading beginning
• Usually priced at a discount to the market (15-
20%)
• May be underwritten ie underwriter
guarantees the dollar amount raised
 Private Placement
• Issue to a small number of large investors (usually
institutions)
• Usually a fixed price on a best endeavours basis (that is,
not underwritten) and without an offering document
• limited to 15% of the amount of the security class
outstanding unless firm approval is obtained at a general
meeting
• Discount limited to 15%
– small-cap companies now allowed to issue up to 25%
of their share capital at a discount of up to 25%
• Advantages : speed, price and direction.
• allow a firm to raise capital within a short time
period
• usually priced close to the market, at a small
discount to the current market price (2.5% to
7.5%)
• allows the firm board control over the choice of
new shareholder if there are control implications
• disadvantage is that the percentage ownership of
existing security holders is diluted because the
capital is increased without their participation.
 Market Reactions to the
Announcement of New Issues
• Equity:
– Public issues of equity have the most negative
announcement effect
– Rights issues of equity have a smaller negative
announcement effect
– Placements generally have a positive
announcement effect
– Consistent with adverse selection
 Homework
• Chapter 23: 5, 6, 8, 13