Week 8 Long Term Financing - Equity

Download as pdf or txt
Download as pdf or txt
You are on page 1of 30

Venture Capital

• Private financing for relatively new businesses in


exchange for equity
• Play an active role in overseeing, advising, and
monitoring companies in which they invest
• The company should have an “exit” strategy.
▪ Sell the company – VC benefits from proceeds from sale
▪ Take the company public – VC benefits from IPO
• Many VC firms are formed from a group of investors
that pool capital and then have partners in the firm
decide which companies will receive financing.
• Some large corporations have a VC division.
4
Venture Capital Process

5
Stages of Financing

1. Seed Money Stage

2. Start-Up

3. First-Round Financing

4. Second-Round Financing

5. Third-Round Financing

6. Fourth-Round Financing
The venture capital cycle
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?


Angel Investor vs Venture Capitalist

10
Funding and Ownership

• You founded your own firm two years ago. Initially you
contributed $100,000 of your own money and, in return,
received 1.5 million shares of stock. Since then, you have sold
an additional 500,000 shares to angel investors.
• Now you are considering raising even more capital from a
venture capitalist (VC). This VC would invest $6 million and
would receive 3 million newly issued shares. What is the post-
money valuation?
• Assuming that this is the VC’s first investment in your company,
what percentage of the firm will she end up owning?
• What percentage will you own? What is the value of your
shares?

11
Solution…

• After this funding round, there will be a total of 5 million


shares outstanding:
Your shares 1,500,000
Angel investors’ shares 500,000
Newly issued shares 3,000,000
Total 5,000,000

• The VC would be paying $6,000,000


=$2 per share.
3,000,000

12
Continue…

• Post-money valuation would be

5,000,000 × $2 = $10 million,

• Because she is buying 3 million shares, and there will be 5


million total shares outstanding after the funding round, the VC
will end up owning
3,000,000
= 60% of the firm.
5,000,000
• You will own
1,500,000
= 30% of the firm,
5,000,000

1,500,000 × $2 = $3,000,000.
13
Taking Your Firm Public: IPO

• Management must obtain permission from the Board of


Directors.
• Firm must file a registration statement with the SEC.
• The SEC examines the registration during a 20-day
waiting period.
▪ A preliminary prospectus, called a red herring, is distributed
during the waiting period.
▪ If there are problems, the company is allowed to amend the
registration and the waiting period starts over.
• Securities may not be sold during the waiting period.
• The price is determined on the effective date of the
registration.
15
Advantages and Disadvantages of
Going Public
• Advantages:
• Greater liquidity
• Better access to capital
• Give investors the ability to diversify
• Disadvantages:
• Equity holders more dispersed
• Must satisfy requirements of public companies

18
Underwriters

• Services provided by underwriters:


▪Formulate method used to issue securities
▪Price the securities
▪Sell the securities
▪Price stabilization by lead underwriter
• Syndicate – group of investment bankers that market
the securities and share the risk associated with selling
the issue
• Spread – difference between what the syndicate pays
the company and what the security sells for initially in
the market
19
Firm Commitment Underwriting

• Issuer sells entire issue to underwriting syndicate.

• The syndicate then resells the issue to the public.

• The underwriter makes money on the spread between the


price paid to the issuer and the price received from
investors when the stock is sold.

• The syndicate bears the risk of not being able to sell the
entire issue for more than the cost.

• Most common type of underwriting in the United


States
Best Efforts Underwriting
• Underwriter must make their “best effort” to sell the
securities at an agreed-upon offering price.

• The company bears the risk of the issue not being sold.

• The offer may be pulled if there is not enough interest at the


offer price. In this case, the company does not get the
capital, and they have still incurred substantial flotation
costs.

• Not as common as it previously was


Valuing IPO using Comparable

• Wagner, Inc., is a private company that designs,


manufactures, and distributes branded consumer products.
During its most recent fiscal year, Wagner had revenues of
$325 million and earnings of $15 million. Wagner has filed
a registration statement with the SEC for its IPO.
• Before the stock is offered, Wagner’s investment bankers
would like to estimate the value of the company using
comparable companies. The investment bankers have
assembled the following information based on data for
other companies in the same industry that have recently
gone public. In each case, the ratios are based on the IPO
price.

22
Continue…

• After the IPO, Wagner will have 20 million shares


outstanding. Estimate the IPO price for Wagner using the
price/earnings ratio and the price/revenues ratio.

23
Solution…

• The average P/E ratio for recent deals is 21.2.


• Earnings = $15 million, the total market value of Wagner’s
stock will be
$15 million × 21.2 = $318 million
$318 million
• Price per share should be = = $15.90.
20 million

• If Wagner’s IPO price implies a price/revenues ratio equal to


the recent average of 0.9, then using its revenues of $325
million, the total market value of Wagner will be
325 million × 0.9 = $292.5 million,

$292.5
= $14.63 per share
20
24
IPO Underpricing
• May be difficult to price an IPO because there isn’t a
current market price available

• Private companies tend to have more asymmetric


information than companies that are already publicly
traded.

• Underwriters want to ensure that, on average, their clients


earn a good return on IPOs.

• Underpricing causes the issuer to “leave money on the


table.”
New Equity Issues and Price
• Stock prices tend to decline when new equity is issued.
• Possible explanations for this phenomenon:
1. Signaling and managerial information
2. Signaling and debt usage
3. 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.
Issuance Costs
• 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
Question

The L5 Corporation is considering an equity issue to finance


a new space station. A total of $15 million in new equity is
needed. If the direct costs are estimated at 7% of the
amount raised, how large does the issue need to be? What is
the dollar amount of the flotation cost?

Solution:
Amount raised x (1 – 0.07) = $15 million

Amount raised = $15 million = $16.129 million


0.93
Costs of going public

On July 21, 2016, Impinj, the Seattle-based radio-frequency


identification company, went public via an IPO. Impinj
issued 4.8 million shares of stock at a price of $14 each. The
lead underwriter on the IPO was RBC Capital Markets,
assisted by a syndicate of other investment banks. Even
though the IPO raised a gross sum of $67.2 million, Impinj
only got to keep $62.496 million after expenses. The biggest
expense was the 7 percent underwriter spread, which is the
usual spread for an offering of that size. Impinj sold each of
the 4.8 million shares to the underwriters for $13.02, and the
underwriters in turn sold the shares to the public for $14
each. company.
Costs of going public

On July 21, 2016, Impinj, the Seattle-based radio-frequency


identification company, went public via an IPO. Impinj issued 4.8
million shares of stock at a price of $14 each. The lead
Amount raised
underwriter on=the
$13.02 X 4,800,000
IPO was RBC Capitalshares = $62,496,000
Markets, assisted by a
Underwriter
syndicate of cost*
other = ($14 - $13.02)
investment X 4,800,000
banks. Even shares
though the IPO raised
a gross sum of $67.2 million, Impinj only got to keep $62.496
= $4,704,000
million after expenses. The biggest expense was the 7 percent
underwriter spread, which is the usual spread for an offering of
*Underwriter cost is
that size. Impinj considered
sold as direct
each of the cost shares to the
4.8 million
underwriters for $13.02, and the underwriters in turn sold the
shares to the public for $14 each. company.
Direct cost
Impinj spent $7,458 in SEC registration fees and $11,609 in
FINRA filing fees. The company also spent $125,000 in exchange
listing fees, $1.6 million in legal fees, $417,000 on accounting to
obtain the necessary audits, $5,000 for a transfer agent to
physically transfer the shares and maintain a list of shareholders,
$255,000 for printing and engraving expenses, and finally,
$261,000 in miscellaneous expenses.
• Impinj’s expenses totaled $7.39 million, of which $4.7 million
went to the underwriters and $2.69 million went to other parties.
• Net amount raised = $62,496,000 – $2,690,000 = $59,806,000
• Flotation cost of Impinj was 12.36 percent of the net amount
raised by the company. (7,390,000 ÷ 59,806,000)
What about indirect cost?

• If let’s say, the stock rose to $15.41 per share in the first
few minutes of trading. Is this a cost to Impinj?
• YES – Indirect cost due to IPO underpricing

Underpricing cost = ($15.41 - $14) X 4,800,000 = $6,768,000

Total cost = Total direct cost + Total indirect cost


Total cost = $14,158,000

Flotation cost (including indirect cost)


= $14,158,000 ÷ 59,806,000
= 23.67%
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.
Price R < Market price S

• 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.
Value = Old SP – New SP
Example: Rights Offering
• Suppose a company wants to raise $10 million.
• The subscription price is $20, and the current stock
price is $25.
• The firm currently has 5,000,000 shares outstanding.

▪How many shares must be issued?


Number of new shares to issue
= Funds to be raised ÷ Subscription price
= $10,000,000 ÷ $20
= 500,000 shares
Continue…

How many rights will it take to purchase one share?

Number of rights to purchase 1 share


= Old shares ÷ New shares
= 5,000,000 ÷ 500,000
= 10 rights

→ A shareholder has to give up 10 rights and $20 to


purchase one new share.
Continue…
What is the value of a right?

After rights offering:


New market value = (5,000,000 x $25) + $10,000,000 =
$135,000,000
Total number of shares = 5,000,000 + 500,000 = 5,500,000
Share price = New market value ÷ Total number of shares =
$24.54
Value of one right = $25 - $24.54 = $0.45

You might also like