MOS 1023

Lesson 7
Today’s Agenda
1. Bootstrapping and Venture Capital Financing
2. Initial Public Offering
3. Private Markets
4. Dividends, Stock Repurchases, and Payout
Policy
Financing Sources
Bootstrapping
and
Venture Capital Financing
Bootstrapping
INITIAL FUNDING OF THE FIRM

The process by which many entrepreneurs raise

“seed” money and obtain other resources
necessary to start their businesses

The initial “seed” money usually comes from

the entrepreneur or other founders.
Bootstrapping
INITIAL FUNDING OF THE FIRM
Other cash may come from personal savings,
the sale of personal assets, loans from family
and friends, use of credit cards.
The seed money, in most cases, is spent on
developing a prototype of the product or service
and a business plan.
Usually lasts 1 to 2 years
Venture Capital
 Venture capitalists are individuals or firms that
help new businesses get started and provide much
of their early-stage financing.
 Individual venture capitalists or angel investors,
are typically wealthy individuals who invest their
own money in emerging businesses at the very
early stages in small deals.
Venture Capital
Three reasons exist as to why traditional sources of
funding do not work for new or emerging businesses:
1.The high degree of risk
2.Types of productive assets
3.Informational asymmetry problems
 When dealing with highly specialized tech, or
companies emerging in new business areas, most
investors do not have the expertise to distinguish
between competent and incompetent
entrepreneurs & are reluctant to invest.
Venture Capital
 The venture capitalists’ investments give them an
equity interest in the company.
 Often in the form of preferred stock that is
convertible into common stock at the discretion
of the venture capitalist.
Venture Capital
Venture Capitalists Provide More Than Financing

 The extent of the venture capitalists’ involvement

depends on the experience of the management team.
 One of their most important roles is to provide advice.
 Because of their industry and general knowledge
about what it takes for a business to succeed, they
provide counsel for entrepreneurs when a business is
being started and during early stages of operation.
Venture Capital
How Venture Capitalists Reduce Their Risk
 Venture capitalists know that only a handful of new
companies will survive to become successful firms.
 Tactics to reduce risk:
• funding the ventures in stages
• requiring entrepreneurs to make personal
investments
• syndicating investments
• in-depth knowledge about the industry
Venture Capital
Syndication
 It is a common practice to syndicate seed- and early-
stage venture capital investments.
 Syndication occurs when the originating venture
capitalist sells a percentage of a deal to other venture
capitalists.
Venture Capital
The Exit Strategy

 Venture capitalists are not long-term investors in

the companies, but usually exit after a period of
three to seven years.
 Every venture capital agreement includes provisions
identifying who has the authority to make critical
decisions concerning the exit process.
Timing (when to exit)
The method of exit
What price is acceptable
Venture Capital
There are three principal ways in which venture capital
firms exit venture-backed companies:
 Sell to a strategic buyer in the private
market.
 Sell to financial buyer in the private
market (private equity firm- does not
expect to gain from synergies).
 Initial Public Offering: selling common
stock in an initial public offering (IPO).
Initial Public
Offering
What is an IPO?
Initial Public Offering
Advantages of Going Public
• Amount of equity is larger
• Additional equity can be
raised at a low cost
• Can fund growing business
without giving up control
• Creates secondary market for
trading
• Easier to attract top
management and motivate
current managers
Initial Public Offering
Disadvantages to Going Public
• High cost of the IPO itself
• Costs of complying with
ongoing SEC disclosure
requirements
• Transparency that results from
this compliance can be costly
for some firms
Initial Public Offering
INVESTMENT-BANKING SERVICES
To complete an IPO, a firm will need the services of
investment bankers, who are experts in bringing new
securities to the market.
Investment bankers provide three basic services when
bringing securities to market–
1. origination,
2. underwriting,

3. distribution.
1. Origination
Includes giving the firm
financial advice and
getting the issue ready
to sell.

File a registration The investment banker

statement with the helps the firm determine
Securities Exchange whether it is ready for an
Commission (SEC). IPO.

Once the decision to sell

stock is made, the firm’s
management must
obtain a number of
approvals.
2. Underwriting
The risk-bearing part of investment banking.
The securities can be underwritten in two ways:

Firm
Best-Efforts
Commitment
Basis
Basis

Investment banker guarantees

The investment banker makes no
the issuer a fixed amount of money
guarantee to sell the securities at
from the stock Sale. The banker
a particular price. It promises only
actually buys the stock from the firm
to make its “best effort” to sell as
at a fixed price and then resells it to
much of the issue as possible at a
the public.
certain price.
Firm Commitment Basis
An IPO’s offer price is $20 per share to issue 2M shares
and the underwriter’s spread is 7%.

What is the total expected proceeds?

2M x $20= $40M
What is the issuer’s expected net proceeds?
2M x $20 x 0.93= $37.2M
What is the underwriter’s expected net proceeds?
2M x $20 x 0.07= $2.8M
Firm Commitment Basis
An IPO’s offer price is $20 per share to issue 2M shares
and the underwriter’s spread is 7%. Only ended up
being sold for $19 per share due to unsuccessful IPO.

What is the total proceeds?

2M x $19= $38M
What is the issuer’s net proceeds?
2M x $20 x 0.93= $37.2M/2M= $18.60 per share
What is the underwriter’s net proceeds?
38M – 37.2M= 0.8M/2M= $0.4/share
2. Underwriting
Underwriting Syndicates
 To share the underwriting risk and to sell a new
security issue more efficiently, underwriters may
combine to form a group called an underwriting
syndicate.
 Participating in the syndicate entitles each
underwriter to receive a portion of the
underwriting fee as well as an allocation of the
securities to sell to its own customers.
2. Underwriting
Determining the Offer Price

One of the investment banker’s most

difficult tasks is to determine the
highest price at which the bankers will
be able to quickly sell all of the shares
being offered and that will result in a
stable secondary market for the shares.
2. Underwriting
Due Diligence Meeting
Before the shares are sold, representatives from the
underwriting syndicate hold a due-diligence meeting
with representatives of the company.
Investment bankers hold due-diligence meetings to
protect their reputations and to reduce the risk of
investors’ lawsuits in the event the investment goes
sour later on.
3. Distribution
Once the due-diligence process is complete, the
underwriters and the issuer determine the final offer
price in a pricing call.
The pricing call typically takes place after the market
has closed for the day.
By either accepting or rejecting the investment
banker’s recommendation, management ultimately
makes the pricing decision.
IPO Pricing and Cost
Three basic costs are associated with issuing stock in an
IPO: Out-of-
pocket
Underwriting expenses Underpricing
Spread

Difference between the Difference between the

proceeds the issuer offering price and the
receives and the total Includes: other closing price at the end
amount raised in the investment banking fees, of the first day of the
offering. legal fees, accounting IPO.
expenses, printing costs,
travel expenses, SEC
filing fees, consultant
fees, and taxes.
Private Markets
Private Markets
Private versus Public Markets

 Cheapest source of external funding for smaller firms

and firms of lower credit standing is often the private
markets.
 When market conditions are unstable, some smaller
firms that were previously able to sell securities in the
public markets no longer can.
 Bootstrapping and venture capital financing are part of
the private market as well.
Private Placements
 Private placement occurs when a firm sells
unregistered securities directly to investors such as
insurance companies, commercial banks, or
wealthy individuals.
Private Placements
 Private lenders are more willing to
negotiate changes to a bond contract.
 If a firm suffers financial distress, the
problems are more likely to be resolved
without going to a bankruptcy court.
 Other advantages include the speed of
private placement deals and flexibility in
issue size.

The biggest drawback of private

placements involves restrictions
on the resale of the securities.
Dividends, Stock
Repurchases, and
Payout Policy
Dividends
Dividend policy: a firm’s overall policy regarding
distributions of value to stockholders.

 A dividend is something of value that is distributed

to a firm’s stockholders on a pro-rata basis.
 A dividend can involve the distribution of cash,
assets, or something else, such as discounts on the
firm’s products that are available only to
stockholders.
Dividends
 When a firm distributes value through a dividend,
it reduces the value of the stockholders’ claims
against the firm.
 A dividend reduces the stockholders’ investment
in a firm by returning some of that investment to
them.
Dividends
Regular Cash Special
Dividend Dividend

Extra Liquidating
Dividend Dividend
Dividends
Regular Cash Dividend
Most common form.
Generally paid on a quarterly basis.
Common means by which firms return some of their
profits to stockholders.
Set at a level that management expects the company to be
able to maintain in the long run, barring some major change
in the fortunes of the company.
Dividends
Extra dividends
Management can afford to err on the side of
setting the regular cash dividend too low
because it always has the option of paying
an extra dividend if earnings are higher than
expected.
Often paid at the same time as regular cash
dividends.
Dividends
Special Dividend
A one-time payment to stockholders.
Are larger than extra dividends and
occur less frequently.

Liquidating Dividend
Paid to stockholders when a firm is liquidated.
The Dividend Payment Process
Time Line for a Public Company
 LO3

Quick Check 
You would like to own a common stock that has a
record date of Friday, September 5, 2014. What is the
last date that you can purchase the stock and still
receive the dividend?

41
Stock Repurchases
 They do not represent a pro-rata distribution of value
to the stockholders, because not all stockholders
participate.
 When a company repurchases its own shares, it
removes them from circulation.
 Stock repurchases are taxed differently than dividends.
Stock Repurchases
HOW STOCK IS REPURCHASED: 3 WAYS

Tender Offer

Open-market
Repurchase Targeted Stock
Repurchase
Fixed Price
Dutch
Auction
Tender Offer
Fixed price- management announces the price that will
be paid for the shares and the max number of shares that
will be repurchased. Interested stockholders “tender”
their shares by responding with how many shares they are
willing to sell.
 Shares repurchased up to max, repurchased in proportion to the
fraction of the total shares each shareholder tendered (if over max)
Dutch auction- management announces the number of
shares it would like to repurchase and offers it at a series
of prices above the market price, to see which price is best
to allow for the required shares to be purchased
Stock Dividends
 Does not involve the distribution of value.
 When a company pays a stock dividend, it distributes
new shares of stock on a pro-rata basis to existing
stockholders.
 Value of company does not change.
 The stockholder is left with exactly the same value as
before.
Stock Splits
 A stock split is quite similar to a
stock dividend, but it involves the
distribution of a larger multiple of
the outstanding shares.
 We can often think of a stock split
as an actual division of each share
into more than one share.
Stock Split
Stock Splits
 One real benefit of stock splits is that they can send a
positive signal to investors about the outlook that
management has for the future and this, in turn, can
lead to a higher stock price.
 Management is unlikely to want to split the stock of a
company two-for-one or three-for-one if it expects
the stock price to decline.
 LO3

Quick Check 
Management has just declared a 3-for-1 stock split. If
you own 12,000 shares before the split, how many
shares will you own after the split?

49
Practical Considerations in Setting a
Dividend Policy
 A company’s dividend policy is about how
the excess value in a company is
distributed to its stockholders.
 It is extremely important that managers choose
their firms’ dividend polices in a way that enables
them to continue to make the investments
necessary for the firm to compete in its product
markets.
Practical Considerations in Setting a
Dividend Policy
 Managers should consider several practical
questions when selecting a dividend policy:
1. Over the long term, how much does the company’s
level of earnings (cash flows from operations)
exceed its investment requirements? How certain
is this level?
2. Does the firm have enough financial reserves to
maintain the dividend payout in periods when
earnings are down or investment requirements are
up?
Practical Considerations in Setting a
Dividend Policy
3. Does the firm have sufficient financial flexibility to
maintain dividends if unforeseen circumstances
wipe out its financial reserves when earnings are
down?
4. Can the firm quickly raise equity capital if
necessary?
5. If the company chooses to finance dividends by
selling equity, will the increased number of
stockholders have implications for the control of
the company?