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Chapter 13

How Companies Raise Long-Term Capital

Shapiro and Balbirer: Modern Corporate Finance:

A Multidisciplinary Approach to Value Creation

Graphics by Peeradej Supmonchai

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Learning Objectives Describe how venture capitalists assist

entrepreneurs in financing new businesses.

Discuss the functions performed by an investment banker in helping a firm wanting to raise funds in the financial markets.

Describe how the financial markets respond to new security offerings.

Discuss the regulatory requirements that must be met before bringing a new security issue to market.

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Learning Objectives (Cont.)

Explain the mechanics of a rights offering

and indicate when it may be superior to a

public offering as a way of selling new

common stock.

Calculate the value of a right.

Discuss the advantages and dis-advantages

of raising funds through a private placement

rather than through a public offering.

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Venture Capitalists

Venture capitalists are investors who take an equity

position in new businesses. These investment are

often high-risk propositions promising enormous

returns if the venture survives. Venture capitalists

make their money by cashing in their holdings

when the company goes public.

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Rad Neato Enterprises: First-Stage Financing

Balance Sheet (Market Values)

Cash from venture $ 500,000 Equity from first- $ 500,000

capital stage financing

Growth option on $1,000,000 Equity held by $1,000,000

Boomboard market founders

Total Assets $1,500,000 Total Equity $1,500,000

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Limiting Downside Risks

Staged financing

Limit founder’s compensation

Assist in management of the company

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Rad Neato Enterprises: Second-Stage Financing

Balance Sheet (Market Values)

Cash from venture $1,000,000 Equity from second- $1,000,000

capital stage financing

Other tangible assets $ 500,000 Equity from first- $1,250,000

stage financing

Growth option on $3,250,000 Equity held by $2,500,000

Boomboard market founders

Total Assets $4,750,000 Total Equity $4,750,000

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Market Response to New Security Offerings

The market response to new security offerings of

all kinds is either negative or neutral. Market

reaction is more negative for common stock

issues than to preferred stock or debt offerings.

Convertible of-ferings show a more negative

reaction than straight-debt issues.

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Information Symmetry Hypothesis

Used to explain market response to new

security offerings, the information symmetry

hypothesis relies on the fact that managers, as

insiders, have better information about a firm’s

prospects than outside investors. Management

would (presumably) exploit this informational

asymmetry by issuing “overpriced” securities.

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Information Asymmetries and the Financing Pecking Order

The creditability problem associated with

information asymmetries helps explain the strong

corporate preference for internal versus external

funding. It also explains why firms that must raise

external capital issue securities in ascending order

of risk: first debt, then hybrid securities, then

external equity as a last resort. This set of

preferences is known as a financing pecking order.

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Competitive Bids versus Negotiated Offerings

In making a public offering, a firm must select an investment banker on either a competitive bid basis or a negotiated basis.Negotiated Offering: Firm works with a

particular investment banker to work out the features and characteristics of the offering.

Competitive Bid: Firm decides on the details of the offering and then asks a number of investment bankers for bids.

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Functions of Investment Bankers

Advice and council

Terms and characteristics of the issue

Pricing the issue

Underwriting

Firm commitment

Best efforts

Marketing the issue

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Securities Registration Process

Register the issue with the SEC. Registration Statement Prospectus

SEC approves or disapproves the registration statement.

Firm may issue a preliminary prospectus while waiting for approval.

Upon approval, a final prospectus to the public is issued.

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SEC Approval and Issue Quality

In passing on the registration statement,

the SEC is not certifying the quality of the

issue. It is only making sure that there is

full disclosure of relevant facts.

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Flotation Costs on Public Offerings

Cost of readying the issue for market

Administrative, legal, and accounting expenses

in preparing the registration statement

Printing and mailing costs

Underwriting fees

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Shelf Registration

Under Rule 415, companies can file a single registration statement outlining their long-term financing plans over a two-year period.Firm can sell securities at any time by

taking them “off the shelf.”This gives qualifying firms flexibility in

issuing securities.This reduces the flotation costs on small

transactions.

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Rights Offering

Instead of selling a new issue through a public

offering,some firms will first offer the securities

to their shareholders on a privileged-

subscription basis. These rights offerings are

mandatory in those firms where shareholders

have a preemptive right.

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Mechanics of a Rights Offering

Rights offering must be registered with the SEC

Shareholders receive one right for each share of

common they own

Rights are like options; shareholders can Exercise them

Sell them

Let them expire unexercised

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Rights Offering - An Example

Suppose a share of stock is currently selling

rights-on for $50; the subscription price is $45

and it takes four rights to subscribe to one

share. What’s the value of a right?

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Right Offering - An Example

The value of a right is

R = (P-S)/(N+1)

Where R is the value of one right, P is the rights on price, S is the subscription price, and N is the number of shares required for one new share. The value of the right is:

R = ($50 - $45)/(4+1)

= $1

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Rights Offering versus Public Offering

Advantages of Rights Offering With a low enough subscription price, the cost of underwriting

can be eliminated.

Firm can tap a market that already exists.

Current shareholders can retain their present ownership

proportion.

Disadvantages of Rights Offering More costly to complete than a public offering

Does not broaden the shareholder base

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Private Placements

Direct sale of securities to a limited number of

institutional investors

Exempt from SEC registration

SEC Rule 144A allows institutional investors

to trade private placements among themselves

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Advantages of Private Placements

Avoids lengthy and costly SEC registration process

Speed of placement

Minimizes disclosure of strategically sensitive information

Can be tailored to meet the needs of borrowers and lenders

Easier to negotiate terms relative to a public offering

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Disadvantages of Private Placements

Private investors typically require tighter and

more restrictive loan covenants.

Investors typically demand higher yields.