Financing Process
05/14/07Ch. 17
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Financing
Internal Financing – funds raised from cash flows of existing assets
External Financing – funds raised from outside the company (VC, debt, equity, etc.)
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Internal vs. External Financing
Firms may prefer internal financing because External financing is difficult to raise External financing may result in loss of control Raising external capital tends to be expensive
Projects funded by internal financing must meet same hurdle rates
Internal financing is limited
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A Life Cycle View of Financing Choices
Stage 2Rapid Expansion
Stage 1Start-up
Stage 4Mature Growth
Stage 5Decline
ExternalFinancing
Revenues
Earnings
Owner’s EquityBank Debt
Venture CapitalCommon Stock
Debt Retire debtRepurchase stock
External fundingneeds
High, but constrained by infrastructure
High, relative to firm value.
Moderate, relativeto firm value.
Declining, as a percent of firm value
Internal financing
Low, as projects dryup.
Common stockWarrantsConvertibles
Stage 3High Growth
Negative orlow
Negative orlow
Low, relative to funding needs
High, relative tofunding needs
More than funding needs
Accessing private equity Inital Public offering Seasoned equity issue Bond issuesFinancingTransitions
Growth stage
$ Revenues/Earnings
Time
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Process of raising capital
Private firm expansion
From private to public firm: The IPO
Choices for a public firm
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VC process Provoke equity investors’ interest
There is an imbalance between the number of small firms that desire VC investment and the number of VCs
Firms need to distinguish themselves from others to obtain VC funding
Type of business Dot.com in the 90s, bio-tech firms this decade
Successful management
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VC process Perform valuation and return assessment (Venture capital
method) Estimate earnings in the year the company is expected to go
public
Obtain a P/E multiple for public firms in the same industry
Exit or Terminal Value = P/E multiple * forecasted earnings
Discount this terminal value at the VC’s target rate of return
Discounted Terminal Value = Estimated exit value (1 + target return)n
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VC process
Structure the deal Determine the proportion of firm value that VC
will get in return for investmentOwnership Proportion = Capital
Provided Disc. Exit
Value
VC will establish constraints on how the managers run the firm
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VC process Participate in post-deal management
VCs provide managerial experience and contacts for additional fund raising efforts
Exit VCs generate a return on their investment by exiting
the investment. They can do so through
An initial public offering Selling the business to another firm Withdrawing firm cash flows and liquidating the firm
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VC process Stages of Venture Capital Investments
Seed financing is capital provided at the “idea” stage.
Start-up financing is capital used in product development.
First-stage financing is capital provided to initiate manufacturing and sales.
Second-stage financing is for initial expansion. Third-stage financing allows for major expansion. Mezzanine financing prepares the company to go
public.
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Going public vs. staying private
The benefits of going public are: Firms can access financial markets and tap
into a much larger source of capital Owners can cash in on their investments
The costs of going public are: Loss of control Information disclosure requirements Exchange listing requirements
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Initial Public Offering (IPO) process
Most public offerings are made with the assistance of investment bankers (IBs) which are financial intermediaries that specialize in selling new securities and advising firms with regard to major financial transactions.
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IPO process The role of the investment banker
Origination - design of a security contract that is acceptable to the market;
prepare the state and federal Securities and Exchange Commission (SEC) registration statements and a summary prospectus,
Underwriting-the risk-bearing function in which the IB buys the securities at a given price and turns to the market to sell them.
Syndicates are formed to reduce the inventory risk.
Sales and distribution-selling quickly reduces inventory risk. Firm members of the syndicate and a wider selling group distribute the securities over a wide retail and institutional area.
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IPO process
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IPO process IPO costs
Underwriting commission (usually around 7%)
Underpricing of issue Represents the first day returns generated by the firm,
calculated as Closing Price – Offer price
Offer price
Issues are underpriced to Provide investors with a “good taste” about the investment banker
and firm Compensate investors for the information asymmetry between firm
and investor
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IPO process
Valuing the company and setting issue details Investment banker and firm need to determine
Value of company Valuation is typically done using P/E multiples
Size of the issue Value per share Offering price per share
This will tend to be below the value per share, i.e., the offer will be underpriced
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IPO process Determining the offer price
The investment banker will gauge the level of interest from institutional investors for the issue by conducting road shows. This is referred to as building the book.
After the offer price and issue details are set, and the SEC has approved the registration, the firm places a tombstone advertisement in newspapers, that outlines the details of the issue and the investment bankers involved
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IPO process Waiting period – The period between the submission
of the registration to the SEC and the SEC’s approval. It is during this time that the company releases the red herring
Quiet period – a period after the registration is submitted until approximately a month after the issue where the company cannot comment on the earnings, prospects for the company
Lock-up period – a period of usually 6 months following the issue date in which the insiders of the company cannot sell their shares
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Choices for a publicly traded firm
General subscription (or Seasoned Equity Offering)
Private placements
Rights offerings
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General subscription (SEO) Although for IPOs the underwriting agreement almost
always involves a firm guarantee from the underwriter to purchase all of the issue, in secondary offerings, the underwriting agreement may be a best efforts guarantee where the underwriter sells as much of the issue as he can
SEOs tend to have lower underwriting commissions because of IB competition.
The issuing price of an SEO tends to be set slightly lower than the current market price
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Private placement
Securities are sold directly to one or few investors
Saves on time and cost (no registration requirements, marketing needs)
Tends to be less common with corporate equity issues. Private placement is used more in corporate bond issues.
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Rights offerings Existing investors are provided the right to purchase
additional shares in proportion to their current holdings at a price (subscription price) below current market price (rights-on price)
Each existing share is provided one right.
The number of rights required to purchase a share in the rights offering is then determined by the number of shares outstanding and the additional shares to be issued in the rights offering.
rights required to purchase one share = # of original shares # of shares issued in RO
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Rights offerings Because investors can purchase shares at a lower price, the rights
have value:
Value of the right = rights-on price – subscription pricen + 1
where n = number of rights required for each new share
Because additional shares are issued at a price below market price, the market price will drop after the rights offering to the ex-rights price
ex-rights price = New value of equity New number of shares
The value (or price) of the right can also be calculated as:
rights-on price – ex-rights price
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Rights offerings Costs are lower because of
Lower underwriting commissions – rights offerings tend to be fully subscribed
Marketing and distribution costs are significantly lower
No dilution of ownership
No transfer of wealth