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Topics Covered

Venture CapitalThe Initial Public OfferingOther New-Issue ProceduresSecurity Sales by Public Companies

– Rights Issue

Private Placements and Public Issues

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Venture Capital

Since success of a new firm is highly dependent on the effort of the managers, restrictions are placed on management by the venture capital company and funds are usually dispersed in stages, after a certain level of success is achieved.

Venture Capital

Money invested to finance a new firm

16- 3Eight Stages of Venture Development and Financing

(Please refer to the table distributed) Stage 1 : Seed Financing – efforts to formulate a

vision based on the original concept. Financing provided by bootstraps & angels

Stage 2 : Start –Up – this stage ensues only if the results of stage 1 is promising. A proper management team looks at a more detail business plan. Product developed, prototype tested and marketing potential is tested.

16- 4Eight Stages of Venture Development and Financing

Stage 3 : Early Development – risk is greatly reduced, the firm secures initial property, plant and equipment(PP&E). Products or services are shipped in commercial quantities.

Usually Angels will cash-out at this stage, and replaced by VC firm or even a bank (usually with government guarantee).

16- 5Eight Stages of Venture Development and Financing

Stage 4: Expansion – firm accumulates experience in the market, though success is still questionable.

Usually losses money on operations and requires additional financing for PP&E.

Usually financed by VC and BanksStage 5: Profitable but cash-poorThe downside risk is substantially eliminated,

retain earnings starts to become source of financing, besides VC and banks

16- 6Eight Stages of Venture Development and Financing

Stage 6: Rapid growth towards liquidity point. Stable and low risk. The potential of debt financing increases.

Stage 7: Bridge Stage ( Mezzanine Financing) – it is the final growth and preparation stage before the harvest takes place. The harvest alternative is already decided at this stage and all activities are tailored towards the harvest stage.

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Eight Stages of Venture Development and Financing

Stage 8: Harvest Stage – cashing-out and exit of short-term investors. The alternatives involves remaining private with long-term investors; being acquired; or go public (IPO).

What is the difference between VC firm and a Bank?

• Equity shares (VC) and Debt (Banks)• Early stage financing (VC) and stable stage (Banks)• Involved in management (VC)• Less regulated (VC)

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Initial Offering

Initial Public Offering (IPO) - First offering of stock to the general public.

Underwriter - Firm that buys an issue of securities from a company and resells it to the public.

Spread - Difference between public offer price and price paid by underwriter.

Prospectus - Formal summary that provides information on an issue of securities.

Underpricing - Issuing securities at an offering price set below the true value of the security.

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Motives For An IPO

Percent of CFOs who strongly agree with the reason for an IPO

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The Top Managing Underwriters

UnderwriterValue of Issues

($billion) Number of issues

Citigroup 667 1966J.P. Morgan 506 1738Deutsche Bank 475 1444Morgan Stanley 455 1419Lehman Brothers 477 1306

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Average Initial IPO Returns

0 20 40 60 80 100

return (percent)

DenmarkCanadaNetherlandsSpainTurkeyFranceAustraliaNorwayHong KongUKUSAItalyJapanSingaporeSwedenTaiwanGermanySwitzerlandKoreaBrazilIndiaChina

256 %

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Initial Offering

Average Expenses on 1767 IPOs from 1990-1994Value of Issues

($mil)

Direct

Costs (%)

Avg First Day

Return (%)

Total

Costs (%)

2 - 9.99 16.96 16.36

10 - 19.99 11.63 9.65

20 - 39.99 9.7 12.48

40 - 59.99 8.72 13.65

60 - 79.99 8.2 11.31

80 - 99.99 7.91 8.91

100 - 199.99 7.06 7.16

200 - 499.99 6.53 5.70

500 and up 5.72 7.53

All Issues 11.00 12.05

25 16

18 15

18 18

17 95

16 35

14 14

12 78

11 10

10 36

18 69

.

.

.

.

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.

.

.

.

.

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General Cash Offers

Seasoned Offering - Sale of securities by a firm that is already publicly traded.

General Cash Offer - Sale of securities open to all investors by an already public company.

Shelf Registration - A procedure that allows firms to file one registration statement for several issues of the same security.

Private Placement - Sale of securities to a limited number of investors without a public offering.

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Underwriting Spreads (2006)

Type CompanyIssue Amount ($ millions)

Underwriter's spread

Common Stock:

IPO Mastercard 2,399 4.70%

IPO Golfsmith International 29 7.00%

IPO Luna Innovators 21 7.00%

IPO Verigy 128 7.00%

Seasoned Nasdaq Stock Market 556 4.00%

Seasoned Parker Drilling 101 1.06%

Seasoned KFX, Inc. 131 4.00%

Seasoned Walter Industries 149 1.28%

Seasoned Natural Gas Services Group 50 5.77%

Debt (cupon rate, type, maturity) :5.37% floating rate notes, 2009 Honeywell International 300 0.25%5.75% debentures, 2036 Boston Edison 200 0.88%

5.2% senior global notes, 2011 Home Depot 1,000 0.35%7% senior notes, 2016 Navigators Group 125 0.65%5% senior convertible notes, 2013 BioMartin Pharma 125 3.00%

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IPOs

Benefits of going public:– - Reduce risk through diversification– - Increase liquidity of the stocks– - Lower costs of capital– - Reduces debt– Dilute voting power and the influence of pre-

IPO shareholders

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IPOs

Costs of going public:– - Underpricing– - Issuance costs (about 5-10%)– -Loss of Control– - Agency costs of managerial distress– - Information asymmetry– - Performance pressures– -Distractions

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IPO Process

Choice of underwriter is based on:– - Size– - Reputation– - Specialization– - After-market support– - On –going commitment– - Costs (includes fees for service, ‘greenshoe’

option and valuable warrants)

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Why are IPOs Underpriced?

Litigation RiskThe Winners CurseSignaling ModelsIs Underpricing related to the Firm’s stated use of the

Proceeds of the IPO?

-General corporate purposes or working capital

- debt retirement or stock repurchase

Unit IPOS? – it consists of share of stock and one or more warrants that give the investor the right to purchase additional shares at a later date at a specified price.

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Unit IPOs

Rationale:– Unit IPOs mitigate the principal-agent problem in the sense that if

the firm receives more proceeds than it needs in a normal IPO the management will squander the excess. In unit IPO, the management only gets what it needs with a promise that they can raise new funds later via the warrants.

– It is an effective signal of firm’s value under conditions of severe information asymmetry. This relates to different private valuations of the value of underlying warrants to the shares of the company. The insiders will assign lower private value (less costly) of the warrants of the firm that has higher risk and higher expected cash flows.

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Private Placement

It is a seasoned equity offering (SEO) that is an additional issuance of shares by publicly traded firm. Whereas IPO is an unseasoned equity.

Rationale: When a firm has fixed its capital expenditure program and its debt equity structure to finance these investments, and internal funds are insufficient to support the investment program…

Then the firm will either resort to external equity (via SEO) or scale back its planned investments.

One form of SEO is private placement. It is a private sale of equity, when the firm usually sells a block of shares to single or a group of investors.

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Private Placement Usually the ‘information effect’ of private placement announcements

shows positive market reactions to the sales….because sales are usually made discount to market value …could be explained by;

The discounts are compensation for the expert advise and monitoring services provided by private investors…

The resolution of information asymmetries and anticipated effects of changes in the ownership structure are reflected in the positive market reaction to announcements.

Information Hypothesis- reflects the changes in firm value around private placements due to market assessment of value of existing firm assets and investment opportunities.

Ownership Structure Hypothesis – implies that market revaluation can be the result of anticipated changes in managerial performance.

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Rights Issue

Rights Issue - Issue of securities offered only to current stockholders. Current shareholders are given the preemptive rights to purchase new shares on a pro-rata basis. The exercise price is usually at a deep discount to market price as to ‘strongly encourage’ the shareholder to exercise the rights. However, the shareholder could also sell the rights in the secondary markets, if there is no wish to purchase additional shares of the company.

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Rights Issue

Current Market Value = 10 x €77.40 = €774.00 Total Shares = 10 + 1 = 11 Amount of funds = 774 + 65.40 = €839.40 New Share Price = (839.40) / 11 = €76.31 Value of a Right = 76.31 – 65.40 = €10.91

Example - BNP Paribas Bank needs to raise €5.50 billion of new equity. The market price is €77.40/sh. Lafarge decides to raise additional funds via a 1 for 10 rights offer at €65.40 per share. If we assume 100% subscription, what is the value of each right?

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Rights Issue

Slightly More Difficult Example

Lafarge Corp needs to raise €1.28billion of new equity. The market price is €60/sh. Lafarge decides to raise additional funds via a 4 for 17 rights offer at €41 per share. If we assume 100% subscription, what is the value of each right?

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Rights Issue

Current Market Value = 17 x €60 = €1,020 Total Shares = 17 + 4 = 21 Amount of funds = 1,020 + (4x41) = €1,184 New Share Price = (1,184) / 21 = €56.38 Value of a Right = 56.38 – 41 = €15.38

Example - Lafarge Corp needs to raise €1.28billion of new equity. The market price is €60/sh. Lafarge decides to raise additional funds via a 4 for 17 rights offer at €41 per share. If we assume 100% subscription, what is the value of each right?

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Case and Readings

Case: Jet Blue Airways IPO evaluation (Refer to Pages 381-400 of the Book,

Case Studies in Finance: Managing for Corporate Value Creation, by Robert F. Bruner, Kenneth M. Eades and Michael J. Schill, 6th Edition, McGraw-Hill International Edition, 2010).

Articles: (Venture Capital) 1. KB Subhash, Venture Capital Financing and Corporate Governance:

Role of Entrepreneurs in minimizing information/Incentive Asymmetry and Maximization of Wealth, Journal of portfolio Management, Fall 2009, Vol. 12, No. 2, pp: 113-129.

2. Carlos Marques DeSliva, Matej Janazic and R.D Hisrich, Five ways to operate and succeed as a venture capitalist in Southeast Europe, Journal of Private Equity, Spring 2012, Vol. 15, No. 2, pp: 84-89.

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Case & Readings

(IPOs) 1. Daniel Konku, Vivek Bhargava and DK Malhorta, Long-term

performance of Penny Stock IPOs, The Journal of wealth Management, Summer 2012, Vol. 15. NO. 1, pp: 104-121.

2. Joseph W. Bartlett, Public or Private? A review of the Eclipse of the Public Company in the current Environment, The Journal of Private Equity, Summer 2011, Vol.14, NO. 3, pp: 7-15.

(Private Placement) Normazia, M., M., Ariff, Taufiq, H., and Shamsher, M., Private

Placements, Share Prices, Volume and Financial Crisis: An Emerging Market Study, Paper under review by the Global Finance Journal.