Raising Capital

Chapter 15

Created by David Moore, PhD

Topics

  1. Life cycle of firm
    • How it raises capital, specifically equity
  2. Process of going public: IPO
    • Issues and costs
  3. Examples

Venture Capital

Private Equity

Intro to VC (Private Equity)

Private financing for new, high risk businesses in exchange for stock
  • Done be individual investors, angel investor, venture capital firms, other investment firms.
  • Usually involves active participation by VC
  • Ultimate goal: take company public; the VC will benefit from the capital raised in the IPO
  • Hard to find and expensive

Stage Financing

  • Funding provided in several stages
  • Contingent upon specified goals at each stage
  • First stage
    • "Ground floor" or "Seed money"
    • Fund prototype and manufacturing plan
  • Second Stage
    • "Mezzanine" financing
    • Begin manufacturing, marketing, and distribution

More about VC financing

  • Rounds following seed are labeled Series A,B,C, etc
  • Funding follows life cycle of start-up
  • Seed: Initial idea A: Optimizing B:Build C: Scale

Fun fact: Unicorn refers to startup's valued at $1 Billion

Example: Uber

Uber

Choosing a Venture Capitalist


Need to consider:
  • Financial strength
  • Compatible management style
  • Obtain and check references
  • Contacts
  • Exit strategy

Note: very basic intro to VC.

Bad Blood

Book: Bad Blood: Secrets and Lies in a Silicon Valley Startup.

  • 2003 Start-up health technology company: founder Elizabeth Holmes
  • Seed money: $\$$6 million at $\$$34 million valuation
  • By 2010: Series B and C: $\$$45 million at $\$$1 billion valuation
  • Estimated Valuation $\$$9 billion ($\$$810 million VC raised)
  • Company found fraudulent and ceased operations in 2018
  • Holmes Net worth 4.5 Billion to 0
  • Major investors (Walton family:150M; Murdoch:121M; Betsy DeVos:100M; Cox family:100M)- now worthless.
Fun fact: Movie coming out starring JLaw and directed by Adam McKay.

Selling Securities to the Public

Timeline

  1. Management obtains permission from the Board of Directors
  2. Firm files a registration statement with the SEC (discloses all material information)
  3. SEC examines the registration during a 20-day waiting period
  4. Securities may not be sold during the waiting period

Timeline, cont'd

  1. A preliminary prospectus, called a red herring, is distributed during the waiting period
    • If problems, the company amends the registration, and the waiting period starts over
  2. Price per share determined on the effective date of the registration and the selling effort begins
    • A final prospectus must accompany delivery of securities or confirmation of sale.

Prospectus



A legal document describing details of the issuing corporation and the proposed offering to potential investors.

YETI

Yeti

Lyft

Lyft

Issue Methods

  • Public Issue
    • Registration with SEC required
    • General cash offer = offered to general public
    • Rights offer = offered only to current shareholders
    • IPO = Initial Public Offering = Unseasoned new issue
    • SEO = Seasoned Equity Offering
  • Private Issue
    • Sold to fewer than 35 investors
    • SEC registration not required

Note on Crowdfunding

  • Limits on equity raised and investments
    • Can only issue $\$$1 million in equity per 12 months
    • Investors will be permitted to invest up to $\$$100,000 in crowdfunding issues per 12 months
  • Most "crowdfunding" you think of (Kickstarter) does not involve equity.

Underwriting

Underwriters

Act as intermediary between company selling securities and the investing public
Provide the following services:
  • Formulate method to issue securities
  • Price the securities
  • Sell the securities
  • Price stabilization by lead underwriter in the aftermarket

Underwriter Terms

  • 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 in the market. (direct cost/fee of IPO)

Tombstone

Advertisement announcing public offering.
  • Investment banks in syndicate divided into brackets
  • Firms listed alphabetically within each bracket
  • "Pecking order": higher bracket = greater percentage
  • Underwriting success built on reputation

Tombstone Example

Uber

Types of Underwriting

  1. Firm Commitment
  2. Best Efforts
  3. Dutch Auction

Firm Commitment Underwriting

  • Issuer sells entire issue to underwriting syndicate
  • Syndicate resells issue to the public
  • Underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold
  • 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

More on Firm Commitment

  • Underwriters meet with potential buyers to determine offering price
    • Road show: pitch stock in multiple cities
  • Bookbuilding: Process of soliciting information about buyers and the prices and quantities they would demand.

Best Efforts Underwriting

  • Underwriter makes "best effort" to sell the securities at an agreed-upon offering price
  • Issuing company bears the risk of the issue not being sold
  • Offer may be pulled if not enough interest at the offer price
    • Company does not get the capital and they have still incurred substantial flotation costs (cost of "floating" new issue)
  • Not as common as it used to be

Dutch or Uniform Price Auction

  • Buyers:
    • Bid a price and number of shares
  • Seller:
    • Work down the list of bidders
    • Determine the highest price at which they can sell the desired number of shares
  • All successful bidders pay the same price per share.
  • Encourages aggressive bidding

Auction Example

The company wants to sell 1,500 shares and receives the following bids:
Bidder Quantity Bid
A 500 $20
B 400 18
C 250 16
D 350 15
E 200 12

The firm will sell 1,500 shares at $15 per share.
Bidders A, B, C, and D will get shares.

Other Terms

Aftermarket



Period after new issue is initially sold to the public. Underwriter only allowed to buy shares if they fall below offer price (provide price support)

Green Shoe Provision

  • "Overallotment Option"
  • Allows syndicate to purchase an additional 15% of the issue from the issuer
  • Allows the issue to be oversubscribed
  • Provides some protection for the lead underwriter as they perform their price stabilization function
  • In all IPO and SEO offerings but not in ordinary debt offerings

Lockup Agreements

  • Not legally required but common
  • Restricts insiders from selling IPO shares for a specified time period
    • Common lockup period = 180 days
  • Stock price tends to drop when the lockup period expires due to market anticipation of additional shares hitting the Street

Quiet Period

  • From initial contemplation of IPO to 40 days after the IPO
    • No non-ordinary announcements may be made
    • All relevant information about firm should be in prospectus
    • Fun fact: Google's IPO almost delayed due Brin and Page interview appearing in Playboy

IPOs and Underpricing

What is underpricing?

  • IPO pricing = very difficult
    • No current market price available
  • Dutch Auctions designed to eliminate first day IPO price "pop"
  • Underpricing causes the issuer to "leave money on the table"
  • Degree of underpricing varies over time

How severe is IPO underpricing?

Uber

IPO Underpricing Reasons

  • Underwriters want offerings to sell out
    • Reputation for successful IPOs is critical
    • Underpricing = insurance for underwriters
    • "Winner's Curse"
  • Smaller, riskier IPOs underprice to attract investors

Seasoned Equity Offering (SEO)

A new equity issue by a company that has previously issued securities to the public
  • Stock prices tend to decline when new equity is issued
  1. Signaling explanation
    • Equity overvalued: If management believes equity is overvalued, they would choose to issue stock shares.
    • Debt usage: Issuing stock may indicate firm has too much debt and can not issue more debt
  2. Issue costs for equity – direct and indirect - are significantly more than for debt

Costs of Issuing Securities

  1. Gross spread: direct fees paid
  2. Other direct expenses: filing fees, legal fees, taxes
  3. Indirect expenses: Cost of managements time
  4. Abnormal returns: Related to SEO price drop
  5. Underpricing: loss from selling below true value
  6. Green shoe option: selling additional shares at offer price

Cost Statistics

  • Total direct costs ≈ 10.4%
    • Direct costs very large, especially for issues < $\$$10 million (25.22%)
  • Underpricing cost ≈ 19.3%
  • Average spread = 7%
  • Patterns:
    • Substantial economies of scale
    • Costs of selling debt < issuing equity
    • IPO costs > SEO costs

IPO Examples

King Entertainment "Candy Crush" IPO

Uber

King Entertainment "Candy Crush" IPO

  • Received $\$$84 Million in VC financing (2 rounds)
  • Issue preliminary prospectus: 2/2014
  • Initial price range: $\$$21-24 a share
  • Revised price range: none

Twitter IPO

Uber

Twitter IPO

  • Received $\$$15 Billion in VC financing (13 rounds)
  • Issue preliminary prospectus: 10/2013
  • Initial price range: $\$$17-20 a share
  • Revised price range: $\$$23-25

King Entertainment "Candy Crush" IPO

  • King is issuing 7% of its stock
    • 70% offered by company
    • 30% offered by VC investors
    • Funds raised: $\$$350M
  • Market cap will be $7 billion

Twitter IPO

  • Twitter is issuing 15% of its stock
    • Funds raised: $\$$2 billion
  • Market cap will be $\$$13.6 billion
  • Currently unprofitable

King Entertainment "Candy Crush" IPO

  • King priced at $22.5/share
    • Spread was $1.29/share or 5.73%
    • King raised $21.21/share
  • First trade took place at 9:55am on 11/7/2013
    • $\$$20.50 (closed at $\$$19.70 a share)
    • Down 12.5% from IPO price
    • Acquired by Activision in 2016 for $\$$18 a share

Twitter IPO

  • Twitter priced at $\$$26/share
    • Spread was $\$$0.845/share or 3.25%
    • Twitter raised $\$$25.155/share
  • First trade took place at 10:50am 11/7/2013
    • $\$$45.10/share (closed at $\$$44.90)
    • Up 75.69% from IPO price
    • Assuming green shoe, TWTR will sell 80.5MM shares
  • Left $\$$1.6 billion on the table
  • Current price: $\$$32.95

Example Problems

Shares Needed

Nu Tech wants to raise $\$$21 million to purchase equipment by issuing new securities. Management estimates the issue will cost the firm $\$$320,000 for accounting, legal, and other costs. The underwriting spread is 7.5 percent and the issue price is $\$$21 per share. How many shares of stock must be sold if Nu Tech is to receive sufficient funds to purchase all the desired equipment? 

Flotation Costs

Entertainment 720 Inc went public under a firm commitment agreement. The company received $\$$32.75 for each of the 15 million shares sold. The offer price was set at $\$$36 per share and stock rose to $\$$39.74 on the first day of trading. Direct costs were $\$$1.2 million and indirect costs were $\$$520,000 What was the spread? What was the flotation cost as a percentage of funds raised?

Not covered

  • Rights
  • Dilution
  • Issuing Long-term Debt

Key Learning Outcomes

  • Venture Capital (Private Equity)
  • Selling Securities to the Public
    • IPOs and SEOs
    • Timeline
    • Underwriters
    • Underpricing
    • Terminology

Next time

Chapter 17: Dividends and Payout Policy