How Companies Raise Long-Term Capital

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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 founders 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 firms 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. Whats the value of a right?
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Right Offering - An Example
The value of a right is R (P-S)/(N1) 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)/(41) 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.