Chapter 15 – Raising Capital

1. Financing Lifecycle
- Venture capital
o Private financing for relatively new businesses
 Exchange for stock and a share of profits
 Entails hands on guidance
 Financing provided in stages
 Restrictions placed on management of the firm
 If successful, the company goes public and the vc benefits from the capital
raised in the process
o Who are the financiers?
 Specialized venture capital firms, financial and investments institutions,
and government agencies
 Angel investors – Wealthy individuals investing in the early stage
 Google, Comcast, Dell, Microsoft, etc., Have professional active venture
arms
 Recent phenomenon: Crowdfunding

Types of VC Companies
- Private independent firms
- Labour sponsored funds
- Corporate venture capital funds
- Government run funds
- Institutional funds

Stages of Development
- Seed stage  Start-up stage  Expansion stage  Acquisition/buyout stage 
Turnaround stage

Venture capital exits

- Acquisition by third party
- Merger with another party
- Company buys back by the entrepreneur
- Initial public offering
- Write off

Choosing a Venture Capitalist

- Financial strength
- Choose a VC that has a management style that is compatible with your own
- Obtain and check references
- What contacts does the VC have?
- What is the exit strategy?
 2. Raising Funds from Public & Role of Underwriters
- The Public issue
o Creation and sale of securities to be traded on the public markets
o All companies on the TSX comes under the Ontario Securities Commissions
(OSC) jurisdiction
o Once a firm decides to go public, the first step is to select the Underwriter –
Investments Bankers that help the company to sell their securities to the public
o Flotation costs
 Costs incurred when a firm issues new security to the public
 Includes commissions, legal, accounting, and other administrative costs

Selling Securities to the Public Steps

- Step 1: Management obtains permission from the Board of Directors
- Step 2: Firm prepares and distributes copies of a preliminary prospectus to the OSC and
to potential investors
o Formal summary providing information on an issue of securities
Warns investors about the risk involved on investment in the firm
- Step 3: Once the prospectus is approved, the price is determined, and security dealers
begin selling the new issue (primary market)
o SEDAR contains information on all newly issued securities

Alternate Issue Methods (Equity)

- For equity sales, there are two kinds of public issues:
o General Cash Offer – New securities offered for sale to the public on a cash basis
o Rights Offer – New securities are first offered to existing shareholders

General Cash offer: Types

- IPO – Initial Public Offering. A company’s first equity issue made available to the public
- SEO – Seasoned Equity Offering. A new issue for a company that has previously issued
securities to the public

Issuing New Securities – Methods

- Public
o Traditional negotiated cash offer
 Firm commitment
 Best efforts
 Dutch auction
o Privileged Subscription
 Direct rights offer
 Standby rights offer
o Non-traditional offer
 Shelf offer
 Competitive firm offers
- Private
o Direct placement
Underwriters/Investment Bankers
- Services provided by underwriters
o Formulates method to issue securities: Advice on when/hoe to issue securities
with what attributes
o Price the securities using
 Discounted cash flow calculations
 Comparable like P/E or P/S principal competitors
o Sell the securities
o Price stabilization
- How IBs take an issue to market
o Syndicate – forming a group of underwriters that market the securities and share
the risk associated with selling the issue
- How IBs are compensated
o Spread – difference between what the syndicate pays the company for the share
and what the security tells for in the market
o Management fee
o Selling concession

Firm Commitment Underwriting

- “Bought deal” where issuer firm sells entire issue to underwriting syndicate
- The syndicate then resells the issue to the public
- The underwriter makes money on the spread between the price paid to the issuer and the
price received from investors when the stock is sold
- The syndicate bears the risk of not being able to sell the entire issue for more than the
cost
- Most common type of underwriting in Canada
- Usually carried out for higher quality offerings and involves smaller offer price discount
and smaller underwriting fee

Best Efforts Underwriting

- Underwriting must make their “best efforts” to sell the securities at an agreed upon
offering price
- Underwriter agrees for a commission to sell as much of the issue as possible but does not
guarantee to sell the entire issue – issuing company bears the risk of the issue not being
sold
- The offer may be pulled if there is not enough interest at the offer price
o In such situation the company does not get the capital and they have still incurred
substantial flotation costs

Dutch Auction Underwriting

- “Uniform price auction”
- Underwriter conducts an auction and investors bid for shares
- Offer price is determined based on the submitted bids
o Highest bid price at which all intended shares are sold is the price that all winning
bidders pay
 o Shares distributed on a pro rata basis after the price is set and winners are
determined
- More commonly used in bond markets

Public Issue and Flotation Costs

Selling Period
- While the issue is being sold to the public the underwriting syndicate agrees not to sell
securities for less than the offering price until the syndicate dissolves
- The principal underwriter buys the shares of the market price falls below the offering
price to support the market and stabilize the price from temporary downward pressure
- If this issue remains unsold after a time members can leave the group and sell their shares
at whatever price the market allows

Overallotment Option/Green Shoe Provision

- Allows syndicate to purchase an additional 15% of the issue from the issuer
- Allows the issue to be oversubscribed
- Happens for ‘underpriced’ IPOs and ‘in-demand’ companies

Lockup Agreement
- Number of days insiders must wait after the IPO before they can sell stock
o 180 days
- To ensure that insiders maintain a significant economic interest in the company going
public
- Companies backed by the venture are likely to experience a loss in value on the lockup
expiration day as investors cash out

Quiet Period
- Period for which all communications with the public must be limited to ordinary
announcements and other purely factual matters after a new issue
o 10 days after IPO, 3 days after SEO
o Also, the time between submitting preliminary prospectus to OSC and its
acceptance
o The underwriter’s analysts are prohibited from making recommendations to
investors during quiet period
o End of quiet period leads to favourable “Buy” recommendation from managing
underwriters

IPO Underpricing
- IPOs are difficult to price because there isn’t a current market price available
- Additional asymmetric information associated with companies going public
- Underwriters want to ensure that their clients earn a good return on IPOs on average
- Underwriters also want to avoid being stuck with IPO shares in case the market thinks the
offer price is too high
- Underpricing = Price on the 1st day of secondary market trading – Offer price in IPS
Seasoned Equity Offering
- Stock prices tend to decline when new equity is issued
- Why?
o Managerial information and signaling
o Debt usage and signaling
o Issue costs
- Since the drop in price can be significant it is important for management to understand
the signals that are being sent and try to reduce the effect when possible

Empirical Evidence – Flotation Cost

- Substantial economies of side exist – larger firms can raise equity more easily and at a
lower cost
- The cost associated with underpricing can be substantial and can exceed the direct costs
- The issue cots are higher for an initial public offering than for a seasoned offering

Privileged Subscription: Rights Offering

- Company offers its shareholders the right to buy additional shares at subscription price
which is significantly below the market value of the shares
- Allows current shareholders top avoid the issue dilatation that occurs with the a new
stock issue
- “Rights” are given to the shareholders specifying
o Number of shares that can be purchased
o Purchase price
o Time frame
- Rights are separated from the stocks and usually trade on the same exchange as the
company’s stock

Who has the Rights?

- The firm announces the rights issue and set a holder of record date
o The date on which shareholders appearing on the company’s record are entitled to
receive the stock rights
o Two trading days before the holder of record date is the ex-rights date
 If the stock is sold before this date the new owner will receive the rights so
the price will be with rights
 If stock is solder after this date the buyer is not entitled to the rights – sold
ex-rights or without the right attached

Effects of Rights on Stock Prices

- Rights-on and Ex-rights price
- On the Ex-rights day the price of the stock will drop the value of the right on the day as
the stock no longer carriers the “right”
- Value of Right = Rights on price – Ex-rights price
o Value of Right, R0 = (M0 – S) / (N + 1)
 M0 = Rights on stock price
 S = Subscription Price
 N = Number of Rights to buy one new share
Value of a Right Nuances
- The price specified in a rights offering is generally less than the current market price
- The share price will adjust based on the number of new shares issued
- The interest shareholder will have to pay the subscription price and produce the requisite
number of rights to purchase one new share

Rights Offering Example

- Suppose a company wants to raise $5 million. The subscription price is $10, and the
current stock price is $20. The firm currently has 1,000,000 shares outstanding.
- How many shares must be issued?
o Number of shares = Funds to be raised/Subscription price = $5m/$10 = 500,000
- How many rights will it take to purchase one share?
o Number of rights to buy one new share = # of old shares /# of new shares =
1m/500,000 = 2
- What is the value of a right?
o R0 = (M0 – S)/(N+1) = (20 -10)/(2+1) = $3.33

Example: Rights Offering

ABC Corp currently has 9 million shares outstanding. The market price is $15 per share. ABC
decides to raise additional funds via a 1 for 3 rights offer at $12 per share. If we assume 100%
subscription, what is the value of each right?
- Market Value before rights offering = 9 mil  $15 = $135 mil
- New shares issued in rights offering = 9 mil/3 = 3 mil
- Total Shares after rights= 9 mil + 3 mil = 12 mil
- Amount of new funds = 3 mil  $12 = $36 mil
- Market value after the rights offering = $135 mil + 36 mil = $171 mil
- Share Price after rights offering = $171 mil/12 mil = $14.25 per share
- Value of a Right = Rights-on price – Ex-rights price = 15 - 14.25 = $0.75
o Alternatively, R0 = (M0 – S)/(N+1) = $(15 – 12)/(3+1) = $0.75

Standby Rights Offer

- Underwriter agrees to buy any shares that are not purchased through the rights offering
- Stockholders can either exercise their rights or sell them – they are not hurt by the rights
offering either way
- Company may give its shareholders an Oversubscription Privilege allowing them to
purchase any unsold shares at the subscription price

Types of Long-term Debt

- Public issue: Bonds
- Private issues
o Term loans
 Direct business loans from commercial banks, insurance companies, etc
 Maturities 1 – 5 years
 Repayable during life of the loan
o Syndicated Loans
 Very large loans
 Loans from a group of banks or other institutional investors
 May be a line of credit or fully used by the borrowing firm/country
 Rated investment grades
o Private Placements
 Longer maturity term loans
 Easier to renegotiate than public issues
 Lower cost than public issues