Chapter 20

Raising Capital

Copyright 2015 by the McGraw-Hill Education (Asia). All rights reserved.

Key Concepts and Skills
Understand the venture capital market and its
role in financing new businesses
Understand how securities are sold to the
public and the role of investment bankers
Understand initial public offerings and the
costs of going public
Understand the process of secondary offerings
and the impact of dilution
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Chapter Outline
20.1 Early-Stage Financing and Venture Capital
20.2 The Public Issue
20.3 Alternative Issue Methods
20.4 The Cash Offer
20.5 The Announcement of New Equity and the Value of the Firm
20.6 The Cost of New Issues
20.7 Rights
20.8 The Rights Puzzle
20.9 Dilution
20.10 Shelf Registration
20.11 Issuing Long-Term Debt
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Venture Capitalists (VCs)
Financial intermediaries that are typically set
up as limited partnerships
Play an active role in overseeing, advising,
and monitoring companies in which they
invest
Generally do not want to own the investment
forever

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Stages of Financing
1. Seed-Money Stage
2. Start-Up
3. First-Round Financing
4. Second-Round Financing
5. Third-Round Financing
6. Fourth-Round Financing

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20.2 The Public Issue
The Basic Procedure In The U.S.
Management gets the approval of the Board.
The firm prepares and files a registration
statement with the SEC.
The SEC studies the registration statement
during the waiting period.
The firm prepares and files an amended
registration statement with the SEC.
If everything is satisfactory with the SEC, a price
is set and a full-fledged selling effort gets
underway.
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The Process of a Public Offering
Steps in Public Offering Time
1. Pre-underwriting conferences Several months
2. Registration statements 20-day waiting period
3. Pricing the issue Usually on the 20th day
4. Public offering and sale After the 20th day
5. Market stabilization 30 days after offering

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An Example of a Tombstone

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20.3 Alternative Issue Methods
There are two kinds of public issues:
The general cash offer
The rights offer

Almost all debt is sold in general cash

offerings.

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Table 20.1 - I

20-9
Table 20.1 - II

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20.4 The Cash Offer
There are three methods for issuing securities
for cash:
Firm Commitment
Best Efforts
Dutch Auction
There are two methods for selecting an
underwriter
Competitive
Negotiated

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Firm Commitment Underwriting
The issuing firm sells the entire issue to the
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.
This is the most common type of underwriting in the
United States.

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Best Efforts Underwriting
Underwriter must make their best effort to sell the
securities at an agreed-upon offering price.
The 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. The company does not get the
capital, and they have still incurred substantial
flotation costs.
This type of underwriting is not as common as it used
to be.

20-13
Dutch Auction Underwriting
Underwriter accepts a series of bids that include
number of shares and price per share.
The price that everyone pays is the highest price that
will result in all shares being sold.
There is an incentive to bid high to make sure you get
in on the auction but knowing that you will probably
pay a lower price than you bid.
The Treasury has used Dutch auctions for years.
Google was the first large Dutch auction IPO.

20-14
Investment Banks
Also called underwriters
Perform critical functions:
Help determine type of security, method of sale, and
offering price
Sell the securities
Typically using a syndicate to limit risk
For compensation the spread
Stabilize IPO prices in the aftermarket

20-15
IPO Underpricing
May be difficult to price an IPO because there is
not a current market price available.
Private companies tend to have more asymmetric
information than companies that are already
publicly traded.
Underwriters want to ensure that, on average,
their clients earn a good return on IPOs.
Underpricing causes the issuer to leave money
on the table.

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IPO Underpricing In Asia And Various
Countries

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20.5 The Announcement of New
Equity and the Value of the Firm
The market value of existing equity drops on the
announcement of a new issue of common stock.
Reasons include
Managerial Information
Since the managers are the insiders, perhaps they are
selling new stock because they think it is overpriced.
Debt Capacity
If the market infers that the managers are issuing new
equity to reduce their debt-equity ratio due to the specter
of financial distress, the stock price will fall.
Issue Costs 20-18
20.6 The Cost of New Issues
1. Gross spread, or underwriting discount
2. Other direct expenses
3. Indirect expenses
4. Abnormal returns
5. Underpricing
6. Green Shoe Option

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The Costs of Equity Public Offerings
Proceeds Direct Costs Underpricing
(in millions) SEOs IPOs IPOs
2 - 9.99 35.11% 25.22% 20.42%
10 - 19.99 13.86% 14.69% 10.33%
20 - 39.99 9.54% 14.03% 17.03%
40 - 59.99 13.96% 9.77% 28.26%
60 - 79.99 6.85% 8.94% 28.36%
80 - 99.99 6.72% 8.55% 32.92%
100 - 199.99 5.23% 7.96% 21.55%
200 - 499.99 4.94% 6.84% 6.19%
500 and up 3.37% 5.50% 6.64%` 20-20
20.7 Rights
If a preemptive right is contained in the firms
articles of incorporation, the firm must offer
any new issue of common stock first to
existing shareholders.
This allows shareholders to maintain their
percentage ownership if they so desire.

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Mechanics of Rights Offerings
The management of the firm must decide:
The exercise price (the price existing shareholders
must pay for new shares).
How many rights will be required to purchase one
new share of stock.
These rights have value:
Shareholders can either exercise their rights or sell
their rights.

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Rights Offering Example
Popular Delusions, Inc. is proposing a rights
offering. There are 200,000 shares outstanding
trading at $25 each. There will be 10,000 new
shares issued at a $20 subscription price.
What is the new market value of the firm?

What is the ex-rights price?

What is the value of a right?

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What is the new market value of the firm?
$25 $20
$5,200,000 200,000 shares 10,000 shares
share shares

There are 200,000 There will be 10,000 new

outstanding shares at shares issued at a $20
$25 each. subscription price.

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What Is the Ex-Rights Price?
There are 210,000 outstanding shares of a
firm with a market value of $5,200,000.
Thus the value of an ex-rights share is:

$5,200,000
= $24.7619
210,000 shares
And, the value of a right is:
$0.2381 = $25 $24.7619

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Alternative Way to Compute the Ex-
Rights Price and Value of a Right
10,000 new shares will be issued for 200,000
outstanding shares, or this is a 1 for 20 rights issue
Hence we have:
20 shares @ $25 = $500
plus 1 share @ $20 = $20
equals 21 shares with value of $520
so price of 1 share ex-rights $520/21 = $24.7619

Value of 1 right = $25 - $24.7619 = $0.2381

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20.8 The Rights Puzzle
The vast majority of new issues in the U.S. are
underwritten, even though rights offerings are much
cheaper.
A few explanations:
Underwriters increase the stock price. There is not much
evidence for this, but it sounds good.
The underwriter provides a form of insurance to the issuing
firm in a firm-commitment underwriting.
Underwriters certify the price to the market.
The proceeds from underwriting may be available sooner
than the proceeds from a rights offering.
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20.9 Dilution
Dilution is a loss in value for existing
shareholders:
Percentage ownership shares sold to the
general public without a rights offering
Market value firm accepts negative NPV
projects
Earnings per share may decline even with
positive NPV projects (at least in short run)
Book value occurs when market-to-book value
is less than one
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20.10 Shelf Registration
Permits a corporation to register an offering that it
reasonably expects to sell within the next two
years.
Not all companies are allowed shelf registration.

Qualifications include:
The firm must be rated investment grade.
They cannot have recently defaulted on debt.
The market capitalization must be > $150 m.
No recent SEC violations.
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20.11 Issuing Long-Term Debt
Public issuance follows the same general
process as stocks
Direct financing
Term loans
Private placements
Direct financing may have more restrictive
covenants and higher rates, but is less costly to
issue and easier to negotiate.

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Quick Quiz
What is venture capital, and what types of firms receive
it?
What are some of the important services provided by
underwriters?
What type of underwriting is the most common in the
United States, and how does it work?
What is IPO underpricing, and why might it persist?
What are some of the costs associated with issuing
securities?
What is a rights offering, and how do you value a right?
What is shelf registration?
What are the advantages of direct financing as opposed to
public issuance of long-term debt?
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