FINS3625 Applied Corporate Finance

Lecture 6 (Chapter 14) Jared Stanfield April 4, 2012

14.1 Equity Financing for Private Companies • Sources of Funding:

– A private company can seek funding from several potenNal sources:

• Angel Investors • Venture Capital Firms • InsNtuNonal Investors • Corporate Investors

14.1 Equity Financing for Private Companies • Angel Investors: – Individual investors who buy equity in small private firms – The first round of outside private equity financing is oSen obtained from angels

14.1 Equity Financing for Private Companies • Venture Capital Firms: – Specialize in raising money to invest in the private equity of young firms – In return, venture capitalists oSen demand a great deal of control of the company

Figure 14.1 Most AcNve U.S. Venture Capital Firms in 2009 (by Number of Deals Completed

Figure 14.2 Venture Capital Funding in the United States

14.1 Equity Financing for Private Companies • InsNtuNonal Investors: – Pension funds, insurance companies, endowments, and foundaNons • May invest directly

• May invest indirectly by becoming limited partners in venture capital firms

14.1 Equity Financing for Private Companies • Corporate Investors: – Many established corporaNons purchase equity in younger, private companies • corporate strategic objecNves • desire for investment returns

14.1 Equity Financing for Private Companies • SecuriNes and ValuaNon – When a company decides to sell equity to outside investors for the first Nme, it is typical to issue preferred stock rather than common stock to raise capital • It is called converNble preferred stock if the owner can convert it into common stock at a future date

Funding and Ownership Problem:

• You founded your own firm three years ago. You iniNally contributed $500,000 of your money and, in return received 100,000 shares of stock. Since then, you have sold an addiNonal 50,000 shares to angel investors. You are now considering raising even more capital from a venture capitalist (VC).

Funding and Ownership Problem (cont’d): • This VC would invest $15 million and would receive 1,000,000 newly issued shares. What is the post-­‐money valuaNon? Assuming that this is the VC’s first investment in your company, what percentage of the firm will he end up owning? What percentage will you own? What is the value of your shares?

Funding and Ownership SoluNon: Plan:

• ASer this funding round, there will be a total of 1,550,000 shares outstanding:

Your shares

500,000

Angel investors’ shares

50,000

Newly issued shares

1,000,000

Total

1,550,000

Funding and Ownership Plan (cont’d):

• The VC is paying $15,000,000/1,000,000=$15/share. The post-­‐money valuaNon will be the total number of shares mulNplied by the price paid by the VC. The percentage of the firm owned by the VC is his shares divided by the total number of shares. Your percentage will be your shares divided by the total shares and the value of your shares will be the number of shares you own mulNplied by the price the VC paid.

Funding and Ownership Execute: • There are 1,550,000 shares and the VC paid $15 per share. Therefore, the post-­‐money valuaNon would be 1,550,000($15) = $23,250,000. • Because he is buying 1,000,000 shares, and there will be 1,550,000 total shares outstanding aSer the funding round, the VC will end up owning 1,000,000/1,550,000=64.5% of the firm. • You will own 500,000/1,550,000=32.3% of the firm, and the post-­‐money valuaNon of your shares is 500,000($15) = $7,500,000.

Funding and Ownership Evaluate: • Funding your firm with new equity capital, be it from an angel or venture capitalist, involves a tradeoff—you must give-­‐up part of the ownership of the firm in return for the money you need to grow. The higher is the price you can negoNate per share, the smaller is the percentage of your firm you have to give up for a given amount of capital.

14.1 Equity Financing for Private Companies • ExiNng an Investment in a Private Company • AcquisiNon • Public Offering

14.2 Taking Your Firm Public: The IniNal Public Offering • The process of selling stock to the public for the first Nme is called an iniNal public offering (IPO)

Table 14.1 Largest Global Equity Issues, 2009

14.2 Taking Your Firm Public: The IniNal Public Offering • Advantages and Disadvantages of Going Public

– Advantages: • Greater liquidity • Beier access to capital

– Disadvantages: • Equity holders more dispersed • Must saNsfy requirements of public companies

14.2 Taking Your Firm Public: The IniNal Public Offering • IPOs include both Primary and Secondary offerings • Underwriters and the Syndicate – Underwriter: an investment banking firm that manages the offering and designs its structure • Lead Underwriter

– Syndicate: other underwriters that help market and sell the issue

Table 14.2 InternaNonal IPO Underwriter Ranking Report for 2007

14.2 Taking Your Firm Public: The IniNal Public Offering • SEC Filings – RegistraNon Statement • preliminary prospectus or red herring

– Final Prospectus

14.2 Taking Your Firm Public: The IniNal Public Offering • ValuaNon – Underwriters work with the company to come up with a price • EsNmate the future cash flows and compute the present value • Use market mulNples approach

– Road Show – Book Building

Valuing an IPO Using Comparables Problem: • Wagner, Inc., is a private company that designs, manufactures, and distributes branded consumer products. During the most recent fiscal year, Wagner had revenues of $200 million and earnings of $15 million. Wagner has filed a registraNon statement with the SEC for its IPO.

Valuing an IPO Using Comparables Problem (cont'd): • Before the stock is offered, Wagner’s investment bankers would like to esNmate the value of the company using comparable companies. The investment bankers have assembled the following informaNon based on data for other companies in the same industry that have recently gone public. In each case, the raNos are based on the IPO price.

Valuing an IPO Using Comparables Problem (cont'd)

Company Ray Products Corp. Byce-Frasier Inc. Fashion Industries Group Recreation International Average Price/Earnings 17.5× 14.4× 14.9× 13.3× 15.0× Price/Revenues 2.1× 2.3× 1.3× 2.7× 2.1×

• ASer the IPO, Wagner will have 30 million shares outstanding. EsNmate the IPO price for Wagner using the price/earnings raNo and the price/ revenues raNo.

Valuing an IPO Using Comparables SoluNon: Plan: • If the IPO price of Wagner is based on a price/earnings raNo that is similar to those for recent IPOs, then this raNo will equal the average of recent deals. Thus, to compute the IPO price based on the P/E raNo, we will first take the average P/E raNo from the comparison group and mulNply it by Wagner’s total earnings. This will give us a total value of equity for Wagner. To get the per share IPO price, we need to divide the total equity value by the number of shares outstanding aSer the IPO (30 million). The approach will be the same for the price-­‐to-­‐revenues raNo.

Valuing an IPO Using Comparables Execute: • The average P/E raNo for recent deals is 15.0. Given earnings of $25 million, we esNmate the total market value of Wagner’s stock to be ($25 million)(15.0) = $375 million. With 30 million shares outstanding, the price per share should be $375 million / 30 million = $12.50. • Similarly, if Wagner’s IPO price implies a price/revenues raNo equal to the recent average of 2.1, then using its revenues of $200 million, the total market value of Wagner will be ($200 million)(2.1) = $420 million, or ($420/30)= $14.00/share

Valuing an IPO Using Comparables Evaluate: • As we found in Chapter 10, using mulNples for valuaNon always produces a range of esNmates—you should not expect to get the same value from different raNos. Based on these esNmates, the underwriters will probably establish an iniNal price range for Wagner stock of $12 to $15 per share to take on the road show.

14.2 Taking Your Firm Public: The IniNal Public Offering • Pricing the Deal and Managing Risk – Firm Commitment IPO: the underwriter guarantees that it will sell all of the stock at the offer price – Over-­‐allotment allocaNon, or Greenshoe provision: allows the underwriter to issue more stock, amounNng to 15% of the original offer size, at the IPO offer price

14.2 Taking Your Firm Public: The IniNal Public Offering • Other IPO Types

– Best-­‐Efforts Basis: the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price – AucNon IPO: The company or its investment bankers aucNon off the shares, allowing the market to determine the price of the stock

Figure 14.4 AggregaNng the Shares Sought in the HypotheNcal AucNon IPO

AucNon IPO Pricing Problem:

• Fleming EducaNonal SoSware, Inc., is selling 1,000,000 shares of stock in an aucNon IPO. At the end of the bidding period, Fleming’s investment bank has received the following bids: Price ($) Number of Shares Bid 20.00 250,000 19.50 225,000 19.00 175,000 18.50 200,000 18.00 150,000 17.50 125,000 17.00 75,000

• What will the offer price of the shares be?

AucNon IPO Pricing SoluNon: Plan:

• First, we must compute the total number of shares demanded at or above any given price. Then, we pick the lowest price that will allow us to sell the full issue (1,000,000 shares).

AucNon IPO Pricing Execute:

• Convert the table of bids into a table of cumulaNve demand: Price ($) Cumulative Demand 20.00 250,000 19.50 475,000 19.00 650,000 18.50 850,000 18.00 1,000,000 17.50 1,125,000 17.00 1,200,000

AucNon IPO Pricing Execute (cont'd): • For example, the company has received bids for a total of 725,000 shares at $19.50 per share or higher (250,000 + 225,000 = 475,000). • Fleming is offering a total of 1,000,000 shares. The winning aucNon price would be $18.00 per share, because investors have placed orders for a total of 1,000,000 shares at a price of $18.00 or higher. All investors who placed bids of at least this price will be able to buy the stock for $18.00 per share, even if their iniNal bid was higher.

AucNon IPO Pricing Execute (cont'd): • In this example, the cumulaNve demand at the winning price exactly equals the supply. If total demand at this price were greater than supply, all aucNon parNcipants who bid prices higher than the winning price would receive their full bid (at the winning price). Shares would be awarded on a pro rata basis to bidders who bid exactly the winning price.

AucNon IPO Pricing Evaluate: • While the aucNon IPO does not provide the certainty of the firm commitment, it has the advantage of using the market to determine the offer price. It also reduces the underwriter’s role, and consequently, fees.

Table 14.4 Summary of IPO Methods

14.3 IPO Puzzles • Four IPO puzzles: – Underpricing of IPOs – “Hot” and “Cold” IPO markets – High underwriNng costs – Poor long-­‐run performance of IPOs

14.3 IPO Puzzles • Underpriced IPOs – On average, between 1960 and 2003, the price in the U.S. aSermarket was 18.3% higher at the end of the first day of trading • Who wins and who loses because of underpricing?

Figure 14.5 InternaNonal Comparison of First-­‐Day IPO Returns

14.3 IPO Puzzles • “Hot” and “Cold” IPO Markets – It appears that the number of IPOs is not solely driven by the demand for capital. – SomeNmes firms and investors seem to favor IPOs; at other Nmes firms appear to rely on alternaNve sources of capital

Figure 14.6 Cyclicality of IniNal Public Offerings in the United States, (1980-­‐2009)

14.3 IPO Puzzles • High Cost of Issuing an IPO – In the U.S., the discount below the issue price at which the underwriter purchases the shares from the issuing firm is 7% of the issue price. – This fee is large, especially considering the addiNonal cost to the firm associated with underpricing.

Figure 14.7 RelaNve Costs of Issuing SecuriNes

14.3 IPO Puzzles • Poor Post-­‐IPO Long-­‐Run Stock Performance – Newly listed firms appear to perform relaNvely poorly over the following three to five years aSer their IPOs – That underperformance might not result from the issue of equity itself, but rather from the condiNons that moNvated the equity issuance in the first place

14.4 Raising AddiNonal Capital: The Seasoned Equity Offering • A firm’s need for outside capital rarely ends at the IPO – Seasoned Equity Offering (SEO): firms return to the equity markets and offer new shares for sale

14.4 Raising AddiNonal Capital: The Seasoned Equity Offering • SEO Process – When a firm issues stock using an SEO, it follows many of the same steps as for an IPO. – Main difference is that the price-­‐seqng process is not necessary. • Tombstones

14.4 Raising AddiNonal Capital: The Seasoned Equity Offering • Two kinds of seasoned equity offerings:

– Cash offer – Rights offer

Raising Money with Rights Offers Problem:

• You are the CFO of a company that has a market capitalizaNon of $5 billion. The firm has 250 million shares outstanding, so the shares are trading at $20 per share. You need to raise $500 million and have announced a rights issue. Each exisNng shareholder is sent one right for every share he or she owns.

Raising Money with Rights Offers Problem (cont'd): • You have not decided how many rights you will require to purchase a share of new stock. You will require either five rights to purchase one share at a price of $10 per share, or ten rights to purchase three new shares at a price of $6.67 per share. Which approach will raise more money?

Raising Money with Rights Offers SoluNon: Plan:

• In order to know how much money will be raised, we need to compute how many total shares would be purchased if everyone exercises their rights. Then we can mulNply it by the price per share to calculate the total amount raised.

Raising Money with Rights Offers Execute:

• There are 250 million shares, each with one right aiached. In the first case, 5 rights will be needed to purchase a new share, so 250 million / 5 = 50 million new shares will be purchased. At a price of $10 per share, that would raise $10 x 50 million = $500 million.

Raising Money with Rights Offers Execute (cont’d):

• In the second case, for every 10 rights, 3 new shares can be purchased, so there will be 3 x (250 million / 10) = 75 million new shares. At a price of $6.67 per share, that would also raise $500 million. If all shareholders exercise their rights, both approaches will raise the same amount of money.

Raising Money with Rights Offers Evaluate:

• In both cases, the value of the firm aSer the issue is $5.5 billion. In the first case, there are 300 million shares outstanding aSer the issue, so the price per share aSer the issue is $5.5 billion / 300 million = $18.33. This price exceeds the issue price of $10, so the shareholders will exercise their rights. Because exercising will yield a profit of ($18.33 – $10.00)/5 = $1.67 per right, the total value per share to each shareholder is $18.33 + 1.67 = $20.00.

Raising Money with Rights Offers Evaluate (cont'd):

• In the second case, the number of shares outstanding will grow to 325 million, resulNng in a post-­‐issue stock price of $5.5 billion / 325 million shares = $16.92 per share (also higher than the issue price). Again, the shareholders will exercise their rights, and receive a total value per share of $16.92 + 3($16.92 -­‐ $6.67)/10 = $20.00. Thus, in both cases the same amount of money is raised and shareholders are equally well off.

14.4 Raising AddiNonal Capital: The Seasoned Equity Offering • Researchers have found that, on average, the market greets the news of an SEO with a price decline (about 1.5%) – OSen the value lost can be a significant fracNon of the new money raised – Adverse selecNon (the lemons problem)

14.4 Raising AddiNonal Capital: The Seasoned Equity Offering • SEO Costs – In addiNon to the price drop when the SEO is announced, the firm must pay direct costs as well. UnderwriNng fees amount to 5% of the proceeds of the issue