CHAPTER 1: Raising Equity Capital

Chapter 23
Raising
Equity Capital
Chapter Outline
23.1 Equity Financing for Private Companies
23.2 The Initial Public Offering
23.3 The Seasoned Equity Offering
Copyright 2014 Pearson Education, Inc. All rights reserved.
23-2
Learning Objectives
1. Describe four ways in which a private
company can raise outside capital.
2. Discuss the effects of a company founder
selling stock to an outsider.
3. Identify the two main exit strategies used
by equity investors in private companies.
4. Define an initial public offering, and
discuss their advantages and
disadvantages.
23-3
Learning Objectives (cont'd)

5. Distinguish between primary and
secondary offerings in an IPO.
6. Describe typical methods by which stock
may be sold during an IPO; discuss risks
for parties involved in
each method.
7. Evaluate the role of the underwriter in an
IPO.
23-4

8. Describe the IPO process, including the
methods underwriters use to value a
company before its IPO.
9. Identify ways in which underwriters can
mitigate risk during an IPO.
10.List and discuss four puzzles associated
with IPOs.
23-5

11.Define a seasoned equity offering,
describe two ways in which they are
brought to market, and identify the stock
price reaction to the announcement of a
seasoned equity offering.
23-6
23.1 Equity Financing

for Private Companies
The initial capital that is required to start a
business is usually provided by the
entrepreneur and their immediate family.
Often, a private company must seek
outside sources that can provide additional
capital for growth.
It is important to understand how the infusion of
outside capital will affect the control of the
company.
23-7
Sources of Funding
Angel Investors
Individual Investors who buy equity in small
private firms
Finding angels is typically difficult.
23-8
Sources of Funding (cont'd)

Venture Capital Firm
A limited partnership that specializes in raising
money to invest in the private equity of young
firms
Venture Capitalists
One of the general partners who work for and
run a venture capital firm
23-9

Venture capital firms offer limited partners
advantages over investing directly in startups themselves as angel investors.
Limited partners are more diversified.
They also benefit from the expertise of the
general partners.
23-10

The advantages come at a cost.
General partners usually charge substantial fees.
Most firms charge 20% of any positive return they
make.
They also generally charge an annual management fee
of about 2% of the funds committed capital.
23-11
Table 23.1 Most Active U.S. Venture

Capital Firms in 2011 (by number of deals
completed)
23-12
Figure 23.1 Venture Capital

Funding in the United States
Source: PricewaterhouseCoopers MoneyTree Report (https://www.pwcmoneytree.com)

23-13

Private Equity Firms
Organized very much like a venture capital firm,
but it invests in the equity of existing privately
held firms rather than start-up companies.
Private equity firms initiate their investment by
finding a publicly traded firm and purchasing the
outstanding equity, thereby taking the company
private in a transaction called a leveraged
buyout (LBO). In most cases, the private
equity firms use debt as well as equity to
finance the purchase.
23-14
Figure 23.2 Total U.S. LBO Volume

and Number of Deals
Source: Standard & Poors Leveraged Buyout Review
23-15
Table 23.2 Top 10 Private Equity

Funds in 2011
23-16

Institutional Investors
Institutional investors such as pension funds,
insurance companies, endowments, and
foundations are active investors in private
companies
Institutional investors may invest directly in private
firms or they may invest indirectly by becoming limited
partners in venture capital firms.
23-17

Corporate Investor
A corporation that invests in private companies
Also known as Corporate Partner, Strategic
Partner, and Strategic Investor
While most other types of investors in private firms are
primarily interested in the financial returns of their
investments, corporate investors might invest for
corporate strategic objectives, in addition to the
financial returns.
23-18
Outside Investors
Preferred Stock
Preferred stock issued by mature companies
usually has a preferential dividend and seniority
in any liquidation and sometimes special voting
rights.
Preferred stock issued by young companies has
seniority in any liquidation but typically does not
pay regular cash dividends and often contains a
right to convert to common stock.
23-19
Outside Investors (cont'd)

Convertible Preferred Stock
Preferred stock that gives the owner an option
to convert it into common stock on some future
date
23-20

RealNetworks, which was founded by
Robert Glaser in 1993, was initially funded
with an investment of approximately $1
million by Glaser.
As of April 1995, Glasers $1 million initial
investment in RealNetworks represented
13,713,439 shares of Series A preferred stock,
implying an initial purchase price of about $0.07
per share.
23-21

RealNetworks needed additional capital
and management decided to raise this
money by selling equity in the form of
convertible preferred stock.
The companys first round of outside equity
funding was Series B preferred stock.
RealNetworks sold 2,686,567 shares of Series B
preferred stock at $0.67 per share in April 1995.
After this funding round the distribution of
ownership was: (next slide)
23-22
23-23

The Series B preferred shares were new
shares of stock being sold by RealNetworks.
At the price the new shares were sold for,
Glasers shares were worth $9.2 million and
represented 83.6% of the outstanding
shares.
23-24

Pre-Money Valuation
At the issuance of new equity, the value of the
firms prior shares outstanding at the price in
the funding round
$9.2 million in the RealNetworks example
Post-Money Valuation
At the issue of new equity, the value of the
whole firm (old plus new shares) at the price the
new equity sold at
$11.0 million in the RealNetworks example
23-25

Over the next few years, RealNetworks
raised three more rounds of outside equity
in addition to the Series B funding round.
23-26
Exiting an Investment
in a Private Company
Exit Strategy
It details how investors will eventually realize
the return from their investment.
In July 1997, the post-money valuation of

existing preferred stock was $8.99 per
share.
However, because RealNetworks was still a
private company, investors could not liquidate
their investment by selling their stock in the
public stock markets.
23-27
Textbook Example 23.1
23-28
Textbook Example 23.1 (cont'd)
23-29
Alternative Example 23.1

Problem
Assume:
You founded your own firm two years ago.
You initially contributed $50,000 of your money and in
return received 1,000,000 shares of stock.
Since then, you have sold an additional 750,000 shares
to angel investors.
You are now considering raising even more capital from
a venture capitalist.
23-30

(contd)
Problem
Assume:
The venture capitalist would invest $2 million and
would receive 2,000,000 newly issued shares.
23-31

(contd)
Problem
What is the post-money valuation?
Assuming that this is the venture capitalists 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?
23-32

(contd)
Solution
Your shares
1,000,000
26.67%
750,000
20.00%
Venture capitalists shares
2,000,000
53.33%
Total shares outstanding
3,750,000
100.00%
Angel Investors Shares
The venture capitalist is paying $1 per share.

Thus, the post-money valuation is $3,750,000
You will own 26.67% of the firm and the postmoney valuation of your shares is $1,000,000.
23-33
23.2 The Initial Public Offering

Initial Public Offering (IPO)
The process of selling stock to the public for the
first time
23-34
Advantages and Disadvantages

of Going Public
Advantages:
Greater liquidity
Private equity investors get the ability to diversify.
Better access to capital

Public companies typically have access to much larger
amounts of capital through the public markets.
23-35
Advantages and Disadvantages

of Going Public (cont'd)
Disadvantages:
The equity holders become more widely
dispersed.
This makes it difficult to monitor management.
The firm must satisfy all of the requirements of

public companies.
SEC filings, Sarbanes-Oxley, etc.
23-36
Table 23.3
Issues
Largest Global Equity
23-37
Types of Offerings
Underwriter
An investment banking firm that manages a
security issuance and designs its structure
23-38
Types of Offerings (cont'd)

Primary and Secondary Offerings
Primary Offering
New shares available in a public offering that raise
new capital
Secondary Offering
Shares sold by existing shareholders in an equity
offering
23-39

Best-Efforts, Firm Commitment and Auction
IPOs
Best-Efforts Basis
For smaller IPOs, a situation in which the underwriter
does not guarantee that the stock will be sold, but
instead tries to sell the sock for the best possible price
Often such deals have an all-or-none clause: either all of
the shares are sold on the IPO or the deal is called off.
23-40

IPOs
Firm Commitment
An agreement between an underwriter and an issuing
firm in which the underwriter guarantees that it will sell
all of the stock at the offer price
23-41

IPOs
Auction IPO
A method of selling new issues directly to the public
Rather than setting a price itself and then allocating
shares to buyers, the underwriter in an auction IPO takes
bids from investors and then sets the price that clears
the market.
23-42
23-43
23-44

Problem
Ashton, Inc., is selling
900,000 shares of
stock in an auction
IPO.
At the end of the
bidding period,
Ashtons investment
bank has received the
following bids.
Price ($)
Number of
Shares Bid
$10.00
$9.75
175,000
200,000
$9.50
275,000
$9.25
275,000
$9.00
300,000
23-45

(contd)
Problem
What will the offer price of the shares be?
23-46

(contd)
Solution
The winning auction
price would be
$9.25.
Price ($)
Number of
Shares Bid
$10.00
$9.75
175,000
375,000
$9.50
650,000
$9.25
925,000
$9.00
1,225,000
23-47
The Mechanics of an IPO

Underwriters and the Syndicate
Lead Underwriter
The primary investment banking firm responsible for
managing a security issuance
Syndicate
A group of underwriters who jointly underwrite and
distribute a security issuance
23-48
Table 23.4 Global IPO Offerings by U.S.

Issuers, Ranked by 2011 Proceeds
23-49
The Mechanics of an IPO (cont'd)

SEC Filings
Registration Statement
A legal document that provides financial and other
information about a company to investors prior to a
security issuance
Preliminary Prospectus (Red Herring)

Part of the registration statement prepared by a
company prior to an IPO that is circulated to investors
before the stock is offered
23-50

SEC Filings
Final Prospectus
Part of the final registration statement prepared by a
company prior to an IPO that contains all the details of
the offering, including the number of shares offered
and the offer price
23-51
Figure 23.3
The Cover Page
of RealNetworks
IPO Prospectus
Source: Courtesy RealNetworks, Inc.

23-52

Valuation
There are two ways to value a company.
Compute the present value of the estimated future
cash flows.
Estimate the value by examining comparables
(recent IPOs).
23-53
23-54
23-55

Problem
RAXHouse is a private company considering going public.
RAXHouse has assets of $585 million and liabilities of
$415 million. The firms cash flow from operations was
$137 million for the previous year. After the IPO,
RAXHouse will have 118 million shares outstanding.
The industry average cash flow per share multiple is 3.0
and the average book value per share is 2.3.
Based on these multiples, estimate the IPO price for
RAXHouse.
23-56

(contd)
Solution
RAXHouses book value of equity is the difference between

the value of the assets ($585 million) and the value of the
liabilities ($415 million), or $170 million. With 118 million
shares outstanding, book value per share is $170
million/118 million shares = $1.44/share. Given the
industry average of 2.3, the estimated IPO price would be
$1.44 2.3 = $3.31 per share.
The firms cash flow from operations was $137 million,
thus cash flow per share is $137 million/118 million shares
= $1.16 per share. Given the industry average multiple
of 3.0, the estimated IPO price would be $1.16 3.0 =
$3.48.
23-57

Valuation
Road Show
During an IPO, when a companys senior management
and its underwriters travel around promoting the
company and explaining their rationale for an offer
price to the underwriters largest customers, mainly
institutional investors such as mutual funds and
pension funds
23-58

Valuation
Book Building
A process used by underwriters for coming up with an
offer price based on customers expressions of interest
23-59

Pricing the Deal and Managing Risk
Spread
The fee a company pays to its underwriters that is a
percentage of the issue price of a share of stock
For RealNetworks, the final offer price was $12.50 per
share and the company paid the underwriters a spread of
$0.875 per share, exactly 7% of the issue price.
Since this was a firm commitment deal, the underwriters
bought the stock from RealNetworks for $11.625 per
share and then resold it to their customers for $12.50 per
share.
$12.50 $0.875 = $11.625
23-60

When an underwriter provides a firm
commitment, it is potentially exposing itself to
the risk that the banking firm might have to sell
the shares at less than the offer price and take a
loss.
However, research shows that 75% of IPOs experience
an increase in share price on the first day (only 9%
experience a decrease).
23-61

Over-Allotment Allocation (Greenshoe Provision)
In an IPO, an option that allows the underwriter to
issue more stock, usually amounting to 15% of the
original offer size, at the IPO offer price
23-62

RealNetworks IPO had a greenshoe provision.
The prospectus specified that 3 million shares would be
offered at $12.50 per share. In addition, the greenshoe
provision allowed for the issue of an additional 450,000
shares at $12.50 per share.
23-63

Underwriters initially market both the initial
allotment and the allotment in the greenshoe
provision by short selling the greenshoe
allotment.
If the issue is a success, the underwriter exercises the
greenshoe option, thereby covering its short position.
If the issue is not a success, the underwriter covers the
short position by repurchasing the greenshoe allotment
in the aftermarket, thereby supporting the price.
23-64

Lockup
A restriction that prevents existing shareholders from
selling their shares for some period, usually 180 days,
after an IPO
23-65
IPO Puzzles
Underpricing
Generally, underwriters set the issue price so
that the average first-day return is positive.
As mentioned previously, research has found that 75%
of first-day returns are positive.
The average first day return in the United States is
18.3%.
23-66
IPO Puzzles (cont'd)

Underpricing
The underwriters benefit from the underpricing
as it allows them to manage their risk.
The pre-IPO shareholders bear the cost of
underpricing. In effect, these owners are selling
stock in their firm for less than they could get in
the aftermarket.
23-67
Figure 23.4
International
Comparison
of First Day
IPO Returns
23-68

Underpricing
Although IPO returns are attractive, all investors
cannot earn these returns.
When an IPO goes well, the demand for the stock
exceeds the supply. Thus the allocation of shares for
each investor is rationed.
When an IPO does not go well, demand at the issue
price is weak, so all initial orders are filled completely.
Thus, the typical investor will have their investment in
good IPOs rationed while fully investing in bad IPOs.
23-69

Underpricing
Winners Curse
Refers to a situation in competitive bidding when the
high bidder, by virtue of being the high bidder, has
very likely overestimated the value of the item being
bid on
You win (get all the shares you requested) when
demand for the shares by others is low, and the IPO is
more likely to perform poorly.
23-70
23-71
23-72
Cyclicality
The number of issues is highly cyclical.
When times are good, the market is flooded with
new issues; when times are bad, the number of
issues dries up.
23-73
Figure 23.5 Cyclicality of Initial

Public Offerings in the United States
23-74
Costs of an IPO
A typical spread is 7% of the issue price.
By most standards this fee is large, especially
considering the additional cost to the firm
associated with underpricing.
It is puzzling that there seems to be a lack of
sensitivity of fees to issue size.
One possible explanation is that by charging lower
fees, an underwriter may risk signaling that it is not
the same quality as its higher-priced competitors.
23-75
Figure 23.6 Relative Costs of

Issuing Securities
Source: Adapted from I. Lee, S. Lochhead, J. Ritter, and Q. Zhao, The Costs of Raising
Capital, Journal of Financial Research 19(1) (1996): 5974.
23-76
Long-Run Underperformance
Although shares of IPOs generally perform
very well immediately following the public
offering, it has been shown that newly
listed firms subsequently appear to perform
relatively poorly over the following three to
five years after their IPOs.
23-77
23.3 The Seasoned Equity

Offering
Seasoned Equity Offering (SEO)
When a public company offers new shares for
sale
Public firms use SEOs to raise additional equity.
When a firm issues stock using an SEO, it follows many
of the same steps as for an IPO.
The main difference is that a market price for the stock
already exists, so the price-setting process is not
necessary.
23-78
The Mechanics of an SEO

Primary Shares
New shares issued by a company in an equity
offering
Secondary Shares
Shares sold by existing shareholders in an
equity offering
Tombstones
A newspaper advertisement in which an
underwriter advertises a security issuance
23-79
The Mechanics of an SEO (cont'd)

There are two types of seasoned equity
offerings.
Cash Offer
A type of SEO in which a firm offers the new shares to
investors at large
Rights Offer
A type of SEO in which a firm offers the new shares
only to existing shareholders
Rights offers protect existing shareholders from
underpricing.
23-80
23-81
23-82
Price Reaction
Researchers have found that, on average,
the market greets the news of an SEO with
a price decline.
This is consistent with the adverse selection
discussed in Chapter 16.
23-83
Figure 23.7 Post-SEO Performance
Source: Adapted from A. Brav, C. Geczy, and P. Gompers, Is the Abnormal Return Following
Equity Issuances Anomalous, Journal of Financial Economics 56 (2000): 209249, Figure 3.
23-84
Issuance Costs
Although not as costly as IPOs, seasoned
offerings are still expensive.
Underwriting fees amount to 5% of the proceeds
of the issue.
Rights offers have lower costs than cash offers.
23-85
Chapter Quiz
1. What are the main sources of funding for
private companies to raise outside equity?
2. What is a venture capital firm?
3. What are some of the advantages and
disadvantages of going public?
4. List and discuss four IPO puzzles.
5. What is the difference between a cash
offer and a rights offer for a seasoned
equity offering?
23-86

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Chapter 23

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Learning Objectives (cont'd)

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Learning Objectives (cont'd)

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Learning Objectives (cont'd)

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23.1 Equity Financing

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Sources of Funding (cont'd)

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Sources of Funding (cont'd)

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Sources of Funding (cont'd)

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Table 23.1 Most Active U.S. Venture

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Figure 23.1 Venture Capital

Source: PricewaterhouseCoopers MoneyTree Report (https://www.pwcmoneytree.com)

Sources of Funding (cont'd)

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Figure 23.2 Total U.S. LBO Volume

Source: Standard & Poors Leveraged Buyout Review

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Table 23.2 Top 10 Private Equity

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Sources of Funding (cont'd)

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Sources of Funding (cont'd)

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Outside Investors (cont'd)

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Outside Investors (cont'd)

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Outside Investors (cont'd)

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Outside Investors (cont'd)

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Outside Investors (cont'd)

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Outside Investors (cont'd)

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Outside Investors (cont'd)

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In July 1997, the post-money valuation of

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Textbook Example 23.1

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Textbook Example 23.1 (cont'd)

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Alternative Example 23.1

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Alternative Example 23.1

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Alternative Example 23.1

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Alternative Example 23.1

Venture capitalists shares

Total shares outstanding

Angel Investors Shares

The venture capitalist is paying $1 per share.