Chapter 13 - Raising Equity Capital

Equity Financing for Private Companies
Any initial capital that is required to start a business is usually provided by the entrepreneur or immediate family. The ability of these individuals to continue funding their business as it grows becomes problematic. There are several other options that can be taken to raise capital for your business.

Sources of Funding
Angel Investors: Individual investors who buy equity in small private firms. These individuals are often friends or acquaintances of the business owner. Angel investors typically receive a large equity share in the business in return for their financing. Because of their large share of ownership in the business, they can have substantial influence on business decisions that take place. They can also bring expertise to the firm. Finding angels to fund your business can be a difficult process... it often comes down to how well connected you are within the surrounding community.

Venture Capital Firms: A limited partnership that specializes in raising money to invest in the private equity of young firms. Institutional investors (pension funds) are limited partners in the venture capital firm. The general partners are called venture capitalists. They work for and run the venture capital firm. Limited partners are more diversified than if they invested on their own. They also benefit from the expertise of the general partners. General partners usually charge significant fees as well as an annual management fee. Because venture capital firms can provide large amounts of capital to young firms, they often demand a great deal of control. These use this control to protect their investments.

Institutional Investors: Institutional investors are often pension funds, insurance companies, endowments, and foundations which manage large quantities of money. They may choose to invest directly in private firms or they may indirectly invest by becoming limited partners in venture capital firms.

Corporate Investors: A corporation that invests in private companies. Corporate investors are also known as corporate partners, strategic partners, and strategic investors. While other investors usually invest in young firms for the return, corporate investors invest for the corporate strategic objectives as well as the returns.

Securities and Valuation
Companies often issue preferred stock when selling equity to outside investors for the first time. Preferred stock has a preferential dividend and seniority when it comes to liquidation of the company. It also can have special voting rights. The downside is that preferred stock usually does not pay regular dividends. Preferred stock usually comes with the option to convert it into common stock in the future. This is is known as convertible preferred stock.

Just because a company sells equity to outside investors does not mean that the company is public. Companies can still be private which means that they do not have to file financials with the SEC and they are not listed on an exchange. When companies do issue new equity, the value of the prior shares outstanding at the price in the funding round is known as the pre-money valuation. The value of the whole firm at the funding round price is known as the post-money valuation.

Exiting an Investment in a Private Company
It is important for investors in private firms to consider how they will exit the firm. This is known as their exit strategy - how they will eventually realize the return from their investment. This can be done in two ways: through an acquisition or through a public offering.

Taking Your Firm Public: The Initial Public Offering
An initial public offering (IPO) is the process of selling stock to the public for the first time.

Advantages and Disadvantages of Going Public
Going public provides a company with greater liquidity and better access to capital. Private equity investors are able to diversify their investment. Companies will also have access to larger amounts of capital through the public market. However, the major advantage of an IPO is also its disadvantage. When investors sell their stake and diversify their holdings, the equity holders of the corporation become more dispersed which makes the company more difficult to manage. In addition, a public company must comply with all the legal requirements set forth by the SEC and Sarbanes Oxley.

Primary and Secondary IPO Offerings
When a company decides to go public, they often work with an underwriter which is an investment banking firm that manages the security issuance and designs its structures. The shares that are sold during an IPO can be new shares that raise new capital (primary offering) or existing shares that are sold by current shareholders (secondary offering).

The lead underwriter is the primary banking firm responsible for managing the security issuance. He provides most of the advice on the sale and arranges for a group of other underwriters (syndicates) to help market and sell the issue. Underwriters market the IPO and help with all the filing requirements. They also help determine the offer price.

The SEC requires that companies prepare a registration statement which is a legal document that provides financial and other important information about the company to investors prior to the IPO. Part of this statement is known as the preliminary prospectus or red herring. This circulates to investors before the stock is offered and is only preliminary... it is not an offer to sell the shares. Once the SEC reviews the registration statement, the company prepares a final registration statement including the final prospectus which contains all the details of the IPO (number of shares offered and at what price).

There are two ways to value a company to determine what the price should be for the IPO: estimate the future cash flows and compute the present value or estimate the value by examining comparable companies. When these give dramatically different answers, many underwriters will rely on comparables which are based on the most recent IPOs in the market. During a road show, senior management and the lead underwriters travel promoting the company and explaining their rationale for the offer price to the underwriters' customers. The customers in turn tell the underwriters their interest by stating how many shares they would be willing to purchase. The process for coming up with the offer price based on customers' expressions of interest is called book building.

Most often, the underwriter and firm agree to a firm commitment IPO where the underwriter guarantees that it will sell all of the stock at the offer price. The underwriter purchases the entire issue and then sells it at the offer price. The issuing company will often pay the underwriters a fee or spread which is a percentage of the issue price of a share of stock. With firm commitments, underwriters are exposing themselves to the risk that they may have to sell shares for less than the offer price. Because of this, IPOs are often intentionally underpriced. Another mechanism that underwriters use is over-allotment allocation or greenshoe provision. This allows the underwriter to issue more stock, usually 15% more, at the IPO offer price.

Once the IPO takes place, a firm's shares trade on a public exchange. The existing shareholders are subject to a lockup which is a restriction that prevents them from selling their shares for a period of time... usually 180 days after the IPO takes place.

Other IPO Types
Best Efforts Basis: Often used for smaller IPOs. The underwriter accepts the deal on a best efforts basis meaning that he does not guarantee that the stock will be sold but tries to sell the stock for the best possible price. These often have an all or none clause: sell all the shares or the deal is off.

Auction IPO: An online method for selling new issues directly to the public that lets the market determine the price through bids from potential investors. The auction IPO sets the highest price such that the number of bids at or above that price equals the number of offered shares.

IPO Puzzles
Four characteristics of IPOs puzzle financial economists
  1. On average, IPOs appear to be underpriced. The price at the end of trading on the first day is often substantially higher than the IPO price
  2. The number of IPOs is highly cyclical. During good economic times, the market is flooded with IPOs. However, during poor economic times, the number of IPOs drops substantially as well.
  3. The transaction costs of an IPO are very high and it is not clear why firms are willing to incur these costs.
  4. The long run performance of a newly public company (3-5 years) is poor.

Underpriced IPOs
As discussed earlier, underwriters set the issue price so that the average first day return is positive. The one day average return for IPOs has been very large worldwide. However, underpricing is generally smaller in developed capital markets. By underpricing, underwriters are able to manage their risks. In addition, investors who are able to buy stock from underwriters at the IPO price also gain because the price usually rises significantly only after one day. Shareholders prior to an IPO are the ones that suffer. They are selling stock as part of their exit strategy for less than they could get after the IPO.

Hot and Cold IPO Markets
Trends related to the number of IPO issues are cyclical. There is a greater need for capital when there are growth opportunities present in the economy. However, because of the magnitude of the swings, there is obviously other factors affecting the number of IPOs besides the demand for capital.

High Cost of Issuing an IPO
In the US, the spread that companies pay underwriters is 7% of the issue price. This fee covers the cost to the underwriter of managing the syndicate and helping the company prepare for the IPO. Internationally, spreads are usually half the amount paid in the US. The cost of issuing stock for the first time is substantially larger than the cost for other securities. There is also a lack of sensitivity of fees to the size of the issue.

Poor Post-IPO Long-Run Stock Performance
The shares of IPOs generally perform very well immediately after the public offering. However, these same firms perform poorly over the following 3 to 5 year time period after the IPO. This underperformance might not result from the issue of equity itself but rather from the conditions that motivated the equity issuance in the first place.

Raising Additional Capital: The Seasoned Equity Offering
Even though firms can finance growth by using their retained earnings, this is not always feasible. A public company therefore often returns to the equity markets and offers new shares for sale in a seasoned equity offering (SEO).

SEO Process
The process of a SEO is very similar to an IPO. The one big difference is that a market price already exists for the company's stock so the process of determining a reasonable price does not have to take place. Primary shares are new sharees issued by a company while secondary shares are shares sold by existing shareholders. When it comes to IPOs and SEOs, underwriters have been known to advertise in the newspaper with advertisements called tombstones. However, with the rise in technology, investors are often informed of new IPOs and SEOs through the media and also by road shows and the book building process. There are two types of SEOs: a cash offer and a rights offer. In a cash offer, the firm offers new shares to investors at large. In a rights offer, the firm offers the new shares to only existing shareholders. In the US, most offers are cash offers. Rights offers protect existing shareholders from underpricing. In a cash offer, the windfall in the stocks price is at the expense of old shareholders. With a rights offer, however, this windfall accrues to existing shareholders.

SEO Price Reaction
In general, the market doesn't respond well to the news of an SEO. SEOs usually bring a price decline to a company's stock. When quality is hard to judge, the average quality of goods being offered for sale will be low. This concept is referred to as adverse selection.

SEO Costs
SEOs are still expensive although not as much so as IPOs. Underwriting fees for SEOs are about 5% of the proceeds of the issue. In addition, rights offers have lower costs than cash offers. A cash offer does provide an advantage however. With a cash offer, the underwriter takes on a larger role and can credibly attest to the issue's quality.