BF3326 Corporate Finance

Raising Capital
Financial Planning for Your Business

❑ Financial planning involves finding the right kind of

financial resources at the right time in the right amount.

❑ Financial planning involves:

• Identifying the stages of growth in your business
• Identifying milestones that require resources
• Identifying business advisers
• Hiring an excellent management team
How to Obtain Financing

✓ To obtain financing, you must create pro forma

financial statements to include in your business plan.

✓ pro forma: proposed or estimated financial statements based on predictions of how

the actual operations of the business will turn out
Sources of Equity Financing

Personal Friends and

savings family

State-
sponsored
Forms of Equity Private
venture
investors
capital Financing
funds

Venture
Partners
capitalists
Venture Capital
• Private financing for relatively new businesses in
exchange for equity
• Usually entails some hands-on guidance
• The company should have an “exit” strategy
– Sell the company – VC benefits from proceeds from sale
– Take the company public – VC benefits from IPO
• Many VC firms are formed from a group of investors
that pool capital and then have partners in the firm
decide which companies will receive financing
• Some large corporations have a VC division
Choosing a Venture Capitalist

• Look for 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?
Selling Securities to the Public
• Management must obtain permission from the Board of
Directors
• Firm must file a registration statement with the Securities
Exchange Commission (SEC)
• The SEC examines the registration during a 20-day waiting
period
– A preliminary prospectus, called a red herring, is distributed during the
waiting period
– If there are problems, the company is allowed to amend the registration
and the waiting period starts over
• Securities may not be sold during the waiting period
• The price is determined on the effective date of the registration
Selling Securities to the Public
Selling Securities to the Public
Private Placement

Private placement is a way to raise capital by selling

ownership interests in your private corporation or
partnership.
✓ private placement: private offering or sale of securities
directly to a limited number of institutional investors
who meet certain suitability standards; ownership
interests are called securities
Initial Public Offering (IPO)

An initial public offering (IPO) is a popular way to raise a lot of

money for growth since all proceeds go to the company.

✓ Initial public offering (IPO): the sale of stock in a company on a

public stock exchange
✓ The CEO of a company that has made an IPO is primarily
responsible to the people who own the company stock.
✓ Stock/Shares: a type of security that signifies ownership in a
corporation and represents a claim on part of the corporation’s
assets and earnings
 There are five steps to
become a public
company with stock for
sale on a public

The IPO
exchange.

Process
1. Choose an underwriter or
investment banker.
2. Draw up a letter of intent.
3. File a registration
statement with the SEC.
4. Announce the offering in
the financial press.
5. Do a road show.
Advantages of Going Public

• Source of interest-free growth capital

• More prestige and recognition
• Easier to form alliances and negotiate deals
• Public stock used to attract employees and reward
existing employees
Disadvantages of Going Public

▪ Expensive process
▪ Time-consuming
▪ Company information is public
▪ CEO responsible to shareholders
▪ Owner/Founder may not control stock
▪ Pressure to perform in the short term
▪ SEC reporting requirements
Underwriters
• Services provided by underwriters
– Formulate method used to issue securities
– Price the securities
– Sell the securities
– Price stabilization by lead underwriter
• Syndicate – group of investment bankers that market
the securities and share the risk associated with
selling the issue
• Spread – difference between what the syndicate pays
the company and what the security sells for initially in
the market
Firm Commitment Underwriting

• Issuer 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 the United States
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. In this case, the company does not
get the capital, and they have still incurred substantial
flotation costs
• Not as common as it previously was
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 Initial Public Offering
Green Shoes and Lockups
• Green Shoe provision
– Allows the syndicate to purchase an additional 15% of the issue from
the issuer
– Allows the issue to be oversubscribed
– Provides some protection for the underwriters as they perform their
price stabilization function
• Lockup agreements
– Restriction on insiders that prevents them from selling their shares of an
IPO for a specified time period
– The lockup period is commonly 180 days
– The stock price tends to drop when the lockup period expires due to
market anticipation of additional shares hitting the street
IPO Underpricing

• May be difficult to price an IPO because there isn’t 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”
Initial Public Offering

Insert figure 15.2 here

Initial Public Offering

Insert figure 15.3 here

New Equity Issues and Price
• Stock prices tend to decline when new equity is issued
• Possible explanations for this phenomenon
– Signaling and managerial information
– Signaling and debt usage
– Issue costs
• Since the drop in price can be significant and much of
the drop may be attributable to negative signals, it is
important for management to understand the signals
that are being sent and try to reduce the effect when
possible
Issuance Costs

• Spread
• Other direct expenses – legal fees, filing fees, etc.
• Indirect expenses – opportunity costs, i.e., management time
spent working on issue
• Abnormal returns – price drop on existing stock
• Underpricing – below market issue price on IPOs
• Green Shoe option – cost of additional shares that the syndicate
can purchase after the issue has gone to market
Rights Offerings: Basic Concepts
• Issue of common stock offered to existing
shareholders
• Allows current shareholders to avoid the dilution
that can occur with a new stock issue
• “Rights” are given to the shareholders
– Specify number of shares that can be purchased
– Specify purchase price
– Specify time frame
• Rights may be traded Over The Counter (OTC) or on
an exchange
The Value of a Right

• 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 value of the right is the difference between the
old share price and the “new” share price
Rights Offering
Suppose a company wants to raise $10 million.
The subscription price is $20, and the current
stock price is $25. The firm currently has
5,000,000 shares outstanding.

– How many shares must be issued?

– How many rights will it take to purchase one share?
– What is the value of a right?
Rights Offering
How many shares must be issued?
– Shares issued = 10,000,000/20 = 500,000

How many rights will it take to purchase one share?

– Rights to buy one share = 5,000,000/500,000 = 10

What is the value of a right?

– Total investment = 10*25 + 20 = 270
– Price per share = 270 / 11 = 24.55
– Value of a right = 25 – 24.55 = .45

Buy 10 rights = .45*10 = 4.50 + 20 = 24.50 share price (difference is due to

rounding)
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
• Book value and EPS – occurs when market-to-book
value is less than one
Dilution
• The first type of dilution arise when firm sells additional shares to the
general public.
• This is done without rights offering.

Example, Joe Smith owns 5,000 shares of Merit Shoe Company. Merit Shoe
currently has 50,000 shares of stock outstanding; each share gets one vote. Joe
thus controls 10 percent (5,000/50,000) of the votes and gets 10 percent of the
dividends.

If Merit Shoe issues 50,000 new shares of common stock to the public and Joe
does not participate in the new issue, how much is his ownership in the firm?
Dilution

✓ His ownership will drop to 5 percent (5,000/100,000)

✓ What happen to the value of Joe’s shares?

✓ Does dilution occur?

Dilution Market vs Book Value
Suppose Upper States Manufacturing (USM) wants to build a new
electricity- generating plant to meet future anticipated demands. USM
currently has 1 million shares outstanding and no debt. Each share is
selling for $5, and the company has a $5 million market value. USM’s
book value is $10 million total, or $10 per share. The company have
200 shareholders holding 5,000 shares each.

USM has experienced a variety of difficulties in the past, including cost

over runs, regulatory delays in building a nuclear-powered electricity-
generating plant, and below normal profits. These difficulties are
reflected in the fact that USM’s market-to-book ratio is $5/10= 0.50
(successful firms rarely have market prices below book values).
Dilution Market vs Book Value

If the company decided to go ahead with the project;

• What is the Book Value per share?

• What is the EPS?
• Find the ROE
• What is the NPV?
Dilution Market vs Book Value
• Net income for USM is currently $1 million.
• With 1 million shares, earnings per share are $1, and the return on
equity is $1/10=10%.
• USM will have to issue 400,000 new shares ($5 x 400,000 $2
million).
• There will thus be 1.4 million shares outstanding after the issue.

The ROE on the new plant is expected to be the same as for the
company as a whole.

• Net income is expected to go up by .10 $2 million $200,000. Total

net income will thus be $1.2 million.
Dilution Market vs Book Value

• The following will result if the plant is built:

1. With 1.4 million shares outstanding, EPS will be $1.21.4 $.857, down from $1.
2. The proportionate ownership of each old shareholder will drop to 5,000/1.4 million .36
percent from .50 percent.
3. If the stock continues to sell for five times earnings, then the value will drop to 5 x
$.857 = $4.29, representing a loss of $.71 per share.
4. The total book value will be the old $10 million plus the new $2 million, for a total of
$12 million. Book value per share will fall to $12 million1.4 million $8.57.
Dilution Market vs Book Value
Sources of Debt Financing

Banks Trade credit

Small Minority
business Sources of enterprise
investment Debt development
companies Financing programs

Commercial
SBA loans finance
companies
Types of Long-Term Debt
Bonds – public issue of long-term debt
Private issues
– Term loans
• Direct business loans from commercial banks, insurance companies,
etc.
• Maturities 1 – 5 years
• Repayable during life of the loan
– Private placements
• Similar to term loans but with longer maturity
– Easier to renegotiate than public issues
– Lower costs than public issues
Shelf Registration

• Permits a corporation to register a large issue with the SEC and

sell it in small portions over a two-year period
• Reduces the flotation costs of registration
• Allows the company more flexibility to raise money quickly
• Requirements

– Company must be rated investment grade

– Cannot have defaulted on debt within last three years
– Market value of stock must be greater than $150 million
– No violations of the Securities Act of 1934 in the last three years
Ethics Issues

• Brokers have been known to sell securities based on sales

scripts that have little to do with the information provided in
the prospectus. Also, investors often make investment
decisions before receiving (or reading) the prospectus. Who
is at greater fault in this case?

• Traditionally, IPO share allocations have been reserved for

the underwriting syndicates’ best customers. What is the
ethical implications?
Problem

A company wants to raise $20 million. The subscription price is $40, and the
current stock price is $50. The firm currently has 5,000,000 shares
outstanding.

– How many shares must be issued?

– How many rights will it take to purchase one share?
– What is the value of a right?
Problem

• Shares issued = $20,000,000/40 = 500,000

• Rights to buy one share = 5,000,000/500,000 = 10
• Total investment = 10*50 + 40 = 540
• Price per share = 540 / 11 = 49.09
• Value of a right = 50 – 49.09 = .91

Buy 10 rights = .91*10 = 9.10 + 40 subscription price = 49.10, which

equals the share price (difference is due to rounding)