Company Financing

Week 2
IB125 Foundations of Financial Management
Jesús Gorrín

Key Readings: Hillier et al. Chapters 14.1-14.5, 16.7, 19.1-19.8

IMPORTANCE OF FINANCING

 Private Equity
 Private Equity
 Public Equity

 Loan
 Public Equity

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SOURCES AND USES OF FUNDS

Sources Uses
Banks Land
Financial Markets Buildings
Venture Capital Equipment
Private Equity Labor
Working Capital

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START-UPS AND VENTURE CAPITAL
 Young firms often require venture capital to finance growth
 The issuance of securities is a complex process that the successful financier must
comprehend
 Venture capital provides entrepreneurs with financing to grow their firms
 Firms issue securities to further finance their growth

Venture Capital
Money invested to finance a new firm

Since success of a new firm is highly dependent on the effort of the managers,
restrictions are placed on management by the venture capital company and funds
are usually dispersed in stages, after a certain level of success is achieved.

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SOURCES OF VENTURE CAPITAL

 Angel investors: Investors who finance companies in their earliest stages of

growth

 Corporate venturers: Corporations that offer venture assistance to finance

young, promising companies

 Private equity investing: Investors who offer funds to finance firms that do
not trade on public stock exchanges such as the NYSE or NASDAQ

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INITIAL PUBLIC OFFERING
 Initial Public Offering: when a firm requires more capital than private investors
can provide, it can choose to go public through an initial public offering, or IPO.
(First offering of stock to the general public)

 Primary Offering: when new shares are sold to raise additional cash for the
company

 Secondary Offering: when the company’s founders and venture capitalists

cash in on some of their gains by selling shares

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INITIAL PUBLIC OFFERING
 Initial Public Offering (IPO): First offering of stock to the general public

 Underwriter: Firm that buys an issue of securities from a company and resells it
to the public

 Spread: Difference between public offer price and price paid by underwriter

 Benefits of Going Public

 Ability to raise new capital
 Stock price provides performance measure
 Information more widely available
 Diversified sources of finance
 Reduced borrowing costs

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IPO FLOWCHART

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Underwriter Firm Investors
3

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1. Underwriter provides advice to firm
2. Underwriter pays firm for a number of shares
3. Firm provides shares to underwriter to be resold
4. Underwriter offers shares to investors
5. Investors purchase shares from underwriter
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UBER: HOTTEST IPO OF 2019?

 Value: $73.6bn
 Please read the FT article below
 https://on.ft.com/3qy1ySI (You need to subscribe first, WBS has a free subscription)

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UBER: HOTTEST IPO OF 2019?

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PERFORMANCE OF IPOS OVERTIME
 Please read the FT article below  Share Price History of Uber after its IPO
https://www.ft.com/content/7457ee7e-
f074-11e7-ac08-07c3086a2625

 Decline of US listed companies

overtime (Doidge et al., 2017)

 Dotcom bubble: 2/3 of IPOs of

technology firms went bust in a period
of five years after the IPO.  Source: Doidge et al. (JFE, 2017)

 Snap was the largest US tech deal

since Facebook in 2012. We observe a
huge drop in the price of Snap (more
than 60% lower than the IPO price) by
this year.

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SOURCES AND USES OF FUNDS

Sources Uses
cash
Banks Land

Financial Markets Buildings

OCF
Venture Capital Equipment

Private Equity cash Labor

Working Capital

OCF = operating cash flow

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SOURCES OF FUNDS = USES OF FUNDS
 Sources of funds…
 = operating cash flow (OCF)
 + proceeds from equity issues (∆E)
 + proceeds from debt issues (∆D)
 (+ proceeds from issues of other
securities)
 In this lecture, we focus on the sources
of funds…
 Internal (OCF)
 External
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 …always equal the uses of funds
 = capital expenditure (CapEx)
 + investment in working capital
(∆WC)
 + dividend payments (Div)
 + interest payments (Int)
 (+ payments to holders of other
securities)
 + increase (- decrease) in cash
position (∆Cash)
DEBT VS EQUITY
 Debt:
 promises pre-determined (not necessarily fixed) return, on regular basis
(= coupon interest) and/or one final payment (= return of principal)
 many varieties: e.g. secured vs. unsecured, senior vs. junior, fixed-rate vs.
floating rate, callable, convertible, Eurobonds...
C C C C + FV
...
0 1 2 3 T

P
 Equity (= ordinary shares):
 limited-liability security that confers voting rights to shareholders (= owners)
 residual claim on cash flows of company after other liabilities (interest on
debt, tax, suppliers, labour) have been met
 provides returns to shareholders in the form of dividends (which need not to
be paid) and capital gain (or loss)
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CORPORATE DEBT
 Debt has the unique feature of allowing the borrowers to walk away from their
obligation to pay, in exchange for the assets of the company

 “Default Risk” is the term used to describe the likelihood that a firm will walk
away from its obligation, either voluntarily or involuntarily

 “Bond Ratings” are issued on debt instruments to help investors assess the
default risk of a firm

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RAISING FINANCE VIA CAPITAL MARKETS
 Primary vs. Secondary market:
 Primary market is where firm raises fresh  The Pecking Order Theory
capital (e.g. IPOs, rights issues, placings) • Maximizes
 Secondary market is where existing Use Internal
Financing management
securities are traded flexibility
Issue Debt • Tax Shield
 Why use capital markets to raise finance?
 central markets make it easier to raise funds Issue Equity • Last Resort!
but. . .
 it might be costly

 Alternative forms of funding: crowdfunding

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ALTERNATIVE FOR START-UPS: CROWDFUNDING

Source: Anthony Paglino, @iCuriousTravel

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VEVOX QUESTION
 Use the following link:
https://warwickbusschool.dashboard.vevox.com/#/present/161398/9UOXBV3ITBQ847N
5T1ZH

 Michael is looking for investors to start his new firm: the Vegan Burrito Inc. SoftBank
Vision Fund offers him £1bn to open a series of restaurants in exchange for owning
half of the firm. The firm is owned by Michael and SoftBank after the financing. This
is an example of:

 A) A venture capital investment.

 B) A bank loan.
 C) An initial public offering.
 D) A corporate bond.
 E) None of the above.

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RIGHTS ISSUES
 Firm offers existing shareholders opportunity to buy new shares pro rata to no. of shares
they already own
 Every existing share gives one subscription right
 The number of subscription rights needed to buy one new share equals
 ratio between the number of old shares N and new shares M
 M for N rights offering
Only
for existing
shareholders.
Normally firms must sell to
existing shareholders before
going to the public.
Shareholders have the option to buy a specified
number of new shares from the firm at a
specified price with a specified time.

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RIGHTS ISSUES
 Firm offers existing shareholders opportunity to buy new shares pro rata to no. of shares
they already own
 Issue of new shares increases the total number of shares and the value of company

Before rights issue After rights issue

 But: Issue price of new shares is set below current market price:
 money for nothing?

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RIGHTS ISSUES AS A CALL OPTION
 Shareholders have short period (~3-5 weeks) to decide whether or not to take up offer

 Right to buy new shares in issuing firm is an example of a call option:

 existing shareholders are under no obligation to buy new shares
 can sell their rights for cash, if they prefer
 but: think of voting rights!

 If existing shareholders do exercise their option, firm has to issue new shares: earnings per
share are diluted
Exercise Sell all
rights rights

Sell some
rights to
raise
Do nothing
financing to
buy
remainder

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EXAMPLE
 Growing plc has 2 million shares currently trading at £1 each and wishes to raise additional £1 million
via rights issue.

“1-for-1” “2-for-3”
Prior to issue:
No. of existing shares 2 million 2 million
Share price £1 £1
Value of company £2 million £2 million
Expiry of issue:
New money raised £1 million £1 million

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EXAMPLE
 Growing plc has 2 million shares currently trading at £1 each and wishes to raise additional £1 million
via rights issue.
“1-for-1” “2-for-3”
Prior to issue:
No. of existing shares 2 million 2 million
Share price £1 £1
Value of company £2 million £2 million
Expiry of issue:
New money raised £1 million £1 million
No. of new shares 2 million
Issue price 50p
No. of shares in total 4 million
Share price £3m/4m=75p
# rights needed to buy 1 share 2m/2m=1
Value of right to buy 1 new share at expiry (75p-50p)/1 = 25p

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 EXAMPLE
 Growing plc has 2 million shares currently trading at £1 each and wishes to raise additional £1 million
via rights issue.
“1-for-1” “2-for-3”
Prior to issue:
𝐹𝑢𝑛𝑑𝑠 𝑡𝑜 𝑏𝑒 𝑟𝑎𝑖𝑠𝑒𝑑
No. of existing shares 2 million 2 million
𝑆𝑢𝑏𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛 𝑃𝑟𝑖𝑐𝑒
or Share price £1 £1
No of existing
Value of company £2 million £2 million
shares*M/N
Expiry of issue:
New money raised £1 million £1 million
No. of new shares 2 million 1.33 million
′𝑂𝑙𝑑′ 𝑆ℎ𝑎𝑟𝑒𝑠 Issue price 50p 75p
′𝑁𝑒𝑤′ 𝑆ℎ𝑎𝑟𝑒𝑠
No. of shares in total 4 million 3.33 million
Share price £3m/4m=75p £3m/3.33m = 90p
# rights needed to buy 1 share 2m/2m=1 2m/1.33m = 1.5
Value of right to buy 1 new share at expiry (75p-50p)/1 = 25p (90p-75p)/1.5 = 10p

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WEALTH TRANSFER IN RIGHTS ISSUES
 Existing shareholders:
 get a right worth 10p = 10p
 loss per share = £1 – 90p = -10p
 net loss = 0p

 New shareholders:
 price paid for 1.5 rights@10p = -15p
 gain per share = 90p-75p = 15p
 net gain = 0p

 There is no wealth transfer, independently of the price at which the rights are issued

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 TIMELINE OF RIGHTS ISSUE
Scum

Sex

Rights issue Shares traded Ex-rights Shares and rights

Expiry date
announced together with date traded separately
rights

 Note that Scum > Sex > I.

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RIGHTS ISSUES ARE FAIR
 Assume terms of rights issue are M-for-N at I:
 you can buy M new shares
 at issue price I
 for every N shares you already own.

 N shares priced at S cum plus cash M  I are exchanged for (N + M) new shares at S ex

N  S cum  M  I  ( N  M )  S ex
 Shareholders lose (Scum - Sex) on each existing share, but gain (Sex – I) on each new
share. Thus, total gain/loss for each set of N existing shares is:

M  ( S ex  I )  N  ( S cum  S ex )  0

Gain per share Loss per share

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VALUE OF UNDERWRITING
 Issuing firm can insure itself against failure of rights issue:
 For a fee, the underwriter agrees to buy all new shares not taken up by existing
shareholders

 Marsh (1994):
 700 UK rights issues between 1986 and 1993
 average underwriting fee is 1.45% (of issue)
 excess return to underwriter is 0.98% (of issue)
 so underwriting appears overpriced, on average

 Issuing firm should therefore:

 either set issue price I sufficiently high that underwriter earns its fee
 or set issue price I sufficiently low that there is negligible chance of failure, and not
have the issue underwritten

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CONCLUSIONS
 Sources of funds should always equal uses of funds

 Main sources of funds:

 Internal (operating cash flow)
 External: equity and debt

 In UK, new equity has to be raised via a rights issue.

 Pre-emptive rights assigned to existing shareholders ensures wealth is not transferred to

outside investors:
 existing shareholders can either exercise their option to buy new shares pro rata or
sell their rights
 they are no better nor worse off financially, regardless of terms of issue

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