Chapter 20

Raising Capital
 Understand the venture capital market and its role in
financing new businesses
 Understand how securities are sold to the public and
the role of investment bankers
 Understand initial public offerings and the costs of
going public
 Understand the process of secondary offerings and
the impact of dilution

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20.1 Early-Stage Financing and Venture Capital
20.2 The Public Issue
20.3 Alternative Issue Methods
20.4 The Cash Offer
20.5 The Announcement of New Equity and the Value of the
Firm
20.6 The Cost of New Issues
20.7 Rights
20.8 The Rights Puzzle
20.9 Dilution
20.10 Shelf Registration
20.11 Issuing Long-Term Debt

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 Financial intermediaries that are typically set up as
limited partnerships
 Play an active role in overseeing, advising, and
monitoring companies in which they invest
 Generally do not want to own the investment
forever

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1. Seed-Money Stage
2. Start-Up
3. First-Round Financing
4. Second-Round Financing
5. Third-Round Financing
6. Fourth-Round Financing

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 The Basic Procedure
◦ Management gets the approval of the Board.
◦ The firm prepares and files a registration statement
with the SEC.
◦ The SEC studies the registration statement during the
waiting period.
◦ The firm prepares and files an amended registration
statement with the SEC.
◦ If everything is copasetic with the SEC, a price is set
and a full-fledged selling effort gets underway.

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Steps in Public Offering Time
1. Pre-underwriting conferences Several months
2. Registration statements 20-day waiting period
3. Pricing the issue Usually on the 20th day
4. Public offering and sale After the 20th day
5. Market stabilization 30 days after offering

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 There are two kinds of public issues:
◦ The general cash offer
◦ The rights offer
 Almost all debt is sold in general cash offerings.

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 Copyright © 2016 McGraw-Hill Education. All rights reserved.
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 There are three methods for issuing securities for
cash:
◦ Firm Commitment
◦ Best Efforts
◦ Dutch Auction
 There are two methods for selecting an underwriter
◦ Competitive
◦ Negotiated

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 The issuing firm sells the entire issue to the
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.
 This is the most common type of underwriting in the
United States.

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 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. The company does not get the
capital, and they have still incurred substantial
flotation costs.
 This type of underwriting is not as common as it used
to be.

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 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 IPO.

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 Also called underwriters
 Perform critical functions:
◦ Help determine type of security, method of sale, and
offering price
◦ Sell the securities
 Typically using a syndicate to limit risk
 For compensation – the spread
◦ Stabilize IPO prices in the aftermarket

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 May be difficult to price an IPO because there is not 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.”

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 The market value of existing equity drops on the
announcement of a new issue of common stock.
 Reasons include
◦ Managerial Information
Since the managers are the insiders, perhaps they are
selling new stock because they think it is overpriced.
◦ Debt Capacity
If the market infers that the managers are issuing new equity to
reduce their debt-equity ratio due to the specter of financial
distress, the stock price will fall.
◦ Issue Costs

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1. Gross spread, or underwriting discount
2. Other direct expenses
3. Indirect expenses
4. Abnormal returns
5. Underpricing
6. Green Shoe Option

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 Proceeds Direct Costs
Underpricing
(in millions) SEOs IPOs IPOs
2 - 9.99 35.11% 25.22% 20.42%
10 - 19.99 13.86% 14.69% 10.33%
20 - 39.99 9.54% 14.03% 17.03%
40 - 59.99 13.96% 9.77% 28.26%
60 - 79.99 6.85% 8.94% 28.36%
80 - 99.99 6.72% 8.55% 32.92%
100 - 199.99 5.23% 7.96% 21.55%
200 - 499.99 4.94% 6.84% 6.19%
500 and up 3.37% 5.50% 6.64%
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 If a preemptive right is contained in the firm’s articles
of incorporation, the firm must offer any new issue of
common stock first to existing shareholders.
 This allows shareholders to maintain their percentage
ownership if they so desire.

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 The management of the firm must decide:
◦ The exercise price (the price existing shareholders must
pay for new shares).
◦ How many rights will be required to purchase one new
share of stock.
 These rights have value:
◦ Shareholders can either exercise their rights or sell their
rights.

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 Popular Delusions, Inc. is proposing a rights offering.
There are 200,000 shares outstanding trading at $25
each. There will be 10,000 new shares issued at a $20
subscription price.
 What is the new market value of the firm?
 What is the ex-rights price?
 What is the value of a right?

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 $25 $20
$5,200,000  200,000 shares  10,000 shares 
share shares

There are 200,000 There will be 10,000 new

outstanding shares at shares issued at a $20
$25 each. subscription price.

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 There are 210,000 outstanding shares of a firm
with a market value of $5,200,000.
 Thus the value of an ex-rights share is:

$5,200,000
= $24.7619
210,000 shares

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 Thus, the value of a right is:

$0.2381 = $25 – $24.7619

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 The vast majority of new issues in the U.S. are
underwritten, even though rights offerings are much
cheaper.
 A few explanations:
◦ Underwriters increase the stock price. There is not much
evidence for this, but it sounds good.
◦ The underwriter provides a form of insurance to the issuing
firm in a firm-commitment underwriting.
◦ Underwriters “certify” the price to the market.
◦ The proceeds from underwriting may be available sooner
than the proceeds from a rights offering.

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 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
◦ Earnings per share – may decline even with positive NPV
projects (at least in short run)
◦ Book value– occurs when market-to-book value is less
than one

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 Permits a corporation to register an offering that it
reasonably expects to sell within the next two years.
 Not all companies are allowed shelf registration.
 Qualifications include:
◦ The firm must be rated investment grade.
◦ They cannot have recently defaulted on debt.
◦ The market capitalization must be > $150 m.
◦ No recent SEC violations.

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 Public issuance follows the same general process as
stocks
 Direct financing
◦ Term loans
◦ Private placements
 Direct financing may have more restrictive covenants
and higher rates, but is less costly to issue and easier
to negotiate.

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 What is venture capital, and what types of firms receive
it?
 What are some of the important services provided by
underwriters?
 What type of underwriting is the most common in the
United States, and how does it work?
 What is IPO underpricing, and why might it persist?
 What are some of the costs associated with issuing
securities?
 What is a rights offering, and how do you value a right?
 What is shelf registration?
 What are the advantages of direct financing as opposed to
public issuance of long-term debt?

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