Raising Equity Capital

FINC 361 Fall 2016

Professor Mahdi Mohseni

Todays agenda

Raising equity capital

Financing life-cycle

1.
2.

The Early Years: Owners Equity and Angel Financing

The Teen Years: Venture Capital

3.

Adulthood: Initial Public Offering (IPO)

Underwriting Mechanics

Direct costs of issuing

Indirect costs of issuing

Underpricing puzzle

Setting IPO price

Valuation
Fees and placement of shares

Costs and Benefits of IPO

RealNetworks example

Restricting supply of stock

Evidence from around the World

Long-run underperformance of IPOs

Startup Financing Cycle

Equity financing of start-ups

High growth: Need external financing, most often equity. Why?
1. Entrepreneur
2. Family and friends
3. Business angels

Individual investors who buy equity in small private firms

4. Venture capital funds

Limited partnership: Specialized in raising money to invest in

young private firms

Similar to private-equity partnerships but focused on young companies

5. Institutional investors
6. Corporate investor

Corporation taking a strategic stake in a young firm in its field

Google Ventures

Angel Financing
Angel Investors

Successful businessmen, lawyers, doctors, affluent individuals

Provide capital for a business start-up

Usually in exchange for convertible debt or ownership equity

Angels tend to take bigger risks and accept lower returns if they
like the idea
Characteristics:

Technologies that they understand

Close to where they live
Very early-stage companies
Less than $1 million

Angel Financing: Google Example

Andy Bechtolsheim
Larry Page and Sergey Brin
Their first visit with a faculty members friendmet Andy Bechtolsheim, one of
the founders of Sun Microsystems.
As Sergey tells it, We gave him a quick demo. He had to run off somewhere,
so he said, 'Instead of us discussing all the details, why don't I just write you a
check?' It was made out to Google Inc. and was for $100,000."

Venture Capital
No standard definition
It is generally agreed that:
1. The traditional VC era began in 1946
2. George Doriot founded American Research &
Development (AR&D), the first corporation specializing in
investing in illiquid securities of early stage issuers

One way to define traditional "venture capital is to

look at Doriots rules of investing on the next slide

Doriots rules of VC investing

New technology and new product application possibilities
A significant participation by the investors in the company's
management
Products or processes which have passed through at least the
early prototype stage and are adequately protected by
patents, copyrights, or trade-secret agreements
Situations which show promise to mature within a few years
to the point of an IPO or a sale of the entire company
(commonly referred to as the "exit strategy")
Opportunities in which the venture capitalist can make a
contribution beyond the capital dollars invested (often
referred to as the "value-added strategy")

Benefit of venture capitalists

They have experience on:

how to run a company

how to bring in professional management
how to handle the fast growth
how to talk to potential investors

Quality VCs send a strong signal to the market

Benefit of venture capitalists

Googles example
Feb 1999: Moved to an office on University Avenue in Palo Alto
Google's staff had nearly tripled to 8 employees, and the service was
answering more than 500,000 queries per day

June 7, 1999: Firm announced that it had secured a round of funding

$25 million from the two leading venture capital firms in Silicon Valley,
Sequoia Capital and Kleiner Perkins Caufield & Byers (KPCB)
Both VC firms took seats on the board of directors

Structure of a Venture Capital Firm

Fund(s) organized as limited partnerships.
The investors in the fund are called limited partners (LPs)
The venture capitalist is called general partner (GPs)
A venture capital management company can have many
funds, usually with different general partners

Structure of Typical VC Firm

Venture Capital (VC) Financing in U.S.

Dot-com
bubble!

Source: NVCA.org

Pro-cyclical pattern

Hybrid Financing of young firms

Often not common stock
Preferred Stock
Hybrid security
Key characteristic when issued by
1.

2.

Mature companies:

Preferential dividend

Seniority in any liquidation and sometimes special voting rights

Young companies:

Usually no cash dividends

Seniority in any liquidation

Often has right to convert to common stock

Convertible Preferred Stock

Multiple Classes of Stock

One share one vote: Often companies have one class of
common stock and each share has one vote
Some firms have two or more classes of stock, which
differ in their voting rights
Very common in IT industry (e.g. Google, Facebook, etc.)

Why?
1. Need for lots of capital in order to expand
2. Desire to stay in control
Create dual class shares!

Stages of Financing
1. Seed-Money Stage
Small amount of money to prove a concept or develop a product.

2. Start-Up
Funds are likely to pay for marketing and product refinement

3. First-Round Financing
Additional money to begin sales and manufacturing

4. Second-Round Financing
Funds earmarked for working capital for a firm that is currently selling its product
but still losing money

5. Third-Round Financing
Financing for a firm that is at least breaking even and contemplating expansion;
a.k.a. mezzanine financing

6. Fourth-Round Financing (sometimes)

Financing for a firm that is likely to go public within six months;
a.k.a. bridge financing

RealNetworks example
Steps in fund-raising:
1. 1993: Founder (Robert Glaser) invests

$1M (Series A stock)

2. April 1995: 1st round of external financing:

$1.8M (Series B stock)

3. Oct 1995: 2nd round of external financing:

$5.7M (Series C stock)

4. Nov 1996: 3rd round of external financing:

$17.9M (Series D stock)

5. July 1997: 4th round of external financing:

$30M (Series E stock)

Valuation after first round of financing

Series B: New shares sold to outside investors

Agreement: $1.8M would give them 2,686,567 shares (or 16.4% of firm)
It corresponds to them paying $0.67 per share
$1.8M/2.686M = $0.67

Post-financing valuation:
The terms of the financing implicitly give us a new valuation for the firm:
$0.67 per share
Now:
Value of founders stake (83.6%) = 13,713,439*$0.67 = $9.2M
Value of entire firm= 16,400,006*$0.67 = $11M

Exit strategy
Firm value of RealNetworks increased dramatically
over timebut
Very poor liquidity
No market for stock
Initial investors could not easily sell their stake

Initial Public Offering (IPO)

Selling stock to the public for the first time

Mechanics of an IPO
Step 1: Select Underwriters and the Syndicate
1. Lead Underwriter
Primary investment banking firm managing IPO

2. Syndicate
Group of underwriters who jointly underwrite and distribute
a security issuance
(-): Split the underwriting fees
(+): Spread the risks among several underwriters
(+): Broaden the base of potential investors

Mechanics:
Primary and Secondary Offerings
1. Primary Offering
New shares available in a public offering
Raises new capital

2. Secondary Offering
Shares sold by existing shareholders in an
equity offering
Not raising new capital

SEC filings
1. Registration Statement
2. Preliminary Prospectus

Red Herring

3. Final Prospectus
Contains details of the
offering, including the
number of shares offered
and the offer price

Grubhubs SEC S-1 Filing 2/28/14

Googles Prospectus April 2004

Google Inc. is offering 14,142,135 shares of Class A common stock and the selling
stockholders are offering 5,462,917 shares of Class A common stock. We will not
receive any proceeds from the sale of shares by the selling stockholders. The
initial public offering price is $85.00 per share.
Following this offering, we will have two classes of authorized common stock, Class
A common stock and Class B common stock. The rights of the holders of Class A
common stock and Class B common stock are identical, except with respect to
voting and conversion. Each share of Class A common stock is entitled to one vote
per share. Each share of Class B common stock is entitled to ten votes per share
and is convertible at any time into one share of Class A common stock.
Price to Public
$85.00
Per Share
Total
$1,666,429,420

Underwriting
Discounts and
Commissions

Proceeds to
Google

Proceeds to
Selling
Stockholders

$2.3839
$46,736,483

$82.6161
$1,168,368,039

$82.6161
$451,324,897

IPO valuation

SEC filings
(prospectus)

Current
market
conditions

Promotion of the offering to

the financial community
(roadshow, etc.)

Sometimes
already
trading
(www.share
spost.com)

1. Multiples
2. DCF

Fees and placement of shares

1. Spread
Fee paid to underwriters

%issue price of a share

RealNetworks example:
Final offer price = $12.50 per share
Company paid underwriters a spread of $0.875 per share, exactly 7% of the issue price
$12.50 $0.875 = $11.625

Buy the stock from RealNetworks for $11.625 per share and then resell the stock to
their customers for $12.50 per share

2. Firm commitment
Very typical: Underwriters guarantee to sell all shares
Its a risk for them. If not enough demand, they will have to buy the remaining shares

3. Over-Allotment Allocation (Greenshoe Provision)

Option allowing underwriter to issue more stock, at the IPO offer price
RealNetwork example:
3 million shares offered at $12.50 per share
In addition, greenshoe provision allowed for an additional 450,000 shares

Lockup Agreements
Lockup agreements
Prohibit company insidersincluding employees, their friends and
family, and venture capitalistsfrom selling their shares for a set
period of time
The terms of lockup agreements may vary, but most prevent insiders from selling
their shares for 180 days.
Lockups also may limit the number of shares that can be sold over a designated
period of time.

Google example:
agreed with the underwriters that for a period of 180 days after the
date of this prospectus, we will not sell any shares of our common
stock, or securities convertible into shares without prior written
consent of the lead underwriters

Benefits of an IPO
1. Greater liquidity
Early investors get the ability to diversify
Venture capitalists, founders, etc.

2. Better access to capital

Public companies typically have access to much larger
amounts of capital through the public markets
Improves access to debt markets
Improves visibility of the firm

3. Greater ease to perform M&A deals

Why?

Costs of an IPO

1. Transaction costs
A.

Direct cost of issuing: Investment banker fees

B.

Indirect cost: Underpricing the stock issue

2. Agency costs

Shareholder base More widely dispersed

Creates the Manager vs. Shareholder conflict

Separation of management and ownership

3. Regulatory costs

Costly listing requirements to satisfy

SEC filings, Sarbanes-Oxley (SOX), etc.

Since SOX:
1.
2.

Significantly fewer foreign firms listing in U.S. after SOX and;

Significant increase in delistings after SOX

Proof that these costs are real!

Transaction costs:
Direct cost of issuing

IPOs: Most expensive type of external financing

Not surprising given all the work and uncertainty involved

Typical spread is 7%

Transaction costs:
Twitter Example (only 3.25%)

Transaction costs
Indirect cost: Underpricing
Stock price usually jumps on first day of trading
Investment bankers underprice stocks by 15%-20%
on average over last 40 years!
Are they leaving money on the table?

What is going on?

1. Margin of security for Underwriters
2. Good publicity for the issue

Supply effects!
The firm and its bankers want a strong price reaction at IPO

Can they manipulate the stock price by restricting the supply of stock offered
to the market?
Answer: It depends!

1. Perfectly elastic demand curve

Restrict supply: No effect on price
Only fundamental value matters

2. Downward sloping demand curve

Restrict supply: Positive effect on price
Demand beyond fundamental value
Can you think of a reason why mutual
funds would want to hold a stock, even if
priced above its fundamental value?

Stock
Price

$12
$10

$10

Q1

Q0

Quantity

Q1

Q0

Quantity

Supply and demand effectsin practice

Evidence from recent Internet IPO:
Groupon only listed 6% of shares outstanding
Clearly they believe that demand curves are not flat!
How could this strategy limit the stock price growth potential in
the future?

Number of Offerings and Average First-day Returns

on U.S. IPOs, 1980-2010

Lower volumes since 2001

SOX compliance, Reg FD, Global Settlement (less analyst coverage of small firms), etc.

Strong cyclical pattern

Almost no deals during most recent financial crisis

Explosion in first-day return at the height of dot-com bubble

1st day IPO returns 2004 - 2014

140%

Average first-day returns

120%
100%
80%
60%
40%
20%
0%

Average first-day returns for IPOs around the World

Long-run underperformance of IPO stocks

Phenomenon:
IPO stocks tend to underperform relative to:
1. The market
2. Publicly-traded firms with similar characteristics
3. Effect concentrated among small stocks

Period: 1 to 5 year period after IPO

Ritter (1991) and Loughran and Ritter (1995)

Seems to defeat market efficiency!

So what could explain it?

Explaining long-run IPO

underperformance
Valuation
given by
market

Issue when high demand for your stock

Long run underperformance

IPO

Time

Market timing

Firms choose optimally their IPO timing!

Shelf-registrationwait until conditions are right

Fledgling small firms benefit the most from timing it right!

Markets seem to never learn

Behavioral explanations?

Interesting pattern:
Less profitable firms outperform on first day
but underperform in the long-run. Why?

Life after the IPO

Seasoned Equity Offerings (SEOs)
New securities are issued and offered to the public
Primary and/or Secondary shares can be issued
Primary new shares issued by firm
Secondary shares sold by existing shareholders such as founder

Cash offer versus rights offer

Cash offer - offer shares to investors at large
Rights offer offer share to existing shareholders

Often viewed negatively by the market

Signaling overvalued shares

Recap
Life-cycle effects

Early-on: Venture capital

Life changing event for a firm: IPO

Pros
1.
2.

Increased liquidity (for investors)

Relaxation of financing constraints (for firm)

1.
2.
3.
4.

Direct costs: ~7%

Indirect costs: Underpricing
Agency costs: Bigger separation of ownership and control
Regulatory costs: SOX

Cons

Performance
1.
2.

Jump on first day

Long-run underperformance