AFC 3140 – Advanced Corporate Finance

Equity Finance and Initial Public Offerings

(Lecture Notes)

How do firms
raise capital for
investment? Two
principle methods
are considered.
The first is
through raising venture capital. The
second involves raising capital through an
initial public offering (IPO’s). Some
anomalies in IPO’s are considered from the
perspective of the efficient market
hypothesis. Although many anomalies can
be explained, some questions remain
unanswered.
The Characteristics of Ordinary Shares

• Ordinary shares represent an ownership interest in

a business.

• The holder has a claim to the profits of the

business (through dividends). In the event of
failure, the holder has a claim to the residual value
of the assets after claims of all other entitled
parties are met.

• Due to this residual claim, shareholders are more

likely to lose their investment if the company fails
(shareholders are said to provide the company’s
risk capital).

• To compensate for this risk, shareholders expect a

return that is greater than that received by
lending.
The Characteristics of Ordinary Shares

• Limited liability:
– Protects shareholders' liability to meet a
company’s debts. The liability is limited to
the value of the shares (shares cannot have
a negative value).

• Rights of shareholders:
– Entitled to proportional share of any
dividend declared.
– Right to exert a degree of control over
management through use of voting rights
attached to ordinary shares — (typically
need at least 50% of shares to execute
rights).
– Shareholders have the right to sell their
shares.
Advantages and Disadvantages of Equity as a
Source of Finance

• Advantages
– Dividends are discretionary.
– No maturity date.
– The higher the proportion of capital
structure made up by equity, the lower the
cost of debt.

• Disadvantages
– Issuing more shares can dilute existing
shareholders’ ownership and control.
– Returns to shareholders can be subject to
double taxation (non-residents).
– Transaction costs of issuing shares.
Private Equity

• What is private equity?

– Securities issued to investors that are not
publicly traded. This includes family
members and friends, but a more formal
source is a private equity fund.
– Private equity or venture capital — not only
for new ventures.
• Four categories of private equity financing:
– Start-up: new companies, funds to develop
products.
– Expansion: additional funds required to
manufacture and sell products
commercially.
– Turnaround: assist a company in financial
difficulty.
– Management Buy Out (MBO): where a
business is purchased by its management
team with the assistance of a private equity
partner or fund.
Sources of Finance for New Ventures

• Sources include bank loans, private equities and

IPO funds.
• Stages of a venture include:
– R&D phase.
– Start-up phase, equipment and personnel
assembled.
– Rapid growth, if product is successful.
– Slower growth, followed by maturity and
possible decline.
• Different sources of finance are appropriate at
different stages.
• Personal savings, personal loans and home
mortgages are the most likely sources at R&D
stage.
• Business angel may enter the R&D stage if
these other sources are exhausted.
Equity Financing for Private Companies

The initial capital that is required to start a business

is usually provided by the entrepreneur and their
immediate family. Often, a private company must
seek outside sources that can provide additional
capital for growth.

Angel Investors and Business Angels - Investors who

buy equity in small private firms. Finding angels is
typically difficult. The term 'business angel' was
used in the theatre when financial backers invested
in a theatrical production and contributed their
skills and contacts to enhance the success of the
show. The same term was used centuries ago by
traders searching the world for merchants. Business
Angels began investing in a wide range of
commercial ventures. They are often retired and
invest their business skills as well as their capital
into new and developing enterprises.
Sources of Funding

Venture Capital Firm

A limited partnership that specializes in raising

money to invest in the private equity of young firms.
For centuries, people have developed ways of pooling
their money to undertake risky ventures. The East
India Company was an early example, and the
fictional voyage of the Pequod in Moby Dick was
illustrative of the high-risk, high-return whaling
ventures of the nineteenth century. Venture capital
is simply a modern variation on a long-established
practice of pooling money to finance risky ventures.
Often the limited partner is a corporate entity such
as a superannuation fund. Both Google and
Starbucks were initially funded by venture capital
firms.
Sources of Funding

A Venture Capitalist is one of the general partners

who work for and run a venture capital firm.
Venture capital firms offer limited partners
advantages over investing directly in start-ups
themselves as angel investors.

 Limited partners are more diversified, they spread

their investments amongst a number of risky
projects.
 Frees management time to focus on the business,
not financing the business.
 They also benefit from the expertise of the
general partners.
 Often finance a project so that it can be sold as an
IPO some years down the track (at a considerable
profit – they hope!!).
Venture Capital Around the World

Based on the available data, Australia’s venture

capital intensity appears to be around the median
for OECD countries. At June 2006, the ABS
estimates around $11 billion had been committed to
venture capital and later stage private equity funds.
Venture Capital

The mix of venture capital activity that is conducted

domestically will be influenced by Australia’s
industry structure. Only around 20 per cent of
venture capital in Australia is in the high-technology
sectors of health and biotechnology,
communications, and information technology.

In contrast, almost 90 per cent of venture capital

activity in the US occurs in these sectors. Australia’s
lower venture capital intensity may be due to
relatively smaller high-technology sectors. Another
possible explanation for Australia’s level of venture
capital activity is that the scale and geographical
dispersion of economic activity in Australia place a
natural constraint on the development of a large
venture-capital-financed, high-technology sector.
(e.g. compared to California’s ‘Silicon Valley’)
Sources of Funding

The advantages funding from a venture capitalist

comes at a cost.

 General partners usually charge substantial fees.

• Most firms charge 20% of any positive return they

make.

• They also generally charge an annual management

fee of about 2% of the fund’s committed capital.
(this may also amount to a large proportion of the
profit).
Sources of Funding

Institutional investors such as superannuation

funds, insurance companies, endowments, and
foundations are active investors in private
companies. Institutional investors may invest
directly in private firms or they may invest indirectly
by becoming limited partners in venture capital
firms.

Corporate Investor - A corporation that invests in

private companies. Also known as Corporate
Partner, Strategic Partner, and Strategic Investor.

Corporate investors might invest for corporate

strategic objectives, in addition to the financial
returns. Reasons may include obtaining rights to
new ideas or expanding into a related area of
business.
What are investors looking for?

• Looking for projects with high growth prospects.

• Private equity investments are relatively risky —
higher rates of return are typically required.
• To obtain private equity, require a well-
structured and convincing business plan.
• Private equity fund managers usually require a
seat on the board of the company.
• These managers specialise in new, fast-growing
companies. They can offer specialised expertise
to help the venture succeed.
Sources of Funding

Corporate Investor - A corporation that invests in

private companies. Also known as Corporate
Partner, Strategic Partner, and Strategic Investor.

While most other types of investors in private firms

are primarily interested in the financial returns of
their investments, corporate investors might invest
for corporate strategic objectives, in addition to the
financial returns. Reasons may include obtaining
rights to new ideas or expanding into a related area
of business.
Outside Investors

Preferred Stock

 Preferred stock is issued by mature

companies and usually has a preferential
dividend and seniority in any liquidation
and sometimes special voting rights.

 Preferred stock issued by young companies

has seniority in any liquidation but typically
does not pay regular cash dividends and
often contains a right to convert to common
stock.

Convertible Preferred Stock - Preferred stock that

gives the owner an option to convert it into common
stock on some future date.
Outside Investors

Definitions

Pre-Money Valuation
 At the issuance of new equity, the value of
the firm’s prior shares outstanding at the
price in the funding round.

Post-Money Valuation
 At the issue of new equity, the value of the
whole firm (old plus new shares) at the price
the new equity sold at.

Exit Strategy
 It details how investors will eventually
realize the return from their investment.
Outside Investors

Example

Assume:

• You founded your own firm two years ago.

• You initially contributed $50,000 of your
money and in return received 1,000,000
shares of stock.
• Since then, you have sold an additional
750,000 shares to angel investors.
• You are now considering raising even more
capital from a venture capitalist.
• The venture capitalist will invest $2 million
and will receive 2,000,000 newly issued
shares.
Outside Investors

Questions

 What is the post-money valuation?

 Assuming that this is the venture capitalist’s
first investment in your company, what
percentage of the firm will he end up
owning?
 What percentage will you own?
 What is the value of your shares?
Outside Investors

Solution

Your shares 1,000,000 26.67%

Angel Investors’ Shares 750,000 20.00%

Venture capitalist’s shares 2,000,000 53.33%

Total shares outstanding 3,750,000 100.00%

The venture capitalist is paying $1 per share. Thus,

the post-money valuation is $3,750,000

You will own 26.67% of the firm and the post-money

valuation of your shares is $1,000,000.
Initial Public Offerings

A privately owned company may wish to list on the

stock exchange so that it can:

(a) raise extra capital through equity rather than

debt,
(b) create liquidity for the existing shareholders.

Thus a company may initiate an ‘Initial Public

Offering of Shares’ (IPO). Direct costs of ‘floating’ a
company include:

 Stock exchange listing fees

 Prospectus costs
 Underwriting fees
 Commissions
Initial Public Offerings

Indirect costs of floating include:

 IPO’s are typically underpriced

 IPO’s force management to share information
with shareholders and regulators and potentially
competitors
 Management may be pressured from investors
and interest groups

There may be indirect benefits to existing

shareholders in the form of:

 Listing may provide monitoring and information

to management
 The listed company may enjoy greater credibility
with customers, employees and suppliers.
Offers of Unlisted Securities

On 1 Feb, 2010 the following firms were listed on the

Australian Stock Exchange (ASX) as an IPO.

Proposed ASX
Company Proposed listing date/time
code *
Altus Renewables Limited AWR 09 February 10#
Australian Governance Masters Index
AQF 10 February 10#
Fund Limited
Careers MultiList Limited CGR 04 February 10#
CBio Limited CBZ To be advised
Doray Minerals Limited DRM To be advised
Hunnu Coal Limited HUN 12 February 10#
Kimberley Metals Limited KBL To be advised
Matrix Gold Limited MXD 12 March 10#
Mobilarm Limited MBO To be advised
01:00PM - Monday, February 1
NT Resources Limited NTR
2010##
Olympus Pacific Minerals Inc OYM 29 January 10#
Q Copper Australia Limited QCU 15 February 10#
Scandinavian Resources Limited SCR To be advised
Shree Minerals Limited SHH To be advised
Wild Acre Metals Limited WAC 05 March 10#
Xiaoxiao Education Limited XXL To be advised
The Prospectus

IPO’s cannot proceed until disclosure document has

been lodged with the Australian Securities and
Investment Commission (ASIC).

• Prospectus:
– Most comprehensive disclosure document.
– Contains details of the issue, capital sought,
price, use of funds, etc.
– Non-financial information on issuer —
description of business and reports from
directors and/or industry experts.
– Risks associated with business and
expensive disclosure documents to prepare.
– Financial information on issuer — most
recent and audited financial statements.
– Contributors to prospectus are liable for
prosecution by investors over losses
resulting from misstatements in, or
omissions from, disclosure documents.
Underwriting and Managing a New Issue

• Underwriting is a service provided by a

stockbroker or investment bank.

• For a fee, the underwriter contracts to purchase

all shares for which applications have not been
received by the closing date of the issue.

• Having Institutional investors initially bid for the

shares is referred to as book building.

• If book building process is used to issue shares,

there is no need for underwriting, but an
institution needs to manage the issue.

• Underwriter can limit exposure by sub-

underwriting (to insurance companies, banks,
superannuation funds).
Initial Public Offerings

However there does exist some market anomalies

(violations of the EMH) in regard to IPO’s. These
include:

(a) Consistent underpricing of IPO’s (average first

day returns of 10%-15%)

(b) Cycles in the extent of underpricing

(c) Long run underperformance by IPO’s after

listing.
Selling a New Issue

• If a stockbroker is an underwriter or lead

manager, he/she will usually act as selling agent
for the issue.

• Promotion reduces the need to purchase

underwritten shares and will generate brokerage
fees.

• Even without underwriting, a broker is engaged

to assist in the distribution of shares.

• Brokerage depends on size of issue, but usually

ranges between 1% and 2% of funds raised.
Evidence on the pricing of IPO’s.

Country Sample Time Average

Size Period Initial
Return (%)

Australia 266 1976-89 11.9

France 187 1983-92 4.2

Korea 347 1980-90 78.1

Singapore 128 1973-92 31.4

UK 2,133 1959-90 12.0

USA 10,626 1960-92 15.3

Explanations for the underpricing of IPO’s

Under pricing of IPO’s are a violation of the EMH.

Explanations for this anomaly include:

(a) The Winners Curse Hypothesis – It is

assumed all potential investors are of two
types; completely informed investors (who
know the future price of the stock), and
completely uninformed investors. Informed
investors only invest in IPO’s which are
underpriced whilst uninformed investors
invest in all IPO’s. Since uninformed investors
know that on average they are subscribing to
the less lucrative IPO’s, they demand that on
average IPO’s should be underpriced.
Explanations for the underpricing of IPO’s

(b) Dynamic Information Acquisition – Investment

bankers underprice IPO’s to induce regular
investors to reveal information during the pre-
selling period. As information accumulates for
the investment banker, the offer price may be
readjusted.

(c) Information Cascades – It is assumed

potential investors wait to see if others invest
in an IPO. If some investors do indeed invest,
then a ‘cascade’ of investors will subscribe to
the IPO. Hence an issuer may underprice an
IPO to initiate a cascade.
Hot Issue Markets

The number of new listings on the ASX from 1991 to

1997 were:

1991 1992 1993 1994 1995 1996 1997

23 176 104 120 45 75 87

It appears that there are periods of time when far

more listings are offered to the market than at other
times. Furthermore these high listing periods cluster
together. Periods when relatively many IPO’s occur
are referred to as ‘Hot issue markets’.

A similar pattern exists for US markets.

Hot Issue Markets

Number of IPO’s and Average Initial Returns for US

markets.

Average initial return per month

Number of IPO’s per month

1960 1970 1980 1990

Hot Issue Markets

The years 1,999 and 2,000 saw a huge market

‘bubble’ related to information technology and
internet stocks.
Hot Issue Markets

IT share prices peaked in March 2000 at almost

eight times their end 1998 level and fell sharply
thereafter, reverting to their end 1998 level by end
2002.
Hot Issue Markets

Explanations for the existence of hot issue markets

include:

(a) Changes in Firm Risk – It is hypothesised that

their exist periods which are far more risky to
launch an IPO so the IPO is underpriced to a
greater extent to compensate for this risk.
(b) Positive Feedback – Because there is positive
autocorrelation in the initial returns of IPO’s,
investors bid up the price of an IPO as a self
fulfilling prophesy.
(c) Windows of Opportunity – Markets may go
through periods when IPO’s can be sold for
relatively higher value (as proxied by for
example a high market to book value). Issuers
may time the launch of IPO’s to correspond to
these periods of high investor optimism.
Hot Issue Markets

Empirical research suggests that none of the above

explanations fully explain the existence of hot issue
markets. Some researchers suggest that to date the
existence of hot issue markets has simply defied
rational explanation.
Long Run Underperformance

The third IPO anomaly is the poor price performance

of IPO’s in the long run.

For example, during the period 1975-1984, IPO’s

traded on the NYSE had an average return of 34.5%
after 3 years. However, all other companies averaged
a return of 61.9% after 3 years. That is, IPO’s
underperformed in the long run relative to other
stocks.

While IPO’s underperformed as a group, the

underperformance was far more pronounced for
young companies relative to older more established
firms.
Long Run Underperformance

Other evidence suggests that established firms

launched in non-hot issue periods do not
underperform at all relative to the whole market.

Two explanations of long run underperformance

have been proposed:

(a) Excessive Optimism – It is proposed that

buyers of IPO’s are excessively optimistic
about the value of the share, particularly
during periods of high volatility. As time goes
by, the ‘true’ value of the share will be found
by the market as share information is
released.
Long Run Underperformance

(b) Impresarios – Just as rock concert & boxing

promoters ‘talk up’ the event, so do investment
bankers in regard to IPO’s. If this hypothesis is
correct, then the long run underperformance
of IPO’s should be negatively related to short
run under pricing.

Empirical evidence is consistent with both of the

above explanations.