Capital Markets - Equity Financing

Question 1

If a startup is “bootstrapping,” what does this mean?

Answer 1

If a startup is currently in the “bootstrapping” stage, operations are currently being funded entirely by the cash
flows generated by the business and through the out-of-the-pocket funds from the entrepreneur. This term is
often closely aligned with the concept of a startup remaining “lean” and holding off on raising outside,
“unnecessary” capital to first maximize the utilization of their resources (e.g., human capital, intellectual
property, product, and market strategy ideas/plans).
The startup is likely attempting to minimize expenses while building its cash flow to reduce the need to raise
outside capital. Alternatively, it may not have the option to raise capital even if it wanted to due to insufficient
proof-of-concept. Once the startup has become more established and made more progress, it can raise capital
with more negotiating leverage (rather than being at the mercy of early investors).

Question 2

For an early-stage company, what are a few options for liquidity events?

Answer 2

A liquidity event is an opportunity for the founder of a private company and its early investors to sell some or
all of their equity ownership. Given the illiquid nature of the investment and the high-risk nature of early-stage
companies, it’s reasonable to see a liquidity event.
Often, this will begin with a minor partial liquidity event to take some profits (i.e., partial “cash-out”), with the
provider of the capital being a venture capital firm. Later examples of liquidity events as the startup grows will
be raising financing from venture firms and being acquired by a strategic.

Question 3

Who are angel investors?

Answer 3

An angel investor is most often a wealthy, accredited individual investing in seed and early-stage companies.
Once a startup has exhausted its funding from friends and family members, the angel investor is often the first
outside investor to provide capital.
The company may often not even have a working product, and therefore, the angel investor is taking on a
substantial risk of losing their initial investment. For this reason, the check size of an angel investor is rarely
more than $1 million per startup investment.

Question 4

Walk me through the various funding rounds in venture capital.

Answer 4

Venture Funding Rounds
Seed Round: The seed round will involve friends and family of the entrepreneurs and individual angel
investors. Seed-stage VC firms can sometimes be involved, but this is typically only when the founder has
previously had a successful exit in the past.
Series A: The Series A round would include early-stage investors and typically represents the first time
institutional investment firms will provide financing. During this stage, the startup’s focus will be on
optimizing its product offerings and business model and developing a better understanding of its users.
Series B/C: These rounds represent the expansion stage and still involve mostly early-stage venture firms.
The startup has gained initial traction and shown enough progress for the focus is now be trying to scale,
which involves hiring more employees (especially in sales & marketing, business development).
Series D: The Series D round (and onward) represents late-stage investments where the new investors
providing capital will usually be growth equity shops that invest under the belief the company has a real
chance at undergoing an IPO in the near term.

Question 5

From the perspective of an entrepreneur, what are the pros and cons of raising outside capital?

Answer 5

For entrepreneurs, the primary reason for raising outside capital is often first to ensure the business has
sufficient funds even to operate. This will particularly be the case for startups that require high R&D for
continued product development and to scale further.
Using the newly raised capital, the entrepreneur has various options to improve their operations, including:
Hire more talented employees and increase overall employee count (more job functions)
Move the business to a better location (i.e., be closer to target customers, VCs, a state with lower taxes)
Invest more in sales & marketing, advertising, and other operational roles
Implement new growth strategies that otherwise could not be done without this funding
Most venture capitalists are rarely simple providers of capital. These investors are often former entrepreneurs
who had their own successful exits and can develop a strong mentor-mentee relationship with the
entrepreneur. Under the guidance of the new advisors, the entrepreneur can better navigate the difficulties all
startups inevitably face as they attempt to achieve growth and scale.
In addition, an investor’s willingness to not only risk the loss of their capital but to spend their time and
resources to provide guidance to the management team proves the validity of the entrepreneur’s business idea
(i.e., this product and business plan could be viable).
The major downside of raising outside capital is that the entrepreneur must give up more ownership of their
business as more capital is raised. However, this is often a necessary decision if the entrepreneur wants to grow
the business and eventually IPO (or have a similarly successful exit).

Question 6

What does the proof-of-concept stage involve?

Answer 6

When a company is at the proof-of-concept stage, there’s no working product on-hand. Instead, there’s just a
proposed idea for a certain product, technology, or service. Thus, it’s difficult to raise much capital; however,
the amount of funding required is usually very minimal since it’s only meant to build a prototype and see if this
idea is feasible in terms of product-market fit. At this stage, the investors providing this type of seed investment
are usually friends, family, or angel investors.

Question 7

Explain to me what the commercialization stage is.

Answer 7

The commercialization stage is when the value proposition of a startup and the possibility of a product-market
fit has been validated, meaning institutional investors have been sold on this idea and contributed more capital.
The focus shifts almost entirely to revenue growth, as profitability is not the priority, since the company has
more than enough capital raised and investors will contribute more if needed.
The commercialization stage usually refers to Series C to D (and beyond), and there’ll be several large,
institutional venture firms and growth equity firms involved in guiding this high-growth company to help
refine the product or service offering, as well as the business model.

Question 8

Explain the power law of returns in venture capital investing and its implications?

Answer 8

Peter Thiel famously said, “The biggest secret in VC is that the best investment in a
successful fund outperforms the entire rest of the fund combined.” The return
distribution that Thiel was referring to is known as the power law of returns.
Venture capital investments are made under the expectation that most will
inevitably fail. However, a single investment by itself can enable the firm to meet its
return hurdle. The implication of this is the considerable emphasis on market size
when looking for prospective companies given the risk/return profile.
If the revenue opportunity present in the market is not large enough, the fund could not meet its return
threshold even if the startup turned out to be a success. This illustrates why VCs target large industries worth
at least ~$500 million to achieve their target of ~$100 million revenue based on their market penetration
assumptions with a reasonable margin of safety.

Question 9

What role does a lead investor have in a round of financing?

Answer 9

The lead investor in a company is a venture capital firm or individual investor that organizes a round of funding
for a particular company. The lead investor is usually one of the first institutional investors in the company and
will contribute the largest amount of capital (i.e., “lead the round”).
The lead investor will often use their network to help the startup raise more funding from various investment
firms and make introductions as needed. Therefore, the more credibility the lead investor has within the
investment community, the higher the likelihood that other VC firms will trust their judgment and be more
willing to participate in the upcoming financing rounds.

Question 10

Give me an example of the drag-along provision in use?

Answer 10

The drag-along provision protects the interests of the majority shareholders (usually the early, lead investors)
by enabling them to force major decisions such as exiting the investment.
This provision will prevent minority shareholders from holding back a particular decision or taking a specific
action, just because a few shareholders with small stakes are opposed to it and refusing to do so.
For example, suppose the stakeholders with majority ownership desire to sell the company to a strategic, but a
few minority investors refuse to follow along (i.e., drag-along the process). In that case, this provision allows
the majority owners to override their refusal and proceed onward with the sale.

Question 11

What are the typical characteristics of preferred stock?

Answer 11

Preferred stock can be best described as a hybrid between debt and equity – and sits right in between the two
in the capital structure. Preferred stock has a higher claim on assets than common stock and receives
dividends, which can be paid out as cash or “PIK.”
Unlike common equity, the preferred stock class doesn’t have voting rights but has seniority in the capital
structure, but still has a lower claim than any debt holders. Sometimes preferred stock can be convertible into
common equity, creating additional dilution.

Question 12

What are the two main types of preferred equity investments?

Answer 12

1. Participating Preferred: The investor receives the preferred proceeds (i.e., dividends) amount + has a
   claim to common equity afterward (i.e., “double-dip” in the exit proceeds).
2. Convertible Preferred: Also referred to as non-participating preferred, the investor receives either 1)
   the preferred proceeds or 2) common equity conversion amount – whichever is of greater value.

Question 13

What is a liquidation preference?

Answer 13

The liquidation preference of an investment represents the amount the owner must be paid at exit (after
secured debt, trade creditors, and other company obligations). The liquidation preference determines the
relative distribution between the preferred shareholders and the common shareholders.
Often, the liquidation preference is expressed as a multiple of the initial investment (e.g., 1.0x, 1.5x).

Liquidation Preference = Investment $ Amount × Liquidation Preference Multiple

Question 14

A preferred shareholder has a 2.0x liquidation preference. What does this mean?

Answer 14

A liquidation preference is a clause in a contract that gives a certain class of shareholders the right to be paid
ahead of other shareholders in the event of a liquidation. This feature is commonly seen in venture capital
investments. Given the high failure rate in venture capital, certain preferred investors desire assurance to get
their invested capital back before any proceeds are distributed to common stockholders.
If an investor owns preferred stock with a 2.0x liquidation preference – this is the multiple on the amount
invested for a specific funding round. Thus, if the investor had put in $1 million with a 2.0x liquidation
preference, the investor is guaranteed $2 million back before common shareholders receive any proceeds.

Question 14

What does it mean if the liquidation preference is a capped participation preference?

Answer 14

A capped participation preference (often called “capped participating preferred”) indicates that the preferred
shareholders can share in the liquidation proceeds on a pro rata basis until total proceeds reach a certain
multiple of the original investment, plus any accrued dividends. This is similar to participating preferred
equity, but the proceeds are capped once a certain multiple has been reached.

Question 15

What is the difference between the pre-money and post-money valuation?

Answer 15

Pre-Money Valuation: The pre-money valuation refers to the company’s value prior to the first (or the
next) financing round.
Post-Money Valuation: The post-money valuation accounts for the new investment amount after the
financing round. It can be calculated as simply the new financing amount added to pre-money valuation, or
the formula below can be used:

Post Money Valuation = (New Financing Amount / % of Equity)

Question 16

Tell me about the difference between an up round vs. a down round.

Answer 16

Prior to a new financing round, the pre-money valuation will first be determined. The difference captured
between the starting valuation and then the ending valuation after the new round of financing determines
whether the financing was an “up round” or a “down round.”
Up Round: An up round refers to financing in which the valuation of the company raising additional
capital increases when compared to its prior valuation.
Down Round: A down round refers to when the valuation of a company has decreased after a financing
round when compared to the previous financing round.

Question 17

Can you give me an example of when dilution would be beneficial for a founder?

Answer 17

As long as the startup’s valuation has increased sufficiently (i.e., “up round”), dilution to the founder’s
ownership can be beneficial. For example, let’s say that a founder owns 100% of a startup that’s worth $5
million. In its seed-stage round, the valuation was $20 million, and a group of angel investors collectively want
to own 20% of the company in total. The founder’s stake will be reduced from 100% to 80%, while the value
owned by the founder has increased from $5 million to $16 million post-financing despite the dilution.

Question 18

Can a startup recover from a down round?

Answer 18

For certain, despite the dilution and potential internal conflict created from the unsuccessful new round of
financing – the capital raised could have eliminated the risk of bankruptcy and given it enough money to turn
the business around. This down round may have been the lifeline the startup needed to stay afloat and still
have a chance at achieving its goals. While a down round is not a positive sign, it’s not necessarily a sign that
the end is near (although it may be more challenging to raise capital in the future unless clear improvements in
performance are made).

Question 19

What are anti-dilution protection clauses?

Answer 19

The purpose of anti-dilution protection clauses protects shareholders (usually the early investors) following a
down round. In effect, their conversion ratio remains the same to shield their investment from potentially
losing value due to the additional dilution created post-financing.

Question 20

What is the term sheet in venture capital?

Answer 20

Term sheets establish the specific agreements of investment between an early-stage company and a venture
firm. The term sheet is a non-binding agreement that forms the basis of more enduring and legally binding
documents, such as the Stock Purchase Agreement (SPA) and Voting Agreement.
The term sheet is usually less than ~10 pages and is prepared by the investor. Although short-lived, the term
sheet’s purpose is to list out the initial specifics of an investment, such as the valuation, dollar amount raised,
class of shares, investor rights, and investor protection clauses.
The term sheet would then flow into the capitalization table, which is essentially a numerical representation of
the investor ownership specified in the term sheet.

Question 21

What is the pay-to-play provision and what purpose does it serve?

Answer 21

A pay-to-play provision incentivizes investors to participate in future rounds of financing. Simply put, these
provisions will require existing preferred investors to invest on a pro rata basis in subsequent financing
rounds. If not, the investors will lose some (or all) of their preferential rights, which most often include
liquidation preferences and anti-dilution protection. In most cases, the preferred shareholder will accept being
automatically converted to common stock with a down round.

Question 22

What is a right of first refusal (ROFR) and is it an interchangeable term with a co-sale agreement?

Answer 22

While a ROFR and co-sale agreement are both provisions intended to protect the interests of a certain group of
stakeholders, the two terms are not synonymous.
Right of First Refusal: The ROFR provision gives the company and/or the investor the option to purchase
shares being sold by any shareholder before any other 3rd party.
Co-sale Agreement: The co-sale agreement provides a group of shareholders the right to sell their shares
when another group does so (and under the same conditions).

Question 23

What are redemption rights?

Answer 23

A redemption right is a feature of preferred equity that enables the preferred investor to force the company to
repurchase its shares after a specified period. It protects them from a situation when the company’s prospects
turn bleak. However, this is a rare occurrence to see exercised, as most of the time, the company would not have
sufficient funds to make the purchase even if legally required to so.

Question 24

What is a full ratchet provision, and how does it differ from a weighted average provision?

Answer 24

Full Ratchet Provision: A full ratchet is an anti-dilution provision that protects early investors and their
preferred ownership stakes in the case of a down-round, the investor with the full ratchet’s conversion
price will be re-priced to the lowest price at which any new preferred stock is issued. In effect, the
investor’s ownership stake is maintained at the expense of substantial dilution to the management team,
employees, and all other investors.
Weighted Average: A similar anti-dilution provision used far more often is the weighted average method,
which uses a weighted average calculation that adjusts the conversion ratio to account for any past share
issuance and the prices they were raised. In effect, the conversion rate is lower than that of a full-ratchet
strategy, making the dilutive impact far less severe.

Question 25

What is the difference between broad-based and narrow-based weighted average anti-dilution
provisions?

Answer 25

Both broad-based and narrow-based weighted average anti-dilution protections will include common and
preferred shares. However, broad-based will also include options, warrants, and shares reserved for purposes
such as option pools for incentives. Since more dilutive impact from shares is included in the broad-based
formula, the magnitude of the anti-dilution adjustment is thereby lower.

Question 26

What is a capitalization table and what purpose does it serve for early-stage companies and their
shareholders?

Answer 26

A capitalization table (“cap table”) for any early-stage company tracks the equity ownership of a company in
terms of number and type of shares (as well as series) along with any special terms such as liquidation
preferences or protection clauses. For this reason, a cap table must be kept up-to-date to calculate the dilutive
impact from each funding round, employee stock options, and issuances of new securities or convertible debt.
Thus, all stakeholders can accurately calculate their share of the proceeds in a potential exit (i.e., liquidation
event such as a sale to a strategic or IPO).

Question 27

What is an option pool?

Answer 27

An option pool is a reservation of a certain percentage of shares (usually between 5% and 20%) set aside for
future issuance to key employees, investors, or advisors of a company. The option pool is often used to attract
talented employees by a cash-strapped startup that cannot afford to pay out high salaries due to insufficient
cash and provide an incentive to perform well for the options to vest.
Another case an option pool is used is when a private equity firm performing an LBO allots a portion of equity
as an incentive tool for the management team to reach their targets (called a “management option pool”).

Question 28

What is an employee stock ownership plan (ESOP) pool?

Answer 28

When a startup has an employee stock ownership plan (ESOP), it allocates a certain percentage of shares to
early employees and later hires. The key distinction of this specific type of options pool is that it’s not intended
for the founding team, first employees, or current employees. Instead, an ESOP aligns incentives for future
employees and is used to hire the top talent once the business scales. By the time a startup is nearing its Series
A, the ESOP pool size typically ranges around ~10% of the fully diluted equity.

Question 29

What is growth equity and how does it differ from earlier-stage venture capital investments?

Answer 29

Growth equity involves taking minority equity stakes into high-growth companies that have moved beyond the
initial startup stages. The investments made by growth equity firms are often called growth capital because
they help the company advance into the next development stage. Since the growth equity firm doesn’t have a
majority stake, the investor has less influence on the portfolio company’s strategy and operations. However, the
objective is more related to riding the ongoing, positive momentum and taking part in the IPO ideally.

Question 30

How does the typical growth equity investment differ from traditional buyouts?

Answer 30

Traditional buyout funds take majority stakes in stable growth, mature companies (usually ~90-100% equity
ownership), whereas growth equity investors take minority stakes in high-growth companies attempting to
disrupt a particular industry. For growth-oriented investors, differentiation is a key factor that’s often the
leading rationale for investing. To these investors, what makes a product worth investing in is the value it
derives from its proprietary technology that’s difficult to replicate or protected by patents. The end goal in
growth equity investing is almost always an IPO.

Question 31

When growth equity investors pursue industries to invest in, how does it differ from industries
targeted by traditional buyout firms?

Answer 31

Growth equity is centered on disruption in “winner-takes-all” industries; whereas traditional private equity is
more about defensibility in revenue and free cash flows. In the industries that traditional buyouts take place,
there’s enough room for there to be multiple “winners.” In addition, traditional buyouts typically rely heavily on
the use of leverage in their investments, in contrast to growth equity firms, which may not use any debt, and
usually are more focused on the pure growth of the equity in their investments.

Question 32

What is an initial public offering (IPO)?

Answer 32

An initial public offering (IPO) is the process of a privately held company offering its equity to the public in a
new stock issuance. For a company to undergo an IPO, specific requirements must be met that are set by the
Securities and Exchange Commission (SEC). An IPO presents a company with an opportunity to get further
capital by offering shares through the primary market channel.
Traditionally, the company will hire several investment banks (often called the “underwriters”) to advise on the
transaction as the company “goes public.
” The investment bank will market the company (i.e., the
“roadshows”), secure demand from institutional investors, and set the IPO price and listing date.

Question 33

From the perspective of management, what are some downsides of going public?

Answer 33

While the benefits of becoming publicly traded from a monetary perspective are clear, there are several
disadvantages to management once their company has gone public:
The foremost concern for management teams is that they could lose control over their company, especially
if shareholders are not pleased with its financial performance and believe they should be replaced.
The disclosure requirements will open up the company to scrutiny by investors and their closest
competitors can access their financials as their operations and playbook are an open-book for viewing.
Going public puts more pressure on the management team to meet near-term performance metrics, as
public market investors can be more short-term focused and expect companies to meet their quarterly or
annual earnings guidance.

Question 34

What are the key differences between common and preferred stock?

Answer 34

Common Stock: Common stock is often referred to as basic shares and represents ownership in a
particular company. Usually, common shares come with voting rights, and the amount of voting power a
common shareholder has is directly related to the number of shares owned.
Preferred Stock: Preferred stock is a hybrid between bonds and common stock, which can be appealing to
more risk-averse investors. Preferred stockholders are usually paid preferred dividends consistently, hence
its comparison to bonds. But if dividends cannot be paid out to any equity investors, preferred
shareholders have a higher claim on the distributions than equity shareholders – so no dividends can
legally be paid to common shareholders without first paying the preferred shareholders. On the downside,
preferred shareholders have no (or limited) voting rights in the company’s corporate governance and are
still below all debt holders in the capital structure. In the event of liquidation, the preferred shareholders
will have a higher claim on the liquidated assets relative to common shareholders, assuming there’s
remaining collateral after the debt holders have received their share.

Question 35

What are preemptive rights?

Answer 35

Preemptive rights allow existing shareholders to purchase a new issuance before it’s offered to other potential
buyers. This provision protects early shareholders from dilution when the company issues new shares.

Question 36

How can founders maintain control over their company post-IPO?

Answer 36

Once a company has gone public, it’s inevitable for ownership to become diluted for all stakeholders. For many
founders, this is the primary concern when considering selling shares to the open public.
Three methods for management to help protect their control over their company are:
1. Create Different Share Classes (Dual-Class Share Structure): This would mean there are distinct
classes of common stock with different voting rights or voting power. The most common practice is the
issuance of Class A and Class B shares. When a company goes public, the founders and early investors can
be given shares with extra voting rights (often called “super-voting shares”).
2. Maintain Majority Control: While it’s near impossible for the founders to maintain majority control,
close relationships with their early investors and investors with large stakes in the company would be
very beneficial to have on their side and a way for them to maintain majority control in the company to an
extent. Having the backing of the largest shareholders is reassuring from the perspective of management.
3. Control the Internal Board of Directors (BOD): While regulations are increasingly forcing companies
to include more independent board members, the more BOD members that have a close relationship with
the founders – the more beneficial it is for management. Ideally, the entire board respects and believes
the current management team is the right team to lead the company. The absence of this type of dynamic
could lead to management being voted out if performance suffers. Therefore, it’s in management’s best
interest to have as many inside directors as possible (rather than outside directors).

Question 37

What are no-vote common shares and which headline IPO brought it into discussion?

Answer 37

The mainstream IPO that included no-vote common shares was the IPO of Snap Inc. in 2017. While common
shares with differing voting rights are frequently seen during IPOs, the no-vote common shares were a rarity. In
Snap’s IPO, most shareholders were not given voting rights, which was controversial, as investors would be
completely hostage to management decisions under the proposed corporate governance. Even Snap’s S-1 filing
wrote that “to our knowledge, no other company has completed an initial public offering of non-voting stock on
a US stock exchange” and acknowledged this decision could lead to a lower share price and fewer investors.
In Snap’s IPO, there were three classes of stock: Class A, Class B, and Class C. Class A would be the shares traded
on the NYSE with no voting rights, Class B would be for early investors and executives of the company and
come with one vote each, and Class C would be held only by Snap’s two co-founders, CEO Evan Spiegel and CTO
Bobby Murphy. The Class C shares would come with ten votes apiece, and the two holders would have a
combined 88.5% of Snap’s total voting power post-IPO.

Question 38

During an IPO, what is the role of the underwriter?

Answer 38

The underwriter, most often an investment bank, will serve as an intermediary between the company issuing
securities and the investing public. The underwriter will be tasked with handling the new issuance of stock and
to ensure the public, primarily institutional investors (e.g., mutual funds, pension funds, hedge funds), commit
to purchasing the issuance before actually becoming available for purchase in the open market. Some key
obligations that the underwriter will have are to handle the roadshow strategy, generate interest from potential
investors, and price the IPO optimally to maximize the value received.

Question 39

What is the purpose of a syndicate of underwriters?

Answer 39

A group of investment banks, called a syndicate, will purchase the new issuance of securities for a negotiated
price and then promote the securities to their network of investors in a process called a roadshow. Doing so
spreads the risk across several underwriters instead of placing all the pressure on one underwriter, which
maximizes the chance of the entire issuance being sold to the public (but mainly to institutional investors).

Question 40

What events take place during management roadshows?

Answer 40

A roadshow is when the management of a company raising capital will travel around to give presentations to
institutional investors such as large asset management firms, hedge funds, and pension funds. The reason for
doing the roadshows is to generate interest from investors for an upcoming issuance of equity or debt.

Question 41

What is the difference between the primary and secondary markets?

Answer 41

Primary Market: The primary market is when securities are first issued via an IPO – i.e., this is the first
time shares are offered to the public.
Secondary Market: The secondary market is when the securities are traded amongst investors, which
include institutional firms (e.g., asset managers, hedge funds), as well as individual investors.

Question 42

What is a red herring, and when is it filed with SEC?

Answer 42

More formally called the preliminary prospectus, the red herring provides prospective investors with
information regarding an upcoming IPO. Included in the prospectus are details related to the company’s
products, growth plans, intended uses of the raised funds, potential risk factors, and more background details
on the company (e.g., detailed financial statements, management team biographies).
The filing must be filed with the SEC, not just accompany the bankers on the roadshow and be used to raise
investor interest, but to describe the issuance of equity and the proposed details of the IPO offering.

Question 43

What is the S-1 filing, and how does it differ from the red herring?

Answer 43

The SEC Form S-1 is a required filing with the SEC for all US companies seeking to become publicly listed and
registered on an exchange (i.e., planned IPO). Found in the S-1 is information on the planned usage of the
raised capital proceeds, the current business model, full detailed historical financials, commentary on the
competition landscape, a prospectus of the planned security issuance, the method for setting the offering share
price, and commentary on existing securities and dilution.
Compared to the red herring, the S-1 is lengthier and more formalized regarding the IPO’s information and set
strategy. The red herring is a preliminary prospectus that comes before the S-1 and is circulated during the
“quiet period” before the registration has become official with the SEC. Often, the SEC may request additional
material to be included or changes to the red herring. The final prospectus, the official S-1, would then be filed
before the company can proceed with the distribution of shares.

Question 44

Why is there a lockup period associated with IPOs?

Answer 44

The 180-day lockup period associated with IPOs prevents insiders from selling their shares immediately once
the company has undergone an IPO. The sudden increase in selling volume could cause the share price to drop
significantly, as many early investors might want to liquidate their positions as soon as possible.

Question 45

What is the difference between a seasoned equity offering (SEO) and a rights offering?

Answer 45

Seasoned Equity Offering: A SEO is when a company that’s already public (i.e., underwent an IPO) issues
additional shares. This is often referred to as a “follow-on offering.”
Rights Offering: A rights offering gives existing shareholders the exclusive right to purchase new shares at
a pre-specified price below the current share price on a pro rata basis.

Question 46

During an IPO, what does a firm commitment mean?

Answer 46

A firm commitment refers to when an investment bank, the underwriter of an IPO, agrees to assume all the
risks associated with failing to sell all the shares being listed by purchasing all the securities being issued
directly from the company. Under this method, the underwriter would bear all the risk because it purchases the
entire issuance of new securities (hence, syndicates are far more common).

Question 47

What do “best efforts” underwriting agreements involve?

Answer 47

An underwriting arrangement based on “best efforts” refers to the equity underwriters’ commitment to
making their best effort to sell as much as possible of the securities issuance. However, there’s no guarantee
that all the securities will be sold, so there are no negative implications for them failing to achieve the set
capital raising target (other than potential reputational damage).

Question 48

Could you explain the Dutch auction pricing method in an IPO?

Answer 48

In an IPO that uses the so-called Dutch auction pricing strategy, the share price is lowered until all the shares
would be sold. Then, all the shares are sold at that price, which is the highest price where all the shares would
be sold. Rather than setting the price based on valuation alone, the price is based on the bids placed by the
interested buyers that will submit how much they would pay and the number of shares they can buy at their
proposed price. In effect, bringing in a game theory element to this type of auction pricing strategy.

Question 49

What is a direct listing and how does it differ from the traditional IPO?

Answer 49

An alternative to the traditional IPO is a direct listing, which involves the company selling shares directly to the
public market without the advising of an investment bank. Companies that decide to proceed with this route
can avoid the lock-up period associated with IPOs, minimize the dilutive impact, and save a significant amount
of money by not having to pay fees to investment banks. This option is riskier, however, since the process is
relatively new, and there’s no assurance that the shares will be priced correctly or enough shares will be sold.
Direct listings come with fewer transaction costs (paid to investment banks) and the ability to avoid the lockup
period but are not viewed as a “replacement” for an IPO because they’re not ideal for a company that wants to
raise capital. However, the SEC recently announced a rule change that companies undergoing a direct listing
can now raise capital, making direct listing a more compelling alternative to IPOs. One of the first companies to
do a direct listing was Spotify in 2018, as well as Slack in 2019. Two of the most prominent IPOs in 2020,
Palantir Technologies and Asana Inc, both opted to go public under the non-traditional direct listing.

Question 50

In the past couple of years, IPOs have increasingly been scrutinized for leaving “money on the
table.” Could you explain what this criticism is regarding?

Answer 50

Following an IPO, the shares often surge and the market capitalization of the company can jump in excess of
$50-$80 million on the 1st day of trading. This has led to criticism, including from prominent VC Bill Gurley, one
of the leading critics of the underpricing of IPOs by investment banks for “leaving money on the table.
”
In defense of investment banks, this underpricing can be attributed to how their priority is to sell all the shares
being listed, which often requires pricing it lower than some would pay. However, many investment banks are
still accused of having conflicts of interest to serve both the company going public and institutional investors.
For example, imagine an unrealistic scenario where shares were priced to “perfection” and the share price
didn’t budge once listed, meaning no share appreciation for the investors. Therefore, this discounted feature of
IPO pricing could be seen as a way to establish long-term relationships with investors because if they achieve a
high return from an IPO, they’ll be more likely to invest in the next IPO managed by the same investment bank.

Question 51

A syndicate in an IPO has exercised the greenshoe option. What does this mean?

Answer 51

The greenshoe option (or “over-allotment”) is a clause outlined in the underwriting agreement of an IPO that
allows the underwriting syndicate to purchase up to an additional 15% of the shares at the offering price. The
option can be exercised, and more shares can be sold if demand from the public exceeded expectations, and the
shares are trading above the offering price, which allows the issuing company to raise more capital.
Alternatively, the underwriters are granted this right to buy more shares from investors to stabilize the price
and decrease the supply if the share price dropped.

Question 52

What is a special purpose acquisition company (SPAC)?

Answer 52

A special purpose acquisition company (SPAC), often referred to as a “blank check company,” is a shell company
formed strictly to raise capital through an initial public offering to acquire an existing company or merge
multiple companies. Prior to having a specific target, the SPAC raises funds through an IPO of the SPAC’s equity
securities, with the sponsor retaining ~20% of the post-IPO SPAC. The invested capital is moved into an escrow
until the target to be acquired is determined, or else the capital will be returned to investors. While SPACs have
been around for a while, 2020 has been a record year for this type of investment vehicle.
From the company’s perspective, SPACs have quickly become a popular method to go public in a simple, time-
efficient manner (usually ~4-6 months). Arguably, it’s even more convenient than a reverse merger with added
benefits such as involving significantly less work than the traditional IPO. Most of the strenuous work involved
in an IPO, such as making investors interested and raising capital, has already been done by the SPAC sponsor.
The capital has already been raised, so all that remains is for the company to agree to a valuation. Here, the
valuations paid technically have more accuracy (or at least are more straight-forward) since a SPAC deal is
more like an M&A negotiation with buyers rather than an underwriter telling you what the market might pay.
Thus, SPAC acquisitions come with a certainty of pricing aspect and less risk of “leaving money on the table”
because there’s no risk of failing to issue all the shares (hence no need for a discount).
SPACs provide many advantages for companies looking to go public compared to a traditional IPO or direct
listing, such as simplicity, faster timeframe, better valuation, and well incentivized long-term partners. As a side
benefit, most SPAC sponsors are reputable individuals and asset management firms; otherwise, they would not
have been able to secure the capital in the first place.

Question 53

What is a private placement?

Answer 53

A private placement is when a company raising capital issues shares to only a select few institutional investors.
In contrast to a public issuance, the securities are not made available for sale to the open market and are not
required to be registered with the SEC. A private placement is a more direct approach to selling to a group of
accredited investors, consisting of institutional firms, mutual funds, and pension funds. Both public and
privately held companies can partake in private placements.

Question 54

What are the characteristics of a shelf offering?

Answer 54

Filed with the SEC, a shelf offering provision (S-3 registration) enables a company to make an issuance in a
three-year period, rather than selling it all in one sale. This can be beneficial as the market conditions could
turn more favorable, and it gives the company raising capital more flexibility with the timing of the sales.
Hence, many shares will be “on the shelf” until the company sells them.

Question 55

What does a private investment in public equity (PIPE) mean?

Answer 55

Private investment in public equity (PIPE) refers to the private placement of securities in a public company by
accredited investors such as hedge funds, private equity funds, and mutual funds. The purchase will be made at
a discounted price, usually as an unregistered convertible or preferred security.
PIPEs have become an alternative way for companies to raise capital and this financing structure became more
prevalent due to the relative cheapness and efficiency vs. a traditional secondary offering. There are also fewer
regulatory requirements, as there’s no need for expensive roadshows.