CF chapter 23

Question 1

Advantages of venture capital firms

Answer 1

1) Limited partners are more diversified.

2) They also benefit from the expertise of the general partners.

Question 2

Disadvantages of venture capital firms

Answer 2

1) General partners usually charge substantial fees.

2) 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.

Question 3

Venture capital definition

Answer 3

Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential

Question 4

An offer by VC or a Private Equity firm to buy equity in the firm has two effects:

Answer 4

1) Information: an external party offers a valuation for the equity
2) Flow of funds: if accepted, the firm receives an inflow of capital

Question 5

Pre-money valuation

Answer 5

The new valuation of the firm’s outstanding shares before the infusion of capital and the issuance of new shares.

Question 6

Post-money valuation

Answer 6

The value of the whole equity (old plus new shares) at the price at which the new equity is sold.

Question 7

Liquidation preference

Answer 7

The liquidation preference specifies a minimum amount that must be paid to these shareholders before any payment to common stakeholders.

Question 8

Seniority

Answer 8

In case of liquidation investors get paid as long as every investor with higher
seniority has already been paid.

Question 9

Participation rights

Answer 9

Holders of convertible shares without participation rights must choose between demanding their liquidation preference or converting their share to com-
mon stock. Participation rights allow investors to “double dip”.

Question 10

Initial public offering

Answer 10

Process of selling shares for the first time

Question 11

Advantages and disadvantages of IPO

Answer 11

Great liquidity
Better access to capital

Equity holders become more widely dispersed
The firm must satisfy all requirements of public companies (sec etc.)

Question 12

Best effort basis offering

Answer 12

For smaller IPOs, a situation in which the underwriter does not
guarantee that the stock will be sold, but instead tries to sell the stock for the best
possible price. (usually have an all-or-noneclause).

Question 13

Firm commitment offering

Answer 13

An agreement between an underwriter and an issuing firm in which the underwriter guarantees that it will sell all of the stock at the offer price.

Question 14

Auction IPO

Answer 14

A method of selling new issues directly to the public. The underwriter in an
auction IPO takes bids from investors and then sets the price that clears the market.

Question 15

Underwriter Definition

Answer 15

a bank or other financial institution that pledges to buy all the unsold shares in an issue of new shares

Question 16

Setting the IPO price: two methods

Answer 16

Compute the present value of the estimated future cash flows.

Estimate the value by examining comparable IPOs.

Question 17

Roadshow

Answer 17

the firm and the underwriter pitch the idea behind the firm’s plans to a set of large institutional investors, aiming at gaining insight into the demand that these large investors have for the stock, and these investors’
reservation price for the stock.

Question 18

Managing risk: when a firm
When an underwriter provides a firm commitment, it becomes exposed to sell the shares at less than the offer price and take a loss

Answer 18

Lockup:
A restriction that prevents existing shareholders from selling their shares for some period, usually 180 days, after an IPO.

Over allotment allocation (green shoe provision):
An option that allows the
underwriter to issue more stock, usually 15% of the offer size, at the IPO price.

Question 19

Underpricing during IPOS:

Answer 19

The underwriters benefit from the underpricing because it allows them to manage their
risk.

The pre-IPO shareholders bear the cost of underpricing.

Although IPO returns are attractive, all investors cannot earn these returns.
When an IPO goes well, the demand for the stock exceeds the supply. Thus the
allocation of shares for each investor is rationed.
When an IPO does not go well, demand at the issue price is weak, so all initial
orders are filled completely.

Thus, the typical investor will have their investment in “good” IPOs rationed while fully investing in “bad” IPOs.