Chapter 15: How corporations raise venture capital and issue securities Flashcards
How do venture capital firms design successful deals? (LO15-1)
Infant companies raise venture capital to carry them through to the point at which they can make their first public issue of stock. Venture capital firms try to structure the financing to avoid conflicts of interest. If both the entrepreneur and the venture capital investors have an important equity stake in the company, they are likely to pull in the same direction. The entrepreneur’s willingness to invest his or her own cash also signals management’s confidence in the company’s future. In addition, most venture capital is provided in stages that keep the firm on a short leash and force it to prove at each stage that it deserves the additional funds.
How do firms make initial public offerings, and what are the costs of such offerings? (LO15-2)
The initial public offering or IPO is the first sale of shares in a general offering to investors. The sale of the securities is usually managed by an underwriting firm that buys the shares from the company and resells them to the public. The underwriter helps to prepare a prospectus, which describes the company and its prospects. Underwriting firms have expertise in such sales because they are in the business all the time, whereas the company raises capital only occasionally. The costs of an IPO include direct costs, such as legal and administrative fees, as well as the underwriting spread—the difference between the price the underwriter pays to acquire the shares from the firm and the price the public pays the underwriter for those shares. Another major implicit cost is the underpricing of the issue—that is, shares are typically sold to the public somewhat below the true value of the security. This discount is reflected in abnormally high average returns to new issues on the first day of trading.
What are some of the significant issues that arise when established firms make a general cash offer of securities? (LO15-3)
There are always economies of scale in issuing securities. It is cheaper to go to the market once for $100 million than to make two trips for $50 million each. Consequently, firms “bunch” security issues. This may mean relying on short-term financing until a large issue is justified. Or it may mean issuing more than is needed at the moment to avoid another issue later.
A seasoned offering may depress the stock price. The extent of this price decline var- ies, but for issues of common stocks by industrial firms, the fall in the value of the existing stock may amount to a significant proportion of the money raised. The likely explanation for this pressure is the information the market reads into the company’s decision to issue stock.
Shelf registration often makes sense for debt issues by blue-chip firms. Shelf registration reduces the time taken to arrange a new issue, it increases flexibility, and it may cut under- writing costs. It seems best suited for debt issues by large firms that are happy to switch between investment banks. It seems least suited for issues of unusually risky securities or for issues by small companies that most need a close relationship with an investment bank.
How do companies make private placements? (LO15-4)
In private placements, the firm places the newly issued securities with a small number of large institutions. These arrangements avoid registration expenses, may be tailored to the special needs of the issuer, and, in the case of debt, allow for a more direct relationship with the lender. However, buyers need to be compensated for the fact that such issues are not easily resold. Private placements are well suited for small, risky, or unusual firms, but the advantages are not worth as much to blue-chip borrowers.
