Chapter 15 - Raising Capital

Question 1

Know how rights are issued to existing shareholders and how to value those rights

Answer 1

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Question 2

What is venture capital and what types of firms receive it?

Answer 2

> Private financing for relatively new businesses in exchange for stock
Usually entails some hands-on guidance
The ultimate goal is usually to take the company public and the VC will benefit from the capital raised in the IPO

Question 3

Why is venture capital often provided in stages?

Answer 3

> To limit their risk.

> At each stage enough money is invested to reach the next milestone, such as a prototype or a needed major investment.

Question 4

What are important factors in choosing a Venture Capitalist?

Answer 4

> Look for financial strength
> Choose a VC that has a management style that is compatible with your own
> Obtain and check references
> What contacts does the VC have?
> What is the exit strategy?

Question 5

What is one major difference between the regulation of the securities market in Canada versus the US?

Answer 5

In the US securities regulations are handled by a federal body, the SEC. In Canada regulation of the securities market is carried out by provincial commissions through provincial securities acts.

Question 6

What are some of the important services provided by underwriters?

Answer 6

> Formulate method used to issue securities
Price the securities
Sell the securities
Price stabilization by lead underwriter

Question 7

What are the basic procedures in selling a new issue?

Answer 7

1. Management must obtain permission from the Board of Directors
2. Firm must prepare and distribute copies of a preliminary prospectus (red herring) to the OSC and to potential investors
3. OSC studies the preliminary prospectus and notifies the company of required changes (usually takes 2 weeks)
4. When the prospectus is approved, the price is determined and security dealers can begin selling the new issue

Question 8

What is a preliminary prospectus?

Answer 8

It contains some of the financial information that will be contained in the final prospectus; it does not contain the price at which the security will be offered

Question 9

What is the SFPD system and what advantages does it offer?

Answer 9

> Short form prospectus distribution

> A registration system designed to reduce repetitive filing requirements for large companies.

Question 10

What is the difference between a rights offer and a cash offer?

Answer 10

> General Cash Offer – New securities offered for sale to the general public on a cash basis.
Rights Offer – New securities are first offered to existing shareholders. These are more common outside North America.

Question 11

Why is an initial public offering necessarily a cash offer?

Answer 11

Because if the firms existing shareholders wanted to buy the shares, the firm wouldn’t have to sell them publicly in the first place.

Question 12

What is the Green shoe provision?

Answer 12

> Overallotment Option / Green Shoe provision
Allows syndicate to purchase an additional 15% of the issue from the issuer
Allows the issue to be oversubscribed. ie If the market price of a new issue rises immediately it allows the underwriters to buy additional shares from the issuer and immediately resell them to the public at a profit.
Provides some protection for the lead underwriter as they perform their price stabilization function

Question 13

What is the Green shoe provision?

Answer 13

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Question 14

What is a syndicate? What is the Spread?

Answer 14

> Syndicate – group of underwriters that market the securities and share the risk associated with selling the issue

> Spread – difference between what the syndicate pays the company and what the security sells for in the market

Question 15

Describe Firm Commitment Underwriting

Answer 15

> Also called a “bought deal”
Issuer sells entire issue to underwriting syndicate
The syndicate then resells the issue to the public
The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold
The syndicate bears the risk of not being able to sell the entire issue for more than the cost
Most common type of underwriting in Canada

Question 16

Describe Dutch Auction Underwriting

Answer 16

> Underwriter conducts an auction and investors bid for shares
Offer price is determined based on the submitted bids
More commonly used in bond markets
Also called uniform price auction
When the price is determined, those bidders within the price range will receive and allotment of shares based on the percentage of their bid. For example, if 400 shares were being issues but 600 shares are bid, then each bidder gets 400/600 = .67 , or 67% of their bid.

Question 17

Describe Dutch Auction Underwriting

Answer 17

> Underwriter conducts an auction and investors bid for shares
Offer price is determined based on the submitted bids
More commonly used in bond markets
Also called uniform price auction
When the price is determined, those bidders within the price range will receive and allotment of shares based on the percentage of their bid.

Question 18

What is IPO underpricing

Answer 18

> It may be difficult to price an IPO because there isn’t a current market price available
Additional asymmetric information associated with companies going public may not be known publicly
Underwriters want to ensure that their clients earn a good return on IPOs on average
Yet Underpricing causes the issuer to “leave money on the table”

Question 19

Why is underpricing a cost to the issuing firm?

Answer 19

Because it leaves money on the table. ie. additional funds that could have been raised if the share price had not been under priced.
> it is considered an indirect cost of issuing new
securities.
> Note: although the firm does not raise as much as it could have, the existing owners will still be happy; because they own the majority of shares that are priced well. perhaps a firm only offer 10% of its existing shares when going public.

Question 20

Why might underpricing it persist?

Answer 20

> Underwriters may intentionally underprice new issues to remain attractive to average investors, in order to counteract the “winners curse”. This is where average investors could perpetually lose more with IPO’s, as they get less allotment of the underpriced and a full allotment of the overpriced.
underpricing ensures that that do not overprice and anger their customers.
Underpricing is also a kind of reward for institutional investors that reveal their interest in an IPO honestly.

Question 21

Why might underpricing it persist?

Answer 21

> Underwriters may intentionally underprice new issues to remain attractive to average investors, in order to couunteract the “winners curse”. This is where average investors could perpetually lose more with IPO’s, as they get less allotment of the underpriced and a full allotment of the overpriced.

Question 22

Why do Stock prices tend to decline when new equity is issued?

Answer 22

Possible explanations for this phenomenon
> Managerial information and signaling. Management may be trying to take advantage of their firm being overvalued by the market.
> Debt usage and signaling. The new issue may reveal too much debt of too little liquidity.
> Issue costs. It cots money to issues securities.

Question 23

What is a rights offering and how do you value a right?

Answer 23

> An issue of common stock offered to existing shareholders.
Articles of incorporation may include a preemptive right for to existing shareholders to receive the offer first. to avoid the dilution that can occur with a new stock issue
It has value because it will allow a shareholder to purchase a share at a price lower than market.

Question 24

What are the questions that financial management must answer in a rights offering?

Answer 24

1. What should the price per share be for the new stock?
2. How many shares will have to be sold?
3. How many shares will each shareholder be allowed to buy?
4. What is the likely effect of the rights offering on the per share value of existing stock?

Question 25

What is the Value of a Right?

Answer 25

> The price specified in a rights offering is generally less than the current market price
The share price will adjust based on the number of new shares issued
The value of the right is the difference between the old share price and the “new” share price
1 share = 1 right. so, if 4 rights are required, then 4 shares needed plus the $

Question 26

What are the different kinds of dilution?

Answer 26

Dilution is a loss in value for existing shareholders
> Percentage ownership – shares sold to the general public without a rights offering
> Market value – firm accepts negative NPV projects
> Book value and EPS – occurs when market-to-book value is less than one

Question 27

What are some of the characteristics of private placement debt?

Answer 27

Private placements
> Similar to term loans with longer maturity
> Easier to renegotiate than public issues
> Lower costs than public issues

Question 28

What are the types of Long-term Debt?

Answer 28

1. Bonds – public issue of long-term debt
2. Private issues
   > Term loans
   > Direct business loans from commercial banks, insurance companies, etc.
   > Maturities 1 – 5 years
   > Repayable during life of the loan
3. Private placements
   > Similar to term loans with longer maturity
   > Easier to renegotiate than public issues
   > Lower costs than public issues