Chapter 5 - Equity Financing

Question 1

What are the two main reasons that companies seek equity financing?

Answer 1

1 - they have reached max debt financing

2 - when the shareholders prefer the added flexibility of equity relative to debt

Question 2

what stage of companies usually warrant a greater proportion of equity in their capital structure? and why?

Answer 2

younger companies, as their cashflows are inherently riskier

Question 3

what are some major disadvantages to equity as a means for financing compared to debt? (5)

Answer 3

1 - dilution of ownership and control
2 - investors usually want say in decisions
3 - expensive capital
4 - dividends are not tax deductible
5 - difficult and more costly to raise

Question 4

what are some major advantages of equity as a means for financing compared to debt? (5)

Answer 4

1 - no set repayment or need for guarantees
2 - longer-term, patient capital
3 - less restrictive generally than debt
4 - offers flexibility and capacity to realize growth objectives
5 - strengthens balance sheet

Question 5

what are the various types of equity investors? (6)

Answer 5

angel investors
vc investors
private equity investors
public equity investors
public investment in public enterprise investors
distressed investors

Question 6

what are angel investors?

Answer 6

wealthy individuals, usually with entrepreneurial background, that provide start-up capital to other entrepreneurs - infancy stage of business cycle, little to no profitability, substantial risk with high upside and large ownership

Question 7

what are VC investors?

Answer 7

still companies that have little to no profitability, but VC is usually represented by institutions including funds, corporate investment arms, and HNW family offices - targeted IRR of 30%+

Question 8

what is the formula for a typical VC investment to arrive at a post money company value?

Answer 8

pre money company value + investment amount = post money company value

Question 9

what types of companies do private equity investors usually invest in?

Answer 9

established profitable companies that fall within growing to mature lifecycle - with funds from high net worth or family offices usually

Question 10

are PE investors subject to more risk or less risk than VC investors?

Answer 10

usually more, even though the companies are more mature. this is because PE usually has the benefit of leverage via debt, meaning any residual value is subject to debt issuers in a realization scenario

Question 11

what are the two types of PE investors and what is the difference between the two?

Answer 11

Growth investors - injecting capital for a growth plan that cannot be facilitated with debt alone

buyout investors - investors who are purchasing shares directly from existing SH’s to obtain control of company, creating a liquidity event for recapitalization

Question 12

what types of return do typical PE investments aim for?

Answer 12

20%+ IRR, yielding overall 2x-3x initial investment sometimes

Question 13

what types of returns do typical public equity investors aim for?

Answer 13

5-10% over a risk free return, which should be higher than avg debt investors, but lower than private equity investors

Question 14

what is the main distinction for the lower return goal in a public equity over a private equity investment?

Answer 14

this is driven by a combination of company scale, and inherent liquidity discount

Question 15

what is a PIPE investment?

Answer 15

PIPE - or Private Investment in Public Enterprise investors, represent private placements into public companies, that have otherwise been unsuccessful in raising their required financing via debt or public markets

Question 16

are PIPE investments sold at public equity value?

Answer 16

no - due to the fact that a private placement needs to occur in a public company, this is usually completed at a discount to public price, to incentivize investors in purchasing larger blocks of shares

Question 17

who are distressed investors?

Answer 17

specialist investors who invest primarily in struggling or failing companies, and as such, typically demand returns like PE or better as these companies are over-levered or otherwise near bankruptcy or liquidation

Question 18

what are the 3 main rights associate with shares?

Answer 18

voting
entitlement to dividends
claim on assets upon dissolution (subject to hierarchy in capital structure)

Question 19

what are some common examples of matters that require shareholder votes? (4)

Answer 19

appointing members to the board of directors
approving changes to company dividend policy
approving business acquisition, divestitures, mergers
approving issuance of new equity/stock splits

Question 20

what are the four dividend rights? (4) briefly describe each

Answer 20

1 - no right to dividends
2 - right to dividends on a pari-passu basis, which is pro-rated to total shareholdings
3 - stated right to dividends on a non-cumulative basis, which means that if the company is unable to pay in certain years, there is no “catch-up” on foregone dividends
4 - stated right to dividends on cumulative - if unable to pay in certain years, that class has rights to receive historical foregone dividends before any other class can receive

Question 21

in a claim of assets scenario between pref and common shares, who has first right to residual value?

Answer 21

pref shares, up to their initial investment value (unless otherwise stated or agreed upon)

Question 22

what are three other rights of shares, above voting, dividends, and claim on assets?

Answer 22

1 - conversion rights
2 - retraction rights
3 - redemption rights

Question 23

what are conversion rights of equity shares?

Answer 23

the right but not obligation to convert the underlying share into another type of security that may be more valuable

Question 24

what are retraction rights of equity shares?

Answer 24

most commonly associated with preferred equity, pref shares can force the issuing company to retract the pref shares for a stated price, typically equal to the initial investment (think deeply subordinated debt)

Question 25

what are redemption rights of equity shares ?

Answer 25

provide the company the right but not the obligation to retract shares at a stated price from the underlying shareholders

Question 26

what are three common derivatives seen in corporate finance transactions?

Answer 26

1 - options
2 - warrants
3 - rights

Question 27

what are options?

Answer 27

options are contracts that give the purchaser the right to obtain from the seller an asset on a given day, for a premium to the writer/issuer

Question 28

what are the two types of options and what do they provide?

Answer 28

call - the purchaser’s right to buy an underlying security until a date, at a specified price
put - the purchaser’s right to sell an underlying interest until a date, at a specified price

Question 29

what are the key features of all stock options? (5) briefly describe each

Answer 29

premium - price of the option
strike price - price that option holder must pay/receive for underlying security
in the money - option contract that if exercised today, would result in value creation for the holder
out of the money - option contract that if exercised today, would result in value destruction for the holder
at the money - refers to an option contract that if exercised today, would have neither negative nor positive value

Question 30

what are the 5 functions of option prices? briefly describe each

Answer 30

exercise price - price at which option will be either bought/sold if exercised
expiration date - date of expiry on option
stock price - underlying stock price at the time
variability of stock - volatility of stock
risk free rate - high int. rates adversely affect value of put but help value of call, as it would diminish the value via discounting

Question 31

what are warrants?

Answer 31

warrants are issued by companies and provide the holder with the opportunity to acquire common stocks at fixed price at some time in the future (can also be for bonds / gold / etc.)

Question 32

what is the key distinction between warrants and options?

Answer 32

companies issue warrants and individuals write options

Question 33

are warrants dilutive?

Answer 33

yes - a company has to issue a stock and as a result, is dilutive to existing equity holders on an EPS basis

Question 34

what are rights?

Answer 34

similarly to warrants, rights provide a right to purchase company shares at a specified price by a specified date

Question 35

what is the key distinction between rights and warrants?

Answer 35

rights tend to have an exercise price that is below market value, thereby providing an incentive to provide further capital at a later date - warrants are issued “out of the money” in that they provide investors with future potential return but are not issued with the goal of raising capital

Question 36

briefly describe employee stock options

Answer 36

ESOP’s are defined as rights granted to individuals to purchase shares of common stock in accordance with an agreement, at a future time (or within a period), and after payment of a specified price (often below their real value at the time of granting)

Question 37

what are employee stock options’ primary purpose?

Answer 37

to incentivize and compensate employees vs. actually raising capital

Question 38

What is an IPO?

Answer 38

Initial public offering - a company’s first issuance of stock on a public exchange

Question 39

what are the three types of arrangements for completing an IPO?

Answer 39

1. all or none contract
2. best efforts contract
3. firm commitment (bought deal)

Question 40

what is an ‘all or none contract’ in terms of IPO’s?

Answer 40

when the entire allotment of shares must be sold during the IPO, otherwise IPO will be cancelled

Question 41

what is a ‘best efforts contract’ in terms of IPOs?

Answer 41

when the underwriting banks provide no assurance to company, and sell shares on a “best efforts” basis - less attractive companies may be reticent to enter into this as it may end up being an extensive process for minimum capital

Question 42

what is a ‘firm commitment’ in IPO terms?

Answer 42

similarly called a bought deal, this is when the issuing bank guarantees a certain level of financing to the company, by essentially purchasing the shares to be issued at a discount to market, but for promised capital. the issuing bank then bears risk of floating these shares into the market, via their sales and trading desk (retail + institutional)

Question 43

what are the two overarching pricing tactics for IPOs?

Answer 43

1 - fixed price offering

2 - book building offering

Question 44

what is a fixed price offering in the context of IPOs?

Answer 44

where a fixed price is set on shares, forcing investors to either buy or pass at that price. can be risky on both sides, as either company may leave potential capital on the table with too much of a discount, but also may not attract investment if the fixed offering price is too high

Question 45

what is a book building offering in terms of IPO pricing?

Answer 45

where a range of prices are offered to investors (ie. $14-$16/share) and investors are asked to make formal bids, indicating price tolerance and quantity requested to purchase - this is generally the more efficient method of raising capital, as it allows supply to match demand

Question 46

what is the difference between primary and secondary shares, in an IPO?

Answer 46

primary shares are newly issued shares from the company, as a means of capital raising for the growth or rebalancing of capital structure

whereas, secondary shares are shares repurchased from existing shareholders, to provide these old shareholders with liquidity

Question 47

what is a “follow-on offering”? (2 situations)

Answer 47

a follow-on offering is an additional equity raise following an IPO, that allows for founding shareholders to seek liquidity without jeopardizing the attractiveness of the IPO

2. can ALSO be a quick raise for large, established companies

Question 48

what is a reverse takeover? what is another name for this?

Answer 48

a back door listing - is a means of obtaining a public listing without undergoing a full IPO process. essentially a shell company is funded with enough cash to list on an exchange, and then merges with a previously privateCo to obtain the end goal of listing a formerly private company without an IPO

Question 49

what are the three major distressed investing strategies?

Answer 49

1 - turn around equity investing
2 - loan-to-own debt issuance
3 - distressed-to-control

Question 50

what is turn around equity investing? what is it also called?

Answer 50

rescue financing - a form of distressed investing, this is where equity investors will provide capital to a distressed company at a steep discount, to inherently reflect the increased risk profile - this is usually for much needed liquidity to avoid creditors coming in and defaulting/liquidating

Question 51

what is loan-to-own debt issuance?

Answer 51

with a lower cost of capital than turn around equity, sophisticated debt investors can issue debt with conversion potential to equity in a further distressed scenario via restructuring - many investors will go in with the expectation that the company may fail, hence “loan-to-own”

Question 52

what is “distressed-to-control”?

Answer 52

in a situation where a company is so overlevered that the debt outstanding face value > company’s EV, some distressed investors will purchase the existing debt from existing creditors at a discount. this will potentially enable them to further enact their rights as creditors, assume all assets, and obtain 100% of equity for a fraction of existing debt value. this is similar to loan to own except there is no new capital being put into the business