L15 - Equity Financing

Question 1

What is Venture Capital?

Answer 1

• Venture capital: Equity investment in new private companies (i.e., money invested to finance a new firm)
• Most new companies rely initially on family funds and bank loans.
• Some of them continue to grow with the aid of equity investment provided by wealthy individuals known as angel investors. –> they invest in the person or the idea rather than the company
• However, many adolescent companies raise capital from specialist venture-capital firms.

Question 2

What do venture capitalist firms do?

Answer 2

Venture capital firms:

• pool funds from a variety of investor
• seek out promising start-up companies
• finance the firm’s operation (in exchange for a large share of the firm’s stock)
• and work with these companies as they try to grow.

Sometimes other established companies also provide equity investment to new innovative firms; they act as corporate ventures.

Recently crowdfunding has been used to raise money from small investors via the web.

Question 3

Why does using Venture capitalist firms come at a cost?

Answer 3

Venture capital firms are not passive investors;

• they tend to specialize in young high-tech firms; they monitor these firms closely;
• they provide ongoing advice;
• the major role in recruiting senior management team; their contacts are valuable to the business;
• they can help the firm to bring its products more quickly to the market.

they guide you along the way, they already have distribution networks set-up which is a lot easier that setting it up yourself

Question 4

When was the Venture capital boom?

Answer 4

during the 2000s during the dotcom bubble

Question 5

What is the legal structure of venture capital funds?

Answer 5

• Most venture capital funds are organized as limited private partnerships with a fixed life of about 10 years.
• Pension and mutual funds and other wealthy private investors are the limited partners.
• The management company of the venture capital firm is the general partner –> tends to have unlimited liability but normally the management company itself is limited corporation and has limited liability and thus they themselves are protected
• The general partner is responsible for:
  
  • making and overseeing the investments; receiving a fixed fee
  • plus a share of profits (called carried interest).

Question 6

What is the success of a venture capitalist fund dependent on?

Answer 6

• Since the success of a new firm is highly dependent on the effort of the managers,
• some restrictions are placed on management by the venture capital company,
  
  • can borrow any further fund until the company reaches a certain stage
  • who can be on the board on management
• and the funds are usually dispersed in stages after a certain level of success is achieved.
  
  • If the venture capital can cash out if you are not progressing to the next stage and they can also stop loaning any money

Question 7

What is the Investment Policy?

Answer 7

this is for a venture capitalist firm

• accept high uncertainty if there is even a small chance that the company will become big/successful (returns can be significant)
  
  • have to see that company will and wants to grow in the first place
• identify failed investments early and accept the loss rather than trying to fix the problems

Question 8

When may a venture capitalist cash in on their investment?

Answer 8

When the new business establishes itself, venture capitalists can sell their shares to a larger firm. –> normally when the company is established in its teenage stage

But, entrepreneurs may not like losing control of their firm –> they will now be subjected to all the red tape and bureaucracy of being in a large corporation - ideally, they don’t want to give up control like these

alternatively, the firm may become public;

• its stocks can be traded in the capital market;
• so, ventures have the opportunity to sell their stock and cash-in on their initial investment;
• and entrepreneurs can retain control of the company.

The success of the venture capital market requires:

• an active stock exchange that specialises in trading the shares of young and rapidly expanding firms (e.g. Nasdaq in the US).

Question 9

What are Public Offerings?

Answer 9

It occurs at a later stage of a company’s ‘lifetime’ (mainly, after it has established itself).

there are Two kinds:

• Primary offering: new shares are sold to raise additional cash.
• Secondary offering: existing shareholders cash in by selling part of their equity holdings (e.g., when governments sell their shareholdings in companies).

Many IPOs are a mix of primary and secondary offerings.

Question 10

What are the motives/benefits of going public?

Answer 10

Question 11

What is the process of an IPO?

Answer 11

1. Selection of an underwriter
   
   1. underwriters: firms that buy an issue of securities from a company and resell it to the public; they also provide procedural and financial advice.
   2. Top underwriters include JPMorgan, Goldman Sachs, BAML
2. Preparation of a registration statement
   
   1. for approval by the authority responsible for the operation of the stock exchange,
      1. registration statement: a detailed document with information about:
         
         1. the firm’s history & existing situation
         2. the proposed projects intended to be financed with the funds raised - raise x amount by selling y amount of shares at z price
3. Publication of the prospectus
   
   1. prospectus: a formal summary of the most important information from the registration statement –> must also include the risk of investing with the company
4. Arrange a Road Show
   
   1. Roadshow: talk to potential investors (e.g. pension and mutual funds) to get an idea of how much stock they wish to but and for how much.
5. Book building and decision on the appropriate issue price
   
   1. Book building: build a book of likely orders and use this information to set issue price.
   2. issue price: the initial price per share at which investors will buy the company’s stock.

Question 12

What are the Costs of an IPO?

Answer 12

Spread the payment of the underwriter — the difference between the price at which the underwriter buys the new issue and the issue price at which it is offered to the public (offering price).

Administrative costs: management of the process; legal counsels; financial advisers; accountants; the fee for the registration of new equity with the Stock Exchange Commission (SEC) /Financial Conduct Authority (FCA).

Other direct costs: printing; mailing, etc.

Question 13

What is a problem with underpriced IPOs?

Answer 13

• Since the offering price is usually less than the true value of the issued securities, investors who buy the issue got a bargain at the expense of the firm’s original shareholders.
• This “underpricing” is a type of ‘hidden cost’ in the IPOs.
• It occurs when the new stock has an issue price below the ‘true’ or ‘fair’ valuation of the company’s share.’
• By ‘true’ (or ‘fair’) valuation, we refer to the company’s fundamentals (i.e., future cash flows, growth potential etc.).
• For existing shareholders, there is a cost in terms of the lower value of their stock.

Question 14

What is the rationale for underpricing?

Answer 14

1. The evidence shows that investors who buy at the IPO (low) issue price, on average, realize very high returns over the following days (when those shares started to be traded in the stock market).
2. the price reaches and, many times, exceeds its true valuation
3. excessive returns make the specific share desirable
4. enhances a firm’s ability to raise further equity capital in future

Question 15

How was eBay underpriced?

Answer 15

Example:

• When the prospectus for the IPO of eBay was first published, the underwriters indicated that the company would sell 3.5 million shares at a price between $14 and $16 each.
• However, the enthusiasm for eBay’s Web-based auction system was such that the underwriters increased the issue price to $18.
• The next morning dealers were flooded with orders to buy eBay and over 4.5 million shares were traded.
• The stock closed the day at a price of $47.375.

Question 16

What is the second reason for underpricing?

Answer 16

-the ‘winner’s curse’

• come about due to asymmetric information
• If you apply for an issue and have no difficulty in getting all the shares (low demand?), then you may get the impression that you overestimated their value and overpaid for them.
• If you are smart, you will play the game only if there is a substantial underpricing.
• The issuers are aware of this problem → possible rationale for the underpricing of new issues.
• You have to underprice shares to factor in this asymmetric information

Question 17

How can a company raise funds after its IPO?

Answer 17

A company’s IPO is seldom its last issue of new stock.

As it grows, it is highly likely that it will make further issues in order to raise funds.

Those issues can be of two kinds:

• General cash offer
• Rights Issue (Privileged subscription)

Question 18

What is a General Cash offer?

Answer 18

►General cash offer: sale of securities (equity or debt) open to all investors by an already public company; more or less the same procedure as with IPOs.

• Seasoned Offering - sale of securities by a firm that is already publicly traded.
• •Shelf Registration - a procedure that allows firms to file one registration statement for several issues of the same security.
  
  • do not need to issue the shares to get the approval –> you are given an expiry date and can issue however many shares during that time (in line with the agreement)

Question 19

How large are the costs of an IPO in comparison to other financing methods?

Answer 19

Question 20

What are different securities and bonds that can be issued to raise finances?

Answer 20

• International security issues: sale of securities in other countries.
• Foreign bonds – companies issue bonds in another country’s domestic currency (governed by the rules of that country).
• Eurobonds - bonds underwritten by a group of international banks and offered simultaneously to investors in a number of countries. (at the moment it is dealt with by the london branch of their bank)
• Global bonds - bonds where one part is sold internationally in the Eurobond market and the remainder sold in the company’s domestic market.

Question 21

What are Right’s issues?

Answer 21

Rights issues (or privileged subscription): issue of securities offered first or only to current stockholders.

• used to maintain the value of shareholders holding during a new equity release which normally lowers the share price

right on –> old share price

• old share price - issue price/(no. of share you need to hold for every one share + 1)

ex rights –> new share price

• new share price - issue price/ no. of share you need to hold for every one share

in an exam calculate both to make sure you have the right answer

issue price = subscription price