Lesson 12: Equity Financing

Question 1

Companies start out as private

Answer 1

the founders invest their own money. To supplement their funds, they seek out other individual investors: angel investors

Question 2

Reasons why it has become easier to find angel investors

Answer 2

1. There are more angel investors, angel groups
2. The cost of starting a business has dropped

Question 3

Since it is difficult to assess the value of a new company

Answer 3

Angel investors get convertible notes. Convertible notes pay interest, but may e converted to equity at a discounted rate when the company starts issuing equity

Question 4

After the company expands, it can raise capital from

Answer 4

venture capital firms

Question 5

Venture capital firms

Answer 5

limited partnerships that invest in small private companies, providing diversification to investors. General partners receive management fee of 1.5% - 2.5% plus 20% of profits
+ carried interest: latter fee (20% of profits)
+ venture capital firm has a substantial amount of control, typically they get 1/3 of the seats on the board of directors

Question 6

How can existing private companies (not start-up) raise capital?

Answer 6

They can raise capital from private equity firms, institutional investors, or corporate investors

Question 7

Private equity firms

Answer 7

+ private equity firms charge fee similar to venture capital firms
+ private equity firms may buy out a public company using borrowed money and make it private -> leveraged buyout

Question 8

Institutional investors

Answer 8

+ investors who manage funds for clients = the nature of their business: pension funds, insurance companies, endowments
+ invest directly in private companies, or limited partners in private equity firms

Question 9

Corporate investors

Answer 9

+ buy a large share of private companies, sometimes for strategic reasons. They may invest in a related business, eg: automobile manufacturer may invest in a car rental company

Question 10

At each funding round

Answer 10

another series of stock is issued, in alphabetical order: Series B, Series C, etc. These series may have different terms attached to them

Question 11

Pre-money valuation

Answer 11

the value of the company before the funding round

Question 12

Post-money valuation

Answer 12

the value of the company after the funding round, based on the price per share of the new series

Question 13

To protect themselves, venture capitalists require favorable terms in their financing agreement:

Answer 13

1. Liquidation preference
2. Seniority
3. Participation rights
4. Anti-dilution protection
5. Board membership

Question 14

Liquidation preference

Answer 14

if the company is liquidated, they receive a certain minimum amount before common stockholders get anything

Question 15

Seniority

Answer 15

they get seniority over all earlier series -> they get paid first, if they have the same priority as earlier series: they are pari passu

Question 16

Participation rights

Answer 16

clause let convertible preferred stock participate in the common stock dividends and retain their liquidation preference

Question 17

Anti-dilution protection

Answer 17

decreases the purchase price per share for the earlier rounds
(When the price per share drops in a funding round, the funding round is called a down round. A down round leads to dilution of ownership from earlier rounds, since the purchasers in later rounds get more shares, or a greater position of the company, for a given amount of money)
+ full ratchet protection: lower the conversion price to be equal the later funding price
+ broad-based weighted average protection
-> Conversion price
= [(number of old shares)(value of old shares) + (number of new shares)(value of new shares)] / [(total number of shares)*(value of old shares)]

Question 18

Board membership

Answer 18

The investor gets seats on the board of directors

Question 19

When can shareholders in a private company can cash in their ownership

Answer 19

Only if the company liquidates, is purchased = another company, or goes public through an IPO

Question 20

Advantage and disadvantage of going IPO

Answer 20

Advantage:
(+) liquidity and greater access to capital
Disadvantage:
(-) spreading of ownership
(-) costly requirements of financial disclosure

Question 21

An IPO may sell new shares or current stockholders may sell their shares to the public

Answer 21

Primary offering: the former, secondary offering: the latter

Question 22

Ways that the underwriter may sell an IPO

Answer 22

sell on a best-efforts basis, a firm commitment basis, or an auction

Question 23

Best-efforts basis

Answer 23

• In best-efforts basis, the underwriter tries to sell all shares, but does not guarantee success
• Best-efforts is common for small firms

Question 24

Firm commitment basis

Answer 24

• The most common type
• The underwriter guarantees that all shares will be sold at the offer price
• If the underwriter can’t sell them all at that price, he sells them at a lower price and absorbs the loss

Question 25

Auction IPOs

Answer 25

• in auction IPOs, investors bid for shares, the highest bidders get shares
• All winning bidders pay the lowest winning price, if there aren’t enough shares for the lowest winning price, those bidders get a prorata portion of their bid

Question 26

Underwriters and IPOs

Answer 26

• IPOs are managed = a group of underwriters, or a syndicate, with a lead underwriter doing much of the work
• Underwriters file a registration statement with SEC
  + Part of the registration statement is a preliminary prospectus or red herring which is distributed to potential investors
• After the SEC approves the offer, the company prepares a final registration statement and potential investors get a final prospectus
• Underwriters work with the company to come up with a reasonable offer price
• Company management and underwriters then go on a road show, traveling around the country to gauge interest
• Book building: the process of coming up with an offer price and gauging interest
• To protect themselves, underwriters may put a green shoe provision in the IPO

Question 27

Green shoe provision

Answer 27

• the provision allows selling additional shares above the amount the company is offering ~ 10 - 15%
• Example: if 1 million shares were offered and there is a 15% over-allotment, the underwriter sells 1.15 million shares with 0.15 mil shares sold short.
  + If the price rises, underwriter covers the short sale = using green shoe provision to buy 0.15 million shares at the offer price
  + If the price falls, the underwriter buys the 0.15 mil shares back, stabilizing the price