Lesson 12: Equity Financing

Question 1

When a company wants to supplement their own funds who do they seej out?

Answer 1

Angel investors, other individual investors

Question 2

Why has it become easier to find angel investors?

Answer 2

1. There are more angel investors, and even angel groups. Angel groups are investors who decide as a group in what to invest.
2. The cost of starting a business has dropped.

Question 3

What are convertible notes?

Answer 3

Notes that pay interest, but may be converted to equity at a discount rate when the company starts issuing equity.

Question 4

What are venture capital firms?

Answer 4

Limited partnerships that invest in many small private companies, providing diversification to investors. Sought out after angel investors.

Question 5

What do venture capital firms get in return for investing?

Answer 5

The general partners receive a management fee of 1.5%-2.5% of committed capital plus 20% of profits (carried interest). Also typically get one-third if the board seats of directors.

Question 6

What is a leveraged buyout?

Answer 6

When private equity firms buy out a public company using borrowed money and make it private

Question 7

What can an existing private company do to raise capital?

Answer 7

Raise capital from private equity firms, institutional investors, or corporate investors.

Question 8

How does a private company go public?

Answer 8

With an Initial Public Offering (IPO)

Question 9

What is the advantage of going public?

Answer 9

Liquidity and greater access to capital

Question 10

What is the disadvantage of going public?

Answer 10

Spreading the ownership lessens control and financial disclosures are costly

Question 11

What is a primary offering?

Answer 11

When an IPO sells new shares

Question 12

What is a secondary offering?

Answer 12

An IPO where stockholders sell their shares to the public

Question 13

What do venture capitalists require for protection?

Answer 13

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

Question 14

What is the liquidation preference of venture capitalists?

Answer 14

If a company is liquidated, they receive a certain minimum amount before common stockholders get anything. Typically the minimum they receive is 1 to 3 times their investment.

Question 15

What is the seniority preference of venture capitalists?

Answer 15

They get paid first from the proceeds. I’d this class is omitted and they have the same priority as earlier series, they are said to be pari passu.

Question 16

What are the three ways an underwriter may sell an IPO?

Answer 16

Best efforts basis, a firm commitment basis, or an auction.

Question 17

How is a best efforts basis performed?

Answer 17

The underwriter tries to sell all shares, but does not guarantee success

Question 18

How is a first commitment IPO performed?

Answer 18

Most common type, the underwriter guarantees that all shares will be sold at the offer price. If all shares aren’t sold, the underwriter sells them at a lower price and eats the loss.

Question 19

How are auction IPOs performed?

Answer 19

Not common, but investors bid for shares, and the highest bid gets the 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 20

What is a syndicate?

Answer 20

A group of underwriters managing an IPO

Question 21

What is a red herring?

Answer 21

A preliminary prospectus part of the registration statement with the SEC that is distributed to potential investors.

Question 22

What happens when the SEC approves and offering?

Answer 22

The company prepares a final registration statement and potential investors get a final prospectus. The final registration statement states the number of shares offered and the offer price.

Question 23

What is a road show?

Answer 23

When company management and underwriters travel around the company to gauge interest.

Question 24

What is book building?

Answer 24

The process of gauging demand and coming up with an offer price

Question 25

What is the underwriters fee for an IPO?

Answer 25

Usually 7.5% of the offer price.

Question 26

What is a green shoe provision?

Answer 26

A provision made to protect underwriters. This allows selling additional shares above the amount the company is offering, typically 10%-15% (an over allotment)

Question 27

What are the four features of IPOs are puzzling?

Answer 27

1. Underpricing. Prices rise on first day implying they are underpriced.
2. Cyclicality. IPOs don’t occurs more frequently during growth periods
3. Cost. Underwriters charge about 7.5%. Charging less or more is suspicious.
4. Long-run underperformance. Underperform over 3-5 years following IPO