LT (8) IPO's Flashcards
How do young small firms obtain investment capital?
Small businesses are primarily self-financed with equity supplemented with ‘informal finance’: debt from family, friends, moneylenders, even microfinance.
As the firm grows, the ability/willingness of informal finance to meet the needs of the business declines. Options?
Retained earnings: A firm can reinvest profits. But this may not be enough for fast-growing companies.
Banks: Predominant source of small-business finance but there are limits. Banks usually require tangible assets and/or predictable cash flows along with historical and personal knowledge of the borrower’s quality.
Venture Capital: One increasingly important alternative, an institution specialising in financing risky, opaque, intangible firms.
Alternatives: Other possible financers of new firms: angel investors, crowdfunding, corporate ventures, institutional investors.
What is a venture capital firm
Venture Capital Firm: financial intermediary specialising in equity financing new firms
Low probability of success but much higher than usual returns
VC are active investors:
Monitoring: exert significant degree of control through seat(s) on the board and also monitor/advise the start-up company.
Staged financing: Funds are usually dispersed in stages, only after a certain level of success is achieved.
How do you calculate the ownership for each investor after a new funding round?
Suppose a VC contributes $X to a startup.
After contribution, the startup is worth $V (‘post-money valuation’).
Assume an original investor (OI, e.g. owner) holds a fraction s (0 < s ≤ 1) of the pre-contribution firm.
What fraction of the post-contribution company do the VC and OI own?
VC → X/V
OI→ (1−X/V)×s
How does VC monitoring overcome the free-rider problem of small shareholders mointoring companies?
Shareholders of large public companies are often small. They have no skill or incentive to monitor the company.
They have to exert the full cost of monitoring.
But they only enjoy a very small fraction of the benefits. → No one monitors (free-rider problem)
VCs are big shareholders of a company, so they enjoy a big part of the benefits from monitoring.
Explain the fund structure of venture capital firms.
Venture Capital funds belong to the Private Equity industry (as opposed to public equity).
VC funds are usually structured as limited partnerships. Two types of partners: Limited Partners (‘LPs’) General Partners (‘GPs’)
Limited Partners provide capital for the partnership. Dont directly make investment decisions Contribute ∼ 98% of the capital.
General Partners are responsible for choosing and monitoring the fund’s investments (‘portfolio firms’).
Contribute mainly skill + 2% of the total capital.
Private Equity funds are limited-duration (10-12 years), closed-end funds
Limited duration: acts as a strong incentive device for GP Forces the VC (i.e. GP) to be re-evaluated regularly
Without sustained success, impossible to raise capital for next fund
Closed-end: no shares can be redeemed or created after the fund is structured.
Sale of LP stakes normally not allowed. Illiquid!
Benefit: LP structure can be very stable
How are VC’s compensated?
VC compensation usually has two parts:
Fixed fees:
a.k.a ‘Management fee’: a fraction (usually 2%) of the committed capital annually, regardless of performance
Incentive fees:
a.k.a ‘Carry’: a fraction (typically 20%) of any profit made above some promised return (hurdle rate)
Compared to GPs contribution, these are big numbers.
How do VCs exit the portfolio firms?
M&A: The start-up is bought by another company.
IPO: Initial public offering
A company’s equity is available for the public for the first time.
A related terminology is SEO (seasoned equity offerings): sale of new securities by a firm that is already publicly traded.
Note the difference with secondary offerings, which are unrelated to the company.
What are the benefits of an IPO for a firm?
Benefits:
1) Funds for investment
2) Diversify the initial investors.
Founders can cash out and use the money for other ventures. Current equity holders usually sell a fraction of their shares, but not a large fraction. Why not?
3) Exit strategy for VCs and other investors.
Founders want VCs and banks out (would rather have dispersed shareholders)
VCs and other early investors want out. Typically have a 5-10 year timeframe, want to realize return and move on.
What are the disadvantages of an IPO for a firm?
Costs:
1) Monetary costs
Administrative costs
At IPO, 2–10%: there are big economies of scale in IPOs After IPO, expensive to comply with regulatory filing requirements after becoming a publicly traded company
Underwriting costs (7–11%): This is the fee that Investment Bankers charge for their services Underpricing: IPO price << day 1 closing price
2) Disclosure requirements
3) Loss of control
4) Loss of freedom: there is now oversight by the regulator
What are underwriting costs?
Underwriting costs (7–11%): This is the fee that Investment Bankers charge for their services
What is underpricing?
Underpricing: IPO price «_space;day 1 closing price
What are seasoned offerings and what types exist?
A related terminology is SEO (seasoned equity offerings): sale of new securities by a firm that is already publicly traded.
General Cash Offer
Sale of securities open to all investors
Private Placement
Sale of securities to a limited number of investors without a public offering
Rights Issue
Issue of securities offered only to current stockholders
An X for Y rights offer means for every Y shares you own, you have the option to buy X more shares from the company.
What is the value of a right, during a rights issue?
In general:
Value of Right = (Pcurrent − PIssue) × N/N+1
where N is the number of shares per right.
This equation takes into account both the price discount and the dilution.
Checking with the previous example:
15.38=(60−41)× N/N+1 where N=17/4
If an IPO is fairly priced what do existing shareholders lose?
The Bottom line: As long as the issue is fairly priced, existing shareholders only lose issuing costs. (Underwriting costs)
Which are bigger underwriting or underpricing costs?
Underpricing costs are much larger than the
direct costs.
Underpricing varies with uncertainty about the stocks value Larger firms are underpriced less. Underpricing is smaller for older firms.
Long run returns are abnormally small.
