Module 2.3 Flashcards
Private Equity
Private equity is a business that is privately held and the owners cannot sell their shares to the public.
Some business owners hope to go public so that:
They can obtain financing to support the firm’s growth.
They can “cash out” by selling their original equity investment to others.
A public offering is feasible if:
The owners want to sell at least $50 million in stock.
The shareholder base will be large enough to support an active secondary market.
Financing by Venture Capital Funds
Venture capital funds (VC funds) receive money from wealthy investors and from pension funds that are willing to maintain the investment for a long-term period, such as 5 or 10 years.
Investors are not allowed to withdraw their money before a specified deadline.
Financing by Venture Capital Funds (cont.)
Business Proposals Intended to Attract Venture Capital
Venture capital conferences bring together the private businesses that need equity funding and the VC funds that can provide funding.
Terms of a Venture Capital Deal
A VC fund will negotiate the terms of the deal when it decides to invest in a business.
The VC fund will set out requirements for the business and VC fund managers may serve as advisers to the business.
Exit and Performance Stategy of Venture Capital Funds
Exit Strategy of VC Funds
VC funds typically plan to exit in four to seven years by selling the equity stake to the public.
Performance of VC Funds
Tends to vary over time
Funds can be invested more wisely when stock prices are low
Also influenced by the amount of investment received by investors
Financing by Private Equity Funds (cont.)
Private equity funds pool money provided by institutional investors (such as pension funds and insurance companies) and invest in businesses.
Use of Financial Leverage by Private Equity Funds
They also rely heavily on debt to finance their investments.
Performance of Private Equity Funds
Tends to vary over time
Funds can be invested more wisely when stock prices are low
May be especially prone to making bad investments when they receive large amounts of funds from investors
Financing by Crowdfunding
Companies also have the option of trying to raise funds from a large number of investors through a process called “crowdfunding” over the Internet.
The founders of a company provide information about their business or project on an Internet platform.
Investors then can invest their funds in the projects of their choice.
Examples are Crowdfunder, Indiegogo, and Kickstarter.
Public Equity
When a firm goes public, it issues stock in the primary market in exchange for cash.
Going public has two effects on the firm:
It changes the firm’s ownership structure by increasing the number of owners.
It changes the firm’s capital structure by increasing the equity investment in the firm.
Stock markets are like other financial markets in that they link the surplus units (that have excess funds) with deficit units (that need funds). (Exhibit 10.1)
The secondary market allows investors to sell the stock they previously purchased to other investors.
Ownership and Voting Rights
Owners of small companies also tend to be the managers. In publicly traded firms, most shareholders are not the managers.
Ownership of common stock entitles shareholders to a number of rights.
Normally, only the owners of common stock are permitted to vote on certain key matters concerning the firm.
Many investors assign their vote to management through the use of a proxy.
Preferred stock
— Represents an equity interest in a firm that usually does not allow for significant voting rights.
Preferred shareholders share the ownership of the firm with common shareholders and are therefore compensated only when earnings have been generated.
A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred stock dividends have been paid.
Because the dividends on preferred stock can be omitted, a firm assumes less risk when issuing it than when issuing bonds.
Dividends are not tax-deductible for the firm, making preferred stock less desirable than bonds.
Participation in Stock Markets
Investors can be classified as individual or institutional (Exhibit 10.2)
Individual investments commonly exceed 50% of the total equity.
Because of the size of investment, institutional investors can significantly affect stock market prices.
How Investor Decisions Affect Stock Prices
When there is a shift in the demand for shares or the supply of shares for sale, the equilibrium price changes.
Overall, the prevailing market price is determined by the participation of investors in aggregate.
Investor Reliance on Information
In general, favorable news about a firm’s performance will make investors believe that the firm’s stock is undervalued at its prevailing price.
Information is incorporated into stock prices through its impact on investors’ demand for shares and the supply of shares for sale by investors.
Initial Public Offerings
A first-time offering of shares by a specific firm to the public.
Process of Going Public
Developing a Prospectus — The issuer must develop a prospectus containing detailed information about the firm, including financial statements and a discussion of risks. The prospectus is filed with the Securities and Exchange Commission (SEC).
Pricing and Bookbuilding — The lead underwriter must determine the offer price at which the shares will be offered at the time of the IPO.
Allocation of IPO Shares — The lead underwriter may rely on a group (called a syndicate) of other securities firms to participate in the underwriting process and share the fees to be received for the underwriting.
Transaction Costs — Usually 7% of the funds raised.
Underwriter Efforts to Ensure Price Stability
Underwriters may attempt to stabilize the stock’s price by purchasing shares that are for sale in the secondary market shortly after the IPO.
Overallotment Option
Allows underwriter to allocate an additional 15% of the firm’s shares for a period of up to 30 days after the IPO.
Gives the lead underwriter the right to purchase those extra shares from the issuing firm at the IPO offer price.
v
Lockup
Prevents the original owners of the firm and the VC firms from selling their shares for a specified period.
Prevents downward pressure that could occur if the original owners or VC firms immediately sold their shares in the secondary market.
Timing of IPOs
Initial public offerings tend to occur more frequently during bullish stock markets.
Initial Returns of IPOs
The initial (first-day) return of IPOs in the United States has averaged about 20% over the last 30 years. Flipping Shares Investors flip shares by buying the stock at its offer price and selling the stock shortly afterward. If many institutional investors flip their shares, the market price of the stock may decline shortly after the IPO.