Part 2: Equity Capital

Question 1

Characteristics of Entrepreneurs

Answer 1

Bear too much risk
Under diversify
Keep illiquid assets
Are optimistic and not rational

Question 2

New ventures are hard to finance because

Answer 2

1. At first, not profitable investments
2. Characterised by high failure rates
3. Risky, uncertain, and capital intense investment decisions
4. Lack tangible assets (lack of collateral, and hard to value)
5. High levels of asymmetric information (moral hazard & adverse selection)

Question 3

Lemon model in the market for equity

Answer 3

1. Owner of a startup offers 70% of his stake because he wants to diversify
2. You suspect the owner might try to cash out before negative information becomes public
   If this happens often, even at smaller stakes, the market for new ventures may collapse. The venture capital system, and in turn the exit of a VC-backed company through an IPO, can be viewed as a solution to this problem

Question 4

How to finance a new venture

Answer 4

1. Entrepreneur’s own money is always cheapest - no conflict of interest and no asymmetric information problem
2. Do not seek financing to early - it is costly in terms of value and control, especially when the risk is high (using own resources shows commitment)
3. If external financing is needed, then start with government funds or subsidies and turn to equity last

Question 5

Alternative sources of capital for ventures

Answer 5

1. Academic funds, government grants
2. Family, friends, bank loan
3. Angel investors (provides capital in a much earlier stage than VCs, serves as a networking role to receive subsequent funding
4. Venture capital (provides value adding services)
5. Corporate venture capital

Question 6

Explain pre-money and post-money valuation

Answer 6

Pre-money valuation - the value of the firm’s prior shares outstanding at the price in the funding round
Post-money valuation - the value of the whole firm (old plus new shares) at the price that the new entity is sold at

Question 7

What are the advantages and disadvantages of going public?

Answer 7

Advantages - liquidity, diversification, access to capital due to public markets
Disadvantages - dispersed ownership, satisfy requirements of public companies, more disclosure of information

Question 8

Methods of IPO offerings

Answer 8

1. Firm commitments - underwriter guarantees that they will sell all of the stock at the offer price
2. Best-effort - underwriter does not guarantee the stock will be sold, but tries to sell it for the best possible price
3. Auction IPOs - underwriter takes bids from investors and then sets the price that clears the market

Question 9

IPO puzzles (we lack the theory to explain them)

Answer 9

1. Underpricing - a substantial price jump on the first day of trading
2. Cyclicality - when times are good, the market is flooded with new issues; when times are bad, the number of issues dries up
3. Cost of an IPO - all IPOs have typically the same spread (7%), one possible explanation is that by charging lower fees, an underwriter may risk signalling that it is not of high quality
4. Long run under performance - newly listed firms appear to perform relatively poorly over the following three to five years after the IPO. However, VC backed tend to outperform non-VC backed, even though this should be incorporated in the price

Question 10

Winner’s curse

Answer 10

You “win” when demand for the shares by others is low, and the IPO is more likely to perform poorly. And loose when the demand and likely performance is reversed

Question 11

Corporate venture capital

Answer 11

An equity investment by an established corporation in an entrepreneurial venture. Most corporations seek strategic benefits in addition to financial returns

Question 12

Private equity

Answer 12

Money invested in companies that are not publicly traded
- or -
Investments in buyouts of publicly traded companies to make them private

Question 13

What’s the difference between Venture capital and Private equity?

Answer 13

Venture capital is capital invested in intellectual assets

Private equity is capital & intellectual assets invested in assets in place

Question 14

Creative destruction

Answer 14

An essential fact of capitalism where a process of industrial mutation revolutionises the economic structure from within, destroying the old one, by creating a new one

Question 15

What are the strategic rationales for an incumbent to invest in outside projects?

Answer 15

• Threat of new entrants
• Increase sales and markets
• Exploiting synergies
• Forming of alliances
• Exploit open-source platforms

Question 16

Under-investment in public goods

Answer 16

Arises from the fact that the consumption of these goods is non-exclusive, but the provision and the maintenance of such goods is costly. Economists refer to public goods as non-rivalrous and non-excludable. In our context, entrepreneurial ideas can be seen as public goods

Question 17

Four ways to invest in CVC according to Chesbrough (XXXX)

Answer 17

1. Driving (strategic, operations) - tight link firm’s business model & technology
2. Enabling (strategic) - boosting sales by creating new markets for existing technology
3. Emergent (financial, operations) - investments in new markets and business
4. Passive (financial) - only looking for financial returns

Question 18

CVC from a resource-based view

Answer 18

Identifying the firm’s potential key resources, rareness, valuable, imitable, or substitutable

Question 19

RBV factors for CVC activity

Answer 19

1. Industry technological change - rapid technology change is a high-risk environment; CVC activity allow firms to spread risks among multiple commitments
2. Industry competitive intensity - strong competition results in low margins, incumbents engage in CVC to increase margins
3. Industry appropriability - how can a firm extract value from R&D and other knowledge-based resources
4. Firm resources - technological (CVC allows for access to existing technology), marketing resources (strong brand and market position will favour CVC)

Question 20

Findings in Basu et al (Resource based view)

Answer 20

1. CVC is a mean to quickly adapt to technological changes
2. Incumbents engage in CVC when:
   - Operating in a dynamic environment
   - High competitive intensity
   - Weak appropriability in the industry
   - Strong firm level resources
   - Diversity of earlier CVC experience
   - Syndication of CVC projects is common (pooling resources to share risk)

Question 21

What is screening (sustainable finance)? And what does it lead to

Answer 21

Negative screening - rejects securities from your portfolio based on moral preferences
Positive screening - include only securities in your portfolio based on some moral goal function
(We cannot hold the market portfolio anymore -> less diversification -> taking on more firm specific risk, that we are not compensated for)

Question 22

Stranded assets

Answer 22

Assets that have lost their value due to:

• regulation
• competing technology
• consumer pressure

Question 23

Stranded assets and EMH

Answer 23

The claim that the risk of stranded assets are not reflected in prices is inconsistent with EMH.

Three potential interpretations:

1. Claim that the assets are incompatible with sustainability is wrong
2. EMH is wrong
3. Both 1 & 2 is correct but there are no substitutions

Question 24

What were the conclusions regarding sin-stocks in Hong & Kacperczyk (2009)?

Answer 24

1. Sin-stocks received less coverage = less demand for the stock
2. The unethical investor stands to gain, however, as the stocks are considered “undervalued”, the firms have a higher cost of capital

Question 25

Seasoned equity offering

Answer 25

The sale of stock by a company that is already publicly traded
It follows many steps as for the IPO
Market prices already exists, so the price-setting process is not necessary

Question 26

Mechanics of a SEO

Answer 26

1. Primary shares - new shares in the equity offering
2. Secondary shares - shares sold by existing shareholders
3. Fully underwritten or cash offer - firm offers the new shares to investors at large
4. Rights offer - firm offers the new shares only to existing shareholders (protects them from underpricing)
5. Private placement - firm directs the offer to a few new and/or existing institutional investors

Question 27

Briefly describe why the first day return for IPOs, on average, must be positive

Answer 27

Some investors are better informed than others and they will avoid participating in overvalued IPOs.
Lesser informed investors will be allocated to overpriced IPOs and stop buying them.
In extreme cases, this will cause a market collapse for IPOs

Question 28

What were the conclusions of Deangelo, Deangelo, & Stultz (2010) regarding SEOs?

Answer 28

Primary reason for an SEO is to meet near term needs for cash
Secondary reasons are selling shares at a high price and the lifecycle stage

Question 29

The Resource-based view (explained)

Answer 29

Argues inter-firm ties are formed when firms have sufficient:
- Inducements (need to access specific competitive resources)
- Opportunities (firms willing to partner)
Environmental conditions and firm resources influence both inducements and opportunities

Question 30

Corporate lifecycle theory

Answer 30

Young firms with high market/book ratios and low operating cash flows will sell stock to fund investment

Mature firms with low market/book pay dividends and fund investment internally

Question 31

Universal ownership

Answer 31

Externalities, in the form of environmental damages is a free-rider problem

Large financial institutions hold well diversified and long-term portfolios (universal owners)

Environmental damages will thus their portfolios and therefore they have incentives to mitigate externalities

Question 32

Why do we lack an efficient market for ideas?

Answer 32

Ideas are like public goods (non-excludable)

If you invest in an idea, you have a problem in receiving a return (non-appropriability)