Week 5 Flashcards
A much smaller but still important market is the
private equity market, where finance is raised by issuing securities that are not publicly traded
private equity includes
venture capital, which refers to the financing of new ventures or ‘start-up’ companies.
what are ordinary shares?
companies issue ordinary shares to raise finance
If a company has 100 000 issued shares and an investor holds 1000 shares, the investor has how much ownership interest?
what does this mean?
the investor has an ownership interest in 1 per cent of the net assets of the company.
when dividends are paid, or if the company is taken over by another company, or is placed into liquidation, the investor has the right to receive 1 per cent of the payments made to ordinary shareholders.
when may a company’s directors pay dividends?
periodically
describe residual claim
The interest held by shareholders is a residual claim in the sense that shareholders will receive dividends only after a company has met its obligations to all other claimants such as suppliers, employees, lenders and governments
describe shareholder’s residual claim during liquidiation
ordinary shareholders have a residual claim on the proceeds from the sale of the company’s assets.
while shareholders face a greater risk than lenders, what do they enjoy?
they enjoy limited liability. This is a legal concept that protects shareholders whose liability to meet a company’s debts is limited to any amount unpaid on the shares they hold
a shareholder is not personally liable for the company’s debt; the liability of shareholders is limited to any amount unpaid on the shares held
give an example of limited liability
For example, if an investor purchases shares with an issue price of $2.50 per share, that are partly paid to $1.75, the investor’s liability for future payments is limited to 75 cents per share.
Consequently, if the company is placed into liquidation and has insufficient cash to pay its creditors, holders of its partly paid shares can be required to contribute up to 75 cents per share towards the payment of creditors
describe the 3 important rights shareholders have in a listed company
- entitled to receive a proportional share of any dividend that is declared by directors
- As part owners of the company, ordinary shareholders exert a degree of control over its management through the voting rights attached to their shares
3, Shareholders have the right to sell their shares
Equity raised by issuing ordinary shares has important advantages as a source of finance
Dividends
A company is not required to pay dividends to ordinary shareholders: payment of dividends is at the discretion of directors. e.g. not pay when there’s a cash shortage, unprofitable
why is equity finance preferred over debt financing in terms of dividends?
failure to pay interest on debt or delays in paying interest can lead to serious legal consequences and can ultimately lead to a company being placed into liquidation.
Pros of ordinary shares
maturity date
Ordinary shares do not have any maturity date (theoretically existing in perpetuity), which means that the issuing company has no obligation to redeem them. (company can buy back the shares)
debt must be repaid (or ‘redeemed’) when it matures.
Pros of ordinary shares
RIsk
The higher the proportion of equity in a company’s capital structure, the lower is the risk that lenders will suffer losses as a result of the borrower experiencing financial difficulty
. Therefore, raising equity by issuing ordinary shares lowers the interest rate that a company will have to pay on debt.
Cons of issuing ordinary shares as a source of equity finance
ownership and control
company issues more ordinary shares to raise new capital, existing shareholders will have to either outlay additional cash or suffer some dilution of their ownership and control of the company.
Small shareholders may not be concerned if their interest in a company is diluted, but investors who own a significant proportion of a company’s shares may be unwilling to have their interest diluted.
Cons of issuing ordinary shares as a source of equity finance
ownership and control
But when you borrow,
there will be no dilution in ownership and control
Cons of ordinary shares
Cost
transaction costs of raising funds by issuing shares are usually higher than the costs of borrowing a similar amount.
- A share issue by a public company often requires a prospectus, which are costly to prepare
- share issues are often underwritten
private equity is used to describe 2 distinct types of investment:
Venture capital what is it?
‘venture capital’ and refers to funding for smaller and riskier companies with potential for strong growth.
Why are venture capitals attractive?
- the amount of capital required may be too small to justify the cost of a share market float.
- future of the venture—which at the earliest stage may be no more than an idea—may be too uncertain to attract funds from a large number of investors
second type of private equity is
the acquisition of a listed public company by a group of investors who ‘privatise’ the company so that it is delisted from the stock exchange.
second type of private equity is
acquisition of a listed public company involves
a high proportion of debt finance and are commonly known as leveraged buyouts (LBOs)
what is private equity? how can it be raised?
Private equity refers to equity securities that are not publicly traded. Private equity can be raised from various sources including family members, friends and ‘business angels’, but the more formal private equity market involves funds being channelled to businesses by private equity fund managers.
what are 4 categories of private equity funding
1. start-up financing for a business less than 30 months old where funds are required to develop the company’s products
- expansion financing where additional funds are required to manufacture and sell products commercially
- turnaround financing for a company in financial difficulty
- management buyout (MBO) financing where a business is purchased by its management team with the assistance of a private equity fund.
The market for new venture finance has some unique features that have developed to minimise the effects of these information problems
The main feature is
The main such feature is that finance for new ventures is normally provided in stages rather than as a single lump sum
- provision of finance at each stage is generally linked to the achievement of milestones, such as completion of a prototype
The market for new venture finance has some unique features that have developed to minimise the effects of these information problems
Providing finance in stages
Raising finance after achieving milestones or other performance benchmarks can help reduce information asymmetry by:
- it provides investors with tangible evidence about the viability of the project.
- provides them with information about the skill and ability of the entrepreneur.
why is staged financing favourable for investors?
If a project is destined to fail due to technical difficulties, lack of consumer demand or high manufacturing costs, it is better to discover these problems before all the funds needed to complete the project have been committed to it
why do entrepreneurs prefer staged financing
it will be difficult to convince others that funds invested in a new venture will be used profitably
raising money from outside investors in the early stages of a venture is generally expensive. In this context, ‘expensive’ means that the entrepreneur will have to give up a large fraction of ownership to raise a relatively small amount of capital. Achievement of each milestone reduces uncertainty and increases the value of a project –> retain greater ownership
what are sources of finance for new ventures?
Many including
- entrepreneur’s personal resources
- private equity funds
- funds raised by an initial public offering of shares associated with listing on a stock exchange
the suitability of the type of finance for ventures depends on
the venture’s stage of development
while many new ventures are different, there are identifiable stages of new ventures which include
- research and development phase which, if successful, will be followed by
- a start-up phase where the equipment and personnel needed for production are assembled
3 . If the product is accepted by customers, the venture may grow, perhaps very rapidly at first
- after which there will often be periods of slower growth, maturity and perhaps decline.
New ventures
nThe initial capital that is required to start a business is?
at the research and development stage, what source of finance is usually used?
entrepreneur’s personal resources e.g. savings, borrowing money that can be borrowed by mortgaging the family home and perhaps lines of credit linked to credit cards
New ventures
Outsiders can provide finance for additional capuital growth. these include
‘business angels’, private equity, venture capital
Outside finance raised in the early stages of a venture’s development is normally in the form of equity
what does this mean
the entrepreneur transfers a share of ownership to the new investors and the returns to these investors will depend directly on the success or otherwise of the venture.
features of business angels
- may provide between tens of thousands to hundreds of thousands of dollars per investment.
- These investors will often provide the funds needed to develop a venture to the stage where it is possible to seek outside finance from private equity funds, banks and other financial institutions
- Business angels are generally prepared to invest in a venture for 5 to 10 years.
- Many of them have business or technical skills and aim to add value to a new venture by providing advice and expertise as well as finance (expertise more important than money they invest(
most business angels restrict their investments to
Most restrict their investments to industries where they understand the technology and to projects located in their own geographical area.
Venture capital managers have two main roles:
raising money from investors (superannuation funds, which are the largest source of funds, wealthy individuals and banks) and selecting suitable companies in which to invest the capital
Venture capital fund managers generally invest amounts
- $500 000 to $20 million for periods of 3 to 7 years.
- look for a business with good prospects for growth
- managed by people who are capable, honest and committed to the success of the business
since private equity investments typically have a higher level of risk than most other investments, fund managers
seek a relatively high rate of return that will vary with the perceived risk.
e.g. provision of seed and start-up capital involves a high level of risk and investors may seek a rate of return of at least 30 to 40 per cent per annum over the life of the investment.
At a later stage when production has commenced and product is being sold, provision of capital for expansion involves lower risk so that the minimum rate of return sought may be 20 to 30 per cent per annum.
As well as becoming part owners of the businesses they invest in, fund managers typically require
seat on the company’s Board of Directors.
Just b/c fund managers require to be on the board directors, does not mean
that they seek day-to-day control. Rather, private equity funds generally take a significant minority share in the company and aim to provide valuable advice on both technical and management issues ( fundmanager can also provide management input based on the experience of helping other companies overcome the problems typically encountered by new, fast-growing businesses)
Most fund managers aim to achieve the majority of their return in the form of
What does this mean?
Most fund managers aim to achieve the majority of their return in the form of capital gain rather than dividends. Accordingly, they usually plan to dispose of the investment, typically within a period of 3 to 7 years.
how can the fund manager dispose the investment?
- an initial public offering associated with stock exchange listing
- sale
- voluntary liquidation.
while disposal of the investment can lead to speculative gains,
the level of risk is high and it is to be expected that a significant proportion of the disposals that occur will involve a loss
In some cases the project will fail and the investment will be liquidated.
disclosure requirements for unlisted companies are
more stringent than listed companies
The general rule is that an offer of securities to investors cannot proceed until
a disclosure document has been lodged with the Australian Securities and Investments Commission (ASIC). Disclosure documents may be given to potential investors as soon as they have been lodged with ASIC.
For unlisted companies, a waiting period of at least 7 days is imposed before applications by investors can be accepted. The waiting period allows the disclosure document to be examined by ASIC and other interested parties.
features of preferred shares
Dividends
¡Preferential dividend (regular fixed cash dividends; i.e., non-participating shares: If it receives more then fixed dividends, it is called participating shares)
preferred shares
What about young companies?
nFor young companies, does not pay regular cash dividends (as young companies require to retain the cash to grow)
