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)
preferred shares
what right is usually contained?
- Often contains a right to convert to common stock. This type of stock is referred to as convertible preferred stock
- seniority in liquidation
- Non-voting
nConvertible Preferred Stock
¡Preferred stock that gives the owner an option to convert it into common stock at some future date
nConvertible Preferred Stock
how does this work?
If the investment of the outside investor is successful and the profitability of the firm increases, the outside investor may want to convert to share-in on the increasing dividends (recall that preferred stock tends to have fixed dividends) and voting rights
Equity financing for private companies
Disadvantage for using outside sources
- loss of control
- new investors disagree with current direciton and push for change
Funding angels typically invest in
ntheir personal funds into a early-stage, high-risk business. Hence, angel investors receive a large slice of ownership and decision-making power
Venture Capital Firm
A limited partnership that specialises in raising money (not providing personal funds like angel investors) to invest in the private equity of early-stage, high-risk, high-potential firms who lack funding for growth
Venture Capitalists
One of the general partners who work for and run a venture capital firm
Venture capital firms also benefit from
the expertise of the general partners in managing and overseeing early-stage firms
what is the cost of accessing venture capital?
General partners usually charge substantial fees
nMost firms charge 20% of any positive return they make (↑risk = ↑return)
nThey also generally charge an annual management fee of about 2% of the fund’s committed capital
Sources of Funding for Established Private Firms
nPrivate Equity Firms
Sources of Funding for Established Private Firms
what are private equity firms
¡Organised very much like a venture capital firm (similar fees and investors are limited partners), but it invests in the equity of existing privately-held firms rather than start-up companies
main difference between private equity and venture capital firms
¡private equity firms have a much larger pool of funds to invest
Private equity firms and LBO
Often, private equity firms initiate their investment by
¡by finding a publicly traded firm and purchasing the outstanding equity, thereby taking the company private in a transaction called a leveraged buyout (LBO)
sources of funding: Going public
why go public?
- Realisation of return
- Funding demand – access to more capital
- Growth potential (especially in the ‘growth stage’ of the firm’s life cycle)
- Favourable market conditions
4.
Adv. of Public Company Listing
Access to additional capital.
Increased negotiability of capital.
Growth not limited by cash resources.
Enhancement of corporate image.
Can attract and retain key personnel.
Gain independence from a spin-off.
The cash the owners received by selling parts of the their shares can be used to diversify their investment portfolio.
Disadv. of Public Company Listing
Dilution of control of existing owners.
Additional responsibilities of directors.
Greater disclosure of information.
Explicit costs.
Insider trading implications.
Role of underwriter
pricing the issue
marketing the issue
engaging sub-underwriters
placing the shortfall
Issuing Securities to the Public (IPO)
Valuation
-Road Show
During an IPO, when a company’s senior management and its underwriters travel around promoting the company and explaining their rationale for an offer price to the underwriters’ largest customers, mainly institutional investors such as mutual funds and pension funds
Pricing a new issue
nPricing methods
Fixed price approach can be used.
Book building—competitive bidding where investors such as institutions nominate quantities they would purchase at different prices.
-A book-building approach is less likely to generate abnormal returns to investors.
underwriters’ fees and brokers’ commissions
¡(generally 4–7% of funds raised)
Costs of floating
shares sold in an IPO are usually
¡underpriced—on average, there is an immediate abnormal return to IPOs.
Costs of Floating a Company: Underpricing
nShares sold in an IPO are usually underpriced — on average, there is an immediate abnormal return to IPOs?
what does this mean for business owners?
This represents a cost to owners of business, they
are selling for less than it is really worth.
Causes of IPO Underpricing
Reason 1: investors
If investors are less informed about the company, they might ‘win’ the bid by overpaying (winner’s curse)
Thus, to attract investors who have difficulty estimating the future market price of the shares being offered, the offer price is set lower (i.e., underpriced).
Causes of IPO Underpricing
- to induce
To induce some potential investors to buy, which may set off a cascade in which other investors are willing to subscribe, ensuring the IPO is fully (or over) subscribed.
Subsequent issues of ordinary shares
Seasoned Equity Offering (SEO)
When an already public company offers new shares for sale.
- follows many of the same steps as for an IPO
- Can cause dilution for existing shareholders as their ownership ratio may become less due to new issues
subsequent issues of ordinary shares
rights issues
issue of rights made to all existing shareholders, who are entitled with rights to take up new shares in proportion to their present holdings.
Rights Offerings—Basic Concepts
Allows current shareholders to
- avoid the dilution that can occur with a new share issue ( no additional shareholders)
- Shareholders can either exercise their rights or sell them.
ex-rights
Shares of stock that are trading but no longer have rights attached because they have either expired, been transferred to another investor or been exercised. The rights originally assigned to the stockholder are, for whatever reason, no longer valid or no longer applicable to the stock.
Ex-rights shares are worth less than shares which are not yet ex-rights - the ex-rights shares do not give a shareholder access to a rights offering. Renounceable rights may trade separately, allowing shareholders to choose to sell their rights rather than exercise them.
difference between cum and ex rights
A share is trading cum-rights as long as buyers will be entitled to a forthcoming rights issue. Once the share goes ex-rights, buyers will no longer be entitled to receive the rights.
the initial capital required to start a business (private company) is usually provided by
The initial capital that is required to start a business usually provided by the entrepreneur or their immediate family/friends.
Often, a private company must seek
Often, a private company must seek outside sources that can provide additional capital for growth Angel investors, Private equity, Venture capital
describe angel investors
Individual Investors who buy equity in small private firms – often the first significant source of outside funding
Leveraged Buyout
When a small group of (usually institutional investors) use a high proportion of debt finance (bonds or loans) to acquire another company i.e. use of leverage to purchase another company Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company -After a buyout the company is privately owned and the shares are not normally listed on a stock exchange
me leveraged buyouts occur in companies
Some leveraged buyouts occur in companies experiencing hard times and potentially facing bankruptcy
why are LBO’s risky
high debt
how is LBO a source of funding for established private firms
public companies become private as the private equity firm purchases all their outstanding stocks
why do public companies have better access to capital than private companies?
because private equity investors are very selective and the terms they require e.g. high return and ownership, may not be attractive to owners
advantages of public company listing
describe how shareholders can cash in on the firm’s success
The cash they receive by selling part of their interest in the company can be used to diversify their investment portfolio.
how is information disclosure a cost for public companies?
- cost and time in preparing disclosure documents
- information disclosed may be valuable to competitors
if the price of a new issue is too high then,
unless it is underwritten, in which case the underwriter will have to meet the shortfall, few investors will want to subscribe and the issue may fail
what happens when too few investors subscribe?
the market price of the shares will fall after they are listed
If the price is set too low,
owners will suffer an opportunity loss because they would have received a higher payment if the new issue had been made at a higher price.
The task of setting the issue price is particularly difficult when the company has just been formed,because
what if the company operated previously as a private company?
no historic records of financial performance
private company: easier because previous profits can help gain insight as to the company’s general profitability and future profits
why may an adviser examine the P/E ratio when determining how to price a new issue
this will give an idea of value when compared to P/E ratios of existing companies in the same industry
describe the fixed price approach as a pricing method for new issues
the price must be set before the prospectus is printed and the offer is usually open for at least 2 to 3 weeks
what is an indication that the fixed price is too low?
What is an indication that the fixed price is too high?
Too low: if the general level of share prices increases significantly during that period
Too high: if share prices decrease significantly during that period –> the issue will close undersubscribed
describe bookbuilding as a pricing method for new issues
potential investors place bids for the shares where they indicate the quantities they wish to purchase at various prices.
The final price is determined at the end of the bidding process
describe open pricing
shares are usually allocated only to bidders who offered prices equal to or higher than the final price
describe constrained open pricing
commonly used in bookbuilding i.e. more common for Australian floats to use constrained open pricing than open pricing
both upper and lower limits are placed on the price and all bids between those limits are considered.
-price range revised if during the bidding process, demand was than expected
bookbuilding
what happens once final price has been determined
Once the final price has been determined, all successful bidders pay the same price
while bookbuilding can result to a lower chance of underpricing,
conducting a book-build is a costly process, so it is usually worthwhile only for larger floats. Hence, the majority of floats in Australia still involve fixed-price offers
main adv of book building
it allows the issuer and its advisers to <strong>obtain feedback from informed institutional investors on their assessment of the value of the shares.</strong>
The information gathered from these investors can be used in setting the issue price
With a fixed-price offer, once the terms have been set,
what is the role of the advisor
the adviser usually ensures
- proposed offer satisfies all relevant legal requirements
- assists in preparing the offer document (usually a prospectus)
- ensures that stock exchange listing requirements are met
- lodges the prospectus with ASIC
- markets the shares to institutional and private investors.
an underwriter is typically a
an investment bank or a major stockbroker
when a fixed-price offer method is used it is subject
to the vagaries of the market from the time when the price is set until the issue closes
a fixed-price offer the issuer is subject to the vagaries of the market from the time when the price is set until the issue closes
who can the issuer pass the risk on to?
commonly, the issuer will pass this risk on to an underwriter
If the issue is underwritten, the obligations of the company and the underwriter are
contained in an underwriting agreement.
what is the underwriter’s duty under the underwriting agreement
The underwriter contracts to purchase all shares for which applications have not been received by the closing date of the issue.
what is the issuer’s duty under the underwriting agreement
to pay the underwriter a fee
(fixed percentage on the amount raised)
what does the underwriter fee depend on?
it is negotiated and will depend on how difficult it was to sell the issue
an underwriter will frequently attempt to limit its exposure to the risk of undersubscription by
by inviting other institutions to act as subunderwriters. e.g. life and general insurance companies, banks and superannuation funds.
what is the role of subunderwriters
to take up a proportion of any undersubscription in return for a fee, paid by the underwriter, which is based on a fixed proportion of the issue price
Where a fixed-price issue is not underwritten,
a broker will still be engaged to assist in distributing the shares.
Brokerage fees are ___
and depend on
Brokerage fees are negotiable and depend on factors
- size of the issue
- the status of the issuing company
- period for which the issue is to remain open.
usually 1-2% of issue price
costs of floating a company
1st cateogry
Stock exchange listing fees and the costs of preparing and distributing a prospectus.
e.g. include legal fees, fees for the preparation of an investigating accountant’s report, fees for expert reports and printing costs.
costs of floating a company:
2nd category
Fees paid to underwriters
commissions paid to brokers for selling the shares.
1 to 5 per cent of the funds raised.
how is an IPO underpriced a cost of issuing?
issue price of shares sold in an IPO is usually less than the market value of the shares once they are listed.
describe how informational asymmetry may cause an IPO to be underpriced
some investors are well informed about the value of the shares being offered
others are uninformed and therefore have difficulty estimating the future market price of the shares –> IPO is underpriced to attracted these uninformed investors
second explanation for underpricing
potential investors will only subscribe for IPOs that they believe will be popular
If an investor perceives that a float is not popular with other investors, then he or she may decide not to subscribe.
since potential investors tend to subscribe to IPOs that are popular, what may the issuer do?
issuers may have an incentive to underprice an issue in order to induce some potential investors to buy.
this is b/c If the issuer sets a price that is perceived as only a little too high, it is very likely that the issue will fail, with investors deciding not to subscribe because others have also decided not to subscribe.
investors tend to subscribe to popular IPOs, so what happens when an IPO is underpriced?
set off a cascade in which other investors are willing to subscribe.
