Financing Process

05/14/07
Ch. 17
Financing
 Internal Financing – funds raised from cash
flows of existing assets
 External Financing – funds raised from
outside the company (VC, debt, equity, etc.)

2
Internal vs. External Financing
 Firms may prefer internal financing because
 External financing is difficult to raise
 External financing may result in loss of control
 Raising external capital tends to be expensive

 Projects funded by internal financing must

meet same hurdle rates

 Internal financing is limited

3
A Life Cycle View of Financing
Choices
Revenues
$ Revenues/
Earnings

Earnings

Time

External funding High, but High, relative Moderate, relative Declining, as a

needs Low, as projects dry
constrained by to firm value. to firm value. percent of firm
up.
infrastructure value

Internal financing Negative or Negative or Low, relative to High, relative to More than funding needs
low low funding needs funding needs

External Owner’s Equity Venture Capital Common stock Debt Retire debt
Financing Bank Debt Common Stock Warrants Repurchase stock
Convertibles

Growth stage Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Start-up Rapid Expansion High Growth Mature Growth Decline 4
Financing
Transitions Accessing private equity Inital Public offering Seasoned equity issue Bond issues
Process of raising capital
 Private firm expansion

 From private to public firm: The IPO

 Choices for a public firm

5
VC process
 Provoke equity investors’ interest
 There is an imbalance between the number of small
firms that desire VC investment and the number of VCs

 Firms need to distinguish themselves from others to

obtain VC funding

 Type of business
 Dot.com in the 90s, bio-tech firms this decade

 Successful management

6
VC process
 Perform valuation and return assessment (Venture capital
method)
 Estimate earnings in the year the company is expected to go
public

 Obtain a P/E multiple for public firms in the same industry

Exit or Terminal Value = P/E multiple * forecasted earnings

 Discount this terminal value at the VC’s target rate of return

Discounted Terminal Value = Estimated exit value

(1 + target return)n

7
VC process
 Structure the deal
 Determine the proportion of firm value that VC
will get in return for investment
Ownership Proportion = Capital Provided
Disc. Exit Value

 VC will establish constraints on how the

managers run the firm

8
VC process
 Participate in post-deal management
 VCs provide managerial experience and contacts for
additional fund raising efforts

 Exit
 VCs generate a return on their investment by exiting
the investment.
 They can do so through
 An initial public offering

 Selling the business to another firm

 Withdrawing firm cash flows and liquidating the firm

9
VC process
 Stages of Venture Capital Investments
 Seed financing is capital provided at the “idea”
stage.
 Start-up financing is capital used in product
development.
 First-stage financing is capital provided to initiate
manufacturing and sales.
 Second-stage financing is for initial expansion.
 Third-stage financing allows for major expansion.
 Mezzanine financing prepares the company to go
public.

10
Going public vs. staying private
 The benefits of going public are:
 Firms can access financial markets and tap
into a much larger source of capital
 Owners can cash in on their investments

 The costs of going public are:

 Loss of control
 Information disclosure requirements
 Exchange listing requirements
11
Initial Public Offering (IPO) process
 Most public offerings are made with the assistance of
investment bankers (IBs) which are financial
intermediaries that specialize in selling new securities
and advising firms with regard to major financial
transactions.

12
IPO process
 The role of the investment banker
 Origination - design of a security contract that is acceptable
to the market;
 prepare the state and federal Securities and Exchange
Commission (SEC) registration statements and a summary
prospectus,

 Underwriting-the risk-bearing function in which the IB buys

the securities at a given price and turns to the market to sell
them.
 Syndicates are formed to reduce the inventory risk.

 Sales and distribution-selling quickly reduces inventory risk.

Firm members of the syndicate and a wider selling group
distribute the securities over a wide retail and institutional
area.

13
IPO process

14
IPO process
 IPO costs

 Underwriting commission (usually around 7%)

 Underpricing of issue
 Represents the first day returns generated by the firm,
calculated as
Closing Price – Offer price
Offer price

 Issues are underpriced to

 Provide investors with a “good taste” about the investment banker
and firm
 Compensate investors for the information asymmetry between firm
and investor

15
IPO process
 Valuing the company and setting issue details
 Investment banker and firm need to determine
 Value of company
 Valuation is typically done using P/E multiples
 Size of the issue
 Value per share
 Offering price per share
 This will tend to be below the value per share, i.e.,
the offer will be underpriced

16
IPO process
 Determining the offer price
 The investment banker will gauge the level of
interest from institutional investors for the
issue by conducting road shows. This is
referred to as building the book.

 After the offer price and issue details are set,

and the SEC has approved the registration,
the firm places a tombstone advertisement
in newspapers, that outlines the details of the
issue and the investment bankers involved
17
IPO process
 Waiting period – The period between the submission
of the registration to the SEC and the SEC’s
approval. It is during this time that the company
releases the red herring

 Quiet period – a period after the registration is

submitted until approximately a month after the issue
where the company cannot comment on the
earnings, prospects for the company

 Lock-up period – a period of usually 6 months

following the issue date in which the insiders of the
company cannot sell their shares

18
Choices for a publicly traded firm
 General subscription (or Seasoned Equity
Offering)

 Private placements

 Rights offerings

19
General subscription (SEO)
 Although for IPOs the underwriting agreement almost
always involves a firm guarantee from the underwriter
to purchase all of the issue, in secondary offerings,
the underwriting agreement may be a best efforts
guarantee where the underwriter sells as much of
the issue as he can

 SEOs tend to have lower underwriting commissions

because of IB competition.

 The issuing price of an SEO tends to be set slightly

lower than the current market price
20
Private placement
 Securities are sold directly to one or few
investors

 Saves on time and cost (no registration

requirements, marketing needs)

 Tends to be less common with corporate

equity issues. Private placement is used more
in corporate bond issues.
21
Rights offerings
 Existing investors are provided the right to purchase
additional shares in proportion to their current
holdings at a price (subscription price) below current
market price (rights-on price)

 Each existing share is provided one right.

 The number of rights required to purchase a share in

the rights offering is then determined by the number of
shares outstanding and the additional shares to be
issued in the rights offering.

rights required to purchase one share = # of original shares

# of shares issued in RO
22
Rights offerings
 Because investors can purchase shares at a lower price, the rights have
value:

Value of the right = rights-on price – subscription price

n+1

where n = number of rights required for each new share

 Because additional shares are issued at a price below market price, the
market price will drop after the rights offering to the ex-rights price

ex-rights price = New value of equity

New number of shares

 The value (or price) of the right can also be calculated as:

rights-on price – ex-rights price

23
Rights offerings
 Costs are lower because of
 Lower underwriting commissions – rights offerings tend
to be fully subscribed
 Marketing and distribution costs are significantly lower

 No dilution of ownership

 No transfer of wealth

24