CHAPTER 23

Raising Equity Capital

Chapter Synopsis
23.1 Equity Financing for Private Companies A private company can raise equity capital from several potential outside sources: Angel investors are individual investorsfrequently friends or acquaintances of the entrepreneurwho buy equity in small private firms. Because their capital investment is often relatively large, they typically receive a sizeable equity share in the business and have substantial influence in the business decisions of the firm. Venture capital firms are limited partnerships formed to invest in the private equity of young firms. Institutional investors, such as pension funds, are typically the limited partners. Most general partners charge an annual management fee of 2% of the funds committed capital plus 20% of any positive return they generate. Institutional investors may invest directly in private firms or they may invest indirectly by becoming limited partners in venture capital firms. Corporate investors are corporations that invest in private companies; they are often referred to as corporate partners, strategic partners, and strategic investors. When a company sells equity to outside investors for the first time, it typically issues convertible preferred stock. This give investors all of the future benefits of common stock if things go well, and if the company runs into financial difficulties, the preferred stockholders have a senior claim on the assets of the firm. Firms generally raise capital in different rounds. The pre-money valuation is the value of the shares outstanding prior to a new funding round at the price in the funding round. The postmoney value is the value of the whole firm (old plus new shares) at the funding round price. The method used by equity investors to realize a return from their initial equity investment is called an exit strategy. There are two general types of exit strategies: an acquisition by another firm or a public equity offering.

2011 Pearson Education

274

Berk/DeMarzo Corporate Finance, Second Edition

23.2 The Initial Public Offering The process of selling stock to the public for the first time is called an initial public offering (IPO). Going public has advantages and disadvantages. The main advantages of going public are improved liquidity for the equity investors and better access to capital, both from the IPO proceeds and in subsequent equity offerings. A disadvantage of going public is that the equity holders of the corporation become more widely dispersed. This undermines investors ability to monitor the companys management and thus represents a loss of control. Furthermore, once a company goes public, it must satisfy all of the increasingly stringent requirements of public companies. Organizations such as the Securities and Exchange Commission (SEC), the securities exchanges (including the New York Stock Exchange and the Nasdaq), and Congress (through the Sarbanes-Oxley Act of 2002) have adopted new standards that require more thorough financial disclosure, greater accountability, and more stringent requirements for the board of directors. Compliance with the new standards is costly and time-consuming for public companies. After deciding to go public, managers of the company work with an underwriter, which is an investment banking firm that manages the offering and designs its structure. The shares that are sold in the IPO may either be new shares that raise capital, known as a primary offering, or existing shares that are sold by current shareholders, known as a secondary offering. Typically, an issuer uses a firm commitment IPO in which the underwriter guarantees that it will sell all of the stock at the offer price. The underwriter purchases the entire issue at a slightly lower price than the offer price and then resells it at the offer price. The difference between the underwriters purchase price and the offer price is the spreadthe primary means of compensation for the underwriter. The lead underwriter is the primary investment banking firm responsible for managing the IPO along with a group of other underwriters, collectively called the syndicate, to help market and sell the issue. Underwriters are responsible for marketing and pricing the IPO, as well as helping the firm with all of the necessary filings. Issuers must file a registration statement that provides financial and other information about the company to investors prior to an IPO. Part of the registration statement, called the preliminary prospectus or red herring, is distributed before the stock is offered. Once the company has satisfied the SECs disclosure requirements, the SEC approves the stock for sale to the general public. The company prepares the final registration statement and final prospectus containing all the details of the IPO, including the number of shares offered and the offer price. To determine the offer price, underwriters work with the issuer to value the company using discounted cash flow and comparable multiple valuation techniques. Underwriters also gain valuation advice from potential investors during the road show, in which senior management and the lead underwriters travel around the country explaining the deal to their largest customersmainly institutional investors such as mutual funds and pension funds. At the end of the road show, customers provide non-binding indications of their demand. The underwriters then study the total demand and adjust the price until it is virtually certain that the issue will succeed. This process is called book building. In most cases, the pre-existing shareholders are subject to a lockup provision, and they cannot sell their shares for 180 days after the IPO.

2011 Pearson Education

Berk/DeMarzo Corporate Finance, Second Edition

275

23.3 IPO Puzzles There are four puzzling IPO characteristics: 1. On average, IPOs appear to be underpriced. On average, between 1960 and 2003, the price in the U.S. aftermarket was 18.3% higher at the end of the first day of trading as underwriters appear to use the information they acquire during the book-building stage to intentionally underprice the IPO. The most prominent explanation of underpricing is the manifestation of a form of adverse selection referred to as the winners curse. An investor who requests shares in an IPO will win (get all the shares requested) when demand for the shares by others is low, and the IPO is more likely to perform poorly. However, the investor will get low allocations in the best IPOs because they are oversubscribed. This effect implies that it may be necessary for the underwriter to underprice its issues on average in order for less-informed investors to be willing to participate in IPOs. 2. The number of issues is highly cyclical. It appears that the number of IPOs is not solely driven by the demand for capital: When times are good, the market is flooded with new issues; when times are bad, the number of issues dries up. In some periods, firms and investors seem to favor IPOs; at other times, firms appear to rely on alternative sources of capital and financial economists are not sure why. 3. It is unclear why firms willingly incur such high costs. Almost all IPOs ranging in size from $20 million to $80 million pay an underwriting spread of 7%. It is difficult to understand how a $20 million issue can be profitably done for $1.4 million, while an $80 million issue requires paying fees of $5.6 million. 4. The long-run performance of a newly public company is poor. On average, a three- to five-year buy and hold strategy has been a bad investment. 23.4 The Seasoned Equity Offering A seasoned equity offering (SEO) is the process in which a public firm issues new shares. An SEO involves many of the same procedures as an IPO. The main difference is that the pricesetting process is not necessary because a market price for the stock already exists. Two kinds of seasoned equity offerings exist: a cash offer and a rights offer. In a general cash offer, the firm offers the new shares to investors at large. In a rights offer, the firm offers the new shares only to existing shareholders. In the United States, almost all offers are cash offers, but the same is not true internationally. For example, in the United Kingdom, most seasoned offerings of new shares are rights offers. On average, a firms stock price falls by 2% to 3% when it announces an SEO. This price decline is consistent with the idea that a firm, concerned about the interests of its existing shareholders, will not issue stock if the firm is undervalued and tend only to issue stock that is overvalued. Thus, investors infer from the decision to have an SEO that the company is likely to be overvalued.

2011 Pearson Education

276

Berk/DeMarzo Corporate Finance, Second Edition

Stocks of firms having SEOs underperform following the offering. This is consistent with the explanation provided for why there is a negative reaction at the SEO issuance and suggests that the stock price decrease at the announcement is not large enough.

Selected Concepts and Key Terms

Angel Investors Individual investorsfrequently friends or acquaintances of the entrepreneurwho buy equity in small private firms. Because their capital investment is often relatively large, they typically receive a sizeable equity share in the business and have substantial influence in the business decisions of the firm. Auction IPO A very rarely used IPO method in which investors place bids in an auction process, which sets the highest price such that the number of bids at or above that price equals the number of offered shares. All winning bidders pay this price, even if their bid was higher. Best-Efforts Offer A rarely used IPO method in which the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price. Such deals may have an all-or-none clause in which the deal is called off if all of the shares are not sold. Book Building A process in which customers provide non-binding indications of their demand early in the IPO process. The underwriters then add up the total demand and adjust the price until it is virtually certain that the issue will succeed. Carried Interest The fee that general partners in a private equity firm make from taking a share of any positive return generated by the fund. General Cash Offer A method of issuing securities where a firm offers new shares to investors in exchange for cash. Exit Strategy The method used by equity investors to realize a return form their initial equity investment. There are two general types of exit strategies: an acquisition by another firm or a public equity offering. Initial Public Offering (IPO) The process of selling stock to the public for the first time. Leveraged Buyout (LBO) In a leveraged buyout (LBO), a group of private investors purchases all the equity of a public corporation.
2011 Pearson Education

Berk/DeMarzo Corporate Finance, Second Edition

277

Lockup An agreement that forbids pre-IPO shareholders from selling their shares for a period generally 180 daysafter an IPO. Over-Allotment Provision, Greenshoe Provision An option which allows an underwriter to issue more 15% more shares in an IPO. Post-Money Valuation The value of the whole firm (old plus new shares) at the funding round price. Pre-Money Valuation The value of the shares outstanding prior to a new funding round at the price in the funding round. Primary Offering Shares that are sold in a security offering in which the proceeds go to the issuing firm. Private Equity Firm A firm that specializes in raising money and undertaking leveraged buyouts (LBOs) on behalf of investors in a private equity fund using the money raised for funding the equity portion of LBOs. Rights Offer A method of raising seasoned equity in which the firm offers new shares only to existing shareholders. Road Show A process in which senior management and the lead underwriters travel around the country explaining the deal to their largest customersmainly institutional investors such as mutual funds and pension fundsbefore an IPO. Seasoned Equity Offering (SEO) The process in which a public firm issues new shares. Secondary Offering Shares that are sold in a security offering by stockholders in which the proceeds go to a stockholder instead of the issuing firm. Spread The difference between the underwriters purchase price and the offer price in a security offering. Syndicate A group of underwriters responsible for managing the IPO process and marketing and selling the issue.

2011 Pearson Education

278

Berk/DeMarzo Corporate Finance, Second Edition

Tombstone An advertisement in newspapers in which intermediaries advertise the sale of stock (both IPOs and SEOs). They were more important several years ago; today, investors become informed about the impending sale of stock by the news media, via a road show, or through the book-building process, so these tombstones are merely a ritual. Underwriter An investment banking firm that manages the security offering and designs its structure. Venture Capital Limited Partnership A limited partnership formed to invest in the private equity of young firms. Institutional investors, such as pension funds, are typically the limited partners. Most firms charge an annual management fee of 2% of the funds committed capital plus 20% of any positive return they generate. Winners Curse An explanation for the underpricing of IPOs. An investor who requests shares in an IPO will win (get all the shares you requested) when demand for the shares by others is low, and the IPO is more likely to perform poorly. However, the investor will get low allocations in the best IPOs because they are oversubscribed. This effect implies that it may be necessary for the underwriter to underprice its issues on average in order for less-informed investors to be willing to participate in IPOs.

Concept Check Questions and Answers

23.1.1. What are the main sources of funding for private companies to raise outside equity capital? Private companies can raise outside equity capital from angel investors, venture capital firms, institutional investors, and corporate investors. 23.1.2. What is a venture capital firm? A venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of young firms. 23.2.1. What are some advantages and disadvantages of going public? The main advantages of going public are improved liquidity for the equity investors and better access to capital, both from the IPO proceeds and in subsequent equity offerings. A disadvantage of going public is that the equity holders of the corporation become more widely dispersed, reducing investors ability to monitor the companys management and thus represents a loss of control. Also, public firms must satisfy all of the increasingly stringent reporting requirements, which is costly and time-consuming. 23.2.2. Explain the mechanics of an auction IPO. In an auction IPO, the company that goes public lets the market determine the price by auctioning off the company. Investors place bids over a set period of time. An auction IPO sorts the bids from high to low, and sells the stock at the highest price that will sell all of the offered shares. All winning bidders pay this price, even if they initially bid something higher.

2011 Pearson Education

Berk/DeMarzo Corporate Finance, Second Edition

279

23.3.1. List and discuss four characteristics about IPOs that financial economists find puzzling. There are four IPO puzzles. First, on average IPOs appear to be underpriced: the price at the end of trading on the first day is often substantially higher than the IPO price. Second, the number of issues is highly cyclical. Third, the costs of the IPO are very high. Fourth, the long-run performance of a newly public company is poor. 23.3.2. What is a possible explanation for IPO underpricing? The most prominent explanation of underpricing is the manifestation of a form of adverse selection referred to as the winners curse. An investor who requests shares in an IPO will win (get all the shares requested) when demand for the shares by others is low, and the IPO is more likely to perform poorly. However, the investor will get low allocations in the best IPOs because they are oversubscribed. This effect implies that it may be necessary for the underwriter to underprice its issues on average in order for less-informed investors to participate in IPOs. 23.4.1. What is the difference between a cash offer and a rights offer for a seasoned equity offering? In a cash offer, a firm offers the new shares to investors at large. In a right offer, a firm offers the new shares only to existing shareholders. 23.4.2. What is the average stock price reaction to an SEO? Researchers have found that the stock price reaction to an SEO is negative on average. Often the value destroyed by the price decline can be a significant fraction of the new money raised.

Examples with Step-by-Step Solutions

Solving Problems Problems may involve determining the pre-money valuation, the post-money valuation, and the fractional ownership interests surrounding a round of financing as in example 1 below. Other problems may involve understanding the mechanics of an auction IPO as in example 2. You should also be able to determine an initial IPO valuation based on comparable firm valuation multiples as in example 3. You should also understand the basic mechanics of a rights offering and be able to calculate the underwriters spread in an IPO or SEO and the initial return (or underpricing) in an IPO. The Questions and Problems section provides examples of all of these applications. Examples 1. You initially funded your start-up company by contributing $250,000 for 250,000 shares of stock. Since then, you have sold an additional 500,000 shares to angel investors. You are now considering raising even more capital from a venture capital limited partnership (VC). This VC would invest $4.5 million and would receive 750,000 newly issued shares. [A] What is the pre-money valuation? [B] What is the post-money valuation? [C] What percentage will you own? What is the value of your shares? [D] What percentage of the firm will the VC end up owning?

2011 Pearson Education

280

Berk/DeMarzo Corporate Finance, Second Edition

Step 1. Determine the pre-money valuation. The pre-money valuation is the value of the shares outstanding prior to a new funding round at the price in the funding round. The number of shares before the new round of financing from the VC is: Stockholder You Angels Total Number of Shares 250,000 500,000 750,000

The VC is paying $4,500,000/750,000 = $6 per share, so the pre-money valuation is: $6 750,000 = $4,500,000. Step 2. Determine the post-money valuation. The post-money value is the value of the whole firm (old plus new shares) at the funding round price. The number of shares after the new round of financing from the VC is: Stockholder You Angels Venture capital firm Total Number of Shares 250,000 500,000 750,000 1,500,000

The VC is paying $4,500,000 / 750,000 = $6 per share, so the post-money valuation is: $6 1,500,000 = $9,000,000. Step 3. Determine your ownership stake and value after the new round of financing. You own

250,000 = 16.66% . 1,500,000

Your stake is worth 250,000 $6 = $1,500,000. Step 4. Determine the VCs ownership stake after the new round of financing. The VC owns 750,000 = 50% . 1,500,000

2. Your firm is ready to issue stock in an initial public offering. You hope to raise $40 million by issuing 4 million shares at $10, but you are using an auction IPO so the auction will ultimately determine how much equity will be raised if 4 million shares are issued. After the deadline for submitting bids, the following bids were received: Price $12.00 11.50 11.00 10.50 10.00 9.50 9.00 Number of Shares 200,000 300,000 500,000 1,500,000 2,000,000 3,000,000 4,500,000

Will you be able to raise $40 million?

2011 Pearson Education

Berk/DeMarzo Corporate Finance, Second Edition

281

Step 1. Determine the cumulative demand schedule. Price $12.00 11.50 11.00 10.50 10.00 9.50 9.00 Number of Shares 200,000 500,000 1,000,000 3,000,000 5,000,000 8,000,000 12,500,000

Step 2. Determine the winning price. The offer price is the highest price such that the number of bids at or above that price equals the number of offered shares. All winning bidders pay this price, even if their bid was higher. The winning price is thus $10. All auction participants who bid prices higher than $10 will receive the number of shares they bid. However, since there are 2 million bids at $10, but only 1 million shares available to these bidders, the shares will have to be rationed. Shares will be awarded on a pro rata basis to bidders who bid $10. 3. You are an investment banker preparing your PowerPoint presentation for the upcoming road show for a client in the satellite radio industry, iRadio. Last year, iRadio had sales of $300 million and EBITDA of $50 million. You have identified the following information for the two closest competitors, XM Satellite Radio and Sirius, which have recently gone public: Company XM Satellite Radio Sirius

Enterprise Value EBITDA 22.3 24.8

Enterprise Value Sales 5.3 7.6

XM, Sirius, and iRadio all have no debt. After the IPO, iRadio will have 50 million shares outstanding. Determine the comparable multiple valuations that should be included in the presentation. Step 1. Determine the valuation based on the EBITDA multiples of the comparable firms. The average comparable firm ratio is 23.6, thus the total equity value is: 50,000,000 23.6 = $1,180,000,000 and the value per share is:

$1,180,000,000 = $23.60. 50,000,000 Step 2. Determine the revenue multiple relative valuation. The average comparable firm ratio is 6.5, thus the total equity value is: 300,000,000 6.5 = $1,950,000,000 and the value per share is: $1,950,000,000 = $39.00. 50,000,000

2011 Pearson Education

282

Berk/DeMarzo Corporate Finance, Second Edition

Step 3. Make a conclusion. Although a discounted cash flow analysis should also be conducted, based on the comparable firm multiples, the price range for iRadio stock is between $24 and $39 per share.

Questions and Problems

1. Starbucks has 800 million shares outstanding trading at $40 per share. They want to raise $2 billion and are considering using a rights offering. [A] If the offering requires 10 rights to purchase one share at $25 per share, how much will they raise? What is the value per share after the rights issue? [B] If the offering requires 8 rights to purchase one share at $20 per share, how much will they raise? What is the value per share after the rights issue? 2. eHealth plans to offer 5 million shares at $10 each with Morgan Stanley and Merrill Lynch serving as co-lead underwriters. [A] If the underwriters spread is the standard 7%, how much will the firm raise? [B] If the first days closing price is $12.44, how much is the issue underpriced by? 3. You initially funded your company by contributing nothing more than some software code you had written in graduate school. You then formed a corporation and raised $1 million in venture capital (VC) financing in exchange for 25% of the firms equity. You are now considering raising more capital from the same VC firm. This VC would invest another $10 million in order to maintain the same fractional ownership. [A] What is the post-money valuation? [B] What is the value of your shares? 4. Your firm is conducting an auction IPO of 1 million shares. After the deadline for submitting bids, the following bids were received: Price $6.00 5.75 5.50 5.25 5.00 4.75 4.50 Number of Shares 0 10,000 40,000 350,000 600,000 1,000,000 1,500,000

How much will the offering raise? 5. You are a mutual fund manager considering an IPO for a firm that produces hydroelectric energy that is expected to be priced at $12 per share. Last year, the firm had sales of $100 million and EBITDA of $5 million. You have identified the following information for the two closest competitors, Gulf Electric and Columbia Power: Company Gulf Electric Columbia Power Price Earnings 26.2 32.5

Price Sales 2.2 2.8

After the IPO, the issuing firm will have 10 million shares outstanding. Based on the comparable firm multiples, is the IPO an attractive investment?

2011 Pearson Education

Berk/DeMarzo Corporate Finance, Second Edition

283

Solutions to Questions and Problems

1. [A]

[B]

If investors exercise their rights, 800 million/10 = 80 million shares will be purchased at $25 raising $2 billion. The value of the firm after the issue is 800 million $40 + $2 billion = $34 billion. The value per share is thus $34 billion/880 million = $38.64. If investors exercise their rights, 800 million/8 = 100 million shares will be purchased at $20 raising $2 billion. The value of the firm after the issue is 800 million $40 + $2 billion = $34 billion. The value per share is thus $34 billion/900 million = $37.78. The spread is the difference between the underwriters purchase price and the offer price. In this case, it equals 0.07 $10 per share = $0.70 per share. Thus the firm would raise $9.30 5 million = $46.5 million. The underpricing, or initial return, equals: $12.44 $10 = 24.4% $10

2. [A] [B]

3. [A] [B]

The post-money value is the value of the whole firm (old plus new shares) at the funding round price. Since the VC is contributing $10 million for 25% of the corporations equity, the post-money valuation is 4 $10 million = $40 million. Determine your ownership stake and value after the new round of financing. You own 75% of the equity, which is worth $30 million. Price $6.00 5.75 5.50 5.25 5.00 4.75 4.50 Number of Shares 0 10,000 50,000 400,000 1,000,000 2,000,000 3,500,000

4. The cumulative demand schedule is:

The offer price is the highest price such that the number of bids at or above that price equals the number of offered shares. All winning bidders pay this price, even if their bid was higher. The winning price is thus $5 and you will raise $5 million before any fees. 5. Determine the P/E multiple relative valuation. The average comparable firm ratio is 29.4, thus the total equity value is: 5,000,000 29.4 = $147,000,000 and the value per share is: $147,000,000 = $14.70. 10,000,000 Determine the revenue multiple relative valuation.

2011 Pearson Education

284

Berk/DeMarzo Corporate Finance, Second Edition

The average comparable firm P/S ratio is 2.5, thus the total equity value is: 100,000,000 2.5 = $250,000,000 and the value per share is: $250,000,000 = $25.00. 10,000,000 Based on the comparable firm multiples, the price of $10 looks attractive.

2011 Pearson Education