06 - Raising Equity Capital

Applied Corporate Finance Week 6 Raising Equity Capital References: Berk and DeMarzo Ch. 23

Lecture Outline • Equity Financing for Private Companies • Initial Public Offerings • Seasoned Equity Offerings

Equity Financing for Private Companies • The initial capital that is required to start a business is usually provided by the entrepreneur and their immediate family. • Often, a private company must seek outside sources that can provide additional capital for growth. – how will the infusion of outside capital affect the control of the company?

Angel Investors • Individual Investors who buy equity in small private firms • Can organize themselves into angel groups or networks to share research and pool their capital, as well as to provide advice to their portfolio companies eg Sydney Angels, Sydney Seed Fund • Crowdfunding regulation • How to be an angel investor

Venture Capital (VC) • A limited partnership that specializes in raising money to invest in the private equity of young firms. • VC firm manages funds that have a fixed-life investment that is typically 10 years plus some number of extensions. • Fund is managed by general partners (venture capitalists) • Investors such as pension funds, universities, insurance companies, foundations, endowments, and high-networth individuals invest in the fund as limited partners (LPs).

• Advantages : – LPs are more diversified. – Benefit from the expertise of the general partners.

• Cost : General partners usually charge substantial fees. – Most firms charge 20% of any positive return they make. – Also generally charge an annual management fee of about 2% of the fund’s committed capital.

• VCs often demand a great deal of control. – Seats in the boardroom. – Significant voting power.

• VC and PE explained

• Start up financing in Australia very low – Accounts for only 0.009% of GDP compared to 0.3% and 0.055% for Israel and US (OECD, 2014).

• AVCAL overview Funds under management

No. of active fund managers

No. of portfolio companies held

Investment in FY2015

A$2.2b

26

270

$224m

• VC fundraising increased in FY2015 from $126m to $368m

Venture Capital Funding in the US

• To VC or not to VC

Private Equity • Organized very much like a venture capital firm, but invest in established businesses with growth potential rather than start-up companies. • Later stage and buyout investing • Typically finance their acquisitions through a combination of equity and debt. • Leveraged buyout (LBO) – purchasing the outstanding equity of publicly traded firm and take the company private – Re-organise, add value and exit by selling the company

• Largest LBOs ever

• But is high risk/leverage and markets can change – TXU – Channel 9

• Australia • PE fundraising rose to $2.7b in FY2015 from $933m Funds under management

No. of active fund managers

No. of portfolio companies held

Investment in FY2014

$23b

45

294

$3.3b

• When a company decides to sell equity to outside investors for the first time, is common practice (in US) to issue preferred stock rather than common stock to raise capital. • Preferred stock issued by young companies has seniority in any liquidation but typically does not pay regular cash dividends and often contains a right to convert to common stock. • Convertible Preferred Stock : Preferred stock that gives the owner an option to convert it into common stock on some future date

Example • You founded your own firm two years ago. • You initially contributed $50,000 of your money and in return received 1,000,000 shares of stock. • Since then, you have sold an additional 750,000 shares to angel investors. • You are now considering raising even more capital from a venture capitalist. • The venture capitalist would invest $2 million and would receive 2,000,000 newly issued shares

• What is the post-money valuation? • Assuming that this is the venture capitalist’s first investment in your company, what percentage of the firm will they end up owning? • What percentage will you own? • What is the value of your shares?

Your shares

1,000,000

26.67%

750,000

20.00%

Venture capitalist’s shares

2,000,000

53.33%

Total shares outstanding

3,750,000

100.00%

Angel Investors’ Shares

• Based on the price paid by the VC, your share price is $1 per share. • Thus, the post-money valuation is $3,750,000 • VC’s ownership is 53.33% • Your ownership is 26.67% • Your shares are worth $1 million

Initial Public Offering (IPO) • Is the first issue of shares to the general public made by a firm seeking listing on the stock exchange. • Benefits of a public raising of capital: – Gives access to a wider pool of equity investors – May liberate the firm from relying on debt as the primary source of financing

• Benefits of listing: – – – – –

Secures liquidity Establishes a market value for the company (pricing) Exit mechanism for investors in the private firm Facilitates raising of further equity capital Public profile

• Costs of a public raising of capital: • High floatation costs

– Direct – legal, auditing and underwriting – Indirect – management time/effort

• Dilution of ownership • Costs of listing:

– Onerous disclosure requirements – Loss of privacy – Loss of control (susceptible to hostile takeovers)

• IPOs include both primary offerings and secondary offerings. – Primary offering: New shares available in a public offering that raise new capital. – Secondary offering: Shares sold by existing shareholders in an equity offering.

• Underwriter: an investment banking firm that manages a security issuance and designs its structure.

Types of Offerings • In Australia, the traditional method of an IPO is to set a fixed offer price before marketing the shares. • Investment banks have increasingly used bookbuilds to handle large IPOs – The underwriter collects bids from investors at various prices, between the floor price and the cap price. – Bids can be revised by the bidder before the book closes. – Final issue price is not determined until the end of the process when the book has closed.

– After the close of the book building period, underwriter evaluates the collected bids on the basis of certain evaluation criteria and sets the final issue price. – Underwriter has complete control over the price and allocation of shares. – Over-Allotment Allocation: an option that allows the underwriter to issue more stock, usually amounting to 15% of the original offer size, at the IPO offer price.

• Auction IPO – Rather than setting a price itself and then allocating shares to buyers, the underwriter in an auction IPO takes bids from investors and then sets the price that clears the market. – More transparent than bookbuild

Example • Aston Inc. is selling 900,000 shares of stock in an auction IPO. • At the end of the bidding period, Aston’s investment bank has received the following bids. • What will the offer price be? Price ($)

$10.00

$9.75 $9.50 $9.25 $9.00

Number of Shares Bid Cumulative Demand

175,000 200,000 275,000 275,000 300,000

175,000 375,000 650,000 925,000 1,225,000

Valuation • There are two ways to value a company. – Compute the present value of the estimated future cash flows. – Estimate the value by examining comparables (recent IPOs).

Example • RAXHouse is a private company considering going public. – Assets of $585 million and liabilities of $415 million. – The firm’s cash flow from operations was $137 million for the previous year. – After the IPO, RAXHouse will have 118 million shares outstanding.

• The industry average cash flow per share multiple is 3.0 and the average book value per share is 2.3. • Estimate the IPO price for RAXHouse.

• Book value of equity = value of the assets – liabilities = $585$415 million = $170 million. • 118 million shares outstanding, book value per share is $170 million/118 million shares = $1.44/share. • Given the industry average of 2.3, the estimated IPO price would be $1.44 × 2.3 = $3.31 per share. • The firm’s cash flow from operations was $137 million, • Cash flow per share is $137 million/118 million shares = $1.16 per share. • Given the industry average multiple of 3.0, the estimated IPO price would be $1.16 × 3.0 = $3.48.

• Road Show – During an IPO, the company’s senior management and 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

• Lockup – A restriction that prevents existing shareholders from selling their shares for some period, usually 180 days in the US, after an IPO – Generally is 1 year in Australia for VCs, 2 years for related parties unless firm meets the ASX profits test (unless ASX decides otherwise)

IPO Puzzles : Underpricing • Generally, underwriters set the issue price so that the average first-day return is positive. • On the first day of listing, issues tend to reveal underpricing – That is, the closing price on the first day of trading is higher than the subscription price • Level of Underpricing = First Day Closing Price -Issue Price Issue Price

• The level of underpricing is about 17-18% in US and UK over 80’s to mid 90s • Underpricing was the greatest during the internet bubble:

–

99-00: initial day return = 65%

• Has returned to pre bubble levels • Research has found that 75% of first-day returns are positive.

International Comparison of First Day IPO Returns

• Why do firms leave so much money on the table? • The underwriters benefit from the underpricing as it allows them to manage their risk. • The pre-IPO shareholders bear the cost of underpricing. – owners are selling stock in their firm for less than they could get in the aftermarket.

• Although IPO returns are attractive, all investors cannot earn these returns. ‒ When an IPO goes well, the demand for the stock exceeds the supply. Thus the allocation of shares for each investor is rationed. ‒ When an IPO does not go well, demand at the issue price is weak, so all initial orders are filled completely. ‒ Thus, the typical investor will have their investment in “good” IPOs rationed while fully investing in “bad” IPOs.

• Winner’s Curse – Situation in competitive bidding when the high bidder, by virtue of being the high bidder, has very likely overestimated the value of the item being bid on • You “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.

• • • •

Agency problems during the late 90s bubble : Dotcon; Wall St fix With underpricing, underwriters can benefit from: Quid pro quo arrangements – Underpriced IPOs allocated to investors in return for future commissions from other trades

• Spinning – Underpriced IPOs allocated to the personal brokerage accounts of top executives in return for company business

• Laddering – Requiring the purchase of additional shares in the aftermarket in return for IPO allocation

• Underwriters were able to underprice significantly because: – Analyst coverage was very important in this new market (analysts almost invariably gave “buy” recommendations) – Issuers experienced unexpected increases in demand for their IPO • – Nasdaq index increased by 256% in 17 months during the period

Cyclicality • The number of issues is highly cyclical- hot markets, returns lead volume • In 1980-2000, an average of 310 firms went public every year, In 2001-2015, an average of 111 firms went public every year

• Number of Offerings (bars) and Average Firstday Returns (black) on US IPOs, 1980-2015 800

80

700

70

600

60

500

50

400

40

300

30

200

20

100

10

0

Average First-day Returns

Number of IPOs

Source: Jay Ritter, University of Florida.

0

IPO underwriter cost • A typical spread is 7% of the issue price. – By most standards this fee is large, especially considering the additional cost to the firm associated with underpricing. – It is puzzling that there seems to be a lack of sensitivity of fees to issue size. • Possible explanation : by charging lower fees, an underwriter may risk signaling that it is not the same quality as its higher-priced competitors.

Long-Run Underperformance • Although shares of IPOs generally perform very well immediately following the public offering, it has been shown that newly listed firms subsequently appear to perform relatively poorly over the following three to five years after their IPOs.

Seasoned Equity Offerings (SEO) • When a public company offers new shares for sale to raise additional equity • Market price for the stock already exists, so the price-setting process is not necessary. • 3 main methods : – Public issue – Rights issue – Private placement

Public Issue • Members of the public are invited to subscribe to the issue – Requires a prospectus

• Public issues are generally only used for IPOs in Australia • Is most common method in US and Japan for raising seasoned capital

Rights issue • Most common method in Australia, Asia and Europe • Existing shareholders are given the option of purchasing the new equity on a pro-rata basis ie in proportion to their holdings • no dilution in the proportional shareholding of each shareholder provided that each shareholder subscribes to his/her full entitlement. • The option/right may be tradeable/sold

• renounceable issue

– The rights are listed on the stock exchange and can either be taken up by the shareholder or traded

• non renounceable

– the rights cannot be traded and the only person eligible to take up the right is the registered shareholder on the ex-rights day.

• Ex rights day

– Date on which share begins trading ex rights. After this date a share does not have the attached right to purchase new shares

• In Australia, the issue price is set at announcement of the issue • In US price set just prior to the issue opening or rights trading beginning • Usually priced at a discount to the market (1520%) • May be underwritten ie underwriter guarantees the dollar amount raised

Private Placement • Issue to a small number of large investors (usually institutions) • Usually a fixed price on a best endeavours basis (that is, not underwritten) and without an offering document • limited to 15% of the amount of the security class outstanding unless firm approval is obtained at a general meeting • Discount limited to 15% – small-cap companies now allowed to issue up to 25% of their share capital at a discount of up to 25%

• Advantages : speed, price and direction. • allow a firm to raise capital within a short time period • usually priced close to the market, at a small discount to the current market price (2.5% to 7.5%) • allows the firm board control over the choice of new shareholder if there are control implications • disadvantage is that the percentage ownership of existing security holders is diluted because the capital is increased without their participation.

Market Reactions to the Announcement of New Issues • Equity: – Public issues of equity have the most negative announcement effect – Rights issues of equity have a smaller negative announcement effect – Placements generally have a positive announcement effect – Consistent with adverse selection

Homework • Chapter 23: 5, 6, 8, 13