Raising Capital Master Class

15.1 Entrepreneurship: Early-Stage Financing and Venture Capital

All firms need capital, either through debt financing or equity financing. For new, high-risk ventures, a key source of funds is the venture capital (VC) market. Venture capital typically refers to financing for new and often high-risk ventures. Angel investors are individuals who invest their own money, while venture capital firms pool funds from various sources like pension funds, insurance companies, and university endowments.

Venture capitalists often provide financing in stages, investing enough money at each stage to reach the next milestone. This staged financing serves as a powerful motivating force for a firm's founders. The stages of financing include:

• Seed/Angel Round: The initial investment, often from friends, family, or angel investors. This stage is used to prove the product's viability.
• Early-Stage VC (Series A, B): Used to cover salaries, market research, and finalize the product (Series A) and then to ignite growth, expand production, and increase market share (Series B).
• Late-Stage VC (Series C, D): Used for greater market share, acquisitions, or to set the company up to go public. Bridge financing is often used to cover IPO expenses.
• Growth Equity: Provides funds for mature companies that wish to stay private longer. These are often unicorns (private companies valued over $1 billion).

Venture capitalists also actively participate in running the firm, providing expertise and experience. However, gaining access to venture capital is difficult, with many proposals going unfunded. The process can also be very expensive, with VCs often demanding significant equity and board seats.

Figures and Tables

Figure 15.1 Cash Flows for a Startup

This figure illustrates the cash flow for a startup over time, showing a period of negative cash flow during the idea and development stages, followed by a positive turn during growth and maturity. The corresponding investment stages are also shown.

Table 15.1 Venture Capital Deals by Round

Table 15.2 Venture Capital Investment by Funding Stage in 2019 (billions)

Table 15.3 Venture Capital Flow by Sector in 2019: First Round

Table 15.4 Largest VC Funds Launched in 2019

Table 15.5 Top States by VC Raised in 2019

15.2 Selling Securities to the Public: The Basic Procedure

The process of selling securities to the public is regulated by federal laws, primarily the Securities Act of 1933 and the Securities Exchange Act of 1934, both administered by the SEC. The key steps in a public issue include:

• Obtain Board Approval: Management must first get approval from the board of directors.
• File a Registration Statement: A detailed registration statement must be filed with the SEC for all public, interstate issues over $5 million.
• Waiting Period: The SEC examines the registration statement. During this time, a preliminary prospectus (or "red herring") can be distributed to potential investors.
• Price Determination: The final price is determined, and a final prospectus is issued. The SEC does not pass on the economic merits, only the factual accuracy.
• Selling Effort: The full selling effort begins on the effective date. Tombstone advertisements are often used by underwriters to announce the issue.

Figure 15.2 An Example of a Tombstone Advertisement

This figure shows a tombstone advertisement for the World Wrestling Federation Entertainment, Inc. IPO. It lists the issuer's name, the number of shares, the price per share, and the names of the investment banks involved in the offering, categorized by their level of participation (brackets).

15.3 Alternative Issue Methods

When a company issues a new security, it can be a public issue (registered with the SEC) or a private issue (sold to fewer than 35 investors without registration). For public equity sales, there are two main types:

• General Cash Offer: Securities are offered to the general public.
• Rights Offer: Securities are initially offered only to existing shareholders.

The first public equity issue for a company is an initial public offering (IPO). A new issue for a company with existing securities is called a seasoned equity offering (SEO).

Table 15.6 The Methods of Issuing New Securities

15.4 Underwriters

Underwriters are typically investment firms that perform services such as formulating the issue method, pricing the securities, and selling them. They often form a syndicate to share the risk. The difference between the price the underwriter pays and the offering price is called the gross spread.

Types of Underwriting

• Firm Commitment: The underwriter buys the entire issue from the issuer and resells it to the public, bearing the risk of not being able to sell all shares. This is the most common type.
• Best Efforts: The underwriter only promises to use its "best efforts" to sell the securities, with no guarantee of the amount of money raised.
• Dutch Auction: The underwriter does not set a fixed price but instead conducts an auction where investors bid for shares. The offer price is then the highest price that results in all shares being sold. All successful bidders pay this same price.

Other important provisions in underwriting include the Green Shoe provision (an overallotment option for underwriters to buy additional shares to cover excess demand) and lockup agreements (which prevent insiders from selling their shares for a specified period, typically 180 days, after an IPO).

15.5 IPOs and Underpricing

Underpricing, or selling stock below its true market value, is a common phenomenon in IPOs. While it benefits new shareholders, it is a significant indirect cost to the issuing firm and its existing shareholders. This can be seen as "money left on the table."

The extent of underpricing can vary dramatically over time, with "hot issue" markets showing severe underpricing. Underpricing tends to be more significant for smaller, more speculative issues. It also correlates with offers priced above the initial file range, a pattern known as the "partial adjustment" phenomenon.

Possible reasons for underpricing include:

• To attract investors, particularly for risky issues.
• As a form of insurance for underwriters against lawsuits.
• To reward institutional investors for providing truthful information during the bookbuilding process.
• The "winner's curse" phenomenon, where an average investor gets all they want only when a smart investor avoids the issue.

Figures and Tables

Table 15.7 Number of Offerings, Average First-Day Return, and Gross Proceeds of Initial Public Offerings: 1960-2019

Figure 15.3 Average Initial Returns by Month for SEC-Registered Initial Public Offerings: 1960-2019

This figure shows the average first-day returns for IPOs on a month-by-month basis, demonstrating that underpricing is highly variable over time and can be very dramatic, exceeding 100% in some months.

Figure 15.4 Number of Offerings by Month for SEC-Registered Initial Public Offerings: 1960-2019

This figure illustrates the number of IPOs issued each month, showing pronounced cycles that tend to follow periods of significant underpricing.

Table 15.8 IPO Underpricing and File Price Range

Table 15.9 Average First-Day Returns, Categorized by Sales, for IPOs: 1980-2019

15.6 New Equity Sales and the Value of the Firm

Contrary to what might be expected, the announcement of a new equity issue often leads to a decline in a firm's stock price. This can be attributed to several factors:

• Managerial Information: Management may be issuing new stock because they believe the firm is currently overvalued.
• Debt Usage: The equity issue may signal that the company has too much debt and cannot take on more, which could be seen as a negative signal about its future prospects.
• Issue Costs: The stock price drop is an indirect cost of selling securities.

15.7 The Costs of Issuing Securities

The costs associated with floating a new issue are called flotation costs. These can be broken down into six categories:

There are significant economies of scale, with costs being much lower (as a percentage) for larger issues. The costs of selling debt are also substantially less than those of selling equity.

15.8 Rights

A rights offering gives existing shareholders the right to buy a specified number of new shares at a specified price within a given time. This ensures that existing shareholders can maintain their proportionate ownership in the company. Rights offerings are generally cheaper than cash offers as they can be done without an underwriter.

The Mechanics of a Rights Offering

The key questions in a rights offering are:

• What should the subscription price be? It must be less than the current market price for the rights to have value.
• How many new shares will be sold?
• How many shares will each shareholder be allowed to buy?

The value of a right is the difference between the rights-on price (the stock price before the offering) and the ex-rights price (the price after the rights have been detached). For an investor, exercising the rights or selling them leaves their total wealth unchanged.

Figure 15.5 Ex-Rights Stock Prices

This figure illustrates the timing of an ex-rights date relative to the announcement and record dates, showing that the stock price drops by the value of the right on the ex-rights date.

Table 15.10 National Power Company Financial Statements before Rights Offering

Table 15.11 The Value of Rights: The Individual Shareholder

Table 15.12 National Power Company Rights Offering

15.9 Dilution

Dilution refers to a loss in existing shareholders' value. There are three main types:

• Proportionate Ownership: A loss of control when a firm sells shares to the general public and existing shareholders do not participate.
• Market Value: The true dilution, where the market price per share falls because a new project has a negative net present value (NPV). This is the most important type of dilution.
• Book Value and EPS: An accounting dilution where the book value per share and earnings per share fall. This is a common misconception and is not necessarily a bad thing if the new project has a positive NPV.

True dilution of market value only occurs when a firm undertakes a project with a negative NPV, regardless of the book-to-market ratio. The drop in stock price is a direct result of the value-destroying project, not the share issuance itself.

Table 15.13 New Issues and Dilution: The Case of Upper States Manufacturing

15.10 Issuing Long-Term Debt

The procedures for issuing long-term debt publicly are similar to those for stocks, including SEC registration and a prospectus. However, a significant amount of long-term debt is issued privately through term loans or private placements. These methods avoid SEC registration costs but may have more restrictive covenants. The flotation costs for debt are also substantially lower than for equity.

15.11 Shelf Registration

Shelf registration (SEC Rule 415) allows a company to register an offering it expects to sell over a two-year period and then sell the issue whenever it wants. This provides flexibility and speed. To be eligible, a company must be investment-grade, not have defaulted on debt in the last three years, and have a market value of outstanding stock over $150 million.

Chapter Review and Critical Thinking Questions