Corporate Valuation and Financing

1. Corporate Valuation and Financing IPOs Prof H. Pirotte

2. Initial Capital • Very early stage “Family, Friends and Fools”, notion of Angel Investors • Venture capital firms=> specialized in raising capital for young firms • => often diversification benefits • =>possibility to benefit from expertise • => substantial costs in terms of control • Private Equity Firms • Invest in firms already existing • Institutional Investors (pension funds, insurance companies etc…) • Corporate Investors • Outside Investors • One general point of attention: the exit strategy Prof H. Pirotte Equity Financing

3. Prof H. Pirotte Going public Introduction • The natural evolution of firm’s capital • Association of founders • Incorporation (shares owned by founders, key-employees and some early investors) • Bank and private loans • Going public, mainly through an IPO  a strategic decision • Steps • Awareness and preparation • Cleansing • Manage as a public firm • Change marketing strategy • Develop key contacts • The offer • The new corporate life • Primary vs. secondary issues

4. Prof H. Pirotte Going public Ex-ante • Examination • Realities, limits, willingness and HR requirements • Don’t neglect other alternatives (is it a good timing for us?) • Is it a good timing for the market? • Estimation of the new cost structure • Advantages: • Diversifying founders’ wealth • Establishing a market value of the firm • Easier future operations • Better visibility • Better liquidity (?) • Ready (+ -) to raise additional funds • Disadvantages • Direct costs (spread) and indirect costs (confidentiality) • Loss of control • Consequences of the information being revealed and public • Suppression of implicit advantages for founders-entrepreneurs • Liquidity  depends on the market mechanisms and the type of the exchange

5. Prof H. Pirotte Going public Ex-post • Evidence • Any decision will be judged by the market • Rumours, internal and external events will have an impact • Never neglect your shareholders • You must keep the contact with the market • The management activity must be more structured, ready to justify any decision • Keep enough breath to guarantee the continuity of the strengths of the firm

6. Prof H. Pirotte IPO process The Market • It is highly dependent on the state of the economy and it generally concerns • Firms of “new economies” and birth of “new markets” • Firms deciding to go public • Privatisations • Spin-offs • In Switzerland

7. Prof H. Pirotte IPO process The Market • In Europe Source:ECMI Paper,n°2, August 2006

8. Prof H. Pirotte IPO process Process • Preliminary phase • After approval of the Board of Directors, the managers ask for an “underwriter”. Role: Advisory / Pricing / Sale of shares / Syndication • Selection of the investment banker: “competitive bid” or “negotiated offer” • Appraisal of fundamental data of the firm • Long-term planning and future opportunities • The firm uses the services of lawyers and expert accountants (via the investment banker) to write the preliminary prospectus (“red herring”). • Due diligence • Follow-up of market conditions • Pre-marketing: analysis of attractiveness, price sensitivity, feedback • Final phase • Roadshow: presentation of the “equity story” • Once the corrections made following the comments of the regulatory commission, the final prospectus is issued. • “Tombstones” are used before and after the issuance (marketing the IPO) • Bookbuilding and the book

9. Prof H. Pirotte IPO process Types of placements • Usually, need of an underwriter • Nature • Cash offer • Rights offer • Market • Public placement • Private placement • Distinction between primary offering (new shares) and secondary offering (existing shares) • Modalities • Best efforts (commissioned, often with all or nothing clauses) • Firm commitment (bought deal) • Auction IPO (Open IPO) => bidders bid, offer is made at the price of the lowest bid allowing the sale of the number of shares planned • Sherman (2005) => sealed bid IPO almost gone, mostly book building… because of risk reduction offered by the second method (number of investors evaluating the offering) • The process lasts several months and is concluded on the day of the issuance

10. Prof H. Pirotte IPO process Price and costs • 3 main actors • the issuing firm, the investment banker and the (potential) investors • How do the firm and banker price the issue? • What are the direct costs incurred by the firm? • Preparing: audit and accounting fees, legal fees, salaries, director’s fees, … • Offering: underwriter’s fees, audit and accounting fees, legal fees, road show, printing costs, … • After! • Indirect costs • Underpricing • offering prices determined by the investment banking firm are systematically set below the fair market value of a security • Announcement effect • Diversion of management

11. Prof H. Pirotte IPO process Types of mechanisms Source:ECMI Paper,n°2, August 2006

12. Prof H. Pirotte IPO underpricing Short-term performance (underpricing) Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.

13. Prof H. Pirotte IPO underpricing Short-term performance (underpricing) Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.

14. Prof H. Pirotte IPO underpricing Short-term performance (underpricing) Ritter & Welch (2002), A REVIEW OF IPO ACTIVITY, PRICING AND ALLOCATIONS, Yale Working Paper

15. Prof H. Pirotte IPO underpricing Short-term performance (underpricing) Source: ECMI Paper, n°2, August 2006

16. Prof H. Pirotte IPO underpricing Short-term performance (underpricing) Source: ECMI Paper, n°2, August 2006

17. Prof H. Pirotte IPO underpricing Short-term performance (underpricing) Source: ECMI Paper, n°2, August 2006

18. Prof H. Pirotte IPO underpricing Short-term performance (underpricing) • Various studies

19. Prof H. Pirotte IPO underpricing But in the long-run… • While all studies show a positive average of 19% abnormal return at the end of the first trading day based on unadjusted returns, they show a negative abnormal performance in the long-run, underperforming the market by 23% over the next 3 years, or underperforming a benchmark portfolio of similar size and book-to-market ratio by 5%.(Copeland, Weston and Shastri 2005) • Puzzle?

20. Prof H. Pirotte IPO underpricing Evidence…

21. Prof H. Pirotte IPO underpricing Evidence… (2) Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.

22. Prof H. Pirotte IPO underpricing Why? • Offer and demand (banker’s explanation) • Truncated distribution (because of flipping…) • Regulation • Maximum issuing price must be filed with the SEC 2 weeks in advance of the actual offering  creates a situation of “heads I lose, tails you win” for the underwriter • Information asymmetry and the winner’s curse (Rock [1986], Beatty & Ritter [1986], Carter & Manaster [1990]) • Underpricing provides both protection and compensation for the se o the underwriter’s reputational capital (Booth and Smith [1986]) • Insurance to protect underwriters against potential due diligence legal liabilities (Tinic [1988]) • Signal by a more informed issuer to indicate firm value and variance of E(R) to less informed investors (Greenblatt & Hwang [1989]) • Other impacts tested through empirical evidence • Trading mechanism • But the debate persists among researchers whether the systematic short-term underpricing of IPOs is rational or not.

23. Prof H. Pirotte IPO underpricing The winner’s curse • The Medium guy and the Smart guy… • Since prices tend to rise during the first hour of trading, Medium invests an equivalent amount in all IPOs. Can Medium obtain an abnormal return? • Example • Smart can take 1’000 sharesMedium can take 1’000 shares, and invests 100 shares by IPO • A is an undervalued firm: Smart asks for 1’000 shares, Medium asks for 100 sharesBut only 110 shares are issued: 100 for Smart and 10 for Medium. • B is an overvalued firm: Medium asks for 100, Smart for 0. • To avoid this phenomenon, issuing prices are understated by 30-40% to ensure a minimum riskfree rate to Medium.

24. Prof H. Pirotte IPO underpricing Rock (1986) • Assumptions • Prices and volumes are fixed • If demand > offer  rationing • The firm wants to issue N shares • Each share has a value v (random variable, know probability density function f ) • 2 types of investors • Uninformed: U investors owning 1€ each, don’t know v. • Informed: total wealth of I, they know v. • The firm doesn’t know v, but chooses p, the issuing price. • I < N E(v)  the firm must attract uninformed investors • The demand of the uninformed investors depends on p, not on v. • Demand of informed investors • I if v > p • 0 if v  p

25. Prof H. Pirotte IPO underpricing Rock (1986) - 2 • Model • The profit of uninformed investors, if they invest is given by • Uninformed investors receive more shares when v < p winner’s curse • To attract uninformed investors, the company must choose a price lower than E(v) such that E(U) = 0 where

26. Prof H. Pirotte IPO underpricing Rock (1986) - 3 • Example • Hypothesis: f (v) is uniform on the following interval • The condition can be written • Typical cases •  = 0