Chapter 20 raising capital equity
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CHAPTER 20: RAISING CAPITAL—EQUITY. Topics: 20.1 Background 20.7 Venture Capital 20.2-20.5 Initial Public Offerings 20.6 Rights Offerings. Background. The procedures for selling debt and equity securities are basically the same—we will focus only on equity here

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Chapter 20 raising capital equity


  • 20.1 Background

  • 20.7 Venture Capital

  • 20.2-20.5 Initial Public Offerings

  • 20.6 Rights Offerings


  • The procedures for selling debt and equity securities are basically the same—we will focus only on equity here

  • Securities market regulation in Canada is handled by provincial commissions (in the U.S. this is handled by the federal SEC)

    • all firms listed on the TSX are under the jurisdiction of the Ontario Securities Commission (OSC)

    • other provinces have similar laws and regulatory agencies

  • Regulators want to protect investors against fraud, promote efficient flow of information about securities, and the smooth functioning of securities markets

  • Regulation is coordinated by the Canadian Securities Administration

Firm life cycle and financing

Firm Life Cycle & Financing

Private debt & equity

-Bank debt

-Private placements of debt and equity



- Insider financing

- Angel Financing

- VC

Mostly public finance (traded bonds and equity)




Firm Life Cycle and Financing

How do firms secure financing a pecking order theory
How do firms secure financing? A Pecking Order Theory

  • Internally generated funds

  • External funds

    • Venture capital

    • Private placement (bank debt/private placement)

    • Public issue (traded bonds and traded equity)

      • Cash offerings: Issues sold to all interested investors

      • Rights offerings: to existing S/H on a pro-rated basis

20 7 financing in the early stages of the firm s life cycle
20.7 Financing in the Early Stages Of the Firm’s Life Cycle

  • Private equity market

    • “Angel” Finance (informal market for direct equity finance provided by high net worth individuals.)

    • Venture capital

      • A venture capitalist is a very active financial intermediary, providing financing to relatively new and small businesses.

      • VCs also participate in strategic planning and operational decisions.

How vc s raise funds
How VC’s Raise Funds

  • “General Partners” put up about 2% of the funds and do all of the work; “limited partners” put up the other 98%:

    • Public pension funds

    • Corporate pension funds

    • Endowments and foundations

  • Funds are typically set up to last about 10 years. Many proven VC’s manage multiple funds simultaneously. Investors may not liquidate early and may not freely sell their LP shares.

How vc s invest
How VC’s Invest

  • VC’s “stage” their investment. Sometimes as many as nine stages. (staged financing)

    • ‘Seed’ (zero-stage) - prototype

    • Early stage - production

    • Later stage – growth.

  • Key: only invest ‘big’ money when odds are good; exit bad investments early. High risk.

  • Most VC’s focus on particular industries and on particular stages.

    • “Waterloo Technology Startup Network”

How vc s make money
How VC’s Make Money

  • VC’s profit by liquidating successful investments through either:

    • Sale back to management, to a buyout firm or to a large corporation

    • Issuance of an IPO. The IPO serves to liquidate the VC investment AND raise new funds.

  • After repaying the initial investments, general partners keep 20% of the profits.

  • General partners also take a fee of 2.5% ‘carried interest’ every year.

The typical vc investment
The Typical VC Investment

  • VC’s take preferred equity (like a debt-equity hybrid). The salient features of a VC contract are:

    • Converts to equity at the time of the IPO

    • The entrepreneur may be removed from control by the VC at any time.

    • VC’s demand that the majority of the entrepreneur’s wealth be invested in the entity; entrepreneurs typically get very small salaries.

20 1 20 5 public equity
20.1 -20.5 Public equity

  • Definition

  • Public equity is available to firms with larger needs for capital.

  • The first issue of public equity is called an IPO:

    • Primary offering (offer for subscription, shares outstanding ____________)

    • Secondary offering (offer for sale, shares outstanding ___________ )

  • Later issues are called ‘seasoned’ equity offerings (SEOs)

2 typical procedure for an ipo
2. Typical Procedure for an IPO

  • Board / shareholder meeting’s approval

  • Preliminary prospectus

    • sent to securities commissions (OSC for firms listed on the TSE and SEC for U.S. firms) and investors - no information on price yet (“red herring” prospectus)

  • Revise prospectus to meet securities commission’s approval /Final prospectus – price determined with a price “window”/ marketing effort commences

  • Road show, where informal ‘orders’ are taken

  • Price setting.

    • 3-way bargain between issuer, investment bank and major purchasers.

  • Trading begins.

    • Rule of thumb: Underwriter keeps 7% of proceeds (“underwriter spread”).

3 underwriting

  • an underwriter is an investment bank that buys an issue of a security from a firm and resells it to the public

    Types of underwriting

  • Regular

    • Form Investment bank syndicate, who purchases securities from issuing firm and resells them to public

    • ‘Out clause’

  • Firm commitment

    • Similar to regular with no ‘out-clause’ – highest price risk

  • Best efforts

    • Does not guarantee any particular amount to issuing firm

  • Which procedure will result in the highest offer price

A tombstone
A tombstone

4 investment bankers roles
4. Investment bankers’ roles

  • Provide advice

  • Pricing

  • Marketing and Underwriting

  • Stabilization

    • In the selling period:

      • while the issue is being sold to the public, the syndicate agrees not to sell securities for less than the offering price

      • the lead underwriter is allowed to buy shares if the market price drops to stabilize the price from downward pressure

      • if the issue remains unsold after a period (e.g. 30 days), the syndicate dissolves and members can sell their shares for whatever price they can get

5 costs
5. Costs

  • direct costs (underwriting spread, accounting, legal fees, overallotment (Greenshoe) option)

    • Spread: the difference between the underwriters’ buying price and the offering price

  • indirect costs

    • underpricing

    • public scrutiny

    • lose privacy - competitors also have access to information

    • restrictions on management’s decision making abilities

Source: 1990-1994. Jay Ritter et. Al (1996), Journal of Financial Research, “The Cost of Raising Capital”

6 salient features of ipo aftermarket
6. Salient Features of IPO Aftermarket Financial Research, “The Cost of Raising Capital”

  • Underpricing

    • Average underpricing for Canadian IPOs: (1971-1999) 6.3% (Jay Ritter)

  • IPO Long-run Performance is poor

  • IPO Cycles: hot market vs. cold market

Why are ipos underpriced
Why are IPOs underpriced? Financial Research, “The Cost of Raising Capital”

  • winner’s curse

    • Almost everywhere in the world, investors who buy at the open price make excess returns. But… it is almost impossible to buy at the open price. One explanation is the winner’s curse.

      Informed investors  “Good issues”  underpricing

      Uninformed investors  Every issue  ?

  • underwriters’ incentives and risk aversion

    • minimize risk of issue failing

    • avoid potential lawsuits if shares subsequently do poorly

  • quality signal (issue seasoned equity later at a higher price)

  • key investors may be able to influence the offering price set by the underwriter

Ipo scandals
IPO “Scandals” Financial Research, “The Cost of Raising Capital”

“What Should be Changed in the IPO Market?”, Jay Ritter, April 2003

  • Spinning:

    • Allocating hot IPOs 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 participation in IPOs

  • Analyst conflicts of interest:

    • Giving “buy” recommendations in return for underwriting and M&A business

  • Commission business in return for IPOs:

    • Underwriters allocated IPOs primarily to investors that generated a lot of commissions on other trades

7 canadian features
7. Canadian features Financial Research, “The Cost of Raising Capital”

  • POP System (Prompt Offering Prospectus)

    • the POP system allows large firms to file annual and semi-annual statements with the OSC whether or not they are issuing securities in a given year, and then to use a shorter prospectus so as to speed up seasoned issues

      • similar to a U.S. system called shelf registration

  • Multi-Jurisdictional Disclosure System (MJDS): U.S. and Canada

    • Large companies may issue securities in both countries while complying with home country regulatory approval

    • Bought deals

      • like firm-commitment underwriting where the underwriter has pre-sold the entire issue to large institutional investors

    • Usually use POP – deals executed quickly

20 4 subsequent equity financing
20.4 Subsequent equity financing Financial Research, “The Cost of Raising Capital”

  • Seasoned equity offerings (SEOs) - average price drops by about 3%

  • we might expect the price to rise, since the firm could be needing financing to take advantage of new investment opportunities

  • Why does the price drop?

    • insider information

    • signal regarding not using debt

    • Insufficient earnings

Case google ipo
Case: Google IPO Financial Research, “The Cost of Raising Capital”

Google Financial Research, “The Cost of Raising Capital”

9/14/05: SEO of 14.2 m shares at $295, 2.7% below closing price of $303.

IPO Underpricng :18%

20 6 rights offerings
20.6 Rights Offerings Financial Research, “The Cost of Raising Capital”

  • 1. Definition

    • New issue offered to existing shareholders

    • Shareholders receive one right for each share owned; rights give the shareholders the option to buy newly issued shares for a subscription price before a specified date

    • Shareholders can exercise their rights, let it expire or sell the rights - usually rights do not expire unexercised; shareholders usually receive an oversubscription option allowing them to buy unsubscribed shares for the subscription price

    • Typically use standby underwriting where underwriter makes firm commitment to buy unsubscribed part of the issue, receives standby fee in return

  • In Canada, rights were popular before POP was introduced (now bought deals are popular)

Example Financial Research, “The Cost of Raising Capital”

  • A firm currently has 10 million shares, which are selling for $15 per share. The firm wants to raise $50 million from a new equity issue. Suppose the subscription price is set at $10 per share.

    (1) How many rights are required to purchase one share?

    (2) What is the value of a right?

    (3) What will the price per share be after the rights offer?

    (4) Does the subscription price matter?


    (1) Number of new shares =

    Number of rights needed to buy a share =

Example cont d a to 2 3
Example cont’d: A to (2) & (3) Financial Research, “The Cost of Raising Capital”

The Formula: R0 = (M0-S)/(N+1)

Example cont d a to 4
Example cont’d: A to (4) Financial Research, “The Cost of Raising Capital”

Suppose instead S=$5?

  • Number of new shares =

  • Number of rights needed to buy a share =

    R0 = (M0-S)/(N+1) =

  • Assigned Problems Financial Research, “The Cost of Raising Capital” # 20.1, 3, 4, 5, 9, 10, 11, 13, 14