Topic 10 - Raising Capital

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This article is a topic within the subject Business Finance.

Contents

Required Reading

Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 454-473.

Early Stage Financing And Venture Capital

[1] Firms at an early stage may seek funds from a venture capitalist (VC) that typically finance new, high risk ventures. There are both individual VC’s (angels) & firms. VC’s can invest in stages, upon completion of milestones as it is less risky & incentivises the founder. If successful the firm may float & VC’s may cash out. Venture capital is expensive e.g. 40% of the equity in convertible preference shares.

Factors In Choosing A Venture Capitalist

  • Financial Strength – for future rounds of investment
  • Style – how the VC involves himself in day to day operations & decisions (some may be happy with a monthly report)
  • Contacts – customers, suppliers, other industry contacts
  • Exit Terms – how & under what terms will the VC cash out

IPO – Procedure for a New Issue to the Public

[2]

  1. Obtain Approval from the Board of Directors
  2. Obtain Opinions (possible pricing, marketing strategy, financing options & expected support for the issue)
  3. Appoint Underwriter – formalises structure, pricing & creates a timetable & prospectus
  4. Lodge a Prospectus with ASIC & ASX – registration period
  5. Prospectus Approval – firm now actively promotes & receives offers from investors to buy the new securities

An IPO occurs when a corporation (promoter) first lists/floats on the SX to become a publically listed corporation. The firm must meet the ASX’s minimum listing requirements. The process of issuing newly created securities involves:

  • Prospectus - Terms & Conditions of an issue of securities to the public (document)
  • Underwritera single underwriter or syndicate buys the unsold securities at closing date of the issue (accepts the risk of not being able to sell all securities – charges a fee)
  • Selling Periodunderwriting group agrees not to sell securities for less than the offering price until the syndicate dissolves
  • Overallotment Optionsallows the underwriters to buy additional shares at the offering price net of fees & commissions

The Role of the Underwriter

[3] Underwriters are used in the public issue of securities (cash offer). They help the firm raise the full amount by advising on structure, price, timing, marketing & the allocation of the issue. The underwriter earns a spread (difference between offer price & what the underwriter pays) & can escape an underwriting agreement with an out clause. E.g. ASX drops below a certain level

  • Formulate a Method used to Issue New Securities
  • Marketing & Pricing of Issue – road shows & book building
  • Selling the New Securities – distribution channels

Types of Deals - Underwriting

  • Regular/Standby – issue is fully subscribed due to the underwriters guarantee to purchase all unsold shares
  • Firm Commitment – underwriter buys entire issue assuming full financial responsibility for unsold shares
  • Best Efforts – underwriters sells as much of the issue as possible but can return unsold shares

The Offer Price And Under-pricing

[4] Determining the correct IPO price is a difficult task undertaken by the underwriter. If it is too high the shares may not be fully sold & the offer will be withdrawn. If it is too low, existing holders sell shares for less than they are worth. Under-pricing is the difference between the offer price & true value (measured by 1st day return). It is fairly common & imposes costs on existing shareholders (leaving money on the table) & is an indirect cost of issuing new securities (usually small speculative issues).

Why Does Under-pricing Exist?

  • Compensation for investing in highly speculative issues (attract funds)
  • Few IPO buyers receive the initial high average returns many issues experience significant price drops
  • Underwriters under-price to reduce their risk exposure (but then they will lose clients)
  • Winners Cursesuccessful issues are oversubscribed (investors are allotted less than requested) & unsuccessful issues are undersubscribed (receive full amount requested) - will get more shares in firms the smart money avoids. To attract average investors the IPO prices on average need to be underpriced to counteract the winners curse (give a profit to average)

All in all, a higher IPO price occurs when firms disclose favourable accounting information, reputable auditors & underwriters, entrepreneurial ownership retention, use of proceeds for (risky) investments).

Costs Of Issuing Securities

[5]

  • Direct Expenses
    • Spreadoffer price minus the price received by the issuer Underwriting Spread is % of offer price (highest)
    • Underwriting & filing, legal & tax fees
  • Indirect Expenses
    • Managers time
    • Abnormal Returns – stock drops after issue (SEO’s) hurts holders
    • Under-pricing of IPO’ssold below market value hurts existing holders
    • Overallotment – right to buy additional shares at the offer price to cover excess demand

The costs of issue are generally 10-15% for small issues ($1M), 6-8% for medium issues (10-50M), 2-4% for large issues (500M) – economies of scale

XYZ issues 2,000,000 shares in an IPO. Underwriters purchased the shares at $2.75 & offered them for $3.00. The spread is $0.25, the spread cost is $500,000 which is 9.09% of the net capital raised (2,000,000 * $2.75) or 8.33% of gross capital raised (2,000,000 * $3).

If XYZ’s 2,000,000 shares reflected 50% of the company ownership & each share jumped to $8, are the original owners happy? The capital raised was $6,000,000 & the original owners wealth (according to MV) = $16,000,000. If the share was issued at $8 instead, only 750,000 shares would be issued for the same amount of capital & the owners would have had more wealth

Seasoned Equity Offers (SEO’s)

[6]

Rights Issue

The firm can choose to offer the issue to existing shareholders or to the public. If a right is contained in the firm’s articles of incorporation, new shares must be issued to existing shareholders (to avoid dilution). Rights offers involve issuing additional shares to existing shareholders on a pro rata basis. The shareholder purchases a new share by paying a subscription price + a stated number of rights.

General Cash Offer vs. Rights Issue

Rights issues are only made to existing shareholders while general cash offers are made to all investors (debt & equity). The issue price of a general cash offer determines the amount raised. Floatation costs are lower for rights issues & have simpler underwriting arrangements. [The subscription price does not matter as the firm can adjust # of rights required].

Additional Ordinary Shares

  • RIGHTS ISSUES - issue of ordinary shares to existing shareholders on a pro rata basis (proportional to holding offer, 1 for 5)
    • Factors influencing price (discount to market price to attract funding)
      • Urgency of cash flow requirements
      • Projected earnings flow from new investments funded by rights issue (more attractive = less discount)
      • Cost of alternative funding sources
    • Renounceable – shareholders may sell the right (instrument providing a future right has value)
    • Non Renounceable – rights may not be sold
    • Pro’s - Right for non dilution of ownership
    • Con’s - Admin burden, 2 month process + mightn’t get full amount
  • PLACEMENTS - Issue of ordinary shares to selected investors (institutions/individuals) deemed to be clients of brokers
    • Minimum subscription 500,000 to not more than 20 participants + require memorandum of information
    • Discount cannot be excessive (ASIC), can’t ‘place’ > 15% of issued shares in less than 12 months (without ratification from the shareholders)
    • Pro’s - Quick response (days), no prospectus, small discount,
    • Con’s - Dilution of ownership (non participants)

Private Placement of Debt

These are loans & are usually long terms provided by life insurers & super funds. In comparison to public issues:

  • Lower registration costs (no prospectus or ASIC registration)
  • More restrictive contract agreements
  • Easier to renegotiate if default
  • Higher interest rates – less liquidity

Reaction To SEO’s

Evidence suggests, prices drop 1-3% on the announcement of a stock offering (but presumably firms issue stocks for + NPV projects). Possible reasons:

  • Asymmetric Information (AI) – issuing equity signals bad information about the company
    • Managers should issue equity when shares are overvalued
    • The company have may have too much debt or too little liquidity
    • Issue Costs
  • Pecking Order Theory & Firm Typeassuming assymetric information, good firms are undervalued & bad firms are overvalued
    • Issuing equity signals the firm is a bad type & can’t raise debt. Good firms should issue debt as they’re undervalued

Google Example

[7] FINS1613101.jpg

End

This is the end of this topic. Click Business Finance to go back to the main subject page for Business Finance

References

Textbook refers to Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010.

  1. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 455-457
  2. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 457-458
  3. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 459-461
  4. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 461-463
  5. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 466
  6. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 465
  7. ASB, UNSW
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