IPO Process and Underwriting Quiz

Fundamentals of Corporate Finance, Chapter 10: How Firms Raise Capital

• Bootstrapping: A common method for new businesses to raise initial funding. It involves using personal resources, assets, or borrowing from friends/family to launch the business. Bootstrapping is often essential for early-stage businesses.
• Bootstrapping Process: Entrepreneurs develop a business plan and a product prototype using initial funds; this typically takes no more than a year or two

Initial Funding of the Firm

• The process of raising seed money and capital for business start-ups
• Funding typically comes from the entrepreneur or their founders, which can include personal savings, the sale of assets, or loans from family/friends/credit cards.
• Seed money is frequently used to develop a product prototype and a business plan.

Venture Capital

• Venture Capitalists: Individuals or firms that finance new businesses. They're crucial for early-stage growth.
• Venture Capital Funding Cycle: A process involving multiple funding stages (ranging from seed stage to later stage financing), and an exit strategy is typically necessary after several years. Venture Capitalists provide multiple funding opportunities, knowledge in the industry, and expertise in business to help the business grow effectively.
• How VC Reduce Risk: Venture capitalists use strategies to mitigate risk in start-ups. These can include funding the business in stages, requiring entrepreneur personal investments, syndicating investments, and maintaining in-depth knowledge in the industry.
• Staged Funding: Funding is given in stages to allow venture capitalists to reassess the company's financial and management performance. Investments in the firm often take the form of convertible preferred stock.
• Staged Funding Practices: Venture capitalists will require substantial personal investments from the entrepreneur. They also will reassess the business's performance throughout the funding stages.
• Syndication: It is a common practice to syndicate seed and early-stage venture capital investments, which are the percentage sales of a deal to other venture capitalists. This can help to distribute risk and provide independent corroboration that the investment is worthwhile. In turn, this reduces the initial investor risk.
• In-Depth Knowledge: VC's rely on their in-depth industry understanding which reduces investor risk. Expert knowledge of the market creates a better understanding and valuation of the company.
• Exit Strategy: Venture capitalists typically don't hold onto their investments long-term. They usually exit within 3-7 years through methods that encompass selling to a strategic buyer, selling to a financial buyer, and an initial public offering.

Venture Capital Industry

• Emergence: Developed in the late 1960s.
• Structure: Thousands of professionals are at about a thousand venture capital firms, with the highest concentration in California and Massachusetts.
• Specialization: Modern VC firms often focus on a specific industry line.
• Technology Focus: A significant portion of VC firms target high-technology investments.

Venture Capital Funding Cycle Characteristics (Data from 2009-2016):

• Growth in Firms and Funds: There was a considerable increase in the number of venture capital firms and funds between 2009 and 2016.
• Investment Activity: Significant growth in the amount of investment activity as well during this period.
• Average Fund Size: The average venture capital fund size was approximately $213.5 million at the end of 2016.

Venture Capital: Cost

• Generally high compared to other investment strategies.

Initial Public Offering (IPO)

• Definition: One way to raise capital or facilitate the exit of a venture capitalist. Firms give their shares to the public to be sold.
• First-Time vs. Seasoned Offerings: First-time (IPO) stock issues have distinctive marketing and pricing from seasoned offerings.
• Advantages of Going Public: Larger amounts of capital can be raised, and additional capital can be raised more affordably through follow-on seasoned offerings after an IPO has been completed.
• Advantages of Going Public (cont): Public companies are better able to attract top management talent, and it is easier to motivate current managers if a firm's stock is publicly traded.
• Disadvantages of Going Public: IPOs are costly, there are costs involved in complying with SEC disclosure requirements, and compliance costs can be considerable for some companies.
• SEC Compliance Concerns: Investors argue that quarterly earnings forecasts and financial statements focused managers on short-term profits, and not long-term ones

IPO: Investment Banking Services

• Investment Banker Services: IPOs require investment bankers for services in origination, underwriting, and distribution.
• IPO Origination: Involves giving the firm financial advice in IPO preparation. The investment banker assists the firm to determine if it is ready for an IPO. The firm obtains the necessary approvals from management
• IPO Underwriting: Investment bankers assume the risk of potentially selling the stock at a price lower than the purchase price.

IPO: Types of Underwriting

• Firm Commitment: The most typical type, in which the underwriter guarantees to raise a specific amount of money, and bears the risk of being unable to sell the stock.
• Best Efforts: The investment banker is less likely to ensure a certain amount of proceeds. Compensation is tied to the actual number of shares sold.

IPO: Underwriting Syndicates

• Purpose: Allows to share the risk of underwriting.
• Structure: Combines underwriting firms to gain greater efficiency and the ability to sell the security issue more efficiently. It allows a bigger allocation of securities to different customers.

IPO: Pricing

• Determining Offer Price: One of the investment banker's most challenging tasks. This includes accurately determining the maximum and minimum values to sell all shares and establish secondary market stability from the outset.
• Due Diligence Meetings: Investment bankers hold meetings with company representatives to confirm that the information presented for the IPO is correct and complete. They also determine if the company is ready to go public.

IPO: Distribution

• Pricing Call: Determines the final price of the offering; occurs after the market has closed for the day. Management will either accept or reject the investment banker's recommendation
• First Day of Trading: Underwriters sell the shares to investors in the market.
• Closing of the IPO: The closing typically occurs on the third business day after the start of trading. Firm-commitment offering procedures include deliver of the security certificates and underwriter payment

IPO: Proceeds

• Investment bankers need to compute and determine the expected proceeds from the common stock sale, the amount expected to be raised for the offering, and the anticipated compensation to the investment bank from the offering
• Calculation Method: Calculate funding allocations per share basis and compute total amounts

IPO Pricing and Cost

• Underpricing: The offering of securities for sale below their perceived true value. Can reduce investor and public trust in stock exchanges and IPOs.
• Underpricing Debate: Issuers want as high price as possible, while underwriters prefer some degree of underpricing. There can be consequences if the pricing is not calculated properly, such as loss of reputation or loss of sales leads to the selling party.

IPOs: Average First-Day Return Data (1997-2016):

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General Cash Offer

• Definition: When a public company issues debt or equity. Allows investors to buy into the company
• Process: Similar to an IPO, management decides the type of security and amount, receives board of directors approval and files a registration statement with the SEC.

Competitive vs. Negotiated Sale

• Competitive Sale: Underwriters bid competitively to buy the securities from the issuer, leading to reduced costs for the issuer.
• Negotiated Sale: The issuer selects a specific underwriter and negotiates for the pricing and fees associated with the securities.

Shelf Registration

• Definition: Allows a firm to register an inventory of securities for a two-year period, which enables securities to be sold as needed without additional steps or registrations
• Costs: Reduced costs for selling multiple securities, as only a single registration statement is required.
• Flexibility: Enables securities to be taken off the shelf and sold quickly when needed.

Commercial Bank Lending

• Prime-Rate Loans: Loans with interest rates based on the prime interest rate.
• Term Loans: Business loans with maturities of more than one year. They can be either secured or unsecured.

Loan Pricing Model

• Components: The interest rate on a loan. The prime rate plus an adjustment for default risk and term loan yield curve must be considered.

Private Equity Firms

• Investment Characteristics: Often invest in mature companies and may purchase 100% of the business.
• Goals: Increase the value of the acquired firm and sell for a profit, usually in 3-5 years.

Private Placements

• Characteristics: Occurs when a firm sells unregistered securities to private investors (e.g., wealthy individuals, financial institutions).
• Advantages: Lower costs, more negotiation flexibility in contracts, and quicker resolution of problems if a firm faces financial distress.
• Disadvantages: Less easily marketable than public securities, therefore requiring a higher return relative to public offerings. Lower liquidity compared to public security offerings.
• SEC Restrictions: Placement restrictions imposed by the SEC on the number of "knowledgeable" investors participating in the sales of these securities.

Private Investments in Public Equity (PIPE)

• Definition: Unregistered stock sold by public companies to private investors, usually at a discount.
• Purpose: Funds companies that have limited or no public access.
• SEC Registration: PIPE transactions are not registered with the SEC.

Additional Notes:

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Test your knowledge on the initial public offering (IPO) process with this quiz. Questions cover key responsibilities of investment bankers, underwriting types, and the implications for firms preparing to go public. Hone your understanding of IPOs and their financial mechanisms.