Financing in an Entrepreneurial Context_ MSc BF Fall 2024 PDF

Financing in an Entrepreneurial Context: Debt Instruments, Private Equity, Seasoned Offerings and IPOs Building Competence. Crossing Borders. Prof. Dr. Mehdi Mostowfi [email protected] Content and Learning Objectives Content Goals Debt Financing...

Financing in an Entrepreneurial Context: Debt Instruments, Private Equity, Seasoned Offerings and IPOs Building Competence. Crossing Borders. Prof. Dr. Mehdi Mostowfi [email protected] Content and Learning Objectives Content Goals Debt Financing 1. Refresh your knowledge on debt Private Equity Financing financing (bank loans and bonds) Seasoned Offerings 2. Know structure and strategies of Private Equity Funds and their Initial Public Offering requirements. Discuss Pros and Cons of equity financing by PE-Funds for entrepreneurial and family firms 3. Know different kind of seasoned offerings and how to value rights in right issues 4. Know how IPOs work and the Pros and Cons for entrepreneurial and family firms 2 Agenda 1 Debt Financing 2 Private Equity and Venture Capital 3 Seasoned Public Offerings 4 Initial Public Offerings 3 Raising Debt Sources of Debt Financing Others (e.g. Insurance Banks Bond Markets Shareholders companies, suppliers) 4 Long Term Debt Financing Bank Loan Individual lending after careful credit assessment; collaterals usually required − Types of loans by repayment conditions: − Loans with bullet repayment − Installment loans (constant principal repayments) − Annuity loans (constant debt service: interest + principal repayment) − Interest rate conditions: fixed or variable interest rate: 3m-Libor + margin (3m-libor +2%) − Security: personal guarantee and/or collateral. For unsecured loans at least a negative pledge is required by the bank. − Project- and acquisition-financing: usually cash flow related lending without external collaterals/guarantees. − Loan contracts ensure lenders certain information right. Further, loan agreements include “loan covenants” that oblige borrowers to fulfill certain conditions or to refrain from certain actions. 5 Loan Covenants Borrower agrees to undertake certain actions Affirmative Covenants  e.g. comply with certain corporate governance rules, reporting requirements, insurance requirements Borrower is restricted to undertake certain actions Negative Covenants  e.g. not invest in certain risky assets, negative pledge, change of control clause Obligation to meet certain figures/balance sheet relations Financial Covenants  e.g. degree of leverage, equity to assets ratio Note: A breach of covenants can result in an immediate termination of the loan and/or even a claim of damages. 6 Debt Financing by Bonds “Public Debt Financing” A bond is a debt instrument that provides a periodic stream of interest payments to investors while repaying the borrowed principal on specified maturity date(s). − Usually listed at a stock-exchange (Exception: private placement bond issues) − Issuing volume usually > 100 Mio. (Exception: SME Bond Market) − Issue price can be below, above or equal to par. − The redemption value is usually the face value but can also differ from it. Criteria Example Time to maturity Usually between 1 and 30 years Coupon payment Monthly, quarterly, semi-annually, annually or at maturity Coupon Fixed or variable interest rate Redemption conditions Bullet repayment, annuity or by termination Yield Based on the rating of the bond which is a function of issuer’s rating, seniority, collateral/guarantees and potential other aspects (covenants, bondholder rights) 7 Example: Microsoft Bond Issue in Nov 2012 Sold $2.25bn of corporate bonds in Nov 2012. Microsoft were vague about how Microsoft Corp. It chose to sell three the money would be spent: individual groups of bonds, To purchase other companies repaying the money at To pay off other more different dates and paying expensive loans different interest rates. Quantity Repayment Coupon Issued $600m 5 years 0.875% pa $750 10 years 2.125% pa $900m 30 years 3.5% pa Total $2,250 8 Features of «Straight» ( also called «Plain Vanilla») Bonds Straight bonds typically unsecured. But the claims of the owners are senior, so they have first priority in the event of default. Straight bonds are repaid at maturity date. Also known as the redemption or Percentage (of of nominal Straight Bonds are typically repayment date. value) paid as interest on traded/listed and can be a periodic basis. Termed sold before they reach their as the COUPON of a maturity date bond. 9 Bonds Terminology YIELD TO MATURITY When the calculation includes the capital gain/or loss if the bond is held until its maturity date. NOMINAL VALUE This is the FACE value of the bond. It is the amount owed by the bond issuer, that will be repaid on repayment date. REPAYMENT/REDEMPTION/MATURITY DATE Is the date when the bond will be paid back to the investor. 10 Bonds Terminology YIELD: This is just another word for “annual return” of a bond (to be calculated as the IRR of the future cash flows) COUPON: This is the INTEREST RATE paid on the FACE/NOMINAL value of the bond YIELD and COUPON are not the same thing. They are only the same when the bond is bought/sold at its FACE/NOMINAL value. Otherwise, generally they are different. Their relationship can be explained as follows: 11 Bonds Prices Bond prices respond to changes in Interest Rates. This is because, for their yield (return) to be attractive to investors it must remain competitive (when compared to the return available on alternative investment opportunities, eg newly issued bonds). If the central banks raise the rate of interest, then alternative investment opportunities may appear to have a more competitive return. In response to this the bond price decreases to make the bond appear cheaper to purchase, and the yield offered needs to increase. 12 Interest Rates and Bond Prices (Recap) Bond prices are susceptible to movements in general interest rates. For the yield offered to be attractive to investors it needs to remain competitive with the return available on alternative instruments. Bank Rate of Interest Bondholders are willing DECREASES to accept a lower return Bond Price INCREASES Bond Yield DECREASES when they buy bonds. Bank Rate of Interest Other products may INCREASES appear to have a more Bond Price DECREASES competitive return. Bond Yield INCREASES 13 Determinants of the (Required) Yield (Required) Yield = f (Interest Rates, Issuer Rating, Determinants of Seniority/Subordination, Bond Rating Collaterals/Guarantees, Covenants and Additional Rights of Issuer/bondholder) The higher the issuer rating, the lower (c.p.) the required yield Subordination of the claims of bondholders increases (c.p.) the required yield Collaterals and external guarantees decrease (c.p.) the required yield Covenants and certain rights of rights of issuer/bondholder increase or decrease (c.p.) the required yield depending on whether they are in favor of the issuer or the bondholder Note: Bond Rating = Issuer Rating if the bond is unsecured and senior/first rank* *and is denominated in local currency 14 Exercise Determinants of Bond Yields Other things equal, will the following provisions increase or decrease the yield to maturity at which a firm can issue a bond? a. A call provision (+) b. A restriction on further borrowing (-) c. A provision of specific collateral for the bond (-) d. An option to convert the bonds into shares (-) 15 Exercise Calculation of Bond Yields Calculate the yield to maturity of a bond with a nominal value of 100, a coupon of 5%, a time to maturity of 4 years and a market price of 98 in an Excel Sheet. Verify the calculated yield (on a sheet of paper) by calculating the NPV of an investment in the bond using the yield as the cost of capital. 16 Agenda 1 Debt Financing 2 Private Equity and Venture Capital 3 Seasoned Public Offerings 4 Initial Public Offerings 17 Sources of Equity Financing Potential Investors Private Equity / VC Family, Friends Firms & Business Stock Market (and Fools) Angels Accessible for listed corporations and IPO candidates 18 Equity Financing for Non-Listed Companies Private Equity Definition and Investment Strategies Private Equity is an asset class consisting of investments in operating companies that are not publicly traded on a stock exchange Venture capital: Early stage financing − Seed Finance: Financing of R&D activities for the development of a product − Start-up Finance: Financing of initial production and market launch − Expansion Stage Finance: Financing market expansion and/or second generation products Growth capital: Financing of medium sized to large, relatively mature companies Leveraged / management buyouts: Acquisition of a large or medium sized company using a significant amount of debt. Relevant for SME as an exit opportunity for the owner family rather than for equity financing. Distressed assets: Investing in companies which are already in default, in distress or heading towards such a condition 19 Characteristics and Strategies of Private Equity Funds Usually fixed term funds with a limited partnership as legal Fund Structure and structure Investment Terms Fund term: 10-12 years Investment period (commitment period): 5-6 years Focus on either Venture Capital, Growth Capital, LBOs, Distressed or Mezzanine Venture Capital and Growth Capital transactions usually entail Investment Strategies minority positions. In case of Buyouts the fund (or a consortium of different buyout funds) always acquires a controlling stake Investment horizon: 3-7 years Trade Sale (Sale to strategic investors) IPO Exit-Strategies Secondary Sale (Sale to other Private Equity Funds) Share buybacks 20 Structure and Funding of Private Equity Funds Investors Limited Partner 1 Limited Partner 2 …….. Limited Partner x Investment Investment Investment Carried Interest General Partner Assumption of Private Equity Fund Liability (Limited Partnership) Management Fees Investment Investment Investment Management (Private Equity Firm) Investment Management Company 1 Company 2 ….. Company y 21 Fixed Term Private Equity Funds: Term and Phases Closing Liquidation t (in years) 0 5–6 10 – 12 Investment Period Harvesting Period Drawdowns Focus on Value Creation of Commitments for and Exit Investments 22 Cash Flow Profile of Private Equity Funds: J-Curve Assuming Total Commitments of USD 1bn (in m USD) 1’750 1’500 1’250 1’000 750 500 Cash Flows to Investors (net of Fees) Cumulated Cash Flows 250 0 0 1 2 3 4 5 6 7 8 9 10 11 12 -250 -500 -750 -1’000 23 Characteristics of Venture Capital Investing Financing early stage companies (Seed, Start up or Expansion stage) Early stage financing Only companies with high growth potential eligible VC firms prefer to advance money in stages (first/ second/ third round) VC funds usually take significant minority stakes (10% to 49%) Significant minority VC firms are active investors: Usually represented in the board of stakes directors (closed monitoring of the firm and advisory) and they own control/veto rights agreed in a shareholder’s agreement VC investing entails a significant amount of risk Uncertainty as regards valuation and probability of success of the High risk investment business model For every 10 VC investments only 2 or 3 survive 24 Private Equity Financing for Entrepreneurial/Family Firms (I) Principle Problem Private equity funds usually prefer control (majority stake), given that it is difficult to exit minority positions. However, firm owners are reluctant to give up control.  Solution: Private equity funds agree to minority ownership if and only if a shareholders agreement (“SHA”) is put in place which defines important minority and certain exit rights.  Typical minority rights:  Veto rights over certain important matters like share issues, material transactions (eg, acquisition of other companies or merger with other companies, material asset disposals, liquidation of the company) and relocation of the headquarter  Right to appoint one or more members to the board of directors  Information rights, such as receiving the financial statements and the budget / business plan on a periodic basis 25 Private Equity Financing for Entrepreneurial/Family Firms (II) Typical Exit Rights Agreed in a SHA Drag along clause gives the minority (majority) shareholders of the company the right to drag the majority (minority) shareholders with them (on certain conditions with regards to the minimum price) in Drag Along Right case the shareholders have received an offer to sell a minimum of x% (50.1% to 100%) to a third party. Drag along rights are usually combined with pre-emptive rights for the majority (minority) shareholders to purchase the shares on the same conditions as the third-party offer. Tag along right gives minority (majority) shareholders of the Tag Along Right company the right to be tagged on the same terms and conditions with the majority (minority) shareholders in case majority (minority) shareholders are selling their stake to a third party. Right to sell the shares to the majority shareholder at a certain price Put Option or based on a pre-defined valuation mechanism. 26 Drag Along Clause Wording Example for a (basic) Drag Along Clause without Pre-emption Rights “In the event that some of the Shareholders accept an Offer from an Outsider to purchase 100% of the common shares of the Company, then all of the Shareholders shall be required to sell all of their common shares to the Outsider on the same terms and conditions, if the offered purchase price is at least equal to the Valuation Schedule attached as Schedule X to this agreement.” 27 Private Equity for Entrepreneurial/Family Firms Pros and Cons Pros Cons For entrepreneurial firms sometimes the Means partly giving up (or sharing only available source of equity financing control) due to the minority rights agreed in the shareholder’s agreement Knowledge (as regards managing the firm) and the network of the VC firm Maybe potential for conflicts due to might be helpful differing views on strategic/operating aspects Might be helpful in raising additional equity in the future (by the VC fund or by Potentially requires willingness to sell the other investors) shares along with the VC fund if the drag along clause is triggered (Positive aspects of equity financing in general) 28 Agenda 1 Debt Financing 2 Private Equity and Venture Capital 3 Seasoned Public Offerings 4 Initial Public Offerings 29 Types of Capital Increases for Listed Companies Seasoned Equity Offering Cash Offer In a cash offer, the firm offers the new shares to investors at large. In a rights offer, the firm offers the new shares only to existing shareholders. Instead of making an issue of stock to investors at Rights Offer large, companies sometimes give their existing shareholders the right of first refusal. Such issues are known as privileged subscription, or rights issue. 30 Rights Issues and Valuation of Rights Introductory Example A listed company decides a rights issue − Existing capital 10 Mio. USD classified as 10 Mio. shares with a nominal value of 1 USD − Increase nominal capital by 2 Mio. USD (by issuing 2 Mio. new shares) − Stock price cum rights (right before capital increase) 130 USD per share − Issue price of new shares 100 USD per share − Number of shares after share issue: 12 Mio. − Expected stock price right after share issue: (10 Mio. * 130 USD + 2 Mio. *100 USD) / 12 Mio. = 125 USD − Fair value of the rights: = (price of the stock) – (expected stock price after capital increase) = 130 USD – 125 USD = 5 USD Note: In order to buy 1 new share you need to own 5 rights 31 Calculating the Value of Rights Rights Valuation Formula Determinants Exchange ratio: Number of rights required to subscribe a new share. Equals ratio of existing shares to new shares. Price of new shares: Is always lower than the stock price of the existing shares. Stock price cum rights: Stock price right before the shares issue. Value of rights (R) 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 − 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑜𝑜𝑜𝑜 𝑛𝑛𝑛𝑛𝑛𝑛 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑅𝑅 = 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 1 32 Appendix to Calculating the Rights Valuation Formula Deriving the Formula Parameters Pe: Price of existing shares Pn: Price of new shares P: Expected price after share issue e: Number of existing shares n: Number of new shares Deriving the formula 𝑒𝑒𝑒𝑒𝑒𝑒 + 𝑛𝑛𝑃𝑃𝑛𝑛 𝑒𝑒 + 𝑛𝑛 𝑃𝑃𝑒𝑒 − 𝑒𝑒𝑃𝑃𝑒𝑒 − 𝑛𝑛𝑃𝑃𝑛𝑛 𝑛𝑛(𝑃𝑃𝑒𝑒 − 𝑃𝑃𝑛𝑛 ) 𝑃𝑃𝑒𝑒 − 𝑃𝑃𝑛𝑛 𝑅𝑅 = 𝑃𝑃𝑒𝑒 − 𝑃𝑃 = 𝑃𝑃𝑒𝑒 − = = = 𝑒𝑒 𝑒𝑒 + 𝑛𝑛 𝑒𝑒 + 𝑛𝑛 𝑒𝑒 + 𝑛𝑛 +1 𝑛𝑛 33 Exercise Rights issues The Irish Company, Pandora Box, makes a rights issue at €5 a share of one new share for every four shares held. Before the issue there were 10 million shares outstanding and the share price was €6. a. What is the total amount of new money raised? b. What is the value of the rights to buy one new share? c. What is the expected stock price after issue? d. How far could the share price fall (before the issue) before shareholders would be unwilling to take up their rights? 34 Agenda 1 Debt Financing 2 Private Equity and Venture Capital 3 Seasoned Public Offerings 4 Initial Public Offerings 35 Initial Public Offering Definition and Components Definition − A company’s first equity offering to the public (stock market) − This offering occurs when a privately held company decides to have a listing at a stock exchange − Also called an “unseasoned public offering” The share offering volume may consist of two components: Primary New shares issued by the company Component Secondary Shares offered by existing shareholders for sale Component 36 Initial Public Offering Motives Motives for Going Public Finance the growth of the company Create mechanism for employee participation Establish a broad and stable investor base Create an attractive and liquid acquisition currency Provide liquidity for the shares (for existing and new shareholders) Maximizing firm value in Exit opportunity for the long run existing shareholders 37  Preparing an IPO Critical aspects and decision areas IPO Project Eligibility for an IPO Offering structure Process management Selecting the I-Banks Formal requirements Offering volume Time schedule Placement power Demonstrate industry, Control aspects Company Team Image market and company Primary versus Coordination of Execution capabilities attractiveness secondary component banks/consultants Offering price Marketable “Equity Use of proceeds indication Story” Offering price Research expertise Timing Offering costs 38  Role of the Syndicate Banks Underwriter Function Besides advisory and process management functions the investment banks (syndicate banks) also take on the role of the underwriters. The underwriter syndicate agrees to purchase the securities from the issuer (and/or selling shareholders) prior to the IPO and to place them on the market. High Global Coordinator Investment bank, who leads the IPO project and acts as (“GloCo”) the book runner. Underwrites a substantial portion of the shares. Joint Global Term used if two GloCos with equal rights/roles have been Coordinator(s) engaged. Relevance (Joint) Bookrunners Member(s) of the syndicate who manage the order book for the (usually the GloCos) transaction Co-Lead Managers Member of the syndicate that is not in the lead but also plays an active role in marketing the transaction. Co-Managers Member of the underwriting syndicate that only has a passive role. Low 39 IPO League Table (Global) Source: Bloomberg, 2019 40 Book Building Process Book Building as a process to determine the IPO Price Before the IPO marketing activities start, the underwriters work closely with the company to come up with a price range (“book building range”) that they believe provides a reasonable fundamental valuation for the firm (using methods described on next slide) Once the initial range is published the senior management of the firm and the underwriters/bookrunners start a road show giving presentations and promoting the firm to investors around the world. At the end of the road show potential investors inform the bookrunners about their interest: how many shares they may want to purchase at what price The bookrunners calculate the total demand, assess the quality of the order book (level of oversubscription and reputation/reliability of the investors) and determine together with the existing shareholders of the firm the final offer price shortly before the allocation of shares takes place 41  IPO Valuation Identification of Application of Company comparable various multiple specific factors IPO discount companies methods (“Underpricing”)  Growth  Same  Price/Book expectations industry ratio  Profit margin  Pre- marketing Competitors Enterprise Off balance Offering price    feedback value/EBITDA Fair Value  Comparable sheet assets  Quality of firm size  Enterprise  Qualitative order book value/EBIT factors  Comparable  Magnitude of market  Market/book over potential value subscription  Market value/ Discounted earnings Cash Flow Method 42 Participants in an IPO Company Team Management Shareholders / Company Legal Investor Roadshow Board Sponsors Counsel Relations Organiser Global Coordinator Team Investment Banking Team Equity Research (Corporate Finance & Equity Capital Lawyers and Auditors (Equity Analysts) Markets)  Positioning of issuer on  Project management and advisory role  Legal and financial due capital markets  Coordination of consultants and due diligence on behalf of the (assessment of Equity diligence GloCo(s) Story, USPs etc)  Consulting the GloCos(s) in  Conduct commercial due diligence  Propose a book building (sometimes supported by consultants) preparing the underwriting range based on an outside- agreement in valuation  Conduct an inside-out valuation (assessment of equity research  Support in preparing the  Support marketing activities valuation prospectus of the Equity Sales Team  Development of marketing strategy  Preparation of comfort letter  Conduct ongoing research  Allocation and price determination 43 Greenshoe Over-allotment Option in an IPO Definition A Greenshoe or over-allotment option allows the underwriter to sell more shares in an IPO than initially agreed, usually amounting to 15% of the original offer size. This enables the underwriters to support the share price in the aftermarket without risking a loss. Greenshoe and Support Purchases: How does it work? If the Greenshoe option amounts to 15% of the original offer size (eg, 1m shares), the underwriting banks are allowed to sell a total of 115% of the original offer size (eg, 1.15m shares). Right before the IPO the underwriters borrow 150’000 shares from the existing shareholders. If the price of the security rises after listing and there is therefore no need for support purchases, the Greenshoe is executed and the company issues 150’000 new shares and sells them to the underwriters.(1) The underwriting banks then use the newly available securities to return borrowed securities to existing shareholders. If the price of a security drops after listing, the underwriters will not execute the Greenshoe. The underwriting banks buy shares of the issuer on the market in order to support the market price and use the shares to return the borrowed securities to existing shareholders. (1) In case the Greenshoe option is used to issue new shares by the company. In some IPOs the shares for the Greenshoe are additional shares sold by existig shareholders. 44 Greenshoe and Support Purchases: How does it Work? Appendix 1 (1) IPO date (Assumption: Primary shares only IPO) Specific existing Company shareholders Sale / 1 million Lend Issue shares 150k shares Investment bank 1.15 million Sale shares Stock market investors 45 Greenshoe and Support Purchases: How does it Work? Appendix 2 (2) Aftermarket Scenario 1: Share price remains stable or goes up Scenario 2: Share price drops => No need to support price => Need to support price Specific existing Specific existing Company shareholders shareholders Return 150k shares Sale / Issue Return 150k shares 150k shares Investment bank Investment bank Repurchase (to Exercises 150k shares greenshoe support price) Stock market investors 46 Alibaba Case Study Questions Calculate the number of primary and secondary shares placed in the Alibaba IPO as a percentage of the total number of shares after the IPO (taking into account the exercised over-allotment option). Calculate the proceeds Alibaba raised in the IPO (IPO price USD 68 per share). 47  The IPO Process Stages and an illustrative schedule Structuring Phase Informal Marketing External Marketing Final Stage  Engaging the GloCos  Invitation of other  Publication of draft  Assessment of order book consortium banks prospectus quality  Strategic and financial assessment  Analyst presentation  Publication of book-  Determining a balanced building range investor structure  Negotiations with  Preparation and important shareholders publication of analyst  Investor roadshow  Determination of offering reports price  Preparing an Equity Story  Collecting investor  Submission of prospectus feedback  Publication of final  Due diligence to stock exchange prospectus  Setting up order book  Drafting the prospectus  Pre-marketing (Book-Building)  Closing, first trading day  Preliminary valuation Pre-IPO reorganisation Start public relations Analyst presentation Publication of analyst Press conference Due diligence Marketing planning Stock exchange reports Final prospectus Prepare business plan registration Publication of prospect Pre-marketing draft Announcement of price range 1. Trading day 16 weeks 7-8 weeks 6-7 weeks 4 weeks 3 weeks 2 weeks 1 week Closing to IPO to IPO to IPO to IPO to IPO to IPO to IPO 48 Costs of an IPO Underwriting spread (% of total proceeds or fixed dollar sum per share sold) Direct Costs Other direct costs: Legal/auditing fees, printing costs, stock exchange registration fees, roadshow organisation and travelling costs IPO underpricing can also be viewed as a component of IPO costs Indirect Costs However, as a kind of opportunity cost this is a “cost” in the economic but not in an accounting sense 49 Questions IPOs 1. Explain what each of the following terms means: a) Primary component of the offering volume b) Secondary component of the offering volume c) Bookbuilding d) Underwriting spread 2. What are the pros and cons of an IPO for a finance seeking, founder owned company in general? 50 Listing/IPO for Entrepreneurial/Family Firms Pros and Cons Pros Cons Allows the company to raise equity Time-consuming and expensive capital without giving up or sharing preparation process and high transaction (necessarily) control uncertainty Benefits of the liquidity of the shares Disclosure/reporting requirements (allows shareholders to exit, allows for (international accounting standards, better employee participation quarterly or semi-annually reports, one mechanism, allows to use shares as analyst presentation per year, ad hoc acquisition currency, facilitates future publicity obligations) share issues…) - Costs/expenses of disclosure Transparency with regards to the - Potential negative impact on the price/value of shares can facilitate debt competitive position financing (or have also other benefits) Net worth of the main For B2C companies: potentially a shareholders/founders becomes positive marketing impact due to more transparent and known to the public press coverage as a listed firm 51 Case Study (I) Private Equity versus IPO You are the CEO and the sole shareholder of the private automotive engines supplier ABC Corporation which can be characterized as a typical family run medium (to large) sized company. Currently, one of your smaller competitors, the company XYZ, is up for sale. You consider XYZ as an attractive acquisition target given that XYZ’s takeover would allow you to expand your market share and to capture cost synergies. Your M&A advisers believe that you will have to bid USD300m as an acquisition price for XYZ to get the deal done. Given the high leverage ratio that ABC currently has, using debt to finance the transaction is not an option. So you consider the following alternatives: Raising equity financing through an IPO or taking on a private equity fund as an investor. You recently met the head of the Equity Capital Markets team at the investment bank Goldberg Lachs. He told you that given the good growth prospects and the high operating margins of your company raising USD 300m in an IPO will most likely be feasible. However, for the time being it is difficult to assess what IPO valuation will be acceptable to investors and (consequently) how many new shares the company will have to issue. A couple of weeks ago, a Managing Director of the VC Fund Locusts on the Block LP contacted you and indicated strong interest in a minority position (in the range of 20% to 40%) in your company. You did not discuss valuation in detail but he indicated that the fund would be willing to pay a price that reflects the fair value of the shares. You know from the discussions with your M&A adviser that Locusts on the Block will certainly insist on drafting and signing a shareholder’s agreement. 52 Case Study (II) Private Equity versus IPO Additional information: In a valuation opinion recently prepared by your M&A advisers ABC’s fair value (market value of equity) is estimated at roughly USD1.0bn. The nominal share capital of the company is USD200m divided in 2m shares. Discuss and evaluate the two financing alternatives for ABC AG considering a) The number of shares and consequently the %-shareholding that you have to give up to raise the required financing. b) Other aspects that seem relevant to you. For the IPO alternative assume the following: Underpricing in the range of 10% and 20% Underwriting spread: 4% Other direct expenses: USD2.0m Further, assume that the PE financing incurs one-off transaction expenses of USD1.0m. 53