Principles Of Corporate Finance Unit K Lectures PDF

Early-Stage Financing Financing Private Firms How do young small firms obtain investment capital? • Small businesses are primarily self-financed with equity supplemented with “informal” finance: debt from family, friends, moneylenders, even microfinance. • As the firm grows, the ability/willingnes...

Early-Stage Financing Financing Private Firms How do young small firms obtain investment capital? • Small businesses are primarily self-financed with equity supplemented with “informal” finance: debt from family, friends, moneylenders, even microfinance. • As the firm grows, the ability/willingness of informal finance to meet the needs of the business declines. Options? • Retained earnings: A firm can reinvest profits. But this may not be enough for fast-growing companies. • Banks: Predominant source of small-business finance but there are limits. Banks usually require tangible assets and/or predictable cash flows along with historical and personal knowledge of the borrower’s quality. • Venture capital: One increasingly important alternative, an institution specialising in financing risky, opaque, intangible firms. Venture Capital (VC) • Venture capital firm: financial intermediary specialising in equity financing new firms • Other possible financers of new firms: angel investors, crowdfunding, corporate ventures, institutional investors • Low probability of success but much higher than usual returns • VCs are active investors • Monitoring: VCs exert a significant degree of control through seat(s) on the board and also monitor/advise the start-up company. • Staged financing: Funds are usually dispersed in stages, only after a certain level of success is achieved. Staged Financing • Angel investors • Only raw ideas, no product; size: $50K to $500K • Seed capital • Prototype perhaps, business plan; size: $1m to $5m • Early-stage venture capital • Generate revenue, perhaps not profitable; size: more than $2m • Late-stage venture capital • Profitable; need cash to invest; size: $5m to $15m • Mezzanine stage • Last stage before initial public offering (VC exit); multiple securities (debt, convertibles) are often used Staged Financing (cont.) How do you calculate the ownership for each investor after a new funding round? • Suppose a VC contributes $X to a start-up. • After contribution, the start-up is worth $V (“post-money valuation”). • Assume an original investor (OI, eg, the entrepreneur) holds a fraction s (0 < s ≤ 1) of the pre-contribution firm. • What fraction of the post-contribution company do the VC and OI own? VC → X V  X OI → 1 − V  ×s The End Modelling 1: Staged Financing Staged Financing: Example Given the following market value balance sheet, calculate the ownership structure. First-Stage Market Value Balance Sheet ($m) Assets Liabilities and equity Cash from new equity 1.0 New equity from venture capital 1.0 Other assets 1.0 Your original equity 1.0 Value 2.0 Value 2.0 • You: → • VC1: → 1 2 1 2 = 50% = 50% Staged Financing: Example (cont.) • Suppose market value of assets increases to $10m • A new VC2 contributes $4m Second-Stage Market Value Balance Sheet ($m) Assets Liabilities and equity Cash from new equity 4.0 New equity from 2nd stage Fixed assets 1.0 Equity from 1st stage Other assets 9.0 Your equity Value 14.0 Value • VC2: 4 14 = 29% • VC1: half the old firm → • You: → 1 2 1 2 × (1 − 29%) ≈ 35% → 5m × (1 − 29%) ≈ 35% → 5m 4.0 ? ? 14.0 The End Venture Capital (VC) Funds Fund Structure, Part I • Venture capital funds belong to the private equity (PE) industry (as opposed to publicly traded equity). • VC funds are usually structured as limited partnerships. This organisational structure consists of two types of partners: 1. Limited partners (“LPs”) 2. General partners (“GPs”) • Limited partners provide capital for the partnership. • Don’t directly make investment decisions • Contribute roughly 98% of the capital • General partners are responsible for choosing and monitoring the fund’s investments (“portfolio firms”). • Contribute mainly skill plus 2% of the total capital Fund Structure, Part II Institutional Investors Funds Returns VCs Cash Equity Portfolio Firms Fund Structure, Part III • PE funds are limited-duration (10 to 12 years), closed-end funds • Limited duration: acts as a strong incentive mechanism for GP • Forces the VC (ie, GP) to be re-evaluated regularly • Without sustained success, impossible to raise capital for next fund • Closed-end fund: no shares can be redeemed or created after the fund is structured • Sale of LP stakes normally not allowed: illiquid! • Benefit: LP structure can be very stable VC Compensation VC compensation usually has two parts. 1. Fixed fees • Also known as “management fee”: a fraction (usually 2%) of the committed capital annually, regardless of performance 2. Incentive fees • Also known as the “carry”: a fraction (typically 20%) of any profit made above some promised return (hurdle rate) Compared to GP’s contribution, these are big numbers. VC Monitoring • Shareholders of large public companies are often small. They have no skill or incentive to monitor the company. • They have to exert the full cost of monitoring. • But they only enjoy a very small fraction of the benefits. • Result: No one monitors (“free-rider problem”). • VCs are big shareholders of a company, so they enjoy a big part of the benefits from monitoring. VC Exit How do VCs exit the portfolio firms? 1. Mergers and acquisitions (M&A) • The start-up is bought by another company. 2. IPO: initial public offering • A company’s equity is available for the public for the first time. • Primary offering: New shares are issued to raise additional capital. • Secondary offering: Existing large shareholder(s) cash in by selling part of their stake in the company (ie, unrelated to the company). • A related terminology is “seasoned equity offering” (SEO): the sale of new securities by a firm that is already publicly traded. The End IPOs IPOs Benefits • Funds for investment • Diversify the initial investors • Founders can cash out and use the money for other ventures. • Current equity holders usually sell a fraction of their shares, but not a large fraction. Why not? • Exit strategy for VCs and other investors • Founders want VCs and banks out (would rather have dispersed shareholders). • VCs and other early investors want out. Typically have a five- to ten-year timeframe, want to realise returns and move on. IPOs (cont.) Costs • Monetary costs • Administrative costs • At IPO, 2% to 10%: there are big economies of scale in IPOs. • After IPO, it is expensive to comply with regulatory filing requirements after becoming a publicly traded company. • Underwriting costs (7% to 11%): this is the fee that investment banks (IBs) charge for their services • Underpricing: IPO price is less than the day 1 closing price • Disclosure requirements • Loss of control and freedom • Dilution of ownership stake and greater regulatory oversight Underwriting Spreads Issue Amount ($ millions) Underwriter's spread Type Common Stock: IPO IPO IPO IPO IPO Company Buffalo Wild Wings Carter's Inc. Genitope Corp. International Steel Group Ipass 45 119 41 462 98 7.0% 7.0% 7.0% 6.5% 7.0% Seasoned Seasoned Seasoned Seasoned Seasoned General Cable Corp. Big 5 sporting Goods Corp. Red Robin Goods Corp. Gibraltar Steel Interstate hotels 41 94 92 102 47 5.5% 5.0% 5.3% 5.0% 5.3% Raytheon Procter & Gamble Eastman Chemical Bausch & Lomb 500 150 248 50 0.6% 0.5% 0.8% 1.0% 4,000 1.8% Debt (cupon rate, type, maturity) : 4.85% Fixed Rate Notes, 2011 4.85% Notes, 2015 6.3% Notes, 2018 5.9% Senior Notes, 2008 6.25% Convertible Senior Debentures, 2033 General Motors Underwriting Spreads: The 7% Solution Source: Chen and Ritter (2000) The End IPO Math IPO Math, Part I Let us see where the money is coming from and going. Pre-IPO firm description • Your privately held company has 34 million shares outstanding and a valuation of $1.9805 billion. • You want to raise $130.2 million net equity for investment. • Direct issuance cost is approximately $9.8 million or 7% of gross proceeds. • What is the value per share before issue? 1.9805b = $58.25 per share 34m IPO Math, Part II Post-IPO firm description 1. What is the post-issue stock price (Pnew ) and how many shares (N) should be issued at this price? Pnew × N = 130.2 + 9.8 = $140m (1) Pnew × (34m + N) = 1.9805b + 130.2m (2) Solving, we get Pnew = $57.96/share and N = 2,415,385 2. How much equity did the original stockholders give up? 2,415,385 = 6.63% (2,415,385 + 34,000,000) IPO Math, Part III Post-IPO firm description 3. What is the value of founders’ shares after the IPO? $57.96 × 34m = $1.9707b (= $1.9805b − $9.8m) 4. What is the value of (new) investors’ shares after the IPO? $57.96 × 2,415,385 = $140m The bottom line: As long as the issue is fairly priced, existing shareholders only lose issuing costs ($9.8m in this case). IPO Math: Direct Costs vs Underpricing 5. Suppose the issue was underpriced at $28/share. How much equity was sold? 140m = 5m shares 28 5 = 12.82% of the new company 34 + 5 6. How much did existing shareholders give away? • “Back-of-the-envelope” underpricing cost calculation: (58.25 − 28) × 5m = $151.25m • Bottom line: Underpricing costs are much larger than the direct costs ($9.8m). • You should verify that the actual total amount given away by old shareholders is roughly $140.4m, underpricing cost is 140.4 − 9.8 = $130.6m The End SEOs Seasoned Equity Offerings (SEOs) • General cash offer • Sale of securities open to all investors • Private placement • Sale of securities to a limited number of investors without a public offering • Rights issue • Issue of securities offered only to current stockholders • An “X for Y” rights offer means for every Y shares you own, you have the option to buy X more shares from the company Rights Issue: Example • Lafarge Corp needs to raise A C1.28 billion of new equity. • The market price is A C60/share. • Lafarge decides to raise additional funds via a 4 for 17 rights offer at A C41 per share. • If we assume 100% subscription, what is the value of each right? Rights Issue: Example (cont.) • For simplicity, suppose there are only 17 shares outstanding. Current market value of the shares is: 17 × A C60 = A C1, 020 • Total shares after rights issue (100% subscription): 17 + 4 = 21 • Total amount of equity after issue: A C1, 020 + (4 × A C41) = A C1, 184 • New share price: 1, 184 =A C56.38 21 • Value of a right: 56.38 − 41 = A C15.38 Rights Issue In general: Value of a right = (Pcurrent − PIssue ) × N N+1 where N is the number of shares per right. This equation takes into account both the price discount and the dilution. Checking with the previous example: 15.38 = (60 − 41) × N where N = 17/4 N +1 The End Empirical Evidence Empirical Evidence on IPOs Short-term returns • Day 1 returns average 16%. • That is, day 1 closing price is on average 16% higher than the IPO price. • Indicates underpricing: Firms could have sold the shares for 16% more. • Returns are risky. • Returns vary widely by year (1960 to 1987). • The worst year of the original study was 1973 when IPOs returned −18% (105 issues). • The best year was 1968 when the return was +56% (368 issues). Empirical Evidence on IPOs (cont.) Short-term returns • Underpricing varies with uncertainty about the stock’s value. • Larger firms are underpriced less. Firms with sales less than $1m when they go public had initial excess returns of 31%. Firms with sales exceeding $25m had initial excess returns of only 5%. • Underpricing is smaller for older firms. • International results are similar. • This is not just a US phenomenon. Underpricing occurs in every country with IPOs. • Smaller issues are again underpriced more than bigger issues. Average First-Day IPO Returns Worldwide 1 1 Source: Berk and DeMarzo Money Left on the Table 2 2 Source: Prof. Jay Ritter’s website Empirical Evidence on IPOs IPO activity is cyclical (comes in “waves”). Empirical Evidence on IPOs (cont.) Long-run returns are low. • Poor relative performance in the subsequent three to five years • For a sample of 1,500 IPOs, the three-year returns were 34%, compared with a 62% return on a portfolio of small stocks in similar industries. The End IPO Underpricing Why Are IPOs Underpriced? • Underwriter price supports • Underwriters can support the price of an IPO by buying shares at IPO price or lower • Benefit the underwriter • Favours for the clients of the underwriters • Risk-averse owners • Once-in-a-lifetime very positive NPV project • Information asymmetry (“winner’s curse”) • Informed investors stay away from bad deals • Uninformed investors receive a disproportionate allocation of shares in bad deals • To participate in IPOs, uninformed investors need a discount on the fair price in order to break even Winner’s Curse: Example, Part I Asymmetric information • Suppose Abbott Enterprises is going public with an offer of 1,000 shares at $1/share. • With 40% chance, Abbott Enterprises is a “lemon”, and with 60% chance it’s a “jewel”. • We will assume lemons have an initial return of −20%. • Assume that Abbott Enterprises has no leverage, an equity beta of 0, and the risk-free rate is also 0. Winner’s Curse: Example, Part II • There exist both informed (very small group for any given issue) and uninformed investors. • Informed investors know with 100% accuracy whether or not Abbott is a lemon or a jewel, and subscribe only to jewels. • Informed investors have capacity to buy 500 shares. • Uninformed investors subscribe to all issues. • In the event of oversubscription, shares are rationed. Winner’s Curse: Example, Part III Informed Uninformed Lemon (40%) Jewel (60%) 0 1,000 500 500 • We need participation by uninformed investors, otherwise the IPO will not go through. • Uninformed investors must earn an average one-day return of 0%. • What is the return required from a jewel to induce uninformed investors to participate in the IPO? Winner’s Curse: Example, Part IV • Assume Rj is the day 1 return from a jewel. Then the expected day 1 return for an uninformed investor is: 0.4 × $1, 000(1 − 0.2)   + 0.6 × $500(1 + Rj ) + $500(1 + 0) = $1, 000(1 + 0) • Solving yields Rj = 26.67%. • What is the expected return on an IPO? E(RIPO ) = 0.4 × −0.2 + 0.6 × 0.2667 = 8% • This is the average day 1 return on an IPO (underpricing!). The End