Financing Process

Financing
Internal Financing funds raised from cash

flows of existing assets External Financing funds raised from outside the company (VC, debt, equity, etc.)

Internal vs. External Financing

Firms may prefer internal financing because

External financing is difficult to raise External financing may result in loss of control Raising external capital tends to be expensive

Projects funded by internal financing must

meet same hurdle rates

Internal financing is limited
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A Life Cycle View of Financing Choices

$ Reven ues/ Earnings

Reven ues

Earnings

Time

Extern al fund in g needs

High, but co nstrained by infrast ruct ure

High, relative t o firm value.

Moderat e, relat ive t o firm value.

Declin in g, as a percent of firm value

Lo w, as project s dry up .

Intern al finan cing

Negat ive or low Own ers Equit y Bank Debt

St age 1 St art-up Accessing private equit y

Negat ive or low Venture Capit al Co mmo n St ock

St age 2 Rapid Exp ansio n

Lo w, relat iv e to fundin g needs Co mmo n st ock Warrant s Co nvert ibles

St age 3 High Growt h

High, relative t o fundin g needs Debt

More th an fundin g needs

Extern al Finan cing

Growt h st age Finan cing Transition s

Retire debt Repurch ase st ock

St age 5 Declin e
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St age 4 Mat ure Growt h Bo nd issues

Inital Public o fferin g

Seasoned equity issue

Process of raising capital

Private firm expansion From private to public firm: The IPO Choices for a public firm

VC process
Provoke equity investors interest There is an imbalance between the number of small firms that desire VC investment and the number of VCs

Firms need to distinguish themselves from others to obtain VC funding Type of business Dot.com in the 90s, bio-tech firms this decade Successful management
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VC process
Perform valuation and return assessment (Venture capital

method) Estimate earnings in the year the company is expected to go public

Obtain a P/E multiple for public firms in the same industry Exit or Terminal Value = P/E multiple * forecasted earnings

Discount this terminal value at the VCs target rate of return Discounted Terminal Value = Estimated exit value (1 + target return)n
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VC process
Structure the deal

Determine the proportion of firm value that VC will get in return for investment Ownership Proportion = Capital Provided Disc. Exit Value
VC will establish constraints on how the managers run the firm

VC process
Participate in post-deal management VCs provide managerial experience and contacts for additional fund raising efforts Exit VCs generate a return on their investment by exiting the investment. They can do so through An initial public offering Selling the business to another firm Withdrawing firm cash flows and liquidating the firm
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VC process
Stages of Venture Capital Investments Seed financing is capital provided at the idea stage. Start-up financing is capital used in product development. First-stage financing is capital provided to initiate manufacturing and sales. Second-stage financing is for initial expansion. Third-stage financing allows for major expansion. Mezzanine financing prepares the company to go public.
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Going public vs. staying private

The benefits of going public are:

Firms can access financial markets and tap into a much larger source of capital Owners can cash in on their investments

The costs of going public are:

Loss of control Information disclosure requirements Exchange listing requirements

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Initial Public Offering (IPO) process

Most public offerings are made with the assistance of

investment bankers (IBs) which are financial intermediaries that specialize in selling new securities and advising firms with regard to major financial transactions.

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IPO process
The role of the investment banker

Origination - design of a security contract that is acceptable to the market;

prepare the state and federal Securities and Exchange Commission (SEC) registration statements and a summary prospectus,

Underwriting-the risk-bearing function in which the IB buys the securities at a given price and turns to the market to sell them.

Syndicates are formed to reduce the inventory risk.

Sales and distribution-selling quickly reduces inventory risk. Firm members of the syndicate and a wider selling group distribute the securities over a wide retail and institutional area.
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IPO process

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IPO process
IPO costs

Underwriting commission (usually around 7%) Underpricing of issue

Represents the first day returns generated by the firm, calculated as Closing Price Offer price Offer price Issues are underpriced to
Provide investors with a good taste about the investment banker and firm Compensate investors for the information asymmetry between firm and investor
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IPO process
Valuing the company and setting issue details

Investment banker and firm need to determine

Value of company
Valuation is typically done using P/E multiples

Size of the issue Value per share Offering price per share
This will tend to be below the value per share, i.e., the offer will be underpriced

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IPO process
Determining the offer price The investment banker will gauge the level of interest from institutional investors for the issue by conducting road shows. This is referred to as building the book. After the offer price and issue details are set,

and the SEC has approved the registration, the firm places a tombstone advertisement in newspapers, that outlines the details of the issue and the investment bankers involved
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IPO process
Waiting period The period between the submission

of the registration to the SEC and the SECs approval. It is during this time that the company releases the red herring

Quiet period a period after the registration is

submitted until approximately a month after the issue where the company cannot comment on the earnings, prospects for the company
Lock-up period a period of usually 6 months

following the issue date in which the insiders of the company cannot sell their shares
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Choices for a publicly traded firm

General subscription (or Seasoned Equity

Offering)
Private placements Rights offerings

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General subscription (SEO)

Although for IPOs the underwriting agreement almost

always involves a firm guarantee from the underwriter to purchase all of the issue, in secondary offerings, the underwriting agreement may be a best efforts guarantee where the underwriter sells as much of the issue as he can
SEOs tend to have lower underwriting commissions

because of competition.
The issuing price of an SEO tends to be set slightly

lower than the current market price

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Private placement
Securities are sold directly to one or few

investors
Saves on time and cost (no registration

requirements, marketing needs)

Tends to be less common with corporate

equity issues. Private placement is used more in corporate bond issues.

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Rights offerings
Existing investors are provided the right to purchase

additional shares in proportion to their current holdings at a price (subscription price) below current market price (rights-on price)
Each existing share is provided one right. The number of rights required to purchase a share in

the rights offering is then determined by the number of shares outstanding and the additional shares to be issued in the rights offering.
rights required to purchase one share = # of original shares # of shares issued in RO
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Rights offerings
Because investors can purchase shares at a lower price, the rights

have value:
Value of the right = rights-on price subscription price n+1 where n = number of rights required for each new share

Because additional shares are issued at a price below market price, the

market price will drop after the rights offering to the ex-rights price ex-rights price = New value of equity New number of shares
The value (or price) of the right can also be calculated as:

rights-on price ex-rights price

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Rights offerings
Costs are lower because of Lower underwriting commissions rights offerings tend to be fully subscribed Marketing and distribution costs are significantly lower

No dilution of ownership
No transfer of wealth

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