Contents

5.5 Raising Capital......................................................................................... 2

5.5.1 Introduction to Raising Capital...........................................................2
5.5.2 Public Issue and Cash Offer................................................................3
Public Issue.............................................................................................. 3
Cash Offer................................................................................................ 3
Why Go Public?........................................................................................ 4
The Underwriting Process........................................................................5
What About Me?....................................................................................... 6
Lock-Up Agreements................................................................................ 6
5.5.3 New Equity Sales................................................................................ 7
Share Price and Secondary Offerings.......................................................7
5.5.4 Cost Of Issuing Securities...................................................................8
5.5.5 Rights................................................................................................. 9
5.5.6 Dilution............................................................................................. 11
5.5.7 Issuing Long-Term Debt....................................................................14

5.5 Raising Capital

5.5.1 Introduction to Raising Capital
When most people think about a company raising capital, they think about a
private company going public - selling an initial public offering (IPO) of stock.
An IPO can indeed be an effective means of raising capital for corporate
ventures, and it has many upsides:
Money to grow the business: With an infusion of cash derived from the sale
of stock, the company may grow its business without having to borrow from
traditional sources, and it will thus avoid paying the interest required to
service debt. This "free" cash spent on growth initiatives can result in a
better bottom line. New capital may be spent on marketing and advertising,
hiring more experienced personnel who require lucrative compensation
packages, research and development of new products and/or services,
renovation of physical plants, new construction and dozens of other
programs to expand the business and improve profitability.
Money for shareholders and others: With more cash in the company coffers,
additional compensation may be offered to investors, stakeholders, founders
and owners, partners, senior management and employees enrolled in stock
ownership plans.
Company stock and stock options may be used in an effective incentive
program. In recruiting talented senior management personnel, stock and
options are an attractive inducement. For employees, a performance-based
program of stock and/or option bonuses is an effective means of increasing
productivity and managerial successes. Stocks and/or options may also be
used in other forms of compensation, as well.
Other benefits of going public: Once the company has gone public,
additional equities may be easily sold to raise capital. A publicly-traded
company with stock that has performed successfully will usually find it
easier to borrow money, and at a more favorable rate, when additional
capital is needed.
A publicly-traded company may also have more leverage in negotiating with
vendors, and it may be more attractive to customers. This is a critical aspect
of business; a company that keeps vendor costs low may post better profit
margins. Customers usually have a better perception of companies with a
presence on a major stock exchange, another advantage over privately-held
companies. This favorable opinion is largely due to the audit and financial
statement scrutiny that public companies have to undergo on a regular
basis.
A publicly-traded company conveys a positive image (if business goes well)
and attracts high-quality personnel at all levels, including senior
management. Such companies are growth-oriented; they answer to a board

of directors and shareholders who continually demand increased

profitability, and are quick to rectify management problems and replace
poorly performing senior executives.
But before undertaking the complex, expensive and time-consuming
preparations and incurring the risks involved, the upside and downside of
this critical move must be fully assessed. Although there are numerous
benefits to being a public company, this prestige comes with an increased
amount of restrictions and requirements. (Learn more in The Murky Waters
Of The IPO Market and The Biggest IPO Flops.)
In this section of our corporate finance walkthrough, we'll first explore how a
company goes public. We'll then look at lesser-known, less-glamorous
methods of raising capital, including new equity securities (secondary
offerings) and rights offerings. We'll also look at how dilution impacts
existing shareholders, and we'll touch on the issuance of long-term debt for
financing.

5.5.2 Public Issue and Cash Offer

Public Issue
If a company decides to raise capital by issuing stock, it must file a formal
registration statement with the Securities and Exchange Commission (SEC)
that details the business's financial history, current financial situation, the
proposed public issue and future projections. The company must also
prepare a preliminary prospectus that contains information similar to that of
the registration statement for potential investors. (Learn more about the
regulation of IPOs in How The Sarbanes-Oxley Era Affected IPOs.)
After a 20-day waiting period, the registration statement is considered
accepted unless the SEC sends a letter of comment asking for changes. The
securities can be sold, and a final prospectus is issued at the conclusion of
the waiting period. An investment bank will act as an underwriter to effect
the sale, which is known as the initial public offering or primary offering. A
primary offering is the first of issuance of stock for public sale from a private
company. This is the means by which a private company can raise equity
capital through the financial markets in order to expand its business
operations.
A primary offering is usually done to help a young, growing company
expand its business operations, but it can also be done by a mature
company that still happens to be a private company. Primary offerings can
be followed by secondary offerings, which serve as a way for a company
that is already publicly traded to raise further equity capital for its business.
After the offering and the receipt of the funds raised, the securities are
traded on the secondary market, where the company does not receive any
money from the purchase and sale of the securities they previously issued.

The secondary market is where investors purchase securities or assets from

other investors, rather than from the issuing companies themselves. The
national exchanges - such as the New York Stock Exchange and the Nasdaq are secondary markets. (Learn more in A Look At Primary And Secondary
Markets.)
If the issue will be for less than $5 million, the company need only file a
concise offering statement with the SEC. A sale to fewer than 35 investors is
considered a private sale and eliminates the need to file a registration
statement with the SEC. However, unregistered securities are not as easy to
sell as registered securities. (For related reading, see Valuing Private
Companies.)
Cash Offer
A cash offer is one of two types of public issues. We'll discuss the other type,
a rights offer, later in this section. A cash offer makes shares available to the
general public in an initial public offering. But first, let's go over the
differences between private and public companies.
A privately held company has fewer shareholders, and its owners don't have
to disclose much information about the company. Anybody can go out and
incorporate a company; just put in some money, file the right legal
documents and follow the reporting rules of your jurisdiction. Most small
businesses are privately held. But large companies can be private, too. Did
you know that as of February 2012, IKEA, Domino's Pizza and Hallmark
Cards are all privately held?
It usually isn't possible to buy shares in a private company. You can
approach the owners about investing, but they're not obligated to sell you
anything. Public companies, on the other hand, have sold at least a portion
of themselves to the public and trade on a stock exchange. This is why
doing an IPO is also referred to as "going public." (Learn more about going
public in IPO Basics: Don't Just Jump In and How An IPO Is Valued.)
Public companies have thousands of shareholders and are subject to strict
rules and regulations. They must have a board of directors, and they must
report financial information every quarter. In the United States, public
companies report to the Securities and Exchange Commission (SEC). In
other countries, public companies are overseen by governing bodies similar
to the SEC. From an investor's standpoint, the most exciting thing about a
public company is that the stock is traded in the open market like any other
commodity. If you have the cash, you can invest. The CEO could hate your
guts, but there's nothing he or she could do to stop you from buying stock.
Why Go Public?
Going public raises cash - usually a lot of it. Being publicly traded also opens
many financial doors:

Because of the increased scrutiny, public companies can usually get

better rates when they issue debt.
As long as there is market demand, a public company can always
issue more stock. Thus, mergers and acquisitions are easier to do
because stock can be issued as part of the deal.
Trading in the open markets means liquidity. This makes it possible to
implement things like employee stock ownership plans, which help to
attract top talent.
Being listed on a major stock exchange carries a considerable amount
of prestige. In the past, only private companies with strong
fundamentals could qualify for an IPO and it wasn't easy to get listed.

The Internet boom changed all this. Firms no longer needed strong financials
and a solid history to go public. Instead, IPOs were done by smaller startups
seeking to expand their businesses. There's nothing wrong with wanting to
expand, but most of these firms had never made a profit and didn't plan on
being profitable any time soon. (Read about what some analysts consider
the second dot-com bubble in What To Expect From The Groupon IPO and
What To Expect From The Zynga IPO.)
Founded on venture capital funding, they spent like Texans trying to
generate enough excitement to make it to the market before burning
through all their cash. In cases like this, companies might be suspected of
doing an IPO just to make the founders rich. This is known as an exit
strategy, implying that there's no desire to stick around and create value for
shareholders. The IPO then becomes the end of the road rather than the
beginning. (Not every dot-com company went bust. Read more in 5
Successful Companies That Survived The Dotcom Bubble.)
How can this happen? Remember: an IPO is just selling stock. It's all about
the sales job. If you can convince people to buy stock in your company, you
can raise a lot of money.
The Underwriting Process
Getting a piece of a hot IPO is very difficult, if not impossible. To understand
why, we need to know how an IPO is done, a process known as underwriting.
When a company wants to go public, the first thing it does is hire an
investment bank. A company could theoretically sell its shares on its own,
but realistically, an investment bank is required - it's just the way Wall Street
works. Underwriting is the process of raising money by either debt or equity
(in this case we are referring to equity). You can think of underwriters as
middlemen between companies and the investing public. The biggest
underwriters as of February 2012 are Goldman Sachs, Credit Suisse First
Boston and Morgan Stanley. (For related reading, see Wanna Be A Bigwig?
Try Investment Banking and The Rise Of The Modern Investment Bank.)
The company and the investment bank will first meet to negotiate the deal.
Items usually discussed include the amount of money a company will raise,

the type of securities to be issued and all the details in the underwriting
agreement. The deal can be structured in a variety of ways. For example, in
a firm commitment, the underwriter guarantees that a certain amount will
be raised by buying the entire offer and then reselling to the public. In a
best efforts agreement, however, the underwriter sells securities for the
company but doesn't guarantee the amount to be raised. Also, investment
banks are hesitant to shoulder all the risk of an offering. Instead, they form
a syndicate of underwriters. One underwriter leads the syndicate and the
others sell a part of the issue.
Once all sides agree to a deal, the investment bank puts together a
registration statement to be filed with the SEC. This document contains
information about the offering as well as company info such as financial
statements, management background, any legal problems, where the
money is to be used and insider holdings. The SEC then requires a cooling
off period, in which it investigates and makes sure all material information
has been disclosed. Once the SEC approves the offering, a date (the
effective date) is set when the stock will be offered to the public.
During the cooling off period the underwriter puts together what is known as
the red herring. This is an initial prospectus containing all the information
about the company except for the offer price and the effective date, which
aren't known at that time. With the red herring in hand, the underwriter and
company attempt to hype and build up interest for the issue. They go on a
road show - also known as the "dog and pony show" - where the big
institutional investors are courted.
As the effective date approaches, the underwriter and company sit down
and decide on the initial share price. This isn't an easy decision: it depends
on the company, the success of the road show and, most importantly,
current market conditions. Of course, it's in both parties' interest to get as
much as possible.
Finally, the securities are sold on the stock market and the money is
collected from investors.
What About Me?
As you can see, the road to an IPO is a long and complicated one. You may
have noticed that individual investors aren't involved until the very end. This
is because small investors aren't the target market. They don't have the
cash and, therefore, hold little interest for the underwriters.
If underwriters think an IPO will be successful, they'll usually pad the
pockets of their favorite institutional client with shares at the IPO price. The
only way for you to get shares (known as an IPO allocation) is to have an
account with one of the investment banks that is part of the underwriting
syndicate. But don't expect to open an account with $1,000 and be
showered with an allocation. You need to be a frequently trading client with
a large account to get in on a hot IPO.

Bottom line, your chances of getting early shares in an IPO are slim to none
unless you're on the inside. If you do get shares, it's probably because
nobody else wants them. Granted, there are exceptions to every rule, and it
would be incorrect for us to say that it's impossible. Just keep in mind that
the probability isn't high if you are a small investor. (Read Investing In IPO
ETFs to learn how you can get a piece of the IPO action.)
Lock-Up Agreements
A lock-up agreement may restrict the stock's trading somewhat after the
company goes public. A lock-up agreement is a legally binding contract
between the underwriters and insiders of a company prohibiting these
individuals from selling any shares of stock for a specified period of time.
Lock-up periods typically last 180 days (six months) but can on occasion last
for as little as 120 days or as long as one year.
Underwriters will have company executives, managers, employees and
venture capitalists sign lock-up agreements to ensure an element of stability
in the stock's price in the first few months of trading. When lock-ups expire,
restricted people are permitted to sell their stock, which sometimes (if these
insiders are looking to sell their stock) results in a drastic drop in share price
due to the huge increase in supply of stock. (Learn more in IPO Lock-Ups
Stop Insider Selling.)

5.5.3 New Equity Sales

A company that has already held an IPO can sell new equity in what is
known as a secondary offering, a follow-on offering or add-on offering.
Usually, these kinds of public offerings are made by companies wishing to
refinance or raise capital for growth. The money raised goes to the company
through the investment bank that underwrites the offering.
A secondary public offering is a way for a company to increase outstanding
stock and spread market capitalization (the company's value) over a greater
number of shares. However, secondary offerings dilute the ownership
position of stockholders who own shares that were issued in the IPO.
Unlike an IPO, which includes a price range at which the company is looking
to sell shares, the price of a follow-on offering is market-driven. Because the
company is already publicly traded, it has been consistently valued by
investors for at least a year before the follow-on offering is floated. Thus,
any investment bank working on the offering will often focus on marketing
efforts, rather than valuation.
From the existing shareholders' perspective, the issuance of add-on stock is
a bad thing because it usually reduces the value of the stock they own. More
shares mean that existing shareholders will see their percentage of
ownership in the company decrease. They may also see the stock's earnings
per share decline. However, if the add-on is able to increase earnings and
shareholder value in the long term, it will generally be viewed as a positive
decision.
Share Price and Secondary Offerings
Why do share prices fall after a company has a secondary offering? The best
way to answer this question is to provide a simple illustration of what
happens when a company increases the number of shares issued, or shares
outstanding, through a secondary offering.
Suppose XYZ Inc. has a successful IPO and raises $1 million by issuing
100,000 shares. These shares are purchased by a few dozen investors who
are now the owners (shareholders) of the company. In the first full year of
operations, XYZ produces a net income of $100,000.
One of the ways the investment community measures a company's
profitability is based on earnings per share (EPS), which allows for a more
meaningful comparison of corporate figures. In its first year of public
ownership, XYZ had an EPS of $1 ($100,000 of net income / 100,000 shares
outstanding). In other words, each share of XYZ stock held by a shareholder
was worth $1 of earnings.
Subsequently, things are looking up for XYZ, which prompts management to
raise more equity capital through a secondary offering, which is successful.
In this instance, the company only issues 50,000 shares, which produces

$50,000 of additional equity. The company then goes on to have another

good year with a net income of $125,000.
That's the good news, at least for the company. However, the point of view
of the original investors - those who became shareholders through the IPO their level of ownership has been decreased with the increase in the
shareholder base. This consequence is referred to as the dilution of their
ownership percentage.
Some simple math will illustrate this event. In the second year, XYZ had
150,000 shares outstanding: 100,000 from the IPO and 50,000 from the
secondary offering. These shares have a claim on $125,000 of earnings (net
income), or earnings per share of $0.83 ($125,000 of net income / 150,000
shares outstanding), which compares unfavorably to the $1 EPS from the
previous year. In other words, the EPS value of the initial shareholders'
ownership decreases by 17%!
While an absolute increase in a company's net income is a welcome sight,
investors focus on what each share of their investment is producing. An
increase in a company's capital base dilutes the company's earnings
because they are spread among a greater number of shareholders.
Without a strong case for maintaining and/or boosting EPS, investor
sentiment for a stock that is subject to a potential dilutive effect will be
negative. Although it is not automatic, the prospect of share dilution will
generally hurt a company's stock price. We'll discuss share dilution in
greater depth later in this section.

5.5.4 Cost Of Issuing Securities

Going public may raise money, but it also has a number of costs, both
implicit and explicit.
Once a company goes public, its finances and almost everything about it including its business operations - are open to government and public
scrutiny. Periodic audits are conducted; quarterly reports and annual reports
are required. Company finances and other business data are available to the
public, which can sometimes work against company interests. A careful
reading of these reports can accurately determine a company's cash flow
and credit-worthiness, which may not always be perceived as positive.
A public company is subject to SEC oversight and regulations, including
strict disclosure requirements. Among the required disclosures is information
about senior management personnel - particularly compensation - which is
often criticized by stakeholders.
A public company is subject to shareholder suits, whether warranted or not.
Lawsuits may be based on allegations of self-trading or insider trading. They
may challenge executive compensation, or they may oppose or question

major management decisions. Sometimes a single, disgruntled shareholder

may bring suit and cause expensive and time-consuming trouble for a
publicly traded firm.
Preparation for the IPO is expensive, complex and time consuming. Lawyers,
investment bankers and accountants are required, and often outside
consultants must be hired. As much as a year or more may be required to
prepare for an IPO. During this period, business and market conditions can
change radically, and it may not be a propitious time for an IPO, thus
rendering the preparation work and expense ineffective.
The pressure for profitability each quarter is a difficult challenge for the
senior management team. Failure to meet target numbers or forecasts often
eventuates in a decline in the stock price. Falling stock prices, moreover,
stimulate additional dumping, further eroding the value of the equities.
Before buyers and original holders of the IPO stock may liquidate their
positions, a no-sell period is often enforced to prevent immediate selloffs.
During this period the price of the stock may decline, resulting in a loss. And
again, business and market conditions may change during this period to the
detriment of the stock price.

5.5.5 Rights
Cash-strapped companies can turn to rights issues to raise money when
they really need it. In these rights offerings, companies grant
shareholders a chance to buy new shares at a discount to the current
trading price. Let's look at how rights issue work and what they mean for
all shareholders.
Defining a Rights Issue and Why It's Used
A rights issue is an invitation to existing shareholders to purchase
additional new shares in the company. More specifically, this type of
issue gives existing shareholders securities called "rights," which give
the shareholders the right to purchase new shares at a discount to the
market price on a stated future date. Essentially, the company is giving
shareholders a chance to increase their exposure to the stock at a
discount price.

Until the date at which the new shares can be purchased, shareholders
may trade the rights on the market the same way they would trade
ordinary shares. The rights issued to a shareholder have a value, thus
compensating current shareholders for the future dilution of their
existing shares' value.
Troubled companies typically use rights issues to pay down debt,
especially when they are unable to borrow more money. But not all
companies that pursue rights offerings are shaky. Some with clean
balance sheets use them to fund acquisitions and growth strategies. For
reassurance that it will raise the finances, a company will usually, but not
always, have its rights issueunderwritten by an investment bank. (Read
more about investment banking in The World's Most Powerful

Bankers, Goldman Sachs By The Numbers and How To Get A Job On Wall
Street.)
How Rights Issues Work
So, how do rights issues work? The best way to explain is through an
example.

Let's say you own 1,000 shares in Wobble Telecom, each of which is
worth $5.50. The company is in a bit of financial trouble and sorely needs
to raise cash to cover its debt obligations. Wobble therefore announces a
rights offering, in which it plans to raise $30 million by issuing 10 million
shares to existing investors at a price of $3 each. But this issue is a
three-for-10 rights issue. In other words, for every 10 shares you hold,
Wobble is offering you another three at a deeply discounted price of $3.
This price is 45% less than the $5.50 price at which Wobble stock trades.
(For further reading, see Understanding Stock Splits.)
As a shareholder, you essentially have three options when considering
what to do in response to the rights issue. You can (1) subscribe to the
rights issue in full, (2) ignore your rights or (3) sell the rights to someone
else. Here's how to pursue each option and the possible outcomes.
1. Take up the rights to purchase in full
To take advantage of the rights issue in full, you would need to spend $3
for every Wobble share that you are entitled to under the issue. As you
hold 1,000 shares, you can buy up to 300 new shares (three shares for
every 10 you already own) at this discounted price of $3, giving a total
price of $900.
However, while the discount on the newly issued shares is 45%, it will
not stay there. The market price of Wobble shares will not be able to stay
at $5.50 after the rights issue is complete. The value of each share will
be diluted as a result of the increased number of shares issued. To see if
the rights issue does in fact give a material discount, you need to
estimate how much Wobble's share price will be diluted.
In estimating this dilution, remember that you can never know for certain
the future value of your expanded holding of the shares, since it can be
affected by any number of business and market factors. But the
theoretical share price that will result after the rights issue is complete which is the ex-rights share price - is possible to calculate. This price is
found by dividing the total price you will have paid for all your Wobble
shares by the total number of shares you will own. This is calculated as
follows:

1,000 existing shares at

$5.50
300 new shares for cash at
$3
Value of 1,300 shares
Ex-rights value per share

$5,500
$900
$6,400
$4.92

($6,400.00/1,300
shares)
So, in theory, as a result of the introduction of new shares at the deeply
discounted price, the value of each of your existing shares will decline
from $5.50 to $4.92. But remember, the loss on your existing
shareholding is offset exactly by the gain in share value on the new
rights: the new shares cost you $3, but they have a market value of
$4.92. These new shares are taxed in the same year as you purchased
the original shares, and they are carried forward to count as investment
income, but there is no interest or other tax penalties charged on this
carried-forward, taxable investment income.
2. Ignore the rights issue
You may not have the $900 to purchase the additional 300 shares at $3
each, so you can always let your rights expire. But this is not normally
recommended. If you choose to do nothing, your shareholding will be
diluted thanks to the extra shares issued.
3 Sell your rights to other investors
In some cases, rights are not transferable. These are known as "nonrenounceable rights." But in most cases, your rights allow you to decide
whether you want to take up the option to buy the shares or sell your
rights to other investors or to the underwriter. Rights that can be traded
are called "renounceable rights," and after they have been traded, the
rights are known as "nil-paid rights."
To determine how much you may gain by selling the rights, you need to
estimate a value on the nil-paid rights ahead of time. Again, a precise
number is difficult, but you can get a rough value by taking the value of
ex-rights price and subtracting the rights issue price. So, at the adjusted
ex-rights price of $4.92 less $3, your nil-paid rights are worth $1.92 per
share. Selling these rights will create a capital gain for you.
Be Warned
It is awfully easy for investors to get tempted by the prospect of buying
discounted shares with a rights issue. But it is not always a certainty that
you are getting a bargain. But besides knowing the ex-rights share price,
you need to know the purpose of the additional funding before accepting
or rejecting a rights issue. Be sure to look for a compelling explanation of
why the rights issue and share dilution are needed as part of the
recovery plan. Sure, a rights issue can offer a quick fix for a troubled
balance sheet, but that doesn't necessarily mean management will
address the underlying problems that weakened the balance sheet in the
first place. Shareholders should be cautious. (Learn about other
investments to be cautious of in 10 Questionable
Investments and Dangerous Advice For Beginner Investors.)

5.5.6 Dilution
Dilutive stock is any security that dilutes the ownership percentage of
current shareholders - that is, any security that does not have some sort
of embedded anti-dilution provision. The reason why dilutive stock has
such negative connotations is quite simple: a company's shareholders
are its owners, and anything that decreases an investor's level of
ownership also decreases the value of the investor's holdings.
Ownership can be diluted in a number of different ways:
1. Secondary Offerings: For example, if a company had a total of 100
shares on the market and its management decided to issue another 100
stocks, then the owners of the first 100 stocks would face a
50% dilution factor. For a real life example of this scenario, consider
the secondary offering made by Google Inc. in the fall of 2005. The
company decided to issue more than 14 million shares of common stock
to raise money for "general corporate purposes," and it diluted thencurrent holdings.
2. Convertible Debt/Convertible Equity: When a company
issues convertible debt, it means that debtholders who choose to convert
their securities into shares will dilute current shareholders' ownership
when they convert. In many cases, convertible debt converts to common
stock at some sort of preferential conversion ratio. For example, each
$1,000 of convertible debt may convert to 100 shares of common stock,
thus decreasing current stockholders' total ownership.
Convertible equity is often called convertible preferred stock. These
kinds of shares also usually convert to common stock on some kind of
preferential ratio - for example, each convertible preferred stock may
convert to 10 shares of common stock, thus also diluting ownership
percentages of the common stockholders.
3. Warrants, Rights, Options and other claims on security: When
exercised, these derivatives are exchanged for shares of common stock
that are issued by the company to its holders. Information about dilutive
stock, options, warrants, rights, and convertible debt and equity can be
found in a company's annual filings. (For more information on
shareholder dilution and its costs, check out our Accounting And Valuing
ESOs Feature and A New Approach To Equity Compensation.) Warnings
Signs of Dilution
Because dilution can reduce the value of an individual investment, retail
investors should be aware of warnings signs that may precede a
potential share dilution. Basically, any emerging capital needs or growth
opportunities may precipitate share dilution.
There are many scenarios in which a firm could require an equity capital
infusion; funds may simply be needed to cover expenses. In a scenario
where a firm does not have the capital to service current liabilities and
the firm is hindered from issuing new debt due to covenants of existing
debt, an equity offering of new shares may be necessary.

Growth opportunities are another indicator of a potential share

dilution. Secondary offerings are commonly used to obtain investment
capital that may be needed to fund large projects and new ventures.
Investors can be diluted by employees who have been granted options
as well. Investors should be particularly mindful of companies that grant
employees a large number of optionable securities. Executives and board
members can influence the price of a stock dramatically if the number of
shares upon conversion is significant compared with the total shares
outstanding. (Learn more about employee stock options in our ESO
Tutorial.)
If and when the individual chooses to exercise the options, common
shareholders may be significantly diluted. Key personnel are often
required to disclose in their contract when and how much of their
optionable holdings are expected to be exercised.
Diluted EPS
Because the earnings power of every share is reduced when convertible
shares are executed, investors may want to know what the value of their
shares would be if all convertible securities were executed.

Diluted earnings per share is calculated by firms and reported in their

financial statements. Diluted EPS is the value of earnings per share if
executive stock options, equity warrants and convertible bonds were all
converted to common shares.
The simplified formula for calculating diluted earnings per share is:

Net Income - Preferred Dividends

(weighted average number of shares
outstanding + impact of convertible
securities - impact of options,
warrants and other dilutive
securities)
Diluted EPS differs from basic EPS in that it reflects what the earnings per
share would be if all convertible securities were exercised. Basic EPS
does not include the effect of dilutive securities; it simply measures the
total earnings during a period, divided by the weighted average of shares
outstanding in the same period. If a company did not have any
potentially dilutive securities, basic EPS would equal dilutive EPS. (Learn
more in What is the weighted average of outstanding shares? How is it
calculated?)
The formula above is a simplified version of the diluted EPS calculation.
In fact, each class of potentially dilutive security is addressed. The ifconverted method and treasury stock method are applied when
calculating diluted EPS.

If-Converted Method
The if-converted method is used to calculate diluted EPS if a company
has potentially dilutive preferred stock. Preferred dividend payments are
subtracted from net income in the numerator, and the number of new
common shares that would be issued if converted are added to the
weighted average number of shares outstanding in the denominator.

For example, if net income was $10,000,000 and 500,000 weighted

average common shares are outstanding, basic EPS equals $20 per share
($10,000,000/500,000). If 10,000 convertible preferred shares that pay a
$5 dividend were issued and each preferred share was convertible into
five common shares, diluted EPS would equal $18.27 ([$10,000,000 +
$50,000]/[500,000 + 50,000]).
The $50,000 is added to net income because the conversion is assumed
to occur at the beginning of the period so there would be no dividends
paid out. Thus $50,000 would be added back, just like when after-tax
income is added back when calculating the dilution of convertible bonds,
which we will go over next.
If-Converted Method for Convertible Debt
The if-converted method is applied to convertible debt as well. After-tax
interest on the convertible debt is added to net income in the numerator,
and the new common shares that would be issued at conversion are
added to the denominator.

For a company with net income of $10,000,000 and 500,000 weighted

average common shares outstanding, basic EPS equals $20 per share
($10,000,000/500,000). Assume the company also has $100,000 of 5%
convertible bonds that are convertible into 15,000 shares, and the tax
rate is 30%. Using the if-converted method, diluted EPS would equal
$19.42 ([10,000,000 + ($100,000 x .05 x 0.7)] / [500,000 + 15,000]).
Note the after-tax interest on convertible debt that is added to net
income in the numerator is calculated as the value of the interest on the
convertible bonds ($100,000 x 5%), multiplied by the tax rate (1-.30).
(For more examples see our CFA Level 1 Study Guide Calculating Basic
and Fully Diluted EPS in a Complex Capital Structure.)
Treasury Stock Method
The treasury stock method is used to calculate diluted EPS for potentially
dilutive options or warrants. No change is made to the numerator. In the
denominator, the number of new shares that would be issued at warrant
or option exercise minus the shares that could have been purchased with
cash received from the exercised options or warrants is added to the
weighted average number of shares outstanding. The options or
warrants are considered dilutive if the exercise price of the warrants or
options is below the average market price of the stock for the year.

Again, if net income was $10,000,000 and 500,000 weighted average

common shares are outstanding, basic EPS equals $20 per share
($10,000,000/500,000). If 10,000 options were outstanding with an

exercise price of $30 and the average market price of the stock is $50,
diluted EPS would equal $19.84 ([$10,000,000/[500,000 + 10,000 6,000]).
Note the 6,000 shares is the number of shares that the firm could
repurchase after receiving $300,000 for the exercise of the options
([10,000 options x $30 exercise price] / $50 average market price). The
share count would increase by 4,000 (10,000 - 6,000) because after the
6,000 shares are repurchased there is still a 4,000 share shortfall that
needs to be created.
Securities can be anti-dilutive. This means that, if converted, EPS would
be higher than the company's basic EPS. Anti-dilutive securities do not
affect shareholder value and are not factored into the diluted EPS
calculation.
Using Financial Statements to Assess the Impact of Dilution
It is relatively simple to analyze dilutive EPS as it is presented in financial
statements. Companies report key line items that can be used to analyze
the effects of dilution: basic EPS, diluted EPS, weighted average shares
outstanding and diluted weighted average shares. Many companies also
report basic EPS excluding extraordinary items, basic EPS including
extraordinary items, dilution adjustment, diluted EPS excluding
extraordinary items and diluted EPS including extraordinary items.

Important details are also provided in the footnotes. In addition to

information about significant accounting practices and tax rates,
footnotes usually describe what factored into the diluted EPS calculation.
Specific details are provided regarding stock options granted to officers
and employees, and the effects on reported results.
The Bottom Line
Dilution can drastically impact the value of your portfolio. Adjustments to
earnings per share and ratios must be made to a company's valuation
when dilution occurs. Investors should look out for signals of a potential
share dilution and understand how their investment or portfolio's value
may be affected. (EPS helps investors analyze earnings in relation to
changes in new-share capital, see Getting The Real Earnings,
or Convertible Bonds: An Introduction.)

5.5.7 Issuing Long-Term Debt

In addition to raising capital from stock issuance, many companies issue
debt securities in the form of bonds to finance their operations. In the
issuance of new bonds, a company has options with respect to how to
place the bonds in the market. These options are as follows:
1. Competitive Bids
Competitive bids are the process by which the bond issuer solicits bids
from the underwriting of various investment banks. This is typically used
when dealing with municipal bonds.

2. Negotiated Sales
A negotiated sale is the process whereby a bond issuer negotiates with
the investment bank with respect to the pricing of underwriting services.
3. Private Placements
A private placement is the process whereby an investment bank "places"
the new bond issue with a small number of buyers, typically large
institutions. Private placements are not registered with the SEC for public
sale.
Three Types of Coupons
A bond is essentially an IOU or promise to pay a predetermined annual or
semiannual interest payment and to pay back the principal (face value)
when the bond matures. When a company issues a bond with coupon
payments that are equal to the current market rate, the bond is said to
be issued at par. From an accounting point of view this means that if a
company issues a $1M bond at par the company will in return have
raised $1M in capital for its efforts.

When bonds are issued with coupon payments that are not equal to the
current market interest rate they are considered to be issued at a
"premium" or "discount" to or from par. Companies that are very active
in bond issuance issue bonds at par more frequently than those
companies that are not as active.
Example of bonds issued at a discount:
Company ABC issues a bond that will pay 9% a year for five years and
similar bonds trading are currently paying 10%.While there are multiple
market related factors that determine the issuing price (supply and
demand, credit ratings, analysts' opinions, state of the economy and
yield curve characteristics), in this simplistic example the bonds would
most like be issued at a discount to its par value to compensate for the
lower coupon payments. The company will ultimately get less money for
its bond than the stated par value, and the bonds are said to sell at a
discount.
Example of bonds issued at a premium:
Company ABC issues a bond that will pay 10% a year for five years and
similar bonds are currently paying 9%. The only way the company will
sell this bond to investors is if the company sells the bond at a premium
to its par value (for more money) to compensate the company for the
paying a higher coupon. The company will ultimately get more money for
its bond than the stated par value, and the bond is said to sell at a
premium.
From an accounting standpoint, a company that sells a bond at a
discount (or premium) will record on a cash basis a smaller interest
payment but in reality will have a higher interest expense because it
received fewer dollars for its bond. In accordance with the matching
principle, premium and discounts must be amortized over the life of the
bond. U.S. GAAP allows companies to amortize premiums or discounts by
using a straight-line amortization or the effective interest rate method.

Discount vs. Premium Pricing

If coupon = market rate, the bond is issued at par.
If coupon > market rate, the bond is issued at a premium. The issuing
company will get more money at initiation than it will pay to investors at
maturity. In exchange it will pay a higher coupon than it would have to if
the bond was issued at par.
If coupon < market rate, the bond is issued at a discount. The issuing
company will get less money at initiation than it will pay to investors at
maturity. In exchange it will pay a lower coupon than it would have to if
the bond was issued at par.
Effects of Debt Issuance
Issuing debt impacts a company's financial statements differently
depending on if the bonds are issued at par, at a premium or at a
discount.

Bonds Issued at Par - Effects On:

Income statement - The income statement will include an

interest expense equal to the bond's coupon payment attributable
to the specified accounting period.

Balance sheet - The balance sheet will include at all times a longterm liability equal to the face value of the bond until its maturity
or redemption.

Cash flow statement - Going forward, cash flow from operations

will include the interest expense recorded on the income
statement. As of the issuing date, the company will account in
cash flow from financing the total amount received for the bond.

Bonds Issued at a Premium - Effect On:

Income statement - The income statement will include an

interest expense equal to the bond's coupon payment minus the
amortized portion of the premium received during the specified
accounting period.

Balance sheet - The balance sheet will include at all times a longterm liability equal to its carrying value. At initiation the carrying
value will be equal to the face value of the bond plus the total
unamortized premium. Every year the bond value recorded on the
balance sheet will be reduced until the bond comes to maturity or
is redeemed, and the bond value displayed on the balance
eventually reaches the bond's original face value.

Cash flow statement - Going forward, cash flow from operations

(CFO) will include the actual coupon paid to the debt holder during

the specified accounting period. Since this is a bond that was sold
at a premium, it is paying out a larger coupon than is currently
stated as an interest expense on the income statement. As a
result, CFO will be understated relative to that of a company that
sold its bond at par. The amortized portion of the bond premium
will be included in cash flow from financing. This will cause the
reported cash flow from financing to be overstated relative to that
of a company that sold its bond at par.
Bonds Issued at a Discount - Effect On:

Income statement - The income statement will include an

interest expense equal to the bond's coupon payment plus the
amortized portion of the discount received during the specified
accounting period.

Balance sheet - The balance sheet will include at all times a longterm liability equal to its carrying value. At initiation the carrying
value will be equal to the face value of the bond minus the total
unamortized discount. Every year the bond value recorded on the
balance sheet will be increased until the bond comes to maturity
and the bond value displayed on the balance is equal to the bond's
face value.

Cash flow statement - Going forward, cash flow from operations

will include the actual coupon paid to the debt holder during the
specified accounting period. Since this is a bond that was sold at a
discount, it is paying out a smaller coupon than is currently stated
as an interest expense on the income statement. As a result CFO
will be overstated relative to that of a company that sold its bond
at par. The amortized portion of the bond discount will be included
in cash flow from financing. This will cause the reported cash flow
from financing to be understated relative to that of a company that
sold its bond at par.

Computation
Company ABC issues a $1M bond that will pay a 10% semiannual
(coupon) for three years; the company will generate $500,000 EBITDA
over the next three years. Contract the effect if market rate at the time
of issuance was 10%, 11% and 9%. (Straight-line depreciation is used for
premiums and discounts). Taxes are not considered.

Opening Balance Sheet

(For more on this subject, read Implications Of Debt Issuance.)

Investors: Ask Why the Company Issued New Debt
When a company issues new long-term debt, it's important for investors
to understand the reason. Companies should give explanations of new
debt's specific purpose rather than vague boilerplate such as "it will be
used to fund general business needs." The most common purposes of
new debt include the following:
1. To Fund Growth - The cash raised by the debt issuance is used for
specific investment(s). This is normally a good sign.
2. To Refinance "Old" Debt - Old debt is retired and new debt is
issued, presumably at a lower interest rate. This is also a good
sign, but it often changes the company's interest rate exposure.
3. To Change the Capital Structure - Cash raised by the debt issuance
is used to repurchase stock, issue a dividend or buyout a big
equity investor. Depending on the specifics, this may be a positive
indicator.
4. To Fund Operating Needs - Debt is issued to pay operating
expenses because operating cash flow is negative. Depending on
certain factors, this motive may be a red flag. Below, we look at
how you can determine whether a company is issuing new debt to
fund operating needs.
Be Careful of Debt that Funds Operating Needs
Unless the company is in the early growth stage, new debt that funds
investment is preferable to debt that funds operating needs. To
understand this thoroughly, recall from the cash flow installment that
changes in operating accounts (that is, current assets and current
liabilities) either provide or consume cash. Increases in current assets except for cash - are "uses of cash." Increases in current liabilities are
"sources of cash." Consider an abridged version of Real Networks'
balance sheet for the year ending Dec 31, 2003:

From Dec. 2002 to Dec. 2003, accounts receivable (a current asset)

increased dramatically and accounts payable (a current liability)
decreased. Both occurrences are uses of cash. In other words, Real
Networks consumed working capital in 2003. At the same time, the
company issued a $100 million convertible bond. The company's
consumption of operating cash and its issue of new debt to fund that
need is not a good sign. Using debt to fund operating cash may be okay
in the short run but because this is an action undertaken as a result of
negative operating cash flow, it cannot be sustained forever.

Valuing Private Companies

While most investors are versed in ins and outs of equity and debt
financing of publicly-traded companies, few are as well-informed about their
privately-held counterparts. Private companies make up a large proportion of
businesses in America and across the globe; however the average investor most
likely cannot tell you how to assign a value to a company that does not trade its
shares publicly. This article is introduction to how one can place a value on a
private company and the factors that can affect that value.
Private and Public Firms
The most obvious difference between privately-held companies and publicly-traded
companies is that public firms have sold at least a portion of themselves during
an initial public offering (IPO). This gives outside shareholders an opportunity to
purchase an ownership (or equity) stake in the company in the form of stock.
Private companies, on the other hand, have decided not to access the public
markets for financing and therefore ownership in their businesses remains in the
hands of a select few shareholders. The list of owners typically includes the
companies' founders along with initial investors such as angel investors or venture
capitalists.
The biggest advantage of going public is the ability to tap the public financial
markets for capital by issuing public shares or corporate bonds. Having access to
such capital can allow public companies to raise funds to take on new projects or
expand the business. The main disadvantage of being a publicly-traded company is
that the Securities and Exchange Commission requires such firms to file numerous
filings, such as quarterly earnings reports and notices of insider stock sales and
purchases. Private companies are not bound by such stringent regulations, allowing
them to conduct business without having to worry so much about SEC policy and
public shareholder perception. This is the primary reason why private companies
choose to remain private rather than enter the public domain.
Although private companies are not typically accessible to the average investor,
instances do arise where private firms will seek to raise capital and ownership
opportunities present themselves. For instance, many private companies will offer
employees stock as compensation or make shares available for purchase.
Additionally, privately-held firms may also seek capital fromprivate
equity investments and venture capital. In such a case, those making an investment
in a private company must be able to make a reasonable estimate of the value of
the firm in order to make an educated and well researched investment. Here are
few valuation methods one could use. (For a related reading, see Why Public
Companies Go Private.)

Comparable Company Analysis

The simplest method of estimating the value of a private company is to
use comparable company analysis (CCA). To use this approach, look to the public
markets for firms which most closely resemble the private (or target) firm and base
valuation estimates on the values at which its publicly-traded peers are traded. To
do this, you will need at least some pertinent financial information of the privatelyheld company.
For instance, if you were trying to place a value on an equity stake in a mid-sized
apparel retailer, you would look to the public sphere for companies of similar size
and stature who compete (preferably directly) with your target firm. Once the "peer
group" has been established, calculate the industry averages. This would include
firm-specific metrics such as operating margins,free-cash-flow and sales per square
foot (an important metric in retail sales). Equity valuation metrics must also be
collected, including price-to-earnings, price-to-sales, price-to-book, price-to-free
cash flow and EV/EBIDTA among others. Multiples based on enterprise
value should give the best interpretation of firm value. By consolidating this data
you should be able to determine where the target firm falls in relation to the publiclytraded peer group, which should allow you to make an educated estimate of the
value of an equity position in the private firm.
Additionally, if the target firm operates in an industry that has seen recent
acquisitions, corporate mergers or IPOs, you will be able to use the financial
information from these transactions to give an even more reliable estimate to the
firm's worth, as investment bankers and corporate finance teams have determined
the value of the target's closest competitors. While no two firms are the same,
similarly sized competitors with comparable marketshare will be valued closely on
most occasions. (To learn more, check out Peer Comparison Uncovers
Undervalued Stocks.)
Estimated Discounted Cash Flow
Taking comparable analysis one-step further,one can take financial information from
a target's publicly-traded peers and estimate a valuation based on the
target's discounted cash flow estimations.
The first and most important step in discounted cash flow valuation is determining
revenue growth. This can often be a challenge for private companies due to the
company's stage in its lifecycle and management's accounting methods. Since
private companies are not held to the same stringent accounting standards as
public firms, private firms' accounting statements often differ significantly and may
include some personal expenses along with business expenses (not uncommon in
smaller family-owned businesses) along with owner salaries, which will also include
the payment of dividends to ownership. Dividends are a common form of self-

payment for private business owners, as reporting a salary will increase the
owner's taxable income, while receiving dividends will lighten the tax-burden.
What's important to remember is that estimating future revenue is only a best guess
estimate and one estimate may differ wildly from another. That is why using public
company financials and future estimates is a good way to augment your estimates,
making sure that the target's sales growth is not completely out of line with its
comparable peers. Once revenues have been estimated, free cash flow can be
extrapolated from expected changes in operating costs, taxes and working capital.
The next step would be to estimate the target firm's unlevered beta by gathering
industry average betas, tax rates and debt/equity ratios.
Next, estimate the target's debt ratio and tax rate in order to translate the industry
averages to a fair estimate for the private firm. Once an unlevered beta estimate is
made, the cost of equity can be estimated using the Capital Asset Pricing Model
(CAPM). After calculating the cost of equity, cost of debt will often be determined by
examining the target's bank lines for rates at which the company can borrow. (To
learn more, see The Capital Asset Pricing Model: An Overview.)
Determining the target's capital structure can be difficult, but again we will defer to
the public markets to find industry norms. It is likely that the costs of equity and debt
for the private firm will be higher than its publicly-traded counterparts, so slight
adjustments may be required to the average corporate structure to account for
these inflated costs. Also, the ownership structure of the target must be taken into
account as well as that will help estimate management's preferred capital structure
as well. Often a premium is added to the cost of equity for a private firm to
compensate for the lack of liquidity in holding an equity position in the firm.
Lastly, once an appropriate capital structure has been estimated, calculate
the weighted average cost of capital (WAAC). Once the discount rate has been
established it's only a matter of discounting the target's estimated cash flows to
come up with a fair value estimate for the private firm. The illiquidity premium, as
previously mentioned, can also be added to the discount rate to compensate
potential investors for the private investment.
The Bottom Line
As you can see, the valuation of a private firm is full of assumptions, best guess
estimates and industry averages. With the lack of transparency involved in
privately-held companies it is a difficult task to place a reliable value on such
businesses. Several other methods exist that are used in the private equity industry
and by corporate finance advisory teams to help put a value on private companies.
With limited transparency and the difficulty in predicting what the future will bring to

any firm, private company valuation is still considered more art than science. (To
learn more, see For Companies, Staying Private A Matter Of Choices)