Faculty of Business and Economics The University of Hong Kong
Spring semester, 2018-2019
Review of Lecture 11 • Basic Goal of Capital Structure • Modigliani-Miller Theorem ‒ M&M without taxes or bankruptcy costs ‒ M&M with corporate tax and bankruptcy costs ‒ Extension: the Pie Theory • The Pecking Order Theory • Observing capital structure of businesses
• Textbook Reading: Chapter 16
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Today’s Roadmap • Venture Capital • Initial Public Offering (IPO) ‒ IPO process ‒ Underwriters ‒ IPO underpricing • Seasoned Equity Offering (SEO) and Price Response
• Textbook Reading: Chapter 15
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Today’s Roadmap • Venture Capital • Initial Public Offering (IPO) ‒ IPO process ‒ Underwriters ‒ IPO underpricing • Seasoned Equity Offering (SEO) and Price Response
• Textbook Reading: Chapter 15
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Venture Capital • General concept: ‒ Financing for new or early-stage businesses (ventures), which are usually with high risk • Goal: ‒ Nurture and grow the business to the extent that it could be sold to the public investors through IPO (exit) • Business model: ‒ Provide financing to ventures in exchange for equity, which could be sold at higher price at exit ‒ Provide expertise in the business and management activities (seats in the board of directors are usually required)
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Stages of VC financing • Angel Investor Individuals (including families and friends) who use their own money to support the very beginning of the businesses, usually only to launch the idea • Seed funding To build prototype and complete a manufacturing plan • Early-Stage The operation starts, but perhaps not yet profitable • Later-Stage Broader commercialization of production and sales, with positive profits and expansion • Mezzanine-Stage The last stage before IPO, multiple securities (such as debt and convertibles) are used
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Stages of VC financing: Facebook • Feb 2004: Mark Zuckerberg and his teammates launch The Facebook from their Harvard dorm room. • Jun-Jul 2004: $500,000 received from Peter Thiel, president of Clarium Capital • May 2005: Thiel and Accel Partners invest $12.7 million, giving Facebook an $87.5 million valuation. • Apr 2006: Investors including Accel, Thiel, Greylock Partners and Meritech raise $27.5 million. Current valuation: $500 million. • Oct 2007: Microsoft invests $240 million, giving it a 1.6% stake and Facebook a valuation of $15 billion. • Nov 2007: Hong Kong businessman Li Ka-Shing invests $60 million. • … • Jan 2011: Goldman Sachs invests $450 million and DST invests $50 million, putting Facebook’s valuation at $50 billion • May 2012: IPO Source: http://fortune.com/2011/01/11/timeline-where-facebook-got-its-funding/
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Venture Capital: Regional Comparison
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Venture Capital: Fund Raising in US
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Venture Capital: Outcome in US
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Choosing A Venture Capitalist • Financial Strength ‒ Sufficient resources for funding future stages • Style ‒ E.g. how much the VC is involved in the management • References ‒ Track record on the past deals • Contacts ‒ Network that helps to secure and expand resources • Exit strategy ‒ How and when the VC plans to cash out the business
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Today’s Roadmap • Venture Capital • Initial Public Offering (IPO) ‒ IPO process ‒ Underwriters ‒ IPO underpricing • Seasoned Equity Offering (SEO) and Price Response
• Textbook Reading: Chapter 15
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IPO: Process 1. Approval from the board of directors, sometimes shareholder vote is required
2. Registration statement prepared and filed to the SEC
3. The preliminary prospectus distributed to potential investors during the waiting
period (between the filing and the approval of the registration statement)
4. A price is determined and a full-fledged selling effort gets underway once the registration statement becomes effective (20 days after filing if the SEC does not suggest changes)
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IPO: Underwriters • Basic concept: ‒ Large investment firms who are involved in the IPO process • Services provided by underwriters: ‒ Formulate the method to issue securities ‒ Price the new securities ‒ Sell the new securities • Business model: ‒ Make money by buying the securities at a price lower than the offering price Gross spread: the price difference ‒ Bear the risk of not being able to sell them ‒ Multiple underwriters combine to form a syndicate (an underwriting group)
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IPO: Underwriters
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IPO: Types of Underwriting • Firm Commitment Underwriting ‒ Most common type in US ‒ The underwriter buys the entire issue and then attempts to resell it ‒ Underwriter fee: the spread ‒ Underwriter risk: not being able to sell the entire issue at the offering price • Best Efforts Underwriting ‒ Not commonly used in recent years ‒ Underwriters promise to make “best-efforts” to sell the securities at the agreed-upon offering price ‒ The issuer bear the risk of not being able to sell the entire issue (offer may even be “pulled”)
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IPO: Types of Underwriting • Dutch Auction Underwriting ‒ New to the IPO market but common in the bond market ‒ Investors bid for shares and the offer price is the lowest successful bid ‒ Example (Selling 400 shares using Dutch auction underwriting): Offering price: $12
Bidder (Potential Investor) Bidding Quantity Price Quantity Sold
A 100 shares $16 80 shares B 100 shares 14 80 shares C 200 shares 12 160 shares D 100 shares 12 80 shares E 200 shares 10 0 shares
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IPO: A Few More Concepts • The Aftermath ‒ The period after a new issue is initially sold to the public ‒ Underwriters try to stabilize the price Avoid selling the securities Buy the securities if market price fall below the offering price • The Quiet Period ‒ Starting from the contemplation and ending 40 days after IPO ‒ No analyst recommendation is allowed • Lockup Agreements ‒ Insiders cannot sell their stock within the lockup period (180 days since IPO) • The Green Shoe Provision ‒ Underwriters can purchase additional stocks at the offering price ‒ Usually lasts for 30 days and involves 15% of the newly issued shares
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IPO Underpricing • Basic concept: ‒ When the offering price is lower than the first trading day’s closing price
Country #IPO Period Avg. Initial Return %
Australia 1,562 1976-2011 21.8% China 2,512 1990-2013 118.4% Hong Kong 1,486 1980-2013 15.8% India 2,964 1990-2011 88.4% Japan 3,236 1970-2013 41.7% United Kingdom 4,932 1959-2012 16% United States 12,496 1960-2013 16.9%
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IPO Underpricing
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IPO Underpricing
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IPO Underpricing Potential reasons for IPO underpricing: • Information asymmetry ‒ The “Lemons Problem” or “winner’s curse” • Book building ‒ The underwriters start with a low price to better assess demand and to motivate information revelation for the true price • Underwriter conflicts ‒ Underwriters set lower offering price (and therefore higher initial return) to benefit themselves and their other clients • Managerial conflicts ‒ With lower offering price driving up demand, (large) investors’ demand is not fully satisfied at the beginning, which could allow managers to sell their shares more easily after the lockup period • Litigiousness and regulation concerns ‒ With underpricing, misstatements will not carry claims from investors
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IPO Underpricing: Information Asymmetry Think about the following example: • A firm is issuing 1,200 shares of equity through IPO ‒ The value per share of stock is $10 if the firm is a good one (type G). ‒ The value per share of stock is $0 if the firm is a bad one (type B). • The informed investor knows the type of the firm. • The uninformed investor does not know which type the firm is. ‒ Each state has a 50% probability to occur. ‒ The uninformed investor thinks about the expected value (50%×$10+ 50%×$0=$5). • Each investor could subscribe 1,000 shares of stock Type G Type B Subscription by the informed investor 1,000 0 Subscription by the uninformed investor 500 500
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IPO Underpricing: Information Asymmetry Type G ($10 per share) Type B ($0 per share) Subscription by the informed investor 1,000 0 Subscription by the uninformed investor 500 500 Shares bought by the informed investor 800 0 Shares bought by the uninformed investor 400 500
• For the uninformed investor,
the offering price P must generates non-negative return:
50% × 400 × $10 − 𝑃𝑃 + 50% × 500 × ($0 − 𝑃𝑃) ≥ 0
𝑃𝑃 ≤ $4.44 The expected IPO initial return is: $5 − 1 = 12.6% 𝑃𝑃
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Today’s Roadmap • Venture Capital • Initial Public Offering (IPO) ‒ IPO process ‒ Underwriters ‒ IPO underpricing • Seasoned Equity Offering (SEO) and Price Response
• Textbook Reading: Chapter 15
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SEO and Stock Price Response • Seasoned Equity Offering (SEO): ‒ Issuing additional new stock by firms that are already publicly traded • Positive price response after SEO: ‒ Additional equity issuance suggests additional financial needs, which further suggests good investment opportunities in hand • Negative price response after SEO: ‒ Managerial information: managers choose to issue equity when it is overvalued (when market price is higher than the true value) ‒ Debt usage: new equity issuance may suggest that the firm has already borrowed too much debt (the Pecking Order Theory) ‒ Issue costs: issuing equity is very costly
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