Subject: Corporate Finance Course Code: MGT 307

Class: BBA 8th Semester

How Corporation Raise Venture Capital and Issue Securities
Venture Capital
The initial public offering
➢ Arranging a public issue
Week 3 & 4
➢ Other new issue procedures
➢ The underwriters
Chapter 15 General cash offer by public companies
➢ General cash offer and shelf registration
➢ Cost of the general cash offer
➢ Market reaction to stock issues
The Private placement

Venture capital: Money invested to finance a new firm.

Equity capital in young businesses is known as venture capital, which is provided by specialist
venture capital firms, wealthy individuals, investment institutions such as pension funds, and
sometimes mature corporations on the hunt for new technology or new products.

Specialist venture capital (or “VC”) firms are the most likely source if your start-up is high risk
and high tech.

It is as hard to convince a venture capitalist to invest in your business.

The first step is to prepare a business plan.

This describes your product, the potential market, the production method, and the resources,
time, money, employees, plant, and equipment needed for success.

It helps if you can point to the fact that you are prepared to put your money where your mouth is.
By staking all your savings in the company, you signal your faith in the business.
The venture capital company knows that the success of a new business depends on the effort its
managers put in.

Therefore, it will try to structure any deal so that you have a strong incentive to work hard.

You are unlikely to persuade a venture capitalist to give you several years of financing all at
once.

Venture capital is rarely disbursed in one large sum payment, but instead is paid to the firm in
stages. Each stage is usually just enough to guide the firm towards its next major checkpoint.

Example: Suppose a Venture Capital firm offers to purchase 1 million of your firm’s shares for
$.50 each, which will give them 50% ownership in the firm.

This will give the VC one-half ownership of the firm: It owns 1 million shares, and you own 1
million shares.

Because the venture capitalist is paying $500,000 for a claim to half your firm, it is placing a $1
million value on the business.

After this first-stage financing, your company’s balance sheet looks like this:

2nd Stage: Receive subsequent staged financing

After two years, you need further financing might involve the issue of a further 1 million shares
at $1 each.

Some of these shares might be bought by the original VC firm and some by other venture capital
firms.
The balance sheet after the new financing would then be as follows:

The value of your initial investment raises to 1 million and because of your success new
investors are prepared to pay $1 to buy a share in the business.

If you could not succeed, the venture capital firm could have refused to put up more funds.

The second-stage investors have paid $1 million for a one-third share in the company.

Venture Capital Companies

Angel Investors: Investors/wealthy individuals who finance firms in their earliest stages of
growth.

Corporate Ventures: Corporations/ large technology firm that offer venture assistance to
finance young and innovative companies. For example, over the past 20 years Intel has invested
in more than 1,300 firms in 56 countries.

Crowdfunding: Some new companies have also used the web to raise money from small
investors. This development, known as crowdfunding

Private Equity Investing: Venture capital partnerships provide funds for companies in distress
or that buy out whole companies and then take them private. The general term for these activities
is private equity investing.
Two rules of success in Venture capital investment:

First, don’t shy away from uncertainty; accept a low probability of success. But don’t buy into a
business unless you can see the chance of a big, public company in a profitable market. There’s
no sense taking a big risk unless the reward is big if you win.

Second, cut your losses; identify losers early, and if you can’t fix the problem—by replacing
management, for example—don’t throw good money after bad.

There’s an old saying in the venture capital business: “The secret of success in VC is not picking
winners, but shutting down the losers before you spend too much money on them.

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The Initial Public Offering

When a firm requires more capital than private investors can provide, it can choose to go public
through an Initial Public Offering (IPO).

➢ Primary Offering: when new shares are sold to raise additional cash for the company.
➢ Secondary Offering: When the company’s founders and venture capitalists cash in on
some of their gains by selling shares. But it does not flow to the company.

Benefits of Going Public:

➢ Enable the existing shareholders to cash out

➢ Ability to raise new capital
➢ Stock price provides performance measure.
➢ Information more widely available
➢ Diversified source of finance.
➢ Reduced borrowing costs.
Arranging Public Issues: Steps to a new public security.

1. SEC Registration: Before any stock can be sold to the public, the company must register
the issue with the Securities and Exchange Commission (SEC).
a. Prospectus – a formal summary that provides information on an issue of securities
2. Select Underwriter/ Undertake Road show: The road show attempts to gauge the
interest that potential investors would have in purchasing the new securities.
If enough public interest, the underwriters issue shares to the public.
Typically, underwriter underprice shares upon issue.
Underpricing – Issuing securities at an offering price set below the true value of
the security.
3. Set final issue price for public.

Underwriter: Firm that buys an issue of securities from a company & resells it to the public.

Underwriters are investment banking firms that act as financial midwives to a new issue.

Usually they play a triple role:

➢ first providing the company with procedural and financial advice,

➢ then buying the stock, and
➢ finally reselling it to the public.

Underwriter Spread:

Spread – the difference between the public offer price and the price paid by underwriter.

Example: Assume the issuing company incurs $1 million in expenses to sell 3 million shares at
$40 each to an underwriter; the underwriter sells the shares at $43 each. What is the spread for
this deal?

3 million (443 - $40) = $9 million

Underwriting Arrangements

Firm Commitment: Underwriter buy the securities from the firm and then resell them to the
public.

Best Efforts Commitment: Underwriters agrees to sell as much of the issue as possible but do
not guarantee the sale of the entire issue.

Underpricing of an IPO
Underpricing: Issuing securities at an offering price set below the true value of the security.

Example: Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40
each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first
day’s trading, the issuing company’s stock price had risen to $70. What is the total cost of
underpricing?

Cost of Underpricing: 3 million ($70 - $43) = $81 million

Floatation Costs:
Flotation Costs: The costs incurred when firm issue new securities to the public.

Example: Direct Cost

➢ legal and administrative fees for preparation of the registration statement

➢ Prospectus cost
➢ Underwriting spread.

Direct Cost

➢ Underpricing

Other New-Issue Procedures

Book building method. The underwriters build up a book of likely orders, buy the issue from
the company at a discount, and then resell it to investors.

Open auction. In this case, investors are invited to submit their bids, stating both an offering
price and how many shares they wish to buy. The securities are then sold to the highest bidders.
The Underwriters
➢ Underwriter are always there whenever a company wishes to raise cash by selling
securities to the public.
➢ Successful underwriting requires considerable experience and financial muscle.
➢ If a large issue fails to sell, the underwriters may be left with a loss of several hundred
million dollars.
➢ Underwriting is not always fun.
➢ Companies get to make only one IPO, but underwriters are in the business all the time.
➢ Wise underwriters will not handle an issue unless they believe the facts have been
presented fairly to investors.
➢ If a new issue goes wrong and the stock price crashes, the underwriters can find
themselves very unpopular with their clients.
➢ “spinning: allocating stock in popular new issues to managers of their important
corporate clients.

General Cash Offers by Public Companies

After the IPO, successful firms may raise money by issuing stock (equity) or bonds (debt).

Seasoned Offering: An issue of additional stock by a company whose stock already is publicly
traded is called a seasoned offering.

➢ Needs to be formally approved by the firm’s board of directors.

➢ Needs consent from shareholders if it requires increase in authorized capital.

Two method of Issue:

General Cash Offer: Sale of securities open to all investors by an already-public company.

Right Issue: Issue of securities offered only to current stockholders at an attractive price.

For example, if the current stock price is $100, the company might offer investors an additional
share at $50 for each share they hold.
General Cash Offers and Shelf Registration

Shelf Registration: A procedure that allows firms to file one registration statement for several
issues of the same security.

Advantages of Shelf Registration:

➢ Security issuance without excessive costs.

➢ Security can be issued on short notice.
➢ Timed issuance to capitalize on favorable market conditions,
➢ The issuing firm can make sure that underwriters compete for its business.

Costs of the General Cash Offer

Following are the firm cost when it makes a cash offer:

➢ Administrative costs.
➢ Underwriter spread

Issue costs are higher for equity than for debt securities. This partly reflects the extra
administrative costs of an equity issue.

In addition, the underwriters demand extra compensation for the greater risk they take in buying
and reselling equity.
Market Reaction to Stock Issues

➢ Issue of new stock in large depress the stock price.

➢ If stock price fall is due to increased supply, then that stock would offer a higher return
than comparable stocks.
➢ However, economist found that the announcement of the issue does result in a decline in
the stock price.

Manager have more information than investors:

If stock undervalued: will benefit new shareholders at the expense of the old shareholders.

If stock is overvalued: Will benefit existing shareholders at the expense of the new ones.

Investor predict that managers issue stock when they think it is overvalued and mark the price of
the stock down accordingly.

Decrease in stock price have noting to do with increase with increased supply, but signal
that well-informed mangers believe the market has overpriced the stock.

The Private Placement

In order to avoid registering with the SEC, a company can issue a security privately.

Private Placement: the sale of securities to a limited number of investors without a public
offering.

Advantages:

➢ Do not have to register with SEC

➢ Private placements cost less than public issues.
➢ Contracts can be customized for each investor

Disadvantages:

➢ Difficult for investors to resell security.

➢ Lenders often require higher return to compensate for higher risk.