Equity Financing: Venture Capital

Agenda

1. What is equity?

2. Venture capital

3. Staged financing
Equity

• Equity/Stock/Share-holders are considered the corporation’s owners

(voting rights) and are protected by limited liability.
• Equity holders are residual claimants to the firm’s cash flows, entitled
to receive payments from after-tax profits, called dividends, at the
firm’s discretion.

• Broadly, two main types:

• Common Stock
• Preferred Stock – preferential claim to dividends and assets vs. common
stock holders, limited voting rights
Equity Financing for Young Companies

Equity financing for private companies typically occurs in stages. Sources

of financing include:
• Angel Investors
• Venture Capital Firms
• Institutional and Corporate Investors
Venture Capital (VC)

• VC firms belong to the Private Equity (PE) industry. Private equity

funds are limited-duration, closed-end funds that invest primarily in
equity stakes in companies. Typically, PE funds:
• Hold large stakes in private companies,
• Are active in the management of their portfolio firms (eg, board seats)

• PE funds are usually structured as limited partnerships:

• Limited partners (investors, such as pension funds, endowments,
investment funds, corporations, or high net worth individuals) provide most
(∼ 98%) of the capital.
• General partners are responsible for choosing and monitoring the fund’s
investments (‘portfolio firms’).
Types of PE Funds

• Venture Capital funds specialise in financing new firms.

• (Leveraged) Buyout funds specialise in buying mature firms.

• In an LBO, a small group of investors acquires all of a (public or private)
company’s equity.
• The acquisition is financed mostly with debt backed by the target’s assets.
• After the acquisition, the target becomes a private firm with very high
leverage (usually 60%-90% debt ratios).
Staged Financing
• Angel Investors
• Only raw ideas, no product. Size: $50K - $500K

• Seed Capital
• Prototype perhaps, business plan. Size: $1M - $5M

• Early Stage Venture Capital

• Generate revenue, perhaps not profitable. Size > $2M

• Late Stage Venture Capital

• Profitable. Need cash to invest. Size: $5M–$15M

• Mezzanine Stage
• Last stage before VC exit (via eg, IPO). Multiple securities (debt,
convertibles) are often used.
Staged Financing
How do you calculate the ownership for each investor after a new funding round?

• Suppose a VC contributes $X to a startup.

• After contribution, the startup is worth $V (post-money valuation).
• Assume an original investor (OI, eg, 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?

X
VC →
V
 
X
OI → 1− ×s
V
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: → 1
2 = 50%

• VC1: → 1
2 = 50%
Staged Financing: Example
• 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 4.0
Fixed assets 1.0 Equity from 1st stage ??
Other assets 9.0 Your equity ??
Value 14.0 Value 14.0

• VC2: 4
14 = 29%

• VC1: half the old firm → 1

2 × (1 − 29%) ≈ 35% → 5M

• You: → 1
2 × (1 − 29%) ≈ 35% → 5M
VC Exit

How do VCs exit the portfolio firms?

1. Mergers and acquisitions (M&A)

• The start-up is bought by another company.

2. During an IPO: Initial Public Offering

• A company’s equity is available for the public for the first time.
The End
Public Equity Markets: IPOs and SEOs
Agenda

1. IPOs
2. Underwriters
3. IPO Underpricing
4. Seasoned Offerings
5. Rights Issues
Initial Public Offerings (IPOs)

Corporations ‘go public’ when they raise equity finance by selling shares to
the public for the first time through a process called an Initial Public
Offering (IPO).
• 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).
IPO Benefits

• Better access to capital (aided by liquidity and transparency of public

markets).

• Diversify the initial investors.

• Current equity holders usually sell a fraction of their shares, but not a large
fraction. Why not?

• Exit strategy for VCs and other investors.

IPO Costs

• Monetary costs
• Administrative costs
• Underwriting costs (7–11%): This is the fee that Investment Banks charge
for their services.
• Underpricing: IPO (ie, issue) price << day 1 closing price.

• Disclosure requirements

• Loss of control and freedom:

• Dilution of ownership stake and greater regulatory oversight
Underwriters
In a typical IPO, the firm hires an investment bank, who acts as the underwriter. The
underwriter performs a number of functions, including offering advice on the pricing of the
issue, preparation of documents, marketing and selling the shares to selected investors,
and (sometimes) guaranteeing the proceeds of the issue.
IPO Underpricing

1
Source: Prof. Jay Ritter’s website (cited in Berk & DeMarzo)
Money Left on Table in IPOs

2
Source: Prof. Jay Ritter’s website
Seasoned 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 £1.28 billion of new equity.

• The market price is £60/share.

• Lafarge decides to raise additional funds via a 4 for 17 rights offer at

£41 per share.

• If we assume 100% subscription, what is the value of each right?

Right Issue: Example
• For simplicity, suppose there are only 17 shares outstanding. Current market value
of shares is:
17 × £60 = £1, 020
• Total shares after rights issue (100% subscription):

17 + 4 = 21

• Total amount of equity after issue:

£1, 020 + (4 × £41) = £1, 184

• New share price:

1, 184
= £56.38
21
• Value of a right:
56.38 − 41 = £15.38
The End
Debt Financing
Agenda

1. What is debt?

2. Features of corporate debt

Debt

• A loan, basically. Many different types, eg, bank loans, bonds, notes.
• Bonds are long-term securitised loans, ie, can be re-sold.
• Creditors/Debtholders typically receive legally obligated interest
payments (fixed or floating rates), and repayment of principal at
maturity.
• Interest payments are generally paid out of pre-tax profits.
Issuing a bond

• Foreign bond – a local-currency denominated bond that is

issued/sold by a foreign company to investors in the local market.
• Bulldog bond – a £-denominated bond sold by a foreign company in the U.K.
• Similarly, Samurai and Yankee bonds are sold by a foreign firm in Japan
and the US respectively.

• Eurobond – a bond that is underwritten by international bond

syndicates and sold in several national markets in a major non-local
currency (e.g. US dollar).
• Global Bond – very large bond issue that is marketed both
internationally (that is, in the eurobond market) and in individual
domestic markets
Credit Ratings
• Corporate bonds carry credit risk, ie, the possibility of default.
• Agencies (eg, Fitch Investors Service, Moody’s, Standard & Poor’s) provide
ratings to indicate the likelihood of default)
S&P MOODYS GUIDE
AAA Aaa Prime quality, gilt-edged- both coupon
and face value are well protected.
AA+,AA,AA- Aa1,Aa2,Aa3 High grade bonds, only slightly weaker
than AAA.
A+,A,A- A1,A2,A3 Upper medium grade, strong current
protection but could be affected by
adverse future economic conditions.
BBB+,BBB,BBB- Baa1,Baa2,Baa3 Lower medium grade, - current
protection is adequate but there may
be future problems.
BB+,BB,BB- Ba1,Ba2,Ba3 Low grade – speculative, future
payments are not well protected.
B+,B,B- B1,B2,B3 Little protection, speculative.
CCC+,CCC,CCC- Caa, Poor protection, highly speculative.
CC,C Ca,C Very risky, may be in default.
D In Default
UK Credit Spreads
Secured vs. Unsecured debt

• Unsecured: no collateral; backed by the company’s creditworthiness.

• Secured: lender can seize collateral upon default.

• Mortgage bonds: long-term debt secured by a firm’s property
• Asset-backed bonds: securities backed by a portfolio of assets.
Seniority

• Who gets paid first in bankruptcy?

• Senior > Subordinated (Junior)
• Secured > Unsecured
• Debtholders > Equityholders (‘Absolute priority’)

• Why would anyone accept junior debt?

• It is riskier, so the yield is higher.

• Recovery rate: the percentage an investor gets back in bankruptcy.

Recovery Rates
Ultimate Percentage Recovery Rates on Defaulting Debt (1983–2017)

1
Source: Brealey, Myers, and Allen
Repayment Provisions
• Sinking fund
• A sinking fund is a established to retire debt gradually before maturity
• The firm is obligated to make regular payments into the sinking fund.

• Call Provision
• The issuer has the right to repurchase the bond at a specific price (‘call
price’) on or after a specific date (‘call date’).
• Why do firms call and pay back debt early?
• Take advantage of lower interest rates.
• Lower leverage.
• The Yield to Call (YTC) of a callable bond is its yield calculated under the
assumption that the bond will be called on the earliest call date.

• Convertible Provision
• Gives the bondholder the right to convert each bond into a prespecified
number of shares (conversion ratio).
Debt Covenants
Debt covenants contained in a bond contract are restrictions imposed by
bondholders on the activities of the borrower.

• Positive covenants specify actions that the firm must take.

• e.g. the interest coverage ratio must be greater than 3, working capital must
remain above a minimum level, etc.

• Negative covenants limit or forbid actions that the firm may take.
• Debt ratios:
• Senior debt limits senior borrowing
• Junior debt limits senior & junior borrowing
• Dividend restrictions
• Poison put: event-risk protections
• Certain events (eg, a merger) may oblige the borrower to repay the
loan.
The End
Cost of Equity
The Cost of Equity

• We can describe a firm (or a project) as a sequence of uncertain

cash flows.
• Asset cash flows
• Cash flows to securities holders (debt and equity)

• We can summarise the relevant properties of the equity in a firm by:

• A sequence of expected cash flows to equity holders.
• A risk-adjusted discount rate re (the cost of equity).

• Start with the simplest case: an all-equity firm.

Cost of Equity: Example

Consider firm ABC, which is fully financed with equity. There are
N = 10 million shares outstanding, all of them owned by you. Today
you have forecasted expected cash flows (in £million) as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 onwards

Expected cash flow (£m) 0 15 20 29 0

• Suppose you want to sell 1 million shares to an investor who is willing

to pay (at most) P = £5 for each share.
• What is ABC’s cost of equity?
Cost of Equity: Example
• The cost of equity (re ) is the minimum rate of return that
shareholders expect to get in order to buy ABC shares.
• We know that the maximum price investors are willing to pay is
P = £5 per share, and therefore P × N = £50m for all the shares of
ABC (assumption: no price impact).
• Minimum return ⇔ Maximum price. What is the implied expected
return?
• Since investors do not want to lose money, what they are willing to
pay must not be larger than the present value of expected cash flows,
discounted at re :
15 20 29
P × N = 50 ≤ + 2
+
(1 + ke ) (1 + ke ) (1 + ke )3
The Cost of Equity Is the IRR

If equity markets are competitive, re is the internal rate of return (ie, the
value that solves)

15 20 29
−50 + + 2
+ =0
(1 + re ) (1 + re ) (1 + re )3

Which is re = 12% (using Excel! The ‘IRR’ function is probably easiest)

Cost of Equity: Assumptions

• Not many! Note that we did not invoke “market efficiency” or “market
rationality” here.
• No price impact or transaction costs; for simplicity only.

• We assumed that you could forecast expected cash flows.

• Thus re is ABC’s cost of equity as perceived by you.
• However, if there is no disagreement about cash flow forecasts, then re is
the same for all investors.
• We will keep the assumption of symmetric information for simplicity, but it
does not need to hold!
Cost of Equity: Assumptions

• The cost of equity is specific to a stream of cash flows. Discount

rates are project specific.

• re = 12% is ABC’s cost of equity in its current business and

assuming ABC is all-equity financed.
• If ABC changes its business, it will have a different cost of equity.
• If ABC is financed with both debt and equity, then re will be different (more
on this later)
The End
Cost of Debt
The Cost of Debt

• We continue with our example of firm ABC, initially all-equity, with

N = 10 million shares outstanding.
• Suppose now that instead of selling 1 million shares for P = £5 per
share, you decide that ABC should borrow £5m from a bank. You will
use this money to pay a special dividend of £5m to yourself.
• The bank will charge interest of £0.3m per year. Debt will be repaid in
full at the end of Year 3.
ABC’s Cost of Debt
• Creditors do not want to lose money, so what the bank is willing to
lend must not be larger than the present value of expected cash
flows to the bank, discounted at the cost of debt, rd :
0.3 0.3 0.3 + 5
5≤ + 2
+
(1 + rd ) (1 + rd ) (1 + rd )3

• rd is then the internal rate of return of:

0.3 0.3 0.3 + 5

−5 + + 2
+ =0
(1 + rd ) (1 + rd ) (1 + rd )3

• Solving (using Excel), ABC’s cost of debt rd = 6%

Cost of Debt: Assumptions

• We assumed that ABC would not default on its interest payments.

• Thus, the debt is risk-free. In this case, the ABC’s cost of debt
should be the same as that of any other risk-free investment.

• Because the debt is risk-free and it is issued at par (that is, the
market price of debt is equal to its face value, £5m), the cost of debt
is equal to the (risk-free) interest rate on the debt:
• Notice that 6% × 5m = 0.3m, which is the annual interest or coupon.
Risky Debt: An Example

• What if ABC’s debt was risky? Suppose that there is a 10%

probability that ABC will have zero cash flows in Year 3, and the bank
then decides to charge a 10% interest rate to compensate for this
risk.
• Compute the IRR of expected cash flows to debt holders (taking the
probability of default into account).

0.5 0.5 (0.5 + 5) × 90%

−5 + + 2
+ =0
(1 + rd ) (1 + rd ) (1 + rd )3

• Which is rd ≈ 6.56% (and not 10%)

The End
The Company and Asset Costs of Capital
The Company Cost of Capital
• The Company Cost of Capital is the expected return on a portfolio
of all the company’s existing securities.
• For example, if E is the market value of the company’s equity, and D
is the market value of the company’s debt, the company cost of
capital is:
! !
D E
rd + re
D+E D+E

• For reasons that will become apparent later, this is sometimes also
known as the Pre-tax Weighted Average Cost of Capital (Pre-tax
WACC).
The Asset Cost of Capital

• ABC is a combination of assets that generate a stream of (uncertain)

cash flows. What is ABC’s (asset) cost of capital?
• Assuming the company remains all-equity, an investor who owns
100% of the shares of ABC would receive all of ABC’s asset cash
flows.
• We have done this already; we know that the discount rate in this
case is 12%.
The Asset Cost of Capital

• Thus, ABC’s cost of capital is ra = 12%.

• ra is called the asset cost of capital or the unlevered cost of
capital.
• Note that ra is identical to the cost of equity for an all-equity company .
• But in general, if the company is financed with both equity and debt,
then ra ̸= re (more on this later).
The End