Fundamentals of Corporate Finance

Fourth Canadian Edition

Chapter 14
Raising Equity Capital

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Chapter Outline
14.1 Equity Financing for Private Companies
14.2 Taking Your Firm Public: The Initial Public
Offering
14.3 IPO Puzzles
14.4 Raising Additional Capital: The Seasoned Equity
Offering

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Learning Objectives
• Contrast the different ways to raise equity capital for a
private company
• Understand the process of taking a company public
• Gain insight into puzzles associated with initial public
offerings
• Explain how to raise additional equity capital once the
company is public

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14.1 Equity Financing for Private
Companies (1 of 7)
• Sources of Funding:
– A private company can seek funding from several
potential sources:
 Angel Investors
 Venture Capital Firms
 Institutional Investors
 Corporate Investors

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14.1 Equity Financing for Private
Companies (2 of 7)
• Angel Investors:
– Individual investors who buy equity in small private
firms
– The first round of outside private equity financing is
often obtained from angels

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14.1 Equity Financing for Private
Companies (3 of 7)
• Venture Capital Firms:
– Specialize in raising money to invest in the private
equity of young firms
– In return, venture capitalists often demand a great deal
of control of the company

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14.1 Equity Financing for Private
Companies (4 of 7)
• Institutional Investors:
– Pension funds, insurance companies, endowments,
and foundations
 May invest directly
 May invest indirectly by becoming limited partners in
venture capital firms

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14.1 Equity Financing for Private
Companies (5 of 7)
• Corporate Investors:
– Many established corporations purchase equity in
younger, private companies
 Corporate strategic objectives
 Desire for investment returns

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14.1 Equity Financing for Private
Companies (6 of 7)
• Securities and Valuation
– When a company decides to sell equity to outside
investors for the first time, it is typical to issue preferred
stock rather than common stock to raise capital
 It is called convertible preferred stock if the owner can
convert it into common stock at a future date

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Example 14.1: Funding and Ownership
(1 of 8)

• You founded your own firm two years ago. You initially
contributed $100,000 of your money and, in return
received 1,500,000 shares of stock. Since then, you
have sold an additional 500,000 shares to angel
investors. You are now considering raising even more
capital from a venture capitalist (VC).

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Example 14.1: Funding and Ownership
(2 of 8)

• This VC would invest $6 million and would receive 3

million newly issued shares. What is the post-money
valuation? Assuming that this is the VC’s first
investment in your company, what percentage of the
firm will she end up owning? What percentage will you
own? What is the value of your shares?

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Example 14.1: Funding and Ownership:
Plan (3 of 8)
• After this funding round, there will be a total of
5,000,000 shares outstanding:

Your shares 1,500,000

Angel investors’ shares 500,000
Newly issued shares 3,000,000
Total 5,000,000

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Example 14.1: Funding and Ownership:
Plan (4 of 8)
• The VC is paying $6,000,000/3,000,000 = $2/share.
• The post-money valuation will be the total number of
shares multiplied by the price paid by the VC.
• The percentage of the firm owned by the VC is her
shares divided by the total number of shares.

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Example 14.1: Funding and Ownership:
Plan (5 of 8)
• Your percentage will be your shares divided by the
total shares and the value of your shares will be the
number of shares you own multiplied by the price the
VC paid.

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Example 14.1: Funding and Ownership:
Execute (6 of 8)
• There are 5,000,000 shares and the VC paid $2 per
share. Therefore, the post-money valuation would be
5,000,000($2) = $10 million.
• Because she is buying 3,000,000 shares, and there
will be 5,000,000 total shares outstanding after the
funding round, the VC will end up owning
3,000,000/5,000,000 = 60% of the firm.

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Example 14.1: Funding and Ownership:
Execute (7 of 8)
• You will own 1,500,000/5,000,000 = 30% of the firm,
and the post-money valuation of your shares is
1,500,000($2) = $3,000,000.

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14.1 Equity Financing for Private
Companies (7 of 7)
• Exiting an Investment in a Private Company
– Acquisition
– Public Offering

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14.2 Taking Your Firm Public: The Initial
Public Offering (1 of 7)
• The process of selling stock to the public for the first
time is called an initial public offering (IPO)

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14.2 Taking Your Firm Public: The Initial
Public Offering (2 of 7)
• Advantages and Disadvantages of Going Public
– Advantages:
 Greater liquidity
 Better access to capital
– Disadvantages:
 Equity holders more dispersed
 Must satisfy requirements of public companies

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14.2 Taking Your Firm Public: The Initial
Public Offering (3 of 7)
• IPOs include both Primary and Secondary offerings
• Underwriters and the Syndicate
– Underwriter: an investment banking firm that manages
the offering and designs its structure
 Lead Underwriter
– Syndicate: other underwriters that help market and sell
the issue

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14.2 Taking Your Firm Public: The Initial
Public Offering (4 of 7)
• Regulatory Filings
– Registration Statement
 Preliminary prospectus or red herring: Part of the
registration statement prepared by a company prior to an
IPO that is circulated to investors.
 Final Prospectus: Part of the final registration statement
prepared by a company prior to an IPO that contains all
the details of the offering.

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Key Terms and Definitions (1 of 2)
• Underwriter: An investment banking firm that manages
a security issuance and designs its structure.
• Primary offering: New shares available in a public
offering that raise new capital.
• Secondary offering: An equity offering of shares sold
by existing shareholders.

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Key Terms and Definitions (2 of 2)
• Lead underwriter: The primary investment banking
firm responsible for managing a security issuance.
• Syndicate A group of underwriters who jointly
underwrite and distribute a security issuance.
registration statement
• A legal document that provides financial and other
information about a company to investors prior to a
security issuance.

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Example 14.2: Valuing an IPO Using
Comparables (1 of 8)
• Wagner, Inc. is a private company that designs,
manufactures, and distributes branded consumer
products. During the most recent fiscal year, Wagner
had revenues of $325 million and earnings of $15
million. Wagner has filed a registration statement with
the SEC for its IPO.

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Example 14.2: Valuing an IPO Using
Comparables (2 of 8)
• Before the stock is offered, Wagner’s investment
bankers would like to estimate the value of the
company using comparable companies. The
investment bankers have assembled the following
information based on data for other companies in the
same industry that have recently gone public. In each
case, the ratios are based on the IPO price.

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Example 14.2: Valuing an IPO Using
Comparables (3 of 8)
Company Price-Earnings Price-Revenues
Ray Products Corp. 18.8× 1.2×
Byce-Frasier Inc. 19.5× 0.9×
Fashion Industries Group 24.1× 0.8×
Recreation International 22.4× 0.7×
Average 21.2× 0.9×

• After the IPO, Wagner will have 20 million shares

outstanding. Estimate the IPO price for Wagner using
the price/earnings ratio and the price/revenues ratio.

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Example 14.2: Valuing an IPO Using
Comparables: Plan (4 of 8)
• If the IPO price of Wagner is based on a
price/earnings ratio that is similar to those for recent
IPOs, then this ratio will equal the average of recent
deals. Thus, to compute the IPO price based on the
P/E ratio, we will first take the average P/E ratio from
the comparison group and multiply it by Wagner’s total
earnings. This will give us a total value of equity for
Wagner.

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Example 14.2: Valuing an IPO Using
Comparables: Plan (5 of 8)
• To get the per share IPO price, we need to divide the
total equity value by the number of shares outstanding
after the IPO (20 million). The approach will be the
same for the price-to-revenues ratio.

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Example 14.2: Valuing an IPO Using
Comparables: Execute (6 of 8)
• The average P/E ratio for recent deals is 21.2. Given
earnings of $15 million, we estimate the total market
value of Wagner’s stock to be
($15 million)(21.2) = $318 million. With 20 million
shares outstanding, the price per share should be
$318 million/20 million = $15.90.

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Example 14.2: Valuing an IPO Using
Comparables: Execute (7 of 8)
• Similarly, if Wagner’s IPO price implies a
price/revenues ratio equal to the recent average of
0.9, then using its revenues of $325 million, the total
market value of Wagner will be ($325 million)(0.9) =
$292.5 million, or ($292.5/20) = $14.63/share

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14.2 Taking Your Firm Public: The Initial
Public Offering (6 of 7)
• Pricing the Deal and Managing Risk
– Firm Commitment IPO: the underwriter guarantees that
it will sell all of the stock at the offer price
– Over-allotment allocation, or green shoe provision:
allows the underwriter to issue more stock, amounting
to 15% of the original offer size, at the IPO offer price

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14.2 Taking Your Firm Public: The Initial
Public Offering (7 of 7)
• Other IPO Types
– Best-Efforts Basis: the underwriter does not guarantee
that the stock will be sold, but instead tries to sell the
stock for the best possible price
– Auction IPO: The company or its investment bankers
auction off the shares, allowing the market to determine
the price of the stock

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14.3 IPO Puzzles (1 of 5)
• Four IPO puzzles:
– Underpricing of IPOs
– “Hot” and “Cold” IPO markets
– High underwriting costs
– Poor long-run performance of IPOs

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14.3 IPO Puzzles (2 of 5)
• Underpriced IPOs
– For Facebook, the underwriters offered the stock at an
IPO price of $38.00 per share on May 18, 2012.
Facebook stock opened trading on the NASDAQ at a
price of $42.05 per share, and traded as high as $45
before closing at $38.23. This lack of underpricing is
not at all typical.
– When Twitter had its IPO, its stock closed more than
72% above its offer price on its first day of trading.
– Who wins and who loses because of underpricing?

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14.3 IPO Puzzles (3 of 5)
• “Hot” and “Cold” IPO Markets
– It appears that the number of IPOs is not solely driven
by the demand for capital.
– Sometimes firms and investors seem to favor IPOs; at
other times firms appear to rely on alternative sources
of capital

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14.3 IPO Puzzles (4 of 5)
• High Cost of Issuing an IPO
– In the U.S., the discount below the issue price at which
the underwriter purchases the shares from the issuing
firm is 7% of the issue price.
– This fee is large, especially considering the additional
cost to the firm associated with underpricing.

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14.3 IPO Puzzles (5 of 5)
• Poor Post-IPO Long-Run Stock Performance
– Newly listed firms appear to perform relatively poorly
over the following three to five years after their IPOs
– That underperformance might not result from the issue
of equity itself, but rather from the conditions that
motivated the equity issuance in the first place

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14.4 Raising Additional Capital: The
Seasoned Equity Offering (1 of 5)
• A firm’s need for outside capital rarely ends at
the IPO
– Seasoned Equity Offering (SEO): firms return to
the equity markets and offer new shares for sale

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14.4 Raising Additional Capital: The
Seasoned Equity Offering (2 of 5)
• SEO Process
– When a firm issues stock using an SEO, it follows
many of the same steps as for an IPO.

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14.4 Raising Additional Capital: The
Seasoned Equity Offering (3 of 5)
• Two kinds of seasoned equity offerings:
– Cash offer
– Rights offer

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Chapter Quiz (1 of 2)
1. What are the main sources of funding for private
companies to raise outside equity capital?
2. What is a venture capital firm?
3. What services does the underwriter provide in a
traditional IPO?
4. Explain the mechanics of an auction IPO.

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Chapter Quiz (2 of 2)
5. List and discuss four characteristics about IPOs that
are puzzling.
6. For each of the characteristics, identify its relevance
to financial managers.
7. What is the difference between a cash offer and a
rights offer for a seasoned equity offering?
8. What is the typical stock price reaction to an SEO?

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