Raising Capital

Big Picture

Source: Aswath Damodaran

1
 Outline

• How can a firm raise capital?

üDebt
üEquity
üHybrid Securities
• Benefits and Costs of Debt

How can a Firm Raise Capital?

A) Debt: you promise to make fixed payments in the future (interest payments and
principal). If you fail to make those payments, you lose control of your business.
• Fixed Claim by debtholders
• Fixed Maturity
• Tax impact ?

• Priority in financial trouble?

• Impact on decision-making in company?

2
 How can a Firm Raise Capital?

How to Finance through Debt?

1) Public issue: Issue bonds to the public
2) Private issue: Get a loan from a bank
ü Easier to renegotiate in the event of default than public issues.
vWith public issue there are hundreds of holders that are involved.
ü Less costly to get a loan than issuing corporate bonds

• Pros of corporate bonds over bank loans: cheaper interest rate, flexible loan
condition, less restrictions
5

How can a Firm Raise Capital?

B) Equity: represents ownership.

• Residual claim: investor gets whatever cash flows are left over after debt holders
are paid
• Infinite life
• Tax impact?

• Priority in financial trouble?

• Impact on decision-making in company?

3
 How can a Firm Raise Capital?

How to Finance through Equity?

1) Owner’s equity
2) Retained Earnings
3)Sell equity to venture capital firms
4) Sell equity to private equity firms
5) Issue Common Stock
ü Public Issue: IPOs; Seasoned Equity Offerings
ü Private Issue
6) Issue Warrants: holders receive the right to buy shares in the company at a fixed price
sometime in the future.

Equity - Venture Capital and Private Equity Firms

• Provide financing in exchange for equity.

• Often participate in running the firm.
• Eventually exit, once the company grows in value.
üHow do they exit?
vSell the company to another company
vTake the company public (IPO)
vLiquidate the firm
üThe gains from exit are distributed to investors as returns

4
 Equity - Venture Capital and Private Equity Firms
• Venture Capital (i.e. Sequoia Capital, Andreessen Horrowitz, Accel etc.) :
Invest in early stage/start up companies with long term growth potential
ü The companies generally tend to have negative cash flows
ü They focus on companies in technology and software industries
ü Size of typical investment is $50,000 to $5 mio
• Private Equity (i.e. Apollo, Blackstone, BlackRock, KKR, Carlyle Group etc.):
Invest in mature but financially distressed companies
ü They restructure and turn around the business
ü They focus on companies in energy, paper & pulp manufacturing
ü Size of typical investment is $2 mio to above $200 mio

Equity - Issue Common Stock

• Public Issue: The firm is required to register the issue with the SEC.
üTwo types:
vInitial Public Offering (IPO): Sell common stock to the public the first time
Ø Benefits of going public: Greater access to capital markets
Ø Costs of going public: loss of control, increased disclosure requirements,
transactions costs of going public
vSeasoned Equity Offerings: A new equity issue of securities by a company that has
previously issued securities to the public.
üTwo basic kinds of public issue:
v Cash offer: securities offered for sale to the general public on a cash basis.
v Rights offer: public issue in which securities are first offered to existing
shareholders at a discount.
10

10

5
 Equity - Issue Common Stock

• Private Issue: A registration statement is not required.

üIf the issue is to be sold fewer than 35 investors, the sale can be carried
out privately.
üIt is less costly than public issue because there is no need for underwriter
marketing or SEC filing etc

11

11

The Process of Selling Securities to the Public

• Management must obtain permission from the Board of Directors.
• Management chooses an underwriter (investment banker).
üFocus on investment banker’s experience with your sector and whether you can
benefit from their client base and reputation.
üBecause underwriting involves risk, underwriter forms a syndicate (a group of
investment banks) to market the securities and to share the risk associated with
selling the issue.

• Firm must file a preliminary registration statement (prospectus) with the SEC .
üDescribes the issue and prospects of the company (financial history, details of
business etc.)
12

12

6
 The Process of Selling Securities to the Public
• The SEC examines the registration during a 20-day waiting period.
üDuring the waiting period
vThe security can’t be sold
vMay distribute copies of preliminary prospectus to potential investors
vInvestment banks understand potential investor demand for the security through
book-building (do road shows and talk to potential buyers and prepare a book
listing the price and the number of shares investors would purchase at that
particular price)
• Once registration is approved, the price at which the securities will be offered to the
public is announced
• The issuing firm receives: public offer price less spread (underwriting fee) excluding other
costs related with the issue
13

13

Types of Underwriting
• Three basic types of underwriting
üFirm Commitment underwriting
üBest Efforts Underwriting
üDutch Auction Underwriting

14

14

7
 Firm Commitment Underwriting Best Efforts Underwriting

• Issuer sells entire issue to underwriting • The syndicate makes their “best
syndicate effort” to sell the securities at an
• The syndicate then resells the issue to the agreed-upon offer price
public at the offer price and makes money • The company bears the risk of the
on the spread issue not being sold
• The syndicate bears the risk of not being ü In case the issue is not sold, the
able to sell the entire issue for more than company does not get the capital,
the cost but they still pay the underwriting
• Most common type of underwriting in the fees to the underwriter
United States • Not as common as it previously was

15

15

Dutch Auction Underwriting

• Underwriter accepts a series of bids that include number of shares and
price per share
• The price that everyone pays is the highest price that will result in all
shares being sold
• There is an incentive to bid high to make sure you get in on the auction
but knowing that you will probably pay a lower price than you bid
• Ex: The Treasury has used Dutch auctions for years
• Ex: Google was the first large Dutch auction IPO

16

16

8
 Question: Dutch Auction Underwriting
If you issue 600 shares into the market:
Bidder Quantity Price
A. Bidder A purchases 200 shares at $22
B. Bidder A purchases 200 share at $18 A 200 22

C. Bidder B purchases 300 shares at $20 B 300 20

D. Bidder C purchases 100 shares at $17 C 100 18
D 50 17

If you issue 400 shares into the market: E 200 16

A. Bidder A purchases 140 shares at $22 F 500 15
B. Bidder A purchases 200 share at $20
C. Bidder B purchases 220 shares at $20
D. Bidder A purchases 160 shares at $20

17

17

IPO Underpricing

• Generally, the securities are underpriced

üIf the offering price is set too high,
v it may be unsuccessful and have to be withdrawn
v even if it is sold, the new stockholders may file a lawsuit
• Underpricing causes the issuer to “leave money on the table”
• Ex: General Motors IPO in 2010 opened at $33 and rose to a high of
$35.99 on the first day and closed the day with $34.19. How much
money is left on the table?

18

18

9
 Costs of Issuing Equity
When issuing equity, firms have to consider issuance costs:
• Spread (underwriting commission): The difference between the price the issuer (company)
receives and the offer price.
üWith the Facebook IPO: Morgan Stanley initially sold shares at $38 in the market (offer
price). At the same time they bought shares from the company (issuer) at $37.582. The
difference is the spread.
• Other direct expenses : legal fees, filing fees, cost of preparing registration statements etc.
• Indirect expenses : opportunity costs, i.e., management time spent working on issue.
• Underpricing: for IPOs, losses arise from selling stocks below the true value.
• Abnormal returns : in a seasoned issue of stock, the price on existing stock drops.
üWhy? Signaling
vManagers tend to issue new stocks when market value is over the true value.
vCompany holds too much debt or cannot have access to liquidity.
19

19

How can a Firm Raise Capital?

C) Hybrid Securities: They share some characteristics with equity and some with
debt.
How to Finance through Hybrid Securities?
1) Issue Convertible Bond
2) Issue Preferred Stock
3) Issue Option linked Bonds

20

20

10
 Hybrid Securities - Convertible Bonds
• A convertible bond gives the bondholder the right to exchange the bond for a specified
number of shares of equity.

• Benefit: allows the bondholder to take advantage of increases in stock prices

• Issued at a lower coupon rate than nonconvertible bonds

• The conversion ratio gives the number of shares for which each bond may be exchanged

QUESTION: A bond currently trading at par of $1000 has a conversion ratio of 40 shares. If
the shares are trading at $20 per share, will you convert your bonds into common stock?
How about $30?

21

21

Hybrid Securities - Preferred Stock

• Dividend payments are the same from year to year and they are paid into perpetuity
• It has characteristics in between a debt and an equity
üUnlike equity:
vNo ownership interest and hence no saying in electing board of directors and
no indirect saying in choosing managers
üUnlike debt:
vEven though the company has made a promise to pay dividends, it is not
obliged to do. If a company doesn’t pay dividends, it will not go bankruptcy.
vThey are not tax deductible. They come out after-tax cash.
• In the event of bankruptcy:
üJunior (Second) to debt holders on claim on company’s assets
üSenior to common stock holders.
22

22

11
 Hybrid Securities - Option Linked Bonds
• Commodity Linked Bonds: Commodity companies issue bonds linking principal
and coupon payments to the price of the commodity. If commodity price
increases, coupon payments increase.
üBenefit for the company is that it tailors the cash flows on the bond to the
cash flows of the firm and reduces the likelihood of default.
• Catastrophe Bonds: Insurance companies issue bonds where the principal on the
bond is reduced or coupon payment is suspended in the case of a pre-specified
catastrophe.
üBenefit for the company: it creates flexibility to the insurance company when
a catastrophe creates huge cash outflows for the company.
23

23

Financing Behavior over Life Cycle

24

24

12
 Financing Mix

• Is there an optimal mix of debt and equity?

üIf yes, what is the trade off that lets us determine this optimal mix?
vBenefits of using debt instead of equity: Tax benefit, added discipline
vCosts of using debt instead of equity: Bankruptcy cost, agency cost,
loss of flexibility

25

25

Benefits of Debt
• The cost of debt is lower than the cost of equity because equity is more risky since the
equity investor has the last claim on company’s assets in the case of bankruptcy.
• Tax Benefits: interest payments are tax deductible in most parts of the world, resulting in
a tax saving for firms, while dividends are not tax deductible.
üImplication: The higher the marginal tax rate of a business, the more debt it will have
in its capital structure.

üQUESTION: You are comparing the debt ratios of real estate corporations, which pay
the corporate tax rate, and real estate investment trusts, which are not taxed, but are
required to pay 95% of their earnings as dividends to their stockholders. Which of
these two groups would you expect to have the higher debt ratios?
26

26

13
 Benefits of Debt Continued

• Adds discipline to management:

üIf managers have substantial cash flows and low or no debt, they may take
negative NPV projects since they have a large cushion against mistakes.
üDebt acts as a discipline and the commitment to make interest and principal
payments increases the incentive for management to take positive NPV projects
üLenders (banks, etc.) act as monitors by serving on firm’s board of directors, etc.
üImplication: As the separation between managers and stockholders increases,
the benefits to using debt will go up.

27

27

Question – Disciplining Mechanism

• Assume that you buy into this argument that debt adds discipline to
management. Which of the following types of companies will most benefit from
debt adding this discipline?
a. Conservatively financed (very little debt), privately owned businesses
b. Conservatively financed, publicly traded companies, with stocks held by
millions of investors, none of whom hold a large percent of the stock.
c. Conservatively financed, publicly traded companies, with an activist investor.

28

28

14
 Costs of Debt
• Bankruptcy Costs: Borrowing money will increase your expected probability and cost of bankruptcy.
Expected bankruptcy cost = Cost of bankruptcy × Prob. of bankruptcy
üExample: If the estimated bankruptcy cost is $500 (mil), and the probability of bankruptcy is 5%,
then the expected bankruptcy cost is $500 ×5% = $25 (mil)
• Costs of Bankruptcy:
üDirect costs: Legal and administrative costs
vIn 1992, Macy’s Chapter 11 bankruptcy, at least $100 million (2 to 3 percent of Macy’s value)
üIndirect costs: Costs incurred due to disruption of normal activities
vCustomers may stop buying the product or service because they are concerned about
receiving service or parts
Øe.g., Chrysler in 1980 and Continental Airlines in 1980s.
vFirm’s suppliers may stop extending favorable financing terms
vFirm could lose precious human capital

29

29

Costs of Debt
Implication:
• Firms with more volatile earnings and cash flows will borrow less since they have
higher probabilities of bankruptcy at any given level of earnings.
• Firms with greater bankruptcy costs, will borrow less for any given level of earnings.
QUESTION:

• Rank the following companies on the magnitude of bankruptcy costs from most to
least, taking into account both explicit and implicit costs:

a. A Grocery Store
b. An Airplane Manufacturer

c. High Technology company

30

30

15
 Costs of Debt
• Agency Costs: What’s good for stockholders is not always what’s good for lenders and
that creates costs.
ü You (as lender) are interested in getting your money back.
ü Stockholders are interested in maximizing their wealth.
• In some cases, the clash of interests can lead to stockholders
üInvesting in riskier projects than you would want them to.
üPaying themselves large dividends when you would rather have them keep the cash
in the business.
Implication:
• Firms where lenders can monitor/control how their money is being used (less agency
conflict) should be able to borrow more than firms where this is difficult to do.
31

31

Question – Agency Costs

• Assume that you are a bank. Which of the following businesses would
you perceive the greatest agency costs?
a. A Technology firm
b. A Large Regulated Electric Utility
c. A Real Estate Corporation

• Why?
32

32

16
 Costs of Debt
• Loss of Future Flexibility: When a firm borrows up to its capacity, it loses the
flexibility of financing future projects with debt. This will be disastrous especially
if you need funds but you cannot access capital markets.

Implications:
• Firms that can better forecast future funding needs will be willing to borrow more
today.
• Firms with better access to capital markets will be willing to borrow more today.
• Otherwise, save up your capacity for rainy days.
33

33

17