Master in Finance

Corporate Financing Planning

3. Raising Equity Capital

Bibliography
- Berk and DeMarzo (2011) Ch 23 pages 866-901
- Damodaran (2001) Ch 16 and 17 pages 481-498 and 509-
536
Outline
1. Sources of Funding: Debt-Equity and Internal-External
2. Equity Financing for Private Companies
3. The Initial Public Offering
4. Equity Choices for Publicly Traded Firms
5. The Seasoned Equity Offering
Learning Objectives
1. Describe the ways in which a private company can raise equity.
2. Discuss the effects of a company founder selling stock to an
outsider.
3. Identify the two main exit strategies used by equity investors in
private companies.
4. Define an initial public offering, and discuss their advantages
and disadvantages.
5. Distinguish between primary and secondary offerings in an
IPO.
6. Describe typical methods by which stock may be sold during
an IPO; discuss risks for parties involved in each method.
Learning Objectives
7. Evaluate the role of the underwriter in an IPO.
8. Describe the IPO process, including the methods underwriters
use to value a company before its IPO.
9. Identify ways in which underwriters can mitigate risk during an
IPO.
10. List and discuss the puzzles associated with IPOs.
11. Define a seasoned equity offering, describe two ways in which
they are brought to market, and identify the stock price
reaction to the announcement of a seasoned equity offering.
3.1. Sources of Funding: Debt versus Equity
Equity Debt
Type of Claim Dividends Interest and principal
(residual claim) payments (fixed claim)

Tax Law Not tax deductible Tax deductible

Degree of Control Complete No management

management control control (passive role)

Commitment to make Lowest priority on High priority on cash-

payments cash-flows and assets flows and assets

Maturity Infinite life Fixed maturity

3.1. Sources of Funding: Debt versus Equity
Any financing that shares characteristics of debt and equity
is defined as hybrid securities:
• Convertible bonds
• Preferred Stocks
3.1. Sources of Funding: Internal versus External

- External Funds:
- For private firms, they are typically difficult to raise and
they lead to a lost of control and flexibility
- For publicly traded firms, they are easier to raise but very
expensive in terms of issuing cost and lead to a lost of
flexibility
- Internal Funds
- Firms can use them without incurring large transactions
costs or losing flexibility
- There are limits to their use: internal equity has the same
cost as external equity
3.2. Equity Financing for Private Companies
• The initial capital that is required to start a business is
usually provided by the entrepreneur and their immediate
family.
• Often, a private company must seek outside sources that can
provide additional capital for growth.
– It is important to understand how the infusion of outside
capital will affect the control of the company.
A. Sources of Funding

Initial Capital Subsequent Capital

• Founder • Retained Earnings (Internal Financing)
• Friends • External Financing
• Family • Private Firms
• Venture Capital
• Angel Investors
• Institution Investors
• Corporate Investors
• Public Firms
• Private Equity
• IPO and SEO
A. Sources of Funding
• Angel Investors
– Individual Investors who buy equity in small private firms
• Finding angels is typically difficult.

• Venture Capital Firm

– A limited partnership that specializes in raising money to
invest in the private equity of young firms
A. Sources of Funding: Venture Capital
• Venture capital firms offer limited partners advantages
• Limited partners are more diversified.
• They also benefit from the expertise of the general partners.

• The advantages come at a cost: general partners usually

charge substantial fees to run the business.
• Most firms charge 20% of any positive return they make
(carried interest).
• They also charge an annual management fee of about 2% of
the fund’s committed capital.
A. Sources of Funding: Venture Capital

Venture Capital Model

• Forecast earnings when a firm is expected to go public
• Define a price-earnings multiple to estimate at the time
of the IPO – exit or terminal value

𝑬𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝑬𝒙𝒊𝒕 𝑽𝒂𝒍𝒖𝒆𝒔

𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝑻𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆 =
𝟏 + 𝑻𝒂𝒓𝒈𝒆𝒕 𝒓𝒆𝒕𝒖𝒓𝒏 𝒌
Example
Assume that a firm is expected to have an IPO in 3 years
and that the net income in 3 years is expected to be $4
million. The price-earnings ratio of publicly traded firms in
the same industry is 25. The target return of the venture
capitalist is 30%.
If the venture capitalist is considering investing $12
million, determine the ownership proportion that he/she
will want.
Solution

$𝟏𝟎𝟎
𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝑻𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆 = 𝟑
𝟏 + 𝟑𝟎%
= $𝟒𝟓. 𝟓𝟐 𝒎𝒊𝒍𝒍𝒊𝒐𝒏

$𝟏𝟐
𝑶𝒘𝒏𝒆𝒓𝒔𝒉𝒊𝒑 𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏 = = 𝟐𝟔. 𝟑𝟔%
$𝟒𝟓. 𝟓𝟐
A. Sources of Funding
• Institutional Investors
– pension funds, insurance companies, endowments, and
foundations
• Institutional investors may invest directly in private firms or they
may invest indirectly by becoming limited partners in venture
capital firms.
A. Sources of Funding
• Corporate Investor
– A corporation that invests in private companies
– Also known as Corporate Partner, Strategic Partner, and
Strategic Investor
– Invest for corporate strategic objectives, in addition to the
financial returns.
B. Outside Investors
• Preferred Stock
– issued by young companies has seniority in any liquidation
but typically does not pay regular cash dividends and
often contains a right to convert to common stock -
converted preferred stock:
– Preferred stock that gives the owner an option to convert it
into common stock on some future date
B. Outside Investors
• Pre-Money Valuation
– At the issuance of new equity, the value of the
firm’s prior shares outstanding at the price in the funding
round

• Post-Money Valuation
– At the issuance of new equity, the value of the whole firm
(old plus new shares) at the price the new equity sold
Example
• You founded your own firm two years ago.
• Initially, you 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.
• The venture capitalist has agreed to invest $6
million with a post-money valuation of $10 million
for the firm.
Example

– Assuming that this is the venture capitalist’s first investment in your

company, what percentage of the firm will he end up owning?

– What percentage will you own?

– What is the value of your shares?

Textbook Example 23.1 (2 of 2)
Solution
Because the VC will invest $6 million out of the $10 million post-money
valuation, her ownership percentage is

6 = 60%.
10
From Eq. 23.1, the pre-money valuation is 10 − 6 = $4 million. As there are 2
million pre-money shares outstanding, this implies a share price of
$4 million
= $2 per share.
2 million shares
Thus, the VC will receive 3 million shares for her investment, and after this
funding round, there will be a total of 5,000,000 shares outstanding. You will
own
1,500,000 = 30%.
5,000,000
of the firm, and the post-transaction valuation of your shares is $3 million.
C. Exit Strategies
• How investors will eventually realize the return from their
investment:
• IPO initial public offering
• Sell the private firm to another firm
• Withdraw cash-flows and liquidate the firm

The main disadvantage of holding stocks of a private

company is that investors could not liquidate their
investment by selling their stock in the public stock markets.
3.3. Initial Public Offering (IPO)
– The process of selling stock to the public for the first time.
ADVANTAGES DISADVANTAGES
–Greater liquidity –Loss of control: the equity
•Private equity investors get holders become more widely
the ability to diversify.
dispersed.
–Better access to capital • This makes it difficult to
•Public companies have access monitor management.
larger amounts of capital
–The firm must satisfy all
through the public markets.
information disclosure and legal
–Owners are able to cash in on requirements
their success
–Investor relations
3.3. IPO: Types of Offering
• Underwriter
– An investment banking firm that manages a security
issuance and designs its structure
1. Primary and Secondary Offerings
– Primary Offering
• New shares available in a public offering that raise new capital

– Secondary Offering
• Shares sold by existing shareholders in an equity offering (part of
the exit strategy)
3.3. IPO: Types of Offering
2. Best-Efforts, Firm Commitment and Auction IPOs
– Best-Efforts Basis
• For smaller IPOs, a situation in which the underwriter does not
guarantee that the stock will be sold, but instead tries to sell the
stock for the best possible price
– Often such deals have an all-or-none clause: either all of the shares
are sold on the IPO or the deal is called off.
3.3. IPO: Types of Offering
2. Best-Efforts, Firm Commitment and Auction IPOs
– Firm Commitment
• An agreement between an underwriter and an issuing firm in
which the underwriter guarantees that it will sell all of the stock at
the offer price

– Auction IPO
• A method of selling new issues directly to the public
– Rather than setting a price itself and then allocating shares to
buyers, the underwriter in an auction IPO takes bids from investors
and then sets the price that clears the market.
Auction IPO Pricing
Problem
Fleming Educational Software, Inc., is selling 500,000 shares of stock in
an auction IPO. At the end of the bidding period, Fleming’s investment
bank has received the following bids:
Price($) Number of Shares Bid
8.00 25,000
7.75 100,000
7.50 75,000
7.25 150,000
7.00 150,000
6.75 275,000
6.50 125,000

What will the offer price of the shares be?

Textbook Example 23.3 (2 of 3)
Solution
First, we compute the total number of shares demanded at or
above any given price:

Price ($) Cumulative Demand

8.00 25,000
7.75 125,000
7.50 200,000
7.25 350,000
7.00 500,000
6.75 775,000
6.50 900,000
For example, the company has received bids for a total of 125,000 shares at
$7.75 per share or higher (25,000 + 100,000 = 125,000).
Fleming is offering a total of 500,000 shares. The winning auction price would
be $7 per share, because investors have placed orders for a total of 500,000
shares at a price of $7 or higher. All investors who placed bids of at least this
price will be able to buy the stock for $7 per share, even if their initial bid was
higher.
In this example, the cumulative demand at the winning price exactly equals the
supply. If total demand at this price were greater than the supply, all auction
participants who bid prices higher than the winning price would receive their
full bid (at the winning price). Shares would be awarded on a pro rata basis to
bidders who bid exactly the winning price.
3.3. IPO: The Mechanics of an IPO
• Underwriters and the Syndicate
– 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
3.3. IPO: The Mechanics of an IPO
• SEC Filings
– Registration Statement
• A legal document that provides financial and other information
about a company to investors prior to a security issuance

– Preliminary Prospectus (Red Herring)

• Part of the registration statement prepared by a company prior to
an IPO that is circulated to investors before the stock is offered

– Final Prospectus
• Part of the final registration statement prepared by a company
prior to an IPO that contains all the details of the offering,
including the number of shares offered and the offer price
3.3. IPO: The Mechanics of an IPO
• Valuation
• Compute the present value of the estimated future
cash flows (discount cash-flow models).
• Estimate the value by examining multiples based on
recent IPOs or already publicly traded firms.
Textbook Example 23.4 (1 of 2)
Valuing an IPO Using Comparables
Problem
Wagner, Inc. is a private firm that manufactures specialty industrial lasers. Wagner
forecasts revenues of $320 million and earnings before interest and taxes (EBIT) of $15
million this year. Wagner has filed a registration statement with the SEC for its IPO.
Wagner’s investment bankers have assembled the following information based on data
for other companies with similar growth prospects in the same industry that have
recently gone public. In each case, the multiples are based on the IPO price.

Company Enterprise Value/EBIT Enterprise Value/Sales

Ray Products Corp. 18.8× 1.2×
Byce-Frasier, Inc. 19.5× 0.7×
Fire Industries 25.3× 0.8×
Mean 21.2× 0.9×

Wagner currently has 20 million shares outstanding, $10 million in cash and no debt.
Wagner plans to raise $80 million in its IPO. Estimate the IPO price range for Wagner
using these multiples.
Textbook Example 23.4 (2 of 2)
Solution
Given EBIT of $15 million, and applying the average multiple above, we
estimate Wagner’s current enterprise value to be $15 million × 21.2 = $318
million. Adding existing cash, and dividing by current shares outstanding, we
estimate a share price of $328 ÷ 20 = $16.40. (Note that we can evaluate both
the cash and shares on a pre-IPO basis.)
Similarly, using the enterprise value/Sales multiple, given its revenues of $325
million, Wagner’s estimate enterprise value is $320 million × 0.9 = $288 million,
implying a share price of ($288 + 10)/20 = $14.90.
Based on these estimates, the underwriters might establish an initial price
range for Wagner stock of $13 to $17 per share to take on the road show.
3.3. IPO: The Mechanics of an IPO
Road Show
• During an IPO, when a company’s senior management
and its underwriters travel around promoting the company
and explaining their rationale for an offer price to the
underwriters’ largest customers, mainly institutional
investors such as mutual funds and pension funds
Book Building
• A process used by underwriters for coming up with an
offer price based on customers’ expressions of interest
3.3. IPO: The Mechanics of an IPO
• Pricing the Deal and Managing Risk
– Spread
• The fee a company pays to its underwriters that is a percentage of
the issue price of a share of stock
– For RealNetworks, the final offer price was $12.50 per share and the
company paid the underwriters a spread of $0.875 per share,
exactly 7% of the issue price.
– Since this was a firm commitment deal, the underwriters bought the
stock from RealNetworks for $11.625 per share and then resold it to
their customers for $12.50 per share.
– $12.50 − $0.875 = $11.625
3.3. IPO: The Mechanics of an IPO
• Pricing the Deal and Managing Risk
– Over-Allotment Allocation (Greenshoe Provision)
• option that allows the underwriter to issue more stock, usually
amounting to 15% of the original offer size, at the IPO offer price
– Underwriters initially market both the initial allotment and
the allotment in the greenshoe provision by short selling
the greenshoe allotment.
• If the issue is a success, the underwriter exercises the greenshoe
option, thereby covering its short position.
• If the issue is not a success, the underwriter covers the short
position by repurchasing the greenshoe allotment in the
aftermarket, thereby supporting the price.
3.3. IPO: The Mechanics of an IPO

• Pricing the Deal and Managing Risk

– Lockup
• A restriction that prevents existing shareholders from
selling their shares for some period, usually 180 days,
after an IPO
3.3. IPO: IPO Puzzles
1. On average, IPOs appear to be underpriced. The price at the
end of trading on the first day is often substantially higher than
the IPO price

2. The number of issues is highly cyclical: when times are good,

the market is flooded with new issues

3. The costs of an IPO are very high, and it is unclear why firms
willingly incur them

4. The long-run performance of newly public company (3-5 years

after the date of issuing) is poor.
3.3. IPO: IPO Puzzles - Underpricing
Underwriters set the issue price so that the average first-day
return is positive.
•research has found that 75% of first-day returns are
positive; the average first day return in the U.S is 17%.

Who benefit from the underpricing? The underwriters and the

investors who are able to buy stock from underwriters at the IPO
price
• The pre-IPO shareholders bear the cost of underpricing
because these owners are selling stock in their firm for
less than they could get in the aftermarket.
3.3. IPO: IPO Puzzles Why don’t all investors invest in IPO?
• When an IPO goes well, the demand for the stock exceeds the
supply. Thus the allocation of shares for each investor is rationed.

• When an IPO does not go well, demand at the issue price is weak, so all
initial orders are filled completely.

• Thus, the typical investor will have their investment in “good”

IPOs rationed while fully investing in “bad” IPOs.
• Winner’s Curse:
• Refers to a situation in competitive bidding when the high bidder,
by virtue of being the high bidder, has very likely overestimated
the value of the item being bid on.
• Adverse selection form: You “win” (get all the shares you
requested) when demand for the shares by others is low, and the
IPO is more likely to perform poorly.
Textbook Example 23.5 (1 of 4)
IPO Investors and the Winner’s Curse: Problem
Thompson Brothers, a large underwriter, is offering its customers the following
opportunity:
Thompson will guarantee a piece of every IPO it is involved in. Suppose you are a
customer. On each deal, you must commit to buying 2000 shares.
If the shares are available, you get them. If the deal is oversubscribed, your
allocation of shares is rationed in proportion to the oversubscription.
Your market research shows that typically, 80% of the time, Thompson’s deals are
oversubscribed 16 to 1 (there are 16 orders for every 1 order that can be filled), and
this excess demand leads to a price increase on the first day of 20%.
However, 20% of the time, Thompson’s deals are not oversubscribed, and while
Thompson supports the price in the market (by not exercising the greenshoe
provision and instead buying back shares), on average, the price tends to decline by
5% on the first day.
Based on these statistics, what is the average under-pricing of a Thompson IPO?
What is your average return as an investor?
Textbook Example 23.5 (2 of 4)
Solution
First, note that the average first-day return for Thompson
Brothers deals is large: 0.8(20%) + 0.2(−5%) = 15%. If Thompson
had one IPO per month, after a year you would earn an annual
return of

1.1512 − 1 = 435%!
In reality, you cannot earn this return. For successful IPOs you will
earn a 20% return, but you will only receive
2000
= 125 shares.
16
Textbook Example 23.5 (3 of 4)
Assuming an average IPO price of $15 per share, your profit is

$15 per share × (125 shares ) × ( 20% return ) = $375

For unsuccessful IPOs you will receive your full allocation of 2000
shares. Because these stocks tend to fall by 5%, your profit is

$15 per share × ( 2000 shares ) × ( −5% return ) = − $1500

Textbook Example 23.5 (4 of 4)
Because 80% of Thompson’s IPOs are successful, your average
profit is therefore
0.80 ( $375 ) + 0.20 ( −$1500 ) = $0

That is, on average you are just breaking even! As this example
shows, even though the average IPO may be profitable, because
you receive a higher allocation of the less successful IPOs, your
average return may be much lower. Also, if Thompson’s average
under pricing were less than 15%, uninformed investors would
lose money and be unwilling to participate in its IPOs.
3.3. IPO: IPO Puzzles - Cyclicality
• The number of issues is highly cyclical.
– When times are good, the market is flooded with new
issues; when times are bad, the number of issues dries
up.
3.3. IPO: IPO Puzzles - Cost of IPO
• A typical spread is 7% of the issue price.
– By most standards this fee is large, especially considering
the additional cost to the firm associated with
underpricing.
– It is puzzling that there seems to be a lack of sensitivity of
fees to issue size.
• One possible explanation is that by charging lower fees, an
underwriter may risk signaling that it is not the same quality as its
higher-priced competitors.
3.3. IPO: IPO Puzzles - Long-Run Underperformance
• Although shares of IPOs generally perform very well
immediately following the public offering, it has been
shown that newly listed firms subsequently appear
to perform relatively poorly over the following three
to five years after their IPOs.
Initial Coin Offering (ICO) : CrowdSales
• An unregulated means by which funds are raised for a new
cryptocurrency venture
• bypass the rigorous and regulated capital-raising process required by
venture capitalists or banks.
• IPO and Crowfunding
Start-Up Wants to raise money through ICO
• Whitepaper plan: states what the project is about, what
need(s) the project will fulfill upon completion, how much
money is needed to undertake the venture, how much of the
virtual tokens the pioneers of the project will keep for
themselves, what type of money is accepted, and how long the
ICO campaign will run for.
• Enthusiasts and supporters buy some of the distributed
cryptocoins (tokens) with fiat or virtual currency.
• similar to shares of a company sold to investors in IPO.
Start-Up Wants to raise money through ICO
• If the money raised does not meet the minimum funds required
by the firm, the money is returned to the backers and the ICO
is deemed to be unsuccessful. If the funds requirements are
met within the specified timeframe, the money raised is used to
either initiate the new scheme or to complete it.
• Motivation to buy the cryptocoins: the plan becomes successful
after it launches -> higher cryptocoin value than what they
purchased it for before the project was initiated.
3.4. Equity Choices for Publicly Traded Firms: Sources
When firm decides to go public, it has a number of
alternatives:
• Common Stock
• The price is defined by current market price
• Different classes of common stock will provide different
cash flows and voting rights.
Examples:
• Class A: cash dividends and Class B: stock dividends
• Class A: 2 votes per share and Class B: 1/5 vote per share
3.4. Equity Choices for Publicly Traded Firms: Sources
• Warrants
• option to buy shares in the firm at fixed price in the
future, in return of paying for the warrant today.
• another form of equity, particularly high-growth firms

• Contingent Value Rights

• right to sell stocks for a fixed price
• similar to a put option
3.4. Equity Choices for Publicly Traded Firms: Sources
• Private Equity Firms
– Organized like a venture capital firm, these firms invest in
the equity of existing privately held firms.
– Find a publicly traded firm and purchase the outstanding
equity
– Leveraged buyout (LBO): When a group of private
investors purchase all the equity of a public
corporation and finances the purchase primarily with
debt
3.5. The Seasoned Equity Offering (SEO)
– When a public firms offers new shares for sale to raise
additional equity.
– It follows many of the same steps as for an IPO.
– The main difference is that a market price for the stock
already exists, so the price-setting process is not
necessary.
A. Mechanism of a SEO
• Primary Shares
– New shares issued by a company in an equity offering

• Secondary Shares
– Shares sold by existing shareholders in an equity offering
B. Types of SEO
There are two types of seasoned equity offerings.
– Cash Offer
• A type of SEO in which a firm offers the new shares to investors
at large

– Rights Offer
• A type of SEO in which a firm offers the new shares only to
existing shareholders
• Researchers have found that, on average, the market
greets the news of an SEO with a price decline.

• Although not as costly as IPOs, seasoned offerings are

still expensive.
– Underwriting fees amount to 5% of the proceeds of the
issue.
Example
Assume that a firm intends to raise equity by issuing rights
Currently the firm has 300 million shares outstanding, the
trading price is $10 and each share has one right. You
have been given the task to determine which alternative
generates more money to the firm:

a) 5 rights to purchase 2 new share at 10$/share

b) 6 rights to purchase 3 new shares at 8$/share
Solution
If all shareholders exercise the right:
a)120 million new shares will be purchased at price of $10, raising $1,200
million. Value of the firm after issue is $4,2 billion with 420 million shares
outstanding, so the price per share after the issuing is $10: This price is
equal to the issue price $10, so the shareholders are indifferent of
exercising the rights
b)150 million new shares will be purchased at price of $8, raising $1,200
million. Value of the firm after issue is $4,2 billion with 450 million shares
outstanding, so the price per share after the issuing is $9,3: This price
exceeds the issue price of $8, so the shareholders will exercise the rights
Example
Tech, Inc. has 10 million shares outstanding trading at $25 per
share. It intends to raise $25 million in new equity and decides
to make a rights offering. Each stockholder is provided 1 right
for every share owned and 5 rights can be used to buy
additional share in the company at $12.50 per share.

Determine the value of each right.

Solution

Before the Rights After the Rights

Number of Shares 10 million 12 million
Value of Equity $250 million $275 million
Price per share $25 $22.92

𝑅𝑖𝑔ℎ𝑡𝑠 𝑜𝑛 𝑃𝑟𝑖𝑐𝑒 – 𝑆𝑢𝑏𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛 𝑃𝑟𝑖𝑐𝑒

𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑟𝑖𝑔ℎ𝑡 =
𝑛+1

$25 – $12.50
= = $2.08
6
3.6. Financing Choices and Firm’s Life Cycle
Quiz
1. What are the main sources of funding for private
companies to raise outside equity?
2. What is a venture capital firm?
3. What are some of the advantages and
disadvantages of going public?
4. List and discuss the IPO “puzzles.”
5. What is the difference between a cash offer and a
rights offer for a seasoned equity offering?