Corporate Finance

Twelfth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F.
Jaffe / Bradford D. Jordan / Joe Smolira (digital co-author)

Week 2
Chapter 20
Raising Capital

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
further distribution permitted without the prior written consent of McGraw-Hill Education.
 Key Concepts and Skills

Understand the venture capital market and its role in

financing new businesses
Understand how securities are sold to the public and
the role of investment bankers
Understand initial public offerings and the costs of
going public
Understand the process of secondary offerings

© 2019 McGraw-Hill Education. 20-2

 Venture Capitalists (VCs)

Financial intermediaries that are typically set up as

limited partnerships
Play an active role in overseeing, advising, and
monitoring companies in which they invest
Generally do not want to own the investment forever

© 2019 McGraw-Hill Education. 20-3

 Stages of Financing VC
1. Seed Money.
• A small amount of financing needed to prove a concept or develop
a product.
2. Startup.
• Financing for firms that started within the past year. Funds are
likely to pay for marketing and product development expenditures.
3. First-Round Financing.
• Additional money to begin sales and manufacturing after a firm has
spent its start-up funds.
4. Second-Round Financing.
5. Third-Round Financing.
6. Fourth-Round Financing.
 Stages of Financing VC (cont.)
1. Seed Money.
2. Startup.
3. First-Round Financing.
4. Second-Round Financing.
• Funds earmarked for working capital for a firm that is currently
selling its product but still losing money.
5. Third-Round Financing.
• Financing for a company that is at least breaking even and is
contemplating an expansion.
6. Fourth-Round Financing.
• Money provided for firms that are likely to go public within half a
year.
 The Public Issue

The Basic Procedure

• Management gets the approval of the board.
• The firm prepares and files a registration statement
with the SEC.
• The SEC studies the registration statement during
the waiting period.
• On effective date of registration, price determined
and selling effort gets under way
• Tombstone advertisements used during and after
waiting period

© 2019 McGraw-Hill Education. 20-6

© 2019 McGraw-Hill Education. 20-7
 Tombstone Advertisement
• A tombstone is a written advertisement that gives
investors basic details about an upcoming public offering.
• The Securities and Exchange Commission (SEC) requires
companies to publish advertisements as part of the
disclosure requirements before issuing new shares of
stock.
• The tombstone ad describes the type and number of
securities offered, how they can be purchased, the
availability date, the security's credit rating, and the
names of the syndicate members authorized to sell the
security.

© 2019 McGraw-Hill Education. 20-8

An Example of a Tombstone

© 2019 McGraw-Hill Education. 20-9

 The Process of a Public Offering

Steps in Public Offering

1. Pre-underwriting conferences
2. Registration statements
3. Pricing the issue
4. Public offering and sale
5. Market stabilization

© 2019 McGraw-Hill Education. 20-10

© 2019 McGraw-Hill Education. 20-11
 Issuance without an Underwriter
Direct Listing
• Issuing firms work directly with the exchange
• Spotify Technology S.A. went public (NYSE) on April 3,
2018, using a direct listing.
• Allows early investors/shareholders to exchange
liquidity.
Crowdfunding
• Raising small amounts of capital from a large
number of people, usually via the internet
Initial Coin Offering
• Company sells tokens that grant the owner the
right to use the company’s service in the future.
© 2019 McGraw-Hill Education. 20-12
 20.3 Alternative Issue Methods

There are two kinds of public issues:

• The general cash offer ---- to any interested
investors
• The rights offer --- to existing shareholders

© 2019 McGraw-Hill Education. 20-13

Table 20.1 The Methods of Issuing
New Securities
Method Type Definition
Public Traditional Firm commitment cash offer Company negotiates an agreement with an investment banker to
negotiated cash offer underwrite and distribute the new shares. A specified number of
shares are bought by underwriters and sold at a higher price.
Best-efforts cash offer Company has investment bankers sell as many of the new shares as
possible at the agreed-upon price. There is no guarantee concerning
how much cash will be raised.
Dutch auction cash offer Company has investment bankers auction shares to determine the
highest offer price obtainable for a given number of shares to be
sold.
Privileged subscription Direct rights offer Company offers the new stock directly to Its existing shareholders.
Standby rights offer Like the direct rights offer. this contains a privileged subscription
arrangement with existing shareholders. The net proceeds are
guaranteed by the underwriters.
Nontraditional cash offer Shelf cash offer Qualifying companies can authorize all the shares they expect to
sell over a two-year period and sell them when needed.
Competitive firm cash offer Company can elect to award the underwriting contract through a
public auction instead of negotiation.
Private Direct placement Securities are sold directly to the purchaser. who, at least until
recently, generally could not resell the securities for at least two
years.

© 2019 McGraw-Hill Education. 20-14

 Firm Commitment Underwriting

The issuing firm sells the entire issue to the

underwriting syndicate.
The syndicate then resells the issue to the public.
The underwriter makes money on the spread between
the price paid to the issuer and the price received from
investors when the stock is sold.
The syndicate bears the risk of not being able to sell
the entire issue for more than the cost.
This is the most common type of underwriting in the
United States.

© 2019 McGraw-Hill Education. 20-15

© 2019 McGraw-Hill Education. 20-16
 Best Efforts Underwriting

Underwriter must make their “best effort” to sell the

securities at an agreed-upon offering price.
The company bears the risk of the issue not being
sold.
The offer may be pulled if there is not enough interest
at the offer price. The company does not get the
capital, and they have still incurred substantial
flotation costs.
This type of underwriting is not as common as it used
to be.

© 2019 McGraw-Hill Education. 20-17

 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.
Google was the first large Dutch auction IPO.

© McGraw Hill, LLC 18

 Dutch Auction Underwriting

Notes: Dutch auction underwriting also not common in the US. If

the biding inactive, IPO will burst. Google was the first sizeable
Dutch auction IPO.
© 2019 McGraw-Hill Education. 20-19
• A is willing to buy 100 shares at $16 each, B is willing to buy 100
shares at $14, and so on. The company examines the bids to
determine the highest price that will result in all 400 shares being
sold.
• For example, at $14, A and B would buy only 200 shares, so that
price is too high. Working our way down, all 400 shares won’t be
sold until we hit a price of $12, so $12 will be the offer price in the
IPO. Bidders A through D will receive shares, while bidder E will
not.
• There are two important points here.
• First, all the winning bidders will pay $12—even bidders A and B The
fact that all successful bidders pay the same price is the reason for the
name “uniform price auction.”
• Second, at the $12 offer price, there are bids for 500 shares, which exceeds
the 400 shares Rial wants to sell. Thus, we compute the ratio in our example,
is 400/500=0.8, and allocate bidders that percentage of their bids. In other
words, bidders A through D would each receive 80 percent of the shares they
bid at a price of $12 per ©share.
2019 McGraw-Hill Education. 20-20
 Investment Banks
Also called underwriters
• Help determine type of security, method of sale,
and offering price
• Sell the securities
• Typically using a syndicate to limit risk
• For compensation—the spread
• Stabilize IPO prices in the aftermarket, support the
market for any unsold or remaining shares.

© 2019 McGraw-Hill Education. 20-21

© 2019 McGraw-Hill Education. 20-22
 IPO Underpricing

May be difficult to price an IPO because there is not

a current market price available.
Private companies tend to have more asymmetric
information than companies that are already publicly
traded.
Underwriters want to ensure that, on average, their
clients earn a good return on IPOs.

© 2019 McGraw-Hill Education. 20-23

 20.5 The Announcement of New
Equity and the Value of the Firm
The market value of existing equity drops on the
announcement of a new issue of common stock.
Reasons include
• Managerial Information
• Since the managers are the insiders, perhaps they are
selling new stock because they think it is overpriced.
• Debt Capacity
• If the market infers that the managers are issuing new
equity to reduce their debt-equity ratio due to the
specter of financial distress, the stock price will fall.
© 2019 McGraw-Hill Education. 20-24
 20.6 The Cost of New Issues
1. Gross spread, or underwriting discount
• Underwriters’ spread
2. Other direct expenses
• Filing, legal, admin fees
3. Indirect expenses
• Other costs not mentioned in 1 and 2, if any
4. Abnormal returns
• In a seasoned issue, the price typically drops upon the announcement
of the issue. The drop protects new shareholders from buying
overpriced stock.
5. Underpricing
• For IPO, the stock typically rises after the issue date.
6. Green Shoe option
• Option for underwriters to buy additional shares at offering price. If
the market price of the new issue goes above the offering price within
30 days, the underwriters can buy shares from the issuer and
© 2019 McGraw-Hill Education. 20-25
 20.7 Rights

If a preemptive right is contained in the firm’s articles

of incorporation, the firm must offer any new issue of
common stock first to existing shareholders.
This allows shareholders to maintain their percentage
ownership if they so desire.

Total My stock %
100K 10K 10
120K 10K 8.3%

© 2019 McGraw-Hill Education. 20-26

 Mechanics of Rights Offerings

The management of the firm must decide:

• The exercise price (the price existing shareholders
must pay for new shares).
• How many rights will be required to purchase one
new share of stock.
These rights have value:
• Shareholders can either exercise their rights or sell
their rights.

© 2019 McGraw-Hill Education. 20-27

 Rights Offering Example

Popular Delusions, Inc., is proposing a rights offering.

There are 200,000 shares outstanding, trading at $25
each. There will be 10,000 new shares issued at a $20
subscription price.
What is the new market value of the firm?
What is the ex-rights price?
What is the value of a right?

© 2019 McGraw-Hill Education. 20-28

What Is the New Market Value of
the Firm?

$25 $20
$5, 200, 000 = 200, 000 shares × +10, 000 shares ×
       share
        shares
 
There are 200,000 There will be 10,000 new
outstanding shares at shares issued at a $20
$25 each. subscription price.

𝑃 ∗𝑄 𝑃 𝑅 ∗𝑄 𝑅

© 2019 McGraw-Hill Education. 20-29

 What Is the Ex-Rights Price? - I

There are 210,000 outstanding shares of a firm with a

market value of $5,200,000.
Thus the value of an ex-rights share is:

$5, 200, 000

= $24.7619
210, 000 shares

𝑉𝐹
=𝑃
𝑄𝐹

© 2019 McGraw-Hill Education. 20-30

 What is the value of a right? - II

Thus, the value of a right is:

$0.2381  $25 – $24.7619

𝑃 𝑀 − 𝑃 𝐸𝑥− 𝑟𝑖𝑔h𝑡

© 2019 McGraw-Hill Education. 20-31

 20.8 The Rights Puzzle

The vast majority of new issues in the U.S. are

underwritten, even though rights offerings are much
cheaper.
A few explanations:
• Underwriters increase the stock price. There is not
much evidence for this, but it sounds good.
• The underwriter provides a form of insurance to the
issuing firm in a firm-commitment underwriting.
• Underwriters “certify” the price to the market.
• The proceeds from underwriting may be available
sooner than the proceeds from a rights offering.

© 2019 McGraw-Hill Education. 20-32

 20.10 Shelf Registration
-To simplify the procedure for issuing securities
-Permits a corporation to register an offering that it
reasonably expects to sell within the next two years.
-Sell the issue in small amounts from time to time over those
two years via stock exchange
-Not all companies are allowed shelf registration.
Qualifications include:
• The firm must be rated investment grade.
• The firm cannot have recently defaulted on debt.
• The aggregate market value of the firm must be ≥
$150 m.
• No recent SEC violations. 20-33
© 2019 McGraw-Hill Education.
 20.11 Issuing Long-Term Debt
(bond)
Public issuance follows the same general process as
stocks
• Registered with SEC
• Prospectus vs Indenture
• Prospectus is like a marketing material normally for
stocks
• Indenture is more like a contract with terms and
conditions, normally for bond

© 2019 McGraw-Hill Education. 20-34