How Corporations Raise Venture Capital and Issue Securities: Study Notes

Venture Capital

Introduction to Venture Capital

Venture capital is a critical source of financing for new and growing firms, especially those unable to access traditional funding. The process of issuing securities and obtaining venture capital involves several steps and requires a clear understanding of financial mechanisms.

• Definition: Venture capital refers to money invested to finance a new firm, typically in exchange for equity ownership.

• Role of Management: The success of a new firm is highly dependent on the efforts of its managers; venture capitalists often place restrictions on management to protect their investment.

• Staged Financing: Funds are usually dispersed in stages, contingent upon the achievement of specific milestones.

Steps to Obtaining Venture Funding

• Prepare a business plan: A comprehensive plan outlining the firm's strategy, market, and financial projections.

• Receive first-stage financing: Initial capital provided to launch operations.

• Receive subsequent staged financing: Additional funding provided as the firm meets growth targets.

Market Value Balance Sheets

Balance sheets illustrate the financial position of a firm at different stages of venture capital funding.

First Stage Market Value Balance Sheet ($ millions)
Assets	Liabilities and Equity
Cash from new equity: 0.5	New equity from venture capital
Other assets: 0.5	Your original equity
Value: 1.0	Value

Second Stage Market Value Balance Sheet ($ millions)
Assets	Liabilities and Equity
Cash from new equity: 1.0	New equity from 2nd stage
Other assets: 2.0	Equity from 1st stage
	Your original equity
Value: 3.0	Value

Sources of Venture Capital

• Individual investors: Finance companies in their earliest stages of growth.

• Corporate venturers: Corporations that offer venture assistance to finance young, promising companies.

• Private equity investing: Investors who offer funds to finance firms not traded on public stock exchanges.

Initial Public Offering (IPO)

Introduction to IPOs

An Initial Public Offering (IPO) is the first sale of stock by a company to the general public. It is a major step for firms seeking to raise substantial capital beyond what private investors can provide.

• Primary Offering: New shares are sold to raise additional cash for the company.

• Secondary Offering: Founders and venture capitalists sell their shares to realize gains.

Key Terms in IPOs

• Underwriter: A financial institution that buys an issue of securities from a company and resells it to the public.

• Spread: The difference between the public offer price and the price paid by the underwriter.

• Prospectus: A formal summary providing information on an issue of securities.

• Underpricing: Issuing securities at an offering price set below the true value of the security.

Benefits of Going Public

• Ability to raise new capital

• Stock price provides performance measure

• Information more widely available

• Diversified sources of finance

• Reduced borrowing costs

IPO Process Flow

1. Firm selects underwriter and prepares for offering.

2. Underwriter provides advice and pays firm for shares.

3. Firm provides shares to underwriter to be resold.

4. Underwriter offers shares to investors.

5. Investors purchase shares from underwriter.

Calculating Underwriter Spread

The underwriter spread is calculated as the difference between the price at which the underwriter sells shares to the public and the price paid to the issuing company.

• Formula: $\text{Spread} = \text{Number of shares} \times (\text{Public Offer Price} - \text{Underwriter Price})$

• Example: If 3 million shares are sold at $43 each by the underwriter, but the company receives $40 per share, the spread is: $3,000,000 \times (43 - 40) = 9,000,000$

Underwriting Arrangements

• Firm Commitment: Underwriters buy the securities from the firm and then resell them to the public.

• Best-Efforts Commitment: Underwriters agree to sell as much of the issue as possible but do not guarantee the sale of the entire issue.

Issuance Costs

• Direct Costs: Legal fees, registration fees, and other expenses incurred when a firm issues new securities.

• Net Funding Calculation: Formula: $\text{Net to issuer} = \text{Number of shares} \times \text{Net price per share} - \text{Legal fees}$ Example: For 250,000 shares at $40 each, with a 10% spread and $600,000 legal fees: Net price per share =$\frac{40}{1.10} = 36.36$Net to issuer = $250,000 \times 36.36 = 9,090,000$ Less legal fees = $8,490,000$

Underpricing of an IPO

• Definition: Underpricing occurs when the offering price is set below the true market value, often resulting in a significant price increase on the first day of trading.

• Formula: $\text{Cost of underpricing} = \text{Number of shares} \times (\text{First day closing price} - \text{Offer price})$

• Example: If 3 million shares are offered at $43 and close at $70: $3,000,000 \times (70 - 43) = 81,000,000$

General Cash Offers by Public Companies

Seasoned Offering

A seasoned offering is the sale of securities by a firm that is already publicly traded. General cash offers are open to all investors and provide additional capital for the company.

• Registration: Firms may file one registration statement for several issues of the same security, streamlining the process.

Private Placement

Private Placement of Securities

Private placement refers to the sale of securities to a limited number of investors without a public offering. This method is often used to raise capital quickly and with fewer regulatory requirements.

• Rights Issue: Securities offered only to current shareholders, often at a discount to market price.

Calculating the Value of a Right

• Formula: $\text{Value of a right} = \frac{\text{Pre-issue price} - \text{Issue price}}{\text{Number of new shares per old share} + 1}$

• Example: If Deutsche Bank has 1.379 billion shares at €18/share and offers a 1-for-2 rights issue at €11.65/share:

  • Current market value = $1.379 \text{ billion} \times 18 = €24.82 \text{ billion}$

  • New shares = $1.379 \text{ billion} / 2 = 0.688 \text{ billion}$

  • Total shares after issue = $1.379 + 0.688 = 2.067 \text{ billion}$

  • Amount of new funds = $0.688 \text{ billion} \times 11.65 = €8.02 \text{ billion}$

  • New share price = $\frac{24.82 + 8.02}{2.067} = €15.88$

  • Value of a right = $\frac{18 - 15.88}{1 + 0.5} = €1.41$ (Additional info: Formula inferred from context)