Concepts #
Unlisted firms - private source of capital #
Angel capital
- Informal market for direct equity finance provided by a small number of high net worth individuals
Venture capital
- A venture capitalist is an active financial intermediary, providing financing to early-stage and high-potential start-up companies mainly in high tech industries
- It organizes and manages funds mostly raised from investors (such as pension funds and endowments/foundations) typically for about 5-7 years
- Typically staged financing; significant control over company decisions.
Successful exit strategies: Trade sale or IPO
Public Equity #
- Available to firms with larger needs for capital
IPOs: sell equity to the public for the first time
Seasoned Equity Offerings(SEOs)
- The sale of shares in an already publicly traded company
- Alternate SEO types: private placements, rights issues, DRPs
IPOs #
Motivations #
- To create public shares for future acquisitions
- To establish a market value for firm
- Not subject to what VC thinks
- To enhance reputation: customer recognition
- To broaden the base of ownership
- To allow one or more principals to diversify personal holdings
- To minimize our cost of capital
- To allow VCs to cash out
- Regain control over the company
- Current stockholders can diversify
- Liquidity is increased
- Enables to use stocks as employee incentives
Disadvantages #
- Substantial fees
- Legal, accounting, investment banking fees etc are often 10% of the funds
- Disclosure and scrutiny
- Dilution of control
- Special deals to insiders will be difficult
- Time-consuming management of investor relations
Procedure #
See lecture notes for week 1 p.20
Key points
- Process
- Investment bankers will manage the float process, helping to prepare the prospectus(legal document) and providing underwriting(selling)
- Underwriters are obliged to buy remain unsold shares guaranteed
- Decision of price
- Fixed pricing (common in AU): high risk of under-subscription
- Book building (common in the US): approach institutional investors about the insight of price and the quantity, and record this as a book.
- Lower under-sub risk, but significant costs & possible investment banking conflicts
- Open auction: Usually not taken, and unsuccessful
Cost of IPOs #
Direct costs
- underwriters receive a spread(the difference between the underwriters’ buying price and the offering price)
- Direct administrative costs
Indirect costs - Underpricing
- Issuing securities at an offering price set below the actual market value of the security - captured by closing price
- Leaving money on the table - intentionally underpricing is evident
Explanation of underpricing
- Winner’s curse(information asymmetry)
- The market consists of informed investors and uninformed investors
- Uninformed investors will bid the overpriced IPOs, and informed investors will succeed in underpriced IPOs - which vexes the uninformed and discourage them from buying IPOs
- To ensure the uninformed stays in the market, IPOs in average needs to be significantly underpriced (and also capital constraints on informed investors)
- Market feedback hypothesis
- An issuer may be uncertain as to the true value of the firm
- A initial book-building process offers the issuer an opportunity to find out from the market the true value
- To induce the institutional investors to reveal this information, the issuer must underprice the issue so as to feedback the institutionals.
- Investment banking conflicts
- IBs arrange for underpricing as a way to benefit themselves and their clients
- Underpricing can reduce an investment bank’s own costs - less researches need to be conducted as they need to approach less IIs
- Underpricing can be used by IBs to develop unethical relationships with other clients
- Litigation insurance
- Issuer and underwriter may make misstatement of the IPO
- Underpricing ensures that subscribers earn a positive return
- It will reduce the likelihood of them suing the underwriter and the company if shares subsequently do poorly
- Signalling
- To leave a good-taste with investors provides a mechanism to signal the quality of the issue
- Make it easier to subsequently raise funds at higher prices
SEOs #
Concepts #
Type of SEOs
- Rights issues or DRP - to existing shareholders
- General offers - to the public
- Placement - to financial institutions
Determinants
- Costs
- Time to implement
- Transfer of votes/wealth
Placement
- Very quick, mostly within a few weeks
- Low issue costs
- Do not generally require a prospectus (but a phone call will make it)
- Share issued at a discount - transfer wealth from existing shareholders to new investors
- Dilution of control
Rights Issues
- A new share issue offered to existing shareholders at a fixed subscription price
- Shareholders receive an entitlement to new shares at a fixed proportion of the number of shares already held (on a pro-rata basis)
- Sub price is usually at 10-30% discount to the share price at the time the issue is announced
- Usually takes 2-3 months to complete, a renounceable offer takes at least 23 days to complete
Calculations for rights issue #
Price ex-rights: the weighted average of price of the market price and the sub price
$$P_{ex} = \frac{(N \times P_0) + (M \times P_{sub})}{N + M}$$where:
• N = number of existing shares
• P₀ = current market price
• M = number of new shares
• P₍sub₎ = subscription price
Alternatively, if R is the rights ratio (new shares per existing share):
$$P_{ex} = \frac{P_0 + R \times P_{sub} }{1 + R}$$Value of the right: How much would the market pay for the right to purchase one additional share at the subscription price? - Buying a right and paying a subscription price, you get a share of ex-right value - then we have
$$ \begin{aligned} P_{ex} &= P_R + P_{sub} \\\\ \implies P_R &= P_{ex} - P_{sub} \end{aligned} $$Consequences of choices under renounceable rights
- Exercise the right: No wealth loss, no voting power loss
- Do nothing: wealth loss, voting power loss
- Sell & buy: No wealth loss, voting power loss
Dividend reinvestment plan(DRPs) #
- Use part of all of dividend to apply for new shares without transaction costs (usually) at a discount to the current market price
- DRP is just a very small rights issue
Key points of tutorials #
- On ex-right date, the price may not fall to its theoretical ex-right price is that
- Option value of the right is not considered in the formula
- There may be transaction costs/taxes related to exercising the right
- New information may have been released on the firm on that day, or the market is moved on that day.
Insights from MST Practice #
- 2 for 1 in rights issue: Holding 1 share, you get 2 shares
- Subscription overpriced/underpriced by x%: Set subscription price as X then solve for the equation