FINANCING

AND
RAISING CAPITAL
 FINANCING
AND
RAISING CAPITAL

B L O O M S B U R Y
Copyright © Bloomsbury Information Ltd, 2011

First published in 2011 by

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pp. 41-44, "Raising Capital in the United Kingdom" copyright © Lauren Mills

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Contents
Contributors vii

Best Practice—Issuing Debt l

Optimizing the Capital Structure: Finding the Right Balance
between Debt and Equity Meziane Lasfer 3
Issuing Corporate Debt Steven Lowe 7
Banks and Small and Medium-Sized Enterprises:
Recent Business Developments Sergio Schmukler, Augusto de la Torre,
and Maria Soledad Martinez Peria 11
Capital Structure: A Strategy that Makes Sense John C. Groth 17
Capital Structure: Perspectives John C. Groth 25
Capital Structure: Implications John C. Groth 31
Credit Ratings David Wyss 37
Raising Capital in the United Kingdom Lauren Mills 41
Minimizing Credit Risk Frank J. Fabozzi 45
How and When to Use Nonrecourse Financing Thomas McKaig 49
Understanding the True Cost of Issuing Convertible Debt
and Other Equity-Linked Financing Roger Lister 53
Securitization: Understanding the Risks and Rewards Tarun Sabarwal 57
Using Securitization as a Corporate Funding Tool Frank J. Fabozzi 63
What the Rise of Global Banks Means for Your Company Chris Skinner 69
Public—Private Partnerships in Emerging Markets Peter Koveos and Pierre Yourougou 73

Best Practice—Equity Investment 81

Sources of Venture Capital Lawrence Brotzge 83
Assessing Opportunities for Growth in Small and Medium Enterprises Frank Hoy 89
Equity Issues by Listed Companies: Rights Issues and Other Methods Seth Armitage 93
Attracting Small Investors Wondimu Mekonnen 97
Raising Capital in Global Financial Markets Reena Aggarwal 103
Financial Steps in an IPO for a Small or Medium-Size Enterprise Hung-Gay Fung 109
The Role of Institutional Investors in Corporate Financing Hao Jiang 115
Understanding and Accessing Private Equity for
Small and Medium Enterprises Arne-G. Hostrup 123
Assessing Venture Capital Funding for Small and
Medium-Sized Enterprises Alain Fayolle and Joseph LiPuma 129
Price Discovery in IPOs Jos van Bommel 135
How to Set the Hurdle Rate for Capital Investments Jon Tucker 141
Private Investments in Public Equity William K. Sjostrom, Jr 147
Understanding Equity Capital in Small and Medium-Sized Enterprises Siri Terjesen 151
IPOs in Emerging Markets Janusz Brzeszczynski 159
Managing Activist Investors and Fund Managers Leslie L. Kossoff 165
Acquiring a Secondary Listing, or Cross-Listing Meziane Lasfer 169
The Cost of Going Public: Why IPOs Are Typically Underpriced Lena Booth 173

Checklists—Issuing Debt 177

Assessing Cash Flow and Bank Lending Requirements 179
The Bond Market: Its Structure and Function 181
Financial Intermediaries: Their Role and Relation to Financial Markets 183
Franchising a Business 185
How to Manage Your Credit Rating 187
How to Use Receivables as Collateral 189
Maintaining the Banking Relationship 191
Measuring Gearing 193
Money Markets: Their Structure and Function 195

v
 Financing and Raising Capital

£ Overview of Loan Agreements 197

C Raising Capital by Issuing Bonds 199
£2 Steps for Obtaining Bank Financing 201
fi Understanding and Using Interest Coverage Ratios 203
£.9 Understanding and Using Leverage Ratios 205
Understanding Debt Cover 207
Understanding Fixed-Charge Coverage 209

Checklists—Equity Investment 211

Dealing with Venture Capital Companies 213
Investors and the Capital Structure 215
Options for Raising Finance 217
An Overview of Stockholders' Agreements 219
Raising Capital by Issuing Shares 221
Raising Capital through Private and Public Equity 223
Sovereign Wealth Funds—Investment Strategies and Objectives 225
Sovereign Wealth Funds—Profiles of the Top 10 Players 227
Understanding Capital Markets, Structure and Function 231
Understanding Capital Structure Theory: Modigliani and Miller 233
Understanding the Cost of Capital and the Hurdle Rate 235
Understanding the Weighted Average Cost of Capital (WACC) 237
Using Mezzanine Financing 239

Index 241

U
Z
t
a
vi
Contributors
Reena Aggarwal is the Robert E. McDonough financial services company), and five years as a p"
professor of business and professor of finance at founder of a corporate venturing project, which gj
Georgetown University's McDonough School of resulted in Providian establishing an entirely j-
Business in Washington, DC. She specializes in new business. Since 1994, Brotzge has been an g"
international stock markets, demutualization of independent consultant and an angel investor. 1^
stock exchanges, initial public offerings, He has an ownership position in several small/ *
international investments by mutual funds, and start-up businesses and consults with a number
international corporate governance and market of other companies.
valuation. She has been named among
"outstanding faculty" in the Business Week Guide Janusz Brzeszczynslri is a senior lecturer in
to the Best Business Schoob. She is also a faculty the Department of Accountancy, Economics and
associate of the Capital Markets Research Center. Finance at Heriot-Watt University, Edinburgh,
Dr Aggarwal is a frequent guest on local and and specializes in internationalfinance,financial
international radio and television stations. Her markets, and financial econometrics. Before
research and comments have been cited in the joining Heriot-Watt, he held a Fulbright
Wall Street Journal, the Washington Post, scholarship in the United States and worked as a
Business Week, and the Financial Times, among visiting professor in the Department of
other media outlets. Economics, Arizona State University. He was
also a visiting scholar at the Swiss Institute of
Seth Armitage is a professor of finance and Banking and Finance, University of St Gallen,
director of the MSc in finance and investment at Switzerland, and assistant/associate professor
the University of Edinburgh Business School. at the Chair of Econometric Models and
His research is mainly in the area of corporate Forecasts, University of Lodz, Poland. Besides
finance and includes projects on rights issues the Fulbright scholarship, he was also awarded
and open offers, the cost of capital, the role of an ESKAS post-doctoral scholarship at the Swiss
banks in funding companies, and mutual Institute of Banking and Finance and a DAAD
financial institutions. He is author of The Cost of doctoral scholarship at Kiel University, Germany.
Capital: Intermediate Theory (Cambridge Dr Brzeszczynski has published in a number of
University Press, 2005). He was on the faculty of finance journals.
the University of Edinburgh from 1989 to 2002,
and before rejoining in 2007 he was head of the Augusto de la Torre is the chief economist for
Department of Accounting and Finance at Latin America and the Caribbean at the World
Heriot-Watt University. Bank. Since joining the Bank in 1997, he has held
the positions of senior adviser in the Financial
Lena Booth is associate professor of finance at Systems Department and senior financial sector
the Thunderbird School of Global Management adviser for the Latin American and Caribbean
and served as the first executive director of the regions. From 1993 to 1997 he was the head of the
Thunderbird Private Equity Center (TPEC). Dr Central Bank of Ecuador, and in November 1996
Booth has been a member of the Thunderbird Euromoney nominated him as the year's "Best
faculty since 1995 and has taught and presented Latin American Central Banker." From 1986 to
research in many countries around the world. 1992 he worked at the International Monetary
Her research interests lie mainly in capital Fund, where, among other positions, he was
raising and security issuance by firms, with the the IMF's resident representative in Venezuela
primary focus on initial public offerings. She has (1991-1992). De la Torre has published on a
received several teaching and research awards broad range of macroeconomic and financial
during her tenure at Thunderbird. Born and development topics. He is a member of the
raised in Malaysia, Dr Booth holds a BBA from Carnegie Economic Reform Network.
the National University of Singapore, an MBA
from Northern Arizona University, and a PhD Frank J. Fabozzi is professor in the practice of ^~.
(finance) from Arizona State University. finance at Yale School of Management and H—1
specializes in investment management and 2^
Lawrence Brotzge's business background structured finance. He is editor of the Journal of £>
includes 11 years with Ernst & Young, 10 years as Portfolio Management and has authored and ^
corporate controller and CFO for two major edited many acclaimed books, three of which ("")
divisions of Providian Corp (a Fortune 500 were coauthored with the late Franco Modigliani W

vii
 Financing and Raising Capital

* and one coedited with Harry Markowitz. Professor education and conducts executive development
O Fabozzi is a consultant to several financial programs. In addition to his work in finance, he
t2 institutions, is on the board of directors of the researches and speaks on human capital and
,X2 BlackRock complex of closed-end funds, and is on creativity and is a keynote speaker. In 2006 he
"C the advisory council for the Department of was designated a Mays Faculty Fellow in Teaching
"2 Operations Research and Financial Engineering Innovation.
O at Princeton University. He was inducted into the
O Fixed Income Analysts Society Hall of Fame in Arne-G. Hostrup has been a managing
November 2002 and is the 2007 recipient of the director at netzwerk nordbayern since January
C. Stewart Sheppard Award given by the CFA 2003. His main remits are fiscal planning and
Institute. private equity finance of high-growth companies
by business angels and venture capital. Over the
Alain Fayolle is professor and director of the last ten years, netzwerk nordbayern has matched
entrepreneurship research center at EM Lyon €130 million in venture capital to start-ups. He
Business School, France. He is also visiting has gained professional experience in several
professor at Solvay Brussels School of Economics positions: as commercial leader of a German
and Management, Belgium, and HEC Montreal, medium-sized company, in the franchise
Canada. His current research work focuses on operations of an international fast-food
the dynamics of entrepreneurial processes, the company, as project leader of the Northern
influence of cultural factors on organizations' Bavarian Business Plan Competition, and as
entrepreneurial orientation, and the evaluation of finance director involved in building a start-up
entrepreneurship education. Professor Fayolle's in the media area. As a member of the board of
most recent books are Entrepreneurship and the European Business Angel Network (EBAN)
New Value Creation: The Dynamic of the he has committed himself to the establishment
Entrepreneurial Process (Cambridge University of the business angel culture in Europe.
Press, 2007) and The Dynamics between
Entrepreneurship, Environment and Education Frank Hoy is the Paul Beswick professor of
(Edward Elgar, 2008). entrepreneurship and director of the Collab-
orative for Entrepreneurship and Innovation at
Hung-Gay Fung is a professor of Chinese Worcester Polytechnic Institute. Dr Hoy earned
studies at the College of Business Administration his PhD at Texas A&M University, where he
of the University of Missouri, St Louis. He holds developed a small business outreach program
a BBA (1978) from the Chinese University of for the Texas Agricultural Extension Service.
Hong Kong and a PhD (1984) from Georgia State Subsequently, he became director of the Small
University, in both cases majoring in finance Business Development Center for the State of
with a minor in economics. His teaching areas Georgia. He moved from the University of
are investments, risk management, corporate Georgia to Georgia State University in 1988 as
finance, and international investments. His the Carl R. Zwerner professor of family-owned
research focuses on international finance, businesses. From 1991 to 2001 Dr Hoy was dean
banking, derivative markets, and small business of the College of Business and subsequently
finance. In 1999 he won a best paper award (with director of the entrepreneurship program at the
G. Lai, R. MacMinn and Bob Witt) given by the University of Texas at El Paso.
Committee on Online Services (COOS) of the
Casualty Actuarial Society. Hao Jiang is assistant professor of finance at
Rotterdam School of Management, Erasmus
John C. Groth is professor of finance in the University. Dr Jiang's main research areas
Department of Finance, Mays Business School, include asset pricing, investments, the behavior
at Texas A&M University. He has received many of institutional and individual investors, and
teaching awards, authored numerous publi- international finance. At Erasmus he teaches
pq cations, and been cited as a major contributor to portfolio management, investments, advanced
QJ the finance literature. Dr Groth received his PhD asset pricing, and behavioral finance. His work
^ from the Krannert School, Purdue University. He will appear in the JournalofFinancial Economics
<t* also holds degrees in physics and in industrial and he has conducted industry and academic
*7 administration. He serves as a consultant in the presentations across Europe, the United States,
1—1 areas of corporate finance and management and Asia.

O
viii

Leslie L. Kossoff is an internationally
renowned executive adviser specializing in next
generation thinking and strategy for executives
and their enterprises. For over 20 years she has
assisted clients ranging from start-ups to Fortune
50's across industries and sectors in the United
States, Japan, and Europe. Her clients include
Fidelity Investments, Sony, TRW, Kraft Foods,
Baxter Healthcare, the UK National Health
Service, Seiko/Epson, 3M, Infonet and GM/
Hughes. A former executive in the aerospace/
defense and pharmaceutical industries, Kossoff
enjoys an outstanding reputation as an invited
speaker at conferences worldwide. She is the
author of the Executive Field Guides, the award
winning book, Executive Thinking, and more
than 100 articles in journals and newspapers,
including the Financial Times and CEO
Magazine.
Peter Koveos is professor and chair of the
Finance Department at the Whitman School of
Management, Syracuse University. He is also
the Kiebach chair in international business,
director of the Kiebach Center, and executive
director of the Africa Business Program at the
Whitman School. As director of ExportNY, an
institute for international business executives,
and the International Business Forum he works
closely with New York companies to develop
their international business strategies. He is also
president of the Central New York International
Business Alliance and has worked extensively in
Asia. Professor Koveos is editor of the Journal
of Developmental Entrepreneurship and his
work has appeared in numerous professional
journals.
Meziane Lasfer is professor of finance at Cass
Business School, London, which he joined in
1990. He has written extensively on corporate
finance, capital markets, and corporate
governance issues. His research is widely
reported in the financial press and is published
in top academic journals such as the Journal
of Finance, the Journal of Finance and Quant-
itative Analysis, the Journal of Banking and
Finance, the Journal of Corporate Finance, the
Journal of Business Finance and Accounting,
Financial Management, the National Tax
Journal, and European Financial Management.
He is a visiting professor at University Paris-
Dauphine. He teaches extensively masters,
PhDs, and executives at Cass and abroad.
Contributors
Joseph LiPuma is an affiliate professor in O
strategic management at EMLYON Business 2
School. He has a BS in mathematics and an MBA ^
from SUNY Buffalo, and received his doctorate 3.
in business strategy and policy from Boston ^
University. LiPuma has nearly 20 years of S-
professional experience, including senior ©
management, operating committee and board- G»
level roles. He has established new businesses
(information technology consultancies) in both
US domestic and international environments.
His research focuses on international
entrepreneurship, specifically new venture
internationalization and its relationship to the
manner in which ventures are capitalized. He
teaches masters-level courses in strategy,
international business, and entrepreneurship.
Roger Lister is a chartered accountant and a
professor of finance at Salford University. After
reading modern languages as a major open
scholar at Oriel College, Oxford, he worked for
international accounting firms KPMG and PwC,
specializing latterly in corporate taxation with
particular interest in the taxation of groups. In
his academic posts at Liverpool and Salford
universities, Lister has taught accounting,
corporate finance, and corporate tax and given
specialized courses on capital structure. His
research and publications have focused on
corporate finance. Recent work has included an
interdisciplinary perspective in which he
examines alternative cultural models and
advocates a role for the arts in business
education.
Steven Lowe is a director at Pension
Corporation. Previously he was a senior credit
portfolio manager with Legal and General
Investment Management (LGIM), where he
focused on structured solutions, derivatives, and
investment-grade credit for pension fund clients.
Before working at LGIM, he worked at Barclays
Global Investors, State Street Global Advisors
and Baring Asset Management. Lowe has 15
years of investment experience and was awarded
the Chartered Financial Analyst designation in
1997-
Maria Soledad Martinez Peria is a senior jT\
economist in the finance team of the Development ^^
Economics Research Group of the World Bank. 1—1
Her published research has focused on currency \Z^
and banking crises, depositor market discipline, ?>
ix
 Financing and Raising Capital
* and foreign bank participation in developing
O countries. Currently she is conducting research
t|j on financial sector outreach and on the impact of
jQ remittances on financial development. Prior to
*E joining the World Bank, she worked at the
"2 Brookings Institution, the Central Bank of
O Argentina, the Federal Reserve Board, and the
O International Monetary Fund. She holds a PhD
in economics from the University of California,
Berkeley, and a BA from Stanford University.
Thomas McKaig is a widely recognized
Canadian author with 30 years of international
business experience in 40+ countries. He
delivers quality business solutions to clients in
five languages. He owns Thomas McKaig
International, Inc., found at www.tm-int.com.
He speaks internationally on quality management
and international trade, and is an adjunct
professor, teaching Global Business Today in the
Executive MBA program at the University of
Guelph. His most recent book is Global Business
Today (McGraw Hill-Ryerson), with his next
international business book due in stores in
November 2011. He has served as executive in
residence at the University of Tennessee and
Universidad de Montevideo and was worldwide
strategic marketing adviser to the United States
Treasury Department Bureau of the US Mint's
Gold Eagle Bullion coin program.
Wondimu Mekonnen is a program director
of accounting and finance and a lecturer in
management accounting at the University of
Buckingham. Before joining the University
of Buckingham, he lectured at Addis Ababa
University for many years and briefly at Grafton
College. He also worked for seven and a half years
for JSA Services, a firm of chartered accountants
based in Watford, UK, in the capacity of
accountant and corporate tax accountant, where
he gained extensive experience of dealing with
small investors and private entrepreneurs.
Lauren Mills is a senior financial journalist
with 17 years' experience working for business
publications and national newspapers. She was
retail correspondent for the Sunday Telegraph
for more than five years and went on to become
;_L} enterprise editor at the Sunday Express, before
QJ joining the Mail on Sunday's financial desk
^ covering a range of sectors that now includes
<H banking, insurance, private equity, mining,
>^ pharmaceuticals, and manufacturing. She has
H-H also contributed business articles to the Sunday
o
x
Times, the Daily Telegraph, the Daily Mail, the
Financial Times, and the Independent on
Sunday.
Tarun Sabarwal is assistant professor of
economics and Oswald Scholar at the University
of Kansas. He received his doctorate from the
University of California at Berkeley. His research
interests include microeconomic theory and
financial economics. Dr Sabarwal's work has
been published in a number of academic journals,
most recently in Economic Theory, in Regional
Science and Urban Economics, and in Annals of
Finance, among others. He has presented his
work at conferences around the world.
Sergio Schmukler is lead economist with the
Development Research Group of the World
Bank. He has also worked continuously for the
Office of the Chief Economist for Latin America
and for the East Asia and South Asia regions.
Besides his work for the World Bank, he has
been treasurer of LACEA (Latin American and
Caribbean Economic Association) since 2004,
was associate editor of the Journal of
Development Economics (2001-2004), taught
in the Department of Economics, University of
Maryland (1999-2003), and worked in the
International Monetary Fund Research
Department (2004-2005). He gained his PhD at
the University of California at Berkeley.
William K. Sjostrom, Jr, is a professor of law
at the James E. Rogers College of Law at the
University of Arizona. He graduated magna cum
laude from Notre Dame Law School in 1996,
where he was an editor of the Law Review and a
Dean's Scholar. Prior to law school, Professor
Sjostrom worked as an options trader at the
Chicago Board Options Exchange. He received
his undergraduate degree in finance with high
honors from the University of Illinois in 1991.
Before entering academia, Sjostrom worked for
four years at the Minneapolis law firm of
Fredrikson & Byron, where he focused on public
and private securities offerings, venture capital
financing, and mergers and acquisitions.
Chris Skinner is well known as an authority on
the future of banking. He chairs the Financial
Services Club, a European networking group,
works with the media, and presents extensively
at conferences globally, speaking about the
future of banking. He has written several books
on the subject and keeps a daily blog at

www.thefinanser.co.uk. Previously, he was vice
president of marketing and strategy for Unisys
Global Financial Services and strategy director
with NCR Financial Services. Skinner is also a
cofounder of the website for strategists
www.shapingtomorrow.com.
Siri Terjesen holds a PhD from Cranfield
School of Management (2006), a master's in
international business from the Norwegian
SchoolofEconomicsandBusinessAdministration
(Norges Handelshuyskole), where she was a
Fulbright scholar (2002), and a BS in business
administration from the University of Richmond,
Virginia (1997). She is an assistant professor in
the Kelley School of Business at Indiana
University and a visiting research fellow in the
entrepreneurship, growth, and public policy
group at the Max Planck Institute of Economics
in Jena, Germany. She has been widely published
in leading journals and is a coauthor of Strategic
Management: Logic & Action (Wiley, 2008).
Jon Tucker is professor offinanceat the Bristol
Business School of the University of the West of
England and is director of the Centre for Global
Finance there. He holds a PhD in European
corporate finance (1995) and a BSc in applied
economics (1991), both from the University of
Plymouth. He has published frequently in
leading finance journals and is associate editor
of the Journal of Finance and Management in
Public Services. He is chief examiner in
investment analysis for the Securities and
Investment Institute and visiting professor at
Universitatea Babes-Bolyai, in Romania.
Jos van Bommel is associate professor at CEU
Cardenal Herrera University, in Valencia, Spain.
He was formerly a lecturer in finance at Oxford
University's Said Business School and conducts
empirical and theoretical research in various
areas of corporate finance. He has completed
Contributors
several studies on IPOs, but is also interested in O
private equity, venture capital, and international ©
finance. He also studies the market's S
microstructure and investigates the strategic £2.
behavior of informed and less informed traders O-
to better understand how information is re-
incorporated into market prices. Dr van Bommel ©
holds a university degree in engineering from (ft
the University of Eindhoven, an MBA from the
IESE Business School, and a PhD in finance from
INSEAD. In between his studies he worked in
international sales and marketing.
David Wyss is chief economist at Standard &
Poor's. He is responsible for S&P's economic
forecasts and publications. Wyss joined Data
Resources, Inc., in 1979 as an economist in the
European Economic Service in London, which
was acquired by McGraw-Hill. He returned to
the United States in 1983 as chief financial
economist for DRI/McGraw-Hill, became chief
economist for Standard & Poor's DRI in 1992,
and chief economist for Standard & Poor's in
1999. Wyss holds a BS from the Massachusetts
Institute of Technology and a PhD in economics
from Harvard University.
Pierre Yourougou is associate professor of
finance at the Whitman School of Management,
Syracuse University. He is also managing
director of the Africa Business Program at the
Whitman School. His research and teaching
interests are in the areas of corporate finance,
financial institutions and markets, and emerging
markets. Prior to joining Syracuse University in
2006, Professor Yourougou worked for the
World Bank, where he held various senior level
positions in the corporate finance, financial
products development, and public debt
management departments. He received his PhD
in banking and finance from New York
University's Stern School of Business.
h—(
xi
Best Practice
Issuing Debt
Optimizing the Capital Structure: Finding
the Right Balance between Debt and
Equity by Meziane Lasfer
EXECUTIVE SUMMARY
• Just over 50 years ago Miller and Modigliani (1958) showed that under a certain set of
conditions—namely perfect capital markets with no taxes and agency conflicts—a firm's capital c
structure is irrelevant to its valuation.
• Their results are controversial and have raised a large number of questions from academics and era
practitioners.
• This article summarizes the main issues underlying the choice by firms of an appropriate capital
structure, taking into account their specific fundamentals as well as macroeconomic factors.
• It presents the benefits and costs of borrowing, describes how to assess these to arrive at the
basic trade-off between debt and equity, and examines conditions under which debt becomes
irrelevant.

TYPES OF FINANCING interest and tax, it does not have priority in

There are three financing methods that
companies can use: debt, equity, and hybrid
securities. This categorization is based on the
main characteristics of the securities.
Debt Financing
Debt financing ranges from simple bank debt
to commercial paper and corporate bonds. It is
a contractual arrangement between a company
and an investor, whereby the company pays a
predetermined claim (or interest) that is not a
function of its operating performance, but which
is treated in accounting standards as an expense
for tax purposes and is therefore tax-deductible.
The debt has afixedlife and has a priority claim
on cash flows in both operating periods and
bankruptcy. This is because interest is paid
before the claims to equity holders, and, if the
company defaults on interest payments, it will be
declared bankrupt, its assets will be sold, and the
amount owed to debt holders will be paid before
any payments are made to equity holders.
Equity Financing
Equity financing includes owners' equity,
venture capital (equity capital provided to a
private firm in exchange for a share ownership
of the firm), common equity, and warrants (the
right to buy a share of stock in a company at a
fixed price during the life of the warrant). Unlike
debt, it is permanent in the company, its claim
is residual and does not create a tax advantage
from its payments as dividends are paid after
bankruptcy, and it provides management
control for the owner.
Hybrid Securities
Hybrid securities are securities that share some
characteristics with both debt and equity and
include, for example, convertible securities
(defined as debt that can be converted into
equity at a prespecified date and conversion
rate), preferred stock, and option-linked bonds.
THE IRRELEVANCE PROPOSITION
In 1958 Modigliani and Miller demonstrated that,
under a certain set of assumptions, the choice
between any of these securities (referred to as
capital structure or leverage) is not relevant to a
company's valuation. The assumptions include:
no taxes, no costs of financial distress, perfect
capital markets, no interest rate differentials,
no agency costs (rationality), and no transaction
costs. These assumptions are, in fact, the main
drivers of capital structure and gave rise to the
trade-off theory of leverage.
THE TRADE-OFF OF DEBT
In this so-called Miller-Modigliani framework,
firms choose their optimal level of leverage by
weighing the following benefits and costs of debt o
financing.
Benefits of Debt
There are two main advantages of debt financing:
taxation, and added discipline. O
Taxation: Since the interest on debt is paid

3
 Financing and Raising Capital
before taxation, whereas dividends paid to equity
holders are usually paid from profit after tax, the
cost of debt is substantially less than the cost of
equity. This tax-deductibility of interest makes
u debt financing attractive. Suppose that the debt of
a company is $100 million and the interest rate is
(A 10%. Every year the company pays interest of $10
million. Suppose that the corporation tax rate is
30%. If the company does not pay tax, its interest
will be $10 million and the cost of debt will be
10%. However, if the company is able to deduct
Q the tax on this $10 million from its corporation
tax payment, then the company saves $10 million
c x 30% = $3 million in tax payments per year,
• IN making the effective interest payment only $7
to million. If the debt is permanent, every year
en the company will have a $3 million tax saving,
referred to as a tax shield. We can compute the
present value (PV) by discounting annual value
by the cost of debt, as follows:
k x Dx t
PV of tax shield - - - -Dxt
where kd is the cost of debt, D is the amount of
debt, and the product of kd and D gives the amount
of the interest charge. tc is the corporation tax
rate. We simplify the ratio by kd to obtain the
present value of the tax shield as the product of
the amount of debt and the corporation tax rate.
Thus, the value of a company that is financed
with debt and equity (such a company is referred
to "levered") should be equal to its value if it is
financed only with equity plus the present value
of the tax shield. We can write this value as:
Value of levered firm with debt D =
Value of nonlevered firm + D x f.
These arguments suggest that the after-tax cost
of debt can be computed as 10% x (1 - 30%) =
7%.
Added discipline: In practice, the managers
are not the owners of the company. This so-
called separation of managers and stockholders
raises the possibility that managers may prefer
to maximize their own wealth rather that of the
stockholders. This is referred to as the agency
conflict. In general, debt may make managers
more disciplined because debt requires a fixed
payment of interest, and defaulting on such
payments will lead a company to bankruptcy.
Costs of Debt
Debt has a number of disadvantages, including
a higher probability of bankruptcy, an increase
in the agency conflicts between managers and
4
bondholders, loss of future financial flexibility,
and the cost of information asymmetry.
Expected bankruptcy cost. Given that debt
holders can declare a company bankrupt if it
defaults on its interest payment, companies
that have a high level of debt are likely to have
a high probability of facing such a default. This
probability is also increased when a company is
operating in a high business risk environment.
Debt financing creates financial risk. Thus,
companies that have high business risk should
not increase their risk of default by taking on
a high financial risk through their use of debt.
Evidence indicates that much of the loss of
value occurs not in the liquidation process but
in the stage of financial distress, when the firm
is struggling to pay its bills (including interest),
even though it may not go on to be liquidated.
Agency costs: These costs arise when a company
borrows funds and the managers use the funds to
finance alternative, usually more risky, activities
than those specified in the borrowing contract
to generate higher returns to stockholders. The
greater the separation between managers and
lenders, the higher the agency costs.
Loss of future financing flexibility: When a
firm increases its debt substantially, it faces
difficulties raising additional debt. Companies
that can forecast their future financing needs
accurately can plan their financing better and
may not raise additional funds randomly. In
general, the greater the uncertainty about future
financing needs, the higher the costs.
Information asymmetry: When companies
do not disclose information to the market, their
information asymmetry will be high, resulting in
a higher cost of debt financing.
Redeployable assets of debt: Lenders require
some sort of security when they fund a company.
This security is referred to as collateral. Lenders
accept assets that can be resold or redeployed
into other activities, such as property (real
estate), as collateral. In general, the lower the
value of the redeployable assets of debt, the
higher are the costs.
FINANCING CHOICES AND A FIRM'S
LIFE CYCLE
Although companies may prefer to use internal
financing to minimize the issuance (transaction)
costs, the trend in financing depends critically
on the firm's life cycle.
Start-ups are small, privately owned companies.
They are likely to befinancedby owners' funds and
bank borrowings. Their funding needs are high,
but their ability to raise external funding is limited
because they do not have sufficient assets to offer as
 Optimizing the Capital Structure: Balancing Debt and Equity

security tofinanceproviders. They will try to seek CONCLUSION

private equity funding. Their long-term leverage is
likely to be low as they are mainly financed with
short-term debt.
Expanding companies are those that
have succeeded in attracting customers and
establishing a presence in the market. They
are likely to be financed by private equity and/
or venture capital in addition to owners' equity
and bank debt. Their level of debt is low and they
have more short-term than long-term debt in
their capital structure.
High-growth companies are likely to be
publicly traded, with rapidly growing revenues.
They will issue equity in the form of common
stock, warrants, and other equity options, and
probably convertible debt. They are likely to
have a moderate leverage.
Mature companies are likely to finance their
activities by internal financing, debt, and equity.
Their leverage is likely to be relatively high but
will depend on the costs and benefits of debt and
their fundamental factors, such as business risk
and taxation.
This article discussed the different financing
en
methods companies can use and then argued
that their choice depends on the costs and
benefits of debtfinancingand the firm's life cycle.
For example, whereas start-up companies are
likely to be financed with private personal funds,
making their leverage low, mature companies
tend to have high leverage because they are
Oft
able to mitigate the costs of debt and gain from (ft
the tax benefits. In addition to these factors, s=
in practice firms may choose their financing
mix by mimicking comparable firms, or they «
may adopt the average level of debt of all the
companies in their industry. These methods are 8-
not highly recommendable as they may result in
a suboptimal choice. In other cases they follow
a financing hierarchy, where retained earnings
are the preferred option, followed by external
financing in the form of debt, and then equity.
This preference is driven by the transaction and
monitoring costs.

MAKING IT HAPPEN
The choice of financing is strategic and involves the following issues:
• Both low- and high-debt financing are suboptimal. Companies should aim for the most
advantageous level of debt financing, whereby the costs are minimized and the benefits are
maximized.
• The costs of debt include a greater probability of bankruptcy, an increase in the agency conflicts
between managers and bondholders, a loss of future financial flexibility (including the availability
of collateral assets), and information asymmetry costs.
• The benefits relate mainly to tax shields and the added discipline to mitigate the agency conflicts
between stockholders and managers.
• This equilibrium applies primarily to mature companies. Start-ups and growth companies are
likely to have lower leverage as their borrowing capacity is low. It also applies to companies that
normally pay dividends and do not accumulate cash for reinvestment in order to avoid the need
to raise external financing.
• The recent financial crisis has highlighted another issue in debt financing, namely liquidity.
Leverage concepts were developed mainly in times when debt financing was fully available.
In the current credit crisis this is no longer the case. Companies therefore now have to pay
an extra liquidity cost to raise additional capital. The question is whether this is a temporary
situation or a permanent one, in which case debt will become more costly and leverage will be
lower than in the past.
• Another challenge of debt financing relates to the ethics of the use of excessive debt financing,
particularly by financial institutions. Pettifor (2006) was able to foresee the current crisis, tracing
debt financing back to early times and arguing that religions are against debt because it results
in usury. She provides interesting arguments, challenging the whole structure of debt financing,
payment of interest, and interest tax deductibility. Possibly a new structure of debt that is linked
z>
to the profitability of assets and incurs no interest will emerge from the current crisis.
o

5
 Financing and Raising Capital

4)
.2 MORE INFO
jj Books:
£j Damodaran, Aswath. Applied Corporate Finance: A User's Manual. 2nd ed. Hoboken, NJ: Wiley,
£ 2006.
4-» Pettifor, A n n . The Coming First World Debt Crisis. Basingstoke, UK: Palgrave Macmillan, 2 0 0 6 .
(A
,S» Articles:
Graham, John R., and Campbell R. Harvey. "How do CFOs make capital budgeting and capital
4^ structure decisions?" Journal of Applied Corporate Finance 15:1 (Spring 2002): 8-23. Online at:
*g dx.doi.org/10.1111/j.l745-6622.2002.tb00337.x
^ Lasfer, Meziane A. "Agency costs, taxes and debt: The UK evidence." European Financial
\JT Management 1:3 (November 1995): 265-285. Online at:
PJ dx.doi.org/10.1111/j.l468-036X.1995.tb00020.x
*fl Modigliani, Franco, and Merton H. Miller. "The cost of capital, corporation finance and the theory of
(Z> investment." American Economic Review 48:3 (June 1958): 261-297. Online at:
£ www.jstor.org/stable/info/1809766
Websites:
About.com article "Debt financing—Pros and cons":
entrepreneurs.about.com/od/financing/a/debtfinancing.htm
Answers.com article "Debt financing": www.answers.com/topic/debt-ftnancing
Washington State University teaching module "Financing sources for ICTs: Debt finance":
cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page31.htm

u
z

6
Issuing Corporate Debt by Steven Lowe
EXECUTIVE SUMMARY
• The Nobel Prize-winning Modigliani and Miller theorem that capital structure does not matter
does not reflect the inefficiencies of the real world.
• Taxes, default costs, agency costs, equity dilution issues, credit rationing, and stockholder/
debtholder tensions all impact the economists' perfect market.
• Divergent goals between debt and equity holders lead to a number of behaviors, such as
decision risk shifting, underinvestment, and asset stripping, which can skew the financing
decision. Debt covenants exist to even out the risk/reward structures between debt and equity
holders.
• Current economic theory suggests that an optimal capital structure that balances the risk of
bankruptcy with the tax savings of debt does exist, although it can be a struggle for individual
corporations to hit this target amid the constantly changing influences of the modern operating
environment.

INTRODUCTION of possible explanations for the relevance of

The existence and determination of optimal
capital structure is an ongoing topic of research
in corporate finance. In a perfect market setting,
with no frictions, Modigliani and Miller's seminal
research in 1958 suggested that the market value
of a firm is independent of its capital structure. In
other words, capital structure does not matter.
Miller (1991) explained the intuition for this
with a simple analogy: "Think of the firm as a
gigantic tub of whole milk. The farmer can sell
the whole milk as it is. Or he can separate out the
cream, and sell it at a considerably higher price
than the whole milk would bring." He continued:
"The Modigliani-Miller proposition says that
if there were no costs of separation (and, of
course, no government dairy support program),
the cream plus the skim milk would bring the
same price as the whole milk." The essence of
the argument is that increasing the amount of
debt (cream) lowers the value of outstanding
equity (skim milk)—selling off safe cash flows
to debtholders leaves the firm with more lower-
valued equity, keeping the total value of the firm
unchanged. Put differently, any gain from using
more of what might seem to be cheaper debt is
offset by the higher cost of now riskier equity.
Hence, given a fixed amount of total capital, the
allocation of capital between debt and equity is
irrelevant because the weighted average of the
two costs of capital to the firm is the same for all
possible combinations of the two.
Of course, corporations do not operate in
a perfect world, and few if any companies are
100% debt financed. Since Modigliani and
Miller's Nobel Prize-winning paper, a host
particular financial structures has emerged,
centering around the impact of taxes, the costs
of default, agency costs, equity dilution, and
credit rationing, as well as the differing goals
of management and sponsors. Modigliani and
Miller have also suggested that firms maintain
a reserve borrowing capacity to allow for
economic uncertainty. We will look at each of
these potential inefficiencies in turn.
IMPACT OF TAXES
Of the most obvious violations of Modigliani
and Miller's assumptions are corporate taxes
and the tax deductibility of interest payments.
Usually, interest payments made to debtholders
are deducted from corporate profits before
they are taxed. Consequently, the corporate tax
saved acts as a subsidy on interest payments.
For example, if the tax rate is 34%, then for
every dollar paid in interest payments 34 cents
of corporate taxes are avoided by the company
(although those receiving the interest must pay
tax on their interest income). In contrast, if
income is paid out as dividends to stockholders,
that income is taxed twice, once at the corporate
level via corporate taxes, and again as an income
tax on the equity holder. Hence, any corporation
seeking to minimize its taxes and maximize the
revenues available to investors should finance
itself entirely with debt.
In a 1977 article, "Determinants of corporate
borrowing," Myers showed that considering
corporate taxes in isolation does not reflect
real world economic interactions. Transferring
interest payments to individual bondholders to

7
 Financing and Raising Capital
avoid corporate taxes does not make investors
any better off if they then have to pay higher
personal taxes on that interest income than the
corporation and investors would have owed had
u the corporation not used debt. Miller argued that
OH
because tax rates on capital gains have often been
lower than tax rates on individuals' dividend and
M interest income, the firm might lower the total
tax bill paid by the corporation and investor
combined by not issuing debt at all. Moreover,
-8 taxes owed on capital gains can be deferred until
Q the realization of those gains, further lowering
the effective tax rate on capital gains. Because
of this interaction, there is an optimal level of
debt (less than the 100% suggested above) for
corporations as a whole.
DEFAULT COSTS
Costs associated with financial distress
and, more obviously, bankruptcy also keep
firms from issuing large levels of debt
compared to their level of underlying equity
finance. These costs can take two forms, being
either explicit or implicit. Explicit default
costs include the payments made to lawyers,
accountants, and other professional advisers
in the case of bankruptcy and liquidation,
or filing for Chapter 11 protection. These
costs can represent a significant portion of total
corporate assets, which are lost to investors
in the case of bankruptcy. Corporations also
need to consider the indirect costs of financial
distress that occur as a company moves closer
to default and bankruptcy. These can include
higher costs from suppliers which fear that the
company might not pay its future bills, and the
loss of customers who want stable and long-
term relationships with their suppliers and
counterparties.
Clearly, investors would prefer that firms stay
out of default or financial distress so that these
costs, both explicit and implicit, are not incurred.
However, as a corporation takes on more
and more debt, the probability of bankruptcy
increases. Hence, the marginal benefit of further
increases in debt declines as debt increases. At
the same time, the marginal cost increases, so
that afirmthat is optimizing its overall value will
focus on this trade-off when choosing how much
U debt and how much equity to use for financing.
These costs are one of the factors that restrain
firms from maintaining very high levels of debt,
and are why different industries, with different
earnings volatility, can support different levels
of debt.
8
AGENCY COSTS
The decision to issue corporate debt arises
from the conflict between competing sources of
finance offered by the debt and equity markets.
There are large differences between a firm that
is 100% owner managed and one in which the
equity is owned by external stockholders or a
mix of the managers and outside stockholders.
With external stockholders, the managers act as
agent for the ultimate owners. Although these
agents should run the firm to maximize its value,
they may not be perfect agents for the equity
owners as they may make some decisions to
further their own interests ahead of the ultimate
owners. Agents could award themselves excess
pay or benefits, or indulge in empire-building to
increase their own reputations. They may even
favor the security of the debtholders rather than
the returns of the stockholders. The impact of
these agency costs can affect the distribution of
financing for a corporate.
CREDIT RATIONING
Traditional economics argues from the
standpoint that markets are efficient (as we have
seen with Modigliani and Miller's contribution).
In 1981 Joseph Stiglitz and Andrew Weiss
suggested that markets are only efficient under
exceptional circumstances. To reduce potential
losses, lenders without perfect knowledge of
their counterparties have an incentive not only
to charge higher rates to high-risk lenders, but
also to ration the provision of credit to them
as well. The concern for the lender is that, as it
raises the rate of interest charged for its loans,
only those firms which are most desperate
for finance will take the loans, and these are
precisely the corporations that are most likely
to go into bankruptcy. If bankruptcy occurs, the
corporation is able to walk away from its debt
and the lending institution underwrites the cost
of failure. This suggests that if a firm is able to
obtain a large amount of loan financing, it has a
large incentive to undertake higher-risk projects
because the risk is asymmetric.
Typically, credit rationing will most often
happen with smaller and younger corporations,
which are more likely to be owned by their
founders, rather than to firms that have a track
record or some existing external investors. It is
with these owner-managed firms that the risk
of imperfect knowledge creates most tension
between equity and debt holders. Not only is
it likely that the manager/owner of a firm has
superior information on his business, but he
can also adjust his managerial or investment
strategy after concluding a debt contract.
 Issuing Corporate Debt
Only corporations with riskier projects would the bondholders would be better off with the
be ready to take high interest rate loans, so investment, equity holders will be unwilling to
raising the interest rate without credit rationing pay for them. Alternatively, as corporate default
would increase the proportion of risky borrowers approaches, equity stockholders will be willing
and reduce the overall profitability of the to invest all their current investment in a very
lender. risky project with high potential returns. If the
project fails, the bondholders will lose more, but
EQUITY DILUTION the stockholders can be no worse off because
Myers and Majluf (1984) produced research their claims were worthless anyway. If, however,
suggesting that owner-managers use external the project succeeds, the stockholders will be the
financing (debt or equity) only when there is major beneficiaries.
insufficient internal financing (i.e. their own Finally, and perhaps most obviously, stock-
money) available for new projects. Indeed, they holders could just pay out all of the firm's
go as far as to suggest that managers prefer to assets as dividends to themselves, leaving
issue debt over equity. The idea behind this an empty shell for the bondholders to claim
theory is that managers often believe they have a when the firm is then unable to repay its debt.
better idea of the true worth of their corporation In an effort to prevent this, most debt issues
than potential outside bond or equity investors. or bank lending will have covenants attached
Since potential investors cannot adequately to prevent the equity holders stripping assets,
value stock, it would generally be sold at a price and hence security, away from the corporation
below the price the managers think appropriate. that takes on the debt financing. These covenants
Rather than sell stock too cheaply, therefore, exist to restrict stockholders' freedom of
managers who need externalfinancingwill prefer action, and to try to even out the risk/reward
to issue debt. It can be argued that in issuing structures between debt and equity holders.
equity to outside investors, owner-managers
However, bond contracts cannot prevent all
might think that the firm is overvalued and that
eventualities.
the current owners are taking advantage of this
overvaluation. This reinforces the view that debt All of these strategies—risk shifting, under-
is likely to be preferred over equity in smaller, investment, paying out large dividends—are
private companies. more likely the more indebted is the firm.
Stockholders may adopt policies that benefit
themselves at the expense of the bondholders,
DIFFERING GOALS OF FINANCIAL
and the incentive to do this is strongest when it
SPONSORS
is not clear that the firm will have sufficient cash
The idea of bondholder and stockholder conflict is
flow to cover its debt payments.
widely accepted as a key determinant of financial
policy. Bondholders and stockholders often have Potential lenders know this and limit the debt
competing aims and attitudes to risk-taking they extend accordingly. Similarly, corporate
behavior. Even in highly profitable corporations, managers who want to attract lenders and debt
stockholders bear most of the investment funding have to judge how much debt is suitable
costs but share the benefits with bondholders. for a company in a particular industry and state
Consequently, bondholders typically value a of growth. Youngfirmsin high-growth industries,
risk-averse strategy as that will increase the for example, tend to use less debt, and firms in
chances of getting all their investment back. stable industries with large quantities of fixed
Stockholders, on the other hand, are willing assets tend to use more debt.
to take on riskier projects. If the risky projects
succeed, they will get all the profit themselves, CONCLUSION
whereas if the projects fail the risk is shared with Current economic theory, based on many of the
the bondholders. ideas discussed above, suggests that an optimal
Another area where these divergent goals capital structure exists that balances the risk of
are clearly demonstrated is with the problem bankruptcy with the tax savings of debt. Once
of underinvestment in times of financial established, this capital structure should provide
difficulty. Stockholders have little incentive greater returns to stockholders than they would
to invest in new projects as corporate default receive from an all-equity firm. However, the
approaches, because the funds they contribute complexities of the competitive environment
to the enterprise will benefit bondholders and and the huge diversity of corporations and their
other creditors in the event of default; this is competitive environments all affect an individual
the so-called debt overhang problem. Even if corporation's optimal capital structure.

9
 Financing and Raising Capital

.2 MAKING IT HAPPEN
y • Economic theory can only help so much in deciding the optimal financing structure for a
5J corporation.
QH • Modigliani and Miller's seminal work in 1958 suggested that it did not matter whether a
•M corporation was debt or equity financed, but the perfect assumptions on which their theorem
V rested have proved an unrealistic fit to corporate experience of the real world. Here taxes, the
PQ fear of bankruptcy, and the divergent aims of bond and stockholders, particularly in times of
• financial distress, far outweigh the pull of economic theory.
jS • The ideal mix of financing for an individual corporation is almost impossible to find because of
<W near constantly shifting debt and equity market sentiment in response to perceived risk and
" return, and the competitive environment of an individual corporation.
I? • However, a corporation can benchmark its financing structure against its competitors, similar
•JH industries, and the advice of consultants and investors.
S3
(A
CC

MORE INFO
Books:
Chew, Donald H., Jr. The New Corporate Finance: Where Theory Meets Practice. 3rd ed. New York:
McGraw-Hill, 2 0 0 1 .
Jaffee, D. M. Credit Rationing and the Credit Loan Market. New York: Wiley, 1 9 7 1 .
Articles:
Allen, Franklin, and Douglas Gale. "Optimal security design." Review of Financial Studies 1:3 (Fall
1988): 2 2 9 - 2 6 3 . Online at: dx.doi.org/10.1093/rfs/l.3.229
Donaldson, Gordon. "Financial goals: Management vs stakeholders." Harvard Business Review
(May-June 1963): 116-129.
Hackbarth, Dirk. "Determinants of corporate borrowing: A behavioral perspective." Paper presented
at 14th Annual Utah Winter Finance Conference, February 5 - 7 , 2004.
Harris, Milton, and Artur Raviv. "The theory of capital structure." Journal of Finance 4 6 : 1 (March
1991): 2 9 7 - 3 5 5 . Online at: www.afajof.org/journal/jstabstract.asp7ref = 11098
Jensen, Michael C , and William H. Meckling. "Theory of the f i r m : Managerial behavior, agency
costs and ownership structure." Journal of Financial Economics 3:4 (October 1976): 3 0 5 - 3 6 0 .
Online at: dx.doi.org/10.1016/0304-405X(76)90026-X
Miller, Merton H. "Debt and taxes." Journal of Finance 32:2 (May 1977): 2 6 1 - 2 7 5 . Online at:
www.afajof.org/journal/jstabstract. asp?ref=9267
Miller, Merton H. "Leverage." Journal of Finance 4 6 : 2 (June 1991): 4 7 9 - 4 8 8 . Online at:
www.afajof.org/journal/jstabstract.asp?ref=lllll
Modigliani, Franco, and Merton H. Miller. "The cost of capital, corporation finance and the theory of
investment." American Economic Review 48:3 (June 1958): 2 6 1 - 2 9 7 . Online at:
www.jstor.org/stable/info/1809766
Myers, Stewart C. "Determinants of corporate borrowing." Journal of Financial Economics 5:2
(November 1977): 147-175. Online at: dx.doi.org/10.1016/0304-405X(77)90015-0
Myers, Stewart C. "The capital structure puzzle." Journal of Finance 39:3 (July 1984): 5 7 5 - 5 9 2 .
Online at: www.afajof.org/journal/jstabstract.asp?ref= 10308
Myers, Stewart C , and Nicholas S. Majluf. "Corporate financing and investment decisions when
firms have information that investors do not have." Journal of Financial Economics 13:2 (June
1984): 1 8 7 - 2 2 1 . Online at: dx.doi.org/10.1016/0304-405X(84)90023-0
Simerly, Roy L , and Mingfang Li. "Re-thinking the capital structure decision: Translating research
into practical solutions." B>Quest (2002). Online at:
www.westga.edu/~bquest/2002/rethinking.htm
UA Stiglitz, Joseph E. "On the irrelevance of corporate financial policy." American Economic Review
QJ 64:6 (December 1974): 8 5 1 - 8 6 6 . Online at: www.jstor.org/stable/1815238
v r
pK Stiglitz, Joseph E, and Andrew Weiss. "Credit rationing in markets with imperfect information."
^ American Economic Review 71:3 (June 1981): 3 9 3 - 4 1 0 . Online at:
^7 www.jstor.org/stable/1802787
i—i
LL, Website:
Q^ Wikipedia article on capital structure: en.wikipedia.org/wiki/Capital_structure

lO
Banks and Small and Medium-
Sized Enterprises: Recent Business
Developments by Sergio Schmukler, Augusto
de la Torre, and Maria Soledad Martinez Peria
EXECUTIVE SUMMARY
• Banks consider SMEs to be core strategic businesses with a high profit potential.
• To serve SMEs, banks are now establishing separate dedicated units, standardized processes,
and risk-management systems.
• The relationship manager's role is crucial for attracting new customers, and selling products to
existing SME customers.
• Banks are increasingly serving SMEs through different transactional technologies, which
emphasize cross-selling.
• Large, multiple-service banks are the main players in the SME market.
INTRODUCTION
A common perception is that small and
medium-sized enterprises (SMEs) cannot
access appropriate financing. This perception
is often supported by academic and policy
circles' "conventional wisdom" that banks are
generally not interested in dealing with SMEs,
mainly due to SMEs* perceived opaqueness1 and
higher informality.2 As capital markets do not
compensate for these deficiencies in the banking
sector, the need to receive special assistance, such
as government programs to increase lending, has
been suggested.3 In recent years, SME financing
initiatives included government-subsidized lines
of credit and public guarantee funds.4
In the academic literature, there is evidence
that banks (especially small and niche players)
engage with SMEs through relationship lending.
Relationship lending can overcome opaqueness
due to the primary reliance on "soft" information
gathered by the loan officer through continuous,
personalized, direct contacts with SMEs.5
However, in a series of studies recently conducted
by the World Bank, new stylized facts point to a
gap between the conventional view and the way
banks are actually interacting with SMEs.6
First, new evidence suggests that most banks,
including large and foreign banks, indeed serve
SMEs, finding this segment very profitable.7
Second, different transactional technologies
that facilitate arms-length lending (such as
credit scoring and significantly standardized
risk-rating tools and processes, as well as special
products such as asset-based lending, factoring,
fixed-asset lending, and leasing) are increasingly
applied to SME financing (Berger and Udell,
Gfi
3
CTQ
G
2006). Third, banks try to serve SMEs in a
holistic way through a wide range of products
and services, with fee-based products rising in
importance, placing cross-selling at the heart of
their business strategy.
Under this new model of bank engagement
with SMEs, larger, multiple-service banks
exhibit, through the use of new technologies,
business models, and risk-management systems,
a comparative advantage in offering a wide
range of products and services on a large scale,
becoming leaders in this business segment.
NEW BUSINESS MODEL
Banks' high level of interest towards SMEs
has, consequently, brought major changes to
business models. First, as SMEs have become
a strategic sector, banks are changing their
organizational set-up to approach and serve this
segment efficiently. Two main structures can be
broadly categorized. The first combines the work
of a commercial and credit risk team established
at headquarters, with relationship managers
distributed throughout the branches. The
second consists of business centers or regional
centers that operate as mediators between
headquarters and branches, with a team leader
or regional manager who controls and trains
the relationship managers of the corresponding O
branches. In addition, banks are establishing
separate, dedicated units with new strategies to
cater adequately for the specific needs of SMEs.
These dedicated business units approach SMEs in
an integrated way, offering them a wide variety of
products and services, including both deposits
o
11
 Financing and Raising Capital
and loan products. In this set-up, relationship
o primarily applied to small loans.
managers (RMs) are instrumental in attracting
new customers, and selling products to existing
ones. RMs look for new clients and prepare the
information of each SME that is presented at the
regional centers or at headquarters. They develop
CO
a relationship with the client, and, in some cases,
RMs are allowed to express their opinion, make
recommendations, or even present the case to
the credit committee.
v Second, the new model serves SMEs at all
Q branches, and with standardized processes,
facilitating the reduction of the high transaction
C personnel, and risk analysts).
costs that dealing with each SME entails. In most
cases, branches and headquarters complement
CO each other and undertake different functions.
The initial stages of granting loans to SMEs
are decentralized in most banks, while later
stages, such as risk analysis or loan recovery, are
usually centralized. In addition, banks exploit
the synergies of working with different types of
clients. Using information from existing firm
databases, such as credit bureaus, relying on
existing deposit clients, and attracting clients
with bank credit are also common approaches
that banks use to identify prospective SMEs.
Third, regarding credit-risk management,
banks are reorganizing their systems, with
a greater degree of sophistication among
international banks and the leading, large
domestic banks. Typically, risk management
is a process that is organizationally separated
from sales, and primarily done independently
at headquarters. In most large banks, credit-risk
management is not automated. Furthermore,
in most cases, credit-risk management involves
a credit-risk analyst, who is in charge of
conducting both qualitative and quantitative
risk assessments on the SME. The quality rating
of SME management and SWOT (strengths,
weaknesses, opportunities, and threats)
analysis are the main components of qualitative
assessments, while the financial analysis and
projections of the SME firm and the SME
owner are the main quantitative assessments.
Qualitative assessments usually include an
analysis of the SMEs' products, their demand and
market structure, the quality of the owners and
managers (including the degree of separation
u between management and owners), the degree
z of informality, the years of activity in the sector,
t
and the vulnerability to foreign-exchange-rate
fluctuations. Quantitative assessments entail
an analysis of profitability, cash-flow generation
M
o
capacity, solvency, quality of assets, structure of
balance sheets, and global guarantees. Moreover,
12
scoring models are still being developed, and
Monitoring of the credit-risk outlook is
standardized at the majority of banks. Some
monitoring mechanisms used frequently are
preventive triggers and alerts automatically
generated to signal the deterioration of the
SMEs' payment capacity. However, credit-risk
monitoring still depends on the diligence of the
relationship manager or the credit-risk analyst.
Some banks use a system that allows different
individuals to provide input on each enterprise
(such as auditors, back-office staff, sales
The business and risk-management models
described above can be better pursued by large
universal banks, especially foreign ones, which
can be more aggressive in reaching out to SME
clients, and are better suited to conduct lending
based on automated scoring models for small
loans (as they have the know-how and models
to do so) and template-type rating systems for
larger loans (based on streamlined, standardized
versions of corporate rating).
SME EVIDENCE
SMEs interact with banks using a variety of
products, mostly checking and savings accounts,
as well as term loans.8 Furthermore, SMEs do
not exclusively obtain financing via "relationship
loans." SMEs accessfinancingproducts that do not
depend on the bank processing soft information
on the firm.9 An interesting finding is that the
provision of loans through public programs or
guarantees is low. The highest usage of public
programs observed is in Chile, with 8% of SMEs
reporting using them; other countries are reporting
percentages of around 3% (World Bank, 2007a).
Nonetheless, while SMEs increasingly interact
with banks to purchase a range of products and
services, SMEs still appear unable to obtain
access to crucial products such as loans secured
by certain forms of collateral (for example,
accounts receivable, inventories, equipment,
cattle, and intangible assets), or long-term,
fixed-interest rate loans in domestic currency.
However, it is still unclear how much SMEs
in developing countries would be able to rely
on banks to obtain those products. As the US
literature indicates (Carey et al, 1993; and
Berger and Udell, 1996), SMEs might have
to rely on private placements and non-bank
institutions. Bank financing for certain SMEs,
such as start-ups (in particular, those in high-
tech or research-based industries), is also likely
to remain limited, as has proven to be the case in
developed markets such as the United States.
 Banks and Small and Medium-Sized Enterprises

w
CASE STUDY en
Government Interventions in Colombia10
While direct government funding programs have been described as relatively unsuccessful, policy
innovations could still prove important for SME financing. For example, in Colombia, several policy
measures targeted towards the micro and SME segments have been introduced since 2004. On
the one hand, non-financial instruments have been implemented, including training programs to
increase competitiveness, and promote technological development and exports. On the other hand,
financial instruments have been introduced, including the further expansion of existing government
programs, and promoting the development of alternative financing instruments (investment funds, (ft
C
factoring/supplier financing, fiduciary structures, etc).
Colombian government programs include long-term development funds and partial credit
CFQ
guarantees. Longer-term development funding is mainly provided in the form of rediscounting lines
at below-market rates by the state-owned, second-tier credit institutions, Bancoldex,11 Finagro,12 d
and Findeter.13 Partial credit guarantees—typically around 50% loan-loss coverage—are provided
by FNG,14 as well as by FAG1S for the agricultural sector. The role of these institutions—particularly
Bancdldex and FNG—has been cited as instrumental in promoting access to credit for SMEs.
The authorities have recently embarked on an initiative to improve financial access, including
for SMEs. The low level of financial penetration in Colombia, both in response to pre-crisis levels
and in comparison to regional peers, has prompted the authorities to take measures to expand
access to credit and other financial services. Both demand- and supply-side barriers have been
identified, and will be tackled via regulatory reforms and the Banca de las Oportunidades initiative.
Recent policy measures include the introduction of correspondent banking arrangements, changes
in the definition of the interest-rate ceiling, the passage of legislation on credit reporting, and the
strengthening of creditor rights via a new bankruptcy law. Additional proposed reforms include
changes to the civil code on enforcement procedures and to the financial system structure, as well
as plans for the introduction of a special savings account for low-income households. In addition,
the Banca de las Oportunidades initiative aims to design and propose measures to stimulate
financial access, particularly for low-income households.

CONCLUSION segment, it is likely that the models to work with

In summary, the new evidence shows that the
whole spectrum of private banks Oarge and small,
domestic and foreign) has started to perceive
SMEs as a strategic sector. Banks are aggressively
expanding, or planning to expand, their operations
in the SME segment. As a consequence, the SME
market is becoming increasingly competitive,
although far from saturated. The evidence
suggests that banks are learning how to deal
with SMEs, and, at the same time, making the
investments to develop the structure to deal
with a growing market in the years to come. As
banks have recently discovered a key, untapped
SMEs will evolve significantly as the involvement
with the SME segment increases.
However, there are issues that remain for future
work. Although banks appear to have become
more involved with SMEs, banks may not be
able to measure comprehensibly their exposure
to the segment in terms of income, costs, or risk.
Furthermore, banks are not adequately tracking
their loan-loss experiences. We might be witnessing
a process in which banks are only now developing
the structure to deal with SMEs, and, through their
interactions with the segment, they will be able to
reduce the involved costs and risks.

13
 Financing and Raising Capital

MORE INFO
Books:
2 Berger, Allen N., and Gregory F. Udell. "Universal banking and the future of small business lending."
OH In Anthony Saunders and Ingo Walter (eds). Financial System Design: The Case for Universal
*£ Banking. Burr Ridge, IL: I r w i n , 1996; 5 5 9 - 6 2 7 .
<W de la Torre, Augusto, Maria Soledad Martinez Peria, Mercedes Politi, Sergio Schmukler, and Victoria
tt Vanasco. "How do banks serve SMEs? Business and risk management models." In Benoit Leleux,
* Ximena Escobar de Nogales, and Albert Diverse (eds). Small and Medium Enterprise Finance in
,£) Emerging and Frontier Markets. IMD and IFC, 2008a.
2£ DeYoung, Robert, and William C. Hunter. "Deregulation, the internet, and the competitive viability
of large and community banks." In Benton E. Gup (ed). The Future of Banking. Westport, CT:
Quorom Books, 2003; 1 7 3 - 2 0 2 .
Organisation for Economic Co-operation and Development (OECD). The SME Financing Gap:
55 Volume I—Theory and Evidence. Paris: OECD Publishing, 2 0 0 6 .
| H
- Articles:
Berger, Allen N., and Gregory F. Udell. "A more complete conceptual framework for SME finance."
Journal of Banking and Finance 3 0 : 1 1 (November 2006): 2945-2966. Online at:
dx.doi.org/10.1016/j.jbankfin.2006.05.008
Carey, Mark, Stephen Prowse, John Rea, and Gregory Udell. "The economics of the private
placements: A new look." Financial Markets, Institutions and Instruments 2:3 (August 1993):
1-66.
Carter, David A., James E. McNulty, and James A. Verbrugge. "Do small banks have an advantage
in lending? An examination of risk-adjusted yields on business loans at large and small banks."
Journal of Financial Services Research 2 5 : 2 - 3 (April 2004): 2 3 3 - 2 5 2 . Online at:
dx.doi.org/10.1023/B:FINA.0000020663.21079.d2
DeYoung, Robert. "Mergers and the changing landscape of commercial banking (part I I ) . " Chicago
Fed Letter 150 (February 2000). Online at: tinyurl.com/33afmy7
DeYoung, Robert, William C. Hunter, and Gregory F. Udell. "The past, present, and probable future
for community banks." Journal of Financial Services Research 2 5 : 2 - 3 (April 2004): 8 5 - 1 3 3 .
Online at: dx.doi.org/10.1023/B:FIIMA.0000020656.65653.79

Reports:
Beck, Thorsten, Asli Demirgiic-Kunt, and Marfa Soledad Martinez Perfa. "Bank financing for SMEs
around the world. Drivers, obstacles, business models, and lending practices." Policy Research
Working Paper 4785. World Bank, November 2008. Online at:
dx.doi.org/10.1596/1813-9450-4785
de la Torre, Augusto, Juan Carlos Gozzi, and Sergio L. Schmukler. "Innovative experiences in
access to finance: Market friendly roles for the visible hand?" Policy Research Working Paper
4326. World Bank, November 2007. Online at: dx.doi.org/10.1596/1813-9450-4326
de la Torre, Augusto, Maria Soledad Martinez Peria, and Sergio L. Schmukler. "Bank involvement
with SMEs: Beyond relationship lending." Policy Research Working Paper 4649. World Bank, June
2008b. Online at: dx.doi.org/10.1596/1813-9450-4649
Independent Evaluation Group (IEG). "Financing micro, small, and medium enterprises through
financial intermediaries." Washinton, DC: International Finance Corporation, World Bank, 2008.
Stephanou, Constantinos, and Camila Rodriguez. "Bank financing to small and medium-sized
enterprises (SMEs) in Colombia." Policy Research Working Paper 4 4 8 1 . World Bank, January
2008. Online at: dx.doi.org/10.1596/1813-9450-4481
pq World Bank. "Bank financing to small and medium enterprises: Survey results from Argentina and
QJ Chile." 2007a. Online at: tinyurl.com/26eu78q
^7 World Bank. "Bank lending to small and medium enterprises: The Republic of Serbia." 2007b.
<H Online at: tinyurl.com/22supx6
*jr World Economic Forum (WEF). "World Economic Forum on Latin America: Securing a place in an
»—i u n c e r t a i n e c o n o m i c l a n d s c a p e — C a n c u n , Mexico 1 5 - 1 6 April 2 0 0 8 — R e p o r t . " Online a t :

a
>T. tinyurl.com/2vlgmq7

14
 Banks and Small and Medium-Sized Enterprises
NOTES
1 Opaqueness means that it is difficult to ascertain if
firms have the capacity to pay (for example, viable
projects) and/or the willingness to pay (due to
moral hazard). For example, lack of audited financial
statements prevents banks from engaging in what
is known as financial-statement lending, by which
the loan contract terms are set on the basis of the
company's expected future cash flow and current
financial condition, as reflected in audited statements
(see Berger and Udell, 2006).
2 If firms do not reliably report their full financial
activity on their financial statements, banks do not
count, for example, with complete information on
warranties for lending. See OECD (2006) for more on
the factors that drive SMEs to operate in the informal
economy, especially in emerging economies.
3 The need to provide support to SMEs through
critical government investments was stated at the
World Economic Forum on Latin America Summit in
2008. In addition, re-examination of tax regimes,
regulatory reforms, and provision of capital through
public-private partnerships were mentioned. See WEF
(2008).
4 Chile's Fondo de Caranti'a para Pequenos Empresarios
(FOGAPE) is a fund created to encourage bank
lending to SMEs through partial credit guarantees.
The Colombian Fondo Nacional de Garantias (National
Guarantee Fund) provides similar partial credit
guarantees. Structured finance transactions arranged
by FIRA, a Mexican development financial institution
focused on the agricultural sector, are another
example of a government effort to provide financing
to rural SMEs. Furthermore, the Mexican development
bank, NAFIN, has initiated a reverse factoring
program to provide working capital financing to SMEs
through a process of online sale of receivables from
large buyers. See de la Torre et al. (2007).
5 See DeYoung (2000), DeYoung, and Hunter (2003),
Carter e r a / . (2004), and DeYoung etal. (2004) for a
discussion of the comparative advantages that small
community banks have in lending to small firms
through relationship lending.
6 See de la Torre et al. (2008a, 2008b) for a
comprehensive analysis. Case studies are also
available for Argentina, Chile, Colombia, and Serbia,
describing the institutional and macroeconomic
contexts, their banking industries and trends, and the
data in detail. See World Bank (2007a and 2007b)
and Stephanou and Rodriguez (2008).
7 Using data from 9 1 banks in 45 countries, Beck er
al. (2008) found that all banks in the sample have
SME customers, over 8 0 % perceive the market to be
big and prospects to be good, and more than 6 0 %
have a separate department managing their relations
with SMEs. On average, the share of bank loans to
small (medium) enterprises averages 1 1 % ( 1 3 % ) ,
compared to 3 2 % in the case of large firms. The
share of non-performing loans for small (medium)
enterprises is 7.4% ( 5 . 7 % ) , compared to 4 % in the
case of large firms.
8 Banks have developed a wide range of fee-based,
non-lending products and financial services for SMEs.
Loans are not all always the main product offered
to SMEs. Moreover, loans are often offered as a way
to cross-sell other lucrative fee-based products and
services. See de la Torre etal. (2008a, 2008b).
9 de la Torre et al. (2008b) argue that banks are
developing new technologies and business models to
serve the SME segment, reducing their dependence
on "relationship lending" and the gathering of "soft"
information, which is costly and time-consuming.
10 This case study can be found in Stephanou and
Rodriguez (2008).
11 Banc6ldex's main aim is to provide low-interest lines
of credit via first-tier credit institutions for exporters
and SMEs.
12 Finagro's main aim is to provide low-interest financing
for agriculture, livestock, forestry, and related rural
projects.
13 Findeter was set up in order to lend (via first-tier
banks) to subnational entities for infrastructure and
other development projects.
14 FNG is a guarantee fund that "backs" credits to
all economic sectors (except agriculture) with the
primary objective of facilitating access to credit for
micro enterprises and SMEs.
15 FAG is a guarantee fund that "backs" working capital
and investment loans for the agricultural sector that
are financed either with Finagro discounting, or with a
credit institution's own funds.
15
Capital Structure: A Strategy w
that Makes Sense by John C. Groth
EXECUTIVE SUMMARY
• Perfect capital markets prescribe an optimal capital structure.
a
• Imperfect capital markets, the seasonal and cyclical aspects of an economy, and the variability
of market conditions argue that a company should have a target capital structure and an
operating capital structure range.
• Managers should be sensitive to changes in the business risk of a company, as these alter the
optimal capital structure.
s.
S3
• Maintaining good debt capacity makes sense and may favorably influence stock price. cro
• Using bad debt capacity does not make sense from the viewpoint of stockholders and primary
creditors. «
• Projects with good economic returns restore debt capacity and reduce the debt/equity (D/E)
ratio. Bad projects that do not have attractive economic returns will have an adverse effect on
capital structure, increase the D/E ratio, and eventually decrease the optimal D/E ratio.
• Managers may adjust capital structure quickly or gradually. Whether quickly or gradually hinges
on a variety of factors.
• Capital structure is important for privately held firms.
• Stock repurchase programs call for sensitivity and possible adjustment of debt capital so that
one attains and/or preserves the desired capital structure.
• Leveraged buyouts often distort capital structure. The decision to accept abnormal capital
structures originates with those promoting the buyout and their perceptions about gains relative
to personal capital at risk.
• Issues related to control may influence the choice of capital structure.

INTRODUCTION pursue opportunities even (or especially) during

Perfect capital markets enjoy an array of
assumptions, including no cost to bankruptcy,
infinitely divisible financial assets and liabilities,
no transaction costs, etc. Pursuing a selected
optimal capital structure would allow minute
adjustments, the issuance or redemption of small
amounts of capital, and other conveniences. We
would simply strive for the optimal debt/equity
ratio depicted in Figure 1. Indeed, in this unreal
world one would keep all the equity for control
and to maximize wealth—and employ massive
amounts of debt.1
Imperfect Capital Markets
The rudeness of imperfect markets prompts
us to adopt a reasonable strategy that allows
one to benefit from the tenets of capital
structure theory while respecting the reality
of markets and economies. Imperfect capital
markets, bankruptcy costs, and that a company
with financial flexibility may have attractive
opportunities during periods of adverse
market conditions argue for a strategy for the
management of capital structure. Additionally,
capital market participants may value a company
with the financial flexibility that would allow it to
periods of high market stress. A company with
financial flexibility may find bargains during
periods of distress.
In this article we first address background
issues. Then we will move to recommendations.
We will see that the suggested strategy does not
seek to have the theoretical optimal debt/equity
(D/E) ratio.
Good and Bad Debt Capacity
A company that has a less than optimal D/E ratio
has unused good capacity. Normally a company
with "good" debt capacity can borrow quickly
on favorable terms to pursue an attractive
opportunity. Thus, it can obtain capital quickly
without the delays or possible undesirability of
an equity offering.
Exceeding the optimal D/E ratio results
in the company using "bad" debt capacity.
History tells us that it is possible to do stupid O
things. Occasionally, we also see agents taking
z
»—H
actions that promote their own interests, rather
than acting in a way that benefits owners and
creditors. Bad debt capacity adversely affects the
weighted cost of capital, limits flexibility, and
decreases stock price. o

17
 Financing and Raising Capital
ISSUES AND STRATEGY
Interrelationships
The expected streams of cash flows that
C0 originate in the business or operating side of a
U
company service the sources of capital, including
short-term liabilities such as accounts payable.
Choices on the asset side of the company, and
how successfully the company operates assets
and interacts with the markets for goods and
services, precipitate effects on the financing side
X5 of the company.
Q Although EBITDDA (earnings before interest,
taxes, depreciation, depletion, and amortization)
C is not necessarily a cashflowin a period of time,
'3 for reasons explained in my article "Accounting
and economics—Critical perspectives,"2 let us for
M simplicity assume that it is a cashflow.Those who
have provided financing for the company have a
keen interest in the level of expected cash flows,
and the timing and the uncertainty of those cash
flows. Hence, what the company chooses to do
(its investments) and how well it employs those
assets to generate cash flows (production, sales,
collections, etc.) influence the business risk of
the company.
The business risk, and factors such as tax
rules and rates, influence the optimal financing
for the company and, in turn, the financial risk
of the company. Let us share some summary
comments.
Figure 1. Adjusting capital structure
Return on equity (%)
Cost of
equity
capital,
no debt
RF
P-l
u
z C: Original D/E
$ •
o
OH
Debt/Equity ratio (D/E)
18
MANAGING AND ADJUSTING CAPITAL
STRUCTURE
The company might select a gradual, a lumpy, or a
quick process for adjusting capital structure. For
discussion, we will assume that the company has
the ratio D/E = C in Figure 1, a level which is less
than the optimal D/E = O. Its WCOC is higher
than it need be, and the value of the company
and equity are lower than they could be.
We will examine different ways of altering the
D/E ratio. Our discussion will explain ways to
either increase or decrease the D/E ratio to show
how different variables influence the ratio. Later
we will suggest how this sample company might
move towards the optimal point. Shortly we will
explain why normally we probably don't want to
move to the optimal point.
Possible Gradual Process Steps
To move the D/E ratio to the left (which is not
our objective for the company in Figure 1), do
one or more of the following:
• If a dividend-paying company, have a payout
ratio of less than 100%. To adjust the payout
ratio, one can increase dividends at a slower
rate than the growth in earnings.
• Pay off some of the principal of the debt using
cashflowfrom operations and/or from the
sale of assets.
• Do both.
Weighted
cost of
capital
(WCOC)
Risk-free
O: Optimal D/E interest rate
•
(RF)
 Capital Structure: A Strategy that Makes Sense
To move the D/E to the right, towards the
optimal ratio:
• Increase the payout ratio.
• Delay, if without penalty and with
explanation to the market, the retirement of
principal on debt.3
The Lumpy Approach
The borrowing of chunks of money for corporate
use, such as capital projects, will result in a jump
to the right in the D/E ratio. Employed wisely
in projects that have good economic results, the
freshly raised capital generates fresh additions to
equity. The D/E gradually moves back to the left.
The Quick Process
Adjusting capital structure quickly is relatively
easy if the company has less than the optimal
amount of debt and wants to increase its D/E
ratio. The tactic calls for arrangement for,
and announcement of, the borrowing of the
appropriate amount of money for the purpose
of using the proceeds to repurchase some of
its stock to adjust the capital structure to an
optimal level. Explaining the purpose for the
borrowing gives notice to all stockholders and
offers a positive reason for stock repurchase,
thus avoiding arguments of possible negative
signaling associated with stock repurchase.
To increase the D/E ratio quickly, one
might borrow a chunk of capital (again with
explanation to the market) and declare a
special cash dividend. This approach requires
careful consideration of tax preferences of
the stockholders in tax environments where
dividends are taxed at a high rate.
As part of an acquisition strategy—though not
as a reason for acquisition—the company might
acquire another company that has too much debt.
The combined companies could have a capital
structure closer to the optimum. This is shown as
follows. If the acquiring company has a less than
optimal D/E ratio, its stock price will be depressed.
If the acquired company has a D/E ratio greater
than the optimal, its stock price will also be
depressed. A combination of two companies with
the "correct" proportions will result in an increase
in value traceable to the movement towards a
more optimal capital structure.
This improvement in stock value could be
realized without the acquisition by just adjusting
the capital structure of both companies. We
mention this only because capital structure
considerations and adjustments are sometimes
important in acquisitions.
If a company has more than the optimal
amount of debt, adjusting capital structure may
not be as easy, or at least not as advisable, under td
certain market conditions. Even if capital markets a
are in turmoil, some theorists will argue for the en
it
following approach: announce the issuance of
common stock, with the proceeds dedicated to
retiring some debt. The market's knowledge of
this act of moving towards the optimal debt ratio
should favorably affect the price of the stock.
Practitioners might suggest that such a change
could have adverse effects if the company is
under duress or when markets are in tumult.
Some would argue that the funds realized from
the equity offering make this a poor strategy. S3
Instead, the company should ride out the bad OQ
times or bad markets and make adjustments to
its capital structure at a later date.
s-
ISSUES CONCERNING CONTROL
A company may alter its capital structure for
reasons of control. Equity holders—except for
certain classes of stock found in some markets-
have voting rights. Assume that some current
equity holders value control. We will term these
the "control group." The nature and manner
of altering the capital structure may influence
control in one or more ways:
• The company repurchases some of its stock.
Repurchased shares, or "treasury stock," do
not confer voting rights. Those in the control
group do not sell any stock. The control group
now has a larger percentage of ownership.
The D/E moves to the right.
• The company issues new stock with a rights
offering. The D/E moves to the left. Members
of the control group exercise their rights and
buy the shares. If not all other stockholders
exercise their rights, one or both of the
following may occur:
• Some do not exercise rights at all: the
control group's proportion of ownership
increases.
• Some sell rights to others, who exercise the
rights and buy stock, leading to dispersion
of stockholder ownership. Dispersion
of ownership may increase the effective
control of the control group, even with the
exercise of all rights.4
OTHER ISSUES
Risk Preferences and the Choice of D/E Ratio
Recall a fundamental principle of the valuation o
of risky assets. Markets value assets, not
management or the board of directors. The
z
implications of this fundamental principle are
straightforward—and important. Do what the
markets like. The risk preferences of market
participants, rather than the personal preferences o
19
 Financing and Raising Capital
V of management, should guide decisions and
•rt influence the choice of capital structure. Select
O a target capital structure based on market inputs.
U capital structure. Preserve flexibility for the
Q* Capital Structure and Privately or Closely Held
*j* Organizations
ii Decisions and strategies for privately/closely held
PQ taxable companies rest on the same principles.
• However, the tax scenario for the corporation as
jj-j well as its tax position with respect to the other
W taxable entities owned by the same people—and
M the resultant consolidated tax position—may
W suggest different strategies.
,2 For example, owners with deep pockets who are
P willing and ready to provide infusions of equity in
05 bad times may argue for a more aggressive D/E
l H
" ratio for the company in the hope of garnering
greater tax benefits. Additionally, different
risk preferences influence choice. If one "owns
the store" and currently has no concern about
market valuation, the choice of capital structure
will anchor to personal tax circumstance and
risk preferences. The issues are complex and
very sensitive to the particular consolidated tax
position, as well as to personal risk preferences
and attitudes towards debt.
Agency Costs
Investors should guard against a form of
management agency costs, namely, the use of bad
debt capacity to further management's objectives
and interests at the expense of stockholders, and
possibly creditors. For example, management may
employ excessive debt to protect against takeover,
and thus preserve its position. In another example,
a management might use excess debt rather than
raise equity, because raising equity would dilute
its equity position, including the proportion of
votes it controls—which is important in preserving
board/management control. This dilution could
occur for one or both of the following reasons:
managers own the stock but are not willing to
purchase the correct proportions of the new
equity; ownership of stock is dispersed in a way
such that newly issued shares are held by those
who are less supportive of management.
A R E C O M M E N D A T I O N F O R CAPITAL
STRUCTURE STRATEGY
|i) Transaction costs associated with the issuance
^ of securities, changes in economic and
^j market conditions, the "lumpiness" of capital
<5^ investments, and the arrival of misfortune
J2 despite the best planning, the potential for
>—i unexpected opportunities, as well as other
iT, factors prompt us to suggest a particular strategy
{J for capital structure.
20
Strategy
Pursue a capital structure that garners a
substantial portion of the benefits of an optimal
company. Explain the strategy to the markets.
Hope—and we think it will—that markets value
the strategy.
In my article "Capital structure: Perspectives"
(pp. 25-30), Table 1 depicts the behavior of the
weighted cost of capital as one alters the D/E
ratio. A substantial proportion of the decline
in the WCOC occurs with the first increments
of debt. The decline in the WCOC becomes less
with increasing increments of debt as one moves
towards the optimal D/E. Figure 2 depicts this
relationship. Note the portion of the curve
marked as "Shallow portion" and on the vertical
axis the indication of the WCOC for the two
marked points.
Suppose the company operates with a D/E
ratio in the shallow range. The "Possible price of
flexibility" in Figure 2—the maximum possible
difference in WCOC over this range—represents
the maximum costs of operating in this range
rather than at the optimal D/E.
In Figure 2, let the asterisk represent the
company's current D/E ratio, and recall that
with this ratio the company has unused good
debt capacity. Consider the flexibility offered by
the shallow range, illustrated by the following
example.
Markets are in turmoil. The company
recognizes an opportunity. The good debt capacity
allows it to borrow money quickly to pursue the
opportunity. The borrowing moves the asterisk to
the right by a chunk, but not past the optimal D/E
ratio. The good economic results of the project
generate equity and move the D/E back to the
left, restoring the good debt capacity. This occurs
because good projects increase the value of equity
(and we measure D/E in market values), and
such projects generate returns to equity. As the
company generates cash flow, it may also pay off
principal on the debt, accelerating the movement
oftheD/Etotheleft.
The Value of Flexibility
Investors may value flexibility. We suspect that
both equity and debt holders do place value on
flexibility, especially in the recent years of turmoil
in capital markets. To the extent that investors
value flexibility, the company may not actually
pay the price in terms of WCOC. In fact, the
company and its investors may benefit. Figure
3 depicts possible relationships, showing the
optimal D/E in terms of theory, and the optimum
that exists if investors value flexibility.
 Capital Structure: A Strategy that Makes Sense

Figure 2. Capital structure versus WCOC

w
Return on equity (%) en

Possible price
Cost of
of flexibility Weighted
equity
capital, cost of
M
no debt capital (ft
(A
(WCOC) 0
V
s
cro
Shallow portion O
a
RF I- cr
O: Optimal (high Risk-free
range for D/E) >. interest rate

t^-t
L: Low D/E for strategy
(RF)

Debt/Equity ratio (D/E)

In these figures I have plotted stock price versus
D/E.5 Figure 3 shows the stock price maximized
for the optimal D/E ratio according to theory.
If investors do indeed value the flexibility we
describe, the stock price might be higher if the
company pursued a capital structure that moved
about in the shallow portion of the curve, resulting
in the "Optimal practice" in Figure 3. This scheme
results in a stock price that is maximized with
less than the "Optimal theory" D/E ratio. The
heavy dotted curve for stock price intentionally
has a slightly higher maximum stock price—a
speculation on our part. We caution that many
theorists would not agree with this conclusion. On
the other hand, a number of practitioners as well
as investors might find the assertion reasonable.

Figure 3. Flexible capital structure and value

Stock price

Shift in "optimal" D/E

if investors value flexibility

D
f f Debt/Equity ratio (D/E)
Optimal Optimal
practice theory

21
 Financing and Raising Capital
CONCLUSION, IDEAS, AND ACTIONS
Theory is important. Common sense is powerful.
Strategy benefits from theory and common
sense. The time horizon for strategy depends
u favorable range.
PH on a variety of factors, including the dynamics
of the social, political, economic, and technology
environments. Tactics should be consistent
with short-term success and long-term
opportunities.
Here are some suggestions that might fare
well in dynamic environments and prepare you
ft to survive on a favorable basis in periods of high
economic uncertainty and market turmoil.
• Estimate your current optimal capital
structure.
en
CO • Many (all) economies enjoy/suffer the effects
of cycles. When times are good, and as the tide
moves to flood, pay down some debt. Move to
the left on the shallow portion of the capital
structure curve, rather than remain in the
region of theoretical optimal debt. Increasing
good unused debt capacity not only helps in
survival, but also may allow for harvesting
opportunities when the falling tides have
carried others to peril.
• Operate in the shallow part of the WCOC
curve. Leave a reasonable chunk of unused
debt capacity, enough to allow rapid financing
of unusual opportunities.
• Compare the current D/E to the target D/E
and the shallow curve range for the D/E. If it
lies within the shallow curve range, you don't
need major adjustments now. Continue to
track and anticipate how the company will
"walk about" in the shallow curve range.
• If the company is outside the shallow curve
range, decide on the strategy to move to the
target range. The choice of how to move to
a more optimal debt/equity ratio hinges on
a number of factors, including the expected
internally generated cash flows, the expected
internal generation of equity, the principal
repayment/refunding schedule, cash flow
relative to capital investments, dividend
policies, and external market conditions.
• Compare the business risk of actions you
anticipate taking with your current business.
Recognize and react to a change in the
business risk of the company. If the business
risk of the company increases/decreases
U as a result of good investment choices that
z are of higher risk, adjust financial risk by
decreasing/increasing the target debt/equity
It ratio.
• If you currently have significant unused good
PL, debt capacity, recognize that this good debt
capacity is of potential interest to a company
22
seeking acquisitions. The buying company
can use your unused good capacity as a way
offinancingthe acquisition, or to move the
combined company capital structure to a more
• Changing from the use of bad debt capacity
might involve one or several different actions,
including the acquisition of a company that
has unused good capacity. Do not buy a
company for this reason alone! However,
recognize this potential effect in acquisition
strategies.
• Evaluate whether control issues are important
or even dominant; control is often a concern
for private or closely held companies. We
assert that, for public companies, efforts
by management to protect management's
position and issues of control should rarely if
ever determine the correct course of action.
• Decide on a strategy for capital structure that
is consistent with the corporate strategy.
• Communicate your capital structure target
and strategy to markets. Separately from
the choice of D/E and the strategy, effective
communication reduces the uncertainty in
investors' minds. Here is a sample statement:
• "Given our intended investments, likely
market conditions, and the tax environment,
our target D/E is about 25%. To allow us to
take advantage of favorable opportunities
during different phases of economic cycles,
we will typically maintain a working D/E
capital structure, in the 15% to 25% range."
• "This strategy allows us to employ good
debt capacity to obtain funds quickly to
pursue attractive opportunities, regardless
of economic conditions and capital market
circumstances"
• "We feel that investors value a flexible
financing policy that allows their company to
maintain choice of action and to avoid ever
being forced to take particular actions."
• Behave consistently with your strategy.
Demonstrated behavior builds and sustains
credibility. Increased credibility reduces
investor uncertainty and enhances stock
prices.
• Remember that an increase/decrease in the
corporate tax rate increases/decreases the
value of using debt. Changes in tax rates
should prompt a review and adjustment of
capital structure.
SUMMARY
The prudent use of debt in financing if interest is
tax-deductible offers the prospect of increasing
firm value.
 Capital Structure: A Strategy that Makes Sense

Issues of control also influence the use of debt
versus equity.6 For publicly owned companies,
managers might, inappropriately, use too much
debt as a means of perpetuating management's
control or to promote management's interests.
Making D/E choices to perpetuate control is
defensible (although perhaps not wise) to maintain
control of private and/or family-owned firms.
Perfect capital markets with the tax-
deductibility of interest argue for an optimal debt/
equity ratio. The presence of imperfect capital
markets, seasonal and cyclical business cycles, a
change in the nature and risks of investments,
and human behavior suggest a strategy for the
management of capital structure.
Finance the company in the shallow segment
of the weighted cost of capital curve. Leave
some unused good debt capacity to allow the
company to pursue opportunities even if capital
market conditions are unfavorable, or to use as
an emergency reserve. The emergency reserve
concept rests on the common sense perspective
that a company should never be forced into a
course of action—but should be able to choose to w
follow a course of action. 09
Operate with a debt/equity ratio that is lower
than the optimal ratio. This posture provides
flexibility, allows practical management in raising
capital, and keeps the company away from the
steeply increasing WCOC that occurs above the
optimal D/E. This position of creditworthiness
allows one to raise a chunk of capital from debt
to fund an opportunity independent of the IB
conditions in capital markets.
Investing the raised capital in good 3
investments will generate cash flow and increase ore
the equity base, with a resultant decrease in
O
the D/E ratio, moving it back to the left. Good
projects that are managed well restore good debt
capacity and will allow one to repeat the process
in future periods.
In summary: capital structure makes a
difference in an environment in which interest
is tax-deductible.

MORE INFO
Articles:
Groth, John C , and Ronald C. Anderson. "Capital structure: Perspectives for managers."
Management Decision 35:7 (1997): 5 5 2 - 5 6 1 .
Online at: dx.doi.org/10.1108/00251749710170529
Israel, Ronan. "Capital structure and the market for corporate control: The defensive role of debt
financing." Journal of Finance 46:4 (September 1991): 1391-1409.
Online at: www.jstor.org/stable/2328863
Miller, Merton H. "The Modigliani-Miller propositions after thirty years." Journal of Applied
Corporate Finance 2 : 1 (Spring 1989): 6 - 1 8 .
Online at: d x . d o i . o r g / 1 0 . I l l l / j . l 7 4 5 - 6 6 2 2 . 1 9 8 9 . t b 0 0 5 4 8 . x
Modigliani, Franco, and Merton H. Miller. "The cost of capital, corporation finance, and the theory of
investment." American Economic Review 48:3 (June 1958): 2 6 1 - 2 9 7 .
Online at: www.jstor.org/stable/1809766
Prezas, Alexandres P. "Effects of debt on the degrees of operating and financial leverage." Financial
Management 16:2 (Summer 1987): 3 9 - 4 4 . Online at: www.jstor.org/stable/3666002
Prezas, Alexandres P. "Interactions of the firm's real and financial decisions." Applied Economics
20:4 (April 1988): 5 5 1 - 5 6 0 . Online at: dx.doi.org/10.1080/00036848800000064

NOTES
1 Since in perfect capital markets one has no costs and
bankruptcy has no undesirable consequences.
2 See Groth, John C. "Accounting and economics-
Critical perspectives." qfinance.com. Online at:
tinyurl.com/3yp58zv
3 We want the market to understand that the delay in
repayment of principal is part of altering the capital
structure—to avoid any perception that the company
is unable to make the payments of principal. This
delay approach is only to avoid debt issuance costs
for fresh debt.
4 Depending on circumstances, the structuring of the
rights offering can almost certainly ensure that some
shareholders not in the control group do not exercise
their rights.
5 In many presentations and discussions the plot/ rO
discussion is total firm value versus D/E.
6 Managers and boards of directors that make capital
structure decisions to protect their position or
influence their rewards generate agency costs borne
by stockholders and, in some circumstances, also by
creditors.
o

23
Capital Structure: Perspectives w
ft
by John C. Groth (ft

EXECUTIVE SUMMARY
• Capital structure reflects the financing strategy and potentially influences the value of a
company.
• The potential value to shareholders of capital structure depends on the tax environment.
• Understanding the logic of capital structure and the origin of potential value is of import to as
leaders, strategists, and managers. C
• The greater the business risk, the lower the optimal debt/equity (D/E) ratio.
• Tax strategy and management should consider capital structure. The higher the expected tax
rate, the more important are capital structure decisions and management. d
s-
INTRODUCTION financing relative to total financing. Types of
Capital has three forms: human, tangible, financing fall into broad categories: equity,
and financial. In this article, we focus on how representing ownership; debt; and preferred
financing choices influence the cost of financial financing. Interestingly, in some economies the
capital and company value. Capital structure concept of equity or ownership was unfamiliar
focuses on the sources of financial capital. The until recently, as historically individuals did not
choice of structure affects firm value in some enjoy the privilege of ownership.
economies.1 Capital structure is about dividing up expected
The seminal works of Nobel laureate Franco economic returns (not accounting returns) and
Modigliani conceived important relationships risk, in exchange for providing capital. Those
and issues in capital structure. Subsequently, divisions are specific. For example, a pecking
researchers have nourished the development order exists amongst the different creditors. The
of capital structure theory and the related "covenants" of debt arrangements, as well as
literature, and they have influenced practice. precedent in practice and legal arrangements,
Many companies follow the prescriptions of address these relationships. For example, in
capital structure theory, and create value for practice "normal" trade credit is often not
stockholders and society.2 formalized, and the company routinely pays
We do not have the "perfect" capital markets trade creditors.3
described by economists, and key factors In the context of capital structure and an
influence the choice of capital structure. For "ongoing enterprise," equity ownership is last
example, investors are concerned with the in line with a claim on what others have not
potential for, and cost of, bankruptcy. If a claimed of the returns. Equity holders also bear
company disappoints investors by using too the risks which the creditors and preferred
little or too much debt, its stock price will suffer. shareholders (if present) have not accepted. In
Understanding exactly how the use of some the event of financial distress or bankruptcy,
debt may add to company value is essential to in most economies very specific rules apply to
understanding capital structure. dividing up the carcass.4
First, we will clarify the meaning of capital In Figure 1, the balance sheet depicts the
structure. Then we will address other issues. "assets" and the source of financing, and,
consequently, the claim on the assets. For
CAPITAL STRUCTURE simplicity, we will focus on financing with
The decision on capital structure is the choice a combination of debt and equity, ignoring
of how to finance a company. Capital structure
represents the proportion of each source of
preferred shares as a source of capital. In fact,
many firms do not have preferred shares.
o

25
 Financing and Raising Capital
4) Figure l. Alternative capital structures
O ^^^^^^^^ ^^^^^^^^
^ A B C D debt/equity ratio, has greater financial risk. We
£ ^M MH H I HHI »»
I ^H ^H ••I | 2 HB
&•••••
^^^H ^^^H IH||H ^^^H ^^^9
WD
fi The choice of assets, how well we manage
*jj the assets, and the nature and success of our
* providing product/services to markets, taxes,
M and other factors determine the business risk of
the company. The business risk influences the
cost of equity capital. For a firm without debt,
or an "unlevered" firm, the cost of equity equals
the risk-free rate of interest plus a premium
for business risk. Collectively, the business risk
factors will determine the expected level and risk
of cash flows that originate in the asset side of the
company. These expected cash flows that come
from the asset side of the company must service
any debt. After debt service and the payment of
taxes, the net remaining cash flows provide the
expected returns to equity holders.
The higher the business risk of a company—
and hence, the greater the uncertainty in cash
flows from the asset side of the business—the
less financial risk a company should have, and
the lower the optimal D/E ratio.
Consequently, the more uncertain the
environment, and the greater the sensitivity of
the business side of the company to the economic
environment, the more important it is that one
select a capital structure with care. Companies
with high sensitivity to the cyclical effects of the
economy should consider a more conservative
capital structure, and have a strategy to manage
the structure across economic cycles.
For the purposes of discussion, Figure 1
shows four alternative financing arrangements.
In financing alternative A, only equity holders
provide capital. In finance jargon, situation A
represents an unlevered firm. Each equity holder
has a claim on the after-tax benefits of owning
rT i and operating the assets, as well as on the assets
r -\ themselves. The proportion of total shares
•7 owned determines the claims of each. In some
\"2 instances, different classes of equity exist, with
Sj the rights of each class defined accordingly.
f~ki Alternatives B and C represent different ways
a
p-t of financing the same assets, with C having a
26
higher debt/equity ratio than B. Assuming that
the nature of liabilities (discussed shortly) for
B and C are the same, C, which has the higher
will explain alternative D later in the chapter.
Relative Position and Risk
Capital structure does not involve sharing, but
dividing and ordering. Deciding to use debt
and/or preferred ownership entails dividing
expected returns and risk, and ordering claims—
both for "normal" times, as well as in the event
of bankruptcy. Think of a line of people, an
uncertain future, and expected benefits that may
stem from the operation or sale of a company's
assets, or benefits that might arise from the
financing of the company.
A metaphor helps in understanding the issues
and relationships. Imagine an apple orchard.
Uncertainty exists about future crops in terms of
the size, and quality, of the apples. Variance in
quality means not all apples in a crop have equal
value. Let's see how the ordered line works.
Governments are first in line, taking the most
certain and best apples for taxes. Some taxes are
ardent claims, which are due independent of the
sufficiency of the crop. Equity holders bear this
tax responsibility. However, tax circumstances
also affect creditors and other providers of
capital.
Fundamental Principle: The Division of Risk and
Expected Return
A position first in line gives first access to the
orchard, and the right to take the best apples.
Others enter the orchard according to their
order in the line, each taking the apples they
are allowed—if apples are available. The average
quality of the remaining apples declines with the
successive removal of the best of the remaining
crop, as those in line are careful and claim the
best apples to which they are entitled. Remove
the best, and the quality of what remains must
be lower—and the risk that insufficient or no
apples remain increases.
After the tax authorities, creditors are next
in line, with multiple creditors each careful to
specify and protect their position in the line.
Sometimes creditors limit the number and/
or magnitude of other credit claims in line.
Preferred stockholders (if the company has
any) have a position in line ahead of common
stockholders, but behind creditors. A company
may have different classes of stockholders, with
the classes also ordered.
Equity holders are last in line, expecting to
 Capital Structure: Perspectives

get the lower-quality (higher-risk) apples that sufficient pretax income to allow the deduction
are left, and having a claim on all that are left. of the interest before calculating taxes. The net w
Equity holders, last in line, have the most risk, effects are: en
but also the possibility of unlimited returns. • Lenders expect payment of 10%, whether the
Equity holders bear the risk that others have not company has taxable income or not.
accepted, and they get what is left over. Different • If the company realizes the tax deduction, the
classes of equity holders may exist, with these after-tax cost = 10% (1 - 0.3) = 7%.
classes differentiated and "labeled," for example, • The expected benefit of the tax deduction
class A. The classification scheme specifies the goes to stockholders.
positions, potential rights, and claims of each • The stockholders have increased financial
class. risk that stems from the borrowing—and (ft
With distress or bankruptcy, the provisions letting creditors precede them in line. 0
of the various sources of financing specify the • Stockholders are astute. Increased risk
relative position and claims of each party, but increases the cost of equity capital. orq
with one usual modification: tax liabilities,
attorneys, and related costs often take first from
• However, if the expected value of the tax
savings is attractive to stockholders relative
d
the carcass. After that, an ordered picking over
the corpse follows.
to the added risk of borrowing, stockholders 8-
are happy, and the share price increases.
• The right choice of capital structure will
Motivation for Using Debt result in a reduction of the weighted cost of
A logical question surfaces: why would equity capital—even though the cost of both equity
holders allow others to go ahead of them in and debt capital increase with debt, as Table 1
the line? There are two main reasons for this: illustrates, and we discuss below.
garnering incremental value; and/or issues of Importantly, the tax deduction and its benefit
control. is an expected benefit, as the uncertain pretax
income (EBIT or NOI in several economies) must
Increased Value be large enough to allow the interest deduction.
Potential increases in value stem from "leveraging
effects" (stockholders) and tax effects (total firm Tax Rate and Implications
value). Capital structure theory generally focuses Notice that the higher the tax rate, the greater the
on the value that may originate in tax effects potential impact of the deductibility of interest
that result from the use of debt. This article on the after-tax cost of debt. For example, with
focuses on capital structure, but we will first the same 10% borrowing rate but a 40% tax rate,
briefly comment on the classic financial leverage the after-tax cost is 10% (1 - 0.4) = 6%.
reasons for using debt. We take care not to confuse issues. We don't
benefit from higher tax rates. However, the
Equally Clever Creditors and higher the tax rate we endure, the more important
Stockholders Have Implications becomes the choice of capital structure.
The presence of astute creditors and stockholders To reiterate, the tax benefits of using debt do
will result in no bargains or favors in terms of not alter the promised cash flows in the form of
dividing up expected returns and risks. Creditors interest or principle to creditors. Any tax benefits
will not give stockholders a bargain just to be nice. therefore precipitate to stockholders, and that is
Absent control issues, capital structure is only core to understanding how capital structure can
important if interest on debt is tax-deductible, create value.5
and dividend payments are not deductible.
Asymmetry of Effects
TAX-DEDUCTIBLE INTEREST The use of some debt in place of some equity
In some economies, interest is tax-deductible. will lever up (down) the expected returns to
The expected deductibility of interest payments stockholders. If interest is tax-deductible, the
provides opportunity for value. The expected potential good or bad leveraging effects are
benefit of this deduction flows to stockholders,
which is best illustrated with an example.
asymmetric. If the company has returns on its
assets that exceed the cost of debt, a positive
O
leveraging effect accrues to stockholders. If
Example stockholders view these returns as attractive,
A company borrows money at afixedrate of 10%. given the financial risk of the added debt, the
The tax rate is 30%. The company expects to have stock value increases.
o

27
 Financing and Raising Capital

4) If the EBIT for tax accounting is insufficient to
o allow the deduction of interest, stockholders
must now bear the full cost of debt rather than
a benefit from a lower after-tax cost.6 This shift
u in tax impact results in a greater and adverse
Hi leveraging effect on returns to stockholders, as
*-» equity investors must now cover the full cost of
debt, rather than the after-tax cost of debt. Using
the original example above, the cost of debt
rises from the after-tax 7% to the full 10%. The
inability to realize the interest deduction results
Q in an asymmetric effect on expected returns to
stockholders.
BEHAVIOR OF WEIGHTED COST OF
CAPITAL
An example showing the behavior of the
component costs of capital and the weighted
cost of capital (WCOC) appears in Table 1. For
simplification, we consider only equity and debt
sources of capital. One might employ one or
more models, or different forms of models, as
well as alternative econometric procedures to
estimate the costs of the components of capital
for different levels of leverage.7
Table 1. Calculation of weighted cost of capital (WCOC)
Source of capital Relative proportion Cost of component
Entries reflect the raising of money from debt
and equity in different proportions. The more
debt that is used as a proportion of the total,
the less equity (and fewer shares). Costs are
after-tax costs to the company. The cost of debt
represents the weighted cost of debt, reflecting
the fact that first-in-line creditors have lower
risk, and the borrowing cost is lower. Creditors
that follow in line have greater risk, and demand
a higher rate.
For all entries in this table, the company is
getting the same amount of money. The values
show the effects of getting this money in different
proportions from debt and equity, which is the
capital structure decision.
Choices of capital structure seek to increase
the value of the firm. Hence, in Table 1 and
all discussion in this chapter and the chapter
"Capital structure: A strategy that makes sense"
(pp. 17-23), debt and equity refer to the market
values of debt and equity. Hence, the D/E ratio
we calculate uses the market values of the debt
and equity.
Note in Table 1 that the weighted cost of
capital (WCOC) at first decreases, reaching a
Weighted cost of Weighted cost of
component captial

Debt 0% 5.40% 0.00%

Equity 100% 13.00% 13.00%

13.00%

Debt 10% 5.40% 0.54%

Equity 90% 13.40% 12.10%

12.64%

Debt 20% 6.10% 1.22%

Equity 80% 13.90% 11.12%

12.34%

Debt 30% 6.60% 1.98%

Equity 70% 14.50% 10.15%

12.13%

Debt 40% 7.60% 3.04%

Equity 60% 15.50% 9.30%

U
z 12.34%

t Debt

Equity
50%

50%
9.00%

17.20%
4.50%

8.60%

13.10%

28

minimum when about 30% of capital comes
from debt and 70% from equity. Observe also
that this decrease occurs even though the
weighted cost of debt increases with the use of an
increased proportion of debt capital. Recognize
that successive increments of debt cost more,
as successive creditors in the line of claimants
demand higher expected returns to compensate
for their higher risk.
With an increase in the use of debt, the cost of
equity increases as well. Equity holders recognize
the greater financial risk attendant with a higher
D/E ratio, and demand increased expected
returns.
Seemingly, the WCOC could not decline if the
cost of components increased. The reason for
the decline stems entirely from the expected tax-
deductibility of debt, and equity holders think
the value of the tax benefit is attractive compared
to the added risk. As the D/E ratio increases,
the amount of equity decreases because we are
raising the same amount of capital everywhere in
Table 1. If we raise more from debt, less comes
from equity. The use of some debt rather than all
equity amplifies the effect on a per-share basis,
as the company needs fewer shares for the same
amount of capital. The result is that with an
increasing D/E the expected tax benefits increase,
and these are spread over fewer shares.
In the example in Table 1, note that obtaining
more than 30% of capital from debt results in
an increase in the WCOC. Above 30% debt,
stockholders do not think that the incremental
tax benefits of more debt are attractive enough
to compensate them for the incremental financial
risk, and the uncertainty of realizing the tax
benefits. Hence, the demanded rate of increase in
the cost of equity and debt overpowers the effects
on value of the expected incremental tax benefits
of employing more debt.
Summary
Given a particular business risk of a company,
determined by the asset side of the business and
how well the company employs its assets, an
optimal capital structure exists—optimal, as it
lowers the WCOC of the company. For example,
in Table 1, using about 30% from debt and 70%
from equity will result in the lowest weighted
cost of capital.8 Note in the table that the cost of
components increases in a nonlinear manner as
the use of debt increases. This behavior is related
to several factors, including: the risk of realizing
the expected tax benefit of debt; potential distress
caused by excess debt, and its effects on operations
as well as opportunities and investments; and
possible bankruptcy with attendant loss.
Capital Structure: Perspectives
OTHER ISSUES
The Nature of Liabilities and Optimal D/E
The nature of the liabilities influences the choice
of capital structure. Let alternative D in Figure
1 represent the same capital structure as in
alternative C. Suppose that certain characteristics
of the liabilities for C and D differ. To illustrate,
assume that the weighted maturity of liabilities in
D is less than that in C, and/or that C represents
borrowing at a fixed rate while some debt in D
has a variable rate of interest. (ft
Despite the same D/E ratio, the financial risk
of D is greater than that of C because D is bearing 3
interest-rate risk if the debt has a variable rate of ore
interest, and D has more risk as it faces refunding O
acr
of debt sooner. Less flexibility in the timing of
refunding the debt is a potentially important
issue, as capital market conditions vary over
time. The developments and difficulty for firms
of obtaining "replacement" credit in the 2008
crisis illustrate this refunding risk.
Logically, the nature of the liabilities
therefore affects the optimal D/E ratio. For
A, B, C, and D, the business risk is still the
same. The use of liabilities with greater risk (in
this scenario, maturity and interest rate risk)
results in a lower optimal D/E, despite the
same business risk on the asset side of the
company. Thus, if the structure shown for C is
optimal, the structure shown for D is incorrect.
D should have a lower optimal D/E ratio than
C, as the nature and structure of liabilities for D
results in higher risk on the financing side of the
company.
CONCLUSION
The tax deductibility of interest provides
the opportunity to add to company value by
employing the correct amount of debt relative
to equity. The underlying relationships that
cause this potential increment in value rest on
the logical behavior of informed investors who
agree to divide risks and expected returns.
The deductibility of interest has expected
economic benefits that flow to equity holders.
Consequently, the use of debt is logical if
interest is tax deductible and we expect to realize
the benefit of that deduction. The higher the
corporate tax rate we must endure, the greater
the value of issuing debt.
The choice of how to finance the company,
o
and its resulting debt/equity ratio, is the
capital structure decision. Issues relating to the
strategy and management of capital structure
are discussed in the article "Capital structure: A
strategy that makes sense" (pp. 17-23). o
29
 Financing and Raising Capital

MAKING IT HAPPEN
Remember that the expected tax deductibility of interest is the origin of any value that arises from
the choice of capital structure.
• In capital structure decisions, the examination focuses on the market value of debt and equity.
• Changes in the tax rate will influence the optimal capital structure.
CO
• The greater the business risk, the lower the optimal D/E ratio.
• The choice of capital structure will influence the cost of the individual sources of capital, and, in
turn, the weighted cost of capital.
• "Real world" considerations argue for a target capital structure, and a strategy to pursue that
structure. The chapter, "Capital Structure: A Strategy that Makes Sense," examines these issues
Q
and offers guidance on a strategy.
e
CO
CO
MORE INFO
Articles:
Groth, John C, and Ronald C. Anderson. "Capital structure: Perspectives for managers."
Management Decision 35:7 (1997): 552-561. Online at:
dx.doi.org/10.1108/00251749710170529
Miller, Merton H. "The Modigliani-Miller propositions after thirty years." Journal of Applied
Corporate Finance 2:1 (Spring 1989): 6-18. Online at:
dx.doi.org/10.1111/j.l745-6622.1989.tb00548.x
Website:
Weighted average cost of capital: en.wikipedia.org/wiki/Weighted_average_cost_of_capital

NOTES
1 Issues of control can influence choice of capital
structure, for example, with current managers not
willing to issue equity as the issuance would dilute
management's "personal" control percentage, or alter
the distribution of shares in float.
2 Actions that lower the cost of capital result in benefits
to individuals in economies and societies. In contrast,
in 2008 we have witnessed the adverse and spreading
effects that result from interruptions in the availability
and/or cost of capital in economies.
3 If suppliers perceive unnecessary risk or the likelihood
of financial distress, suppliers may demand trade
notes payable. Trade notes payable formalize trade
u credit, and seek to clearly identify the obligation.
existence of trade notes payable on a balance sheet
signals concerns by trade creditors of the financial
viability of the company.
4 Multiple classes of equity may exist, with specified
relative claimant positions during normal operations as
well as in bankruptcy.
5 In imperfect markets with multiple periods, and with
certain tax rules, the risk of promised cash flows to
creditors may be reduced by the tax-deductibility
of interest in previous periods or by carry-back tax
effects. These issues are beyond the scope of this
article.
6 In some environments, differences exist in accounting
for taxes, and accounting for financial reporting.

z Hence, requiring formalization of obligation with

trade notes payable clarifies as well as "perfects" the
7 The most common approaches include several different
model forms based on the capital asset pricing model,
supplier's interest, and relative claimant position. This multi-factor models, discounted cash flow models, risk-
$ formalization can alter the risks to the suppliers of premium models, and other pricing models.

o receipt of payment, both during ongoing operations

as well as in the case of bankruptcy. Normally, the
8 This is an approximation. Estimating the WCOC curve
and finding the minimum point is not a precise science.

30
Capital Structure: Implications w
ft
by John C. Groth
EXECUTIVE SUMMARY
• Reducing the weighted cost of capital increases the net economic returns, and adds to company
a
n
value. ft
• Place the company in a position that it can choose what it wants to do, rather than have
circumstances force it to take a course of action.
• The use of too little debt (L) results in a lower stock price, and too much debt (M) also lowers
the stock price.
• The more uncertain an environment, the greater the importance of the choice of and the Crq
strategy for managing capital structure. d
• If a company's business risk is very sensitive to economic cycles, a company should manage its
debt/equity (D/E) ratio across the cycle.
s-
• Knowledge of capital structure theory and practice is important in stock repurchase programs,
mergers and acquisitions, divestitures, leveraged buyouts, and strategies aimed at defeating
takeover.

INTRODUCTION
A tax environment that allows for the deduction
of interest charges, but not the deduction of
dividends, results in an optimal capital structure
for a company. The optimal structure results
in a lower weighted cost of capital (WCOC)
for reasons examined in the article "Capital
structure: Perspectives" (pp. 25-30). This article
examines the implications of capital structure,
and some of the key factors that influence capital
structure.
KEY IMPLICATION: WCOC AND VALUE
Recognizing the behavior of the WCOC when
there are changes in the D/E ratio, we now review
how the correct capital structure ultimately
adds benefits in terms of economic margins and
resultant value.
Figure 1 illustrates the origin of value, and
the significance of lowering the WCOC that
results from selecting the optimal D/E ratio for
a company. Recall that value arises from earning
a net economic return that exceeds the cost of
capital. For example, the net present value of
a project represents the dollar value of having
earned economic returns in excess of the cost of
capital while the capital is in a project.

Figure 1. WCOC and net economic returns as D/E ratio varies

Return on
equity (%)
Net economic return (NER) - Optimal

Cost of equity Weighted

capital, no debt cost of
capital

o
(WCOC)
Risk-free
interest rate
(RF)

Debt/Equity ratio (D/E)

o

31
 Financing and Raising Capital

In Figure 1, with no debt the economic returns company. The greater the business risk of
are labeled NER @ D/E = o. Moving down the the company, the higher the cost of equity,
WCOC curve in the diagram increases the net and the lower the optimal debt/equity ratio.
C0 economic returns, with attendant increases in Changes in business risk stem from one or
U value. The WCOC is for projects that do not alter more of the following:
PL,
the business risk of the firm. • Changes in market conditions: For example,
Figure 2 graphically illustrates the impact of an increase in competition, trends in
PQ capital structure on stock price, keeping in mind consumer preferences, greater uncertainty
that as we go from no debt to an increasing D/E we about the costs of inputs, political risk, and
are reducing the number of shares. The use of too other forces over which a company normally
little debt (L) results in a lower stock price, and too has no or little control;
C much debt (M) also lowers the stock price. • Changes in how things are done: for example,
Moving from L to the optimal level is quite easy. management of the operating cycle, decisions
C Borrow money and buy back some shares. Moving on working capital, cost control, efficiency of
S3 from M back to the optimal level is, in theory, operations, effectiveness of product design,
as equally easy, but in practice may face challenges marketing.
«3
depending on market conditions. Capital structure • Changes in what is done: for example, the
strategy is discussed in the article "Capital structure: markets pursued, and the investments made
A strategy that makes sense" (pp. 17-23). to support those choices.

Figure 2. Capital structure and stock price

Stock price
L = Too little debt
M = Too much debt

D/E

Optimal D/E M

The Core Implication Investments and Optimal Structure

Reducing the weighted cost of capital increases
the net economic returns, and adds to company
value. Remember that the relationship between
WCOC and value is non-linear, making the
choice and management of D/E particularly
important.1
u OTHER IMPLICATIONS
Capital structure has numerous additional
implications, including the following.
The interrelationships between capital struc-
ture, assets, and a dynamic environment have
implications in terms of risk, value, choice,
strategy, and actions. For example, if a company
changes the nature or structure of its assets
by investing in projects of greater risk than its
current risk, and/or if external changes and
trends in markets alter the business risk of the
company, then the optimal capital structure
changes.2

t
I—I
Business Risk Change and Capital Structure
• Recall that business risk is the risk associated
Effects of Financial Risk on Business Risk
In imperfect markets, excess financial risk

o
(it with the asset side and operations of the resulting from the financing of the firm may

32

affect the business risk of the company.3 This
crossover or feedback effect alters the risk on the
operating side of the company. Developments
in the economy, and the automotive industry
in the fall of 2008 are an examples. A company
offers a 100,000-mile warranty on its cars, but
customers feel that high financial risk might
result in the company going bankrupt. Hence,
the high perceived financial risk of the company
by customers affects purchase decisions, and the
perceived value of the warranty in their purchase
decision. In reality, the asset side and finance
side of a company are not independent.
Cyclical Business
The choice of capital structure has an impact on
alternatives, decisions, and strategy—especially
across economic cycles. In a cyclical business,
the patterns and magnitudes of expected cash
generation from the business, or "asset side," of
the company are subject to the influence of the
economy, an influence over which a company
has no control. In this scenario, the business risk
of the company changes as it lives through the
ebbs and flows in the economy.
The sensitivity of companies to a cyclical
economy varies. A company may adjust its asset
structure and operations in anticipation of, or in
response to swings in the economy. However,
other than adding liquidity in anticipation of a
deteriorating economy, major changes in other
assets are often costly, or not practical.4 Some
companies may also try to insulate the adverse
effects of the cycle on the business risk of
company with other strategies, such as in-house
finance companies to support credit sales.5
A change in the business risk (BR) alters the
optimal capital structure of the company. An
increase (decrease) in BR decreases (increases)
the optimal D/E. A significant sensitivity to
the business cycle has important implications.6
A company will survive (or perish), or have
opportunities (or miss opportunities), according
to its strategy and financial position at a point
in time.
Place the company in a position that it can
choose what it wants to do-rather than have
circumstances force it to take a course of
action.7
The implication is that a company that
generates cash flow in a cyclical pattern should
reduce its debt during periods of high cash
generation, moving its D/E to the lower D/E limit
of the target capital structure, consistent with
the discussion in the article "Capital structure: A
strategy that makes sense" (pp. 17-23).
Capital Structure: Implications
Stock Repurchase
Knowledge of capital structure theory and w
n
practice is important in stock repurchase en
programs. If the company does not issue new
common stock—for example, issuing stock for
an acquisition, or as a result of the exercise of to
options—the repurchase of a company's own
stock is a reduction in equity that will reduce
the D/E ratio of the company. To maintain the
desired target D/E ratio, a repurchase of stock
will require a corresponding reduction in the Oft
company's debt.
Acquisitions QfQ
A company making an acquisition should d
ft
consider the implications in terms of optimal
capital structure. To the extent the business risk a*
of the target and acquiring companies differ, the
optimal D/E ratios for the target and acquiring
companies differ. One may adjust to the
desired post-acquisition target D/E, coincident
with the acquisition and attendant financing
arrangements. Additional issues are important,
including the following.
Independent of any operational or "synergistic
effects" that may result from a merger, a pure
financial merger benefit may exist. Lewellen
(1971) offered astute arguments addressing
this issue. Essentially, one can demonstrate
that the mere combination of firms may offer
financial benefit. The combined cash flows of
the two companies may result in lower risks to
creditors, with this reduction stemming from a
co-insurance effect.
Capital structure opportunities may also exist
if the target company does not have an optimal
capital structure. These particular benefits differ
from the pure financial rationale, and their
realization is not dependent on the acquisition. If
the current management of the target company
has ignored the prescriptions of capital structure
theory, the acquiring company may benefit by
adjusting the capital structure concurrently with
the acquisition. In a merger, "good" or "bad"
debt capacity in the target or acquiring firms has
practical implications.8 Returning to Figure 2,
we can consider two scenarios:
• Assume the target company has too little
debt, shown by the D/E of L. The target
company has unused good-debt capacity,
and also a share price that is lower than the
optimal level. The acquiring company can
o
use this unused good-debt capacity to help
finance the acquisition, and, at the same
time, realize the increment in share price
represented by the change from the D/E of L
o
33
 Financing and Raising Capital

to the optimal D/E. optimal D/E would remain.9

• Assume the target company has too much
debt, shown by the D/E of M. Unused good-
a debt capacity does not exist in the target
u company. However, if the acquiring company
CN
"refinances" the acquisition and, in effect,
CO moves the acquired company to the optimal
D/E, the acquiring company realizes the
value represented by the share-price gain that
would result from the company moving from
M D/E back to the optimal D/E.
ft Again, the gains for these scenarios have nothing
to do with acquisition itself, but result from
c correcting the mistakes made by management in
• IN the capital structure of the target company.
3 Strategies aimed at defeating a potential takeover
Divestments
Capital structure in the divesting of a portion
of the company is important. Separate from the
appropriateness of the divestment, casting off
the new company with the optimal D/E ratio will
maximize the value realized.
Tax Issues
Assuming interest is tax-deductible, uncertainty
about future tax rates and other changes in
taxes do influence capital structure decisions.
If one knew the effective dates of new tax rates,
or thought tax rates would increase (decrease)
in the future, one would consider altering the
target D/E ratio. Recall that the higher the tax
rate, the lower the after-tax cost of debt—if the
company has sufficient pretax income to allow
the interest deduction.
Implications for capital structure would
exist if dividends also became deductible. If the
tax-rate effect was the same for dividends or
interest deductions, under some circumstances
an optimal D/E would no longer exist, as debt
offers no advantage over equity. If interest and
dividend payments were both deductible, but the
tax rate applicable to these deductions varied, an
In many tax environments, a company may
carry back or forward certain tax variables, and
realize tax effects in previous or future periods.
This results in timing the realization of tax
benefits, and thus affects the present value of
the tax treatment. In addition, tax issues can be
very important in an acquisition, especially if
certain tax options will expire at a point in time.
In some tax environments and circumstances,
an acquisition with attendant changes in capital
structure might allow realization of a tax benefit,
or at least preserve it for a future period.
Other Implications
have, some assert, included exceeding the
optimal amount of debt to make the company
an unattractive target. Following this practice
is inappropriate, and generally not aligned with
shareholder interests. However, the observation
reflects that a management might understand
and employ capital structure theory to promote
management's rather than shareholder
interests.
In a leveraged buyout (LBO), equity
participants often intentionally ignore the
guidelines of capital structure in an attempt
to maximize personal wealth. For example, in
an LBO those with an equity position attempt
to maximize personal return on equity.
Consequently, over the shorter term, they allow
the company to greatly exceed the optimal D/E
ratio, as they seek to maximize the future value
of equity interest, rather than a current share
price. With this approach, the plan is that, over
time, the company can pay down debt, and attain
an optimal D/E ratio. Then those with the equity
interest take the company public with a stock
issue, and the pricing of the equity issue reflects
the now-optimal D/E ratio.

MAKING IT HAPPEN
The implications of capital structure theory are many. We have shared some of the most important.
In summary:
• Recognize that changes in what you do, and how you do it (markets pursued, capital
investments) influence the capital structure decision, and the management of capital structure.

u • Changing the business risk of a company changes its optimal capital structure.

z • Changing the capital structure of a company will change its risk, and its value.
• Reducing unnecessary business risk 10 allows one to derive greater benefits from capital structure
since one will enjoy a higher optimal debt/equity ratio.
• The interrelationships between capital structure, assets, and a dynamic environment have
implications in terms of risk, value, choice, strategy, and actions.
O
34
 Capital Structure: Implications

The nature of liabilities in terms of maturity, variable versus fixed interest rate, principal
repayment schedules, restrictive covenant of debt, etc., influence the optimal capital structure. w
Reduce uncertainty in investors' minds by adopting and disclosing an optimal target D/E ratio. en
Provide a simple explanation of the logic for the company's target D/E ratio, and the strategy
the company will follow. The article "Capital structure: A strategy that makes sense" (pp. 17-23)
focuses on issues in capital structure, and strategy.
If a company's business risk is very sensitive to economic cycles, a company should manage
and adjust its D/E across the cycle. Reducing the D/E ratio during periods of robust economic
a
activity and high cash generation restores debt capacity to sustain and support the pursuit of
opportunities during downturns in the economy.

CONCLUSION Understanding core issues allows one to

The fact that interest is tax-deductible in many
economies is an argument for the use of some debt
in financing a company. The right combination of
debt and equity results in a capital structure that
reduces the weighted cost of capital. The lower
weighted cost of capital results in a higher net
economic margin—the difference between the
economic return on a project and the weighted
cost of capital.
The expected benefit of the tax deduction
flows to shareholders, who bear the added
financial risk associated with the debt. As long
as shareholders view the expected value of the
tax benefits as attractive compared to the added
financial risk, then they welcome the use of
debt.
A dynamic environment complicates decisions.
make/manage prudent actions in a dynamic O
environment. In particular, we should recognize
that although a company should have a target
capital structure, its management must remain
sensitive to internal changes as well as changes
in the markets and economies, and pursue a
strategy that "makes sense." For example, if a
company alters its business risk, it should adjust
its debt/equity ratio. Similarly, if management
perceives greater/less risk in the external
environment, it should decrease/increase the
debt/equity ratio.
In the end, we see the need for a keen awareness
of circumstance and future possibility, coupled
with an understanding of fundamental concepts
better equip us to make judgments—and then
take actions that add value.

MORE INFO
Articles:
Israel, Ronan. "Capital structure and the market for corporate control: The defensive role of debt
financing." Journal of Finance 46:4 (September 1991): 1391-1409. Online at:
www.jstor.org/stable/2328863
Lewellen, Wilbur G. "A pure financial rationale for the conglomerate merger." Journal of Finance
26:2 (May 1971): 521-537. Online at: www.jstor.org/stable/2326063
Prezas, Alexandras P. "Effects of debt on the degrees of operating and financial leverage." Financial
Management 16:2 (Summer 1987): 39-44. Online at: www.jstor.org/stable/3666002
Prezas, Alexandras P. "Interactions of the firm's real and financial decisions." Applied Economics
20:4 (April 1988): 551-560. Online at: dx.doi.org/10.1080/00036848800000064
Website:
Basic Modigliani-Miller theorem: en.wikipedia.org/wiki/Modigliani-Miller_theorem

35
 Financing and Raising Capital

cy
o
CO
u
Pu.
4-*
o

•8
p
WD

ss
CO
CO

NOTES
1 As addressed in Groth, John C. "Risk—Perspectives
and common sense rules for survival." In Approaches
to Enterprise Risk Management. London: Bloomsbury
Information, 2010; 13-17.
2 If investing in projects with a risk different from the
company's normal investment, one must be careful to
adjust the cost of capital used in project evaluation.
3 For example, perfect capital markets assume no cost
to bankruptcy—clearly not the case for shareholders,
creditors, customers, the economy, and society.
4 A company might also seek to mitigate or hedge
certain risks that influence the asset side of the
company.
5 Some companies sales and operations are quite
sensitive to interest rates, and the availability of credit
to their customers. Some suggest one strategy (we
do not): have an in-house finance company to finance
sales to customers; engage in actions to offset the
interest-rate risk in the finance company; and then
u
attempt to reduce the impact on sales of economic
and consumer credit conditions by offering customers
and selling appliances sounds like the correct strategy.
If one wants to be in consumer credit or speculate on
interest rates, then do that elsewhere.
6 Theorists might argue that capital markets anticipate
potential changes in the economy, and recognize that
some companies are more sensitive to economy-wide
swings than are other companies. Consequently, some
argue these "variances in business risk" across time are
recognized, and already captured in the market-derived
estimates of an optimal D/E and attendant WCOC.
7 See Groth.1
8 A discussion of good and bad capacity appears in the
article "Capital structure: A strategy that makes sense"
(pp. 17-23).
9 The issues and arguments concerning these issues are
beyond the scope of this article. For example, whether
a company would or would not pay a cash dividend
would influence the decisions. Issues to do with control

t
cut-rate financing. Remember that an in-house finance
company does not make the risk go away, but rather
parks the risk in a different place. This doesn't sound
like a good idea. For example, if in the business of
making and selling appliances, focusing on making
might also be an argument for debt rather than equity.
For example, if a company issues equity, those with
control dilute their ownership unless they invest at
least proportionately in the new equity issue.
10 See Groth.1

36
Credit Ratings by David Wyss
EXECUTIVE SUMMARY
• A credit rating is an opinion from a credit rating agency about the creditworthiness of an issuer
or the credit quality of a particular debt instrument.
• Primarily, the rating opinion considers how likely the issuer of the debt instrument is to meet its
stated obligations, and whether investors will receive the payments they were promised.
• A failure to meet such payments may be considered a default.
INTRODUCTION
There are three major international rating
agencies in the United States: Standard & Poor's
Ratings Services (a unit of The McGraw-Hill
Companies), Moody's Investors Service, and
Fitch Ratings (a unit of Fimalac SA). In addition,
there are many regional and niche rating
agencies that tend to specialize in a geographical
region or industry. The major agencies state that
their opinions of the credit quality of securities
are based on established, consistently applied,
and transparent ratings criteria. Although the
agencies use different criteria, definitions,
and rating scales, they each state a view on the
probability that an entity or security will default.
Some rating agencies also assess the potential for
recovery—how likely the investors are to recoup
their investment in the event of default.
Issuers of most fixed-income securities issued
in world financial markets request and receive
a credit rating from a rating agency. Although
credit rating evaluations are not always
required, they may increase the marketability
of a debt instrument by providing investors with
an independent opinion about the instrument's
relative credit quality.
WHY DO CORPORATIONS REQUEST A
CREDIT RATING?
A credit rating opinion is often required by
investors before they purchase securities. Many
investors want to see an established opinion
about the credit quality of a security that is not
from the issuer or underwriter. In addition,
some funds have made it a requirement for their
investment guidelines or as part of what they
have promised their investors. Issuers who are
not well known or who are trying to sell into
international markets may benefit from a rating
from a recognized rating agency.
The rating provides market participants with
an opinion on the credit quality of a particular
investment. Ratings from the major credit rating
w
ft
OB
a
(ft
c
agencies have a strong track record, as reported 3
in their default and transition studies. Over the
long run, securities with a higher credit rating O
have consistently had lower default rates than
securities with lower ratings. Ratings are just
opinions, however, and there have been certain
periods when highly rated securities in a specific
sector ultimately performed worse than other
securities rated in the same category. Accordingly,
ratings do not remove the need for the investor to
understand what he or she is buying.
The Standard & Poor's rating scale is a simple
and easy-to-understand shorthand for its credit
opinions. A more detailed analysis is typically
available from Standard & Poor's, including the
rationale behind the rating opinion. Investors
are encouraged to read the detailed analysis
carefully to understand why an agency assigned
a particular rating.
Having a rating may be useful even if a
corporation elects to raise money privately rather
than through a public bond issue. Obtaining a
rating may make it easier for a company to seek
funding from a private lender or bank. Although
not every company needs a credit rating, most
medium-sized or larger firms find it useful.
HOW A RATING IS ASSIGNED
Credit rating agencies assign ratings to issuers,
including corporations and governments, of debt
securities, as well as to individual issues such as
bonds, notes, commercial paper, and structured
finance instruments. The agencies rate an
issuer by analyzing the borrower's ability and
willingness to repay its obligations in accordance
with their terms. The agency's analysts consider
a broad range of business and financial risks that
may interfere with prompt and full payment.
Most rating agencies use a mix of quantitative
O
•—<
and qualitative analysis. Typically, analysts who
consider qualitative factors contact management
at the firm being rated to obtain additional
information that may help them to arrive at
o
37
 Financing and Raising Capital
an informed opinion. In some cases, they will
ask for information that is not available to the
general public, such as details of business plans,
strategies, and forecasts. Agencies generally also
examine the company's audited financial reports
to analyze credit strengths and weaknesses.
A rating can apply to an individual issue,
PQ although the issuer may also be assigned an
underlying rating based on its overall financial
strength. An individual issue is usually given an
42 evaluation based on information provided by the
issuer or obtained from other reliable sources.
Key considerations include:
• the issue's legal structure, including terms
and conditions;
(A
(A • the seniority of the issue relative to the other
M debt of the issuer;
• the existence of external support or credit
enhancements, such as letters of credit,
guarantees, insurance, and collateral—which
are protections that are designed to limit the
potential credit risk.
When an issuer requests a rating, it generally
supplies the rating agency with its audited
financial statements. In most cases, the rating
agency will also meet with the issuer to discuss
any questions that the agency may have and to
learn about any business plans or other factors
considered to be important. Frequent issuers will
often have a longer-term contractual relationship
with the rating agency that may include rating all
new debt issues.
Credit ratings from the major rating agencies
are normally paid for by the issuer of the
securities, and are made public immediately
thereafter, although in some cases issuers or
investors may request a "private" rating on a
security. When ratings are requested by parties
other than the issuer, and without direct access
to the issuer for questioning, they are usually
marked as "public information" or given similar
subscripting by the rating agency. The issuer-
pays model has two hallmarks: First, the major
rating agencies make ratings public (and if they
didn't, that news would quickly become public),
so it is hard to get investors to pay for what they
can get for free on the news. Second, issuing a
rating often involves access to the company's
confidential data, which is not permissible under
a subscriber-pays model.
U In some circumstances, most agencies will
rate some securities without any consultation
with the issuing firm. In these cases the ratings
are based only on public data, and are normally
OH indicated as such.
o Ratings are generally published at the time
38
they are issued. However, sometimes a private
rating may be issued for an individual investor
or group of investors, usually for a security that
is not intended for public trading. Many firms
want a confidential rating for management
purposes and as a second opinion on the credit
quality of a loan.
Ratings are not static, and rating opinions
can change (or transition) if the credit quality
changes in ways that were not expected at the
time the security was issued. Ratings may be
reviewed and updated on a regular basis, or when
a significant change occurs in the performance
of the issuer, the markets, or the economy.
The acquisition or divestiture of a company, a
political threat to (or from) the government,
or erosion in the economy or credit markets
can cause a rating to be adjusted. Normally,
warning of a likely change is provided through
an "outlook" or "credit watch" that states the
direction in which a rating may move. However,
sometimes a sudden deterioration may force a
shift in a rating with little warning.
RATING SCALE
Each credit rating agency uses its own criteria
and methodology to evaluate creditworthiness.
The process may be predominantly quantitative
or qualitative, but is usually a blend of the two.
Once an agency completes the analysis, it issues a
rating based on its own scale. Ratings are typically
expressed as a grade, such as AAA, BB, or CC, with
AAA (or equivalent) denoting the strongest and D
(or its equivalent) the weakest (i.e. that a default
has already occurred). Note that the rating scale
for short-term instruments such as commercial
paper is different from the long-term scale. For
example, at S&P the top long-term rating is AAA,
while the highest short-term credit rating is A-i+.
D stands for default in both scales.
Although a rating scale is relatively
straightforward, the assumptions, consider-
ations, and judgments behind the opinions
can be complex. Most agencies explain their
rationale in published documents that may be
read by investors. Among others, the risk factors
include the financial performance of the firm,
the characteristics of the economy and industry
it operates, and the quality of its management.
Standard & Poor's credit ratings strive to be
forward-looking, focusing not just on the past
but also on the likely future state of the industry
and the firm.
Standard & Poor's ratings are intended to be
consistent across all issuers and debt instruments.
Over the very long term, all instruments with
 Credit Ratings

the same (say, A) rating are expected to have opinion regarding the shariah compliance of
similar default experience. However, the short- any Islamic financing instrument, institution, w
term behavior of these instruments may be very or debt issue. It is the responsibility of the ft
Gfi
different. Different industries respond differently shariah board of the originating institution to
to economic and credit cycles. rule on compliance with Islamic law. The agency
Credit ratings are not exact measures ofthe default rates the security based on its analysis of the
probability of an issue or issuer, but an opinion willingness and ability of the issuer to make the
about relative credit risk. In assigning ratings, agreed payments, as specified in the security.
agencies rank relative credit risk from strongest to
weakest, based on relative creditworthiness and RATINGS AND INVESTMENT
credit quality within the rated universe. Actual Although credit quality is an important element in
default probabilities may change over time. an investment decision, it is not the only or even C
the most important element. Ratings opinions are S3
RECOVERY not investment recommendations. In making any ore
Some credit rating agencies incorporate the investment, the investor should consider the trade-
potential for recovery into their opinions, while off between risk and reward. Credit quality is only
aO
others may give a recovery rating that is separate a partial measure of one of those trade-offs. cr
from the credit rating. Recovery prospects after A security's price is generally one of the most
default are an important component in evaluating important considerations for an investor. If
credit quality, particularly in evaluating more the price is low enough, almost any investment
risky debt issues. becomes desirable; if the price is too high,
any investment becomes unattractive. The
ISLAMIC CREDIT price determines the long-run return on the
Mounting demand for s/iaria/i-compliant investment, assuming that it pays as scheduled.
financial products and services has fueled the As a minimum, three other factors besides
rapid expansion of the Islamic banking industry. price and credit quality should be considered.
More and more banking clients are choosing to First, what is the downside risk or likely recovery
invest in a broadening range of Islamic financial if the security defaults? Second, what is the
instruments (IFI) through long-established liquidity of the investment—how easy is it to
banks in the Gulf Cooperation Council (GCC) sell if it must be disposed of before its maturity
and Malaysia. The model has spread beyond the date, and how responsive is pricing to changes in
Gulf to the Maghreb and Muslim Asia, as well interest rates or the market environment?
as to Muslims in predominantly non-Muslim An important issue for investors buying outside
countries in the West, Asia, and Africa. their home country is the potential for exchange
Demand for sftana/i-compliant instruments rate change or government interference with the
has risen sharply as a result of strong economic ability to collect payment. Fortunately, foreign
growth within the Islamic world and the large exchange controls have become very rare outside
surpluses of the oil-producing countries. The of a few very weak emerging economies, but
volume of sfrari'a/i-compliant instruments foreign exchange risk is very real. The US dollar/
outstanding is estimated at over $500 billion, euro exchange rate went up 20% in early 2008
with sukuk (an Islamic financial certificate) and then down 20% over the next three months.
issuance reaching $100 billion. Islamic banks
have focused on the retail segment in the Arab CONCLUSION
world and Malaysia but are expanding to other Credit ratings may be used by investors and
countries. North Africa has been a recent region other market participants in making investment
of strong growth, with Tunisia and Morocco and business decisions that are aligned with
authorizing Islamic banks for the first time in their risk tolerance or credit risk guidelines.
2007. The central bank of Morocco became Credit ratings are opinions about the perceived
a shareholder in the International Financial credit risk of a particular debt issue. In general,
Services Board (based in Malaysia), which serves the greater the credit risk, the higher the return
as a transnational regulatory body to harmonize investors may expect for assuming that risk. For
O
regulation and supervision for Islamic banks. that reason, credit ratings may be useful for both
Islamic securities such as sukuk are rated issuers and investors when a debt issue is first
by agencies employing the same fundamental issued in the primary markets and continues
analysis as are used for rating other issues. The to be so for investors who trade securities in
rating provided does not, however, express an secondary markets. O

39
 Financing and Raising Capital

.2 MAKING IT HAPPEN
^ • Ratings can be obtained from a variety of agencies. Consider who will be your likely investors
CO
U before deciding t o go with a global or a local rating agency.
Cu
• Have your financial and business plans in order and fully audited by a reputable firm before
K trying to get a rating.
PQ • Ratings are opinions about credit risk, and not investment advice or opinions on pricing.
* • Work with your banker on determining which agency to use and whether a rating is desirable.

£1
Q
%
'3 MORE INFO and Kenneth Singleton. Credit Risk:
Duffie, Darrell, Pricing, Measurement, and Management.
g Books:
Princeton, NJ: Princeton University Press, 2003.
Fuchita, Yasuyuki, and Robert E. Litan (eds). Financial Gatekeepers: Can They Protect Investors?
Baltimore, MD: Brookings Institution, 2006.
Langohr, Herwig M., and Patricia T. Langohr. The Rating Agencies and Their Credit Ratings: What
They Are, How They Work, and Why They Are Relevant. Chichester, UK: Wiley, 2008.
Levich, Richard M., Giovanni Majnoni, and Carmen Reinhart (eds). Ratings, Rating Agencies and
the Global Financial System. Norwell, MA: Kluwer Academic, 2002.

Article:
Cantor, Richard. "An introduction to recent research on credit ratings." Journal of Banking and
Finance 28:11 (November 2004): 2565-2573. Online at:
dx.doi.org/10.1016/j.jbankfin.2004.06.002

Websites:
The main sources of information on ratings are the websites of the three major rating agencies:
www.moodys.com, www.standardandpoors.com, and www.fitchratings.com. A good discussion of
ratings trends is found in the "Guide to credit rating essentials" produced by Standard & Poor's
(2008, 20 pages): tinyurl.com/3942qmn [PDF].

I
• — i

o
Hi

40
Raising Capital in the United Kingdom w
en
by Lauren Mills
65

EXECUTIVE SUMMARY
• It has never been harder to raise capital. The credit crunch means banks are even less willing
to lend money to small and medium-sized enterprizes (SMEs). So raising capital is likely to be
more time-consuming and costly than before. It is therefore vital you know how much money
you need, and what you need it for, before approaching potential backers.
• A lot will depend on whether you are funding a start-up, buying an asset, seeking growth
finance, or looking for an exit. 3
• Whatever stage you are at, you must have a business plan, strong management, and good OQ
growth prospects—or potential backers are unlikely to be interested. re

INTRODUCTION • A £10 billion Working Capital Scheme,

Raising capital to grow a business has never been
more challenging or time-consuming. While
there are still many sources of finance, ranging
from government and EU grants, to bank loans,
private equity, angel investors, or a stock market
flotation, some will be easier to come by than
others in the post-credit crunch climate. One
of the biggest problems will be deciding which
route is best for you.
Before weighing up the pros and cons of each,
carry out a ruthless analysis of your business.
Start by asking yourself some elementary
questions. Do you have strong management
in place? Do you have a business plan? Do you
know what you need to do to move your business
to the next stage? This may sound somewhat
elementary, but it is surprising how many
companies keep drifting in one direction without
knowing whether this is the best route to pursue,
or whether the best captain is at the helm.
It is therefore essential to have a clear idea of
what you want to achieve and how you are going to
achieve it before approaching potential financiers.
GRANTS
In January 2009, the United Kingdom's Business
Secretary, Lord Mandelson, announced a new
package offinancialmeasures to help businesses
with short-term funding issues weather the
economic downturn. Help is also available for
companies looking to finance the next stage of
growth.
The support package consists of loan guarantees
securing up to £20 billion of short-term bank
lending to companies with a turnover of up to
£500 million.
• An Enterprise Finance Guarantee Scheme,
securing up to £1.3 billion of additional bank
loans to small firms with a turnover of up to
£25 million.
• A £75 million Capital for Enterprise Fund
(£50 million from government, plus £25
million from banks) to invest in small
businesses which need equity.
The Working Capital Scheme is a direct response
to the constraint on bank lending to ordinary-risk
businesses with a turnover of up to £500 million
a year. The Government has agreed to provide
banks with guarantees for 50% of the risk on
existing and new working capital portfolios
worth up to £20 billion as part of the scheme.
The Government guarantee will free up capital,
which the banks must use for new lending as a
condition of this scheme. This is lending that
would otherwise not have been provided, the
UK Government has claimed. The first £1 billion
guarantee tranche of the scheme is expected to
be available in March 2009.
The Enterprise Finance Guarantee is intended
to help smaller, credit-worthy companies which
might otherwise fail to access the finance they
need for working capital or investment finance
due to strict lending conditions.
The Government will provide £1 billion worth
of guarantees to support £1.3 billion of bank o
lending to smaller firms with an annual turnover • — 1

and a new Enterprise Fund. It is intended to help of up to £25 million, which are looking for loans
companies which are struggling to obtain finance of up to £1 million for a period of up to 10 years.
for working capital and investment. The guarantee, available through high street
The Government measures include: banks, will apply to loans and can also be used to o

41
 Financing and Raising Capital
^ convert existing overdrafts into loans to enable
W businesses to free up their current overdraft
§ facilities to meet working capital requirements.
Cd To help businesses raise new long-term
£ finance, the UK Government is also offering
+j to invest in viable companies which have high
5R levels of existing debt through t h e new Capital
PQ for Enterprise Fund.
• The Government also provides a range of
•g financial support to businesses—including loans
& and loan guarantees, grants, and equity—through
Q various "Solutions for Business" products.
WD To find out more about what is on offer,
,5 t h e best starting point is your local Business
J3 Link. This is t h e Government's business
05 advice network, which offers an abundance of
M
information online, over the telephone, or via
face-to-face meetings with an adviser.
A new "one-stop shop," easy-to-use web portal
has been launched on the Business Link website
to direct companies to the most appropriate form
of support, and help them assess their eligibility
for the various schemes.
There is also a Grant for Business Investment
(GBI), which provides capital to support
business investment or job creation projects
and is part of the Government's Solutions for
Business portfolio. The idea is to help businesses
grow, become more efficient, modernize, and
diversify.
A grant under GBI is for the acquisition
of key assets such as buildings, machinery,
and equipment, and to help create new jobs
or safeguard existing ones. Grants start at a
minimum of £10,000 and there is no maximum
limit. The final amount will depend on the size
and location of the business, and the size and
quality of the project. It is also worth bearing
in mind that businesses applying for this grant
will be assessed according to the level of skills
they require within their workforce, and their
anticipated productivity improvement. So
companies must be clear about what they hope
to achieve before applying.
In Scotland, this is called the Grant for
Regional Selective Assistance (RSA). Information
about this can be found on the Scottish Business
Grants website.
, In Northern Ireland, it is called the Enterprise
fi NI Loan Fund (ENILF). Information is available
>y. on the Enterprise NI website.
^~j Remember, there is a limited pot of cash
S available, so competition for grant funding is
{£3 extremely fierce. Furthermore, the application
PM process is often long-winded and arduous.
O' Applicants must complete detailed application
42
forms. They must also demonstrate how
they will satisfy the funding conditions and
requirements of any one scheme. It is essential
that you understand the Government's economic
objectives in providing grants and tailor your
application to meet them.
BANK LOANS
Individuals looking for start-up capital, or small
firms seeking finance to pay for assets such as
computer equipment, machinery, or cars, could
look to their bank or building society for the
cash. But lending criteria are far tougher now
than before the credit crunch hit.
The advantage of a bank loan—if you can get
one—is that it will be for a fixed sum, over a fixed
period of time, so you know how much you need
to pay back and for how long. In theory, this
should make it relatively easy to manage your
budgets. And while you will have to pay interest
on bank or building society loans, you will not be
obliged to hand over a percentage of your profits
or a share of your company.
Even before the global financial meltdown
there were drawbacks:
• The banks impose strict terms and conditions
on most loans. In some cases they may even
insist you offer some sort of security. So you
may be required to secure the loan against the
assets of your business or even your home.
• Bank loans are not very flexible, so you may
find yourself paying interest on funds you
are not using. You will also have to make
regular repayments, which may make it hard
to manage cash flow if your customers are not
paying their bills on time.
If you feel a bank loan could cover your business
needs, then remember to research the market
carefully.
A good place to start is the website Money
Supermarket, which offers information on
business current accounts—which will give you
an idea of which banks to approach.
The Institute of Chartered Accountants in
England and Wales (ICAEW) reckons nine out
of 10 SMEs are likely to be contacted by their
banks to discuss the terms of their overdrafts by
the end of 2009.
Clive Lewis, SME expert at ICAEW, believes
businesses should explore a range of financing
alternatives and use "appropriate funding." This,
he says, could include asset finance, factoring,
hire purchase, invoice discounting, leasing, and
equity finance.
Lewis warns of even tougher times ahead. He
advisesbusinessownerstoseekadviceonalternatives
 Raising Capital in the United Kingdom
to bankfinance,because there is an estimated £800
billion funding gap between deposits and lending in
the United Kingdom. This is because savings levels
have dropped off and cheap foreign capital from the
wholesale markets has dried up.
PRIVATE EQUITY OR VENTURE
CAPITAL
Private equity firms and venture capitalists are
still looking to invest in businesses with strong
management and good growth prospects.
However, they are more likely to invest in
companies they have already backed than take
on new risk in the current economic climate.
It is worth remembering that private equity
investors tend to invest in a business for the
medium term, rather than the longer term.
In practice this often means from three to five
years, although they may invest for far longer or
much shorter periods of time.
Unlike lenders, they tend not to have rights to
interest or to be repaid at a particular date. But
they will want a share of the ownership and in
some instances may demand an element of control
of the business. They often insist that a non-
executive is appointed to the board. This is not
necessarily a bad thing. If you do your homework
and bring in an external investor with experience
in your sector, then you could be adding another
dimension to your business by beefing up senior
management expertise. And this can be invaluable
in terms of brainstorming for new ideas.
Venture capital or private equity financing
tends to be best suited to businesses gearing up
for a flotation or trade sale—both of which will
be hard to achieve while stock markets remain
volatile and credit is hard to come by. This is
because the investor will need to be able to
realize a return for the investment via a well-
thought-out exit strategy.
Before approaching potential private equity
investors, it is essential to ask yourself how
credible your management is. Do you have
a solid track record? And do you have the
communications skills necessary to sell your
story effectively? You will need a strong product
or service. And you must be able to show that
you can deliver year-on-year growth to realistic
targets. Ultimately, you must still be highly
ambitious and driven to attract interest from
private equity backers.
Once you have completed a serious analysis of
your business and its prospects, you must draw
up a detailed business plan. It should be written
in plain English, without jargon or fluff—private
equity professionals have a nose for sniffing out
sound ideas from speculative pipe dreams.
The main advantage of private equity financing w
is that the investor will have a vested interest in (ft
your business's success. These types of investors
are also often prepared to offer follow-up funding
as the business grows.
BUSINESS ANGELS
Business angels are high net worth individuals
who invest on their own, or as part of a syndicate, (ft
in high-growth businesses. In addition to money, (ft
they often make their own skills, experience, and c
contacts available to the companies they invest
in. According to the British Business Angels Qrq
Association (BBAA), angel investors rarely have O
a connection with a company before they invest cr
in it. However, they are more than likely to have
experience of its industry or sector, so could
bring invaluable experience to the table.
The BBAA believes business angels are "an
important but still under-utilized" source of
money for new and growing businesses.
Typically, business angels invest between
£10,000 and £750,000 in an investment, making
them an attractive alternative for smaller firms
looking to raise smaller sums.
Before investing, business angels will check out
factors ranging from management expertise and
track record, to a company's competitive edge
and compatibility between the management, the
business plan, and the business angel's skills and
investment preferences.
A good starting point for further information
is the BBAA's website.
STOCK MARKET FLOTATION
The number of companies seeking a stock
market flotation has plummeted in the wake of
the credit crunch. In the first half of 2008, only
333 companies sought to raise finance through
an initial public offering (IPO), compared to 702
companies in the same period a year earlier.
Given the turbulent state of the world's equity
markets, it is unlikely that IPOs will regain their
status as a popular route to new finance in the
foreseeable future.
A stock market flotation involves selling
shares in your business on one of the stock
markets. There are three markets in the
o
United Kingdom. The London Stock Exchange
Main Market is mostly populated with
h-H
larger companies. However, the Alternative
Investment Market (AIM) and the PLUS
market are both aimed at smaller companies.
If an IPO is a realistic option for your business,
it is important to remember it is not an exit—it n
in
43
 Financing and Raising Capital
is the beginning of the next stage of growth.
Companies considering a stock market flotation
must have strong management, a healthy track
record, and excellent growth prospects.
u Traditionally, the main advantage of a stock
market flotation is ready access to funds.
Flotation may also add to your company's
credibility and raise its profile. It also provides
an opportunity for business owners and other
investors, such as private equity backers, to
realize their investment. Having your own traded
shares may also help you grow your business
wo because you can offer shares as well as cash in
any potential takeover bids.
There are disadvantages, however. Costs
(A associated with floating a business can be
02
substantial. There will be higher ongoing
professional fees, as you will need advisers to help
you comply with the added regulatory burden that
floating a business can bring. You will also have
to consider the interests of shareholders when
running the company—and there will be times
when their objectives will differ from yours.
Choosing the right market is vital. London's
Main Market is the most stringently regulated
and is only suitable for the largest companies. A
minimum of 25% of the company's equity must
be traded, to ensure liquidity, and companies
must have been trading for at least three years.
While the main market gives access to the widest
possible audience of potential investors, it comes
at a price. Professional fees and costs are far
higher than for AIM or PLUS.
In contrast to the main market, AIM does
MORE INFO
Websites:
British Business Angels Association: www.bbaa.org.uk
Business Link: www.businesslink.gov.uk/realhelp/finance
Enterprise NI Loan Fund: www.enterpriseni.com/Content.aspx?nSectionId=8&nSubSectionId=84
Money Supermarket: www.moneysupermarket.com
Scottish Business Grants: www.scottishbusinessgrants.gov.uk/rsa/208.html
u
z
$
I—I
a
p-l
44
not require a company to have a trading
record. And while it is part of the London Stock
Exchange, it offers a more flexible regulatory
environment and is less expensive. There is
no minimum percentage of shares that has to
be traded, yet AIM-listed companies attract a
wide range of investors, including institutional
backers. AIM offers tax breaks and incentives for
owner-managers, and is a very liquid market. A
nominated adviser is required at all times.
PLUS is aimed at smaller companies seeking
to raise up to £10 million. While it is regulated,
the rules are not as stringent as those of AIM
or the Main Market. While the costs associated
with floating and running a company on the
PLUS market are lower than its larger rivals,
the pool of investors is not as deep and is mainly
restricted to private investors.
If you think your company is ready for a stock
market flotation, then remember that preparing
for a float is a challenging and expensive process.
It can take months to organize. For businesses
that have not been part of a regulated industry
before, it can be a cultural shock.
CONCLUSION
Choosing the right type of finance for your
business is incredibly important. You must have
a thorough understanding of what stage your
business is at and what you need the money for
before you pursue any one of the options. A lot
will depend on whether you are funding a start-
up, buying an asset, seeking growth finance, or
looking for an exit.
Minimizing Credit Risk by Frank J. Fabozzi
EXECUTIVE SUMMARY
• Credit risk encompasses credit default risk, credit spread risk, and downgrade risk.
• Market participants typically gauge credit default risk in terms of the credit rating assigned by
rating agencies.
• Factors that are considered in the evaluation of a corporate borrower's creditworthiness are: the
quality of management; the ability of the borrower to satisfy the debt obligation; the level of
seniority and the collateral available in a bankruptcy proceeding; and covenants.
• Credit risk transfer vehicles allow the redistribution of credit risk. 3
• Securitization is a credit risk transfer vehicle for corporations that is accomplished by selling a
pool of loans or receivables to a third-party entity.
• Credit derivatives are a form of credit risk transfer vehicle.

INTRODUCTION or issuer will be downgraded, resulting in an

Financial corporations and investors face several
types ofrisk.One major risk is credit risk. Despite
the fact that market participants typically refer to
"credit risk" as if it is one-dimensional, there are
actually three forms of this risk: credit default
risk, credit spread risk, and downgrade risk.
Credit default risk is the risk that the issuer
will fail to satisfy the terms of the obligation with
respect to the timely payment of interest and
repayment of the amount borrowed. This form of
credit risk covers counterparty risk in a trade or
derivative transaction where the counterparty fails
to satisfy its obligation. To gauge credit default risk,
investors typically rely on credit ratings. A credit
rating is a formal opinion given by a company
referred to as a rating agency of the credit default
risk faced by investing in a particular issue of debt
securities. For long-term debt obligations, a credit
rating is a forward-looking assessment of the
probability of default and the relative magnitude
of the loss should a default occur. For short-term
debt obligations, a credit rating is a forward-
looking assessment of the probability of default.
The nationally recognized rating agencies include
Moody's Investors Service, Standard & Poor's, and
Fitch Ratings.
Credit spread risk is the loss or under-
performance of an issue or issues due to an
increase in the credit spread. The credit spread
is the compensation sought by investors for
accepting the credit default risk of an issue or
issuer. The credit spread varies with market
conditions and the credit rating of the issue or
issuer. On the issuer side, credit spread risk
is the risk that an issuer's credit spread will
increase when it must come to market to offer
bonds, resulting in a higher funding cost.
Downgrade risk is the risk that an issue
increase in the credit spread demanded by the
market. Hence, downgrade risk is related to
credit spread risk. Occasionally, the ability of an
issuer to make interest and principal payments
diminishes seriously and unexpectedly because
of an unforeseen event. This can include any
number of idiosyncratic events that are specific
to the corporation or to an industry, including
a natural or industrial accident, a regulatory
change, a takeover or corporate restructuring, or
corporate fraud. This risk is referred to generically
as event risk and will result in a downgrading of
the issuer by the rating agencies.
FACTORS CONSIDERED IN ASSESSING
CREDIT DEFAULT RISK
The most obvious way to protect against credit
risk is to analyze the creditworthiness of the
borrower. In performing such an analysis,
credit analysts evaluate the factors that affect
the business risk of a borrower. These factors
can be classified into four general categories—
the quality of the borrower; the ability of the
borrower to satisfy the debt obligation; the
level of seniority and the collateral available
in a bankruptcy proceeding; and restrictions
imposed on the borrower.
In the case of a corporation, the quality of
the borrower involves assessing the firm's
business strategies and management policies.
More specifically, a credit analyst will study the
corporation's strategic plan, accounting control O
systems, andfinancialphilosophyregardingthe use
of debt. In assigning a credit rating, Moody's states:
"Although difficult to quantify, management
quality is one of the most important factors
supporting an issuer's credit strength. When o
the unexpected occurs, it is a management's

45
 Financing and Raising Capital
^ ability to react appropriately that will sustain the
W company's performance." 1
•§ The ability of the borrower to meet its
etf obligations begins with the analysis of the
*T borrower's financial statements. Commonly
^ used measures of liquidity and debt coverage
$ combined with estimates of future cash flows
QQ are calculated and investigated if there are
• concerns. In addition, the analysis considers
ti industry trends, the borrower's basic operating
Q^ and competitive position, sources of liquidity
Q (backup lines of credit), and, if applicable, the
150 regulatory environment. An investigation of
fl industry trends aids a credit analyst in assessing
3 the vulnerability of the firm to economic
^ cycles, the barriers to entry, and the exposure
^ of the company to technological changes. An
investigation of the borrower's various lines of
business aids the credit analyst in assessing the
firm's basic operating position.
A credit analyst will look at the position as
a creditor in the case of a bankruptcy. The US
Bankruptcy Act comprises 15 chapters, each
covering a particular type of bankruptcy. Of
particular interest here are Chapter 7, which
deals with the liquidation of a company, and
Chapter 11, which deals with the reorganization
of a company. When a company is liquidated,
creditors receive distributions based on the
absolute priority rule to the extent that assets
are available. The absolute priority rule is the
principle that senior creditors are paid in full
before junior creditors are paid anything. For
secured creditors and unsecured creditors, the
absolute priority rule guarantees their seniority
to equity holders. However, in the case of a
reorganization, the absolute priority rule rarely
holds because in practice unsecured creditors do
in fact typically receive distributions for the entire
amount of their claim and common stockholders
may receive something, while secured creditors
may receive only a portion of their claim. The
reason is that a reorganization requires the
approval of all the parties. Consequently, secured
creditors are willing to negotiate with both
unsecured creditors and stockholders in order to
obtain approval of the plan of reorganization.
The restrictions imposed on the borrower
(management) that are part of the terms and
(JLJ conditions of the lending or bond agreement are
QJ called covenants. Covenants deal with limitations
^? and restrictions on the borrower's activities.
<* Affirmative covenants call on the debtor to make
*~Z promises to do certain things. Negative covenants
1—1 are those that require the borrower not to take
j^T. certain actions. A violation of any covenant
\J> may provide a meaningful early warning alarm,
46
enabling lenders to take positive and corrective
action before the situation deteriorates further.
Covenants play an important part in minimizing
risk to creditors.
CREDIT RISK TRANSFER VEHICLES
There are various ways that investors, particularly
institutional investors, can reduce their exposure
to credit risk. These arrangements are referred
to as credit transfer vehicles. It should be borne
in mind that an institutional investor may not
necessarily want to eliminate credit risk but may
want to control it or have an efficient means by
which to reduce it. The increasing number of
credit risk transfer vehicles has made it easier for
financial institutions to reallocate large amounts
of credit risk to the nonfinancial sector of the
capital markets.
For a bank, the most obvious way to transfer the
credit risk of a loan it has originated is to sell it to
another party. The bank management's concern
when it sells corporate loans is the potential
impairment of its relationship with the corporate
borrower. This concern is overcome with the use of
syndicated loans, because banks in the syndicate
may sell their loan shares in the secondary
market by means of either an assignment or a
participation. With an assignment, a syndicated
loan requires the approval of the obligor; that
is not the case with a participation since the
payments by the borrower are merely passed
through to the purchaser, and therefore the
obligor need not know about the sale.
Two credit risk vehicles that have increased in
importance since the 1990s are securitization and
credit derivatives. It is important to note that the
pricing of these credit risk transfer instruments
is not an easy task. Pricing becomes even more
complicated for lower-quality borrowers and for
credits that are backed by a pool of lower-quality
assets, as recent events in the capital markets
have demonstrated.
SECURITIZATION
Securitization involves the pooling of loans and/
or receivables and selling that pool of assets to
a third-party, a special purpose vehicle (SPV).
By doing so, the risks associated with that pool
of assets, such as credit risk, are transferred to
the SPV. In turn, the SPV obtains the funds to
acquire the pool of assets by selling securities.
When the pool of assets consists of consumer
receivables or mortgage loans, the securities
issued are referred to as asset-backed securities.
When the asset pool consists of corporate loans,
the securities issued are called collateralized
loan obligations.
 Minimizing Credit Risk

A major reason why afinancialor nonfinancial
corporation uses securitization as a fund-raising
vehicle is that it may allow a lower funding cost
than issuing secured debt. However, another
important reason is that securitization is a risk
management tool. Although the entity employing
securitization retains some of the credit risk
associated with the pool of loans (referred to
as retained interest), the majority of the credit
risk is transferred to the holders of the securities
issued by the SPV.
CREDIT DERIVATIVES
A financial derivative is a contract designed to
transfer some form of risk between two or more
parties efficiently. When a financial derivative
allows the transfer of credit exposure of an
underlying asset or assets between two parties,
it is referred to as a credit derivative. More
specifically, credit derivatives allow investors
either to acquire or to reduce credit risk exposure.
Many institutional investors have portfolios that
are highly sensitive to changes in the credit
spread between a default-free asset and a credit-
risky asset, and credit derivatives are an efficient
way to manage this exposure. Conversely, other
institutional investors may use credit derivatives
to target specific credit exposures as a way to
enhance portfolio returns. Consequently, the
ability to transfer credit risk and return provides
a tool for institutional-investors; the potential
to improve performance. Moreover, corporate
treasurers can use credit derivatives to transfer
the risk associated with an increase in credit
spreads (i.e., credit spread risk).
Credit derivatives include credit default
swaps, asset swaps, total return swaps, credit
linked notes, credit spread options, and credit
W
spread forwards. In addition, there are index- n
type or basket credit products that are sponsored en
by banks that link the payoff to the investor to a
portfolio of credits. Credit derivatives are over-
the-counter instruments and are therefore not
traded on an organized exchange. Hence, credit
derivatives expose an investor to counterparty
risk, and this has been the major concern in
recent years in view of the credit problems
of large banks and dealer firms who are the
counterparties.
Credit derivatives also permit banks to transfer
credit risk without the need to transfer assets
physically. For example, in a collateral loan d
obligation, a bank can sell a pool of corporate
loans to a special purpose vehicle (SPV) in
8-
order to reduce its exposure to the corporate
borrowers. Alternatively, it can transfer the
credit risk exposure by buying credit protection
for the same pool of corporate loans. In this
case, the transaction is referred to as a synthetic
collateralized loan obligation.
An understanding of credit derivatives is
critical even for those who do not want to use
them. As Alan Greenspan, then the Chairman
of the Federal Reserve Board, in a speech on
September 25,2002, stated:
"The growing prominence of the market for
credit derivatives is attributable not only to its
ability to disperse risk but also to the information
it contributes to enhanced risk management by
banks and other financial intermediaries. Credit
default swaps, for example, are priced to reflect
the probability of net loss from the default of
an ever broadening array of borrowers, both
financial and non-financial."2

CASE STUDY
A credit-linked note (CLN) is a security, usually issued by an investment-grade-rated corporation,
that has an interest payment and fixed maturity structure similar to a standard bond. In contrast
to a standard bond, the performance of the CLN is linked to the performance of a specified
underlying asset or assets as well as that of the issuing entity. There are different ways that a CLN
can be credit linked, and we will describe one case here.
British Telecom issued on December 15, 2000, a CLN with a coupon rate of 8.125% maturing on
December 15, 2010. The terms of this CLN stated that the coupon rate would increase by 25 basis
points for each one-notch rating downgrade of British Telecom below A-/A3 suffered during the
o
life of the CLN. The coupon rate would decrease by 25 basis points for each rating upgrade, with
a minimum coupon set at 8.125%. In other words, this CLN allows investors to make a credit play
based on this issuer's credit rating. In fact, in May 2003, British Telecom was downgraded by one
rating notch and the coupon rate was increased to 8.375%.
o

47
 Financing and Raising Capital

0) CONCLUSION the borrower, the ability of the borrower to satisfy

.S* While market participants typically think of the debt obligation, the level of seniority and the
Jj credit risk in terms of the failure of a borrower collateral available in a bankruptcy proceeding,
2 to make timely interest and principal payments and covenants. Credit risk transfer vehicles
PH on a debt obligation, this is only one form of include securitization and credit derivatives.
to credit risk: credit default risk. The other types of Credit derivatives include credit default swaps,
-Sj credit risk are credit spread risk and downgrade asset swaps, total return swaps, credit linked
# risk. When evaluating the credit default risk of notes, credit spread options, credit spread
•M a borrower, credit analysts look at the quality of forwards, and baskets or indexes of credits.
4>
Q
U MAKING IT HAPPEN
.5 Controlling credit risk requires not just an understanding of what credit risk is and the factors that
J affect a borrower's credit rating but other important implementation issues. These include:
!* • establishing the credit risk exposure that a corporation or institutional investor is willing to
accept;
• quantifying the credit risk by using the latest quantitative tools in the field of credit risk
modeling;
• understanding the various credit risk transfer vehicles that can be employed to control credit
risk;
• evaluating the merits of different credit risk transfer vehicles to determine which are the most
appropriate for altering credit risk exposure.

MORE INFO
Books:
Anson, Mark J. P., Frank J. Fabozzi, Moorad Choudhry, and Ren-Raw Chen. Credit Derivatives:
Instruments, Pricing, and Applications. Hoboken, NJ: Wiley, 2004.
Fabozzi, Frank J., Moorad Choudhry, and Steven V. Mann. Measuring and Controlling Interest Rate
and Credit Risk. 2nd ed. Hoboken, NJ: Wiley, 2003.
Articles:
Fabozzi, Frank J., and Moorad Choudhry. "Originating collateralized debt obligations for balance
sheet management." Journal of Structured Finance 9:3 (Fall 2003): 32-52. Online at:
dx.doi.org/10.3905/jsf.2003.320318
Fabozzi, Frank J., Henry A. Davis, and Moorad Choudhry, "Credit-linked notes: A product primer."
Journal of Structured Finance 12:4 (Winter 2007): 67-77. Online at:
dx.doi.org/10.3905/jsf. 12.4.67
Lucas, Douglas J., Laurie S. Goodman, and Frank J. Fabozzi. "Collateralized debt obligations and
credit risk transfer." Journal of Financial Transformation 20 (2007): 47-59. Online at:
tinyurl.com/24t4qbd [PDF].
Websites:
DefaultRisk.Com—for credit risk modeling and measurement: www.defaultrisk.com
Vinod Kothari's credit derivatives website: www.credit-deriv.com

u
til

z
t
t—I NOTES

o 1 Moody's Investor Service. "Industrial company rating

methodology." Global Credit Research (July 2008): 6.
2 Speech titled "World Finance and Risk Management,"
at Lancaster House, London, United Kingdom.

48
How and When to Use Nonrecourse
Financing by Thomas McKaig
EXECUTIVE SUMMARY
• Nonrecourse financing is debt where the loan is completely secured by collateral, which is
often real estate. In case of default, the borrower is not liable because the lender is limited to
collateral pledged for that loan—the lender has "no recourse" to the borrower's other assets.
• Nonrecourse financing is typically found in infrastructure projects such as the construction
of toll roads and bridges. In this case, the borrower (a large construction company) is under
no obligation to make payments on the loan if the revenue generated from the project on
completion (the bridge or the toll road when built) is insufficient to cover the principal and
interest payments on that loan.
• Although the benefits of such financing are obvious (the borrower is not using its balance sheet
for the loan and can therefore undertake more leveraged projects than it could otherwise), such
financing comes at a cost. Lenders often seek other credit guarantees and will almost certainly
charge more for the loan than with more traditional, recourse financing.
• Nonrecourse financing does not mean "no risk," and some companies may undertake projects
that have a riskier profile than they should otherwise assume, as will be shown in a case study.

INTRODUCTION corporate liability, they do not release whatever

When companies are negotiating loans from
lenders, there are many clauses that are
important points for negotiation over and above
the amount of the loan and interest charged.
These items can include assignment of the
loan (on the part of either the borrower or the
lender), future fund advances, and prepayment
capability. Another key clause is the nonrecourse
clause, under which the lender agrees not to hold
the borrower (the company) liable in the event of
default on the loan.
Typically, therefore, nonrecourse financing is
different from personal loans, such as mortgage
loans, where the lender holds the borrower
personally responsible for the sum borrowed if
the value of the item being financed (the house)
is insufficient to repay the total amount of the
loan. Such loans are often called recourse loans.
On the corporate side, most small business start-
up loans are recourse loans—if the business fails,
the owner is still liable to repay the loan amount
in full.
Not all nonrecourse financing is the same—the
phrase itself is very broad. Nonrecourse clauses in
loan agreements, for example, may state the specific
conditions under which the lender will not hold the
borrower personally liable in the event of default.
If these conditions are not met, then the borrower
becomes liable. Such financing is sometimes
referred to as limited-recourse financing.
It is also important to remember that, while
nonrecourse loans relieve the borrower of
property is used as collateral for the loan—the
lender still has an interest in the property as
security for the loan.
Nonrecourse financing is the norm in the
world of project financing for major projects
that are government or quasi-govemment
sponsored (infrastructure projects such as toll
roads, hospitals, or power generating plants). It
is so much a part of project financing that many
textbook definitions of "project finance" specify
that it is a key component: a project is financed
based on, and secured by, the project itself,
with the lender being repaid out of the project's
cash flow, rather than the project being secured
by the general assets or creditworthiness (the
balance sheets) of the sponsors (the engineering
companies, the construction companies, or even
the government bodies) of an infrastructure
project. In most of these cases, the companies
undertaking the project are either not sufficiently
creditworthy, or else unwilling to assume the
high debt loads associated with traditional
financing for large, multibillion dollar projects.
Nonrecourse financing is also the norm in the
commercial real estate world for the construction
of major projects such as office buildings or
shopping malls.
The benefits of nonrecourse financing to
the borrower are obvious. Borrowers are able
to enter into agreements that they could not
afford under traditional financing methods.
Project financing deals are also highly leveraged,

49
 Financing and Raising Capital

0) allowing borrowers (more accurately called "the nonrecourse financing to fund the construction
,y sponsoring parties" to the agreement) to put of a new building because the institution as a
y fewer of their own funds at risk. Furthermore, whole would not want to put its balance sheet at
2 depending on the structure of the loan agreement, risk to fund the construction of one building.
(^ borrowers may not be required to report any of However, some dangers accompany this
^3 the project debt on their balance sheet. increased exposure to risk. "Non-recourse" is
^ A large firm undertaking a project may use not a synonym for "no downside risk," though
^ nonrecourse debt as a way of limiting its risk some companies may come to believe that. The
4_* exposure by effectively isolating a new project. Case Study illustrates some of the dangers when
*•§ For example, a large university might use companies forget about increased risk exposure.
Q
WD
fl
g CASE STUDY
>•"< Nonrecourse Does Not Mean No Risk
The early 1990s were a tough time for real estate investments in North America and throughout
much of the world. But it was preceded by many profitable years of highly speculative construction
and development of office buildings and retail facilities. This long building boom also encouraged all
parties in the development process to stretch themselves and become more exposed to the overall
project, which everyone agreed could only increase in value. Lenders soon became co-owners of
projects. Developers, who used to sell a project on completion, wished to keep a portion of the
development for themselves, and tenants wondered why they should pay rent when they could
explore co-ownership arrangements.
Consider the example of a mid-size real estate asset management firm that became tired of
managing the assets of others, and wanted a piece of the pie for themselves. Their plan was to
obtain a nonrecourse loan for the construction of a major shopping mall. The real estate company
would make money during the construction process (as construction managers) from ongoing
mall management and from a small equity stake in the mall, which the managers would keep
for themselves. And with a nonrecourse loan, the real estate firm wouldn't be liable for interest
payments if things went badly. It was a "no lose" situation.
However, no liability is not the same as having no exposure. The real estate manager, aided by
the thought that nonrecourse meant no possibility of loss, staked all of the firm's time and effort
on this one project, rather than diversifying among many real estate holdings, as other managers
had done. When the lender eventually took over the half-finished project, it was true that the
real estate manager had no further financial liability for this project. However, because the lender
stopped the project, the construction fees to the manager stopped, their own minority equity stake
shrank to zero, and they didn't survive long enough to benefit from the ongoing mall management
contract. The project was eventually completed many years later, but neither the original lender
nor the real estate asset manager remained in business to enjoy the eventual profit.

Costs
In any negotiation—especially a loan negotiation—no concession, such as a nonrecourse clause,
comes for free. In many cases, the lender may seek to mitigate its increased risk from writing a
nonrecourse loan by seeking additional guarantees or warranties from the borrower, from other
parties that are part of the project finance group, or even from third parties such as governments
or quasi-governmental agencies. Such "credit enhancement" can produce an end result where
pj the borrower ends up with exposure that is very similar to a recourse loan. In still other cases,
(_) additional equity has to be pledged by the borrower to cover the lender's risk. Once again, if the
*7 borrower is pledging assets worth 110% or more of the loan amount, it is wise to question what
<j^ you have to gain from having a nonrecourse loan.
^7 Borrowers also pay for the nonrecourse clause in a loan agreement. This can either come about
H—i in the form of higher interest rates for the loan, or higher up-front financing costs and fees to
]^j arrange the loan, or both. Nonrecourse financing may also result in a shorter list of lenders (and
O therefore a less competitive and higher-priced marketplace) than recourse loans. The final cost

50
 How and When to Use Nonrecourse Financing

comes from the greater amount of time needed to both negotiate and, ultimately, structure a
nonrecourse financing agreement. Legal costs and time costs associated with these more complex w
ft
financing arrangements must be considered in the overall financing equation. Selling property <•+
that is encumbered by a nonrecourse loan will often give rise to a more complex tax situation hj
(depending on the country the company is operating in), which is another factor to consider. p

a
o
o
CONCLUSION have broken ground if more traditional financing *
There are some real advantages to nonrecourse methods were used. But, as the economists say, c«
financing for the borrower. In some cases, such there is no such thing as a free lunch. Be sure g
as large project financing agreements, it allows to take into account the costs of this financing g»
projects to be completed that might not otherwise before rushing into a nonrecourse deal. ^q

_1 ^
o
ft
' cr
MAKING IT HAPPEN *"
• In any loan negotiation ask yourself, "Can I afford to have nonrecourse financing?"
• When any loan is coming up for renewal, ask yourself if nonrecourse financing is appropriate for
your firm.
• When circumstances at your firm change (for example, if your balance sheet strengthens),
examine the appropriateness of nonrecourse financing.
• Also consider the appropriateness of nonrecourse financing when circumstances in the world
change (for example, the credit market is looser/tighter, or a project is nearing completion so its
risk profile changes) and you are renegotiating a loan.
• Government-backed programs can often stand between a lender and a firm, offering
nonrecourse loans to the firm but providing a government guarantee if things go wrong, thereby
offering a service to the lender as well. These programs vary by country and usually apply to
specific, targeted industries—small business, agriculture, or protected industries. Check what
programs apply to your firm, both now and in the future.

MORE INFO
Books:
Liaw, K. Thomas. The Business of Investment Banking. New York: Wiley, 1999.
Ling, David C , and Wayne R. Archer. Real Estate Principles: A Value Approach. 2nd ed. New York:
McGraw-Hill, 2006.
Slee, Robert T. Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business
Interests. Hoboken, NJ: Wiley, 2004.
Tjia, John. Building Financial Models: A Guide to Creating and Interpreting Financial Statements.
New York: McGraw-Hill, 2004.
Websites:
Collaboratory for Research on Global Projects at Stanford University: crgp.stanford.edu
International Project Finance Association (IPFA): www.ipfa.org
National Council for Public-Private Partnerships (NCPPP): ncppp.org
Project Finance Magazine: www.projectfinancemagazine.com
o
j 1 "]
Project Finance Portal, Harvard Business School: www.people.hbs.edu/besty/projfinportal 2
Public Financial Management blog, International Monetary Fund: £>
blog-pfm.imf.org/pfmblog/2008/02/a-primer-on-pub.html 2
Urban Land Institute (ULI): www.uli.org f\
tfl

51
Understanding the True Cost of Issuing w
Convertible Debt and Other Equity-Linked
Financing by Roger Lister
a
EXECUTIVE SUMMARY
• Convertible securities (CSs) combine debt and equity. In option terms, CSs are a call option on
a specified number of shares whose exercise price is the debt claim forgone in exchange for the CA
shares. CSs are also like a stock with a put option whose exercise price is the market value of
the convertible. 3
• Some critics insist that CSs are uneconomic because they address several habitats of investors OfQ
at the same time. Others say that they comprise flexible, non-dilutive, easily executed, and O
cheap finance, which appeals to many professional investors including hedge funds.
• The basic formula defines the cost of CSs but ignores tax and dividends. The formula produces a a*
weighted average of the cost of the debt and the cost of a call option on the issuer's shares.
• Management's task is to measure the cost of CSs with the formula while allowing for the real
world influences that the basic model ignores.
• Cost-influencing factors include dividends, tax, and resolution of agency costs.

INTRODUCTION to investors interested in debt. At the same time

Convertible securities (CSs) and other equity-
linked instruments combine debt and equity.
Depending on the terms and the issuer's future
performance, CSs can range from almost pure
equity to an option-free bond. In option terms,
a CS can be viewed in two ways. It amounts to
a straight bond with a call option on a specified
number of shares. It is also effectively a share
with a put option whose exercise price is the
market value of the convertible.
Some iconoclasts persistently argue that CSs and
other equity-linked instruments are essentially
uneconomic. Classically championed by Tony
Merrett and Allen Sykes, critics maintain that by
jointly approaching the equity and fixed interest
markets a company must offer costly conversion
rights to attract the equity investor while giving
virtually the same rights to the fixed interest
investor who values them less. Likewise, issuers
must give fixed interest investors an acceptable
income. In short, CSs contradict the advantage of
specialization whereby capital-raising is tailored
to habitats of investors. The iconoclasts invoke
studies like Ammann, Fehr, and Seiz (2006) to
the effect that negative equity returns follow the
announcement and issue of CS.
Loss of interest on the part of one habitat
can lead to greater interest from the other. The
mini-boom in convertibles in the spring of 2009
occurred as the reduced value of the equity
element led to higher yields becoming available
some straight equity investors crossed over into
convertibles attracted by the combination of
yield and equity option.
A counterargument is that CSs areflexible,non-
dilutive, easily executed, and cheap finance. CSs
appeal to professional investors, including hedge
funds which exploit arbitrage opportunities.
Rating agencies such as Fitch see sense in
both viewpoints and hold that the desirability of
CSs depends more strongly than other sources
offinanceon individual corporate circumstances
and market context. Fitch (2006) concludes:
"Issuers must find continuing compelling
reasons for such issuance...The lower costs
of such issuance compared with the cost of
issuing equity are certainly supportive, as are
the gradual standardisation, transparency and
consistency of documentation, market practice
and the activities of the agencies. On the other
hand, issuers and their advisers must always
strive to satisfy several constituencies, including
regulators, legal and tax authorities, the
agencies and finally, investors. Investor appetite
underpinned the buoyant corporate activity of
recent years. However, that appetite arose in an
environment of low interest rates that will not
persist indefinitely."
o
What is the true cost of CSs? Definition is less
difficult than measurement. Having defined the
parameters and influences on cost, management •n
must frankly ask whether their measurements

O
53
 Financing and Raising Capital
0) are so unreliable as to make them a dubious basis
W for decision-taking. Of course this applies across
•fi financial management, but it is particularly acute
cd for the cost of capital.
£ THE COST FORMULA
* The cost of a CS is a weighted average of the cost
pq of its debt element and the cost of a call option on
« the issuer's shares, since the investor in a CS is a
•M lender and the holder of a call option on the value
^ of the firm. The difference between a conversion
Q right and a regular call option is that a CS holder
5Q gets new shares upon exercise. It follows that if
fl the price at which the CS holder is entitled to
*;3 shares is below market price, then the value of
^ all corporate equity, including the convertor's, is
M diluted. This explains why a convertible warrant
is worth less than a straight call option on the
company's shares whose exercise leaves existing
equity intact.
The market will discount each element to
the present using appropriate required rates of
return. The cost of CS is an average of the rates
weighted by each element's share of total market
value.
The starting point is the textbook formula
(see, for example, Copeland, Weston and Shastri,
2004, Chapter 15) which can be summarized as
follows.
These are the essential terms: km is the cost of
convertible debt; B is the value of debt element;
Wis the value of equity element, being the value
of a call option on the company's shares; B +
W is the value of the convertible security; kb is
the required rate of return on debt; and kc is the
required rate of return on a call option on the
company's shares. See below.
Using the capital asset pricing model,
* c =/?, + [E(RJ-RJ/3c
where kc is the required rate of return on a call
option on the company's shares with the same
maturity as the CS; Rf is the risk-free rate of
return for a bond with the same maturity as
the CS; E(Rm) is the expected rate of return
on a portfolio comprising all the shares in the
market; /?c is the systematic risk of the call option
expressing its correlation with the market. /?c is
rTl computed by reference to the B of an underlying
r -\ share of the company adjusted to option using
yy the Black-Scholes option pricing programme:
HI
fV The basic Black-Scholes option pricing scheme
54
assumes that the issuer pays neither dividends
nor tax (see, for example, Berk and DeMarzo,
2007, Chapters 21, 22, 23; Brealey and Myers,
2007, Part 6; and packages like the London
Business School's).
FACTORS I N F L U E N C I N G COST
In the real world, dividends, tax, and mitigation
of agency costs influence the cost of a CS.
Dividends: If a company pays dividends then
the value of the call option C changes. A call
option on a dividend-paying share suffers, since
a cash dividend liquidates some corporate value
and the proceeds go to shareholders but not
option holders. The larger the dividends, the
more the option suffers. Option holders who try
to anticipate this by early exercise gain dividends
but lose interest on the exercise price.
Options on dividend-paying stocks with
assumed-continuous or, more realistically,
discrete dividends can now be valued
(Chandrasekhar and Gukhal, 2004), but only
with protracted and complex mathematics
beyond the present scope.
Tax: The impact of tax on cost is unique for
every issuer, holder, and regime. Tax impinges
on C, the value of the call, on R, its systematic
risk and on kb, the cost of debt. The impact in any
particular case depends on:
• the issuer and holder's tax regime;
• interacting intra-group regimes;
• corporate, inter-corporate, and personal
taxes at critical decision points;
• the taxable status of issuer, holder, and
associates;
• how issuer and holder prioritize tax
allowances.
Some aspects of recent relevant tax regulations
for the United Kingdom are illustrative. The issue
price is split between debt and equity. The debt
element is valued by discounting comparable
straight debt at the interest rate that would have
been payable had the security contained no equity
conversion feature. The difference between this
value and the issue price of the security is treated
as being either an equity instrument or an
embedded derivative, according to whether the
company can only issue shares or whether it has
the discretion to pay cash. In the former case the
conversion right is treated as an equity issue and
is disregarded for tax. In the latter case it is in
principle taxable as an embedded derivative. If
so, a chargeable gain or allowable loss will arise
when the company pays cash to the holders. The
gain or loss is determined by a formula based
on the difference between the book value of the
equity element and the amount paid.
 True Cost of Equity-Linked Financing
Any difference between the deemed issue price
of the debt element and the amount payable on
its redemption is amortized and is tax-deductible
over the life of the security.
A company can get a high and timely tax
deduction by paying high interest on a CS with
a short life. This reduces k., the cost of debt.
However if CS holders are taxable, their personal
tax may negate the deduction: if debt is tax-
inefficient relative to equity, such investors will
require compensation by way of a higher return.
Furthermore tax benefits may be truncated
by bankruptcy, voluntary conversion by
bondholders, or a company decision to force
conversion. If cross-border jurisdiction is
involved it becomes necessary to examine how
CSs would be categorized under relevant tax
treaties, EC directives, and double taxation
resulting from any inconsistent classification.
Mitigation of agency costs: Agency costs
are costs of conflict among different classes of
investor and between managers and investors.
They reflect opportunities for equity to exploit
debt and for managers to invest sloppily, forgo
good investments, shirk, and enjoy perks.
Endangered parties impose monitoring costs
on the shareholders. If the endangered party is
a lender, then the cost of debt rises. With CSs an
equity sweetener reduces the monitoring costs
by aligning the interests of debt and equity.
CSs can reduce the managerial incentive
to overinvest in poor, low-return projects.
For example, consider the second of two
Figure 1. Annual global convertible issuance, data through March 10, 2004. (Source;
Standard & Poor's Global Fixed Income Research, Thomson Financial)
Volume of issuance (left scale)
80
60
40
II I I I I I I I I I I I II
20
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
interdependent risky investments, which is only
beneficial if the first succeeds. Either finance can w
be borrowed at the outset for both projects or CSs a
can be issued that will be sufficient for the first to
project while providing enough for the second
a
on conversion. If all goes well, the second project P
will be duly financed by conversion. If the first
project fails, the value of the CS will fall, nobody
will convert, and management will be able to
repurchase the debt at its low value in the open
05
market. Indeed Mayers (2003) has observed a
s.
OB
correlation between conversion and spates of
corporate investment. If all had been borrowed B
upfront and if thefirstproject failed, management crq
might be tempted to invest the unused borrowings d
in easy, unprofitable projects.
s-
A TREND AND ITS REVERSAL
A suitably selected trend illustrates in
combination a number of the factors discussed.
Such was the boom of 2003 (Economist, 2003)
and the subsequent fall.
The factors that prompted the surge in the
early 2000s to issuance to a near-historic high
are concerned with cost, capital structure, value,
financial mobility, and market context:
• The market had no appetite for equity, and at
the same time companies were suffering from
unpalatable gearing levels. CSs with a low coupon
providedfinancialmobility and some reassurance
to anxious investors and garnered tax advantage.
• Hedge funds were attracted to CSs because
they perceived a bargain insofar as the issue
Count (right scale)
700
600
500
400
300
200
O
M
100
0 o
55
 Financing and Raising Capital

^ price underestimated the volatility of the • for tax reasons dividends increased, and
W equity, which meant that the call option, C in this hurt short sellers who had to pay the
"§ the basic formula, was undervalued. dividends to their purchaser.
g • Hedge funds bought the convertible, sold The above trend and its reversal illustrate
^ the debt, and kept the undervalued call an underlying decision process. An issue of
+-i option. They then sold shares short to exploit convertibles may be based on perceived market
<y underestimated volatility. opportunity as above. Alternatively it m a y b e
PQ A reversal of the trend came when a reaction against t h e relative costs of issuing
• • the volatility of equities declined; straight equity or straight debt. Onerous
jlj • companies grew wise to the excessive cost of regulation may further militate against either or
W CSs that they were suffering; both straight instruments.
Q
M — — —
.| MAKING IT HAPPEN
5 The decision to issue CSs follows the answers to a series of questions.
eft • Is there presently a "hot convertible debt window" in the market or are there contraindications?
• Do the causes of the window or the contraindications apply to us?
• What is our debt capacity? If we are near its limits will CSs bust us or will they enable us to stretch
our borrowing?
• Can we tailor CSs to our real investment needs? Can we at the same time mitigate agency costs?
• What tax-planning opportunities do CSs offer? Should we prioritize other tax benefits?
• Measurement of the parameters of the cost of capital is notoriously difficult. How reliable are our
estimates? For example, how stable is our beta and how reliable is our estimate of volatility?

MORE INFO
Books:
Berk, Jonathan, and Peter DeMarzo. Corporate Finance. Boston, MA: Pearson Addison Wesley, 2007.
Bhattacharya, Mihir. "Convertible securities and their valuation." In Frank J. Fabozzi (ed). The
Handbook of Fixed Income Securities. New York: McGraw-Hill, 2005; 1393-1442.
Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 9th ed. New
York: McGraw-Hill, 2007.
Copeland, Thomas, Fred Weston, and Kuldeep Shastri. Financial Theory and Corporate Policy. 4th ed.
Boston, MA: Addison-Wesley, 2004.
Tuckman, Bruce. Fixed Income Securities: Tools for Today's Market. 2nd ed. Hoboken, NJ: Wiley, 2002.
Articles:
Ammann, Manuel, Martin Fehr, and Ralf Seiz. "New evidence on the announcement effect of
convertible and exchangeable bonds." Journal of Multinational Financial Management 16:1
(February 2006): 43-63. Online at: dx.doi.org/10.1016/j.mulfin.2005.03.001
Asquith, Paul. "Convertible bonds are not called late." Journal of Finance 50:4 (September 1995):
1275-1289. Online at: www.afajof.org/journal/jstabstract.asp?ref= 11557
Campbell, Cynthia J., Louis H. Ederington, and Prashant Vankudre. "Tax shields, sample selection
bias, and the information content of conversion-forcing bond calls." Journal of Finance 46:4
(September 1991): 1291-1324. Online at: www.afajof.org/journal/jstabstract.asp?ref= 11156
Economist. "Convertible bombs." November 14, 2002. Online at:
www.economist.com/finance/displaystory.cfm?story_id=El_TQQGNJJ
Economist. "Options and opportunities." July 17, 2003. Online at:
www.economist.com/finance/displaystory.cfm ?story_id=El_TJNSDRJ
Fitch Ratings. "Guide to hybrid securities." 2006. Online at: www.gtnews.com/feature/138_2.cfm
Laurent, Sandra. "Convertible debt and preference share financing: An empirical study." Working
paper, 2005. Online at: ssrn.com/abstract=668364
Gukhal, Chandrasekhar Reddy . "The compound option approach to American options on jump-
diffusions." Journal of Economic Dynamics and Control 28:10 (September 2004): 2055-2074.
PH Online at: dx.doi.org/10.1016/j.jedc.2003.06.002
o
56
Securitization: Understanding the Risks w
ft
and Rewards by Tarun Sabarwal
EXECUTIVE SUMMARY
Securitization creates value for organizations, investors, and consumers:
a
• It separates the funding of receivables from their origination and servicing, and allows
origination and servicing revenues to grow without additional balance sheet financing.
• It provides cash flow and balance sheet management benefits.
• It allows for targeted asset liquidation, improvements in asset liquidity, and access to capital
3
markets at rates different from enterprise credit ratings. w
• The flexibility in transforming risks permits mutually beneficial matches in targeted market
opportunities, both for organizations and investors.
• Deeper capital markets allow for price discovery of illiquid assets, greater access to funds for
new firms and consumers, and greater financial innovation.
Securitization creates risks of moral hazard and lack of transparency:
• Separation of funding from origination can create moral hazard, generating higher-than-
expected risks and leading to conflicts between investors, firm shareholders, and firm creditors.
• Complexity of structural transformations creates lack of transparency, which, in turn, can lead to
greater illiquidity and possible market failure. These effects are worse in globally inter-connected
markets.

INTRODUCTION entity. This entity in turn issues securities

In broad terms, securitization can be viewed as
pooling receivables and selling claims to these
receivables in capital markets. For example, a
mortgage lender may pool together thousands
of mortgages and sell claims on mortgage
receivables to investors. Historically, the first
securitizations in the 1970s in the United States
were those of pools of mortgages. With the
success of mortgage-backed securities, other
groups of receivables were securitized as well,
including auto loan receivables, credit card
receivables, and home equity receivables.
Although a majority of securitizations are of
receivablesonconsumerdebtHwhethermortgage
or nonmortgage), in principle, any cash flow
receivable can potentially be securitized. There
are several so-called "exotic" securitizations—for
example, securitization of mutual fund fees,
movie revenues, tobacco settlement fees, and
even music royalties. Moreover, student loans,
manufactured housing loans, equipment leases,
and commercial mortgages are also securitized.
SECURITIZATION BASICS
Securitized products have some common
characteristics.2 They typically involve an
originator of receivables who forms a pool of
receivables that is then sold to a special-purpose
backed by a beneficial interest in the receivables.
For a successful securitization, it is important to
understand this process in detail.
The originator of receivables identifies a pool
of receivables to be securitized. For example, a
mortgage lender identifies which loans will form
a particular pool for a securitization. As borrower
and loan characteristics affect receivables
and losses on a loan, the credit quality of the
receivable pool is affected by its loan quality.
The originator transfers the receivable pool to
a special-purpose entity (SPE), typically a type of
trust. Accounting rules govern the balance sheet
treatment of such a transfer. For example, if this
transfer is classified as a sale, an originator can
remove these receivables from its balance sheet,
but in the case of a financing, it cannot do so.
Moreover, for a transfer of receivables to be a
true sale, the ownership of these assets should be
separated from the transferor to the extent that
in the case of the transferor's bankruptcy, the
transferor's creditors should not be able to access
these receivables and jeopardize the beneficial
oh i
interest of the investors in the securities.3
The SPE issues securities backed by the >—<
I
collateral of receivables in the pool. Different
securities (or tranches) issued on the same
collateral pool may have very different risk
O
57
 Financing and Raising Capital
4) characteristics.dependingonhowpoolreceivables
W are allocated to securities and depending on
"§ credit enhancements. For example, a senior
Cd tranche may have first access to pool receivables
pu as compared to a junior or subordinate tranche,
4_i a n d therefore, t h e senior tranche would have
K a relatively lower risk. Similarly, a credit
PQ enhancement, such as third-party insurance of
• promised cash flows, lowers the credit risk of the
ti security. Therefore, depending on the structure
V of the transaction, securities issued on the same
Q collateral pool may carry different credit ratings.
64 Over time, securitization structures have evolved
,5 in complex ways to take advantage of diverse
53 d e m a n d s b y investors. 4
05 T h e differential risks of these securities
l H
" m a y change over t h e life of t h e securities.
For example, credit risk for issued securities
depends on the performance of the underlying
collateral pool and on credit enhancements, both
of which may vary over time. Important factors
affecting pool performance include a lender's
underwriting criteria (such as credit score of the
borrower, credit history, down payment, loan-
to-value ratio, and debt service coverage ratio),
economic variables (such as unemployment,
economic slowdown, and bankruptcies), and
loan seasoning (payment patterns over the age
of loans). Credit enhancements affect credit risk
by providing more or less protection to promised
cash flows for a security. Additional protection
can help a security to achieve a higher credit
rating, lower protection can help to create new
securities with differently desired risks, and
these differential protections can help to place
a security on more attractive terms. Violation
of credit enhancements can trigger an "early
amortization" event, which starts prepayments
on securities using available SPE resources.
Therefore, pool performance evaluation,
security cash flow allocation, and servicing of
receivables continue on an ongoing basis. In
particular, bond rating agencies assign a credit
rating to each security issued by the SPE, and
they evaluate this rating periodically. Moreover,
for publicly issued securities, periodic financial
reports are filed with regulatory agencies. The
originator of receivables typically continues to
service the receivables (i.e., collect payments on
J—i the receivables, manage delinquent accounts,
•^ and so on) for a fee.
^ BENEFITS OF SECURITIZATION
f-\ An important idea behind securitization is that
PH it separates the funding of receivables from their
^V origination and servicing. Such a separation can
58
provide cash flow and balance sheet management
benefits, structural flexibility benefits, and
deeper capital markets.
Cash flow and balance sheet benefits are
available to the originator mainly because selling
loans in capital markets allows a lender to raise
funds to originate more loans, which can again be
securitized. As the originator typically continues to
service the securitized receivables, revenue from
origination and servicing activities continues to
grow. Moreover, as securitized assets can typically
be removed from the balance sheet, the net balance
sheet effect is zero. In this sense, securitization
improves revenues without additional balance sheet
financing. A securitization can also improve balance
sheet liquidity by converting long-term and illiquid
receivables into funds that can be used for additional
value-generating investments. A securitization can
also help to manage any mismatch between assets
and liabilities. Finally, to the extent allowable,
selective securitizations of receivables can allow for
regulatory capital arbitrage.
Structural benefits from securitization arise
from the flexibility available in transforming
cash flows and risks of the collateral pool into
those of the securities issued on the pool. For
example, creative use of credit enhancements
allows relatively poor-quality receivables, such
as subprime loans, to be transformed into some
tranches of high credit quality and other tranches
of low credit quality. Similarly, it is possible to
carve out long-term, nonrevolving securities from
short-term, revolving credit card receivables.
Structural flexibility allows originators and
investors to tailor securitizations to their needs.
Originators can sell particular assets with greater
liquidity if these assets can be transformed
creatively into securities desired by investors.
Similarly, investors with particular needs may
have more choices if different originators
innovate to serve their needs.
In principle, deeper capital markets may arise
from improved cash flows, better balance sheet
management, and greater structuralflexibility.A
securitization of high-quality assets may allow a
relatively young firm or a firm with a low credit
rating to access capital market funds at lower cost
than would otherwise be available. Securitization
may facilitate market price discovery of illiquid
assets. It allows for the sale of precisely identified
assets to be independent of the asset owner's
financial condition. It allows greater financial
innovation and better matching of sellers and
buyers, and it may allow for deeper debt market
penetration by opening newer lending markets,
such as subprime lending.
 Securitization: Understanding the Risks and Rewards
RISKS OF SECURITIZATION
While the unique characteristics of securitizations
are capable of providing benefits, they create
additional risks as well.
When standard cash flow risks5 are combined
with the separation of funding of receivables
from their origination and servicing, this may
produce unintended consequences. For example,
if repayment behavior is significantly worse than
expected, investors may be concerned about
moral hazard; that is, receivables in the collateral
pool were "cherry-picked," and investors may
require additional support for the securities. In
extreme circumstances, investors may require
the originator to provide an explicit guarantee
or to take back poorly performing collateral
(sometimes termed moral recourse). As the
collateral pool is off the originator's balance
sheet, recognizing poorly performing assets
jeopardizes the originator's financial condition,
and such actions will be resisted by the originator's
stockholders and bondholders. Similarly, if the
originator is in a poor financial condition, its
creditors might consider going after assets that
are securitized and off the originator's balance
sheet. This can jeopardize investor claims on the
collateral pool and question the legitimacy of the
bankruptcy-remoteness of the SPE. Moreover,
a narrow focus on origination can create an
incentive to over-originate (or overextend) loans
to marginally less creditworthy borrowers.
The structural flexibility in transforming
collateral pool characteristics into very different
security characteristics, while arguably a great
benefit of securitization, also has the potential to
create great risks.
The more complex the structure, the greater
is lack of transparency, and the harder it is to
analyze and forecast security performance.
For example, consider long-term securities
collateralized by short-term credit card
receivables. These are naturally exposed to
amortization risk due to a mismatch between
cash flow receipts on the receivables and cash
flow payments on the securities.6 Add to this a
senior-subordinated security structure. Now add
third-party insurance, and finally add subprime
credit card receivables, which, because of their
recent issue, come with greater uncertainty about
their performance. The riskiness of securities
based on such structural transformations
CA
depends in a complex manner on many factors,
and a reliable evaluation of that risk may be very
hard to obtain, if it can be obtained at all.
s.
Lack of transparency is made worse when the ore
collateral pool in a securitization has opaque or d
otherwise hard-to-value assets. As, in principle, cr
any receivable can be securitized, a security that
was created as a result of securitization can be
used further in a new collateral pool to issue new
securities. As the initial security is hard to analyze,
when several such securities are pooled together
and then tranched off again,7 it is not surprising that
there are cases where afinalsecurity is inscrutable,
even with the most sophisticated analysis.
A complex security, by and of itself, is not an
insurmountable obstacle to reap the rewards
of securitization. But in uncertain times,
complexity combined with lack of transparency
may throw wrenches in the wheels of smoothly
operating markets. In other words, if reliable
information is unavailable, market participants
may be unwilling to pay high prices for securities
that may turn out to be bad investments, and this
can lead to a crisis of confidence severe enough
that trade in particular securities grinds to a halt.
Moreover, interconnected debtors and creditors
may serve to exacerbate such a problem by
extending it to other securities. Such a dynamic
has been mentioned as a core problem resulting
in global credit market disruptions that started
in the United States in 2007.
59
 Financing and Raising Capital

CASE STUDY
The growth of subprime lending in the United States started around the mid-1990s. A subprime
cd borrower typically has some combination of a blemished credit history, a relatively short credit
u history, poorly documented income prospects, and an uncertain repayment ability.
PM
Before the 1990s, subprime borrowers typically found it hard to qualify for bank loans. During
« the second half of the 1990s, in the face of relatively low interest rates, investors were more
willing to seek opportunities with higher yields that came with a greater, but manageable, degree
of risk.
Securitization of consumer debt receivables helped to connect these two sides, with finance
companies serving as intermediaries. Improvements in credit reporting and statistical analyses
facilitated the development of risk-scoring models to lend profitably to subprime borrowers. Credit
enhancements and structured tranches created securities that addressed investor needs.
c The success of initial securitizations fueled rapid growth in securitizations. Debt markets
• IN
deepened to provide loans to subprime borrowers, finance companies found an attractive source
of new financing, and could continue to increase revenues from profitable origination and servicing
fees, investors found securities with desirable characteristics, rating agencies generated additional
fees, and third-party insurers generated additional premiums.
In a span of about ten years, concerns started to arise as securitized products became
exceedingly complex, with the introduction of collateralized debt obligations (CDOs), and of
CDOs of CDOs, or "CDO-squared;" lending started to look indiscriminate, with concerns about
real estate appraisals, and about lack of adequately documented repayment ability; and real
estate prices appeared to defy historical trends. As the US economy slowed and house prices
lowered, and as delinquencies and foreclosures on subprime debt rose, the value of securities
backed by subprime receivables deteriorated. The complexity and opaqueness of the securitization
structures exacerbated the problem by making it virtually impossible to put a reliable value on
these securities. This led to a crisis of confidence that paralyzed trade in some of these securities.
Markdowns in the value of such securities started to hemorrhage balance sheets of security
holders, especially some hedge funds, and led to widespread turmoil on Wall Street, including
casualties of large investment banks such as Bears Stearns and Lehman Brothers in 2008.

CONCLUSION
No doubt, securitization presents new
developments and exciting opportunities.
Securitization allows for more precise targeting
of asset liquidation. It can create value for
originators and investors. It can deepen capital
markets, thereby providing funds for new
borrowers and new businesses. And it can
improve market price discovery for illiquid
assets.
When a securitization gets beyond the
analytical apparatus of market participants,
however, it is capable of destroying value.
The potential harm is greater in globally
interconnected markets.

u
z
I
h—I

a
Hi

60
 Securitization: Understanding the Risks and Rewards

MAKING IT HAPPEN (f
Executives may find it useful to keep in mind the following key ingredients to a successful H>
securitization. hj
• Characteristics of assets to be securitized should be documented well and identified clearly. 3
• Transfer of assets to a SPE to form a collateral pool should be a true, bankruptcy-remote sale. O
• The transformation of collateral pool risks into security risks should be simple enough to provide ?•
clear and robust analysis of the dependence of security risks on collateral performance. O
• Processes for servicing, and for ongoing monitoring of collateral and security performance, •
should be well-defined, with some evidence of success under reliability testing. W
• Using collateral, securities, and structures with an established history or clear evidence of 2
success provides greater liquidity in security trading, and more reliable analysis of collateral g*
performance. (jq
• Using opaque and exotic structures requires considerable expertise and comes with greater M
risks. CD

MORE INFO
Book:
Fabozzi, Frank (ed). The Handbook of Fixed Income Securities. 7th ed. New York: McGraw Hill,
2006.

Reports:
The Bond Market Association and the American Securitization Forum. "An analysis and description
of pricing and information sources in the securitized and structured finance markets." October
2006. Online at: tinyurl.com/38s5g6n [PDF].
European Securitisation Forum. "ESF securitisation data report." Online at:
www.europeansecu ritisation.com/dynamic.aspx?id=194

Websites:
The American Securitization Forum: www.americansecuritization.com
The European Securitisation Forum: www.europeansecuritisation.com
The Securities Industry and Financial Markets Association: www.sifma.org

NOTES
1 Consumer debt is used here in a broad sense,
including secured debt (such as home mortgages,
auto loans, manufactured home loans, and so on) and
unsecured debt (such as credit cards, student loans,
and so on).
2 Although the principles outlined here apply to all
securitizations, for concreteness, specifics are
presented for consumer receivable securitizations.
3 This feature is sometimes termed bankruptcy-
remoteness.
4 For additional details on some common securitization
structures, see Sabarwal, T. "Common structures of
asset-backed securities and their risks." Corporate
Ownership and Control 4:1 (2006): 258-265.
5 Such risks include underwriting risk, interest rate risk,
default risk, prepayment risk, and market risk.
6 This is usually addressed by having a revolving period
and an accumulation period when cash flow receipts 2^
are kept aside for use later in making promised J>
payments on the securities. *Z,
7 Collateralized debt obligations (CDOs) typically have ("")
such a structure. W
Using Securitization as a Corporate w
Funding Tool by Frank J. Fabozzi *i

EXECUTIVE SUMMARY
a
• Securitization involves the creation of one or more securities backed by a pool of loans or
receivables.
• Securitization is an important vehicle for raising funds that are used by nonfinancial and financial on
<ft
firms.
• The motivation for the use of securitization rather than the issuance of a secured corporate bond
is the potential to reduce funding costs, particularly for firms that have a low credit rating.
• Another reason for the use of securitization is to manage corporate risk.
• The securitization process involves the creation of a special-purpose vehicle and the transference n
of assets to that entity. a*
• All securitization transactions require one or more forms of credit enhancement to obtain a
credit rating.

INTRODUCTION TYPES OF ASSETS SECURITIZED

Securitization is the process of creating securities
backed by a pool of loans or receivables. For
a corporation, securitization is an alternative
fund-raising process to the issuance of secured
corporate bonds. The securities issued via the
securitization process differ from traditional
secured corporate bonds, where it is necessary
for the corporate issuer to generate sufficient
earnings to repay the bondholders. So, for
example, if an equipment manufacturer issues
a bond in which the bondholders have a first
mortgage lien on one of its plants, the ability of the
manufacturer to generate cashflowfrom all of its
operations is required to pay off the bondholders.
In contrast, in a securitization transaction, the
burden of the source of repayment to those
holding the created securities shifts from the
cash flow of the corporate issuer to the cash flow
of a pool of loans or receivables, and/or to a third
party that guarantees the payments if the asset
pool does not generate sufficient cash flow.
Although securitization was first used in the
late 1960s by US government entities to create
mortgage-backed securities, it was not used by
nonfinancial corporations (i.e., corporations
whose principal activity is the production of
goods and nonfinancial services) to raise funds in
the public market until March 1985 when Sperry
Lease Finance Corporation (now Unisys) issued
securities backed by a pool of lease receivables.
Despite a major setback in the securitization
market due to problems with one asset
class—residential mortgage-backed securities
backed by subprime borrowers—securitization
continues to be an important funding alternative
for nonfinancial corporations.
The types of assets that have been securitized
can be divided into four general categories:
Mortgage loans, retail loans, wholesale loans,
and operating revenue.
The securities created by securitization of a pool
of mortgage loans are referred to as mortgage-
backed securities (MBS). Those backed by a pool
of high-quality residential mortgage loans are
called residential mortgage-backed securities,
and those backed by a pool of commercial loans
(i.e., mortgage loans for income-producing
properties such as apartment buildings, office
buildings, and shopping centers) are called
commercial mortgage-backed securities.
These securitized products are typically used
as funding vehicles for financial entities such as
depository institutions (banks and savings and
loan associations) and finance companies. For
nonfinancial entities the bulk of securitizations
use account receivables.
When securities are backed by a pool of retail
loans, they are referred to as asset-backed
securities (ABS). The major types of retail loans
securitized include credit card receivables,
home equity loans, automobile loans, and
student loans. In fact, the largest sector of the
asset-backed securities market is the mortgage-
related asset-backed securities market, the
sector that saw a major meltdown starting in the
summer of 2007. The wholesale market includes
commercial loans and bonds. The security
o
h—(
created from the securitization of these types of
debt instruments is called a collateralized debt
obligation. Finally, a special area which has been
used primarily in Europe is the securitization of
operating revenue.
o

63
 Financing and Raising Capital
THE SECURITIZATION PROCESS
To explain the securitization process and the
parties involved, we will use an illustration of a
hypothetical corporation, which we call HCE,
u Inc., which manufactures heavy construction
OH
equipment. Although some of this firm's sales are
for cash, the bulk are in the form of installment
PQ sales contracts. Effectively, an installment sale
contract is a loan to the buyer of the equipment
who agrees to repay HCE over a period of time
specified in the contract. For purposes of this
Q illustration, it is assumed that the loans are all
WD for four years. The collateral for the loan is the
equipment purchased by the borrower. The loan
specifies an interest rate that the buyer pays.
The credit department of HCE makes the
decision as to whether to extend credit to a
customer. It receives a credit application from a
customer and, on the basis of criteria established
by this manufacturer, decides whether to
extend a loan and the amount that will be lent.
The criteria for extending credit or a loan are
Figure 1. Illustration of securitization of $300 million of installment sales contracts
Customers
a
64
referred to as underwriting standards. Because
HCE is extending the loan, it is referred to as the
originator of the loan.
Moreover, HCE may have a department that
is responsible for servicing the loan. Servicing
involves collecting payments from borrowers,
notifying borrowers who may be delinquent,
and, when necessary, recovering and disposing
of the equipment if the borrower defaults on its
obligation. The servicer of loans need not be the
originator of the loans, but in our illustration we
are assuming that HCE is the servicer.
Let us now examine how these loans can be
used in a securitization transaction. Figure 1
summarizes the transaction. We will assume that
HCE has more than $300 million of installment
sales contracts. This amount is shown on the
corporation's balance sheet as an asset, or more
specifically as a receivable. We will further assume
that HCE wants to raise $300 million and that
HCE's treasurer decides to raise that amount by
securitizing these receivables.
HCE, Inc. (seller/originator)
Sell $300 million
installment sales $300 million
contracts
Construction asset trust (SPV)
Sale of $300
$300 million
million ABS
Investors
 Using Securitization as a Corporate Funding Tool
To do so, HCE will set up a legal entity, referred
to as a special-purpose entity (SPE) or special-
purpose vehicle (SPV). For now, we'll postpone
explaining the purpose of this legal entity, but it
will be made clearer later that the SPE is critical in
a securitization transaction. Let's assume that the
SPEthatissetupbyour hypothetical manufacturer
is Construction Asset Trust (CAT). HCE will then
sell to CAT $300 million of the loans and, in
exchange, will receive from CAT $300 million in
cash, the amount that HCE's treasurer wanted to
raise. CAT obtains the $300 million to pay for the
pool of loans by selling securities that are backed
by the pool of loans acquired. It is these securities
issued by CAT that are called asset-backed
securities. The asset-backed securities issued in a
securitization transaction are also referred to as
bond classes or tranches.
A simple transaction can involve the sale of
just one bond class with a par value of $300
million. We will call this Bond Class A. Suppose
that 300,000 certificates are issued for Bond
Class A with a par value of $1,000 per certificate.
Then, each certificate holder would be entitled
to 1/300,000 of the payment from the collateral
after expenses and fees are paid. Each payment
made by the borrowers (i.e., the buyers of the
equipment) consists of principal repayment (i.e.,
amortization) and interest.
The typical securitization transaction has
more than one bond class. For example, there
can be rules for distribution of principal and
interest other than on a pro rata basis to
different bond classes. It may be difficult to
understand why such a structure should be
created. What is important to understand is that
there are institutional investors who have needs
for bonds with different maturities and credit
ratings. A securitization transaction can be
designed to create bond classes with investment
characteristics that are more attractive to
institutional investors to satisfy those needs.
An example of a more complicated transaction
is one in which two bond classes are created,
Bond Class Ai and Bond Class A2. The par value
for Bond Class Ai is $130 million and for Bond
Class A2 it is $170 million. The priority rule can
simply specify that Bond Class Ai receives all the
principal that is paid by the borrowers until all
of Bond Class Ai's $130 million has been paid
off, and then Bond Class A2 begins to receive
principal. Bond Class Ai is then a shorter-term
bond than Bond Class A2.
As will be explained later, there are typically
structures where there is more than one bond
class, but the two bond classes differ as to how
they will share any losses resulting from defaults
of the borrowers in the asset pool. In such a 60
structure, the bond classes are classified as senior
bond classes and subordinate bond classes, and
the structure is referred to as a senior subordinate
structure. Losses are realized by the subordinate
bond classes before there are any losses realized
by the senior bond classes. For example, suppose
a
that CAT issued $250 million par value of Bond
Class A, the senior bond class, and $50 million
par value of Bond Class B, the subordinate bond en
to
class. As long as the aggregated defaults in the 0
asset pool do not exceed $50 million, then Bond
Class A will be repaid its $250 million in full. era
O
POTENTIAL FOR REDUCING
FUNDING COSTS
To understand the potential for reducing
funding costs by securitizing corporate assets
rather than issuing a corporate bond, consider
once again our hypothetical manufacturer, HCE,
Inc. Suppose that this corporation's credit rating
as assigned by the three major rating agencies
(Fitch Ratings, Moody's Investors Service, and
Standard & Poor's) is triple-B. If HCE's treasurer
wants to raise funds of $300 million and it issues
a corporate bond, its funding cost would be
whatever the benchmark Treasury yield is plus
the prevailing yield spread for triple-B issuers
in the bond market. Suppose, instead, that the
treasurer utilizes $300 million of its installment
sales contracts as collateral for a bond issue.
In that case, the cost will be the same as if it
issued a standard corporate bond, because if
HCE defaults on any of its outstanding debt, the
creditors will go after all of the corporate assets,
including the loans to HCE's customers.
Now instead suppose that HCE creates CAT
(the SPE) and sells the loans to that entity as
explained in the previous section. If the sale of
the loans by HCE to CAT is done properly—that
is, the sale of the loans is at the fair market
value—CAT, not HCE, is then the legal owner of
the receivables. This means that if HCE is forced
into bankruptcy, its creditors cannot recover
the loans sold because they are legally owned
by CAT. The implication is that if CAT sells the
asset-backed securities that are backed by the
pool of loans, investors interested in buying the
bonds will evaluate the credit risk associated
with the pool of loans independently of the
O
credit rating of HCE. The credit rating that will
be assigned to the securities issued by CAT will
be whatever CAT wants the credit rating to be! It >
may seem odd that the issuer (CAT) can get any
credit rating it wants, but that is the case. The o
65
 Financing and Raising Capital
^ reason is that CAT will show the characteristics
W of the collateral for the securities (i.e., the loans
•§ it will acquire) to a credit rating agency. In turn,
eg the rating agency will evaluate the credit quality
£* of the loan pool and inform CAT what must be
+J done to obtain a desired credit rating.
$ More specifically, the issuer will be asked to
PQ "credit enhance" the structure. There are various
• forms of credit enhancement that we will review
"g in the next section. Basically, the rating agencies
qj will look at the potential losses from the loan pool
Q and make a determination of how much credit
60 enhancement is necessary for the securities
# fi issued to achieve the targeted rating sought by
3 the issuer. The higher the credit rating sought
$ by the issuer, the more credit enhancement a
•""< rating agency will require. Thus, HCE, which we
assumed is triple-B rated, can obtain funding
using the loan pool as collateral to obtain a
better credit rating for the bonds issued than
its own credit rating. In fact, with enough credit
enhancement, it can issue a bond of the highest
credit rating, triple A.
The key to a corporation issuing bonds with
a higher credit rating than the corporation's
own credit rating is the SPE. Its role is critical
because it is the SPE that legally separates the
assets used as collateral from the corporation
that is seeking funding.
It would seem natural that a corporate
treasurer would always seek the highest credit
rating (triple A) for the securities backed by
the collateral in a securitization transaction.
However, the awarding of a targeted credit rating
requires sufficient credit enhancement, and this
does not come without a cost. As described
in the next section, there are various credit
enhancement mechanisms, and they increase
the costs associated with borrowing via a
securitization. So, when seeking a higher rating,
the corporate treasurer must assess the trade-off
between, on the one hand, the additional cost of
credit enhancing the securities to be issued by
the SPE and, on the other hand, the potential
reduction in funding cost by issuing a bond with
a higher credit rating.
A case study of the use of securitization to
reduce funding costs is provided by Ford Motor
Company. In 2001, the auto manufacturer was
ti} facing the downgrade of its credit rating to that
CJ of noninvestment grade status (more popularly
y r
/A referred to as "junk bond" status). As a result, in
<t^ early 2002 its wholly owned financing subsidiary,
J7*] Ford Motor Credit (FMC), increased its issuance
£-< of asset-backed securities backed by auto loans
iy rather than issue corporate bonds. For example,
w^ in the first two weeks of 2002, FMC issued $5
66
billion in asset-backed securities. In fact, because
of the concern with downgrading, from 2000 to
mid-2003, FMC increased securitizations to $55
billion (28% of its total funding) from $25 billion
(13% of its total funding). Also, while the ratings of
the auto manufacturers were downgraded in May
2005, the ratings on several of their securitization
transactions were actually upgraded due to high
subsisting levels of credit enhancement.
S E C U R I T I Z A T I O N AS A T O O L F O R RISK
MANAGEMENT
The potential to reduce funding costs is the main
reason why nonfinancial corporations will use
securitization, but another important reason is
that it provides a risk management tool. More
specifically, once the loans or receivables are
sold to the SPE, the risks associated with those
assets are transferred to the SPE and, ultimately,
to the owners of the asset-backed securities. One
major such risk is credit risk—the risk that the
borrower will default.
A case study of how securitization has been
used as a risk management tool is once again
provided by Ford Motor Credit. Automobile loans
are assets on the firm's balance sheet and subject
the firm to the risk that borrowers will default on
their obligations. On the use of securitization by
Ford Motor Credit's chief financial officer, David
Cosper, the following comment appeared in a
BusinessWeek article:
"Overall, Ford Credit's balance sheet is
shrinking as it implements its lower-risk
strategy. The pool of loans that it manages is
expected to drop from $208 billion at the end
of 2001 to $180 billion to $185 billion by the
end of this year. 'We have put the brakes on the
business,' says Cosper. That smaller portfolio
is better managed and suffers fewer losses,
boosting profits. Credit losses in the first quarter
totaled $493 million, down from $912 million in
the final quarter of 2001."
CREDIT ENHANCEMENT
There are two forms of credit enhancement-
external and internal. External credit enhancement
involves third-party guarantees such as insurance
or a letter of credit. Internal credit enhancement
includes overcollateralization, senior subordinated
structure, and reserves. Securitization transactions
will often have more than one form of credit
enhancement. The rating agencies specify the
amount of credit enhancement required to obtain
a specific credit rating. Based on prevailing market
conditions, the issuer must assess each form of credit
enhancement to determine the most cost-effective
credit enhancement mechanism or combination of
 Using Securitization as a Corporate Funding Tool

mechanisms. In general, when deciding to improve
the credit rating on some securities in a structure,
the issuer will evaluate the trade-off associated with
the cost of enhancement versus the reduction in
yield required to sell the security.
Below we describe the various forms of credit
enhancement mechanisms.
Third-Party Guarantees
Until the difficulties encountered by monoline
insurers, the most common form of third-party
guarantee was insurance wherein, for a premium,
an insurance provider agrees to guarantee the
performance of a certain amount of the collateral
against defaults. The rating agencies decide on
the creditworthiness of the insurance provider to
determine the credit rating of the asset-backed
securities to be issued. Perhaps the biggest
perceived disadvantage to this form of credit
enhancement is so-called event risk. Triple A
rated bondholders, for example, may only be
able to enjoy triple A status for as long as the
enhancement provider retains its triple A credit
rating status. If the credit enhancement provider
is downgraded (i.e., its credit rating is lowered
by a rating agency), the bonds guaranteed by the
enhancement provider are typically downgraded
as well unless the performance of the collateral
warrants no downgrade.
Overcollateralization
Overcollateralization, a form of internal credit
enhancement, is provided by issuing securities
with a par value that is less than the par value
of the loans or receivables in the asset pool.
For example, if there are $300 million of loans
in an asset pool and the issuer wanted to use
overcollateralization for credit enhancement
to achieve, say, a triple A credit rating for the
securities to be issued, the issuer would obtain
from the rating agencies an indication as to
how much par value of securities it could issue w
ft
versus the $300 million par value of loans in the (ft
asset pool to obtain the target rating. Depending hd
on the characteristics of the loans and their
perceived creditworthiness, the rating agencies
might allow, say, $285 million of par value of
securities to be issued. The cost of this form of
a
o
credit enhancement is implicit in the price paid ft
for $300 million par value of collateral versus
the proceeds of issuing only $285 million par (ft
value of securities. C
Senior Subordinate Structure ore
The senior subordinate structure, which was O
mentioned earlier, involves the subordination ft
of some bond classes for the benefit of attaining
a high investment-grade rating for other bond
classes in the structure. On the basis of an
analysis of the collateral, a rating agency will
decide how many triple A bonds can be issued,
how many double A bonds, and so forth down to
nonrated bonds.
The cost of this form of credit enhancement is
based on the proceeds that will be received from
selling the bonds, which is in turn determined by
the demand for the bonds. The yields that must be
offered on the bond classes are affected by the yields
demanded by investors. The lower the credit rating
of the bond class, the more yield is demanded and
the lower will be the proceeds received by the SPE
from the sale of the bonds for that bond class.
Reserve Funds
Reserve funds come in two forms: Cash reserve
funds and excess spread. Cash reserve funds are
straight deposits of cash generated from issuance
proceeds. In this case, part of the profits from
the deal are deposited into a fund and used to
offset any losses. Excess spread accounts involve

MAKING IT HAPPEN
Using securitization as a funding vehicle requires an understanding not just of the transactions but
also of the implementation issues. These include:
• having the ability to analyze alternative securitization structures in order to maximize the
proceeds received from the sale of the loans/receivables (i.e., best execution);
• determining whether, given market conditions, the issuance of secured debt or asset-backed
securitization is the better funding vehicle;
• having a relationship with an investment banker that can structure the transaction based on o
prevailing market conditions and the characteristics of the collateral, as well as negotiating with
the rating agencies regarding credit enhancement;
• having the ability to service the loans and report on the assets in the pool, or identifying other
entities capable of doing so;
• having an organizational structure and staff that will allow frequent securitizations. o

67
 Financing and Raising Capital

the allocation of excess spread into a separate
reserve account after paying out the coupon to
bondholders, the servicing fee, and all other
expenses on a monthly basis.
u
OH
4-»
CONCLUSION
Securitization, the process of creating securities
(ft
backed by a pool ofloans or receivables, has become
an important funding source for both financial
PQ
and nonfinancial corporations. In addition to the
potential for reducing funding costs, securitization
can be used as a risk management tool. The key
Q as insurance or a letter of credit (external credit
in a securitization process is the role played by
M the SPE. In a properly structured securitization
C transaction, investors in the securities issued by
•*H
the SPE, called asset-backed securities, can only
s
look to the cash flow of the loan pool held by the
SPE to repay the debt obligation and not to the
general assets of the seller/originator of the loans
or receivables.
In a securitization transaction, to obtain
a credit rating that will allow the sale of the
asset-backed securities, the structure must be
credit enhanced. Credit enhancement provides
protection of varying degrees for the bond
classes in the structure. Credit enhancement
mechanisms include third-party guarantees such
enhancement) and overcoUateralization, senior
subordinated structure, and reserves (internal
credit enhancement).

MORE INFO
Books:
Davidson, Andrew, Anthony Sanders, Lan-Ling Wolff, and Anne Ching. Securitization: Structuring
and Investment Analysis. Hoboken, NJ: Wiley, 2003.
Fabozzi, Frank J. (ed). Issuer Perspectives on Securitization. Hoboken, NJ: Wiley, 1999.
Fabozzi, Frank J. (ed). Accessing Capital Markets through Securitization. Hoboken, NJ: Wiley, 2 0 0 1 .
Fabozzi, Frank J., and Vinod Kothari. Introduction to Securitization. Hoboken, NJ: Wiley, 2008.
Kothari, Vinod. Securitization: The Financial Instrument of the Future. 3rd ed. Hoboken, NJ: Wiley,
2006.
Peaslee, James E., and David Z. Nirenberg. Federal Income Taxation of Securitization Transactions.
3rd ed. New Hope, PA: Frank J. Fabozzi Associates, 2 0 0 1 .

Articles:
Fabozzi, Frank J., and Vinod Kothari. "Securitization: The tool of financial transformation." Journal
of Financial Transformation 20 (2007): 3 3 - 4 5 . Online at: tinyurl.com/3ahfwdv [PDF].
Roever, W. Alexander, and Frank J. Fabozzi. "A primer on securitization." Journal of Structured
Finance 9:2 (Summer 2003): 5 - 1 9 . Online at: dx.doi.org/10.3905/jsf.2003.320307

Websites:
Vinod Kothari's securitization website: www.vinodkothari.com
Federal Income Taxation of Securitization Transactions website: www.securitizationtax.com

t
o
68
What the Rise of Global Banks Means for
Your Company by Chris Skinner
EXECUTIVE SUMMARY
• Multinational corporations are consolidating their business requirements for financial services
into a few core global players.
• Global banks offer a platform for global access to cash management, liquidity, and risk (ft
management, thereby improving the methods by which firms can manage their finances. (ft
• Global banks are being driven by their customers, with many multinational businesses moving
from local to global supply chains, which has demanded global financial support.
• Global supply chains demand global banking to enable firms to operate effectively across
w
borders with confidence, rather than having to rely on barter or other less reliable forms of value O
exchange.
• Global banks face a lack of standards across banks and borders, an area that should be
addressed and resolved over time.

INTRODUCTION its acquisitions of Bear Stearns and Washington

Over the past decade, it has seemed that big
banks have only gotten bigger. This is down to a
variety of factors—from mergers and acquisitions
through to technological leverage—but the
most overriding factor has been the impact of
globalization. As corporations and organizations
have created global supply chains, so the largest
banks have tried to follow their clients' needs
by creating global infrastructures. For most
firms, this means is that they can now work
in partnership with a bank that reflects their
multinational capabilities without having to
open separate accounts in each of the countries
of operation.
WHICH ARE THE GLOBAL BANKS?
A small number of banks provide global coverage
and branding. Obvious examples are Bank
of America, Bank of Tokyo-Mitsubishi UFJ,
Barclays, BNP Paribas, Citi, Deutsche Bank,
HSBC, JP Morgan Chase, Royal Bank of Scotland
(RBS), and Santander. All are creating global
brands and global presence through acquisitive
growth, which is why RBS and Santander acquired
the global operations of ABN AMRO outside the
Benelux in 2007 and why HSBC acquired Credit
Commercial de France (CCF) in France and
Household Finance in the United States.
Obviously, the latest liquidity and credit crisis
has changed some of the focus of these banks.
By way of example, JP Morgan Chase has had
Mutual, as have Bank of America and Citigroup,
but the trend is generally toward global presence
and support.
HOW DO YOU RECOGNIZE A GLOBAL
BANK?
The easiest way to spot a global bank is by its
brand, which will typically be just a symbol and
a name acronym.
The reason this is worth mentioning is
that many global banks are trying to create
nonnational identities as a pure name and
logo. For instance, Deutsche Bank has removed
the name from its emblem in many branches
and operations, and Santander is often just
represented by its logo rather than by its name.
For the same reason, these bank brands tend to
be emblazoned on panels and ramps in many
airport terminals. Have you spotted how many
HSBC banners there are as you get on and off an
aircraft, each panel providing a global and local
message? This is to reinforce the global message.
While RBS, Barclays JP Morgan Chase and others
operate in over 50 countries, HSBC would claim
to be the most globalized, with over 80 countries
covered. That is not to deny the existence of
competition from other specialist regional
players, such as Nordea in the Scandinavian
region and Standard Chartered across Asia, but
the difference between a regional and global o
player can be important, especially for firms that M

to refocus upon domestic American soil after want to trade across global borders.

69
 Financing and Raising Capital
WHAT ADVANTAGES DO GLOBAL
BANKS OFFER?
For multinational firms operating across
u multiple regions, the main advantage of global
banks is that they can offer a consolidated view
of all finance across all countries of operation.
This is becoming a critical factor as firms expand
into globalized structures themselves.
For example, a critical discussion that has
42 been taking place amongst these banks is how
to provide effective financial support for supply
chains. As many businesses are moving services
to India and sourcing of product to China and
0 related Asian countries for supply to Europe and
America, there is a need for easy transfer of funds
and payments for supplies between countries
on either side of the planet. Historically, this
has been incredibly difficult. For example, at a
major banking convention in 2004, Heidi Miller,
JP Morgan Chase's Head of the Treasury and
Securities Services, asked: "Why do we make
things so complicated for our clients? ... A friend
who lives in Europe ... bought a boat ... When
the boat was ready, he called his bank to arrange
payment. And his bank told him it would take
about six weeks to transfer the funds."
This example was for a simple payment
from the United States to France, and the
friend she referred to happened to be the
CEO of a major bank. The banking industry
now recognizes it has been slow to respond
to the need for global financial management
and payments. To meet this challenge, many
banks are now developing services in this area.
WHAT SERVICES DO GLOBAL BANKS
OFFER?
The biggest enhancement that global banks
offer is a single, global view of financial flows
for their business clients. This is the offering of
a single connection to their systems for all the
treasury operations of corporations around the
world. Therefore, a business operating in over
100 countries can now have a consistent view
of its cash, risk, and liquidity for all treasury
and finance functions. That view of monetary
movements will be the same for the financial
manager in New York, San Paolo, Sydney,
Tokyo, Frankfurt, and London, because the bank
can provide realtime interfaces to the business
u account on a single platform.
The fact that these banks offer global, realtime
cash management is the critical differentiation
for them. In fact, it goes further than this, with
M many banks competing on the basis of the value-
added services they believe they can provide.
70
Figure 1. Bank logos
HSBC
Cltl «> &
MUFG
BNP PARIBAS
Value-added services may include the
provision of an aggregation capability to all
payment processing systems globally. This
means that you only need to link to one bank
in order to gain access to payment processing
via SWIFT, Fedwire, CHIPS, SEPA systems
such as the Euro Banking Association's STEP2,
and Faster Payments in the United Kingdom
through VocaLink, etc. Today, many firms have
to create a direct connection with each of these
systems through local banks in every country.
The difference now is that you need only connect
once to gain global connectivity.
Another value-added differentiation these
banks claim to have is the ability to provide
the total view of other facets of business, such
as risk. The current view of risk management is
that customers receive intra-day or end-of-day
risk reports for their total liquidity management
positions. The challenge with this approach is that
markets are so volatile today that an intra-day or
end-of-day view may result in overexposure to
the markets for both the business and the banker
to that business. Therefore, realtime liquidity
management to avoid these overexposures has
become another valued service that global banks
can deliver, whilst local banks cannot.
WHY USE A LOCAL BANK?
The fact that global banks offer global services,
global payments processing, and global liquidity
and risk management is great news if yours is a
global business requiring such global services.
Global businesses can gain economies of scale
and the efficiencies of only dealing with a small
number offinancialpartners. However, a regional
or domestic firm with regional or domestic
needs may question whether it requires such
global structures and operations. Some may say
they do, because they source raw materials from
overseas and deliver and distribute products in
multiple nations. However, if you are a small
fish playing in this big pond, you may find you
are paying a high price for such services in terms
 What the Rise of Global Banks Means for Your Company

of both fees and the lack of attention you might
receive by comparison with a more localized
operation.
This is certainly an accusation leveled at many
of the large global operators by small businesses.
It does not necessarily hold true, but many
smaller firms consider that a local bank can
provide a better service than a global operator,
especially with regard to the advice they can gain
access to.
However, every firm seeking a banker has
a choice. Local domestic, regional, and global
banks all offer services that are appropriate to the
clients who want those services, and it is really
the choice of the financial leadership within the
business to determine whether a local or global
service is more appropriate to their needs.
This decision will normally be driven by such
questions as:
• Do you operate in more than 20 countries?
• Do you have regular cross-border
transactions that require currency transfers?
• Would you find it beneficial if your bank
could provide you with a global view of all of
your cash and risk positions?
• Do you have revenues of more than $1 billion
per annum?
• Are you heavily involved in structured finance
and the money markets? en
• Do you have extensive internal expertise in
financial management?
<W
The list can be extensive, but if you answered
"yes" to most of these questions you probably O
would find it beneficial to work with a global
bank. Equally, if you answered "no," then a
domestic or regional bank will probably cater to
most of your needs.

CASE STUDY
HSBC is one of the finest examples of global banking in existence today. This is because HSBC has
operations from the Americas through Europe to Asia. During the credit crisis, HSBC found that
its American operations, represented by a firm it had acquired, resulted in significant writedowns
for the subprime crisis. However, HSBC overcame these issues and still made a considerable profit
thanks to its global diversity. This is why HSBC is one of the few banks not to have been hit by the
issues of weakened capital base that we have seen with other banks.
In addition, HSBC is able to leverage its global positions. By way of example, HSBC recently
spent over $200 million on creating a global banking website service. That's an incredible amount,
and far more than other banks could possibly afford to spend on an internet banking services.
However, HSBC's internet banking service is now a single global platform that can be tweaked
to local demands. Hence, by spending $200 million, HSBC created the world's most powerful
internet banking service with 200 variations appropriate to each country of operation. As a result,
HSBC deploys the world's best internet banking services for $1 million per country, which, on an
economies of scale basis, provides far more efficiency and effectiveness.

CONCLUSION
The rise of global banks is driven by businesses
that now operate globally. The increasing use of
supply chains where goods are sourced from the
growth economies of the past decade—Brazil,
Russia, India, and China—has led to a rethinking
of finance. The fact that banks could not
provide global finance has driven an acquisitive
emergence of new global bank brands that are
now trying to cater for this need. However, the
services of these banks will not be appropriate to
every organization, and it is therefore necessary
to consider carefully the real requirements of a
bank provider before placing all of one's financial
eggs into a single global basket. O

z
o
71
 Financing and Raising Capital

.2 MORE INFO
§ Book:
Ctf Skinner, Chris. The F u t u r e of Banking in a Globalized World. Chichester, UK: Wiley, 2 0 0 7 .
M
^ Websites:
$3 The Financial Services Club: www.fsclub.co.uk
3£ The Financial Services Club blog: www.thefinanser.com
M Independent newswire and information source for the worldwide financial technology community:
www.finextra.com

Hi

U
z
$
Pi
0*
72
Public-Private Partnerships in Emerging w
n
Markets by Peter Koveos and Pierre Yourougou
EXECUTIVE SUMMARY
• A public-private partnership (PPP) is an "arrangement in which the private sector supplies
a
infrastructure assets and services traditionally provided by governments."
• The public and private sectors have different goals and organizational philosophies and cultures.
Reconciling these differences requires a strong commitment, and a clear vision regarding
expectations and outcomes.
• The essence of PPP is risk allocation—whether these operations add value depends primarily on B'
how risk is identified, managed, and priced. w
• In emerging markets, international partners must address not only the project risk and country
risk, but also the risks posed by the lack of local managerial skills, inadequacy of institutions,
d
ft
corruption, lack of transparency, and others. cr
• Project financing can be used for PPP projects, thus clarifying a key element of the partnership
financing structure.
• One of the most significant and interesting global economic developments of the past few years
is the emergence of Africa as a competitive region for business.
• The Bujagali Hydropower Project represents the largest mobilization of private financing for a
power project in Africa.

INTRODUCTION forced governments to reduce costs and limit

Given the state of public sector resources
around the world, governments seek to
enhance resources by attracting private sector
participation. Such participation may be
somewhat unstructured, or more formal. The
public-private partnership (PPP) is one of
the formal approaches to cooperation. PPP,
in various forms, is not a new construct. The
current frailties of the global economy have
Figure l. Bujagali project simplified stockholding structure
risks. This paper examines the nature of PPP,
and describes some of the advantages and
disadvantages of PPP. The discussion then
focuses on the viability of PPP in emerging
markets in general, and African countries in
particular. A case study, Bujagali Hydropower
Project in Uganda, illustrates many of the major
concepts discussed throughout this paper.

DEO JIC Others

18.34% 14.87% 1.66%

_JL_ _l
T
''#ft4K«^ytf'
,J*iMtee Inveslfnertt Co. 42.2%

24.7% _J 33.1%

Li AKFED/IPS/JIC SPV
World Power Holdings Ltd
(Sithe)
50.25% | 49.75% | ^^J oh i
Uaanda ''
Bujagali Energy
Ltd

Data adapted from Bujagali Energy Limited for the Private Power Generation (Bujagali) project. "Project
appraisal document." World Bank/IFC/MIGA Report No. 3 842 1 -UG, pages 68 and 72
o

73
 Financing and Raising Capital

Figure 2. Bujagali project financing plan

European DFIs Equity 22%

18%

ADB
14%
42
Q
• IN Commercial banks
(IDA/MIGA) 14% EIB 16%
CO
(A

Data adapted from Bujagali Energy Limited for the Private Power Generation (Bujagali) project. "Project
appraisal document." World Bank/IFC/MIGA Report No. 3 842 1 -UG, page 16

Figure 3. Project contractual arrangements

GoU
(Equity in kind)

turret

EPC contractor O&M contractor

(Equity in kind) Sithe affiliate

Data adapted from "Project appraisal document" World Bank/IFC/MIGA Report No. 38421-UG, page 21

DEFINITIONS/NATURE OF PPP term used is PFI (private finance initiative);

There are many definitions of PPP. Most versions
of PPP are very similar, although the degree of
control shared by the partners, and several other
characteristics of the partnership may receive
u different emphasis from definition to definition.
Thus, PPP is an "arrangement in which the
private sector supplies infrastructure assets and
t
services traditionally provided by governments"1
(Michel). Other terms for PPP include: PPI
in Australia, the reference is to PFP (privately
financed projects); and P3 is commonly used
in the US (see Yescombe, 2007). Other variants
include the build-transfer-lease (BTL) and
build-own-operate-transfer (BOOT) options.
In some cases, two or more of the above terms
can be used in combination. For example,
project financing can be used for PPP projects,
thus clarifying a key element of the partnership,
financing. Project financing schemes may

o
PH (private participation in infrastructure); PSP involve a variety of instruments such as the
(private sector participation); in the UK, the special-purpose vehicle (SPV), a legal entity with

74
 Public-Private Partnerships in Emerging Markets
its own assets and obligations. Creation of this
joint venture among project sponsors enables
the flow of funds. An SPV is typically a highly
leveraged company, with limited-recourse debt
and limited equity participation. PPP can indeed
be very complicated, and requires thorough
analysis of associated terms and conditions.
PPP: SOME ADVANTAGES AND
DISADVANTAGES
PPP is part of the recent movement of "new public
management." PPP is a means through which
the two sectors can become interdependent.
Managers in each sector must independently
answer some basic questions: Why are we
participating in this partnership? Where are we
going to operate? Who are our partners? How are
we going to proceed? What is our exit strategy?
Specific benefits for the public sector
include:2
• reduces project costs and time, while enhancing
its overall efficiency and effectiveness;
• enables access to and learning from private
sector resources, technology, and managerial
skills;
• credit enhancement and, consequently, access
to long-term financing;
• shifts risk to the private sector;
• pursues an integrated approach to project
completion;
• involves participation from various partners,
and may legitimize the project in the eyes of the
citizenry, and other stakeholders;
• PPP may provide greater economic benefits
than other forms of cooperation, such as public
sector procurement. These extra benefits are
usually referred to as value for money fVfM).
For the private sector participant, the analysis
is based on the profitability of the project in
terms of dollars and cents, and is usually more
objective than that conducted by the public sector.
Participation in a given project can be analyzed
using standard finance tools. These projects
usually involve a great deal of risk, but government
backing and involvement of international financial
institutions help mitigate risks. The limits of risk-
return trade-offs, and the ensuing risk allocation,
are even more crucial factors leading to project
assessment. A great deal of emphasis is placed on
risk management, including the formulation of an
exit strategy.
PPP also involves potential disadvantages. PPP
entails considerable agency costs, as it must be
thoroughly cultivated and managed in terms of
planning, monitoring, and acceptance of loss of
some control. Private and public sectors often have
different goals, and organizational philosophies
and cultures. Reconciling these differences in order
to bring about the desired project results requires
a strong commitment, and a clear vision regarding
expectations and outcomes. i
The above are especially relevant to public
authorities in emerging markets. As emerging
markets are so diverse, the analysis must be adjusted
tofitthe particular country's environment.3
EMERGING MARKETS S3
The term "emerging market" is used to describe
countries whose economies are undergoing
a significant transition through a series of
reforms.4
d
For a private sector firm, operating in an
emerging market can be an attractive prospect
leading to profit generation, increased market
share, and access to growing markets. The firm's
ability to access this opportunity depends on
how risk is identified, managed, and priced.
Business risks exist in every country. Operating
in emerging markets, however, may make these
risks even more prevalent. The risks include:5
• Political risk, defined as a change in
government policy that affects foreign
companies, is often associated with weak
political, legal, and institutional infrastructures.
To manage political risk, foreign organizations
must be familiar with the political landscape,
and learn how to operate in an uncertain and
different environment. Property rights, a
staple of Western economic institutions, can
often be easily undermined. The heavy hand
of government can also interfere with a firm's
plans and desired outcomes.
• Economicrisk.In general, emerging markets
exhibit a higher degree of volatility than that
shown by developed economies. Even assessing
the state of the economy in many of these
markets is challenging, as the "official statistics"
may not be accurate. Partners, then, must
rely on their own analysis of future market
conditions for their services.
• Financial risk, stemming from a country's
financial system weakness, may impact on the
value of the currency and, subsequently, the
company's bottom line.
• Otherrisks.The country's immature economic
infrastructure is vulnerable to a number of o
disruptions. International partners must
address risks posed by the lack of local
managerial skills, inadequacy of institutions,
corruption, lack of transparency, social issues,
income inequalities, pollution, and other
z
elements in the operating environment. o
75
 Financing and Raising Capital

q> AFRICA
.2 One ofthe most significant and interesting global emanate from the region's poverty, numerous
"§ economic developments of the past few years is conflicts, corruption, and health problems,
g the emergence of Africa as a competitive region or from the lack of adequate infrastructure.
^ for business. Africa is the fastest reformer in Risks aiSo present opportunities-for example,
4-. terms of easing business entry.6 It is now easier infrastructure projects are often open to foreign
U for private foreign firms to do business in Africa, i d ion Moreover> many risks can be
PQ d u e t o recently simplified business regulations, .... . , ., , , . , . , «. • i •
_, j 1 , u ,,. °, , mitigated through bilateral official insurers
• strengthened property rights, eased tax b u r d e n s , ,, , ^™^
( f o r exam le
increased access t o credit, a n d other economic P > 0 P I C ) ' multilateral insurers (for
£>
V reforms. African countries are diverse with example, MIGA) and private risk insurers (for
Q respect to their politics and economics. The risks example, AIG). Africa has provided the stage for
M> of doing business may vary in their nature and PPP in such sectors as utilities, energy, minerals,
.5 intensityfromcountry to country. These risks may health, tourism, and others.
d
w

CASE STUDY
Bujagali Hydropower Project, Uganda
The Bujagali Project is a private power generation project. The 250 MW run-of-the-river hydro-
electric power plant is currently under construction on the Victoria-Nile on Dumbbell Island,
Jinja, Uganda. The project achieved its financial closing in December 2007, and is expected to
be commissioned in 2011. Bujagali is the first independent power project (IPP) in Uganda, and
the largest mobilization of private financing for a power project in Africa. It was named "Africa
Power Deal of the Year 2007" by Project Finance magazine. Bujagali is a good example of how
various international financial institutions can work together with private sector project sponsors
to address their financing and risk mitigation concerns, and meet the client country's economic
objectives.

Rationale for P P P
According to the World Bank, the severe shortage of electricity in Uganda contributed to a decline
in GDP growth to around 5% in 2005/06. Bujagali is an essential part of Uganda's energy-sector
strategy to provide a sustainable and affordable source of electricity. The government of Uganda
lacks, however, the necessary technical expertise and financing to complete the project on its own.
Private sector participation was sought to fill the gap.

Project Partners
The Bujagali project is a public-private partnership between the private sector project sponsors
represented by Bujagali Energy Ltd (BEL), the government of Uganda, including the Ministry
of Energy and Mineral Development (MEMD) and Uganda Electricity Transmission Company Ltd
(UETCL), multilateral and bilateral development financial institutions,7 and commercial lenders,
including Absa Capital (South Africa) and Standard Chartered Bank (UK). BEL, a special-purpose
company (SPC), is incorporated in Uganda, and is privately owned by Industrial Promotion
Services (Kenya) Ltd (IPS (K)), the industrial development arm ofthe Aga Khan Fund for
Economic Development (AKFED) and SG Bujagali Holdings Ltd (Mauritius), an affiliate of US-based
Sithe Global Power LLC. The sponsors were selected through international competitive bidding
procedures.

r_q Project Description

{J The Bujagali project is developed, financed, constructed, and maintained by BEL on a BOOT basis.
*~7 BEL also manages the construction of the Interconnection Project on behalf of UECTL, which will
<£ own and operate the project. The Interconnection Project involves the construction of about 100
y
y kilometers of high-voltage electrical transmission line to interconnect the power generation facility
>—t (the Bujagali project) to the national electric grid. Structured as IPP, BEL will sell the electricity
^ j to UETCL, Uganda's national transmission company, under a 30-year power purchase agreement
O (PPA).

76
 Public-Private Partnerships in Emerging Markets

Financing
Finance for the project is structured as an integrated package for both the power plant and
w
rt
transmission components. The total cost for the integrated projects, about $800 million, is %
being mobilized on a limited-recourse basis, through equity and debt in the ratio of 22:78. The hj
government of Uganda provided an in-kind equity contribution of $20 million. The equity financing J*
is shared by the sponsors, IPS (K) and SG Bujagali Holdings Ltd, on a pro rata basis. The equity o
structure of BEL is complex. Figure 1 provides a simplified description. U*
The debt is being financed by loans from the group of lenders, the World Bank group providing ^
a far more substantial amount of $360 million ($130 million loan from IFC, $115 million partial- •
risk guarantee from International Development Association to commercial lenders, and $115 |r<
investment guarantee from Multilateral Investment Guarantee (MIGA) to cover the equity position GA
of SG Bujagali Holding Ltd). The project financing plan is described in Figure 2. {•{,

Contractual Arrangements and Risk-Sharing Mechanism "

Contractual agreements define the transactions and allocation of the commercial, technical, and j~
political risks among the partners. The contractual structure of the Bujagali project is consistent (j*
with industry practice for limited-recourse project finance transactions (see Figure 3). The project **
implementation agreement, also called the concession agreement, signed between the government
of Uganda and BEL on December 13, 2005, defines the terms of the concession the government
grants to BEL to design, finance, own, operate, and maintain the project. Under the 30-year
PPA, BEL agrees to sell exclusively to UETCL all the production, and UETCL agrees to purchase
the contracted capacity (i.e., 250 MW), with the government guaranteeing the UETCL's payment
obligations. In addition to the implantation agreement and PPA, BEL signed a fixed-price, date
certain, turnkey engineering, procurement, and construction (EPC) contract with Salini Costruttori
SpA (Italy), and Alsthom Power Hydraulique (France), and an operation and maintenance (O&M)
agreement with affiliates of Sithe Global. The EPC contract requires the power plant to be
commissioned within 44 months. The EPC contractors were selected through competitive bidding,
in accordance with the EIB procurement rules. The O&M agreement reflects BEL's commitments
under the PPA. own, operate, and maintain the project. Under the 30-year PPA, BEL agrees to sell
exclusively to UETCL all the production, and UETCL agrees to purchase the contracted capacity
(i.e., 250 MW), with the government guaranteeing the UETCL's payment obligations. In addition to
the implantation agreement and PPA, BEL signed a fixed price, date certain, turnkey engineering,
procurement, and construction (EPC) contract with Salini Costruttori SpA (Italy), and Alsthom
Power Hydraulique (France), and an operation and maintenance (O&M) agreement with affiliates
of Sithe Global. The EPC contract requires the power plant to be commissioned within 44 months.
The EPC contractors were selected through competitive bidding, in accordance with the EIB
procurement rules. The O&M agreement reflects BEL's commitments under the PPA.
The contractual structure ensured that the project-related risks, including completion and operation,
were borne by the project sponsors and commercial lenders. However, these risks were mitigated
by contracts and various insurance arrangements. The risks related to supply/input (hydrology risk),
market, political, and natural forces were borne by the government of Uganda under the government
guarantee and implementation agreements. The participation of the IFC and the guarantees provided
by the World Bank group (IDA and MIGA) are critical in mitigating the completion risk, and to provide
Uganda with access to long-maturity commercial loans in favorable terms.

CONCLUSION sector, shifting risks and securing financing are

PPP can offer a win-win situation for both the important benefits. For the private sector, the
public and the private sectors. Globalization environment represents an opportunity to add /•}
, , , . . , value to the organization,
b and act in a socially \2
has led to the emergence ofc new economies. .,, _. ' . , ,. ^ J, Tj
, responsible manner. PPP involves complicated • — i
With scarce resources, the public sector in many a r r a n g e m e n t s ^ r e q u i r e a g r e a t d e a l of ^
economies needs pnvate sector partners. PPP is expertise and flexibility. The essence of PPP is >
a unique opportunity for the two diverse sectors risk allocation—preparation, and proper risk ^
to learn how to work together. For the public management and pricing are a must. (")

77
 Financing and Raising Capital

.2 MAKING IT HAPPEN
jj • Conduct a readiness analysis of your organization.
^ • Know exactly what you want and expect.
^ • Know what the various partners want and expect.
+d • Work to build trust among partners.
^ • Put together a solid risk management process, with clear accountability and understanding of
PQ the risks faced, how they are allocated, and how risk is to be priced.
• • Be as specific as possible about your role and responsibilities.
• Familiarize yourself with the nature and operations of international financial institutions and
5$j agencies, such as the World Bank, its affiliated agencies (IFC, IDA, MIGA), and other cooperating
Q organizations.
bfi • Make sure you do a feasibility study and conduct due diligence.
.2 * ^ ° s ' o w ' Learning about PPP is important. Existing relationships could serve as an easier first
P step.
% • Decide on what valuation techniques would be appropriate (for example, internal rate of return,
>mi
net present value, adjusted present value, and real options).
• Analyze all possible scenarios.
• Review and revize as appropriate.
• Work towards a sustainable relationship, but have an exit strategy.

MORE INFO
Books:
Akintoye, Akintola, Matthias Beck, and Cliff Hardcastle. Public-Private Partnerships: Managing
Risks and Opportunities. Maiden, MA: Blackwell Science, 2003.
Grimsey, Darrin, and Mervyn Lewis. Public Private Partnerships: The Worldwide Revolution in
Infrastructure Provision and Project Finance. Northampton, MA: Edward Elgar, 2007.
Mobius, J. Mark. Mobius on Emerging Markets. New York: Irwin Professional, 1996.
Osborne, Stephen P. (ed). Public-Private Partnerships: Theory and Practice in International
Perspective. London: Routledge, 2000.
Yescombe, E. R. Public-Private Partnerships: Principles of Policy and Finance. Oxford: Elsevier,
2007.
Article:
Michel, Frangois. "A primer on public-private partnerships." Public Financial Management Blog
(February 22, 2008). Online at: blog-pfm.imf.org/pfmblog/2008/02/a-primer-on-pub.html
Reports:
Economist Intelligence Unit. "Operating risk in emerging markets." London: Economist Intelligence
Unit, 2006. Online at: graphics.eiu.com/files/ad_pdfs/eiu_Operating_Risk_wp.pdf
Kennedy, Robert E. "Project valuation in emerging markets." Boston, MA: Harvard Business School,
May 14, 2002. Available from: hbsp.harvard.edu

t
O
78
 Public-Private Partnerships in Emerging Markets

W
en

a
ft

9)

cro
0
a-

NOTES
1 See, for example, Yescombe (2007), especially www.doingbusiness.org/documents/
DoingBusiness2007_FullReport.pdf
Chapter 2.
6 Bujagali Hydropower Project: www.bujagali-energy.

2 See Kennedy (2002) for treatment of valuation in
these markets.
7 The institutions include the African Development
3 See Mobius (1996), p. 6, and Investopedia.com.
4 See, for example, Mobius (1996), Chapter 9, Grimsey
and Lewis (2007), Chapter 9, and The Economist
Intelligence Unit (2007).
5 The International Bank for Reconstruction and
Development/The World Bank, 2007:
o
com; www.worldbank.org/bujagali
Bank (ADB), European Investment Bank (EIB),
the World Bank Group, Agence Frangaise de
Developpement (AFD), Proparco, Netherlands
Development Finance Company (FMO), Kreditanstalt
fur Wiederaufbau (KfW), and Deutsche Investitions
und Entwicklungsgesellschaft (DEG).
o

79
 Best Practice
Equity Investment
Sources of Venture Capital
by Lawrence Brotzge
EXECUTIVE SUMMARY
• Sources of capital depend on whether it is an early-stage company or a rapidly expanding
business that is seeking significant financing.
• Angel investors rather than venture capital funds usually provide seed capital for new
companies.
• Use your network to get connected with sources of venture funding, and know your audience
before you meet with them.
• Venture capitalists look for high rates of return and have a relatively short time horizon.
• These investors will assist the entrepreneurs with many aspects of their business besides capital.
INTRODUCTION
There are many sources of venture capital. They
include:
• friends and family;
• individual angel investors or angel investor
groups;
• early-stage venture capital funds (VCs);
• expansion-stage and later-stage VC funds;
• community-based venture funds; these are
often run by development agencies, which
are usually funded or subsidized by local
government funds designed to stimulate
business growth.
This article answers a number of questions
about obtaining venture capital. When is it
appropriate to seek venture funding rather than
bank financing? How do you go about finding
these funding sources? How do they differ,
and what drives their investment decisions?
Entrepreneurs and their management team
need to understand the role of these investors,
what expectations they will have for return on
their investment, and over what time frame they
will expect to earn those returns.
EARLY-STAGE COMPANIES
Companies are usually started by a single
entrepreneur or a small group of entrepreneurs.
These founders frequently work for no pay, a
situation that is referred to as "sweat equity."1
The initial cash needed is likely to be provided
by the founders, but may be supplemented by
money from friends and family members who
have a variety of reasons to want to be a part of
what the founders are doing. This type of funding
is sometimes referred to as "seed capital."2 The
founders may also seek bankfinancing,but if the
bank is willing to extend credit it will probably
be based on their personal assets or borrowing
capacity. Banks rarely lend to companies that do
w
it
a
!.
I
not have a track record of revenues and profits.
Venture capitalists generally expect to see that
I
the founders have put in a combination of sweat
3
equity and personal cash, and they prefer to see
that they have raised some money from friends
and family. After exhausting these sources,
entrepreneurs may think it is time to approach
VCs to raise the funds they need to grow their
business. In fact, although VCs did invest smaller
amounts in the 1970s and 1980s, they are now
much larger funds and tend only to invest
when companies need multiple millions. As
this transition was taking place, angel investors
began to fill the gap between friends and family
and VCs.
ANGEL INVESTORS
Typically, angel investors are thought of as
wealthy financiers who want to fund startup
companies that have a change-the-world idea
or invention. They do usually have some wealth,
but it is not necessarily the case that they are
extremely rich. Successful business men and
women may be sought out by entrepreneurs
for their particular expertise. These individuals
may not have previously thought of themselves
as angels, but they may become interested in the
business and impressed by the entrepreneurs
and decide to invest. On the other hand there are
those who regularly look for such opportunities.
o
Angels generally invest in companies in their
local area so they can keep an eye on their
money.
Beginning in the mid-1990s, angel investors
began to realize that there were some disadvantages
to being a lone investor. For example, it is unlikely
that one or even a couple of people possess all the
knowledge necessary to make wise investments.
o
83
 Financing and Raising Capital

They may have knowledge of many aspects of the be funded by the VC specialists. But for many new
business they are considering, but they are not businesses there is an overlap between angels and
likely to understand everything about the business "early-stage" VCs, and it is not uncommon that
and how to structure the investment. Additionally, the two groups will coinvest.
u a single investor would have to put a fairly large What constitutes expansion- and later-stage
sum in a single company to have any real say in the companies? Expansion-stage companies have
business. A group of angels is more likely to have a customers and proven revenue, and there are
breadth of knowledge and, by pooling their funds, good reasons to believe that they are positioned
an impact on the company. Angel investment to grow very rapidly, at rates of 30-100%
groups have been forming over the past 10 to 15 annually. And later-stage companies already
c years, and there are now several hundred such have substantial revenues, so the next round

s
CD
groups in the United States and Canada. of financing is meant to grow the company to
A 2008 study of US angel investing3 showed a critical mass and attract public financing, or
that in 2007 some US$26 billion was invested in result in a merger or acquisition by another
g over 57,000 entrepreneurial ventures and that company. In both situations it is likely that this
the number of active investors totaled almost will provide liquidity and at least a partial exit for
260,000. It can readily be seen that individual founders and investors. Many young companies

1 angel investors still make up the lion's share of never get to the point of seeking expansion or
investors, which creates a challenge for those later-stage VC funding, not because they fail, but
entrepreneurs trying to connect with them. rather because they determine that an earlier
Finding angels requires networking. Ask attorneys merger or acquisition makes more sense for both
and accountants, especially those who frequently founders and investors.
work with and specialize in startup companies.
If your business is technical in nature, you might WHAT VENTURE CAPITALISTS
contact universities, and you should certainly try to LOOKFOR
make contact with current and retired executives It makes little difference if it is an angel investor
who come from industries related to yours. or an early-stage VC, they expect to see a
business plan with a detailed description of the
VENTURE FUNDS business model, marketing plans, competition,
Some VCs focus on investing in particular etc. This includes financial statements showing
industry sectors, or geographies, or stages past results and a forecast for the next three
of a company's life. Some may restrict their to five years. Considerable emphasis will be
investments to local businesses. Some will fund placed on the cash flow forecast, as cash flow
early-stage companies, but others may only is a primary concern with any relatively new
entertain investments in what are known as business. Investors will want to know how their
expansion-stage and later-stage companies. investment will be put to use—often referred
The definition of an early-stage business can to as "use of proceeds." They tend to look
vary widely and is not easily denned in terms of unfavorably on large portions of their funds
revenues. If, for example, it is a service business being used for accrued and unpaid expenses,
or software company, it may not require a lot of particularly founders' salaries, or to pay down
investment for the company to achieve positive accounts payable. The prospective investors will
cash flows. At the other extreme, a life sciences perform considerable due diligence, which will
business (biotech, pharmaceutical, and medical include such areas as product reviews; speaking
devices), which involves substantial research and with customers, vendors and distributors; and
regulatory approval, may be years from any real examining any patent filings and pending legal
revenues and will need significant funding along matters. Primary among their assessments will
the way. As a general rule, before a company is be evaluating the management team.
ready for VC funding a number of events will The review performed by expansion-stage and
have taken place, such as completion of proof later-stage VCs does not differ much from that
PL)
of concept, development of prototype products, outlined above; however, their investigations
beta testing of the product or service, and, finally, will look more closely at areas such as market
generation of revenues. However, certain types conditions. Since at this point the business has
of businesses—most notably life sciences or a proven market for its product or services, it
»—I
other large technical projects—require such large is far easier to assess future growth projections
amounts of capital that they are well beyond the than when the company was just entering the
capacity of angels. These businesses tend only to market. Thus, a reasonably accurate assessment

84
 Sources of Venture Capital

can be made of how fast the business can be
scaled up and its ultimate potential. VCs will also
reevaluate the company's management. Often
the skills needed to launch a business differ from
be able to see the potential for significant returns
on each new investment. This means either w
quick returns or, if the time frame will be longer, o
large multiples of their investment. So company
»•*

those required to grow it.
All venture investors have one question in
common: When will they see a return on their
investment? In other words, when will there
be a liquidity event—a sale of the company or a
public offering of the stock? This is called the exit
strategy.4 Venture capital is not generally meant
to be long-term in nature. Most funding assumes
that there will be an exit in three to seven years.
RETURN ON INVESTMENT SOUGHT BY
VENTURE CAPITALISTS
The earlier in a business's life cycle the investment
is made, the greater the risk. Thus, the higher
the potential return on investment the venture
capitalist will seek. Because there is a risk of total
loss on at least some their investments, VCs must
founders should not be surprised to learn that »
venture capitalists would like the opportunity to
earn 10 or even 25 times their investment. That
means that most venture investors have little
a
interest in businesses that do not have excellent
growth and profit prospects. w
The terms of the investment will include the 0
financial structure and the "pre-money value,"5
which is the value placed on the business before
the new investors put their cash into the company. 3
Thus, pre-money value is the amount assigned
to all investors who have invested in the equity en
of the company thus far. This determines what
percentage the new investor will own. If the pre-
money value is $3 million and $1 million is newly 3
invested by VCs, they own 25% of the company.

CASE STUDY
Example of the Actual Results of an Early-Stage VC
The investors put in US$120 million between 1998 and 2002, which is a typical funding period. This
was invested in 31 companies and—although the fund has not yet exited all of these companies-
reported results to date, plus a reasonable projection of ultimate exits, show these results:

Number of companies Exit as a multiple of the amount invested

6 0

6 Less than 1 x

7 1 x to 2 x

5 2x to 3x

3 5 x t o lOx

2 l O x t o 15x

1 5 0 x plus

31 Average: 3.3x

The internal rate of return (IRR) to the investors will be about 23% on an annualized basis. This o
table illustrates how results vary by investment, indicates the degree of risk, and demonstrates
why the VC must have the potential (often unrealized) to earn very large returns on each
investment. In this case, without the three deals that produced very large returns, the overall
results would not have been very attractive.
o

85
 Financing and Raising Capital

There are also many considerations as to
what security the venture investors will own.
They usually require a form of a security that is
a "senior" to the equity held by founders and small
u investors. This provides legal protection and
4-) authority, even though they may be minority
0) investors (in terms of their ownership share of
the company). The instrument often used for
this purpose is preferred stock, with a variety
of provisions attached that allow some level of
control over major business decisions. For the
venture investors to have an opportunity to earn
handsome returns on their investment, they focus
not only on the pre-money valuation,
but also on how many future rounds of
fundraising the company might need as it grows.
Even if future investments are made on the basis
of an increased valuation, the additional capital
will dilute prior investors' ownership stake. So
while the need for additional funding may be a
good indication that the company is growing and
needs more working capital to expand, that must
translate to a much higher ultimate liquidation
value if each investor group is to see healthy
returns on the capital they put atrisk.Historically,
venture capital internal rates of return (IRR)6
have averaged between 20% and 30%.
THE ROLE OF VENTURE CAPITALISTS
AFTER THEY INVEST
Venture investors are not passivefinanciers;rather,
they foster growth in companies by becoming
actively involved with the management team, and
in developing strategic and operational plans,
marketing plans, etc. They will hold one or more
positions on the company's board of directors. VCs
see themselves as entrepreneursfirstand financiers
second.

MAKING IT HAPPEN
Companies will encounter lots of competition when seeking venture funding. So be sure to take the
right steps to increase your company's chances of success:
• Where should I be looking for investors? Be certain to look for help from local organizations that
foster new business development in your area, such as local development agencies and funds
established to encourage innovation and new technologies, and universities.
• How do I get connected to the right funding sources? Talk to all your contacts, ask lots of
questions, and remember that it is far better to arrive at a source via a referral.
• How do I prepare to meet with prospective investors? Consider getting someone to coach your
management team, prepare a first-class, focused business plan, understand your cash flow, and
prepare realistic financial projections.
• What should I know about my audience? They will be assessing the management team as much
as the business. VCs do not invest in businesses that do not have significant growth potential,
but you must be realistic and prepared to defend your numbers. They will also be interested in
knowing that there are multiple exit strategies.
• How do I sell our management team? Show the investors that you are the right people to run
the business, and address areas where you need to add missing skills. Remember that founders
may not be the best people to run the company, and consider supplementing the team with an
advisory board, or ask the VC to assist in identifying advisers.

u
t
M

a
PL,

86
 Sources of Venture Capital

MORE INFO ft
Oft
Book:
Van Osnabrugge, Mark, and Robert J. Robinson. Angel Investing: Matching Startup Funds with ^d
Startup Companies—A Guide for Entrepreneurs, Individual Investors, and Venture Capitalists. pj
San Francisco, CA: Jossey-Bass, 2000. &

Websites: ft
Angel Capital Association (North America's professional alliance of angel groups): •
www.angelcapitalassociation.org
Center for Venture Research, Whittemore School of Business and Economics, University of New jj
Hampshire: wsbe.unh.edu/cvr JS*
Kauffman Foundation: www.kauffman.org ^
hH
National Venture Capital Association: www.nvca.org JJ
$
3
Cft

ft
53

NOTES
1 See "Sweat equity" at
www.businessfinance.com/sweat-equity.htm
2 See "Seed capital" at
www.businessfinance.com/seed-capital.htm
3 Center for Venture Research. "The angel investor
market in 2007: Mixed signs of growth." Online at:
wsbe.unh.edu/files/2007_Analysis_Report_0.pdf
4 See "Exit strategy: Business plan basics" at jT'S
www.bizplanit.com/vplan/exit/basics.html Hj-j
5 See "The pre-money value of a pre-revenue startup"
at www.matr.net/article-25906.html
6 For a basic explanation of IRR and a downloadable
spreadsheet example, see www.solutionmatrix.com/
internal-rate-of-return.html o

87
Assessing Opportunities for Growth in w
en
Small and Medium Enterprises
by Frank Hoy
EXECUTIVE SUMMARY
• The growth stage of a small or medium-size enterprise (SME) typically requires more resources
than the company commands.
• In order to grow in their competitive environments, SMEs should proactively engage in
identifying opportunities.
1.
• The management team should have criteria and procedures for assessing opportunities, as only
the most promising and suitable should be pursued.
• Exploiting opportunities includes obtaining resources to implement the business's growth
strategy.
I
• The long-term health and survival of SMEs depends on their ability to recognize, evaluate, and
pursue growth opportunities in competitive environments.
I
n
3
INTRODUCTION not only from sales of products and services,
Many companies experience rapid growth at but also through acquisition. The growing firm
some stage of their life cycle. For some, this may gains recognition for its brand name and builds
happen soon after they are launched. Others have customer loyalty.
multiple spurts, followed by a leveling-off period Robert Ronstadt coined the term "corridor
or even a decline. A consistent characteristic of principle" to explain how small and medium
the growth stage is that demands exceed existing business owners identify opportunities that a
resources. Consequently, business owners must prospective entrepreneur does not recognize.1
be creative in acquiring and managing the At the time an individual opens his or her first
resources needed to seize growth opportunities. enterprise, it is as if the budding entrepreneur
Successful entrepreneurs are astute at, first, is inside a room consisting of his or her life
identifying opportunities and, second, taking experiences and observations. Starting the
action to pursue those opportunities. The idea business is the equivalent of opening a door,
behind starting a business may have been stepping out, and discovering a corridor. Up
spontaneous. It may come from prior experience and down the corridor are other doors, each
or personal preference. It may have resulted from representing a new opportunity. If the first
loss of employment. Although bankers, investors, door—i.e., starting the business—is not opened,
and educators often emphasize the need for none of the other doors will be seen. Launching
planning in advance of opening an enterprise, the business allows the owner to enter new
the evidence is that most venture creators did networks, obtain access to information, and
not prepare a business plan before they started. otherwise make discoveries that would never
For a small or medium-size enterprise (SME)
have happened without going into business.
that has been operating for some time, however,
a planning process is essential to any assessment From the strategic management literature,
of whether to take up a growth opportunity. we learn about "environmental scanning" as a
technique for being alert to new events, trends,
IDENTIFICATION OF OPPORTUNITIES and changes that may result from legislation and
Opportunity recognition is at the core of an regulation, competitor initiatives and reactions,
entrepreneurial venture. The founder of a customer tastes, technological developments,
company with growth potential will identify and and many other occurrences. Some business
seek to satisfy unmet customer needs. Creativity, executives look at environmental disruptions
new technologies, and new marketing approaches as threats, but those disruptions are invariably
are all characteristics of growing enterprises. A viewed as opportunities for entrepreneurial small
key word in this stage isflexibility.The leaders of and medium business owners. Rita McGrath
the company arefindingnew markets, sometimes and Ian MacMillan proposed formalizing the O
on the international scene. Growth may come scanning procedure by devising a register in

89
 Financing and Raising Capital

which opportunities could be categorized as one
or other of the following:2
• redesign of products or services
• redifferentiation of products or services
u • resegmenting of the market
• reconfiguring of the market
• development of breakthrough competencies
ASSESSMENT OF OPPORTUNITIES
Enterprises that have been functioning for a
c period of time have strategies that were either • the firm overcomes the "liability of newness"
• the competence of the management team;
• the prospects for wealth creation and the
feasibility of harvesting that wealth.
EXPLOITATION OF OPPORTUNITIES
There are numerous triggers that may enable a
small firm to seize a growth opportunity:
• the firm finds an unexploited market niche,
and the newly tapped demand launches the
growth stage

I
(A
formulated or which emerged. The first test of
whether to seize an opportunity is to evaluate
whether it is consistent with thefirm'sstrategy, as
factor as customers, suppliers, and creditors
conclude that it will survive and they increase
the level of business which they are willing to
the risk and cost of failure can be high if there is a conduct
= mismatch. On the other hand, if the business is in • the management team travels up the learning
decline, an opportunity that requires a change in curve, becoming more competent, perhaps
strategy may be the key to renewal and growth. even redefining the nature of the business
Before pursuing the opportunity, firm man- • the founder faces a crisis and is forced to
agers should ascertain the conditions that reinvent the business
produced it. Will they persist? Is there a market • a change of leadership brings in new ideas
of sufficient size to make the opportunity and perspectives
attractive? And what resources are required to • the business acquires and exploits skills it did
succeed in exploiting the opportunity? not previously have
Failure to consider this last question can lead • alliances are formed with partners that
to disaster. Many small and medium enterprises may help the firm to enter new markets or
do not have the resource base to embark on high- introduce new products
growth trajectories. Such growth may demand • managers recognize that the company has
significant capital infusions. Smaller firms may entered a gradual decline that must be
not have access to traditional sources of capital. reversed if the business is to survive
They may not have collateral or credit lines for Because growth opportunities typically exceed
borrowing and are not likely to be publicly traded, the capacity of the small or medium enterprise,
so they can't seek equity investment. Financing at creative approaches may be needed to obtain the
this stage requires creativity. It is not unusual for finance that will build such capacity. Immediate
business owners in the early growth stages to rely sources of equity or debt are most likely to be
first on their own resources—personal savings, the owners themselves and other management
home mortgages, pension funds, etc.—followed team members. This is typically followed by
by funding from family and friends. A family family members who are willing to accept risk
member with a steady income and solid credit in support of their relatives. The willingness of
record may be the cosigner on a bank loan. For banks to provide financing is usually a function
some companies, financing may not be available of the credit history of the firm and economic
at all. In such situations, "bootstrapping" may conditions. In the case of SMEs, banks often
be the appropriate course of action. This term is look to the assets of the owner rather than the
derived from the notion of pulling oneself up by revenue-generating ability of the firm.
the bootstraps, i.e., being self-reliant. It involves Numerous alternative organizations engage
finding ways of achieving goals when capital is in lending practices, however. Credit unions
limited, minimizing the need for outside financing, have become aggressive in business lending. For
maximizing the impact of the entrepreneur's minority and disadvantaged populations, avariety
investment, and/or optimizing cash flow.3 of microlenders provide financial assistance. For
Some additional criteria that SMEs use to those firms whose growth phase has true value-
U screen opportunities include: creating potential, wealthy individuals known
• the competitive environment and profit as business angels may be a source of funds.
potential of the industry; Angel investors often bring the added benefit of
• general and local economic conditions; business management expertise, and may serve
• the ability of the firm to achieve a sustainable in formal or informal advisery capacities with an
competitive advantage; enterprise to which they provide money.

90
 Assessing Opportunities for Growth in SMEs

W
CASE STUDY
on
Spira—Six Billion Customers?
Andrew B. Krafsur, CEO of Spira Footwear, Inc., contends that everyone on the planet is a potential
customer for his company's shoes. Formed in January 1999, Spira was initially funded through
loans from the founder and his wife. In the spring of 2001, the company sold common stock
through a private placement, obtaining proceeds of US$1,155,000. Spira introduced its shoes to
the market in December 2001.
The critical competitive component that Spira offered was a patented "WaveSpring" technology.

t
According to the company website, "WaveSpring technology stores and disburses energy with
every step."4 The spring involved is laterally stable, lightweight, and compact. It can fit in both the
heel and forepart of the shoe.
In July of 2007, Spira issued a private placement memorandum seeking a total of US$4,000,000

I
from accredited investors—i.e., individuals with net worth of at least US$1,000,000 or an annual
income of at least US$200,000. The funds were to be used to reduce debt, to increase inventory,
and for market expansion, including in international markets. Over the next year negotiations with

I
the primary targeted investment group proved slower than expected. Less than US$1,000,000 was (ft
raised, leading the executive team to seek other sources of financing. An additional half million
dollars was raised from the owning family of a department store chain, and an angel investor ft
committed a US$1,000,000 loan that could be later converted to equity. 3
Despite the reduced ability to raise funds and due directly to the economic downturn, Spira's
executives and board of directors chose to concentrate strategic efforts on marketing. They
anticipated that reduced spending by consumers might cause competitors to cut costs by scaling
back on promotional activities and inventory. To the leadership team at Spira, this represented
an opportunity. The company entered into an alliance with the Walt Disney Company, sponsored
athletes of high visibility to the running community, and pushed forward with with new product
development. One early measure of success was a leap in ranking for Spira in search engine
listings.

CONCLUSION
Creativity and an ability to identify opportunities
are seen as characteristics of entrepreneurs at
the time they start their companies. Enterprises
that prosper and grow must continue to identify
and pursue opportunities. In an existing small
or medium business, structuring the process for
recognizing and exploiting opportunities prevents
the management team from slipping into routines
that worked in the past but may not keep the firm
competitive in the future. Enterprise managers
must be able to:
1 identify opportunities;
2 assess whether those opportunities are
appropriate for their firms;
3 devise strategies to exploit the opportunities.
These steps require more planning than entre-
preneurs generally engage in at the time they
create their ventures. And the management team
should always keep in mind that implementing the
plans will be different from formulating them.

o
in

91
 Financing and Raising Capital

« MAKING IT HAPPEN
"jj The growth of an enterprise is often accompanied by increased bureaucratization. When a
rt company is founded and in the start-up stage, the owner is involved with everything. As the firm
P^ grows, even small businesses develop policies, procedures, and guidelines. As these rules develop,
4_i t h e management team must be diligent to prevent them from stifling further growth. Such
^ diligence should lead to an organizational culture that encourages the assessment and pursuit of
PQ opportunities. Actions that can be taken to promote this include:
• • familiarizing new employees with the history and traditions of the enterprise, especially
*£ introducing t h e m to the sacrifices that were made and the initiatives taken;
V • investing in continuing education for all employees, not j u s t on specific j o b requirements, but
H also on improving communication and other interpersonal skills;
•§3 • providing information about industry conditions and forecasts, technological developments, and
^ other topics;
j* • engaging in team-building efforts, particularly those that hone opportunity identification and
•H assessment skills.
& • Devising a system that reinforces experimentation and innovation.

MORE INFO
Books:
Bhide, Amar V. The Origin and Evolution of New Businesses. New York: Oxford University Press,
2000.
Harvard Business Review on Entrepreneurship. Boston, MA: Harvard Business School Press, 1999.
Hitt, Michael A., et al. (eds). Strategic Entrepreneurship: Creating a New Mindset. Oxford:
Blackwell, 2002.

Websites:
Capital Formation Institute: www.cfi-institute.org
National Association of Seed and Venture Funds (NASVF; US): www.nasvf.org
US Small Business Administration: www.sba.gov

QJ NOTES
y* 1 Ronstadt, Robert. "The corridor principle." Journal of Creating Opportunity in an Age of Uncertainty.
<^ Business Venturing 3:1 (Winter 1988): 31-40. Online Boston, MA: Harvard Business School Press, 2000.
^ at: dx.doi.org/10.1016/0883-9026(88)90028-6 3 Cornwall, Jeffrey. Bootstrapping. Upper Saddle River,
rT| 2 Gunther McGrath, Rita, and Ian MacMillan. The NJ: Prentice Hall, 2009.
(~y Entrepreneurial Mindset: Strategies for Continuously 4 spirafootwear.com, accessed February 14, 2009.

92
Equity Issues by Listed Companies: Rights w
ft
en
Issues and Other Methods by Seth Armitage
EXECUTIVE SUMMARY
• A rights issue is a method by which a listed company can issue new shares. The principle of a ft
ft
rights issue is that stockholders are offered new shares in proportion to their existing holdings. If •
stockholders do not want to buy the new shares, they can sell their rights on the stock market.
W
• The main alternative issue methods are the firm-commitment offer, the private placement
or placing, and the open offer. These methods have been replacing rights issues in several •i
countries.
• The average reaction of a company's share price to firm commitments is negative, but it is
positive for placements and open offers. The reaction to rights issues varies by country. 9
• The aim for a company is to have a smooth issue that raises the intended amount of capital for a r.
competitive fee and at a minimum discount.
3
INTRODUCTION In this example, Company X is issuing one ft
This article is about issues of shares to investors new share for every two existing shares in what 2
by companies that are already listed on a stock is known as a "one-for-two" issue. The new
exchange. Such issues are often called rights equity to be raised is $45 million. The offer
issues, although in fact the rights issue is only period starts on the ex-rights date, when the
one of several issue methods used. Other existing shares cease to carry the one-for-two
methods will also be discussed here. A generic entitlement to the new shares. If the underlying
term for issues by listed companies is seasoned value of the company does not change, the share
equity offers (SEOs). price will fall to the theoretical ex-rights price
(TERP) on the ex-rights date. The TERP is the
TYPES OF OFFER weighted average value of the old and the new
Rights Issue shares. In the example, the TERP is $11:
The principle of a rights issue is that the company
offers the new shares to its existing stockholders
10 million x $12 + 5 million x $9
in proportion (pro rata) to the number of shares $11
owned by each stockholder. In most countries 15 million
this is a requirement of company law. The
stockholder's right of first refusal over the new At this market price, each right to one new share
shares is known as the preemption right. If a will be worth $2; that is, $11 - $9.
stockholder does not want to buy some or all of An important point about rights issues is that
the new shares to which he or she is entitled, he a stockholder is as well off whether or not he
or she can sell the rights to them on the stock sells the rights. If he does not sell, and he buys
market during a prescribed offer period. In the the new shares, he loses $10 per old share when
United Kingdom this period is three weeks. they go ex-rights, but gains $2 per new share
The offer price of the new shares is usually because the offer price is $2 below the market
set at a large discount to the market price of the price ex-rights. If he sells the rights, he still loses
existing shares just before the issue is announced. $10 per old share but gains $2 in cash per new
This discount means that the rights are likely to share. However, this ignores the cost of selling
be worth something during the offer period. A rights, which can be substantial if the company's
numerical example is helpful in understanding shares are illiquid.
the rights issue mechanism:
The majority of rights issues are underwritten.
This means that the investment bank arranging
o
Company X:
Number of existing shares 10 million the issue will find sub-underwriters, usually
Number of new shares 5 million investing institutions, to buy the shares at the
Price of existing shares before offer offer price, or will buy them itself if necessary.
is announced
Offer price
$12
$9
The deeper the discount, the less likely it is that
the underwriters will be called upon.
o

93
 Financing and Raising Capital
Firm-Commitment or Public Offer
In the United States, rights issues by commercial
companies (as opposed to investment
ctf companies) have been rare since the 1970s. The
u standard method for larger issues is the firm-
commitment offer. After the issue is announced,
there is a book-building period of about one
month, during which a syndicate of investment
banks invites applications for the new shares
and the share registration document is finalized.
c With a shelf offering, the new shares will already
have been registered with the Securities and
! Exchange Commission. There is no pro rata offer
to existing stockholders.
The offer price is set the day before the shares
e are issued. The offer price used to be the same as,
or very close to, the prevailing market price. But,
during the 1990s, it became common to set the
offer price at a discount to the market price of about
2.5%. Firm-commitment offers are underwritten by
the syndicate of investment banks that market the
issue. Non-underwritten public offers are known
as "best efforts" offers. Both rights issues and firm
commitments are accompanied by a prospectus—a
marketing document and memorandum that
contains information required by the relevant
regulatory authority.
In recent years, a variant known as the
accelerated bookbuilt offer has become more
common. The offer is announced and bids from
investors are invited very quickly, often by the
end of the same day. Accelerated bookbuilding
tends to be used by large companies to raise
small amounts in relation to their size.
Private Placement or Placing
A third type of offer is the private placement. In
the United States, private placement refers to the
sale of a block of shares by private negotiation,
usually to one or two investors only and for
a fairly small amount (a few million dollars).
Placements are less onerous to arrange than
firm commitments, because the shares are not
offered to investors in general and no prospectus
is required. Most placements are made at a
discount, the average being around 15% in the
United States. Many placements are now private
investment in public equity (PIPE) issues, in
which the shares placed can be resold more
P-) quickly than in a conventional placement. In the
United Kingdom the term "placing" is used for
U any sale of shares that does not involve a pro rata
I
offer to existing stockholders. Larger placings
will have 20 or 30 placees.
PH Open Offer
An open offer combines a pro rata offer to existing
94
stockholders with a private placing. Although
stockholders retain their preemption rights, the
rights cannot be traded and are therefore worthless
unless the stockholder chooses to buy new shares.
This type of offer is now standard in the United
Kingdom but appears to be unique to that country.
ASPECTS OF PRACTICE
Market Reaction to SEOs
The share price of US industrial companies
falls by around 3% on average when a firm-
commitment offer is announced. The stock
market reaction to rights issues is mixed; it
is negative in some countries and positive in
others. A negative reaction is surprising on the
face of it, since a company would not be expected
to go to the expense of a share issue unless it
had a good use for the money, i.e. a positive net
present value investment.
The leading explanation (Myers and Majluf,
1984) is that news of an SEO indicates that
the issuer is more likely to be overvalued than
undervalued. An undervalued company is one
in which the market value of the equity is less
than the managers' assessment of its value.
If the managers are correct, issuing shares
when the company is undervalued means that
existing stockholders who do not buy will
lose out to new investors, who will obtain
shares at below the full-information price.
Some undervalued companies will choose
not to issue as a result, even if they need the
money for a worthwhile investment. Therefore,
companies that choose to issue are more likely
to be overvalued, and the market price will fall
as a result.
However, the market reaction to private
placements, placings, and open offers is positive
on average. These issue methods potentially
involve detailed investigation of the issuer by
placees or underwriters, who have access to
private information about the company. So
one explanation for the positive reaction is that
the willingness of these well-informed agents
to buy or underwrite certifies a minimum
value for the issuer. Another explanation is that in
some placements an active placee is introduced,
i.e. an agent who brings know-how or an intention
to intervene in the company, and the market
reacts positively to news of a placement to such
an investor.
Decline of the Rights Issue
The decline of rights issues in the United States,
the United Kingdom, Japan, and elsewhere
is somewhat puzzling. The firm-commitment
method that replaced them in the United States
 Equity Issues by Listed Companies

is more expensive and does not offer an obvious Issue Costs

advantage. Most platings are made at a sizeable
discount, which means that stockholders who
are not invited into the placing lose out. Possible
disadvantages of rights issues include the cost of
selling large blocks of rights, delays in the issue
process compared with platings, and less effective
certification of value than in an open offer or
placing.
Rights issues work best when most of the new
shares will be bought by existing stockholders
The total cost of a firm-commitment offer in the w
ft
United States is, on average, 7% of the amount on
raised, ignoring any discount. The cost of a rights
issue or open offer in the United Kingdom is 6% on
average. Much the largest components of the cost
are the fees to the lead bank and to the underwriters.
The cost is relatively more for smaller companies,
a
partly because there are clear economies of scale ft
and partly because they are riskier.
W

I
willing to take up their rights. There is then littleDiscounts
need to find other buyers. They are therefore Discounts to the market price are a cost to
frequently used by family-controlled firms. nonsubscribing stockholders, except in a rights
Rights issues also work well for the largest
companies, with very liquid shares, because it is
cheap and easy to sell rights on the market.
issue. Why are discounts needed? First, investors
tend to buy large blocks, which could be costly I
I
to sell in future. There is a strong empirical
relationship between depth of discount and the
Long-Run Underperformance Following SEOs bid-ask spread of the issuer's shares. Second,
Companies that raise new equity tend to the value of many issuers is rather uncertain; in ft
underperform in relation to other companies the academic jargon, there is high information 9
matched by industry, size, and risk over a three- to asymmetry. There was a major shift in the 1990s
five-year horizon. This underperformance occurs in the type of company listed on stock exchanges,
for both returns on the shares and operating away from well-established companies with a
profit. The same finding applies to companies successful track record, toward smaller firms
that make or have made an initial public offer. that are still in the product development stage.
One explanation is that, on average, companies The discount could also provide compensation
successfully time their issue for when they are for costs of investigating the issuer, or for future
overvalued. costs of active monitoring.

CASE STUDY
Bradford and Bingle/s "Rights Reissue," May-June 2008
The rights issue of Bradford and Bingley pic, a British mortgage bank, was among the most
extraordinary in living memory. On May 14, 2008, Bradford and Bingley announced that it was
to raise £300 million via a 19-for-25 issue at an offer price of 82p—a discount of 48% on the
preannouncement share price. However, on June 4, 2008, while the offer period was still running,
the bank unexpectedly announced a profit warning, the resignation of its chief executive, and a
restructuring of the issue. In particular, the offer price was cut to 55p to avoid the share price
dropping below the offer price after the profit warning. A price cut mid-offer is extremely rare,
but without it the underwriters would have been left holding much of the issue at a loss, and they
might have sought to escape their obligations by invoking the "material adverse change" clause in
the underwriting agreement.
In a further twist, Bradford and Bingley arranged for Texas Pacific Group (TPG), a private equity
investor, to buy shares at 55p via a placing, acquiring a 23% stake and two seats on the board. o
TPG's shares were not offered to existing stockholders and were therefore not part of the rights
issue proper. TPG's involvement as a potentially active investor was generally welcomed. At the
same time, some institutional stockholders were annoyed at not being given the chance to invest
more at 55p. As one said, "If there was no TPG, the whole thing would have collapsed. But it
comes at a huge price for investors."1 o
in

95
 Financing and Raising Capital

.jj M A K I N G IT HAPPEN
y • An equity issue is an expensive process and time-consuming for senior management.
2 • Key practical aspects include the choice of lead investment bank and other professional-service
OH firms (for example, lawyers), the type of issue, the size and timing of the issue, whether to have
*£ it underwritten, the content of the prospectus, the level of fee, the offer price discount, and who
& the main buyers (future stockholders) will be.
W • Companies are largely in t h e hands of the lead investment bank once the issue process is under
" way, but they can (and do) shop around when selecting the lead bank. When making the choice
E and negotiating the terms of the issue, company managers should be aware of the terms on
3 which recent SEOs have been made by companies of a similar size. The fees and discount should
jj be competitive.
£ • The company should aim for a smooth issue that raises the intended amount and is sold to a
^ group of investors who are, or plan to be, long-term holders of the shares.
B

1 MORE INFO
Book:
Eckbo, B. Espen, Ronald W. Masulis, and 0yvind Norli. "Security offerings." In B. Espen Eckbo (ed).
Handbook of Corporate Finance: Empirical Corporate Finance. Vol. 1 . Amsterdam: Elsevier, 2007;
2 3 3 - 3 7 3 . A thorough review of research on SEOs.

Article:
Myers, Stewart C , and Nicholas S. Majluf. "Corporate financing and investment decisions when
firms have information that investors do not have." Journal of Financial Economics 13:2 (June
1984): 1 8 7 - 2 2 1 . Online at: dx.doi.org/10.1016/0304-405X(84)90023-0

Report:
Myners, Paul. "Pre-emption rights: Final report." UK Department of Trade and Industry, February
2005. Online at: www.berr.gov.uk/files/file28436.pdf. The pros and cons of rights issues from a
practitioner's perspective.

U
z
t —
o
UH NOTES
1 Financial Times (June 6, 2008).

96
Attracting Small Investors w
ft
by Wondimu Mekonnen 00

EXECUTIVE SUMMARY
• Small investors are individuals who purchase small amounts of stocks for themselves, as
opposed to institutional investors such as pension funds.

I.
• Small investors can deposit money in banks and building societies to earn interest on their
savings.
• Although it has been the traditional belief that money deposited in a bank or building society is
safer than an investment in stock, the recent crises experienced by these High Street institutions
have eroded that trust.
• Investments in company stock involves risk, but the rewards can be much greater than from a
deposit or savings account. I
I
• In dealing with small investors, CEOs and CFOs are advised to implement various incentives to
keep existing investors and attract new ones.

INTRODUCTION
A company is financed by various sources, such
as short-term borrowings, long-term debt, and
owner's equity—ordinary shares, preference
shares, and reserves. Small investors can
participate in most of these. A significant portion
of funds finds its way into the bond or stock
markets through financial institutions that are
the repositories of household savings. Therefore,
the size of resources available for financing a
company's activities depends to a large extent on
household savings. Small investors are usually
individuals who purchase small amounts of
stocks for themselves, in contrast to the large
institutional investors such as pension funds.
Small investors are sometimes referred to as
individual, or retail, investors.
In 2005, the Investment Company Institute
reported that 91.1 million household investors
in the United States held US$56.9 million of
various types of equities.1 This constituted 50.3%
of all households. The growing number of small
investors gives the market depth.
BANKS AND BUILDING SOCIETIES
Banks and building societies depend primarily
on household savings, of which they are the
main custodians. The amount of interest they
offer on deposits and savings accounts can be
an incentive to small investors. For their very
survival, therefore, it is vital that such institutions
understand how to deal with small investors. They
have to design incentives to encourage people to
save. One way they do this is by offering savings
accounts with a variety of earning structures
and conditions. The Halifax's fixed saving term
option2 and Abbey's Individual Savings Accounts
ft
(ISAs) offer the kinds of incentives that may 53
encourage household savings.
Companies can raise money by selling bonds
to investors. Although in theory, small investors
could buy corporate bonds and hold them, they
play little role in the primary market. Simply
put, bonds tend to be bought and sold in a closed
circle of insiders and experts.
INVESTMENT IN SHARES
More and more small investors have become
shareholders, and share dealing is no longer
a job reserved for city slickers. In the United
Kingdom, the Building Societies Act 1986
allowed building societies to demutualize and
become public limited companies instead of
mutually owned organizations (i.e. owned by
the customers who borrowed and saved with
the society). A case in point is when the Halifax
Building Society announced that it was to merge
with the Leeds Permanent Building Society
and convert to a pic. The Halifax floated on
the London Stock Exchange on June 2, 1997,
making more than 7.5 million customers of
the Society shareholders in the new bank—the
largest extension of shareholders in UK history.
Of the new shareholders, 2.1 million were small
investors. That is about one-third of all the
investors in the Halifax (Snowdon, 2008). A
report published in May 2008 reveals that small
investors hold a combined total of 770 million
shares worth almost £4 billion in HBOS, as the
O
group is now known. Their average holding is
375 shares.
Another example was when Abbey National
(now Abbey) was demutualized in 1989, in
which 1.7 million small investors held 200 to
n

97
 Financing and Raising Capital
300 shares. Abbey was eventually taken over by
o the Spanish bank Santander (Papworth, 2005).
i £400 million of Bradford & Bingley's funds
come from small investors (Treanor, 2008), 3
£ who form more than a third of its lenders. The
recent nationalization (government takeover) of
Bradford & Bingley will mark the end of the line
PQ for the last independent former building society
to take on bank status.
(3
Figure 1. Equity ownership by US households. {Sources: The Investment Company
S Institute/the Securities Industry Association (ICI/SIA) equity ownership surveys;
Federal Reserve Board Survey of Consumer Finances; US Census Bureau)
60 T
1983 1989 1992
Risk-taking investors may not wish to be
limited to the small amount of interest they can
earn on a deposit account, but prefer to take the
risk of investing in company stocks. With such
investments they can reap the reward if prices rise,
although they have to suffer the consequences if
prices fall. When markets are rising, what a saver
might make in three years from a savings account
can be made in a year, or even in months, in the
stock markets. Thus, the reward for taking risk
can tempt small investors to invest in shares.
Companies should therefore make every effort to
tap into this potential source of finance.
Anyone can trade in shares by him- or herself
or through an agent, called a stockbroker. The
quality and speed of market information has
improved tremendously. Newspapers, especially
the Financial Times, and various websites
report movements in share prices. Using the
internet, up to date information on share prices
can be obtained instantly in the comfort of
U one's home. The London Stock Exchange home
z page4 provides continuous reporting on market
movements in the FTSE indices. Similarly, the
t New York Stock Exchange,5 the largest in the
world, provides information on various indices
a
including S&P500, AEX, and Euronext 100
online. As a result, the number of small investors
98
trading in shares has been steadily increasing.
Figure 1 shows the growth in equity ownership
by US households between 1983 and 2005. 6
THE CREDIT CRUNCH AND SMALL
INVESTORS
Although household savers are one of the most
important sources of funds for investment,
negative news about a financial institution that
_. . 56.9
1995 1999 2002 2005
acts as a custodian of their savings can cause
panic and a rush on banks or building societies
to withdraw their money. This can bring the
financial market tumbling down. Financial
institutions such as banks and mortgage lenders
need to understand the risks associated with
being the custodians of the wealth of individual
investors. The recent crisis that started in the US
banking sector ended by engulfing the world,
prompting panicking savers almost to pull down
even giant healthy banks and mortgage lenders
and initiating a worldwide financial crisis.
The first such panic took place in the United
Kingdom in September 2007 and involved a
bank called Northern Rock. When depositors
started queuing to withdraw their money, the
Bank of England made an unprecedented and
dramatic move to save the collapsing bank.
The Guardian newspaper of Friday September
14, 2007, reported that this intervention by
the Bank was agreed between its governor,
Mervyn King, the chancellor, Alistair Darling,
and the Financial Services Authority. Northern
Rock customers were urged to stay calm—but
it did little to help. It was reported that the
Northern Rock sought the funding because of a
cash shortage caused by the month-long crisis
in global credit markets that began with the

collapse of the subprime mortgage market in the
United States. At the time, depositor's money
in Northern Rock amounted to more than
£100 billion. The unfortunate chain of events
did not stop there. The next casualties of the
panic attack were the Halifax-Bank of Scotland
(HBOS) Group and Bradford & Bingley, and
even Barclays Bank was affected. The bad news
spread among small investors like wildfire. The
large-circulation tabloids in particular fed the
panic, causing more confusion. For example, the
Sun newspaper of November 27, 2008, wrote:
"Britain's biggest mortgage lender, whose
funding position has been in the spotlight in the
wake of the Lehman Brothers collapse, saw its
stock suddenly plunge 30 per cent despite starting
the session up around seven per cent higher."
These events in the United Kingdom were
followed by similar losses of confidence affecting
1KB in Germany, BNP Paribas in France, and
other banks throughout the world.
Times Online (the online version of The Times
and the Sunday Times) of August 14, 2008,
explained what underlay the crises as follows.
"Years of lax lending inflated a huge debt bubble
as people borrowed cheap money and invested
it into property. Lenders were free with their
funds, especially in the United States, where
billions of dollars of so-called Ninja mortgages-
no income, no job or assets—were sold to people
with weak credit ratings." The low interest rates
and easy access to mortgages sent property
prices spiralling up. And whenever the borrowers
ran into trouble with their repayments, rising
house prices allowed them to remortgage their
properties. Eventually, interest rates—which
had been low in 2004—began to rise quickly, US
house prices started to fall, and borrowers began
to default on mortgage payments. This sparked
trouble. The banks became too nervous to lend
money to individuals any more—and even to
each other. When they did lend, it was at higher
rates of interest to cover the risk. It was the last
straw that broke the camel's back. Thus began
the credit crunch that hit the United States and
the world. Lehman Brothersfiledfor bankruptcy
on September 15, 2008. Together with the
problems faced by Merrill Lynch and AIG, this
caused a sharp drop and turmoil in the global
stock markets, a chilling harbinger of the world
economic crisis to follow.
HANDLING SMALL INVESTORS
Small investors need assurance from CEOs and
CFOs that they will not ignore them or overlook
their interests when times get tough. A good way of
doing this is to turn managers into shareholders.
Attracting Small Investors
Managers must be perceived as being ready to CO
make sacrifices in the interests of the company's
investors. In tough times small investors want
to see that those in charge are not losing just
their jobs but also their own investment in the "I
company, because managers faced with such a
prospect can be expected to work hard to turn
the business around to save their own skins.
a
o
They must be seen as having an incentive to put a
m
their blood and sweat into the business to avoid a
personal hit if the venture fails. M
Small investors think about risk. They would
like to see that a company is well secured by
holding a well-diversified portfolio of various
shares. Small investors like to see steady growth in
the profitability of a company and its subsidiaries,
with a corresponding rise in the share price.
The way existing shareholders are treated can
attract potential small investors. Rights issues to
existing shareholders instead of dividends are one 3
way of attracting potential investors. Preference
shares can also be attractive to small investors.
Preference shares offer a guaranteed stream of fixed
income whether the company makes a profit or not,
although it is riskier than debt in terms of priority if
the company goes bankrupt and into liquidation.
Turning workers into shareholders is another way
of creating small investors. And of course that is on
top of the improvement in corporate performance it
may bring about. Six per cent of German employees,
for example, own stock in the company they work
for,7 and the plan is to increase their stake.
Keeping small investors interested in saving and
investing is vital for the protection of the financial
interests of companies. It is therefore important
to create a stable and conducive environment that
encourages people to save and prosper.
CONCLUSION
In conclusion, dealing with small investors can
be a tricky business. Banks, building societies,
and other institutional investors and mortgage
lenders all depend on household savings and small
investors. Between them, the millions of small
investors can raise substantial funds that are a vital
source of economic growth and stability. However,
it is important to win and hold the trust of small
investors so that they are encouraged to save
and invest. Even a whisper of negative comment
about an organization they have entrusted their
money to may make them panic and rush in their
millions to withdraw their cash. This can create a
liquidity problem so severe that it can bring down
the largest of corporations. In dealing with small
investors, therefore, various techniques should be
implemented to encourage them and to maintain
their confidence.
o
99
 Financing and Raising Capital

0)
•8 MAKING IT HAPPEN
W Actions that can be taken to maintain small investors' confidence to continue investing include the
2 following:
PH • Make managers shareholders, and let the small investors know about it.
•£ • Protect your company against any possible financial risk by holding a well-diversified portfolio of
i> various shares.
PQ • Keep the existing shareholders happy, well treated, and looked after. They will bring in more
• investors.
tjjj • Turn your workers into shareholders. Workers with a financial stake in a company work more
4) efficiently when the company's success results in a rise in the share price.
S • Create a stable and conducive environment that encourages people to save and prosper.
to

&
MORE INFO
Books:
3
O* Lindahl, David. Trump University Commercial Real Estate 101: How Small Investors Can Get Started
W and Make It Big. Hoboken, NJ: Wiley, 2008.
Stowe, John D., Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey. Equity Asset Valuation.
Hoboken, NJ: Wiley, 2007.
Articles:
Brush, Michael. "A revolution for small investors." MSN Money (April 30, 2008). Online at:
tinyurl.com/cjhbq9
Hanson, Tim. "Secret advantages for small investors." The Motley Fool (January 9, 2006). Online at:
tinyurl.com/cdjlo5
Lease, Ronald C, Wilbur G. Lewellen, and Gary G. Schlarbaum. "The individual investor: Attributes
and attitudes." Journal of Finance 29:2 (May 1974): 413-433. Online at:
www.afajof.org/journal/jstabstract.asp7ref=8798
Lian, Tan Kin. "Protecting the small investors." The Online Citizen (September 22, 2008). Online at:
tinyurl.com/2erwxth
Luo, Jar-Der. "The savings behavior of small investors: A case study of Taiwan." Economic
Development and Cultural Change 46:4 (July 1998): 771-788. Online at:
dx.doi.org/10.1086/452373
Malmendier, Ulrike, and Devin M. Shanthikumar. "Are small investors naive about incentives?"
Journal of Financial Economics 85:2 (August 2007): 457-489. Online at: tinyurl.com/2vphlj6 [PDF].
Papworth, Jill. "Investors should lose Abbey habit." Guardian (London) (January 22, 2005). Online at:
tinyurl.com/36luklk
Snowdon, Ros. "HBOS cash call sets poser for small investors." Yorkshire Post (April 30, 2008).
Online at: tinyurl.com/32tfqb3
Treanor, Jill. "Small investors threaten to derail B&B fundraising." Guardian (London) (June 28,
2008). Online at: tinyurl.com/359b45k
Varian, Hal R. "Economic scene; despite the recovery in stocks, some of the forces behind the
internet bust are still lurking." New York Times (July 3, 2003). Online at: tinyurl.com/agkjuj
Wilson, Graeme. "Halifax in a fix." Sun (London) (September 17, 2008). Online at:
tinyurl.com/32zjhty
Websites:
M-l Investment Company Institute: www.ici.org
L/ The Motley Fool investment community: www.fool.com
2 MSN Money: moneycentral.msn.com
<^ Securities Industry and Financial Markets Association (SIFMA): www.sifma.org
£
O
lOO
 Attracting Small Investors

ft

P
a
ft

i
I
&
ft
0

NOTES
1 Investment Company Institute, Washington, DC, and 5 www.nyse.com
Securities Industry and Financial Markets Association, 6 As note 1.
New York, Equity Ownership in America, Fall 2005. 7 David Hudson. "Toward a shareholder society."
2 www.halifax.co.uk/savings/personalrates.asp Spiegel Online (March 30, 2000). Online at:
3 theonlinecitizen.com/2008/09/protecting-the-small- www.spiegel.de/politik/deutschland
investors
4 www.londonstockexchange.com/en-gb
/0,1518,71070,00.html o

ioi
Raising Capital in Global Financial w
ft
Markets by Reena Aggarwal (ft

EXECUTIVE SUMMARY
The major changes occurring in the capital-raising process in global financial markets are being
a
impacted by: •
• New regions and countries emerging as financial powers. W
• The growth of alternative investments as an asset class.
• The role of sovereign wealth funds. c
• The globalization and consolidation of stock exchanges.

INTRODUCTION
During the last decade global financial markets
have grown tremendously, becoming large and
liquid, and with substantial depth. At the same time
demand for capital has increased significantly, with
capital markets continuing to play a dominant role
in the allocation of capital. However, some major
shifts are occurring in the roles of suppliers and
users of capital. These shifts became even more
apparent during the recent financial crisis. This
chapter focuses on four such shifts that impact
both global firms that are looking to raise funds
and institutional investors that are suppliers of the
capital. The four areas that are accounting for the
major shifts are: the emergence of new countries
and regions as financial powers; the growth of
alternative investments as an asset class; the role of
sovereign wealth funds as a source of capital; and the
globalization and consolidation of stock exchanges.
The recent global financial crisis has clearly
highlighted the challenges that companies
worldwide face in raising capital. Either funding
is simply not available or the cost has gone up
considerably. The combination of the global
3
<
economic slowdown and challenges in raising
funds in the capital markets has meant that
companies are cutting costs, capital investments, $
and jobs. The financial markets and financial
3
institutions collapsed in a variety of ways, and
this has resulted in structural and regulatory
changes that will impact the raising of capital in
global financial markets.
EMERGING FINANCIAL POWERS
Historically, New York, London, and Tokyo
have been the global financial centers, but now a
number of new regions and countries are catching
up and emerging as dominant players. During the
period May 2007 to May 2008, the McKinsey
Quarterly reports that 35 European companies,
including Air France, Bayer, British Airways, and
Fiat, delisted from the New York Stock Exchange
as it became easier to delist.1 European markets
have integrated and the euro has proven itself to
be a strong currency, and the region has increased
its market share in this decade. At the same time,
the BRIC countries (Brazil, Russia, India, and

Figure 1. Market Capitalization Weighted Index, base values at 100, since 1998.
(Source: MSCI)

800 2500
Deal volume
700 -
Number of deals _ &G^' 2000
600
500 1500
400
300 1000 o
200 t-H
500
100
0 nnnnnnfl
o

103
 Financing and Raising Capital
China) have become new economic powers as
y their economies have grown at rates that are much
higher than those of developed countries. As seen
in Figure l, BRIC's equity markets have also
outperformed Europe and the United States since
2003. This growth has resulted in the formation of
large companies that are competing globally and
have a need for large amounts of global capital.
Private wealth in these countries has grown, and
this also becomes a source of capital.
For a period of time oil-exporting countries
benefited tremendously from the high oil prices.
These countries or regions, which include
Indonesia, the Middle East, Nigeria, Norway,
Russia, and Venezuela, became the world's largest
source of global capital flows. The McKinsey
Quarterly estimates that in 2008 US$5 trillion of
petrodollars went to foreign assets. It is estimated
that even with oil averaging US$50/barrel, net
capital outflows of US$7.4 trillion a year through
2013 from the oil-exporting countries is likely to
occur. The future of the wealth from some of these
countries will depend on oil prices.2
GROWTH OF ALTERNATIVE
INVESTMENTS
During the last decade alternative investments
have attracted a significant portion of allocation
by institutional investors. Within alternative
investments, private equity has become a major
source of funds for small and large companies,
for firms seeking buyout financing, and for firms
in distress. The ten largest private equity firms
ranked by amount of capital raised for direct
Table 1. Largest private equity firms by capital raised for direct private equity
investment between 2003 and 2008
Firm
Texas Pacific Group
Goldman Sachs Principal Investment Area
Carlyle Group
Kohlberg Kravis Roberts
Apollo Global Management
Bain Capital
u
z
CVC Capital Partners
t
Blackstone Group
Warburg Pincus
o Apax Partners
104
private equity investment between 2003 and
2008 are shown in Table 1. Private equity is an
investment in the assets of a company in which
the equity does not trade in the public markets.
Therefore, investment in private equity requires a
long-term approach. Institutional investors such
as pension funds and endowments are major
investors in private equity, and private equity
has become accepted as a distinct asset class.
During the last decade there was considerable
allocation by institutions into this asset class;
however the current economic crisis brought
their capital-raising activities to a halt.
The funds differ in their investment
philosophy. For example, the Blackstone Group
was founded in 1985, went public in 2007,
and is listed on the New York Stock Exchange.
It is diversified into several lines of business,
including corporate private equity, real estate,
hedge funds, credit, and advisory. In contrast,
Apax Partners is a "pure play" global private
equity firm that focuses only on specific sectors.
Until recently, private equity activity was focused
on investing in the United States and Europe,
but now there is an increased focus on the
emerging markets of Asia-Pacific as a destination
for private equity funds. There has been a
significant rise in the amount of private equity
investment flowing to China, Singapore, South
Korea, and India. Private equity will continue to
become a major source of capital for companies
around the world. In addition to private equity,
alternative investments also include hedge funds,
commodities, real estate, and venture capital.
Assets (US$ billion)
52.35
48.99
47.73
40.46
35.18
34.95
33.73
30.80
23.00
21.33
 Raising Capital in Global Financial Markets
SOVEREIGN WEALTH FUNDS AS A
SOURCE OF CAPITAL
Another newcomer on the global financial scene
is sovereign wealth funds (SWFs). SWFs are
government investment funds that invest in
foreign companies in order to earn profits and
increase the wealth of the state. These funds
have existed for a long time, but the increase in
their scope and magnitude has recently made
them a major financial player. The source of
funding for SWFs varies from export revenues
to foreign exchange reserves. In early 2008 the
assets under control by SWFs were estimated to
be US$3 trillion and expected to rise to US$10
Table 2. Top ten sovereign wealth funds by assets under management. (Source:
Sovereign Wealth Fund Institute, October 2009)
Country Sovereign wealth fund
U A E - A b u Dhabi Abu Dhabi Investment Authority
Norway Government Pension Fund—Global
Saudi Arabia SAMA Foreign Holdings
China SAFE Investment Company
China China Investment Corporation
Singapore Government of Singapore Investment Corporation
Kuwait Kuwait Investment Authority
Russia National Welfare Fund
China National Social Security Fund
China—Hong Kong Hong Kong Monetary Authority Investment Portfolio
trillion by 2012. In comparison, assets managed
by institutional investors like pension funds and
endowments amount to $53 trillion. The assets
of SWFs are expected to grow at a tremendous
rate and become a major provider of funding for
companies in both developed and developing
markets.3,4
Some of these funds have already taken
significant positions in several foreign companies.
As shown in Table 2, the largest sovereign fund
is the Abu Dhabi Investment Authority, the
investment arm ofAbu Dhabi, with a size of US$627
billion. The size of the fund grew due to the sharp
rise in oil prices in early 2008. The fund made an
investment of US$7.5 billion in Citigroup, has a
4.5% ownership in the home builder Toll Brothers,
and also has positions in companies such as EFG
Hermes, one of the leading investment banks in the
Arab world, and Banque de Tunisie et des Emirats,
a Tunisian bank.5 Similarly, China Investment
Corporation is estimated to have US$288.8 billion 00
funded by foreign exchange reserves in China.
The fund has large positions in the private equity
firm Blackstone Group (US$3 billion) and in the p
investment bank Morgan Stanley (US$5 billion).
There are other large SWFs based in Norway,
Saudi Arabia, Singapore, and Kuwait, among other
countries.
The growth and size of these funds have W
attracted considerable attention and discussion.
These funds typically make decisions based on
sound long-term investment strategies. They do
not use leverage, unlike hedge fund strategies.
Overall, the impact of SWFs is positive in
I
Assets (US$ billion) 3
627
445
431
347.1
288.8
247.5
202.8
178.5
146.5
139.7
that they invest the resources of the country
efficiently. Their investments have also been
particularly welcomed in companies such as
Citigroup, Morgan Stanley, and Barclays, as
other sources of capital were unavailable to these
companies. For the future, there is concern in
some circles whether these funds will simply be
financial investment vehicles or if they will take
an activist role in companies with the objective of
gaining political clout for their countries. There
o
is also concern about the lack of transparency
and regulation of SWFs.
GLOBALIZATION OF STOCK
EXCHANGES6
Stock exchanges play a critical role in the capital-
raising process. The total market capitalization o
of all publicly traded companies in the world
105
 Financing and Raising Capital
y was US$51.2 trillion in January 2007 and rose
W as high as US$57.5 trillion in May 2008 before
"§ dropping below US$28.7 trillion in February
g 2009. 7 However, exchanges across the world
g^ have transformed through major structural
+d changes in the last few years. Starting with
^ the demutualization of the Stockholm Stock
PQ Exchange in 1993, the number of financial
• exchanges that have adopted a for-profit, publicly
"J* listed organizational form has grown steadily.
0) This trend can be seen both in stock exchanges
H in different countries and in financial exchanges
^5 that trade different types of securities. This rapid
9£ organizational transformation of exchanges
gj from member-owned mutual companies to
w
joint-stock companies is unparalleled, and this
£? process is the manifestation of a number of
"5 innovations and deregulatory events that have
CT1 occurred in the last decade. This for-profit
W structure has allowed exchanges to raise capital
and invest in technology that is essential in order
to compete. Exchanges as public companies have
needed to increase market share and develop
additional sources of revenue. There has been
considerable consolidation among the large
global exchanges. The New York Stock Exchange
acquired Euronext, forming NYSE Euronext;
Nasdaq gained control of OMX; and the Chicago
Mercantile Exchange merged with its rival, the
Chicago Board of Trade.
The globalization of stock exchanges beyond
the authority of a single national regulator has
meant a rethinking of the regulatory framework.
It can be argued that regulatory policy rarely
leads but more often follows market innovations.
o
106
As such, the challenge for regulators will be to
develop regulatory programs that respond to
globalized markets. 8 National regulators are
moving in the direction of increased coordination
and convergence of regulation along mutually
acceptable principles. IOSCO, the international
organization of securities regulators, has played a
key role in promoting greater cooperation and the
development of commonly acceptable regulatory
principles. The financial crisis of 2008 has again
emphasized the need for global coordination in
an environment where capital has no national
boundary. The global consolidation of some of
the largest exchanges has been beneficial both
for companies raising capital and for investors/
traders. This consolidation has made it easier
for companies worldwide to raise large sums
of capital through public offerings and cheaper
for market participants to conduct transactions
in deep liquid markets. In addition to public
capital, there has been a tremendous increase in
the use of private capital.
CONCLUSION
A number of important changes are taking
place in global financial markets that need
to be monitored carefully. There has been a
considerable shift in the regional concentration
of wealth. In addition to the traditional public
capital markets, recent years have seen the
emergence of private equity and sovereign wealth
funds as major players in financial markets.
Stock exchanges have transformed to become
global entities. These changes have impacted the
landscape of global financial markets.
 Raising Capital in Global Financial Markets

MORE INFO w
n
Books: as
Harris, Larry. Trading and Exchanges: Market Microstructure for Practitioners. Oxford: Oxford
University Press, 2003. H
Ineichen, Alexander M. Absolute Returns: The Risk and Opportunities of Hedge Fund Investing.
Hoboken, NJ: Wiley, 2003.
Article:
Fenn, George W., Nellie Liang, and Stephen Prowse. "The private equity market: An overview."
Financial Markets, Institutions and Instruments 6:4 (November 1997): 1-106. Online at:
dx.doi.org/10.1111/1468-0416.00012
Report:
World Economic Forum. Globalization of Alternative Investments Working Papers Volume 1: The
Global Economic Impact of Private Equity Report 2008. Geneva and New York: World Economic
Forum, 2008. Online at: www.weforum.org/pdf/cgi/pe/Full_Report.pdf I
(ft
ft
Websites:
Dow Jones LP Source Galantes. Contact information and investment strategies for US and 3
international VC and PE firms, leveraged buyout firms, leveraged lenders, mezzanine investors, 3
turnaround investment firms, and international PE investors:
www.dowjones.com/privatemarkets/gal.asp
Private Equity Analyst (Dow Jones). News and profiles on VC and PE firms and companies involved
in alternative investment programs: www.fis.dowjones.com/products/pe.html
Private Equity Hub (Thomson Reuters). Create customized search query to locate PE, VC, buyout,
and M&A firms: thomsonreuters.com/products_services/media/media_products/professional_
publishing/deals/pehub
Sovereign Wealth Fund Institute. Studies SWFs and their impact on global economics, politics,
financial markets, trade, and public policy. Provides specialized services to corporations, funds,
and governments: www.swfinstitute.org

NOTES
1 Dobbs, Richard, and Marc H. Goedhart. "Why
cross-listing shares doesn't create value." McKinsey
Quarterly (November 2008). Online at:
www.mckinseyquarterly.com/Why_cross-listing_
shares_doesnt_create_value_2253
2 Lund, Susan, and Charles Roxburgh. "The new
financial power brokers: Crisis update." McKinsey
Quarterly (September 2009). Online at:
web.rollins.edu/~tlairson/ipe/financialpower.pdf
3 Johnson, Simon. "Straight talk: Emerging markets
emerge." Finance and Development 45:3 (September
2008). Online: www.imf.org/external/pubs/ft/
fandd/2008/09/pdf/straight.pdf
4 K i m m i t t , Robert M. "Public footprints in private
markets: Sovereign wealth funds and the world
private-markets
5 Thomas, Landon, Jr. "Cash-rich, publicity-shy, Abu
Dhabi fund draws scrutiny." New York Times (February
28, 2008). Online at: www.nytimes.com/2008/02/28/
business/worldbusiness/28fund.html
6Aggarwal, Reena, and Sandeep Dahiya.
"Demutualization and public offerings of financial
exchanges." Journal of Applied Corporate Finance
18:3 (Summer 2006): 9 6 - 1 0 6 . Online at:
dx.doi.org/10.1111/j.l745-6622.2006.00102.x
7 World Federation of Exchanges, available at:
www.world-exchanges.org/statistics/ytd-monthly
o
8 Aggarwal, Reena, Allen Ferrell, and Jonathan
Katz. "U.S. securities regulation in a world of

economy." Foreign Affairs 8 7 : 1 (January/February global exchanges." In Shahin Shojai (ed). World of
2008). Online at: www.foreignaffairs.com/ Exchanges: Adapting to a New Environment. London:
articles/63053/robert-m-kimmitt/public-footprints-in- Euromoney Books, 2007; ch. 7.

107
Financial Steps in an IPO for a Small or w
o
Medium-Size Enterprise by Hung-Gay Fung OR

EXECUTIVE SUMMARY
• The firm forms an underwriting syndicate by selecting a lead underwriter and co-managers.
a
n
Typically, for small and medium-sized firms underwriters charge a fee of 7% of the issue value.
In the United States, a firm registers with the Securities and Exchange Commission (SEC) for
the IPO issue, and when it has received approval it distributes a preliminary prospectus, known
as a "red herring," to the public. •8
• The firm has to select an exchange on which to list its stock.
• The firm and the underwriter arrange road shows to promote the issue and to find out more
about market demand; later this will provide useful information for setting the offer price and
determining how many shares should be issued.
• After the IPO trading, the lead underwriter provides market research on the issue and other
I
relevant information.

WHY AN IPO? that it isfinanciallyviable in the market.

An initial public offering (IPO) of stocks is a share
offering to the public by a small or medium-sized
enterprise (SME) undertaken to raise additional
cash for future growth or to enable existing
stockholders to cash out by selling part of their
holdings. Among other things, a successful IPO
will provide a company with an objective valuation
of its stock, create a good public image of the
company—thus lowering its cost of borrowing—
and provide it with a pool of publicly owned
shares for future acquisitions of other companies.
However, there are also drawbacks to being a public
company, such as loss of freedom (including costly
disclosure requirements and close monitoring by
the public and government) and, if a takeover is
threatened, potential loss of control.
TYPES OF IPO
There are many types of IPO, illustrating the
different management and owner compensation
contracts in firms.
• The plain vanilla IPO is undertaken by a
privately held company, mostly owned by
management, who want to secure additional
funding and determine the company's fair
market value.
• A venture capital-backed IPO refers to a
company in which management has sold
its shares to one or more groups of private
investors in return for funding and advice.
This provides an effective incentive scheme
for venture capitalists to implement their
exit strategy after they have successfully
transformed a firm in which they invested so
• In a reverse-leveraged buyout, the proceeds
of the IPO are used to pay off the debt
accumulated when a company was privatized
after a previous listing on an exchange. This
process enables owners who own majority
shares to privatize their publicly trading firms,
which are undervalued in the market, thus
realizingfinancialgains after the public was
informed of the high intrinsic value of the
private firm.
• A spin-off IPO denotes the process whereby
a large company carves out a stand-alone
subsidiary and sells it to the public. A spin-
off may also offer owners of the parent firm
and hedge funds the opportunity to capitalize
mispricing in both the subsidiary and parent
if the market is not efficient enough. An
interesting example in the United States was
the spin-off of uBid by Creative Computers in
1998, which enabled arbitragers to capitalize
the mispricing between the two listed
companies.
THE IPO PROCESS
Overview
The first task of management is to select the
underwriters who will be responsible for the
new issue. This is done roughly three months
before the IPO date. The underwriters provide O
the issuing firm with procedural and financial t—i
advice. Later they will buy the stock and then
sell it to the public. The company, with the aid
of lawyers, accountants, and underwriters,
submits a registration statement to a regulatory o

109
 Financing and Raising Capital
body (such as the Securities and Exchange
Commission (SEC) in the United States) for
approval of the public offering. The registration
statement is a detailed document about the
u company's history, business, and future plans.
PL) Specifically, the SEC requires information on the
+•»
«J details of the company (form S-i), its financial
history (form S-2), and expected cash flows
(form S-3). The company must be able to back
up the information provided to the SEC.
c In the United States, about six weeks prior
s to the IPO issue the SEC reviews and approves
the content of the disclosure to the public; this
becomes the preliminary prospectus and is also
as
called the "red herring." In December 2006, the
SEC set new rules on what information must be
included about a public company's executive
compensation, including the level of executive
pay, the benchmark used, and what quantitative
or qualitative methods are employed in
determining that pay.1 The prospectus is a legal
document describing the securities to be offered
to participants and buyers. It is advised on and
distributed by the underwriters, and provides
information such as the types of stock to be
issued, biographies of officers and directors with
detailed information about their compensation,
any litigation in place, and any other material
information.
After publication of the prospectus the
company, with the help of the underwriting
syndicate, prepares for roadshows to meet
potential investors—primarily institutional
investors in major cities like New York, San
Francisco, Boston, Chicago, and Los Angeles.
Roadshows may sometimes be arranged for
overseas investors. After the SEC approves
registration of the IPO, the underwriters and
the company will agree on the amount and
price of the issue. On the day prior to the IPO
issue the exact price of the shares to be issued
is announced by the underwriter. After the IPO,
the lead underwriter provides stock liquidity and
research coverage.
The IPO date is followed by a "lockup" period,
the duration of which varies across different
issues and markets, but is in the region of 180
days for a typical issue. After this "insiders,"
who include the underwriters, are allowed to sell
their shares. Insiders may or may not hold on to
U stock they own, depending on their motives and
I
objectives. However, the lockup period appears
to exert no control on those who bought shares
at the market-offered IPO price, although there
are regulatory restrictions on the types of clients
to whom the firm can sell stock.
HO
Selection of Underwriters
The board of a firm planning to launch an IPO
will first meet with potential candidates for
underwriters among investment banks and
then select the lead underwriter. The choice of
underwriter is based on criteria that include: a
preliminary valuation of the firm based on its
financial information; and the characteristics
of the underwriter, such as previous IPO
experience, strengths and weaknesses, client
network, research capabilities, and support for
post-IPO issues. Discounted cash flow analysis
and earnings multiples (such as the price/
earnings ratio) are typically used to come up
with the preliminary value of the company.
Citigroup was rankedfirstamong underwriters
in 2007, arranging US$617.6 billion of offerings,
and JPMorgan Chase was second with US$554.1
billion. Deutsche Bank was ranked third
and Merrill fourth in underwriting volume.2
Citigroup has been top of the list for the past
eight years. As a result of the global recession
that began in 2008 the underwriting volume has
declined, while fees have increased.
Types of Underwriting
The management of the IPO firm selects
the underwriters and decides on the type of
underwriting it wants. There are two types
of underwriting: firm commitment, and
best efforts. If the underwriter enters a firm
commitment with the company, the underwriter
is confident about the issue and is willing to buy
all the shares if there is insufficient demand. In
a firm commitment offering, the underwriters
will buy the IPO shares at a discount in the range
3.5-7.0% and then sell them on to the public at
the full offer price.
In a best efforts case, the investment bank will
only do as much as it reasonably can to sell the
shares and will return unsold equity to the firm.
This practice is common for less liquid securities.
However, if there is excess demand, the bank will
ask for a "greenshoe" option, allowing it to buy
additional stock from the IPO firm. Typically, a
lead underwriter asks other investment banks to
form an underwriting syndicate to take care of
the IPO issue before final approval by the SEC.
The syndicate serves to expand the marketing
of the company's stock issue and to reduce the
overall risk of the lead bank. The syndicate
members are involved in the underwriting either
through a commitment to sell the shares or just
in marketing of the shares.
Underwriters may face legal consequences if
a new issue goes wrong. Therefore, they have to
 Financial Steps in an IPO for a SME

present accurate and fair facts about the firm to asks institutional investors and individual clients
investors, because otherwise they may be sued about their intention to buy the shares. Each w
for misrepresentation, or for failing to carry out bid indicates the number to be purchased, and ft
due diligence. Some underwriters may allocate may include a limiting price. Such information
stocks of popular new issues to their important is recorded in a "book," from which the name
corporate clients; this is known as "spinning," bookbuilding is derived. These indications of
and is deemed to be unethical and illegal. interest provide valuable information, because all
Underwriters charge different spreads, and bids are compiled to ascertain the market demand
domestic and overseas spreads may differ. for the security. Although these bid indications
The average underwriting fee (spread) runs are not binding, the investment banker can utilize
between about 3.3% and 7% in the United Kingdom the information to set the final offer price, which
w
and the United States (Brealey, Myers, and Allen, is made known on the day before the actual issue •§
2008). (Cornelli and Goldreich, 2003).
The appeal of the bookbuilding method, despite
Selection of an Exchange
Different exchanges have different listing
requirements. In general, they require minimum
its higher underwriting costs, is that investment
banks provide better promotion and research
coverage of the IPO than other IPO issuing
I
on
levels of pretax income, net tangible assets, and procedures. Thus, the networking of the bank with
number of stockholders. For example, a New clients helps to enhance the image of the issuing ft
York Stock Exchange listing requires an income firm. Chief financial officers appear to prefer this 3
of either US$2.5 million before federal income approach to IPOs despite the higher cost.
taxes for the most recent year or US$2 million
pretax for the each of the preceding two years. IPO COST AND PRICING
The firm must have been profitable in the two Underpricing
years before a listing. Besides the substantial underwriting cost and
The NASDAQ (National Association of direct costs of lawyers, printers, accountants,
Securities Dealers Automated Quotations), etc., the IPO firm has to bear notional losses due
the largest electronic screen-based equity to the underpricing of the issue—i.e., the IPO
securities trading market in the United States, price is less than the true price of the stock. If the
has lower listing requirements than the NYSE. offering price is less than the true value of the
Other markets, such as the NASDAQ Small Cap issue, original stockholders effectively provide a
Market and the American Stock Exchange, offer bargain to the new investors. Thefinanceliterature
even lower listing requirements (www.inc.com/ shows that investors that buy at the issue price
guides/finance/207i3.html). Thus, an IPO firm on average realize high returns (for example,
needs to assess its own strengths and weaknesses 18%) over the following days. This high return
in order to pick the right exchange on which to from underpricing is common across the world—
list its shares. especially in China, which provides the highest
Afirmalso needs to select a trading symbol for return of 257% (Loughran, Ritter, and Rydqvist,
useontheexchange. Forexample, Microsoft trades 1994).
as MSFT. A fee, which varies for each exchange, Underpricing, which is most likely to be seen
has to be paid for the services provided. with the bookbuilding method, can be justified
as follows. First, a low offer price makes it
Subscription Procedure probable that shares will later be traded at a
IPO shares are distributed in different ways to higher price in the market, thus enhancing the
investors. One approach is an open auction, where firm's ability to raise capital in future. That is,
investors are invited to submit bids stating the underpricing ensures that the IPO is successful
number of shares they wish to purchase and the and that those who want to buy the issue will
price they will pay for them. The highest bidders follow the same underwriter among those in the
get the securities. The Google IPO of US$1.7 billion market. Second, it is a way to avoid the winner's
in 2004 and the Morningstar IPO of US$140 curse—the feeling of investors that they have
million in 2005 used this open auction method. paid too much. Simply, underpricing makes
o
The bookbuilding method is the most it more likely that an IPO will be successful. It
commonly used in the United States today and appears that stockholders of the IPO firm focus
is gaining popularity and dominance across the more on likely gains in wealth from later stock
globe (Degeorge, Derrien, and Womack, 2007). price increases than on any short-term loss from
During the roadshows, the investment banker underpricing (Loughran and Potter, 2002). o

111
 Financing and Raising Capital

^ New Price and Stock Issue

.2 Suppose that an IPO firm has 10 million shares and new assets of the firm. Pnew and N can be
O with a current valuation of $100 million, that determined as follows:
2 it wants to raise $70 million for the issue, and
QH that it has to pay $4.9 million for the direct cost PnmtxN =
^ of issuance, which is in general about 7% of $70,000,000 (new fund) + $4,900,000 (issue cost) (l)
W the issue value (Hansen, 2001). The post-issue
tt price, Pnew, which includes underpricing, and (10,000,000 +N) x Pnow=
4^ the number of new shares to be issued, N, will be $ 100,000,000 (old assets) + $70,000,000 ( new assets) (2)
fl determined simultaneously. That is, the dollar
2j amount of the new issue will cover the fund Solving these two equations (1) - (2) yields the
£ required and the direct cost to be paid, while the new price of the IPO, Pnew = $9.51. The number
$ augmented value of the firm will include the old of new shares to be issued, N = 7,875,920.
% .
&> MAKING IT HAPPEN
5J • An IPO is a time-consuming process.
5^ • The success of an IPO depends on the successful selling of the firm to the investment banks, to
the regulator, to the analysts, and to the public.
• During the six-month IPO process the firm's operations need to be on autopilot cruise control as
management will be totally tied up during this time.

MORE INFO
Books:
Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 9th ed.
New York: McGraw-Hill, 2008.
Killian, Linda, Kathleen Smith, and William Smith. IPOs for Everyone: The 12 Secrets of Investing
in IPOs. Hoboken, NJ: Wiley, 2 0 0 1 .

Articles:
Cornelli, Francesca, and David Goldreich. "Bookbuilding: How informative is the order book?"
Journal of Finance 58:4 (August 2003): 1415-1443. Online at:
dx.doi.org/10.1111/1540-6261.00572
Degeorge, Frangois, Frangois Derrien, and Kent L. Womack. "Analyst hype in IPOs: Explaining the
popularity of bookbuilding." Review of Financial Studies 20:4 (July 2007): 1021-1058. Online at:
dx.doi.org/10.1093/rfs/hhm010
Hansen, Robert S. "Do investment banks compete in IPOs? The advent of the ' 7 % plus contract.'"
Journal of Financial Economics 59:3 (March 2001): 3 1 3 - 3 4 6 . Online at:
dx.doi.org/10.1016/S0304-405X(00)00089-l
Loughran, Tim, Jay R. Ritter, and Kristian Rydqvist. "Initial public offerings: International insights."
Pacific-Basin Finance Journal 2 : 2 - 3 (1994): 165-199. Online at:
dx.doi.org/10.1016/0927-538X(94)90016-7
Loughran, T i m , and Jay R. Ritter. "Why don't issuers get upset about leaving money on the table in
IPOs?" Review of Financial Studies 15:2 (Spring 2002): 4 1 3 - 4 4 4 . Online at:
W dx.doi.org/10.1093/rfs/15.2.413

•7 Websites:
<£ Hoover's IPO Central: www.hoovers.com/global/ipoc
*7 Inc. magazine articles on IPOs: www.inc.com/guides/finance/20713.html
M Investopedia IPO definition: www.investopedia.com/terms/i/ipo.asp

<y
112
 Financial Steps in an IPO for a SME

a
W

NOTES
. I
^
1 See Wall Street Journal (December 8, 2008). 2 See International Herald Tribune (January 1, 2008).

113
The Role of Institutional Investors in W
a
Corporate Financing by Hao Jiang
EXECUTIVE SUMMARY a
• Institutional investors have become increasingly important in global capital markets.
• In equity markets, institutional investors tend to prefer liquid stocks with larger market
capitalization, higher turnover, and higher price levels.
• Institutional investors particularly favor stocks in popular equity indexes, giving them higher
valuations because their performance is typically benchmarked against those indexes.
• In bond markets that are mainly populated by institutional investors, there is a clear clientele
effect.
• Private equity funds are an important source of capital for entrepreneurial firms.

INTRODUCTION MAJOR INSTITUTIONAL PLAYERS

Institutional investors have become increasingly
important in global capital markets. As of the end
of December 2007, total assets under management
by major global institutional investors reached
US$81.90 trillion. In particular, mutual funds,
pension funds, and insurance companies managed
US$26.2, 28.2, and 19.9 trillion of assets,
respectively, whileassetsmanagedbynontraditional
managers such as hedge funds, sovereign funds,
and private equity funds experienced dramatic
growth, reaching US$2.3, 3.3, and 2.0 trillion in
2007 (Figure 1). In comparison, the world equity
markets amounted to US$60.8 trillion, and the
aggregate value of corporate bonds outstanding
in the United States, the largest corporate bond
market, was US$5.8 trillion in 2007. Clearly, for
any successful corporate managers who raise
capital to finance their future growth, it is crucial to
understand such institutionalization in the global
fund markets.
Institutional investors are a heterogeneous group of
investors that populate the global capital markets.
Based on their legal type, institutional investors
can be broadly classified into mutual funds,
pension funds, insurance companies, sovereign
funds, hedge funds, and private equity funds.
A mutual fund is an investment vehicle
that buys a portfolio of securities selected by
a professional investment adviser to meet a
specified financial goal (investment objective).
Between 2000 and 2007, the total net assets
of mutual funds grew from US$6.96 to 12.02
trillion in the United States, from US$3.29 to
8.98 trillion in Europe, from US$1.13 to 3.67
trillion in Asia-Pacific, and from US$16.92 to
95.22 billion in Africa (Figure 2).
A pension fund is a pool of assets forming an
independent legal entity that are bought with the
contributions to a pension plan for the exclusive
purpose of financing pension plan benefits.

a
Figure 1. Assets under management by different types of institutional investors in
2007. (Source; International Financial Services London)

28.2
30
25
26.2
J 20
£ 15
CO 10
O
ID 2.0
5
^ | 19L9
>
Private
Pension
funds
Mutual
funds
Insurance
companies
Sovereign
funds
Hedge
funds
equity n

115
 Financing and Raising Capital

Figure 2. Total net assets of mutual funds around the world. (Source: 2008 Investment
Company Fact Book, Washington, DC: Investment Company Institute, 2008)

u
PL. Africa
+•>
«5

Asia-Pacific
C

I
(A
Europe

=
United States

2,000 4,000 6,000 8,000 10,000 12,000 14,000

w US$ billions

Table 1 lists the world's 20 largest pension funds Paralleling the growth of traditional
as ranked by Pensions & Investments. Insurance institutions is the universe of nontraditional
companies and banks are also important types institutional investors. Among them, a sovereign
of institutional investor that constitute the wealth fund (SWF) is a state-owned investment
traditional asset managers. fund composed of financial assets such as stocks,
Table 1. The world's top 20 pension funds based on total assets. (Source: Pensions &
Investments; Watson Wyatt, 2006)

Rank Fund Country Assets (US$ million)

1 Government Pension Investment Japan 870,587

2 Government Pension Norway 235,849

3 ABP Netherlands 226,974

4 Notional Pension Korea 214,184

5 California Public Employees US 195,978

6 Pension Fund Association Japan 183,352

7 Federal Retirement Thrift US 167,165

8 Local Government Officials Japan 137,153

9 California State Teachers US 133,988

10 New York State Common US 131,861

11 GEPF South Africa 124,167

u
z 12 Postal Savings Fund Taiwan 117,265

t
I—<
13

14
Florida State Board

General Motors
US

US
114,935

114,271
PL, 15 New York City Retirement US 105,860

116
 The Role of Institutional Investors in Corporate Financing

bonds, real estate, or other financial instruments
funded by foreign exchange assets. Table 2 shows
the top sovereign wealth funds across the world.
A hedge fund is an unregulated pool of money
managed by an investment advisor, the hedge fund
manager, who typically has the right to have short
positions, to borrow, and to make extensive use
w
of derivatives. Hedge fund managers receive both
fixed and performance fees. Table 3 shows the top
ten hedge funds based on assets under management

Table 2. The world's largest sovereign wealth funds. (Ranking by Sovereign Wealth
Fund Institute, 2008)

Country Fond Assets (US$billion) Inception Origin

Abu Dhabi Investment

UAE: Abu Dhabi 875 1976 Oil
Authority

Saudi Arabia SAMA Foreign Holdings 433.0 n/a Oil

Government of Singapore
Singapore 330 1981 Noncommodity
Investment Corporation

China SAFE Investment Company 311.6 1990 Noncommodity

Government Pension
Norway 301 1953 Oil
Fund—Global

Kuwait Kuwait Investment Authority 264.4 2007 Oil

China Investment
China 200 2008 Noncommodity
Corporation

Russia National Welfare Fund 189.7 1998 Oil

Hong Kong Monetary

China: Hong Kong 173 1974 Noncommodity
Authority Investment Portfolio

Singapore Temasek Holdings 134 2006 Noncommodity

Investment Corporation of
UAE: Dubai 82 2000 Oil
Dubai

National Social Security

China 74 2003 Noncommodity
Fund

Qatar Qatar Investment Authority 60 2006 Oil

Libya Libyan Investment Authority 50 Oil

Algeria Revenue Regulation Fund 47 2000 Oil

Australia Australian Future Fund 43.8 2004 Noncommodity

US: Alaska Alaska Permanent Fund 39.8 1976 Oil

Kazakhstan Kazakhstan National Fund 38 2000 Oil

National Pensions Reserve

Ireland 30.8 2001 Noncommodity
Fund

Korea Investment
South Korea 30 2005 Noncommodity
Corporation

Brunei Brunei Investment Agency 30 1983 Oil

117
 Financing and Raising Capital

0) Table 3. The world's top ten hedge funds. (Ranking by Institutional Investor, 2007)

Rank Fund Location Firm capital (US$ millionj

o
1 JP Morgan Asset Management New York, NY 44,700

u 2 Bridgewater Associates Westport, CT 36,000

OH
+•• 3 Farallon Capital Management San Francisco, CA 36,000
CO
V
4 Renaissance Technologies Corp. East Setauket, NY 33,300

I 5

6
Och-Ziff Capital Management Group

DE Shaw Group
New York, NY

New York, NY
33,200

32,240
Cfi
7 Goldman Sachs Asset Management New York, NY 29,206
>
C 8 Paulson & Co New York, NY 28,979

9 Barclays Global Investors London, UK 26,227

10 GLG Partners London, UK 23,900

ranked by Institutional Investor in 2007. extensions). At inception, institutional investors

A private equity fund is a pooled investment
vehicle which invests its money in equity securities
of companies that have not "gone public" (i.e.
are not listed on a public exchange). Private
equity funds are typically limited partnerships
with a fixed term of ten years (often with annual
such as pension funds and endowments (limited
partners) commit a certain amount of capital to
private equity funds, which are run by the general
partners. Table 4 is a list of the ten largest private
equity firms in the world as ranked by Private
Equity International in 2008.

Table 4. The world's ten largest private equity firms. (Ranking by Private Equity
International, 2008)

Rank Firm Headquarters Capital raised 2003-2008

1 The Carlyle Group Washington, DC $52 billion

Goldman Sachs Principal

2 New York, NY $49.05 billion
Investment Area

3 Texas Pacific Group Fort Worth, TX $48.75 billion

4 Kohlberg Kravis Roberts New York, NY $39.67 billion

5 CVC Capital Partners London, UK $36.84 billion

6 Apollo Management New York, NY $32.82 billion

7 Bain Capital Boston, MA $31.71 billion

Permira London, UK $25.43 billion

u
8

9 Apax Partners London, UK $25.23 billion

10 The Blackstone Group New York, NY $23.3 billion

t—I

118
 The Role of Institutional Investors in Corporate Financing
THE ROLE OF INSTITUTIONAL
INVESTORS IN CORPORATE FINANCING
Institutional investors supply capital for firms
seeking to raise finance from both publicly traded
securities markets and from the private domain.
Institutional Investors as Holders of
Publicly Traded Securities
Given their large portfolio size, institutional
investors naturally become dominant holders of
publicly traded securities. According to the 13F
filings that institutional investors are required
to lodge with the Securities and Exchange
Commission (SEC), institutional investors hold
over 68% of the total market value of US common
stocks. According to the "Flow of Funds" data
provided by the Federal Reserve, institutional
investors hold approximately 86% of corporate
bonds in the US corporate bond markets.
Therefore, their investment behavior will have
a significant influence on the pricing of these
securities. For corporate managers who raise
money from capital markets, it is important to
understand the demand structure of institutional
investors for publicly traded securities.
Despite their apparent heterogeneity,
institutional investors share common
characteristics because of the legal environment
that they face as fiduciaries, and because of the
demand for liquidity resulting from the large
sizes of their portfolios and the need to reduce
transaction costs. As a group, institutional
investors exhibit preferences for certain stock
characteristics in their equity portfolio. In
particular, they tend to prefer stocks with larger
market capitalization, higher turnover ratios,
and higher levels of price. In other words,
institutional investors are willing to pay a higher
premium for stocks with these characteristics.1
Because most institutional investors
benchmark their performance against certain
indices, they naturally exhibit preferences for
stocks in popular equity indexes. In the US
market, when stocks are included into the
S&P500 Index, the most prevalent equity index,
the prices of those stocks tend to experience a
2-3% increase over a short period of time.
Firms with access to the corporate bond
market tend to issue bonds as a means of debt
financing. Based on the credit quality of the
issue, corporate bonds can be classified into
investment-grade and noninvestment-grade
(high-yield or junk bonds, which are rated Ba M
and below by Moody's, or BB and below by rt
Standard & Poor's). For corporate bond issuers, %
it is important to recognize the tendency of ^
different classes of corporate bonds to attract g
different types of institutional investor—namely ft
the clientele effect—in corporate bond markets. P1.
Institutional investors generally place ^
restrictions on investing in noninvestment-grade •
bonds. For example, the National Association of fij
Insurance Commissioners (NAIC) imposes on >fi
insurance companies an upper limit of 20% of p,
their assets for investment in high-yield bonds. «jj
Pension funds often impose limits on the value of a M
portfolio that can be invested in high-yield bonds. S|
US investment-grade bond mutual funds place a ^
limit of 5% of assets for investments in junk bonds jjfl
and must sell any security if it falls below a B rating. 3
However, there are institutional investors that o
specialize in junk bonds such as hedge funds with j3
strategies in distressed assets and high-yield bond
mutual funds. A recent study shows that when a
bond receives a downgrade from investment to
speculative grade there is a persistent price decline
of 2%, whereas similar downgrades that do not
cross the junk bond threshold do not experience
such persistent price drops. This result suggests
the importance of investor clientele for the pricing
of corporate bonds.2
Institutional Investors as Fund
Intermediaries for Private Firms
For entrepreneurial firms at the early stage of
their life cycle, private equity funds comprise
an important source of financing. Two primary
categories of private equity funds are venture
capital funds and leveraged buyout funds. In
particular, venture capital funds provide equity
capital for firms that are not yet profitable and
lack tangible assets. Typically, such venture
capital funds are active investors and play a
primary role in shaping the top management
team of the companies in which they invest.
Unlike venture capital funds that invest in
young, fast-growing private companies, leveraged
buyout funds invest in established companies
and facilitate the process of purchasing an entire
company or a controlling part of the stock of a
company involving large amounts of debt—a
'leveraged buyout." During the past two decades, jT\
both types of private equity funds have played an ^~.
increasingly important role in corporate financing. 1—1
119
 Financing and Raising Capital

.2 CASE STUDY
Hedge Funds and the Turmoil of the Convertible Bonds Market
Convertible bonds, which give holders an option to exchange the bonds for a specified number
Ck of shares of common stocks, are an importance source of capital for many firms. Among various
*j* reasons, managers favor convertible bonds because they are less costly than a direct share
V issuance, and because firms to which straight debt and equity are not available can still raise
W money in the convertible bond market. SEC Rule 144A, effective in 1990, allows firms to issue
^ securities to qualified institutional buyers (QIBs) without having to register these securities. This
fi regulation significantly accelerates the capital-raising process from more than one month in the
2* public market to one or two days in the 144A market from announcement to closing. As a result,
J3 nearly all convertible bonds in recent years have been issued via the 144A market.
$ According to the SDC Global New Issues database, convertible bond issuance amounted to $50.2
^ billion in 2006, increasing more than sixfold from $7.8 billion in 1992. It is generally believed
C that hedge funds that conduct convertible arbitrage are the major players in the convertible bond
markets, purchasing more than 70% of convertible bonds in the primary market.

1
In late 2004 and early 2005, large institutional investors in convertible hedge funds,
unimpressed with the performance of hedge funds in 2004, started to withdraw capital from those
y funds. To meet investor redemptions, hedge funds sold convertible bonds, causing their prices to
fall relative to their fundamental values, which in turn lowered the returns on convertible hedge
funds. From January to May of 2005, the Credit Suisse/Tremont Convertible Arbitrage Hedge Fund
Index decreased by 7.2%.3 The lower returns on convertible hedge funds triggered further investor
redemptions and more selling of convertible bonds, forming a vicious cycle. The price of convertible
bonds dropped significantly below fundamental values. The maximum discount of convertible
bonds was 2.7% in May 2005." A gradual price recovery took place in 2006.

CONCLUSION certain indexes, stocks in popular equity indexes

The dramatic expansion of institutional
investors in global capital markets demonstrates
the changing savings pattern of households
in the global economy. As such, corporate
managers who wish to raise funds to finance
the growth of their firms must understand such
institutionalization in the global fund markets,
In equity markets, institutional investors
tend to prefer liquid stocks with larger market
capitalization, higher turnover, and higher price
levels. Because the performance of institutional
investors is typically benchmarked against
are particularly favored by institutional investors
and are thus priced at a higher valuation ratio,
In bond markets that are mainly populated by
institutional investors, there is a clear clientele
effect. Banks, insurance companies, pension
funds, and investment-grade bond mutual funds
place severe restrictions on the holdings of high-
yield bonds, whereas hedge funds and high-yield
bond mutual funds provide capital for high-
yield issuers. Lastly, private equity funds are an
important source of capital for entrepreneurial
firms.

MAKING IT HAPPEN
Institutional investors have dominated global capital markets. As a result, the assets under their
management constitute an important source of capital for corporate managers.
• To attract institutional investors in equity markets, liquidity of shares is a major consideration. In
particular, larger market capitalization, higher turnover, and higher price levels are important in
{.L} attracting institutional holdings. Index membership is a strong sweetener.
• In bond markets, investment-grade bonds have a broader institutional investor base, whereas
Z the issuance of high-yield bonds relies on capital providers such as specialized bond mutual
"S funds and hedge funds.
/-\ • For entrepreneurial firms that seek both capital and strategic support, private equity funds
gtn appear to be increasingly important.

O
120
 The Role of Institutional Investors in Corporate Financing

W
MORE INFO rt
Books: H-
Davis, E. Philip, and Benn Steil. Institutional Investors. Cambridge, MA: MIT Press, 2004. ^
Jaeger, Robert A. All About Hedge Funds: The Easy Way to Get Started. New York: McGraw-Hill, p
2003. Q.
Pozen, Robert C. The Mutual Fund Business. 2nd ed. Boston, MA: Houghton Mifflin, 2002. ^*
Pratt's Guide to Private Equity & Venture Capital Sources. New York: Thomson Reuters, 2008. ft
•
Websites: M
Dow Jones LP Source Galantes: www.dowjones.com/privatemarkets/gal.asp >fi
Institutional Investor: www.institutionalinvestor.com P.
Investment Company Institute (ICI): www.ici.org «^
Pensions & Investments: www.pionline.com HH
Preqin: www.preqin.com 5
Private Equity International (PEI): www.peimedia.com ft
Sovereign Wealth Fund Institute: www.swfinstitute.org ^
Watson Wyatt: www.watsonwyatt.com jjj
ft
p

NOTES ,0
1 Gompers, P. A., and A. Metrick. "Institutional Dame, IN. Online at: *TJ
investors and equity prices." Quarterly Journal of ssrn.com/abstract= 1280834 *~j?
Economics 116 (2001): 229-259. 3 Based on the author's calculations. £>
2 Da, Z., and P. Gao. "Clientele change, persistent 4 Mitchell, M., Pedersen, L. H., and T. Pulvino. "Slow ^
liquidity shock, and bond return reversal after rating moving capital." American Economic Review 97:2 £"*)
downgrades." Working paper, University of Notre (2007): 215-220.
Understanding and Accessing Private
Equity for Small and Medium Enterprises
by Arne-G. Hostrup
EXECUTIVE SUMMARY
• Private equity is an important component of funding for small and medium enterprises (SMEs).
• The goal of securing a company's long-term financing and becoming independent of banks'
continuously changing lending behavior is one that preoccupies many enterprises, from
foundation to sale.
• Very few companies are familiar with the market structure, processes, framework, and
conditions of private equity.
• There are a number of reservations about this type of financing.
DEFINITION OF PRIVATE EQUITY
Private equity is the generic term for all forms
of financing through external equity capital in
the broader sense. The generic term is often
subdivided into:
• Venture capital (VC) is made available by
business angels (who provide so-called
informal venture capital, or IVC) and venture
capital companies, usually management
companies with a venture capital fund
under administration. VC is made use of in
a company's early stages—from foundation,
market entry, and growth, right down to
bridge financing prior to an initial public
offering (IPO).
• Private equity in a narrower sense is
made use of in, for example, expansion,
internationalization, MBO/MBI, general
reorganization of debt capital financing
structures, and turnarounds.
The unequivocal characteristic of private equity
in the SME sector is that the investor makes
the invested capital available without provision
of security and thus participates fully in the
entrepreneurial risk of a business. Capital is
normally made available over the medium to
long term (3-10 years) in the form of liable
equity. The forms of investment range from
acquisition of a stake under the provisions of
company law, with payment of the amount
invested into the company's capital reserve, to a
completely dormant partnership with no direct
relationship under the provisions of company
law. A combination of both options is often
seen, with the investor becoming a shareholder
of the company and making part of his
investment as a nonrepayable payment into the
capital reserve and another part as a repayable
w
&.
3
I
CM
and continuously interest-bearing dormant
partnership investment.
As regards the extent of the stakes acquired
under company law, the range varies from
minority and majority holdings to complete
takeovers by the private equity investor. The
investor's objective is to sell the acquired shares
at a later point in time within the framework of
a so-called exit, thereby making as much profit
as possible. The exit can take place within the
framework of an IPO, a trade sale, or a buy-
back by the previous shareholders. Professional
private equity investors usually expect a rate
of return of more than 30% per annum. The
expectations of business angels may differ.
MARKET STRUCTURE AND
PARTICIPANTS
As a basic principle, the private equity market
can be subdivided into the informal/formal
and private/governmental areas. In general,
the entire field of business angel financing is
regarded as the informal private equity market.
Business angels are wealthy private investors
who use their own capital to acquire stakes in
other companies. The formal private equity
market is the entire "regulated area," i.e. usually
private equity funds or their management
companies. Depending on the investment
motive or situation of the company, the market
subdivides further, with investors specializing in
the following sectors:
• seed-financing (business angels); O
• early-stage businesses;
• later-stage businesses; •n
• medium-sized businesses;
• buy-outs;
• corporate venture capital.
Within these sectors there are investors who
O
123
 Financing and Raising Capital

confine themselves to a certain technology or
geographic region. Usually, there is an umbrella
organization that unites the private equity firms
ctf in any major country and, in some cases, major
u regions. As a rule, umbrella organizations are
4-) a good place to find individual investors and to
research their respective special interests (see
PQ More Info section).
INVESTMENT PROCESS
C of directly addressing such investors. Support
Business Plan
established companies tend to shy away from
"publishing" a request for financing in this
way and often make use of a corporate finance
consultant. The extent of support provided
by such a consultant ranges from the simple
establishment of contact with investors to
comprehensive support for the entire process. For
instance, many CF consultants offer support when
it comes to compilation of the business plan, then
present a list of suitable investors and take charge

I A substantive business plan is the basic

requirement for any involvement of private
during the due diligence process and contract
negotiations is also customary. Consultants are
mainly remunerated on the basis of a fixed daily
equity investors. Within the framework of the
SI business plan, the company's strategy and rate (€700-2,000) and a performance-related
s objectives are usually articulated for at least fee in the event that a private equity investment
the next five years. In addition, the firm seeking materializes. The usual commission ranges from
equity capital must highlight all business and 1 to 4% of the investment. The amount varies
financial aspects of a project. At an international depending on the agreed fixed remuneration and
level, the following structure is commonly found the support services provided.
in business plans:
• executive summary Due Diligence
• product or service After an investor has voiced interest, he or she
• market and competition begins with the due diligence process. The entire
• marketing and sales company is "put to the test." Its history, current
• business model, business system and market and competition, and strategy for the
organization future are closely examined. Some investors
• entrepreneurial team, management, prefer to undertake parts of the due diligence
personnel themselves, but as a rule the task is passed to
• implementation schedule external consultants. The due diligence process
• opportunities and risks is often divided into the following parts:
• financial planning and financing • Legal: Fulfillment of the duty to provide
• appendix. information or limitation of liability risks;
The business plan is the basis for an investor's identification and valuation of legal risks.
decision to invest and usually becomes an • Product/technique: Assessment of products/
integral part of a participation agreement. services at the development stage, technical
Moreover, the plan is a helpful controlling feasibility, market acceptance, etc.
instrument for management over the following • Strategic/business: Description and, if
years. The business plan should therefore be possible, quantification of potential on the
compiled with care. market and resource side.
• Commercial: Assessment of the future
Selecting and Addressing Investors development of the market in which the
How do I find and select the right investor for my business operates.
company? And how do I address this person or • Financial: Assessment of the company's past
fund? Generally, there are three ways in which commercial situation and its future earnings
an SME can identify potential investors: potential.
• research on the internet, followed by a direct • Tax: Identification of tax-related risks and a
approach with submission of the business tax-optimized design for the transaction.
plan • Environmental: Disclosure of any
• presentations at investor conferences environment-related liabilities that may
U • hiring a corporate finance (CF) consultant. impose a heavy cost burden following
For smaller or younger companies, direct conclusion of the deal.
addressing or presentation at conferences is a In most cases analysis focuses on the financial
common method. In particular, this applies to and strategic/business areas. Depending on the
the entire venture capital segment. Larger or company's age and history, legal due diligence

124
 Understanding and Accessing Private Equity for SMEs
may also become a focal point. The objective is
to provide a background for decisions that are
in accordance with the investment, based on
the performed corporate analysis. Due diligence
requires careful preparation by the management
of the business to ensure that information and
data requested by the investor or his agent are
properly and fully presented.
An important factor in preparation and
organization of materials for the due diligence
process is the selection of a team, and thereby
the establishment of responsibilities for the
collection and processing of data and making
available contact persons for interviews.
Before the start of the due diligence process,
the company that is going to be scrutinized
should create a "data room" in which all required
information is gathered so that it can be accessed
and inspected bythe examiners. This can range from
a simple folder or CD to a professionally designed
online platform (these are offered by specialized
service providers). With an online platform all the
required data are input in electronic form so that
they can be checked by external examiners with
authorization to access the information. Clearly,
the younger a company is, the fewer materials there
may be available for examination. In the case of a
foundation project, this material is often confined
to the business plan.
Practice has shown that the due diligence
process can often become protracted, or that
there may even be a breakdown of the entire
contract negotiations, for the following reasons:
• incomplete documents;
• contact persons not available for interviews;
• unconvincing budget planning (e.g.
unrealistic assumptions, inconsistent
planning, poor or incomplete data sources);
• legal disputes with uncertain outcomes in
respect of liability, or warranty and patent
risks as well as risks related to the legal
protection of registered designs;
• environmental risks;
• tax-related risks;
• insufficient recoverability/value of
inventories and accounts receivable;
• management is unable to convince an
investor of its ability to realize the business
objectives beyond a limited extent.
Company Valuation
Valuation of the company is almost always the
most critical issue in contract negotiations, and
intended projects frequently fail at this particular
point as the parties involved are unable to reach
agreement on the price. Company valuation can
be based on various internationally recognized w
procedures, such as:
• discounted cash flow; en
• multiples like price-earnings ratio or price-
cash flow ratio;
• asset value procedure; P
a
• exit value procedure.
Which procedure is used depends on many
I.<?
factors, such as the preferences of the investor, W
the country in which the company's registered
office is located, and the age of the company.
When determining a company value that is
appropriate for both sides, the following should I—I
be borne in mind:
• there is no such thing as a correct value; I
en
I
• although valuation procedures are objectively
comprehensible, the range of results they give
can be extremely wide;
o
• company valuation is always a reflection of
3
opinions, which can differ widely—especially
with young companies. However, a valuation
can indicate a plausible value;
• in the final analysis, it is offer and demand
that determine the value of a company.
In conclusion, the general rule is that there is a
value, and there is a price.
Contracts
Participation agreements are very extensive
contracts, often consisting of several hundred
pages. Therefore, a lawyer should always
be consulted. As a general rule, in the case of
participation in a limited liability company, such
an agreement has the following components:
• participation agreement;
• partnership agreement;
• articles of association;
• contract on the establishment of a silent
partnership;
• advisory committee statute;
• management board regulations;
• managing director employment contract.
How individual agreements are allocated among
the above-mentioned documents may vary
from one investor to another. For instance,
certain agreements may be incorporated in the
participation agreement by one investor, while
another investor may place the same agreements
within the partnership agreement.
o
Participation agreements include a large number
of clauses that often raise problems for companies
which are seeking private equity for the first time.
For instance, investors have comprehensive rights
o
125
 Financing and Raising Capital

Q to information and codetermination, but, at the
,y same time, the rights of original shareholders
y regarding the sale of their corporate shares are
u massively restricted. Within the framework of the
04 entire contract negotiations and the composition
of the contract, one main thing should be
remembered: Investors and previous shareholders
have the same objective—they both wish to make
the company as successful as possible.

•g CASE STUDY
§ InkJet
S The German company InkJet Ltd., founded in 2000, has developed an innovative and patented
"Jj inkjet technology for industrial use. During the first two years the company focused on
P development, and in subsequent years it made a successful entry into the German market. In
53 2007, with turnover at €4.5 million, InkJet decided to expand its business internationally, with a
HM
focus on the European market as a first step. After drawing up the business plan it was known
j? that between €2 and €2.5 million would be needed to finance the expansion. Up to that point the
'j3 company had been entirely financed by founders' capital and debt. It was very quickly realized
Cf that this method of financing would not work for the planned internationalization. The company
W therefore began to seek out a private equity investor, and found one in 2008.
The investor was a corporate venture capital company that focuses on industrial technology,
and is backed by an Austrian enterprise. This company invested €2.5 million in cash. The payment
was arranged in three parts, linked to the fulfillment of three technology and finance milestones
(for example, a turnover of €12 million in 2010). The VC obtained 35% of the corporate shares
for €1.3 million. The other €1.2 million was injected as a silent partnership with a current rate of
interest of 10% plus an exit kicker. Furthermore, the founders accepted a subsequent adaptation
of the company valuation in favor of the investor if results fall short of the business plan forecasts
by more than 10%.
The entire participation process from initial contact to execution of the participation agreements
took nine months, of which the pure due diligence process took approximately four months.
The rest of the time was used for internal preliminary examinations by the investor, contract
negotiations, and coordination processes. Technical and commercial due diligence was carried out
by the investor itself, while the tax and legal due diligence was conducted by external consultants.

I
M

o
Pi

126
 Understanding and Accessing Private Equity for SMEs

MAKING IT HAPPEN g
In summary, the following aspects should be taken into consideration before the decision to finance •"*'
a company with the help of private equity is executed: £»
• Company's business model: The business model must be checked as to whether it is suitable p
for private equity. Features to look for are high growth potential, sufficient market size, unique %
selling propositions, customer benefit, and competitive advantage. ^*
• Management team: Complementary talents, professional experience and knowledge of the ^
trade, key positions filled or capable of being filled over the short term.
• Professional business plan: Compilation of the business plan is the prime responsibility of the
entrepreneur and his management team. It is not delegable to consultants, who only have
an auxiliary function. The management, especially the founder, is personally responsible for
the business plan's content, and must "sell" and defend it. Attention must be paid to the !
plan's completeness and formal structure. Beware of exaggerated assumptions with regard to ^
projected sales and capital requirements. ^
• Select appropriate investors: Look for experience, background, track record, potential for a>
adding value, references from the portfolio, team structure, age of the fund, financial resources R
available for new investments, participation agreements, information, codetermination, and ^
controlling rights. £3
• Contacting: Establishing contact with the selected private equity fund should preferably be done
through informal channels.
• Due diligence: The management should use the investor's check-up to amend the business plan/
business model if required, or to develop it further, and they should be open to criticism and
suggestions.
• Cooperation: Management should do their utmost to support the due diligence process in
an open and honest manner, tell the truth, and submit suitable references. They should
not conceal anything from the investor, as he will be the future copartner, able to make the
founder personally liable for years to come based on the liability provisions of the participation
agreement.
• If a memorandum of understanding is reached: Negotiations about company valuation shouldn't
start too early: "The longer they check, the hotter they become, the more they are willing
to pay"! Founders should not attempt to play off investors against each other, as the various
private equity players in any one country usually know each other personally.
• Consultants: The advisability of calling in legal and tax consultants to conduct contract
negotiations is self-evident. Any money saved by not doing so may well be completely negated
by consequent losses or expenses incurred at the exit stage.

MORE INFO
Websites:
African Venture Capital Association: www.avcanet.com
Association Frangaise des Investisseurs en Capital (France): www.afic.asso.fr
Australian Private Equity and Venture Capital Association: www.avcal.com.au
British Private Equity and Venture Capital Association: www.bvca.co.uk
China Venture Capital Association: www.cvca.com.hk
European Private Equity and Venture Capital Association: www.evca.eu
German Private Equity and Venture Capital Association: www.bvkap.de
Indian Venture Capital Association: www.indiavca.org ^Q
I
National Venture Capital Association (US): www.nvca.org TJ

127
Assessing Venture Capital Funding for
Small and Medium-Sized Enterprises
by Alain Fayolle and Joseph LiPuma P

EXECUTIVE SUMMARY
• Entrepreneurs and small and medium-sized enterprise (SME) managers capitalize their firms
with debt equity investments, or a combination of both.
• Equity investments such as venture capital can erode executive control but can enable access to
the investor's knowledge, advice, and networks.
• Venture capital can be provided by business angels, independent venture capital firms (IVCs1),
corporations, or universities.
• The sources' differing investment objectives, backgrounds, and control mechanisms deliver
3
varying levels of added value to the SME.
• Companies seeking venture capital should select investors whose objectives, potential to add
value, and expectations of control mesh most closely with those of the entrepreneur.

INTRODUCTION value-adding resources, comprising the human

Entrepreneurs and SME managers face two capital (knowledge and experience) and social
key choices when financing their ventures: debt capital (network) of the venture capitalist—who
or equity. Debt in the form of personal loans oversees the investment—in addition to the
(including credit cards) and bank loans, key financial capital. The value and productivity
sources for most nascent ventures, gives efficient of these nonfinancial aspects of VC can be
incentives for managers to exert effort and significant, influencing a venture's offering,
allow entrepreneurs to maintain control. The geographic diversity, and growth. Venture
availability and utility of debt vary significantly capitalists can help to professionalize a new
with economic conditions, which, in turn, will venture through representation on the board
have an impact on the supply and cost of capital. of directors, executive recruiting, or by exerting
To a lesser extent, entrepreneurs rely on equity rights of control (over, for example, cash flow
financing,2 in which parties external to a venture and liquidation) in exchange for6
capital. Despite
obtain partial ownership (and control) in exchange modest levels of investment, venture capital-
7
for financial capital, thus diluting managers' backed companies accounted for over ten
incentives to expend effort. Equity financing is million jobs and $1.8 trillion in revenue in the
8
particularly important for high-growth ventures, United States in 2003 —approximately one-
since the amount of debt financing available may sixth of GDP.
not permit sufficiently rapid growth in volatile Venture capital can come from business
industries (for example, technology). Objectives angels, independent VC firms (IVCs),
and incentives that are well aligned between corporate venture capital (CVC) programs, and
investor and manager are the most efficient and universities. The different ways in which these
facilitate additional value for the venture. are funded, investments are managed, and
partners are compensated (see Table 19) result
in varying allocations of control rights between
VENTURE CAPITAL the investor and the venture. Angel investors,
Venture capital (VC) refers to independently for example, rarely require representation
managed, dedicated pools of capital which the on corporate boards, whereas IVCs generally
providers channel into equity or equity-linked do seek directorships. Investment objectives
investments in privately held, high-growth influence the nature of companies in which VCs O
companies.3 Worldwide, more than $30 billion invest and, correspondingly, the value they are •—-1

is invested annually as venture capital,4 with the able to add. Independent VC firms invest solely
most intensive use in the United States, Europe, for financial reasons and may best add value to
and Israel (with $28 billion, $6 billion, and $.7 SMEs by helping them to recruit key executives
billion invested respectively in 2007).5 Venture or access additional capital. Corporations that
z
capital represents a bundle of productive, provide CVC often invest for strategic reasons, o
129
 Financing and Raising Capital
frequently in ventures with complementary
offerings. These corporations are generally
multinational, enabling them to add more
cd value in the development of foreign networks
u
PL. of customers, suppliers, and partners. However,
CVC investors generally do not invest in early-
stage ventures, usually waiting until an IVC
invests before committing their resources.
C Table 1. Characteristics of the different providers of venture capital
s
CO Typical background
Angel
Ex-entrepreneur
I Motivation Financial and
"giving back"
I
Fund source Self
Investment method Direct
General partner Gain from exit or
compensation early buyout
Average invested per -$10,000°
venture
a Allen, Kathleen A. Launching New Ventures: An Entrepreneurial Approach. Boston, MA: Houghton Mifflin Company, 2 0 0 6 .
b PricewaterhouseCoopers/National Venture Capital Association. "MoneyTree™ report." Data: Thomson Reuters,
c Ibid.
d Miles, Morgan P., John B. White, and Eve White. "University sponsored venture capital: An exploratory study." Journal of
Business and Entrepreneurship 13:1 (2001): 129-134.
SELECTING THE RIGHT TYPE OF VC
Though only a small percentage of companies
receive venture capital,10 those that do can
usually choose its source and should therefore
select investors whose objectives, added-value
potential, and expectations of control are most
in accord with those of the business owner. Since
the process of pitching ventures to investors
and negotiating terms can be time-consuming,
especially for SMEs and young ventures, it is
crucial to establish your objectives and target
VC sources early on. This may also help to avoid
later contract issues, optimize venture capitalist
contributions, and increase the venture's value.
Questions to consider are:
What stage are we at? At the seed or startup
stage, angel financing is best because it comes
with fewer strings attached and is easier to "buy
out." Angel investors are good stewards and
u may take active, informal roles in the company.
Corporations generally do not invest at early
stages, so IVC is most likely at the next stage,
with CVC most used in expansion stages.
How big a VC provider do you need? While
this answer often depends on capital needs,
prestigious or "big name" IVC providers bring
130
broad and helpful networks, in addition to
status, that can help when exiting via a public
offering or acquisition. However, prominent
VCs often require more control over cash flow,
voting, board representation, and liquidation.
Such rights are often contingent on observable
performance measures. If the venture does
badly, VCs obtain more control, whereas if the
IVC
Ex-entrepreneur or
CVC
Large, tech-savvy
UVC
Patent holder
financial
Financial
multinational
Strategic and
financial
Commercialize
patents
Limited partners Corporate University,
government
Direct Direct and indirect Direct and indirect
Percentage of Salary plus bonus Salary plus bonus
valuation increase
~$8 million 0 ~$4.5 million 0 <$250,000 d
venture does well, VCs relinquish most control
and liquidation rights.
Do I need a specialized VC provider with
specific industry knowledge and contacts?
Industry specialization helps VCfirmsto develop
skills for vetting and selecting investments, and
for developing relevant industry knowledge and
networks. Generalist firms are able to thrive and
grow as industries evolve and ebb, and they have
cross-industry experience and networks that
may benefit nascent ventures.
How much capital do we need, and what do
we need the funds for? If funds are needed for
initial technology development, CVC, with the
associated corporate technology knowledge, may
provide access to technical skills. In addition to
supplying capital of their own, IVCs are good at
helping companies in which they invest to obtain
access to other funds because of their legitimacy
and the networks they have.
Are we planning to enter foreign markets?
The VC industry is globalizing,11 and since VC
providers tend to invest in ventures that are
geographically proximate, there is limited foreign
investment. In addition, some VC providers
tend to eschew investments in internationalized
 Assessing Venture Capital Funding for SMEs

ventures, since they cannot easily monitor their of detailed information about development M
activities. CVC associated with a multinational projects, product specifications, and marketing ft
enterprise may provide foreign market plans. Corporations often invest for strategic 2+
knowledge and assist in market penetration, and reasons based on industry or market congruity H5J
permit access to foreign customers, suppliers, with new ventures. Such congruity suggests 3
and partners who can help to monitor the that the investor could easily appropriate the ft
internationalized venture. intellectual property of the SME. Research g»
How vulnerable is my intellectual property? suggests that receiving investments from ($
Working with a VC provider requires an exchange multiple corporations may limit that risk. •
w
CASE STUDY
.g5
Tessera Enterprise Systems ^\
Tessera Enterprise Systems, a custom software developer, was founded in Boston in 1995 by 3
an executive team that had previously worked together for three years. Tessera's target market Jg
included some of the largest American retail and financial companies, such as Eddie Bauer and a
Charles Schwab. The founders provided initial funding for the venture, but after one year it was R
decided that venture capital was required to expand the company. Tessera, however, secured an 3
investment offer from Greylock Management, a prominent Boston-based IVC. Greylock's status {5
Pt
added legitimacy to the fledgling venture, permitting it to obtain contracts with target companies
such as Charles Schwab, Eddie Bauer, and other prominent clients. Subsequent expansion and
third-stage funding from two other prominent IVCs solidified Tessera in the market and led
to a corporate expansion to San Francisco. At the same time, Tessera considered establishing
an office in Switzerland to serve potential European clients. One of the VC providers likened
internationalization to loading an airplane with stacks of cash and opening the doors while flying
over the Atlantic.
Tessera nevertheless pursued its foreign market entry strategy and, while it slowly obtained
some European contracts, it did so without the involvement or aid of its IVC investors. Had
Tessera sought investment from a technology corporation such as Oracle (on whose products its
offerings were often based), it might have been better able to leverage its investor's networks and
knowledge to the benefit of its foreign business. A modest capital round was provided by IVCs and
a private investor in preparation for an exit. Tessera, originally planning on a public offering and
broad foreign expansion, was acquired in 2001 by iXL, an Atlanta-based internet services provider
company with offices in San Francisco and London.

MAKING IT HAPPEN
Since VC has the potential to change the nature of resources in an SME so dramatically,
entrepreneurs must approach it with a strategic view of how it may best add value, and source it
accordingly. At the same time as they assess their financial capital needs, SME managers should
do the following:
• Carefully consider the type of advice, information, and network access you want from an
investor in the light of current needs and strategic direction.
• Identify VC providers that have great reputations for providing value in a manner consistent with
your willingness to cede some control.
• Ask others who have undertaken VC-backed ventures about their experience with investors—
both IVC and CVC—and the success and problems they encountered.
• Identify companies that had exits—IPOs and acquisitions—most consistent with your goals and rO
ask about their investors. T1

131
 Financing and Raising Capital

^ CONCLUSION the growth and development of such ventures

•£ SMEs and young ventures that receive capital demands that entrepreneurs and SME managers
0* investments can often choose their source, make their choice in a considered manner that
i* The boundary-spanning role of investors, as is consistent with their overall strategy. Careful
+J both advisers and links to external networks, consideration of investor types can lead to an
<y places VCs in a unique position t o add value to efficient selection process that provides value
PQ a venture. T h e potential for investors t o aid in throughout t h e life of t h e venture.
•
fi
g MORE INFO
£ Books:
K Gompers, Paul A., and Josh Lerner. The Venture Capital Cycle. Cambridge, MA: MIT Press, 1999.
>• Maula, M., and G. C. Murray. "Corporate venture capital and the creation of US public companies:
fl The impact of sources of venture capital on the performance of portfolio companies." In Michael
^ A. Hitt, Raphael Amit, Charles E. Lucier, and Robert D. Nixon (eds). Creating Value: Winners in
£ the New Business Environment. Oxford: Blackwell Publishing, 2002.
13, McNally, Kevin. Corporate Venture Capital: Bridging the Equity Gap in the Small Business Sector.
London: Routledge, 1997.
Articles:
Maula, Markku V. J., Erkko Autio, and Gordon C. Murray. "Corporate venture capitalists
and independent venture capitalists: What do they know, who do they know and should
entrepreneurs care?" Venture Capital 7:1 (January 2005): 3-21. Online at:
dx.doi.org/10.1080/1369106042000316332
Sapienza, Harry J., Allen C. Amason, and Sophie Manigart. "The level and nature of venture
capitalist involvement in their portfolio companies: A study of three European countries."
Managerial Finance 20:1 (1994): 3-17. Online at: dx.doi.org/10.1108/eb018456
Smith, Gordon. "How early stage entrepreneurs evaluate venture capitalists." Journal of Private
Equity 4:2 (Spring 2001): 33-45. Online at: dx.doi.org/10.3905/jpe.2001.319981
Van Osnabrugge, Mark, and Robert J. Robinson. "The influence of a venture capitalist's source of
funds." Venture Capital 3:1 (January 2001): 25-39. Online at:
dx.doi.org/10.1080/13691060117288
Websites:
National Venture Capital Association (NVCA): www.nvca.org
European Private Equity and Venture Capital Association (EVCA): www.evca.eu

u
z
t
a
132
 Assessing Venture Capital Funding for SMEs
NOTES
1 We wish to emphasize that the acronym "IVC" here
refers to formal venture capital investments by
independent firms specialized for this purpose. Other
literature uses "IVC" to refer to informal venture
capital investments.
2 For example, in the United States fewer than 7 % of
companies obtain outside equity financing, whereas
4 5 % take on outside debt (Robb, Alicia, and David
T. Robinson. "The capital structure decisions of
new firms: Second in a series of reports using data
from the Kauffman firm survey." Kansas City, MO:
Kauffman Foundation, 2008). New Zealand
businesses are almost six times more likely to seek
additional debt financing than equity financing
(www.stats.govt.nz), whereas nearly 20 times more
Canadian companies sought debt financing than
equity financing (www.sme-fdi.gc.ca).
3 Gompers and Lerner (1999).
4 Ernst & Young. "Transition: Global venture capital
insights report 2006."
5 PricewaterhouseCoopers/National Venture Capital
Association. "MoneyTree™ report." Online at:
www.pwcmoneytree.com/MTPublic/ns/index.jsp.
Data: Thomas Reuters (accessed March 5, 2009);
www.evca.com; and www.investinisrael.gov.il
respectively.
6 From 1999 to 2002, less than 0.5% of GDP was
en
W
!.
invested via venture capital in the United States
(OECD report).
7 This includes those that are now public companies,
such as Intel, Microsoft, eBay, and Home Depot.
8 Global Insight. "Venture impact 2004: Venture capital
benefits to the U.S. economy." June 2004. Online
at: www.ihsglobalinsight.com/publicDownload/
genericContent/07-20-04_fullstudy.pdf
9 Note that this table is based on examples from the
United States. In Europe, for example, research
institutes often take the place of universities in
conducting research and formulating approaches to the
commercialization of intellectual property.
10 For example, in the United States fewer than 0 . 1 %
of all companies founded in the 1990s received
venture capital (authors' analysis of US data from the
NVCA). In Europe, the probability of receiving VC is
approximately 0.07% (Achtmann, Eric. "Getting a view
o
of VC in Europe...from the centre." 4th Annual MIT
VCPI Conference, Cambridge, MA, December 1, 2001).
11 See, for example: Hall, G., and C. Tu. "Venture
capitalists and the decision to invest overseas."
Venture Capital 5:2 (2003): 1 8 1 - 1 9 0 ; and Manigart,
S., e r a / . "Human capital and the internationalization of
venture capital firms." International
and Management Journal 3:1 (2007): 1-125.
Entrepreneurship
o
133
Price Discovery in IPOs by Jos van Bommel w
n

EXECUTIVE SUMMARY
• When a company goes public, the issuer's intermediating investment bank (aka the underwriter,
bookrunner, or lead manager) expends efforts and resources to discover the price at which the a
firm's shares can be sold. o
• Buy-side clients also expend effort and resources to value the firm. The market price will be a
weighted average of the many resulting value estimates.
• To discover the price at which the issue can be sold, the issuer helps buy-side clients with their •§
analysis by providing a prospectus and meeting with their analysts during road show meetings.
• To extract newly produced information from the market, the issuing team asks selected buy-side
clients for their indications of their interest. 3
• Investment banks compensate buy-side clients for their costly analysis by setting the price at a <
discount from the expected market price.
• In addition, investment banks allocate more shares to those buy-side clients who are more
helpful in the price discovery exercise. Because of the repeated interaction between banks and
their clients, free riding is curtailed, and price discovery is optimized. p

PRICE DISCOVERY advantage in their dealings with the issuer: If they

The most important, yet most difficult, part of
the initial public offering (IPO) process is setting
the offer price. In an IPO, the issuer, aided by an
intermediating investment bank, plans to sell a
relatively large number of shares of common
stock in which there is at that point no market.
However, they know that soon after the IPO
process the secondary market will impute all the
information in the market in an efficient manner.
Investors who believe the price to be too high will
sell; investors who believe the price to be too low
will buy. The key outcome of this competitive
trading is the market price of the stock.
Naturally, the issuing team (the issuer and its
investment bank would like to know the market
price in advance. If they had a crystal ball, they
would set the price at a small discount (say 3%)
to the future market price, so as to generate
sufficient interest from buy-side clients, and
place the issue. In fact this is exactly what issuers
do when they sell securities which already have
a market price. Unfortunately, there is no
secondary market for IPO shares, and neither
are there crystal balls.
To estimate the market price as best as they
can, issuers and their advisers conduct a costly
analysis to estimate the value of the firm. We call
this process price discovery.
Note that not only do the issuer and its
investment bank analyze the firm. Prospective
investors also conduct costly analysis to predict the
future market price. Naturally, a good estimate of
the future market price gives them a substantial
have strong indications that the offer price is set
too high, they stay away from the offering. If they
believe the price to be below the future market
price, they sign up for IPO shares enthusiastically.
ENTERPRISE VALUATION
There are two main methods to estimate the
market value of the firm: multiple analysis, and
discounted cash flow (DCF) analysis.
Multiple Analysis
When employing the multiple method, analysts
gather performance measures of the firm. A
popular measure is earnings or net income.
They multiply these performance measures with
multiples. The appropriate multiple for a firm's
earnings is the price-earnings ratio, or P/E.
The multiples are obtained from similar firms,
(so-called proxies, or pure-plays). For example,
if listed paper manufacturers trade at an average
P/E of 9, and we want to estimate the value of an
unlisted paper company that recently reported a
net income of $1 million, we would estimate the
market price to be $9 million. Because this single
estimate is bound to be imprecise, analysts collect
many performance measures so as to get many
estimates. Popular accounting performance
measures are earnings, sales, operating income
o
(EBIT), and cash flow (EBITDA). Apart from
these, analysts use industry-specific performance
measures such as passenger miles (for airlines),
overnight stays (for hotels), or page visits (for
internet companies). By employing more and
o

135
 Financing and Raising Capital
more multiples, analysts aim to arrive at an ever
more precise estimate of the market price.
Discounted Cash Flow Analysis
u A more fundamental valuation method is
PL. discounted cash flow analysis. In an efficient
+•»
as market, securities should be worth the present
value of the future cash payments that accrue to
M
the shareholders. Since cash today is always more
valuable than cash tomorrow, investors discount
projected future cash flows at the opportunity
I
CO
cost of capital. For example, if investors want to
value a one-year promissory note of $100, and
the one-year interest rate is 10%, they conclude
that the note is worth $100/1.10 = $90.91. If
C future cash flows are uncertain (risky), investors
use a higher discount rate (see p. 896 to see how
the discount rate depends on risk).
3 financial performance. In addition, they invite
Apart from deciding on an appropriate discount
rate, investment analysts forecast the company's
free cash flows, which are denned as the cash
generated by operations less the cash dedicated
to new investments. Often, young companies do
not distribute cash flows to their financiers, but
instead solicit cash from the financial markets.
In fact, this is an important reason for doing an
IPO in the first place. Naturally, the investments
are expected to add to the future cash flows.
Hence, analysts often predict negative free cash
flows early in life, but expect them to become
positive as the firm matures.
Forecasting a firm's free cashflowsis difficult.
To obtain reasonable conjectures, analysts
make a model to project the revenues, expenses,
and investments. Analysts' models can be very
sophisticated. They analyze the products or
services that the company provides, conduct
industry analysis to gauge where the company
stands vis-a-vis its competitors, consult market
forecasts (of the firm's products and production
costs), interview the firm's executives and other
employees (as far as this is allowed by the laws
that govern financial markets), and conduct
sensitivity analysis.
Whatever method investment analysts use
to estimate the market value of as yet untraded
securities, valuing financial securities is a task
that requires skill and effort.
ESTIMATES ARE OFTEN WRONG
U Being an investment analyst does not just require
hard work, it is also ariskyjob. After all, despite
our best efforts, estimates often turn out to be
t—(
wrong. That is the nature of estimates.
a
Each valuation is different. Analysts use
different multiples, different proxies, and give
136
different weights to individual multiple estimates.
DCF valuations are highly sensitive to the many
assumptions incorporated into a model, and to
the discount rate used to arrive at a present value.
Clearly, if we have many independent estimates,
the highest estimate is likely to be too high and
the lowest estimate is probably too low. If we
assume that the estimates are unbiased, the true
market value will lie somewhere in the middle.
Hence, there are two ways to engage in
price discovery. The first is to help analysts
to make more precise estimates. To do this,
the issuer and its intermediaries (investment
bank, auditor, legal advisers) provide buy-
side analysts with a detailed prospectus,
which explains the structure of the issue (for
example, how many shares are sold), describes
the company's business, and presents recent
analysts to information sessions on the firm's
products and managers. During such road-
show presentations, the company presents its
business plan, its managers, and its products to
prospective investors. An important part of the
road-show meetings is the question and answer
session, during which analysts can pepper the
issuing team with questions so as to fine-tune
their models and estimates.
The second way to improve the price discovery is
to involve more buy-side clients and more analysts.
A statistical property called the law of large
numbers says that if we have more estimates, the
average ofthese will be closer to the true value. The
problem, however, is that if we invite too many
prospective investors, it will adversely affect the
incentives to produce information.
SOUNDING OUT THE MARKET
When buy-side clients have done their analysis
and have become "informed," issuers will find
it easier to sell them their securities. However,
there are still important differences in opinion
among clients. Extracting these opinions is
not an easy task. Clearly, buy-side clients will
be reluctant to part with their hard-earned
information. Nevertheless, issuers can sound
out the market by individually targeting large
and well-informed buy-side clients. They do
this by ringing them up, and asking them for
their opinions and indications of interest. The
investment bank writes down indicative orders
in a book of orders. This exercise is called book-
building. Indicative orders can take three main
forms. First there are strike orders, which
indicate a demand that is independent of the
price. Second, there are limit orders, such as "I
 Price Discovery in IPOs

sign up for 150,000 shares as long as the price
is not higher than $10." Finally, there are step
orders, which are combinations of several limit
orders. For example, "If the price is set at $9 or
below, we want 130,000 shares; if it is set at $10
or less, we want 80,000 shares; and if you set it
higher, we don't want any shares."
After one or two weeks of making phone calls,
the bookrunner will have compiled a book of
orders, which forms a downward sloping demand
curve (see Figure 1). Naturally, this demand
curve represents very valuable information for
the price discovery process.
to value IPO firms tend to be discounted more,
which is consistent with the "compensation for w
ft
analysis efforts" story. en
The promise of a discount can be made credible
because of the investment bank's reputation
and its repeated interaction with the market's
buy-side. For example, because Fidelity knows
that Goldman Sachs will price IPO shares at a
reasonable discount, they are willing to expend
effort to analyze the IPO firm.
The problem with setting the offer price at a
discount is that it attracts "free riders." It seems •8
that investors who simply signed up for all IPOs

Figure 1. Example of an order book. During book-building, the lead manager calls up
prospective buy-side clients and asks them for indicative orders. This results in an
aggregate demand curve. However, the bookrunner knows that not all indications of
I
on
interest are equally sincere, and he or she has to gauge what the real demand is—i.e.
the demand that is not due to strategic overbidding (due to anticipated rationing).
Notice that the real demand is invisible. Investment bankers use their experience and
I
3
judgment to estimate it

140
Book demand
Real demand

8.0 9.0 10.0 11.0 12.0

Offer price
SETTING THE PRICE
One would think that the issuing team can
now simply set the price so that demand
equals supply. If all orders were genuine, this
would be the optimal strategy. However, the
new shareholders would feel fooled if, after
expending significant efforts to analyze the firm,
they received no surplus in return. To reward
large and sophisticated buy-side clients for their
analysis of the firm, investment banks set the
offer price at a discountfromthe expected market
price. Historically, the average discount, which
translates into an average initial return (the
return from the offer price to the market price)
has been around 15%. Initial returns have been
extensively studied. Average discounts differ
between countries and time periods. All studies,
however, find that smaller and more difficult
would, on average, make a profit because of the
discount. For this reason, investment banks
only invite large and sophisticated investors to
submit orders in the book. From experience and
repeated interaction, investment bankers know
whose indicative orders are most informative.
Still, even among the invited bidders there is a
temptation to overbid. Because they know that the
shares will be set at a discount, buy-side clients
want to bid for as many shares as possible. In
other words, even the orders of the repeat clients
may not be entirely genuine. An important task
o
for the investment bank is to distinguish the real
demand from the book demand (Figure 1). They
can never do this perfectly, but, through skill and
judgment, experienced bookrunners can assess
the seriousness of book orders. So, after closing
O

137
 Financing and Raising Capital
the book, the issuer compiles the book demand
o curve, gauges where the real demand is, and
then sets the price at a small discount.
The price is set during the pricing meeting,
CM which typically takes place on the evening
before the actual floatation. During the pricing
meeting the issue is officially underwritten, so
M that the bookrunner becomes legally liable for
placing the shares. By scheduling this important
meeting shortly before the actual selling day, the
bookrunner reduces the risk of being stuck with
IPO shares on its books. In the example of Figure
£ l, the issuers may set the price at $9.50, so as to
1
place all the shares, and leave some money on
the table for the buy side analysts.
ALLOCATING THE SHARES
1
As mentioned, the IPO process is a repeated
game for buy-side clients and investment banks.
Both parties to the price discovery process
develop long-term relationships. Investment
bankers know which buy-side analysts provide
the most accurate indications of interest, and
reward them with higher allocations. One way
to gauge the quality of the buy-side analysts
is to monitor their order submission strategy
and their trading behavior after the IPO. Strike
orders may indicate poor analysis, while limit or
step orders are better signals for price discovery.
If a client often asks for large allocations, but
then quickly sells ("flips") its shares in the
secondary market, this is an indication of poor
analysis. Orders that are submitted in the early
stage of the book-building indicate confidence
and informed decision-making. Hence, it is not
surprising that we see that clients who put in
limit or step orders early, and do not flip their
shares in the secondary market, receive higher
allocations on average.
THE OVER-ALLOTMENT OPTION
Almost all IPOs have an over-allotment option,
also known as a greenshoe, named after the
company that first used this mechanism. The
over-allotment option gives the bookrunner the
right to buy a specified number of additional
shares from the issuer and seU them on to the
buy-side. Or, they have the right to over-allocate.
Typically, the option is for 15% ofthe offering size.
In practice, the underwriter always over-allocates,
u so that after the offering the bank is technically
z
2
i—i
138
"short": they have sold shares they do not yet
own. The bookrunner will exercise the over-
allotment option if the price in secondary market
trading increases beyond the offering price, which
is usually the case. If, however, the price in the
secondary market comes under pressure (i.e.
there is a lot of flipping), the underwriter buys
back the shares in the open market.
This is sometimes referred to as price support
or price stabilization. The over-allotment option
is therefore a clever way to adjust the supply
of shares to the uncertain demand for shares.
By keeping track of flippers, bookrunners can
monitor buy-side clients and gauge their quality
for the price discovery process.
BOOK-BUILDING VERSUS AUCTIONS
The book-building mechanism has become the
standard way of selling shares in initial public
offerings. The characteristic difference from
other IPO mechanisms is the close and personal
interaction between relatively few players
on both sides of the transaction. These cozy
relationships, and the subsequent preferential
allocations, sometimes make small investors,
issuers, and regulators uneasy about the book-
building mechanism. Naturally there is the
chance that investment banks and buy-side
clients collude to set the offer price low and
share the profits of large initial returns. Although
there certainly have been instances of doubtful
allocations of conspicuously underpriced shares,
the book-building mechanism has survived and
is widely accepted. The key advantage is that it
results in more information production.
An obvious alternative to book-building is the
auction. Due to its fair and transparent nature,
the auction mechanism has been used in several
countries, including the United Kingdom,
Denmark, and France. However, evidence
shows that they are less effective in achieving a
high price and a liquid aftermarket. Empirical
studies have found that book-built IPOs have, on
average, lower initial returns, especially if they
were floated by prestigious investment banks.
The Google IPO and a stylized example (see
Case Studies) further illustrate how targeted
information exchange between relatively few
informed players may be more effective for price
discovery than an impersonal auction.
 Price Discovery in IPOs

CASE STUDIES «
The Google IPO %
When Google went public in August 2004, it announced upfront that the price would be determined hj
by a competitive Dutch auction in which everybody could participate on equal terms. Large and 3
small investors were invited to submit their limit and step orders through the internet. The price ft
would be set at the point where the 19.6 million shares could be sold. Large institutional investors *••
openly grumbled and complained about the "cheap" way in which Google was selling its shares, O
saying that they would not bother to get out of bed for an auction. •
The result was that, due to the lack of a targeted information exchange, the market price was
not fully discovered. The auctioneers set the offer price at $85. When secondary market trading
began, the price shot to above $100 within days, and above $200 within months, which suggested
•g
that Google did not get the full value for its shares. Many industry watchers (and the author of this ^
article) believe that if Google had opted for a standard book building method, its shares may have S*
fetched a higher price in the primary market. ^

I
Illustration of Targeted Information Exchange 2,
Imagine that you receive a surprise inheritance from a distant uncle. The inheritance is a trunk
full of foreign coins. Most are post-war coins from various countries, but your seven-year-old son ft
has spotted some gold, silver, and very ancient coins. You are not much of a coin collector and are £+
strapped for cash, so you decide to sell the coins. To do this you go to a coin collectors' fair. At the
fair there is an auction session where you can put your coins up for sale. Alternatively, you can
approach the three largest collectors, let each have a close look at your collection, explain your
situation, and ask them for their offer. If your collection is difficult to value (as a company is), the
second route may well get you a higher price.

MORE INFO
Books:
Draho, Jason. The IPO Decision: Why and How Companies Go Public. Cheltenham, UK: Edward
Elgar Publishing, 2006.
Gregoriou, Greg N. Initial Public Offerings: An International Perspective. Oxford: Butterworth-
Heinemann, 2006.
Article:
Benveniste, Lawrence M., and Walid Y. Busaba. "Bookbuilding versus fixed price: An analysis of
competing strategies for marketing IPOs." Journal of Financial and Quantitative Analysis 32:4
(1997): 383-403. Online at: dx.doi.org/10.2307/2331230
Websites:
IPO Financial Network (IPOfn) news, analysis, and resources: www.ipofinancial.com
IPO Monitor—Coverage of IPOs and secondary equity offerings: www.ipomonitor.com
IPO Renaissance Capital—research and investment management services on newly public
companies: www.ipohome.com

o
(71

139
How to Set the Hurdle Rate for Capital
en
Investments by Jon Tucker
EXECUTIVE SUMMARY
• There exists a wide range of approaches to setting the hurdle rate for capital investments.
• It is essential that we do not set the hurdle rate too high, thereby foregoing valuable investment
opportunities, or too low, thereby destroying value for shareholders. w
• While academics tend to advocate a series of, at times, complex adjustments, most CFOs settle
for a relatively simple approach, and allow for complexity instead in their cash flow projections.
• The most common approach is to employ a CAPM-based equity cost as an input to a WACC
t
calculation.
• A company-wide hurdle rate is typically employed by companies, although adjustments are
made for projects of atypical risk.
I
(ft

to arriving at the hurdle rate—even academics

PRICE DISCOVERY
Chief financial officers are charged with the
task of maximizing shareholder wealth. They
do this by pursuing two key goals: Maximizing
the stream of future cash flows, and minimizing
the company's cost of capital. Cognizant of the
separation theorem, we tend to separate one goal
from the other. However, both are of strategic
importance—a healthy stream of cash flows
can actually destroy value (and hence reduce
shareholder wealth) if the company suffers
from a high cost of capital. In a very real sense,
then, a company's cost of capital represents
an important "hurdle," which its portfolio of
projects must exceed in order to create wealth
for shareholders. Clearly, the cost of capital, as
implied by the company's financing mix, is a good
starting point when arriving at the hurdle rate for
capital investment appraisal (capital budgeting),
but the way in which the company arrives at
this cost of capital, and the adjustments made
thereafter to arrive at the hurdle rate, warrant
further explanation.
HURDLE RATE: A DEFINITION
The hurdle rate is the required rate of return
on investment appraisal, above which an
investment project is worth pursuing. We
know when computing a project's net present
value (NPV) that if the discount rate exceeds
the project's internal rate of return (IRR), then
we should not proceed with the project. The
starting point for the hurdle rate is, then, the
company's cost of capital, to which a company
?
a
cannot agree on the best way forward.
Some examples of the difficulties involved are:
3
How do we arrive at the cost of equity capital?
How do we arrive at the cost of debt and other
financing components? Do we employ the
weighted average cost of capital (WACC), or some
other metric, to arrive at the cost of capital? If we
do employ the WACC, how do we weight the cost
of each financing component? What additional
adjustment do we make for risk? We will tackle
each of these issues in turn, and explore the broad
alternative approaches available to the CFO.
THE COST OF EQUITY
There are a variety of ways in which CFOs tend
to compute the cost of equity capital. The most
prominent and widely employed approach
is the capital asset pricing model (CAPM):1
where:
re = the expected cost of equity capital for a
company;
v. = the risk-free rate of return;
p = the share beta;
rm = the return on the market portfolio;
rm - r,= the expected premium offered by the
market portfolio over and above the risk-free
rate.
However, we encounter a number of difficulties o
with this approach in a practical setting. Which
risk-free rate should be employed—a three-month i—i

may then decide to make some adjustment for

that project's specific risk, perhaps adding a
Treasury bill rate, or a long-term government
bond rate? Most academics would suggest the I
risk premium. The difficulty for practitioners is
that there exists a wide variation of approaches
latter, although in practice, the three-month rate
is often employed. Should CFOs compute their n
141
 Financing and Raising Capital
own beta coefficient, or employ a beta computed
by data agencies such as Bloomberg? This is a
matter of personal choice, although in practice
most companies probably employ an externally
u published source. What equity risk premium
should be employed, and is it realistic in terms
of expectations? We could apply an average
historical risk premium here, or even estimate
the rate implied by current asset prices. Further,
if we compute our own average historical
premium figure, then applying the geometric
I average premium is probably the best approach.
Each of these issues could warrant a chapter to
itself—in the real world, CFOs arrive at a CAPM-
based equity cost of capital after much debate
c within the company, and consultation with their
external corporate advisers (such as investment
banks). Academics have extended the CAPM to a
multi-factor framework to better capture equity
risk, adding size and book-to-market factors,
although in practice it is unlikely that companies
employ such models extensively.
An alternative approach is to employ an earnings
model to arrive at the cost of equity capital, that
is, to compute the price-to-earnings (PE) ratio (or
earnings yield) for a company. This is a relatively
simple procedure, given the wide availability of
PE ratios, and the broad understanding and use
of asset yields in the financial media, although it
is most appropriately employed for non-growth
companies. The cost of equity, then, is equal to
the inverse of the PE ratio:
where:
r, = the company's cost of equity capital;
E = the company's earnings;
P = the company's share price.
A further alternative is to arrive at the cost
of equity capital by means of a simple dividend
model. When we rearrange the dividend model,
the cost of equity capital equals the expected
dividend yield (DJP^ plus the constant
compound growth rate of dividends, the latter
often based on past trends as a proxy for growth
expectations:
u where:
Z re = the company's cost of equity capital;
Dt = the dividend in year 1;
z
<
P = the company's share price in year o;
g = the growth rate of dividends.
til In the real world, CFOs should probably
compute a cost of equity using all three
142
approaches, benchmark their rate with other
companies in their industry (which are likely to
have similar betas, business models, and enjoy
similar access to financial markets), and only
then settle on a suitable figure. In the case of
pure equity-financed companies, the cost of
equity capital is, by definition, the pivotal figure
in arriving at the hurdle rate.
THE COST OF DEBT
A minority of companies set their overall cost
of capital at the cost of debt. However, even the
cost of debt presents a number of interesting
issues to the CFO. First, do we employ the
historical cost of debt, or the more meaningful
expected cost of debt? Do we look at the cost of
total debt, thereby including the cost of short-
term debt, or do we focus upon the cost of
long-term debt? Regardless of these variations,
we certainly need to take into account the tax
advantage to debt arising from the deductibility
of debt interest payments (whereas equity enjoys
no such advantage). Even here, we face an added
complication—do we apply a tax advantage based
upon statutory corporate tax rates, or marginal
rates? Many CFOs will, in practice, employ a
long-term debt rate, expressed after tax, based
on the marginal corporate tax rate. Further,
for the purposes of economic consistency,
debt should also include lease obligations. If
a company is bond-financed, and there is an
active market for those bonds, then the yield
to maturity is the appropriate rate, whereas
with non-traded debt (such as bank loans)
the stated interest rate is the appropriate rate.
THE WEIGHTED AVERAGE COST OF
CAPITAL
The WACC is simply the average discount
rate applied by the debt-holders and equity-
holders of the company to its future cash
flows. Discounting the stream of a project's
future cash flows by the WACC gives us the
capitalized value of that project, whereas so
doing for the company's total cash flows gives
us the capitalized value of the entire company.
We compute the WACC as follows:
where:
WACC = the weighted average cost of capital;
D = the market value of debt;
E = the market value of equity;
rd = the company's cost of debt capital;
re = the company's cost of equity capital;
T = the corporate tax rate.
 How to Set the Hurdle Rate for Capital Investments
The WACC for a company, then, is simply the
cost of the company's financing components
(rd and r,), weighted by the proportion of those
components in the company's capital structure
(£>/(£> + E) and E/(D + E), respectively). We
can easily extend this expression for additional
forms of financing by weighting them by their
proportion in the company's capital structure.
The correct approach to weighting here is to
compute the market value of each component
as a proportion of the total market value of all
claims against the company. Note that the cost
of debt is effectively reduced by virtue of the
fact that there is a tax advantage to debt, as
discussed earlier, hence the cost is not rd but
rd (1 - T). This merely reflects the calculation
of the corporate tax liability after debt interest
costs have been deducted. Employing the WACC
as the basis for the hurdle rate makes intuitive
sense, as the company must ensure that it is
exceeding, on average, the average rate of return
required by all of its claimholders. If it is not,
then it is destroying value for shareholders.
DEALING WITH RISK
As a general rule, the company should consider
investing in projects that generate returns
which are higher than the company's hurdle
rate. Further, the hurdle rate should be higher
for riskier projects than for safer projects.
How do we adjust for risk then? We could
adjust the hurdle rate for numerous project
characteristics, including: The size of the project,
the division within which the project is located,
whether the project will be at home or overseas,
whether the project is new or existing, and so on.
The simplest approach is to apply a company-
wide cost of capital as the hurdle rate. The
dangers of this approach, however, are that the
project under consideration may be more or less
risky than the "average" risk of the company's
portfolio of investment projects. Large projects
are often scrutinized more carefully than smaller
projects, given their more material impact on
the company's cash flows, and a premium for
risk is added to the cost of capital figure to arrive
at an appropriate hurdle rate. Most companies
add a premium over and above the domestic
project hurdle rate for foreign investments. New
projects are more risky than existing projects,
and should therefore reflect a premium over and
above the observed earnings yield of an existing
project investment. Ventures such as mergers
are more risky still, and thus their returns should
exceed a much higher hurdle rate before being
sanctioned. Some companies employ a sliding
scale of discount rates, depending on a project's
w
nature—discount rates increase as we move
from equipment upgrading, through expansion
of existing business lines, through new project
p
a
investments, to more speculative projects.2
In the real world, some practitioners argue
that we cannot expect the hurdle rate to "take
all of the strain" when adjusting for risk. n
1.
Instead, many argue that the project cash flows
themselves should be adjusted for risk to achieve
a more realistic estimation of a project's IRR or
NPV. Project risk will have a differential impact
on the range of cash inflows and outflows and,
%
therefore, a risk-adjusted hurdle rate does not
always adequately deal with risk—it can be
too blunt an instrument. A carefully computed
hurdle rate, in conjunction with risk-adjusted
1
cash flows, and a comprehensive scenario
analysis, might be the best way forward, taking
care not to double-count risk in the process.
However, presuming that we do indeed
employ a hurdle rate which captures risk in some
objective and appropriate manner, one way
of assuring a more robust approach to capital
investment appraisal is to accept only those
projects with the highest IRRs, that is, those that
exceed the hurdle rate by the highest margin.
This may be necessary for most companies
in the real world, anyway, in the presence of
limited investment funds, and capital rationing.
FREQUENCY OF REVISION
Given the real-world complexity and strategic
sensitivity of the hurdle rate figure, it is likely
that most companies do not revise the rate on
a very frequent basis, often maintaining the
same figure for months, or even as long as a
year. Events which may encourage CFOs to take
another look at the company-wide hurdle rate
might include changes in the returns required
by investors (such as interest-rate changes),
the consideration of major projects, and the
prospect of corporate restructuring. Major
corporate restructuring has an impact not only
on the profile of future cash flows, but also on
the returns required by both existing and new
claimholders in relation to those cash flows. o•n
Given the strategic importance of the hurdle rate, »—<
it is typically decided at the level of the board of
directors, who take the advice of the CFO, and his/
her advisers (consultants, bankers, and so on).
O
143
 Financing and Raising Capital

CASE STUDY
Determining the Hurdle Rate for a Food Retailer
03
s- Company X pic is a FTSE 100 food and drug retailer, listed on the UK stock exchange. The market
value of its capital structure components is £12 billion for equity, and £8 billion for debt. The B
computed by a reputable data agency is 0.9. The UK 3-month Treasury bill rate is 4.5%, and
you estimate that the market tends to pay a premium over and above this rate, of 4.7%. The UK
corporate tax rate is 30%, and the rate paid by the company on its 10-year bonds is 5.5%.
We start by computing X pic's cost of equity capital:
C
r
e = r, + P ( r m " rr)
= 4.5% + 0.9 (4.7%)

1
= 8.73%

We then compute the proportions of debt and equity in the company's capital structure:

D -r (D + E) = 40%
and
E -f (D + E) = 60%
We can then compute its weighted average cost of capital:

WACC = D -r (D + E) x rd (1 - Te) + E -r (D + E) x re
= 40% x 5.5% x (1 - 0.30) + 60% x 8.73%
= 6.78%

Company X pic applies a hurdle rate of 6.78% to projects of average risk, but adds a margin
for projects of higher risk such as an investment in a new product line (+5%) or a company
acquisition (+10%).

CONCLUSION
In the real world, most practitioners have little
appetite for adjusting the hurdle rate for the
multitude of factors advocated so fervently by
academics. Excepting the all-equity financed
case, company CFOs should typically pursue a
CAPM-based weighted average cost of capital,
and then make sensible and consistent risk
adjustments to determine project hurdle rates.
All capital structure components should be
expressed at market values, and all costs should
be forward looking. A company-wide hurdle
rate is probably adequate for many investment
projects, although the figure should always be
reviewed when dealing with more material,
large-scale projects, or indeed corporate
restructuring.

MORE INFO
Books:
Bierman, Harold, Jr., and Seymour Smidt. The Capital Budgeting Decision: Economic Analysis of
Investment Projects. 9th ed. New York: Routledge, 2006.

Articles:
u Bruner, Robert R, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins. "Best practices
z in estimating the cost of capital: Survey and synthesis." Financial Practice and Education 8:1

t
(Spring/Summer 1998): 13-28.
McLaney, Edward, John Pointon, Melanie Thomas, and Jon Tucker. "Practitioners' perspectives on
I—H
the cost of capital." European Journal of Finance 10:2 (April 2004): 123-138. Online at:
dx.doi.org/10.1080/1351847032000137401
o
p-(

144
 How to Set the Hurdle Rate for Capital Investments

on

•8

3
ft

&
0

NOTES
1 See Sharpe, William F. "Capital asset prices: A theory (February 1965): 1 3 - 3 7 . Online at: www.jstor.org/
of market equilibrium under conditions of risk." stable/1924119
Journal of Finance 19:3 (September 1964): 4 2 5 - 4 4 2 . 2 A useful discussion of the cost of capital, and how

z
Online at: www.jstor.org/stable/2977928; and Lintner, we deal with risk, can be found in Brealey, Richard
John. "The valuation of risk assets and the selection A., Stewart C. Myers, and Franklin Allen. Principles
of risk investments in stock portfolios and capital of Corporate Finance. New York: McGraw Hill/Irwin,
budgets." Review of Economics and Statistics 47:1 2008; 2 3 9 - 2 4 0 . o
145
Private Investments in Public Equity w
n
by William K. Sjostrom, Jr
P
EXECUTIVE SUMMARY
• A private investment in public equity (PIPE) is a type of public company financing transaction
a
o
that is prevalent in the United States.
• In a typical PIPE transaction, a public company privately issues common stock or securities W

1
convertible into common stock to a small number of sophisticated investors in exchange
for cash. The company then registers the resale of the common stock issued in the private
placement, or issued on conversion of the convertible securities issued in the private placement
(the PIPE shares), with the US Securities and Exchange Commission (SEC).
• Generally, investors must hold securities issued in a private placement for at least six months.
However, because the company registers the resale of the PIPE shares, investors are free to sell

I
them into the market as soon as the SEC declares the resale registration statement effective
(typically at most within a few months of the closing of the private placement).
• In 2009, companies closed on 1,072 PIPE deals in the United States, raising approximately
$36.7 billion in the aggregate.
• While companies of all sizes have used PIPEs to raise money, PIPE deals have emerged as a vital
source of financing for small public companies, with the overwhelming majority of deals being
completed by companies with market capitalizations of $250 million or less. This is driven by the
reality that PIPEs represent the only available financing option for many small public companies.

TYPES OF PIPE movements of the issuer's common stock. For

PIPE transactions are highly negotiable; hence,
there is a fair amount of variation from deal
to deal with respect to the attributes of the
PIPE securities. PIPE securities may consist
of common stock or securities convertible into
common stock, such as convertible preferred
stock or convertible notes, and may be coupled
with common stock warrants.
Regardless of the type of securities involved,
PIPE deals are categorized as either traditional
or structured. With a traditional PIPE, the
PIPE shares are issued at a price fixed on the
closing date of the private placement. This fixed
price is typically set at a discount to the trailing
average of the market price of the issuer's
common stock for some period of days prior to
closing of the private placement. As mentioned
above, securities regulations generally prohibit
investors from selling PIPE shares prior to the
SEC declaring the resale registration statement
effective. Thus, because the deal price is fixed,
investors in traditional PIPEs assume price risk,
which is the risk of future declines in the market
price of the issuer's common stock during the
pendency of the resale registration statement.
With a structured PIPE, the issuance price of
the PIPE shares is not fixed on the closing date
of the private placement. Instead, it adjusts
(often, downward only) based on future price
example, investors may be issued convertible
debt or preferred stock that is convertible into
common stock based on a floating or variable
conversion price, i.e., the conversion price
fluctuates with the market price of the issuer's
common stock. Hence, with a structured PIPE,
investors do not assume price risk during the
pendency of the resale registration statement.
If the market price declines, so too does the
conversion price, and therefore the PIPE
securities will be convertible into a greater
number of shares of common stock.
For example, say an investor purchases
a $1,000,000 convertible note in a PIPE
transaction, and the note provides that the
principal amount is convertible at the holder's
option into the issuer's common stock at a
conversion rate of 90% of the per share market
price of the stock on the date of conversion. Thus,
if the market price of the issuer's common stock
is $10 per share, the note is convertible at $9.00 a
share into 111,111 shares of common stock. If the
market price drops to $8 per share, the note is
then convertible at $7.20 per share into 138,889
o
shares of common stock. Regardless of how low
the price drops, on conversion the investor will
receive $1,000,000 of common stock based on
the discounted market price of the stock on the
day of conversion.
o

147
 Financing and Raising Capital
Some structured PIPEs do contain floors on how
low the conversion price can adjust downward,
or caps on how many shares can be issued on
conversion. If a structured PIPE has neither
u a floor nor a cap, it can potentially become
OH
convertible into a controlling stake of the PIPE
(A issuer. Continuing the example from above, if the
0)
market price dropped to $0.01, the note would
m then be convertible into more than 100 miUion
shares, which would constitute a controlling
stake unless the issuer had at least 200 million
s shares outstanding. Hence, structured PIPEs
lacking floors or caps are pejoratively labeled
1
"death spirals" or "toxic converts," because
investors in these deals may be tempted to push
down the issuer's stock price through short sales,
circulating false negative rumors, etc., so that
their structured PIPEs become convertible into a
controlling stake of the issuer.
REGISTRATION REQUIREMENT
The registration requirement of a PIPE
transaction can be either concurrent or trailing.
With a concurrent registration requirement,
investors commit to buy a specified dollar amount
of PIPE securities in the private placement, but
their obligations to fund are conditional on the
SEC indicating that it is prepared to declare
the resale registration statement effective. If
the SEC never gets to this point, the investors
do not have to go forward with the deal. Thus,
the issuer bears the registration risk; that is, the
risk that the SEC will refuse to declare the resale
registration statement effective.
With a trailing registration rights requirement,
the parties close on the private placement and
then the issuer files a registration statement.
Consequently, the investors bear the registration
risk. If the issuer never files, or the SEC never
declares the registration statement effective,
the investors will not be able to sell their PIPE
shares into the market for at least six months.
As a result, PIPE deals that include such trailing
registration requirements typically obligate the
issuer to file the registration statement within 30
days of the private placement closing date and
require that it be declared effective within 90 to
120 days of such date. If these deadlines are not
met, the issuer is obligated to pay the investors
u a penalty of 1% to 2% of the deal proceeds per
month until filing or effectiveness.
I
PIPE ISSUERS
As mentioned above, companies of all sizes have
»—I
used PIPEs to raise money. Larger companies
0* pursue PIPEs as a quicker and cheaper route to
148
funding than a registered public offering. The vast
majority of PIPE deals, however, are undertaken
by small public companies. These companies
generally pursue PIPEs not because they offer
advantages over otherfinancingalternatives, but
because the companies have no other financing
alternatives. By and large, PIPE issuers are not
only small in terms of market capitalization
but have weak cash flow and poorly performing
stocks. Thus, traditional forms of financing are
simply not an option. Few, if any, investment
bankingfirmsare willing to underwrite follow-on
offerings for small, distressed public companies.
Further, these companies lack the collateral and
financial performance to qualify for bank loans
and the upside potential to attract traditional
private equity financing.
Given the distressed status of PIPE issuers,
PIPEfinancingcan, of course, be very expensive.
Not only does the company typically issue
common stock or common stock equivalents
at a discount to market price, but PIPE deals
often involve other cash flow rights such as
dividends or interest (typically paid in kind not
cash) and warrants. For example, in August
of 2007, Callisto Pharmaceuticals, Inc., a
biopharmaceutical company located in New
York, raised $11.2 million in a PIPE financing
consisting of 1,124,550 shares of Series B
Convertible Preferred Stock, and 22,491,000
warrants. The conversion price of the Series
B Preferred Stock was set at a 23% discount to
Callisto's market price on the day prior to the
deal. This compares to a typical discount of 4%
for a traditional seasoned equity public offering.
INVESTORS IN PIPES
Hedge funds constitute a large percentage of
the investors in micro-cap PIPEs. Hedge funds
invest for the obvious reason: their returns
from PIPE investments meet or beat mark^
benchmarks. Hedge funds are able to
market-beating returns notwithste-
poor performance of PIPE issue-
relatively straightforward tradin-
sell short the issuer's common t»v
after the PIPE deal is publicly di&^
execute a short sale, a fund borrows su.
the PIPE issuer from a broker-dealer and se».
this borrowed stock into the market. The fund
then closes out or covers the short sale at a later
date by buying shares in the open market and
delivering them to the lender. By shorting stock
against the PIPE shares, the fund locks in the
PIPE deal purchase discount. With a traditional
PIPE, if the market price of the issuer's common
 Private Investments in Public Equity

stock drops below the discounted price following In addition to short selling, many hedge ^
a PIPE transaction, the fund will take a loss on funds retain up-side potential by negotiating for &
the PIPE shares, but this loss will be exceeded warrants as part of a PIPE transaction. Hedge %
by gains realized when it closes out its short funds typically hold on to these warrants even hj
position because it will be able to buy shares in after unwinding their PIPE shares positions J*
the market to cover the position at a lower price so that they can profit further in the event o
than it earlier sold the borrowed shares. If the the issuer's stock happens to rise above the M»
market price of the issuer's common stock rises warrant exercise price. In sum, hedge funds fp
after the PIPE transaction, the fund will take a are able to garner superior returns through •
loss when closing out the short position, because PIPE investments because they purchase the W
it will have to buy shares to cover the position at PIPE shares at a substantial discount to market, •§
a higher price than it earlier sold the borrowed manage their downside risk through short sales M.
shares. This loss, however, will be exceeded by and floating conversion prices, retain up-side ^
an increase in the value of the PIPE shares since potential through warrants, and liquidate their JH
they were purchased at a discount to the pre-rise positions a relatively short time after closing on ^
market price. the private placement. fp

I
MAKING IT HAPPEN £
• Explore other financing options first; PIPE financing is often very expensive, especially for
smaller public companies.
• Retain experienced PIPE counsel (see the league tables at www.sagientresearch.com PIPE
agents).
• Retain a PIPE agent to advise on deal structure and locate investors (see the league tables
mentioned above.
• If pursuing a structured PIPE deal, insist on a floor on how low the conversion price can adjust
downward, or a cap on how many shares can be issued on conversion.
• Consider restricting investors' ability to engage in short selling.
• Consider the amount of dilution existing investors will suffer as a result of the PIPE financing and
how to address their complaints.
• Make sure you consult your accountant because, depending on structure, the deal may produce
a noncash charge to earnings.

MORE INFO
Book:
Dresner, Steven, with E. Kurt Kim (eds). PIPES: A Guide to Private Investments in Public Equity.
Revised and updated ed. New York: Bloomberg Press, 2006.
Article:
Sjostrom, William K., Jr. "PIPEs." Entrepreneurial Business Law Journal 2:1 (2007): 381-413.
Online at: tinyurl.com/32m83e5 [PDF].

Websites:
The PIPEs Report—News, information, and analysis concerning PIPE deals:
pipes.dealflowmedia.com y<^
Sagient Research publishes data on PIPE deals: www.sagientresearch.com 'Sr
Sichenzia Ross Friedman Ference (SRFF), leading PIPE issuer legal counsel: www.srffllp.com HH

o
tn

149
Understanding Equity Capital in Small and w
en
Medium-Sized Enterprises by Siri Terjesen <•+

P
EXECUTIVE SUMMARY
• Equity capital or financing is funding raised by a business in exchange for a share of the
ownership.
• Equity financing enables firms to obtain money without incurring debt, or without needing to
repay a specific amount of money at a particular time.
w
• There are four stages of equity investment: seed, early-stage, expansion, and late-stage •3
financing.
• Equity capital sources differ in terms of timing, amount provided, type of firm funded, extent of
due diligence, contract type, expectations of timing and payback, and monitoring of business
decisions.

INTRODUCTION capital forces the entrepreneur to relinquish some

Entrepreneurs may require both debt and equity
financing, and often start theirfirmsby financing
growth through equity. Equity capital is money
invested in the venture with no legal obligation
on the entrepreneur to repay the principal
amount or to pay interest on it; however, it
requires sharing the ownership and profits with
the funding source, and possibly also paying
dividends to equity investors.
After value has been built, entrepreneurs may
consider debtfinancing,which involves a payback
of the funds (with interest) for use of the money.
In short, debt places a burden of repayment and
interest on the entrepreneur, whereas equity
3
degree of ownership and control.
The stages of equity financing are depicted
in Figure 1. In the first stage, known as the
seed stage, entrepreneurs tend to raise capital
from their own savings, though they may
also seek informal investment from family,
friends, business angels, and public sources.
Entrepreneurs may then choose to pursue formal
equity capital through rounds of early-stage,
expansion, and late-stagefinancing.This may be
followed by an initial public offering (IPO) and,
finally, raising of finance from public markets
and banks. Summary details of the financing
stages are as follows:

Figure 1. The stages of equity financing

Strategic
investors ^
Public
markets,
Mezzanine banks

Entrepreneur,
family, friends, 3rd round
% business
O angels, public
i_ sources
CD
Breakeven 2nd round
point .
o
yR round

\seedyS Early Exf.)ansion Late IPO

Finar icing sta

o

151
 Financing and Raising Capital
0) • Seed financing is the initial funding to develop
a business concept, for example by expenditure
on research, product development, and initial
cd marketing to reach early-adopter customers.
OH Companies that receive seed funding may be in
+•• the process of incorporation, or may have been
in operation for a while.
• Early-stage financing is sought by companies
that have completed the product/service
development stage and test marketing but
require additionalfinancingto expand.
• Expansionfinancingis provided when the
company is poised to grow rapidly. The funds
1
may be used to increase production capacity,
marketing, or product development, and/or
provide additional working capital.
• Late-stage funding refers to pre-IPO
investments to strengthen a company's
positioning and to gain endorsements from
top venture capital (VC)firmsas the company
prepares to list.
At any stage, equity investment can come from
informal or formal sources. However, it is more
usual to access informal sources in the seed and
early stages, and formal sources in the expansion
and late stages.
INFORMAL EQUITY SOURCES
Informal and Angel Investment
Informal investment refers to equity provided by
individuals. In addition to accessing their own
savings and those of family, friends, and even
neighbors, entrepreneurs seek informal "angel"
investors who provide financial capital as well as
Figure 2. Rates of informal investment around the world. (Source: Global
Entrepreneurship Monitor data)
14.00
152
business expertise for running a company.
As shown in Figure 2, the rates of informal
investment vary dramatically around the world,
from a high of 13% in Uganda to a low of 0.5% in
Japan. Business owners are approximately four
times more likely to make informal investments
than are non business-owners (Bygrave and
Hunt, 2005). As can be seen in the figure, many
informal investors have experience as owners/
managers of their own businesses.
Although the profile of angel investors varies,
in developed economies, angels tend to have
entrepreneurship experience, be retired from
their own firm or a corporation, and have net
incomes in excess of US$100,000 a year. Most
angels invest in companies within a two-hour
traveling distance of their home, and therefore
the informal investment market is geographically
diverse. On average, the angel capital market is
approximately ten times the size of the formal
venture capital market. Indeed, small firms are
eight times more likely to raise finance from
business angels than from formal institutions.
Business angels tend not to have any previous
relationship with the entrepreneur, and are often
more objective. Angel investors can be passive
(backing the judgment of others) or active
(hands-on, with advice or direct management
input to help the business to establish itself).
Angels tend to invest as individuals or as part
of a larger group, and generally as a part-time
interest rather than as a full-time job (as is
the case of venture capitalists). In addition to
financial goals, informal investors often seek
 Understanding Equity Capital in SMEs
other, nonfinancial returns, among them the
creation of jobs in areas of high unemployment,
development of technology for social needs (for
example, medical or energy), local revitalization,
provision of assistance to indigenous peoples,
and just personal satisfaction from the assistance
they give to entrepreneurs.
Business angels prefer to fund high-risk
entrepreneurial firms in their earliest stages.
They fill the so-called equity gap by making
their investments in precisely those areas where
institutional venture capital providers are reluctant
to invest. Angels may also prefer to fund,the
smaller amounts (within the equity gap) that are
needed to launch new ventures, and they invest in
almost all industry sectors. Angels tend to be more
flexible in theirfinancialdecisions, and also tend to
have different criteria, longer investment horizons
("patient" money), shorter investment processes,
and lower targeted rates of return than venture
capitalists. Business angel funding can make a
firm more attractive for other sources of finance.
However, business angels are less likely to make
follow-on investments in the same firm.
FORMAL EQUITY SOURCES
Venture Capital
Venture capitalists can be a valuable and
powerful source of equity funding for new
ventures, providing, in addition to capital, help
with a full range of financial services for new
or growing ventures. These include market
research, strategy, management consulting,
contacts with prospective customers/suppliers/
others, assistance in negotiation and with
management and accounting controls, employee
recruitment, risk management, and counseling
on regulations. Venture capitalists tend to have
ambitious expectations for both the return on
and the increase in their investment, as shown
Table 1. Typical returns on investment (ROI) and increase on initial investment
sought by venture capitalists. {Source: Terjesen and Frederick, 2007)
Stage of business Expected annual ROI (%)
Seed 60+
£arly 40-60
Expansion 30-50
Late 25-40
Turnaround situation 50+
in Table 1.
The process of seeking venture capital ft
financing includes the following four stages:
• Initial screening to assess the firm's ability to
meet the VC's particular requirements.
• Detailed reading of the business plan. p
• Verbal presentation to the venture capitalist.
• Final evaluation, including visiting suppliers,
customers, consultants, and others; the
venture capitalist then makes a final decision. W
This four-step process screens out approximately
98% of all venture plans, with the remaining
2% receiving some degree of financial backing.
1.
Venture capitalists reach a go/no-go decision in 1—t
an average of 6 minutes on the basis of the initial
screening, and in less than 21 minutes on the
basis of an overall proposal evaluation. The main
factors in their decision are the firm's expected
long-term growth and profitability, although an a
entrepreneur's background and characteristics 3
are also taken into account.
Venture capitalists tend to agree on an exit
strategy at the time of investment, with the
following five main mechanisms:
• Trade sale to another company.
• Repurchase of the venture capital shares by
the investee company.
• Refinancing or purchase of the venture
capital equity by a longer-term investment
institution.
• Stock market listing.
• Involuntary exit.
Table 2 summarizes the differences between
business angels and venture capitalists.
Initial Public Offering
As the firm grows, managers may consider an
initial public offering (IPO), which is when a
company's shares are first sold to the public.
An IPO is often the first time people outside the
Expected increase on initial
investment
10-15 times
6 - 1 2 times
o
4 - 8 times
3 - 6 times
8-15 times
o
153
 Financing and Raising Capital

Table 2. Differences between business angels and venture capitalists. (Source:

Terjesen and Frederick, 2007)

cd Investor type
Differential factor
Business angel Venture capitalist
+••
(A
Personal Entrepreneurs Investors

Firms funded Small, early-stage Large, mature

Due diligence done Minimal Extensive

Location of invesfment Of concern Not important

Contract used Simple Comprehensive

Monitoring after investment Active, hands-on Strategic

Exiting the firm Of lesser concern Highly important

!
Rate of return Of lesser concern Highly important

company have the opportunity to buy its shares;
hence, IPOs are referred to as "going public" or
"floating" the company. An IPO has advantages
and disadvantages. The advantages are:
• Amount and efficiency of capital raised:
Selling shares is one of the fastest ways to
raise large sums of capital in a short period of
time.
• Liquidity: A public market provides liquidity
for owners, who can readily sell their shares.
• Value: The market puts a value on the
company's shares, which in turn allows a
value to be placed on the company.
• Image: Publicly traded companies are
often perceived to be stronger by suppliers,
financiers, and customers.
However, an IPO also has several disad-
vantages:
Cosr: IPO expenses are significantly higher
than for other sources of capital due to fees
for accounting, legal services, prospectus
printing and distribution, and the cost of
underwriting the shares. The cost can easily
exceed $1 million.
Disclosure: An IPO requires detailed public
disclosure of company affairs, but new
firms may prefer to keep this information
private. Furthermore, the paperwork
involved in meeting regulation requirements
and providing regular information about
performance may drain large amounts of
management time, energy, and money that
could be better invested in opportunities for
company growth.
Stockholder pressure: Stockholders are
interested in a strong performance record

Table 3. Advantages and disadvantages of IPO funding. {Source: Terjesen and

Frederick, 2007)
Advantages Disadvantages

Stronger capital base Pressure for short-term growth

Improves other financing prospects Disclosure and confidentiality

U Better placed to make acquisitions Costs—initial and ongoing

Z
t
Diversification of ownership Restrictions on management

Increased executive compensation Loss of personal benefits

a
>—1

Increased company and personal prestige Trading restrictions

154
 Understanding Equity Capital in SMEs

on earnings and dividends, and so may put officers) are prohibited from selling shares without
pressure on managers to focus on short-term the written permission of the lead underwriter w
performance. If managers do this, it can until a certain amount of time has passed. On a
be at the expense of long-term growth and average, the waiting time is 180 days. These lockup «•+

improvement. provisions control the supply of shares sold during

The advantages and disadvantages of IPO
funding are summarized in Table 3.
Should a firm decide to pursue an IPO, it is
important that it be aware of laws with respect
to securities and investments, which vary across
countries but include the following common
elements.
Investor information: Firms must provide
investors with key information.
Investment banker or underwriter: Most
firms select a lead investment banker to sell the
new shares, usually at fees of about 7% of the issue
value.
Ownership structure: The shares sold in the
IPO are designated as primary shares, which are
new shares, and secondary shares, which were
previously owned by existing stockholders, usually
the founders and managers of thefirm.The size of
the new issue relative to the existing shares and
their distribution change the ownership structure.
The IPO often results in moving from management
byfirmfounders toward professional management
of the firm. The IPO generally occurs when the
founder's entrepreneurial activities are coming to
an end, but often he or she will play a role in the
future of the company.
Lockup provisions: When going public, IPOs
almost always commit to a lockup period, whereby
insiders (major stockholders, directors, and senior
the period after the IPO by insiders or existing
stockholders who might have inside knowledge
and, thus, unfair advantage.
a
Presence of venture capitalists: Many firms
may be financed by VCs, who take an ownership
o
position and have partial control over the
entrepreneurs. The IPO may change this control W
as the VC distributes the shares to their limited
partners. The use of an IPO may be a cheaper form
of financing than that provided by VCs, and will
certainly provide liquidity to the existing pre-IPO
s
I
stockholders.
Issue size: With the fixed costs of an IPO to
create a liquid market, the number of new shares
in the IPO should be large enough to provide 3
sufficient liquidity, but small enough so that the
issuing firm does not raise more cash than it can
profitably use.
Mechanisms for pricing IPOs: IPOs may be
priced through auctions,fixed-priceoffers, or book-
building. In auctions, the market-clearing price is
determined after bids are submitted. In a fixed-
price offer, the price is set prior to the allocation.
If there is excess demand, shares are rationed on
a pro rata or lottery basis. In book-building, the
investment bankers canvas potential buyers and
then set an offer price. Book-building is now the
predominant mechanism by which IPO shares are
sold around the world.

CASE STUDY
An Angel in England
Anita Roddick started her own business, The Body Shop, creating and selling beauty products.
Roddick was keen to open a second shop in Chichester, but the bank turned down her request
for a loan. In desperation, Roddick asked her friend Aidre, who was helping to manage the first
store, for help. Aidre had a boyfriend named Ian Bentham McGlinn, who had some spare cash from
operating a local garage. Scottish born McGlinn offered Roddick £4,000 in 1976 in return for 50%
equity in the business. Anita accepted the offer but wrote to her husband Gordon (who was on a
two-year hike in South America) to inform him of the offer. Gordon wrote back suggesting that she
"not do it, not give away half the company," but it was too late.
With his equity investment, McGlinn became a business angel and sat on the board of The
Body Shop, resigning just before it was floated on the stock market in 1984. At the time of the
flotation McGlinn was worth £4 million, but he avoided the press by taking a holiday in Portugal. By
1991, McGlinn's 52 million shares were worth £150 million, though his dividends were worth only
o
hrl
£638,000 annually. The Roddicks and McGlinn together owned 56% of The Body Shop, preventing
a takeover. In 1996, McGlinn sold 3.5% of the business for £12 million. When L'Oreal took over
The Body Shop in 2006, McGlinn's 22% stake was worth £137 million. As of 2007, Ian McGlinn was
ranked no. 28 on the Sunday Times Rich List, with an estimated worth of £146 million.
o

155
 Financing and Raising Capital

MAKING IT HAPPEN
When approaching venture capitalists, entrepreneurs must remember that VCs are inundated with
potential business opportunities. It is therefore advisable to keep the following in mind.
PH
•M Do
Prepare all your materials before soliciting firms.
Send a business plan and a covering letter first.
Contact several firms with this material.
Keep phone conversations brief—prepare a one-minute and a three-minute pitch.

I Remain positive and enthusiastic about your company and its product or service.
Know your minimum deal and walk away if necessary.
Negotiate a deal you can live with.
Investigate the venture capitalist's previous deals and current portfolio structure.

Don't
Don't expect a response.
Don't dodge questions.
Don't give vague answers. Know what you can and cannot disclose before you start talking, so
that you do not stumble over awkward questions.
Don't switch off—be an active listener as you will always learn something.
Don't hide significant problems.
Don't expect immediate decisions.
Don't become fixated on pricing.
Don't embellish facts or projections.

When considering an IPO, managers should ask the following questions:

• Can the company run without you while you are managing the IPO process? The work leading up
to a public offering is time-intensive and can deflect your focus away from everyday operations,
ultimately hurting the business. If the company lacks a strong management team, it can be
helpful to appoint an interim CFO with experience of taking companies, preferably small, through
the rigors of going public.
• Can you get to a market capitalization of $100 million within three years of going public? The
value of a public company is a multiple of what it earns. If the result isn't near $100 million,
staying private may be best. This number is a good indicator because it is the level of earnings
at which the company can attract brokers and investors.
• Are you building a company with high gross and operating margins? High margins are important
because they keep companies out of the volume game. For a company to reach critical mass in
earnings with low margins, it must generate enormous sales growth.
• Can your business deliver double-digit sales and earnings growth? The competition among public
companies, mutual funds, and other investment networks is fierce. Investors won't look twice at
a company that doesn't grow fast enough to warrant the use of their time and money.
• Are you building a family business? If the succession plan for the business is set in stone to
be passed on to the kids, public may not be the right route. Families measure the success of
a business generation by generation. Money movers are interested in the quarter-to-quarter
progress.
• Can the business be built inexpensively? The main reason companies go public is to raise initial
funds for major growth. As a result, sales and growth need to reflect the use of the first round
of financing. If another round of financing is needed to achieve the original plan, investors may
look elsewhere.

o
156
 Understanding Equity Capital in SMEs

Prospectus: If a company is raising capital
by offering its shares to the public for the first
time, it will issue a disclosure document called a
prospectus. The prospectus is a formal written
offer to sell shares and provides an investor
with the information necessary to make an
informed decision. All negative information must
be clearly highlighted and explained. Some of
the specific detailed information that must be
presented includes: the history and nature of the
company, its capital structure, a description of any
material contracts, a description of the securities
that are being registered, the salaries of major
officers and directors and the price paid for any
security holdings they may have, underwriting
arrangements, an estimate of and planned use for
the net proceeds to be raised, audited financial
statements, and information about the competition
with an estimate of the probabOity that the firm
will survive.
w

MORE INFO
Books:
Cendrowski, Harry, James P. Martin, Louis W. Petro, and Adam A. Wadecki. Private Equity: History,
Governance, and Operations. Hoboken, NJ: Wiley, 2008.
Gadiesh, Orit, and Hugh MacArthur. Lessons from Private Equity Any Company Can Use.
Cambridge, MA: Harvard Business School Press, 2008.
Terjesen, Siri, and Howard Frederick. Sources of Funding for Australia's Entrepreneurs. Raleigh,
NC: Lulu, 2007.
Report:
Bygrave, William D., with Stephen A. Hunt. "Global entrepreneurship monitor 2004 financing
report." Babson College and London Business School, 2005.
Websites:
Global Entrepreneurship Monitor (GEM) data: www.gemconsortium.org
US Small Business Administration on equity financing:
www.sba.gov/services/financialassistance/basics/financing

o
h-H

157
IPOs in Emerging Markets
by Janusz Brzeszczynski
EXECUTIVE SUMMARY
• IPO activity in emerging markets depends strongly on the macroeconomic environment,
business cycles, and stock market phases.
• The number of IPOs increases during bull markets and decreases during bear markets.
• Companies launching IPOs during bull markets can count on raising more capital than if they go
public in a bear market.
• There is usually a time lag of about a year between changes in stock market index returns and
the subsequently observed IPO activity.
INTRODUCTION
An initial public offering (IPO) is the sale of a
company's shares to the public for the first time,
leading to a stock exchange listing. This process is
known also as a public offering, or "going public."
The main reason for IPOs is the need for fresh
capital to finance various business activities, such
as the development of new products or expansion
into new markets. Most IPOs are launched by
relatively small but dynamic companies, which
grow too fast to be financed only in traditional
ways such as by bank loans. Nevertheless, many
big privately owned companies also decide to
become publicly traded.
Decisions about an IPO are predominantly
based on the actual capital requirements and
the expansion plans of the management, but the
timing of the IPO is very strongly determined
by the current macroeconomic environment,
business cycles, and stock market phases.
IPOs are considered to be risky for both the
issuers and the investors. The issuers may
miscalculate the value of the company and
choose the wrong time to go public. In this
event, the amount of capital raised from the
IPO will be less than expected, and control of
the company may be lost by diluting the shares
of previous stockholders in the new ownership
structure after the IPO. However, when an IPO
is successful, a company can raise more capital
than anticipated, and the original stockholders
may still be able to control the company.
As for the risks faced by the investors, first,
they may make errors in assessing the company
value, and second, it is very difficult to predict how
the share price will behave once the company is
listed on the stock exchange. Investors normally
have access only to limited historical data,
which makes the valuation and the appraisal
W
a
en
a
ft
of the firm's financial situation rather difficult.
Moreover, the majority of IPOs are companies
I
that are experiencing a transitory growth stage. 3
This creates even more uncertainty about their
value in the future. Last but not least, the stock
market before and after an IPO may behave in
an erratic way and exhibit high volatility, which
in a short period of time may lead to either
unexpected profits or unexpected losses.
INITIAL PUBLIC OFFERINGS
The main advantage of an IPO is that the
company is not obliged to return the capital
raised from the investors. The downside is that
new stockholders are entitled to a share of future
profits (usually in the form of a dividend). The
stockholdings of the existing owners will be
diluted in the new ownership structure, and in
many cases they may even lose control over the
company. However, they expect their shares to
become more valuable after the IPO, when the
company should be able to generate higher profits
from the capital raised in the IPO process.
In an IPO the issuers are usually assisted by
underwriting firms, such as investment banks,
which help to decide on the best offer price and
the timing of the offer. They also deal with the
legal aspects of the entire process. Furthermore,
the underwriter approaches investors with offers
to sell the shares of the IPO company.
The sale of shares in an IPO may take place
using different methods. These are: Dutch
auction, firm commitment, best efforts, bought
deal, or self distribution of stock. When the IPO o
is successful and the underwriters sell the shares,
they are rewarded by a commission calculated as
a certain percentage of the value of the shares
issued and sold.
The number of new IPOs in any market always
depends on business cycles. One of the best
n
159
 Financing and Raising Capital
examples is the dot-com bubble in the United
States during the 1990s, when share prices were
rising sharply and many young companies from
cti the high-tech sector were seeking capital through
u IPOs. After the companies were listed on the
stock market, their share prices skyrocketed—
CO and continued to do so until the bubble burst.
The value of the IPO of a company is usually
relatively high in comparison to alternative
methods of financing such as bank loans.
c The largest IPOs in history so far have been:
I Industrial & Commercial Bank of China ($21.6
billion) in 2006; NTT Mobile Communications
1
CO ($18.4 billion) in 1998; Visa Inc. ($17.9 billion)
in 2008; and AT&T Wireless ($10.6 billion) in
2000.
Pricing of Public Offers
In order to sell a large number of new shares and
raise significant amounts of capital, an IPO has
to offer investors a strong incentive to buy. That
is why most IPOs tend to be underpriced. On
one hand, a consequence of this is that investors
who buy the shares at the offering price can earn
substantial returns, and this tends to happen
over a relatively short period of time. On the
other hand, when an IPO is severely underpriced
the result may be what is known as "money
left on the table." This term is used to describe
the situation when the company experiences
a relative loss of capital, i.e. the loss of money
that could have been raised from the market in
an IPO if the shares had been offered and sold at
a higher price.
If the shares are overpriced, the underwriters
may not be able to sell all of them. They then
face the problem of acquiring the shares
themselves—which is even more troublesome
when the current market price is lower than the
issuing price.
The public offering price (POP) is the price
at which IPOs are offered to the public by an
underwriter. Several factors affect this price,
including data about a company's financial
situation (past, current, and forecasted),
macroeconomic conditions and stock market
trends (current and predicted), as well as
information about investor confidence.
A preliminary registration statement filed
with the securities commission, which describes
U
z a new IPO, is called a "red herring." It does not
t
include the price or issue size and it may be
updated many times before it becomes the final
prospectus. The process of soliciting orders to
buy an IPO before its registration is approved
by the securities commission is known as "gun
l6o
jumping." An advertisement published by the
underwriters giving information about the
details of an IPO is called a "tombstone." The
first recommendation issued by an underwriter
for an IPO is known as the "booster shot." Its aim
is to promote the new shares of the IPO company
and to increase the chance of its successful sale
to the public. The underwriters cannot, however,
promote the IPO during the "quiet period,"
which is the period of time following the filing
with the securities commission and before the
registration statement. The term "quiet period"
refers also to a certain number of days after an
IPO is listed on the stock market, during which
the company and those underwriters directly
engaged in the IPO are not allowed to issue any
financial forecasts or recommendations for the
company concerned.
IPOs in Emerging Markets
In many emerging markets the term "going
public" may seem confusing. In countries that
did not have free-market economies in the past,
and where government ownership was dominant
over private ownership, most companies that
launched IPOs were in fact privatized, because
they were sold by the government to private
investors through the stock market. Hence,
they were in fact going private rather than going
public.
A problem in emerging market financial
systems is that many small, young private firms
that have good investment opportunities can
show little evidence of past business and financial
performance. They therefore face serious
problems when they want to attract external
finance for new ventures. This is because in these
countries either firm financing is intermediated
or the capital markets are underdeveloped.
Furthermore, in many emerging markets the
legal and regulatory environment is rather weak,
and financial intermediaries tend to give priority
to large companies that have a relevant track
record and own a certain value of physical assets
which can be used as collateral for loans. There is
also a danger that intermediaries may favor firms
controlled by politicians. In emerging markets,
the development of public equity markets has
been found to be beneficial for the financial
systems. It is believed that public capital markets
are more immune to the influence of politicians
and other lobbying groups.
The development of capital markets in
emerging market countries, combined with
their dynamic macroeconomic growth in recent
years, has triggered IPO activity on their stock
 IPOs in Emerging Markets

exchanges. However, it is worth distinguishing
between the various sources of capital that
are being invested in IPOs. In many emerging
markets the limited availability of capital has
been a major problem. Even though the economic
growth of emerging countries in recent years
has helped in the accumulation of capital from
domestic sources, much of the capital invested
in IPOs has its origin in developed countries. An
become public in emerging markets and launch
an IPO are easier access to capital in the future,
increased liquidity of their shares, and, last but
not least, visibility and prestige when they are
listed on the stock market.
p
The number of IPOs in emerging markets is
variable overtime and depends on many keyfactors,
among which the macroeconomic environment
and the rate of growth of the economy are the

important role here is played by venture capital
companies, which often use an IPO as their exit
strategy. However, the activity of venture capital
funds may differ from country to country—it
is, for example, traditionally higher in Asian
markets and lower in the emerging market
countries in Europe.
A typical IPO process in an emerging market
starts when a company enters a high growth
phase and the management decides that there
is a momentum in the firm's life during which
a relatively large amount of new capital can be
raised for further expansion. It is then that the
shares can be sold via an IPO at prices that
result in high multiples of the most commonly
used financial ratios, such as price/earnings
ratio (P/E), or price/book value ratio (P/BV).
Other typical reasons why companies decide to
I
dominant ones. There is evidence to show that IPO
activity in emerging markets is related to phases
of the stock market, which in turn are connected
to business cycles. Bull and bear market periods
always depend on the macroeconomic indicators
and the prospects of economic growth.
%
Macroeconomic activity also affects the
degree of underpricing of IPOs. Although this to
effect tends to be more significant in emerging
market countries than in developed economies,
it is in fact always time-varying in its nature,
and depends periodically on macroeconomic
conditions. Nevertheless, there are cases in
which the underpricing was so severe that the
share price on the first day of listing reached a
level more than 100% higher than the offer price
in the IPO—in well-established markets the
underpricing is typically below 20%.

Figure 1. New IPOs versus stock market returns in Poland in the period 1997-08.
{Source: Warsaw Stock Exchange and author's calculations. The data exclude the
NewConnect market segment)

90 • 100
New IPOs T

80" • 80 co
Returns ck -
70" • 60 3
CO
<D
60" L_

o 50"
• 40
O
Q_
4 0 ••
• 20
£
• 0 X
30 • <D
-20 -O
20 - C_

10- -40 ^
60 O
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 " £
o

161
 Financing and Raising Capital

« CASE STUDY
jj IPOs in the Emerging Market in Poland
2 Figure 1 shows the number of new IPOs and the main stock market index (WIG) returns for the
P^ Polish stock market over a period of 12 years from 1997 to 2008. An important feature of this
4-* graph is the one-year shift of new IPOs relative to the situation in the stock market, where the
y pattern of volatility of index returns clearly leads the IPO activity. The correlation coefficient
PQ between those two variables is only 0.0244 (2.44%) when IPOs and stock market index returns
• are analyzed simultaneously, but increases to as high as 0.5683 (56.83%) when the WIG returns
"H are lagged by one year.
4) Following the period 2 0 0 3 - 2 0 0 6 , during which the WIG index increased at an annual rate of

Syj
nearly 4 0 % , in 2007 the number of new IPOs jumped to 8 1 from an annual average of less than

seven in 2001-2003 and 33 in 2004-2006. When global stock markets collapsed in 2007 and
<U continued to seek new bottoms in 2008 (events that were reflected in the returns of the Polish
£ market index WIG), the number of new IPOs in 2008 fell more than fourfold to less than 20 from
•H the peak of just over 80 the year before.
£> This finding shows that decisions about IPOs are strictly dependent on stock market phases
*S and that IPOs tend to increase when share prices are rising and to decrease when they fall. The
QN relationship is not simultaneous, with some lagged effect being observed that may be linked to the
M length of time decision-makers need to assess the profitability of a new IPO, given the financial
environment and predictions of how much capital can be raised from the stock market at current
prices.

CONCLUSION
The number of IPOs in emerging markets and
the profitability of the public offers are related
to macroeconomic conditions (both global and
local), business cycles, and stock market activity.
In most emerging market countries there is a
time lag between movements of the stock market
index and decisions to launch new IPOs.
The correct timing of an IPO is very important
for a company that plans a public offering. An
IPO may raise different amounts of capital from
investors depending on whether stock markets
are in a bull or a bear phase.

MAKING IT HAPPEN
• Emerging markets are not immune to trends in global financial markets. Hence, it is important
for company executives who plan IPOs in these countries to have a good understanding of the
global macroeconomic environment and of the financial linkages with developed countries.
• There are research institutes that sell forecasts of future macroeconomic trends and predictions
of stock market performance. Forecasts of the world economy are also offered by such
institutions as the World Bank, the International Monetary Fund, and the United Nations, as well
as by central banks and the finance ministries of individual countries.
• Any decision to launch an IPO should be very carefully analyzed using not only past financial
data for the company, but also macroeconomic forecasts. These may provide valuable
information about future economic growth, which is likely to impact stock market activity and
share prices directly.
pj • Timing an IPO correctly may lead to substantial gains if the IPO shares sell at a high price. Poor
Q^) timing may result in the loss of capital if stock market prices are too low.
z<
z
>—(
a
162
 IPOs in Emerging Markets

MORE INFO g
Articles: •"+
Beck, Thorsten, Asli Demirgug-Kunt, and Vojislav Maksimovic. "Financial and legal constraints to JJ
firm growth: Does firm size matter?" Journal of Finance 60:1 (February 2005): 137-177. Online p
at: 10.1111/J.1540-6261.2005.00727.X Q,
La Porta, Rafael, Florencio Lopez-de-Silanes, and Guillermo Zamarippa. "Related lending." rt*
Quarterly Journal of Economics 118:1 (February 2003): 231-268. Online at: &
dx.doi.org/10.1162/00335530360535199
Rajan, Raghuram G., and Luigi Zingales. "The great reversals: The politics of financial development w
in the 20th century." Journal of Financial Economics 69:1 (July 2003): 5-50. Online at: "gj
dx.doi.org/10.1016/S0304-405X(03)00125-9
Shleifer, Andrei, Rafael La Porta, Florencio Lopez-de-Silanes, and Robert W. Vishny. "Legal
determinants of external finance." Journal of Finance 52:3 (July 1997): 1131-1150. Online at: £j
www.afajof.org/journal/jstabstract.asp?ref= 11724 <J

§
Websites:
International Monetary Fund (IMF): www.imf.org
United Nations: www.un.org £D
World Bank: www.worldbank.org £+

163
Managing Activist Investors and Fund w
n
Managers by Leslie L. Kossoff en

•i

a
P
EXECUTIVE SUMMARY
• Organizations not previously of interest to activist investors or hedge funds should prepare to be n
targeted.
• Be proactive in understanding why investors become agitators, and address their concerns W
before they escalate.
• Organizational governance—particularly the combined chairman/CEO position—and financial •8
management will be the easiest targets for activists.
• Activists often succeed because they communicate better than management—particularly to
tagalong investors who become part of the proxy fight.
• Unlocking stockholder value and simultaneously developing and executing on a long-term
strategy will give activists less reason to agitate and less success with tagalongs; executive en
management will then have a less volatile financial landscape within which to work.
I
3
INTRODUCTION with what has happened in the past, they're also
Whether or not your organization has been a not happy about what they see coming next.
target in the past for activist investors and fund For management, that is a wake-up call in the
managers, you have to plan on it becoming a fact best possible way. It puts the onus on you to look
of life from now on—things have changed. at those components of your business that might
It used to be that only a few organizations were lead investors to become activist—and take action
hit by activist investor activity. From the almost accordingly. Because if they're seeing something
prophetic, and beautifully constructed, Benjamin they don't like, either they need to understand
Graham move on Northern Pipeline in 1951, to why it is the right thing for the business to do, or
Carl Icahn's dramatic moves on Yahoo! during the you need to take a different, objective, look at what
"Microhoo" (Microsoft-Yahoo!) debacle of 2008, they're not liking so that you can determine the
activist investors were a rarity—something other relative merit of what they see.
organizations had to deal with. A problem for the Also, by looking at the organization the way
really Big Boys. Not everyone else. Not you. the activists do, you will see other weaknesses—in
Not any longer. everything from your strategy, to your operations,
Whether or not you have any known activist to your financial management—that might be the
investors currently rearing their heads, you'll next focus of their attention. You don't want that;
have to plan for when they show up—because you want to make thefixbefore they ever have the
they will. If you work it right, proactively, as well chance to raise their voices.
as when the activism hits, you'll manage your way
through those very choppy waters and find a safe TOO GOOD AN OPPORTUNITY TO MISS
haven at the end. And then there are those activist investors who get
in because they see something that your company
WHY INVESTORS BECOME ACTIVIST has to offer that is just too good an opportunity to
Historically, the reason that most activist investors miss. It may be because they have a history of being
became active was because they saw something activist and simply see a new opportunity on which
wrong with the way things were being managed. to bring their activist skills and financial acumen
The value ofthe company was not fully represented to bear. Or it may be because your company is
in the share value. Management was taking the such a good target for some other opportunity
organization in a direction—usually with a direct
correlation to falling share value or dividends—
which you're not considering (like M&A) that they
want to get in and make fast money. Whatever the o
»Trt
that was making the investors unhappy. reason, they'll find a way.
But those reasons are historical, and they were Activist investors have a profile. They are
retrospective. One of the big changes is that now identifiable, as is their methodology. Part of that
investors become activists proactively. They see methodology is to get others who own shares in
things on the horizon that they don't like, and they
act accordingly. Not only may they not be happy
your company to tag along. In most cases, they
can't pull off what they want on their own. They
o
hi

165
 Financing and Raising Capital

need proxy votes. That being the case, they're
making a case to their counterparts that you
have to counter in its entirety.
Activist investors identify where your
u organization is exposed. That's where their
opportunities lie. Then, once they've got a handle
CO on where, from their perspective, you're going
wrong, their next move is to start communicating
that shortfall to others they can bring on board.
They create the tagalongs. Tagalongs start out
C knowing nothing more than what they are told.
Then, if you've done your homework and
figured out where your exposure lies, you'll
be able to address those problems before the
activists can take the initiative. You will also be
in a stronger position to tell all your investors—
especially those proxy candidates—exactly what
you're doing, and why the management is on
top of the problems and opportunities that
everything from economic conditions to global
competition are throwing your way.
Activists can't win if management is doing its

s Many of them, on seeing where the activists

are going, will become involved in finding out
information for themselves—but those tend to
job—and well.

THE EASY TARGETS

be the larger investors who already have analysts
working your organization or your sector anyway.
If the activists can get enough small investors
involved and on side, they'll win.
On your side is that if you can identify those
activist investors and fund managers with large
stockholdings in your firm, you will be able, with
a high sense of assurance, to begin figuring out
what their strategy will be. Track their track
record.
There are some problems which organizations
create for themselves that are easy pickings for
the activists—and provide some of the highest
exposure for management. Now and going
forward, corporate governance is the easiest
target that activist investors will be able to find.
Since the Sarbanes-Oxley Act of 2002, the
question of whether the same person can be
both chairman and chief executive officer, and
still ensure that the organization is safe for its

CASE STUDY
Microsoft/Yahoo!
It was bad enough for Yahoo! when Microsoft decided to make an unsolicited offer for its takeover.
Initially offering $31 per share—a 62% premium over the then share price—Microsoft had decided
to expand its internet presence through a big acquisition. This was even though Microsoft, at
number three in the search engine business, with Yahoo! in second place, had little or no chance of
coming close to the big beast, Google, for the advertising revenues that were there to be had.
When Carl Icahn decided to get into the fray, however, all the rules changed. Buying 5% of
Yahoo!, Icahn started actively lobbying for the so-called Microhoo (or Micro-Hoo) deal to go
through. He wanted those premiums—especially when Microsoft upped its offer price to $33 per
share.
But Jerry Yang, Yahool's chief executive, and Roy Bostock, its nonexecutive chairman, didn't
want to sell—at least not at that price. They had other plans, with and without Google. As a result
a three-way fight started, but after a while it wasn't altogether clear who was on whose side-
especially because so much of the fight was conducted using the business media.
The proxy fight was about to begin. Icahn was fighting to remove all the current members of
Yahool's board, including Yang, and to replace them with a new set chosen by him. But at that
point Microsoft decided that neither was it willing to pay the price Yahoo! was asking, nor was it
comfortable doing a deal with Icahn tacitly setting the terms. The fight to create Microhoo was
over before it began.
That was in 2008.
For Icahn, holding 5% and looking for a way to ensure his shares would gain value in the future,
he had to create an alternate win and he did so. His initial demands and wins were changes to
u the board of directors and a new CEO. The Yahoo! board expanded from 10 seats to 11, with one
current board member stepping down, and three new board members—one of which was to be
Icahn, the other two selected from his list of alternates to be added. Carol Bartz became CEO in
2009 and one of her first deals was an alliance collaborating on Microsoft's search engine, Bing.
$ On the face of it, Icahn was right. The Microsoft deal was the best deal going. Now, the question

a is how long Icahn continues to support Bartz in her new strategic direction for the company.

166
 Managing Activist Investors and Fund Managers

stockholders, is—and will continue to be—the AVOIDING THE ACTIVISTS' GLARE

easiest target of all. It doesn't matter in which
country the organization is headquartered. All
that matters is that it is publicly traded and that
stockholders should not fear that having the
same person in the two roles, with their different
responsibilities, is creating an increase in risk.
Activist investors and fund managers are
looking for situations where the board is
perceived as being entrenched. Unfortunately,
even if having the same person as your chairman
and CEO is the best thing that's happened to
your organization in years, from an outside
perspective it looks like cronyism on the board.
This is a situation that many will associate with
lack of transparency and with untrustworthy and
A clear-cut corporate strategy for addressing w
stockholder concerns will do more to avoid the
possibility of successful activism than anything
else.
First, the stockholders need to see, on an
ongoing basis, that the company is dedicated to a
(I
unlocking stockholder value; that it is committed
to finding new ways to make their investment pay
W
off for them—now and in the future.
That is achieved by ensuring that the long- C
term strategic objectives that are set are not only
well communicated, but are also fully executed
M
to the stockholders' satisfaction. By setting
and delivering on those long-term objectives, <

inadequately considered decisions.
That puts the onus on the chief executive and
the board, in toto, to ensure that stockholders
see a level of transparency in governance that
goes beyond what existed before. Transparency
of voting structures—and even a periodic,
situational decision to rescue him or herself
by the chairman/chief executive—will go far
to calm what could otherwise give rise to very
contentious criticisms of the board and how the
company is managed at the top.
Issues surrounding everything from
operational decisions to, most particularly,
executive compensation and bonuses will also
be fodder for the activists, both now and in the
future. The tolerance for perceived cronyism and
mismanagement is lower than ever—and is likely
to stay that way.
In effect, just as politicians have to deal
with a 24-hour news cycle, so too do corporate
executives. There is no rest and no hiding from
activists once they decide they want to engage.
1
executive management can build long-term
investor trust and commitment, leading to a much
less volatile financial landscape for the companies
operations. 3
And, finally, it's all about communication.
Activists become activists—particularly the
successful ones—by doing a better job of getting
their message across to stockholders than corporate
management does. By working diligently to ensure
that stockholders not only have the information
they need, but never feel that anything is being
withheld from them, the chances of activists getting
involved and their capability to bring in others can
be severely reduced.
Ultimately it's all about good management,
and about thinking like an activist before they can
make their arguments stick. By being proactive
and objective about the company—and then
doing the right things—you'll stop the activists
getting a toehold. More importantly, they'll have
no reason to try to do so.

MAKING IT HAPPEN
• Before the activists get the chance, take an objective look at where the business is exposed, and
then take action to correct those deficiencies.
• Identify activist investors who already own shares in the company, then research how, and on
what particular issues, they have agitated in the past.
• Be proactive in taking steps to address the activists' issues—from leveraging, to corporate
governance, management structure, strategy execution, and more—to reduce the activists'
opportunities to act. o
• Recognize that activism is now future-oriented—not just retrospective and based on the board's h-H
previous decisions. Make sure that forward planning and the ability to execute and deliver are
sound.
• Message well and continuously to your stockholders, so that it is the company's message that
gets the most traction—not that of the activists.

167
 Financing and Raising Capital

« MORE INFO
§ Books:
Ctf Burke, Edmund M. Managing a Company in an Activist World: The Leadership Challenge of
£* Corporate Citizenship. Westport, CT: Praeger, 2 0 0 5 .
^ Schroeder, Alice. The Snowball: Warren Buffett and the Business of Life. L o n d o n : Bloomsbury,
«> 2008.
PQ Articles:
• Greenwood, Robin, and Michael Schor, "When (not) to listen to activist investors." Harvard
"B Business Review 86:1 (2008). Online at: tinyurl.com/29yah3f
4) Levin, Timothy W., and Phillip T. Masterson. "Implications of hedge funds as activist investors: No
2 longer flying under the radar." Investment Lawyer 13:10 (October 2006): 19-26.
W Websites:
2; The Icahn Report: www.icahnreport.com
0 Investopedia: www.investopedia.com
M
it

U
z
$

168
Acquiring a Secondary Listing, w
ft
or Cross-Listing by Meziane Lasfer it

EXECUTIVE SUMMARY
• Over the last three decades an increasing number of companies have sourced their equity capital
in foreign countries by listing their stock abroad.
• This strategy of parallel listing on both domestic and foreign stock exchanges, referred to as
"cross-listing," is used by companies from both developed and emerging markets.
w
• In 2008, for example, 121 companies from BRIC countries (Brazil (7), Russia (24), India (24),
and China (66)) were listed on the London Stock Exchange Alternative Investment Market (LSE-
AIM), an equivalent to NASDAQ in the United States.
• Although the major stock markets for cross-listing are in the United States (NYSE and NASDAQ)
and London (LSE and LSE-AIM), with a 43% market share in 2007, firms are also likely to cross-
list in other markets of the world, such as the Singapore, Euronext, Hong Kong, and Mexico
stock exchanges.
• According to the Bank of New York Mellon, during the first half of 2008 more than $2.4 trillion of
depository receipts (DRs) traded on US and non-US markets and exchanges, up 85% from the 3
previous year.

INTRODUCTION keeps foreign and local prices of any given share

Cross-listing is controversial and raises a
number of academic and practitioner questions,
particularly: Why and how does a firm cross-list,
and does cross-listing create additional value
for existing stockholders? The purpose of this
article is to discuss the institutional framework
of cross-listing, the classification of depository
receipts (DRs), the types of DR available in
the United States, the reasons why companies
list abroad (by contrasting the advantages and
disadvantages of raising equity capital in foreign
markets), and the cross-listing process.
INSTITUTIONAL BACKGROUND
Companies cross-list by issuing depository
receipts. These are certificates that are first
issued by the company to a bank in a foreign
country, which in turn issues the certificates
to investors in that country. Indirectly, DRs
represent ownership of home market shares in
the overseas corporation. The underlying shares
remain in custody in the home country, and DRs
effectively convey ownership of those shares.
DRs are quoted and normally pay dividends in
the foreign country's currency (for example, US
dollars or euros). DRs can be established either
for existing shares that are already trading, or
as part of a global offering of new shares. Each
the same after adjustment for transfer costs.
DRs can be exchanged for the underlying foreign
shares, and vice versa.
CLASSIFICATIONS OF DEPOSITORY
RECEIPTS
There are a number of classifications of
depository receipts, two of which are:
• Trading location: Global depositary receipts
(GDRs) are certificates traded outside the
United States; American depositary receipts
(ADRs) are certificates traded in the United
States and denominated in US dollars.
• Sponsorship: A sponsored ADR is created at
the request of a foreign firm that wants its
shares to be traded in the United States. In
this case, the firm applies to the Securities
and Exchange Commission (SEC) and to a
US bank for registration and issuance. In
contrast, an unsponsored ADR occurs when
a US security firm initiates the creation of an
ADR. Such an ADR would be unsponsored,
but the SEC still requires all new ADRs to be
approved by the firm itself.
TYPES OF LISTING
In the United States there are four types of
depositary receipt: Levels l and 2 apply to cases
o
where the DR is created using existing equity; I—H

DR normally represents some multiple of the Levels 3 and 4 apply to cases where new equity is
underlying share. This multiple allows the DR to issued, such as an initial public offering (IPO).
possess a price per share that is appropriate for Level 1 is the least costly, as the DRs are
the foreign market, and the arbitrage normally traded over the counter in the United States, o

169
 Financing and Raising Capital
in the pink sheet market. There is little
o additional disclosure requirement, apart from
the translation of the home country's financial
statements into English. On average, about 56%
u of the approximately 1,500 DR programs are
+>» classified as Level 1.
CO Level 2 is relatively more costly. The DRs
PQ are traded on the NYSE, NASDAQ, and AMEX
exchanges, with greater cost as the initial fee can
exceed US$1 million. A cross-listed firm must
also reconcile to US GAAP, report quarterly, and
l meet the listing requirements of the US exchange
on which it trades.
1
CO Level 3 is similar to Level 2 for existing quoted
companies, except that it applies to IPOs; the
firm raises new equity capital in a public offering
and trades on the NYSE, NASDAQ, or AMEX.
A company must meet full SEC disclosure
requirements, comply with US GAAP, report
quarterly, and meet the listing requirements of
the exchange.
Level 4, now referred to as 144A, applies to
firms that raise new equity capital through
a private placement. The securities are not
registered for sale to the public; rather, investors
follow a buy and hold strategy. Firms that use this
method are exempt from disclosure requirements
of a new equity issue in the United States, such
as the SEC disclosure and the US GAAP. In April
1990 the SEC approved Rule 144A, which permits
qualified institutional buyers to trade privately
placed securities without SEC registration.
These securities are traded on a screen-based
automated trading system known as PORTAL,
established to create a liquid secondary market
for those private placements.
In other countries, the requirements depend
mainly on the type of markets in which the
company is going to be cross-listed. For example,
requirements to list on the London Stock
Exchange Official List are more extensive than
those for the Alternative Investment Market.
The choice between listing in the United
States (ADR) and in other markets through
GDR depends on a number of factors. In
particular, companies are likely to prefer listing
in the United States through ADRs only if their
objective has a powerful appeal to US retail
investors and they are able to cover the significant
cost of Sarbanes-Oxley compliance and major
exposure to liability for management and board
of directors. ADRs are also useful if they can
benefit by selling new shares at a premium.
Cross-listing through GDR may be cheaper and
M The market reaction is also positive when the
quicker, and could achieve the same purpose
with fewer downsides. For example, cross-listing
in the London Stock Exchange involves two
170
main rounds, where the firm receives comments
from the UK Listing Authority (UKLA) in about
two weeks. Furthermore, since July 2005, the
UKLA no longer requires 25% of GDR issues to
be distributed to European investors.
As an alternative to depository receipts,
companies can have "Euroequity public issue."
Under this method, instead of listing a share on
the home market and then cross-listing, shares
are issued simultaneously in multiple markets.
The term Euroequity has nothing to do with
Europe per se. Euroequity public issue simply
refers to equity issues that are sold globally. Often
these are used for very large equity issues, and
different tranches are sold in different markets.
WHY DO COMPANIES CROSS-LIST?
In general, companies cross-list when the size
of their financial needs exceeds their domestic
market capacity. There is a limited liquidity in
the domestic market, and the price of stock may
be more attractive in a foreign market, especially
if there is market segmentation and DRs offer
diversification benefits to investors. The existing
domestic investors also benefit, since cross-
listing is likely to mitigate the agency conflicts
with their managers. A company becomes more
visible internationally, and the share prices
are likely to be more efficient (known as price
discovery), because trading happens in two
or more markets and more financial analysts
follow the cross-listing. However, some costs
make cross-listing less attractive. This section
provides a summary of the benefits and costs of
cross-listing.
Benefits of Cross-Listing
The most widely cited benefit is the reduction in
the cost of capital. Cross-listing is likely to reduce
the cost of capital, because in close domestic
markets the efficient frontier is determined only
by the set of domestic assets. Therefore, the equity
cost of capital depends on the risk premium of
the domestic market portfolio. However, if the
firm is cross-listed it can reach foreign investors
who will be able to invest in both foreign and
domestic firms, and the market risk premium
will be lower because the level of diversification
that investors can attain in an open capital
market is far greater. As a result, a cross-listed
firm's cost of capital will be lower. Karolyi (1998)
reports that the cost of capital of UK cross-listed
firms in the United States decreases by 2.64%,
from 15.56% before to 12.91% after cross-listing.
firm announces the decision to list abroad.
However, it is not clear whether the market
 Acquiring a Secondary Listing, or Cross-Listing

reacts positively because of the decrease in the
cost of capital or whether it is driven by one or
more of the additional benefits of cross-listing.
These are:
• Improved liquidity of existing shares and
broadening of the stockholder base, with, as a
result, a reduced probability of takeovers.
• Establishment of a secondary market for
shares used in acquisitions.
• An increase in the firm's visibility and political
acceptability to its customers, suppliers,
creditors, and host governments.
• Creation of a secondary market for shares that
can be used to compensate local management
and employees in a foreign subsidiary.
• The recently developed bonding hypothesis,
which suggests that managers will adhere to
stricter regulatory regimes when their firm
is cross-listed, because they will face the
regulation and corporate governance codes
of their home country as well as the foreign w
market. en
Costs of Cross-Listing
The positive market reaction to cross-listing
could also reflect the trade-off between the
benefits of cross-listing discussed above and
some potential costs, namely disclosure costs.
In cross-listing and selling equity abroad, a firm
faces two barriers: an increased commitment to
full disclosure and a continuing investor relations
program. Non-US firms must think twice before
I
cross-listing in the United States. Not only can M
the disclosure requirements be onerous, but
timely quarterly information is also required by o
US regulators and investors. Costs are likely to
be higher for firms that have been accustomed to
revealing far less information.
3

MAKING IT HAPPEN
Over the last few years, an increasing number of firms have listed their shares in foreign markets.
The decision to cross-list is strategic and involves the following issues:
• Where to cross-list: Companies can go to the United States and issue American depository
receipts (ADRs), or to other non-US stock exchanges by issuing global depository receipts
(GDRs).
• The choice of a particular market depends on a number of factors. In particular, the firm needs
to know whether its stock is attractive to US investors, and whether it can comply with all the
requirements of listing, including stronger information disclosure, before it issues ADRs.
• A firm also needs to understand the reasons for cross-listing before issuing depository receipts.
The most fundamental is often financing needs, and the inability of the firm to cover this from
the domestic market.
• In general, cross-listing leads to an increase in share prices on the announcement date. Such
market reactions are likely to be driven by a number of factors, including a reduction in the
cost of capital, a wider geographical range of stockholders, an increase in visibility and financial
analysts' coverage, and the adoption of stricter corporate governance codes.

o
>—i

z
o
in
171
 Financing and Raising Capital

.Jj MORE INFO

y Articles:
2 Baker, H. Kent, John R. Nofsinger, and Daniel G. Weaver. "International cross-listing and visibility."
OH Journal of Financial and Quantitative Analysis 37:3 (September 2002): 4 9 5 - 5 2 1 . Online at:
-M dx.doi.org/10.2307/3594990
U Coffee, John C , Jr. "Racing towards the top? The impact of cross-listings and stock market
PQ competition on international corporate governance." Columbia Law Review 102:7 (November
• 2002): 1757-1831.
pj Dobbs, Richard, and Marc H. Goedhart. "Why cross-listing shares doesn't create value." The
CL> McKinsey Quarterly (November 2008). Online at: tinyurl.com/6xonzo
5 Doidge, Craig, G. Andrew Karoiyi, and Rene M. Stulz. "Why are foreign firms listed in the U.S.
to worth more?" Journal of Financial Economics 71:2 (February 2004): 205-238. Online at:
Sj dx.doi.org/10.1016/S0304-405X(03)00183-l
fj Doidge, Craig, G. Andrew Karoiyi, and Rene M. Stulz. "Has New York become less competitive
M
in global markets? Evaluating foreign listing choices over time." Working paper 2007-03-012,
£* Fisher College of Business, Ohio State University, 2007. Online at:
"jj www.cob.ohio-state.edu/fin/dice/papers/2007/2007-9.pdf
6 Karoiyi, G. Andrew. "Why do companies list their shares abroad? A survey of the evidence and its
W managerial implications." Financial Markets, Institutions and Instruments 7 : 1 (February 1998):
1-60. Online at: dx.doi.org/10.1111/1468-0416.00018
Karoiyi, G. Andrew. "The world of cross-listing and cross-listings of the world: Challenging
conventional wisdom." Review of Finance 10:1 (January 2006): 9 9 - 1 5 2 . Online at:
dx.doi.org/10.1007/sl0679-006-6980-8
Korczak, Adiana, and Meziane A. Lasfer. "Does cross listing mitigate insider trading?" Working
paper, Cass Business School, City University, London, 2009.
Leuz, Christian. "Cross listing, bonding and firms' reporting incentives: A discussion of Lang, Raedy
and Wilson (2006)." Journal of Accounting and Economics 4 2 : 1 - 2 (October 2006): 2 8 5 - 2 9 9 .
Online at: dx.doi.org/10.1016/j.jacceco.2006.04.003
Leuz, Christian. "Was the Sarbanes-Oxley Act of 2002 really this costly? A discussion of evidence
from event returns and going-private decisions." Journal of Accounting and Economics 4 4 : 1 - 2
(September 2007): 146-165. Online at: dx.doi.org/10.1016/j.jacceco.2007.06.001
Licht, A. N. "Cross-listing and corporate governance: Bonding or avoiding?" Chicago Journal of
International Law 4 (Spring 2003): 141-164. Online at:
cjil.uchicago.edu/past-issues/spr03.html
Pagano, Marco, Ailsa A. Roell, and Josef Zechner. "The geography of equity listing: Why do
companies list abroad?" Journal of Finance 57:6 (December 2002): 2651-2694. Online at:
dx.doi.org/10.1111/1540-6261.00509
Sarkissian, Sergei, and Michael J. Schill. "The overseas listing decision: New evidence of proximity
preference." Review of Financial Studies 17:3 (Fall 2004): 769-810. Online at:
dx.doi.org/10.1093/rfs/hhg048
Websites:
Bank of New York Mellon press releases 2008:
www.bnymellon.com/pressreleases/2008/pr071408b.html
Crosslisting.com: www.crosslisting.com
London Stock Exchange: www.londonstockexchange.com
Open University learning module on cross-listing:
openlearn.open.ac.uk/mod/oucontent/view.php?id=397385&direct=l

u US Securities and Exchange Commission: www.sec.gov

z
t
a
172
The Cost of Going Public: Why IPOs Are w
Typically Underpriced by Lena Booth (ft

EXECUTIVE SUMMARY p
• The underpricing of initial public offerings (IPOs) is an indirect cost of going public that is
borne by the issuing firm. Its magnitude varies across IPOs with different issue characteristics,
allocation mechanisms, underwriter reputations, and general financial market conditions.
• Commonly used share allocation methods in IPOs are auction, fixed price, and book-building.
Book-building is the most popular method, and it allows smaller, less known companies to go •8
public.
• IPOs are underpriced to signal issue quality, mitigate adverse selection problems, reward
investors for truthfully revealing information, lessen underwriters' potential legal liabilities, allow
underwriters to curry favor with their clients, promote ownership dispersion for liquidity and
control, and attract media attention/publicity.
• Issuing firms can attempt to reduce underpricing by engaging reputable underwriters and
auditors, having frequent disclosures, waiting until they possess desirable characteristics, and/or
using the auction method if they are of high quality.

INTRODUCTION offer price/proceeds than what they could have

When firms go public, they incur direct and
indirect costs associated with the initial
public offering (IPO) process. Direct costs are
fairly predictable—they include registration,
underwriting, and attorney and auditing fees.
The indirect cost, commonly known as IPO
underpricing, is one of the most perplexing
puzzles in finance. It is observed in almost
every financial market in the world and across
all procedures of share allocation. IPOs are, on
average, underpriced by 18-20% in the United
States. During the hot issue period, underpricing
was much higher, as many of the IPO firms did
not have strong financials or growth potential
and simply rode the wave to go public. In
countries where regulations and restrictions
are imposed in the IPO market, underpricing is
higher as well.
WHAT IS IPO UNDERPRICING?
Underpricing refers to the price run up of the
IPO on the first day of trading. It is also known as
the initial return or first-day return of the IPO.
First-day closing price - Offer price
Underpricing
Offer price x 100%
The first-day closing price represents what the
investors are willing to pay for the firm's shares.
If the offer price is lower than the first-day
closing price, the IPO is said to be underpriced
and money is left on the table for new investors.
Since existing shareholders settle for a lower
got, money left on the table represents the
wealth transfer from existing shareholders to
new shareholders.
Money left on the table • (First-day closing price
- Offer price) x Number of shares
On average, the amount of money left on the table
is about twice the amount of direct underwriting
fees, and for many IPO firms it can equal several
years of operating profit.
Although most IPOs are underpriced, the level
of underpricing varies across IPOs with different
issue characteristics, allocation mechanisms,
underwriter reputation, and general financial
market conditions. For example, the level of
underpricing is reduced for larger IPOs, those
underwritten by prestigious investment banks,
firms with a longer operating history or more
experienced insiders on the board, and those
which intend to use the proceeds to repay debt.
On the other hand, technology firms, firms
backed by venture capital, firms with negative
earnings prior to the IPO, or firms that went
public during a bull market experience greater
underpricing.
o
SHARE ALLOCATION IN IPOS
IPO underpricing happens regardless of whether
issuers use the auction, the fixed-price, or the
book-building method to go public. In the
auction method, investors submit their desired
price and quantity bids. The offer price that will
allow the firm to sell all its shares is determined
o

173
 Financing and Raising Capital
0) after bids are submitted, and hence incorporates
the demand for the shares. A maximum price
i is usually chosen as well, so that unrealistic
bids (bids well over the clearing price) can be
u eliminated. This is done to prevent investors
from placing very high bids to ensure that they
CO are allocated shares. Shares are then allocated,
on a pro rata basis, to all the investors who placed
bids between these two prices. In a uniform price
auction, all the investors receiving shares will
pay the same market clearing price. In the less
I
CO
common discriminatory price auction, investors
pay the prices they bid for.
In a fixed-price offer, the issuer and the
> underwriter jointly determine the offer price, and
(3 investors place orders for shares at this price. If
the issue is oversubscribed, shares are either
allocated through lottery or on a pro rata basis.
In the book-building method, the underwriter
promotes the IPO by disseminating information
about the issuing firm via road shows. They gather
indications of interest by soliciting from potential
investors their desired prices and quantities
for the issue. The underwriter then uses this
information to determine the final offer price.
Under this method the underwriter has complete
discretion on the allocation of new shares.
Of the three allocation mechanisms, evidence
has shown that IPOs under the auction method
show the lowest average underpricing. However,
firms that choose the auction method sometimes
fail to go public because bids for their shares are
insufficient. This problem is especially common
for smaller, less known companies, which
require substantial information production and
dissemination by the underwriters. For these
firms, the book-building method might be the
only option that will allow them to go public. It is
therefore not surprising to see the book-building
method, a method that is used predominantly in
the United States, gaining popularity around the
world.
WHY ARE IPOS UNDERPRICED?
IPO underpricing continues to be a global
phenomenon despite a vast amount of research
that attempts to explain it. Theories based on
information asymmetry suggest that high-quality
issuers deliberately underprice their IPOs to
u signal their quality to outside investors, hoping
that it will be too costly for low-quality issuers
Z to mimic. Underpricing also helps to overcome
I
adverse selection problems. Since uninformed
investors tend to get a higher allocation of
overpriced shares, they will stop participating in
P-t
174
IPOs if issues are not, on average, underpriced.
In the book-building framework, the theory of
partial adjustment suggests that investment
banks only partially adjust IPO offer prices
upward when they receive positive information
about the value of the issue. They purposely
leave money on the table to reward investors
who truthfully reveal their information about
the issue and threaten access to future deals for
those that do not.
Some studies suggest that investment banks
underprice IPOs to protect their reputation.
When new issues are priced lower than they
should be, investment bankers reduce their legal
liability by lowering the chance of price declines.
There is also evidence that greater underpricing
leads to more aftermarket trading volume, which
increases the revenue of investment bankers
when they subsequently become the market-
makers for these IPO firms. Investment bankers
also benefit from underpricing because it allows
them to curry favor with their clients in exchange
for their loyalty and continued business. These
explanations do not make it clear why issuing
firms approve underpricing as it only benefits
the investment banks.
There are explanations of underpricing that are
based on information production and ownership
dispersion which will benefit the issuing firms.
If issuing firms want to have a more dispersed
ownership, they need to underprice their IPOs
so that more investors will be induced to produce
information about the issue and subsequently
buy the shares. Dispersed ownership increases
liquidity and aftermarket trading, and also helps
existing owners to retain control of their firms.
These explanations predict a positive relationship
between underpricing and aftermarket liquidity.
However, there is also an explanation that
predicts an inverse relationship between these
two variables. When aftermarket trading for
an IPO is expected to be thin, investors face
higher aftermarket trading costs associated with
asymmetric information; thus, they demand a
higher level of underpricing to compensate them
for the liquidity risk.
It has also been argued that underpricing
is a substitute for marketing expenditure.
Hugely underpriced IPOs tend to receive a
disproportionate amount of media attention
and publicity. Research shows that an extra
dollar left on the table reduces other marketing
expenditure by about the same amount. Higher
underpricing also attracts more analyst coverage
post IPO.
 The Cost of Going Public: Why IPOs Are Underpriced

CASE STUDY w
o
The Google IPO en
Google, the world's most widely used search engine, filed for an IPO in April 2004. Founded in
1998 by Sergey Brin and Larry Page, Google grew rapidly in the internet space, due mainly to

a
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its superior search technology. With a core business in selling search-based advertising, by 2004
Google had shown impressive sales growth and handsome profit margins. According to its filing,
Google generated US$961.9 million of revenue and US$106.5 million of net profit in 2003. It had o
been profitable since 2001.
Google decided to use the auction method to go public, a deviation from the book-building W
method that is primarily used in the United States. According to Brin and Page, an auction would
provide a fair process for all investors and help to determine the share price that reflected a •s
fair market valuation of Google. They believed that auction mitigates problems associated with
unreasonable speculation, which can result in boom-bust cycles that may hurt investors in the
long run. They also wanted their shares to be within reach for any investors, unlike book-built
IPOs, which are available only to those who have special relationships with the underwriters. The
lead underwriters of the Google IPO, Morgan Stanley and Credit Suisse First Boston, helped to
decide on a preliminary price range of US$108 to US$135 a share. That range was later revised to
US$85-95, and the number of shares offered was reduced after it became apparent that the IPO
wasn't as popular as expected.
3
Google successfully went public on August 19, 2004, at US$85 per share, selling 19.6 million
shares. The first-day closing price was US$100.34, resulting in an underpricing of 18.05% and
US$300.7 million left on the table. The underpricing of 18% was about average compared to other
US IPOs but low relative to other internet IPOs, especially those that went public during the bubble
period of 1999-2000. Google managed to go public using the auction method because it waited
six years until it was well established, became a household name, and had a record of positive
earnings.
However, many industry watchers felt that Google did not fare well in its IPO because it
chose the auction method. It started as a hot IPO, yet had to reduce its filing price range due to
insufficient demand at the higher price range that was originally proposed. Some attributed the
low demand to lack of participation by institutional investors. Others claimed that Google was
sabotaged by investment bankers, who prevented their clients from bidding because it had chosen
a method that offered them little benefit. Could Google have got a higher offer price and larger
issue proceeds if it had used the book-building method? It is a question we cannot answer but
which will leave us wondering for a long time.

CONCLUSION
Underpricing comes at the expense of the original
owners and venture capitalists of the issuing firm.
However, these insiders typically do not strongly
oppose or even attempt to avoid it, because they
generally do not sell their shares until about six
months later, after the lockup period expires.
To them, underpricing creates excitement that
could help create sustainable interest in the
firm's shares, thus keeping demand strong until
they are ready to sell. Additionally, insiders are
so contented with their new-found wealth that
they do not mind leaving some money on the
table for new investors. Underpricing is simply
viewed as an inevitable cost of going public.

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175
 Financing and Raising Capital

.2 MAKING IT HAPPEN
jj Although underpricing may be inevitable due to certain risk and liquidity constraints, there are
£j ways in which issuing firms can reduce it if they want to. Here are some suggestions:
(^ • Engage reputable underwriters and auditors: Prestigious underwriters use their reputation
+J capital to certify the value of the firm and reduce investor uncertainty about the value of the
^ issue, and that consequently lowers the level of underpricing. Reputable auditors are better
PQ able to certify the accuracy of the financials and reduce uncertainty as well. From a partial
• adjustment perspective, prestigious underwriters are expected to have more future deals to
r* compensate investors. They do not have to pre-commit a large underpricing for each issue and
V thus are expected to underprice less.
S • Frequent disclosure: Issuing firms can also reduce underpricing by voluntarily and frequently
as disclosing information about themselves in the press, provided that the quiet period rule is not
S£ violated. Frequent disclosures reduce asymmetric information, and hence lower the information
g production costs incurred by investors.
^ • Issuer characteristics: IPO underpricing is lower with certain issuing firm characteristics.
J? If issuing firms can wait until they are larger in size, have a longer operating history, and
"jj possess a record of positive earnings before going public, they are likely to reduce the level of
Cf underpricing. Underpricing can also be reduced if there are more experienced insiders sitting on
H the board of the issuing firm.
• Use the auction method if feasible: As noted above, many explanations of underpricing were
derived from the book-building framework. To reduce underpricing, issuers in IPO markets
in which the auction mechanism is available might want to go public that way. However, the
auction method works only if the issuing firm is a superior quality firm that has high investor
awareness. Also, if the issuing firm is concerned more about factors other than underpricing—for
example, price stabilization and post-IPO analyst coverage provided by investment banks—book-
building may be a better choice.
• might want to go public that way. However, the auction method works only if the issuing firm is
a superior quality firm that has high investor awareness. Also, if the issuing firm is concerned
more about factors other than underpricing—for example, price stabilization and post-IPO
analyst coverage provided by investment banks—book-building may be a better choice.

MORE INFO
Book:
Jenkinson, Tim, and Alexander Ljungqvist. Going Public: The Theory and Evidence on How Companies
Raise Equity Finance. 2nd ed. Oxford: Oxford University Press, 2001.
Articles:
Derrien, Frangois, and Kent L. Womack. "Auctions vs. book-building and the control of underpricing
in hot IPO markets." Review of Financial Studies 16:1 (Spring 2003): 31-61. Online at:
dx.doi.org/10.1093/rfs/16.1.31
Ritter, Jay R., and Ivo Welch. "A review of IPO activity, pricing, and allocations." Journal of Finance
57:4 (August 2002): 1795-1828. Online at: dx.doi.org/10.1111/1540-6261.00478

Websites:
IPO data—Jay R. Ritter's page of IPO links: bear.cba.ufl.edu/ritter/ipodata.htm

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r"3 IPOresources.org: www.iporesources.org

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 Checklists
Issuing Debt
Assessing Cash Flow and Bank Lending
Requirements
DEFINITION
Lack of cash flow is a major cause of a business
failing as, even though it may be turning a
profit, if the money does not flow in on time the
business will not be able to settle its debts. Cash
flow is basically the measure of a company's
financial health, showing the amount of cash
generated and used by a company in any given
period. Cashflowis essential to ensure solvency,
as having enough cash ensures that creditors and
employees can be paid on time. Banks require
companies to show the difference between sales
and costs within a specified period, which acts
as an indicator of the performance of a business
better than the profit margins. Sales and costs
and, therefore, profits do not necessarily coincide
with their associated cash inflows and outflows.
Even though a sale has been secured and goods
delivered, payment may be deferred as a result
of credit to the customer, yet suppliers and
staff still have to be paid and cash invested in
rebuilding depleted stocks. The net result is that
although profits may be reported, the business
may experience a short-term cash shortfall.
The main sources of cash flow into a business
are receipts from sales, increases in bank loans,
proceeds of share issues and asset disposals,
and other income, such as interest earned. Cash
outflows include payments to suppliers and
staff, capital and interest repayments for loans,
dividends, taxation, and capital expenditure.
Cash flow planning entails forecasting and
tabulating all significant cash inflows and
analyzing in detail the timing of expected
payments, which include suppliers, wages, other
expenses, capital expenditure, loan repayments,
dividends, tax, and interest payments.
A computerized cash flow model can be
used to compile forecasts, assess possible
funding requirements, and explore the financial
consequences of other strategies. Computerized
models can help prevent major planning errors,
anticipate problems, and identify opportunities
to improve cashflowand negotiate loans.
Banks must ensure that a business is viable,
which entails asking pertinent questions. Lenders
will insist on up-to-date information on the
type of industry, management capabilities and
experience, business plans and daily operations,
key competition, and PR and marketing plans.
o
sr
They have to know that the business makes
sense and can repay a loan, and what security
is available in case of insolvency. Companies 03
have to keep within their cash limits regardless
of anticipated business. Business factoring is an
alternative to bank loans—a factoring company S3
buys your credit invoices and provides you with CfQ
immediate cash in exchange for a small fee d
ft
ranging between 1.5% and 5.0%. Factoring is
moreflexiblethan a bank loan.
ADVANTAGES
Ensuring good cashflowthrough a company
helps to:
• increase sales;
• reduce direct and indirect costs and overhead
expenses;
• raise additional equity;
• gain the confidence of banks and potentially
secure more loans.
DISADVANTAGES
• If your profit margins are already low, you
might not be able to afford bank fees.
• The banks have a tendency to up fees and
charge for late payments.
ACTION CHECKLIST
It is essential to keep track of your cash and
not allow any surplus to sit idle. Accounts must
be carefully monitored and cash invested to
maximize returns. There are many ways to
increase cash flow:
^ r e d u c i n g credit terms for historically slow
payers;
v ' reviewing customer payment performance;
>/becoming more selective when granting
credit;
y'seeking other ways to pay rather than all
in one installment, such as deposits or
staggered payments;
*/ reducing the amount of time of the credit
terms; o
^ i n v o i c i n g immediately the work has been
done; Z
v ' i m p r o v i n g collection systems for billing;
oz
V'adding late payment charges.
hi
179
 Financing and Raising Capital

4-*
CO DOS AND DON'TS
DO
Do understand the way your company works,
using a detailed analysis of banking procedure
X and taking into consideration:
• overdraft facilities and investment accounts;
• the number of monthly transactions;
• the number of written monthly checks;
Q • how customers pay y o u ;
• the suitability of electronic banking for your
a business;
• cash access facilities;
• interest income;
• overall expenses and fees.
DONT
• Don't overestimate sales forecasts.
• Don't underestimate costs.
• Don't underestimate delays in payments.
• Don't forget to check your debtors' credit
history carefully.

03
OS

MORE INFO
Books:
Fight, Andrew. Cash Flow Forecasting. Oxford: Butterworth-Heinemann, 2006.
Mulford, Charles W., and Eugene E. Comiskey. Creative Cash Flow Reporting and Analysis:
Uncovering Sustainable Financial Performance. Hoboken, NJ: Wiley, 2005.
Reider, Rob, and Peter B. Heyler. Managing Cash Flow: An Operational Focus. Hoboken, NJ: Wiley,
2003.

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The Bond Market: Its Structure and
Function
DEFINITION
The bond market is the market for debt
securities in the form ofbonds where buyers and
sellers determine their prices and therefore their
accompanying interest rates. It is also known as
the fixed-income or debit or credit market.
In purchasing a bond you are effectively
lending money to a government, corporation, or
municipality, known as the issuer, which agrees
to pay you a certain rate of interest during the
lifetime of the bond and repay its principal or
face value when it matures or becomes due.
The international bond market is estimated
to have a size of almost US$47 trillion. The US
bond market is the largest in the world, with an
outstanding debt of more than US$25 trillion. In
2007, the volume of trade in the US bond market
was US$923 billion.
Since 2000, the international bond market
has doubled in size as a result of the activity of
big multinational companies. According to the
International Capital Market Association, about
US$10 trillion worth ofbonds were outstanding
in 2007.
The individual government bond markets
have a high level of liquidity and considerable
size—these are included in the international
bond market. They are noted for their low credit
risk and are unaffected by interest rates.
Trading generally takes place over the counter
(known as OTC) between broker dealers and big
institutions. The stock exchanges list a small
number ofbonds too.
The largest centralized bond market is the
New York Stock Exchange (NYSE), which mainly
represents corporate bonds. In contrast to this,
most governments have bond markets that lack
centralization, mostly due to the fact that bond
issues vary widely and there is a large choice of
different securities by comparison.
Most outstanding bonds are in the hands of
institutions: pension funds, mutual funds, and
banks. This is because individual bond issues are
so specific and a large number of smaller issues
lack liquidity.
The volatility of the bond market is in direct
proportion to the monetary and economic policy
of the country of the participant.
The main difference between corporate and
government bonds is that the latter are guaranteed
and thus carry a low risk of investment, albeit at
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CD
a lower rate of return. Corporate bonds generally
offer a higher rate of return on investment,
but carry more risk—if the company fails, the
5»
bondholder risks losing their investment.
•Mi
ADVANTAGES NNfft
S3
• It is considered a wise move to invest in bonds QfQ
as part of a considered diversified investment
portfolio that also consists of stocks and o
cash. They are considered to be a relatively ft
cr
safe investment for increasing capital and
receiving a reliable interest income. The
principal and interest are set at the time the
bond is purchased. If the owner collects the
coupon and holds it to maturity, the market
is irrelevant to final payout. As a long-term
investment, bonds may be considered a wise
choice—bearing in mind the disadvantages.
DISADVANTAGES
• Bonds are not advisable for short-term savings
for the individual participant in the market.
• Long-term commitment is essential as the
participant who cashes in before maturity
is open to the risk of fluctuations in interest
rates. Whenever there is an increase in interest
rates, there is a corresponding decrease in the
value of existing bonds. Conversely, a decrease
in interest rates will correspond to a rise in the
value of existing bonds. This is due to the fact
that new issues pay out a lower yield. The basic
concept of bond market volatility is that the
value ofbonds and changes in interest rates
run inversely to each other.
• When interest rates drop, investors have to
reinvest their interest income and return of
principal at lower rates.
• The final purchasing power of an investment
in bonds is reduced by a corresponding
increase in inflation, which also results in
higher interest rates and correspondingly
lower bond prices.
» If there is a decline in the bond market as a
whole, individual securities also fall in value.
• Timing is crucial: a security may in the future
unexpectedly underperform relative to the
market.
• A bond may perform poorly after purchase, or
o
it may improve after you sell it.
• Corporate bonds have relatively low liquidity
compared with government bonds, which
usually have a short lock-in period (i.e. they
can be cashed in quickly). n
181
 Financing and Raising Capital

ACTION CHECKLIST DOS AND DONTS

V'Make sure that you can afford to invest DO
in long-term savings before you commit • Be sure to choose a security that is approved
yourself to taking out bonds. by a financial expert.
v ' H a v e another form of savings as an
emergency fund in case you meet with an DONT
unexpected financial problem in the future. • Don't rush into a transaction or pay over the
X V'Read all the available literature and take odds for it.
advice from an impartial financial consultant
P before making a final commitment.
C
s
as

MORE INFO
Books:
Adams, Tom. Savings Bond Adviser: How U.S. Savings Bonds Really Work—With Investment, Tax,
and Estate Strategies. 5th ed. New York: Alert Media, 2007.
Pederson, Daniel J. Savings Bonds: When to Hold, When to Fold and Everything In-Between.
4th ed. Detroit, M I : TSBI Publishing, 1999.

Website:
Investopedia introduction to bonds: www.investopedia.com/university/bonds

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182
Financial Intermediaries: Their Role
and Relation to Financial Markets
DEFINITION
Generally, when a company wants to enter a
financial market, it uses the services of a financial
intermediary rather than entering directly. In
many transactions the intermediary will be the
company's commercial bank, which will broker
financial deals such as loans. For more complex
or specialist deals a company is likely to turn to
an intermediary that specializes in transactions
for financial products such as mutual funds,
pension funds, bonds and shares, and insurance.
In such cases, the intermediary may be a fund or
insurer itself.
A financial intermediary typically facilitates
the channeling of funds between lenders and
borrowers indirectly, in the form of a loan or a
mortgage. Sometimes the intermediary may lend
money directly via the financial markets. This is
known as financial disintermediation.
The intermediary's role is to seek the best
possible investment opportunities on behalf
of its clients. The intermediary will often have
contacts within its areas of expertise that would
not be accessible to private individuals using
a retail bank, for example. This enables the
intermediary to broker the most appropriate
deals for its client, which is spared the trouble of
having to seek these out itself. The intermediary
charges a fee to the client for its services.
ADVANTAGES
• Lending is often less risky through an
intermediary, who can, for example, diversify
lending, providing the company with a
variety of different loan plans. If some
loans then prove themselves to be unviable,
they are offset by those that are sound.
Experience is an important element of this.
By making many and diverse loans, financial
intermediaries gain experience in identifying
clients who will be able to repay their loans,
as well as those who will not. This reduces
risk and minimizes the number of unviable
loans for the client, who is spared the burden
of making expensive mistakes.
• Financial intermediaries have liquidity,
which means they are in a position to convert
assets to money quickly. This has obvious
advantages in terms of obtaining cash when
it is needed. For a company this can be of
crucial importance if it experiences difficulties
such as temporary cash flow problems.
DISADVANTAGES
• The main disadvantage is that, on top of
their fee, financial intermediaries often
take a percentage of profits as part of any
transaction they broker. Direct loaning can
significantly increase the potential income of
such a loan for the intermediary. However,
the advantages outlined above significantly
mitigate any such disadvantages. That is why
many companies use intermediaries rather
than entering the market directly.
ACTION CHECKLIST
\/Ask around for recommendations. Your
bank should have knowledge of specialist
intermediaries who can cater for your needs,
for example. Your accountant or lawyer may
also have useful contacts.
V Investigate a financial intermediary
thoroughly before entering into a
relationship. Check that they have any
necessary certification or license.
V You should be confident that your
intermediary is a responsible and
experienced broker and/or lender.
DOSANDDON'TS
DO
• Approach your decision by comparing and
contrasting several choices of intermediary.
• Research your options carefully to ensure
that potential intermediaries are both
experienced and economically sound.
• Have interview meetings with intermediaries
you are considering to ensure that you will
be able to work with each other before you
enter into any financial relationship.
DONT
• Don't rush hastily into a relationship with an
intermediary.
• Don't use an intermediary who cannot
produce evidence of the right certification or
license to practice.
183
 Financing and Raising Capital

•£ MORE INFO
'A Books:
^ Harrison, Tina. Marketing Financial Services. 2nd ed. New York: FT Prentice Hall, 2000.
V Taylor, Bernard, and Ian Morison (eds). Driving Strategic Change in Financial Services. Cambridge,
^ UK: Woodhead Publishing, 1999.

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184
Franchising a Business
DEFINITION
The term "franchising" can refer to a number of
different business models, including licensing,
distributor, and agency arrangements. Here,
however, we take it to mean "business-format
franchising." The British Franchise Association
defines this concept as the granting of a license
by a franchisor to a franchisee that "entitles
the franchisee to trade under the trademark/
trade name of the franchisor and to make use of
an entire package, comprising all the elements
necessary to establish a previously untrained
person in the business and to run it with
continual assistance on a predetermined basis."
Franchising can provide an excellent means
of expanding a business rapidly and in a cost-
effective manner. It can also generate a number
of revenue streams for the franchisor. These
include: the franchise fee; franchise royalties;
equipment sales; supplies; material sales; sales
of services; property rental; and rebates from
vendors of equipment and supplies.
Each business outlet is owned and operated by
the franchisee. However, the franchisor retains
control over the way products and services are
marketed and sold, and controls the quality and
standards of the business. Not all businesses can
be franchised, but most business concepts can
be. Businesses that can be franchised tend to be
unique and very new, with the potential to expand
nationally or internationally, and profitable, with
the ability to generate continuous and predictable
profits. They tend to have a systemized business
model, with efficient operating procedures that
can be easily transferred from one location to
another, and an easily understandable format,
so that it is straightforward to train other people
to manage the operation. They should also be
affordable, so that a wide range of potential
franchisees can be attracted.
ADVANTAGES
• It can be difficult to raise capital to expand a
business. If you use franchising, the capital is
provided by the franchisee.
• Franchisees tend to be highly motivated,
since it is their capital that is at risk.
• Franchising allows you to expand a business
very rapidly.
• Expanding the business leads to economies
of scale, with benefits such as greater buying
power.
DISADVANTAGES
• You need an effective marketing program and
very good salespeople to develop the concept
and drive sales forward once the franchise
network has been established.
• You inevitably lose some control of the
business unless you have a very strict
operating model and the ability to oversee the
way each franchisee is operating the business.
• It can be difficult to manage the business if it
grows very rapidly (as is often the case with
franchise networks).
• The threat of litigation between franchisor
and franchisee can be high, particularly if
the franchisee fails to make the profits they
expected.
ACTION CHECKLIST
>/ Identify whether the business concept you
are developing is suitable for a franchise
arrangement.
• Register your trade name and trademarks
with the relevant trademark office. You
should also register your name and marks in
all the countries or provinces where you do
business or intend to do business.
• Open four or five business units before
embarking on a national expansion. This
will give you time to identify any potential
pitfalls. You will also be able to gauge
whether the business format can be copied
from one geographic location to another.
DOSANDDONTS
DO
• Avoid conflict and potential litigation by
supporting your franchisees and ensuring
that they are successful.
• Make sure you have enough staff to support
the growth of your franchisees and service
their needs.
• Draw up a very strict franchise agreement
that allows the franchisee little latitude to
vary from your system.
185
 Financing and Raising Capital

DONT
• Don't ignore the importance of training. Even
franchisees in a simple business model will
require a very strong training program so
that they are completely conversant with
6 your systems and procedures.
Don't think you can relax once franchisees
have signed on. They will need continuous
support if their business, and thus you, are
to be successful.

-8
c MORE INFO
Books:
Shook, Carrie, and Robert L. Shook. Franchising: The Business Strategy that Changed the World.
Englewood Cliffs, NJ: Prentice Hall, 1993.
Spinelli, Stephen, Jr., Robert M. Rosenberg, and Sue Birley. Franchising: Pathway to Wealth
Creation. Upper Saddle River, NJ: FT Prentice Hall, 2004.
Tarbutton, Lloyd T. Franchising: The How-to Book. Englewood Cliffs, NJ: Prentice Hall, 1986.
Articles:
Kaufmann, Patrick J., and Rajiv P. Dant. "Multi-unit franchising: Growth and management issues."
Journal of Business Venturing 11:5 (September 1996): 343-358. Online at:
dx.doi.org/10.1016/0883-9026(96)00057-2
Mathewson, G. Frank, and Ralph A. Winter. "The economics of franchise contracts." Journal of Law
and Economics 28:3 (October 1985): 503-526. Online at: dx.doi.org/10.1086/467099
Website:
UK government website providing advice for businesses: www.businesslink.gov.uk

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How to Manage Your Credit Rating n
DEFINITION
A credit rating is an assessment of the ACTION CHECKLIST
Gfi
creditworthiness of an entity such as an v^Buy access to your credit history and use it
individual, a corporation, or even a country. to check your credit rating.
•
Credit ratings are worked out from past financial ^ M a k e sure that any spent court judgments M
history as well as current assets and liabilities, and are recorded as such on your file. Gfi
(ft
are used to inform a potential lender or investor ^ E n s u r e that any annulled or discharged
about the probability of the entity being able to bankruptcy order is recorded as such on your c
pay back a loan. However, in recent years credit file. w
ratings have been used more widely. They have, V'Keep up with all payments. O
for example, been used to make adjustments to n
insurance premiums or to establish the amount cr
of a leasing deposit.
Credit reference agencies compile credit
histories on individuals using information DOS AND DON'TS
from sources such as electoral registers, court DO
judgments, and lenders. Anyone applying for • Understand what your credit rating is.
credit can expect to have their request recorded • Check for errors in your credit rating, and
for the credit agencies to access and use. Financial have them amended.
institutions compile their own credit ratings for • Work to make your credit history better if it
companies. The best known credit raters are has been poor in the past.
Moody's and Standard & Poor's, which produce • Ask a potential lender if you fit their profile
credit ratings for listed companies, banks, and of a typical successful credit applicant as this
even countries. may help you to avoid an actual credit check.
Credit reference agencies do not make the • Pay your creditors on time. If you miss a
decision on whether to offer credit to would- payment, inform your creditor straight away.
be borrowers. It is for the lenders to reach a • Make sure you are on the electoral register.
decision using information amassed by the • Make sure you complete credit card
credit agencies, combined with their own lending application forms correctly.
criteria and knowledge. • Make your credit card, store card, loan, and
Having a bad credit rating limits your mortgage repayments on time.
borrowing options. Court judgments, defaults on • Consider asking a family member or friend
payments, and bankruptcy orders will all reduce with a good credit rating to co-sign for a
your credit rating score. This applies equally small loan or credit card. This can help your
to individuals and businesses. Where a credit own rating.
applicant has a poor credit rating, credit may
still be obtained through the subprime market, DONT
where the borrower is charged much higher • Don't miss any payments.
rates of interest. • Don't check your credit record too often.
• Don't apply for loans too often, especially if
ADVANTAGES you have a doubtful credit record.
Managing your credit rating can help to: • Don't avoid having any credit—no credit
• ensure that you have access to credit in the record is as bad as a poor credit record.
future;
• enable you to take out a mortgage or loan; give
you peace of mind.

DISADVANTAGES O
• Repeated applications for credit (particularly
unsuccessful ones) are recorded on your file.
• Repeated checks of your credit rating are
recorded on your file.
o

187
 Financing and Raising Capital

tS MORE INFO
£ Books:
^ de Servigny, Arnaud, and Olivier Renault. The Standard & Poor's Guide to Measuring and Managing
V Credit Risk. New York: McGraw-Hill, 2004.

fl Ong, Michael K. (ed). Credit Ratings—Methodologies, Rationale and Default Risk. London: Risk
Books, 2002.

•8
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09

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188
How to Use Receivables as Collateral
DEFINITION
Receivables are money owed by customers,
whether they are individuals or businesses, to
another entity for goods or services that have
been delivered or used, but have not yet been
paid for. Receivables are usually due within a
short time period, which typically ranges from a
few days to a year.
Accounts receivable financing is used by
companies facing short-term cash flow problems,
and it can take many forms. The major source
of accounts receivable financing is commercial
finance companies and factoring companies, as
well as banks that will consider receivables as
security or collateral for a business loan. Most
companies operate by allowing a portion of
sales to be on credit, usually to customers that
are invoiced periodically, which removes the
burden of physically making payments as each
transaction occurs. Credit acts as an IOU for
goods or services already received or rendered
and is given in good faith. Collateralizing
receivables is a form of secured lending that
gives companies short-term financing by selling
their trade receivables or pledging receivables
as collateral for a loan from a lender. Until the
global financial crisis of 2008, receivables were
securitized as well.
Direct sale of accounts receivable is called
factoring. A loan from a bank secured or
collateralized against accounts receivable is
known as a discount, where the borrower draws
against a line of credit that is less than the full
value of the trade credits. Accounts receivable
financing is a flexible way of obtaining credit, and
borrowers' financing costs are related directly to
their business cycle. In a general assignment,
all receivables can serve as collateral, with new
receivables substituted for those collected. In
a specific assignment, the parties involved can
specify who will receive collection, whether
customers will be notified of the arrangement,
and which accounts are to be collateralized.
Accounts receivable factoring is different
from using accounts receivable as loan collateral
because you sell the receivables to a factor at a
discount; the factor then collects the debt and
you don't have to worry about loan repayments.
Accounts receivable factoring makes up about
a third of all financing secured by American
companies using accounts receivable and
inventory as collateral.
9
When a loan is obtained from a bank with
receivables as collateral, there are rather more
formal guidelines. Banks and finance companies
insist on weekly reports on sales, collections, •
and ineligibility analysis, as well as internally
generated financial statements with detailed en
accounts receivable and accounts payable
&
C
information. The amount borrowed is then 3
repaid within a specified short-term period as W
the receivables are collected. d
ft
ADVANTAGES
• Collateralizing receivables can provide
a-
another source of working capital, freeing up
essential funds for items such as payroll and
taxes.
• This form of financing can provide relief
from the responsibility of collection from
nonpaying and slow-paying clients.
DISADVANTAGES
• Receivables financing is often priced at
spreads above the bank prime rate and is
relatively expensive compared with other
forms of credit, particularly factoring.
• The older the account, the less value it has.
ACTION CHECKLIST
• When you sell an account to an accounts
receivable factoring company, try to get a
personal recommendation for the company
and ensure that your accounts receivable
factoring agreement states the exact
conditions and charges for the purchase of
your accounts receivable.
• Check the rates carefully and find out the
amount a lender is willing to advance against
the value of your collateralized receivables.
The borrowing base is determined by
multiplying the value of the assigned
collateral by a discount factor, a process
known as margining.
DOSANDDONTS
DO o
• Set up an easy-to-check accounts receivable
report.
• Have a system in place to assess monies
owed and monies unpaid.
o
189
 Financing and Raising Capital

« DONT
$3 • Don't wait too long to take action on debts. • Don't use accounts receivable factoring as a

3S • Don't fall back on sentiment and loyalty.

• Don't forget to check bank rates, loan rates,
w a y to get ready cash.

V and factoring rates.

C? MORE INFO
3 Books:
Cfi Bond, Cecil J. Crec/Zr Management Handbook: A Complete Guide to Credit and Accounts Receivable
H Operations. New York: McGraw-Hill, 1993.
Salek, John G. Accounts Receivable Management Best Practices. Hoboken, NJ: Wiley, 2005.

U
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190
Maintaining the Banking Relationship
DEFINITION
A banking relationship is about much more than
just selecting a bank to handle a company's bank
accounts. Managed well, a banking relationship
can help a company to thrive.
Companies that use more than one bank will
need to manage multiple banking relationships.
A company will first have a business account (or
several) at a retail bank (or banks) for all day-to-
dayfinancialtransactions. Bigger companies will
almost certainly have dealings with investment
banks as well. (This applies to companies that
are publicly listed, but even private unlisted
companies often use investment banks to either
handle their investments or to supply financing
for the business.) There may also be relationships
with other financial entities such as hedge funds
or pension funds.
Whether retail or investment, the bank is
most likely to have a team of business banking
advisers on hand to advise and guide a company.
It's important to ensure continuity—the bank
will usually offer contact with a designated
person and in turn expect to deal with the
same person or persons from the company. A
good banking relationship depends not only on
personal rapport but also on the banking adviser
having a solid understanding of the company
and its financial needs. Over time, a banking
adviser should build up a good understanding of
the company's preferred ways of doing business
and incorporate that into how their banking
requirements are handled.
ADVANTAGES
• The bank is more likely to offer loans
and other lines of credit, potentially at
preferential rates of interest, if the bank
advisers feel there is a good relationship
with the company. The potential to sell other
financial products also increases.
• The bank's advice can be tailored for the
company's needs and personal style, rather
than given generically.
• In times of crisis, a company having its bank's
support will be crucial. Even if a company is a
text-book case of insolvency, strong personal
rapport with a company representative
means that the bank is more likely to offer
leeway if it knows that directors are doing
their utmost to keep the company going.
9
re
DISADVANTAGES
• There are no disadvantages to building up
good relationships with the companies that
do business with a bank. Failure to develop
a strong relationship, however, means that
the company is likely to miss out on good GA
(ft
advice and, crucially, support in times of
trouble. Conversely, the bank may miss out
0
on opportunities to increase business. ore
d
n
ACTION CHECKLIST cr
</ Aim to work with a designated representative
from the company and ensure you have good
personal rapport with each other.
• if the company is dealing with more than
one financial institution, it can be useful to
find out which individuals at other banks are
handling the company's needs. It's possible
the various advisers may already know
each other, which can strengthen the overall
banking relationships for the company and
your own bank.
DOSANDDONTS
DO
• Work to ensure continuity in your banking
relationships.
• Maintain regular contact and make sure the
company keeps you informed of its financial
situation and decisions.
• Encourage the company to be honest and
open. A bank cannot help, advise, or support
if the company does not disclose important
financial information.
• Consider advising the company representative
to attend a short course on managing banking
relationships. Many financial organizations
offer short courses which can be helpful in
terms of managing their expectations, which
in turn can improve the relationship.
DONT
• Don't push products onto clients or pressure
clients to make decisions quickly, as this could
have a damaging effect on the relationship.
• Don't neglect relationships. Even if you only
D
need to see the company representatives
once or twice a year, periodic phone calls can
help to maintain contact.
o
191
 Financing and Raising Capital

§ MORE INFO
Books:
3
^ Cranston, Ross. European Banking Law: The Banker/Customer Relationship. 2nd ed. London: LLP
V Professional
Gandy, Anthony.Publishing,
Customer1999.
Relationship Management—Profit through Knowledge. Chicago, IL:
Glenlake Publishing Co, 2000.
^ Leahy, Gordon, and Gerald Leahy. Managing Banking Relationships. Cambridge, UK: Woodhead
»g Publishing, 1997.
Q Militello, Frederick C. Reassessing Corporate Banking Relationships: Issues, Practices and New
M Directions. Morristown, NJ: Financial Executives Research Foundation, 1998.
fi
3
<*>
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192
Measuring Gearing
DEFINITION
Gearing, also known as leverage, is an indicator
of a company's ability to service its debt. Gearing
is usually expressed as a percentage and is
calculated by dividing the company's debt by its
equity. Gearing shows the degree to which a firm's
activities are funded by owners' funds versus
creditors' funds. The higher a company's degree
of leverage, the more the company is considered
risky. If a company has a large amount of debt in
proportion to its equity, this could be a warning
that the company may have problems paying its
debts in the future. As when using most ratios,
an acceptable level of risk is determined through
comparison with other companies in the same
industry.
The three most common examples of gearing
ratios are:
• The debt/equity ratio (total debt/total
equity), multiplied by interest earned
(earnings before interest and taxes, divided
by total interest).
• The equity ratio: total equity/total assets.
• The debt ratio: total debt/total assets.
In derivatives markets, gearing compares the
amount of cash spent purchasing an option or
a futures contract with the actual value of the
underlying position. The more highly leveraged
the trading position, the bigger the risk that a
minor change in market prices will totally wipe
out the investment. Equally, however, a minor
change in markets in the right direction could
generate large profits in relation to the size of
the investment.
Negative gearing is when an investor borrows
to buy an asset, but the returns on the asset do
not cover the interest on the loan. A negative
gearing strategy works when the asset rises in
value and creates enough capital gains to cover
the initial investment loss. The investor must
finance the shortfall until the asset is sold.
ADVANTAGES
• Gearing ratios allow potential investors to
judge the viability, liabilities and likely future
performance of a company or industry.
• Gearing ratios permit analysts to read
between the lines of financial statements
and quantify a company's strengths and
weaknesses.
sr
• Gearing ratios provide lead indications of
potential problem areas and allow corrective
£
measures to be taken.
DISADVANTAGES
Oft
• Gearing ratios may not always reflect the true
C
nature of a company's accounts, as managers
may attempt to gloss over problems.
• Gearing ratios are only predictive, based d
on past performance; and cannot take into n
account future events.
or
• Using gearing ratios to make comparisons
between companies and industries is not
always possible, due to different worldwide
accounting standards.
ACTION CHECKLIST
^Obtain as much information as you can, and
compare a company's ratios to those of other
firms in the same industry, before committing
to an expensive decision.
^Make sure that you have analyzed the
gearing ratios in detail. If in doubt, consult
an expert analyst.
^ B e sure you thoroughly understand the
ratios. Economizing by taking shortcuts or
skipping details may cost more in the long
run.
DOSANDDONTS
DO
• When comparing a business's gearing ratios
with its competitors, allow for any material
differences in accounting policies between
the compared company and industry norms.
DONT
o
• Don't rely solely on gearing ratios. Use
market research to confirm the results. Don't
fall into the trap of thinking that gearing
ratios are infallible.
>
o
r-rl
193
 Financing and Raising Capital

§ MORE INFO
'A Books:
^ Chadwick, Leslie. Essential Finance and Accounting for Managers. Harlow, UK: Pearson Education,
V 2002.

6 Fraser-Sampson, Guy. Private Equity as an Asset Class. Chichester, UK: Wiley, 2007.
Myddelton, David Roderic. Managing Business Finance. Harlow, UK: Pearson Education, 2000.
Articles:
4) Calder, Stephen. "Super leverage." Australasian Business Journal (January 2008).
Q Rees, Mathew. "On leveraged buyouts." The International Economy (June 2008).
two
£ Website:
*S The Motley Fool on gearing: www.fool.co.uk/school/2005/sch050803.htm
CQ

U
Z
$

o
194
Money Markets: Their Structure and
Function
DEFINITION
Money markets are the part of the global financial
market that deals with short-term lending and
borrowing. They are often used as a solution to
short-term cash needs by governments, large
institutions, and, sometimes, individuals.
Generally, participants in the money markets
are retail banks and large corporate organizations
that can trade with each other using the
benchmark of the London Interbank Offered
Rate (Libor). This rate is generated on a daily
basis through researching the interest rates at
which banks are prepared to lend on unsecured
assets. The money markets are considered to
be quite a low-risk investment, but they do not
promise particularly high gains either.
Typically, a transaction in a money market
will be of very short duration and will be of
a particular type of dealing called "paper."
Examples of papers are treasury bills, repurchase
agreements, and foreign currency swaps. The
time frame of the transaction may range from
one day to 13 months, and it is this short-term
approach that sets money markets apart from
the capital market.
Repurchase agreements, or "repos," are very
short term loans, often lasting for only a day,
where assets are sold to an investor with an
agreement to repurchase them at a later date
for a fixed price. In foreign currency swaps,
currencies are swapped with an agreement to
reverse the deal at a later, agreed date.
ADVANTAGES
• For an organization in need of a quick cash
injection the money markets are extremely
useful. They generally allow easy borrowing
or lending in a low-risk environment. For
example, a one-day loan where the seller can
repurchase its securities for a set price at a
certain time in the future is extremely safe.
If we compare this transaction to those made
in the unforgiving world of the stock market,
where investors have no control over the
future performance of their stocks, it is easy
to see the appeal of money markets.
9ft
ft.
DISADVANTAGES
• Money markets are particularly low risk and
therefore are not suitable for an investor
looking for high returns.
• The money markets are used for short-term
loans only and are not designed to achieve 3
long-term growth of assets.
• Despite the apparent low risk of the money org
markets, all transactions in them must be d
properly assessed in the context of the global
market. When the global financial markets
go through one of their periodic cycles of
turmoil and instability, one should always err
on the side of caution with any investment.
ACTION CHECKLIST
• Consider your reasons for investing. Do
you require a quick cash release or are you
planning for the long term?
• What kind of investment are you looking for?
Consult your financial adviser to determine
what type of transaction would work best for
your company.
• Check carefully on the financial status of the
organization with which you are considering
entering into a money market agreement.
DOS AND DONTS
DO
• Research all the available fundraising options
fully.
• Give yourself as comprehensive an
understanding of the current financial market
as you can before investing.
• Examine your motives for using the money
markets as a long-term investment may
make more sense.
DONT
• Don't invest in the money markets if you
are looking for a high return on your
investments.
• Don't believe that because the money O
markets are low risk your assets are perfectly
safe.
195
Financing and Raising Capital

MORE INFO
Books:
Choudhry, Moorad. Bond and Money Markets: Strategy, Trading, Analysis. Oxford: Butterworth-
Heinemann, 2003.
Choudhry, Moorad. The Money Markets Handbook: A Practitioner's Guide. Singapore: Wiley, 2005.
Article:
Fleming, Jeff, Chris Kirby, and Barbara Ostdiek. "Information and volatility linkages in the stock,
bond, and money markets." Journal of Financial Economics 49:1 (July 1, 1998): 111-137. Online
at: dx.doi.org/10.1016/S0304-405X(98)00019-l
Websites:
The Bank of England's framework for its operations in the sterling money markets:
www.bankofengland.co.uk/markets/money
The US Federal Reserve's policy for its dollar operations: www.federalreserve.gov/monetarypolicy

196
Overview of Loan Agreements
DEFINITION
Most businesses need to borrow money, and
obtaining a loan from a bank is the most usual
way of financing a business. If successful in an
application for a loan, an individual, partnership,
or company has to enter into a loan agreement
that sets out the terms on which the loan is
given.
A loan agreement is entered into by the bank
as lender, and by the individual, partnership, or
company that borrows as borrower.
A loan agreement contains all the terms and
conditions under which the lender will lend the
borrower the money. It states the amount of the
loan, when the amount will be lent, the tranches
if the money is to be lent in amounts at different
dates, the repayment schedule, the interest to
be paid by the borrower, and other conditions,
terms, and warranties required by the lender
from the borrower.
The repayment schedule is usually very precise
and will state the exact dates on which the lender
expects to be paid back by the borrower. The loan
agreement can contain a voluntary prepayment
clause that will allow a borrower to prepay the
loan in certain circumstances. It may also set out
mandatory prepayment obligations that apply in
certain cases—for example, if the borrower sells
or lists its business, or if the business is acquired
by someone else and control changes hands.
A loan agreement specifies the rate of interest,
and how this will be calculated and paid by the
borrower. It also deals with the consequences
and penalties in the case of default on payments
by the borrower.
The borrower usually has to pay the lender an
arrangement fee for the loan and is also expected
to pay all reasonable legal, accountancy,
valuation, and due diligence costs and other fees,
costs, and expenses of arranging the loan.
In general, a bank will not give a loan without
obtaining security for that loan. The loan
agreement will contain details of the debentures,
guarantees, or charges given by the borrower as
security for the loan.
The borrower will be asked to make and
give certain representations and warranties
in relation to its constitution and business. It
will also be required to give certain covenants
(promises) as to how it will conduct its business
in the future.
9
ADVANTAGES
• A loan agreement sets out the terms and
ft
conditions upon which a bank will lend
money to a borrower.
• Because it is an agreement, it can be
ft
negotiated and agreed by the two parties. ft
• A loan agreement protects both parties and is C
a legally enforceable agreement.
w
O
DISADVANTAGES a
• In practice, a bank sets its own conditions for w
lending, and a borrower will have to comply
and agree to such terms if it needs the funds.
• Negotiating a loan agreement can be complex
and time-consuming. The documentation
must be thoroughly understood, and if
specialist legal advice is required the process
may be expensive.
ACTION CHECKLIST
</Study a loan agreement carefully before you
sign. Obtain as much information from as
many sources as you can before committing
to an expensive agreement.
^Shop around for a better deal. Go to several
banks and see if there are better offers and
conditions for the loan you want.
v'Be prepared for long and complicated
negotiations, which could prove time-
consuming and costly.
DOSANDDONTS
DO
• Choose your bank carefully.
• Make sure that you understand the conditions
of your loan.
• Involve your solicitors in the evaluation of
both the risks and benefits of entering into a
loan agreement.
• Check if it's possible to negotiate the terms
and conditions of the loan.
• If in trouble with repayments, tell your
bank as they may be able to help in various
ways, such as temporarily reducing your
repayments.
197
Financing and Raising Capital

DONT
• Don't make the mistake of being attracted by
a loan without understanding the implications
of all the terms of the loan and the total cost
to your business.
• Don't overlook the importance of negotiating
warranties and indemnities that you will be
able to give with confidence. If you know
of anything that may go against these
warranties, disclose it to the bank.
Don't ignore the importance of telling the
bank if you have problems with repayments.
It might prove to your advantage.

MORE INFO
Books:
Clasen, Thomas F. (ed). International Agency and Distribution Agreements. Looseleaf ed.
Charlottesville, VA: Lexis Law Publishing, 1991.
Singleton, Susan. Commercial Agency Agreements: Law and Practice. 3rd ed. Haywards Heath,
UK: Bloomsbury Professional, 2010.
Websites:
About.com Business Finance: bizfinance.about.com
AIIBusiness: www.allbusiness.com
National Federation of Independent Business (US): www.nfib.com
Western Economic Diversification Canada: www.wd-deo.gc.ca

198
Raising Capital by Issuing Bonds
DEFINITION
Raising capital by issuing bonds is a popular
alternative to selling shares, as it allows a
company to avoid relinquishing ownership of
part of the business. A bond is a loan in the form
of a debt security. The authorized issuer (the
borrower) owes the bondholder (the lender) a
debt and has an obligation to repay the principal
and the coupon (interest) on the maturity of the
loan. Bonds enable the issuer to finance long-
term investments with external funds.
The loan collateral may be the company's
land, buildings, or other physical assets that can
be sold off if the issuer defaults on repayment of
the principal. In today's bond markets, however,
a much wider range of assets can fulfill the
function of collateral, such as receivables that
produce a flow of income.
ADVANTAGES
• Taking on debt by issuing bonds is usually
cheaper than either a bank overdraft or the
cost of raising equity through a share issue.
A major advantage is that the return on
debt (interest) is tax-deductible, whereas
the return on equity (dividends) is paid
out of a company's profits, which are taxed
before dividend payments can be made to
stockholders.
• Financing by raising debt is a useful way of
monitoring a corporation's overall health,
as the ability to repay the debt reflects the
overall financial stability of the company.
• Bonds offer a more secure return for
investors—dividends are paid out purely
at the discretion of the company, whereas
interest on debt must be paid according to
the set terms of the bond.
• Debt issuance can also be advantageous from
a governance point of view. In the United
States and United Kingdom, for example,
creditors have no influence on the board or
company policy—unlike stockholders, who
often have the right to vote on policies and
the appointment of directors. Financing
through debt can thus be very useful for
companies that do not want to relinquish
control to others.
DISADVANTAGES
• The risks for bondholders rise as more debt is
issued.
The debt covenants may prove too restrictive
for the company. A company that is highly
leveraged is more likely to face cash flow
difficulties as it has to meet the coupon
payments regardless of its income. The cost
of servicing the debt may rise beyond the en
ability to pay, either because of external GO
events, such as falling income, or because C
of internal problems, such as poor company 3
management. The company may find that it cro
runs into solvency problems if the amount O
a
of debt becomes higher than the value of its cr
realizable assets. Thus, the cost of debt rises
as its proportion rises in relation to equity.
The higher the debt-to-equity ratio, the
greater the risk.
If the company is publicly listed on a
stock exchange, the risk to stockholders
increases when debt is issued. This is due
to the increased claims of the creditors, or
bondholders, on the company's capital and
earnings, which must be used to service the
debt before anything else. And if the company
has problems servicing the debt, stockholders
risk the loss of their equity in the case of
bankruptcy.
ACTION CHECKLIST
y Choose the right type of debt. For large
investments, you generally have a choice
of borrowing the principal from a creditor,
usually a bank, or issuing bonds underwritten
by the bank that can be sold to investors. If
the bond can be retraded, it is beneficial for
the bondholders as they can exit at the right
moment, but the company still has access to
the funds via new purchasers.
• Choose the right interest rate. Bonds
usually have either a fixed interest rate for a
specified period or a floating rate linked to an
agreed index. Fixed-rate debt means that the
issuer knows the exact cost across the debt's
lifetime and can budget for the principal and
interest payments each year. Floating-rate
debt usually has a mark-up over the base
rate set by the central bank in charge of the
currency that is being borrowed, meaning O
that the issuer may have to pay more if M
monetary policy is tightened and interest
rates rise during the period of the loan.
n
in
199
 Financing and Raising Capital

CO DOSANDDONTS
DO DONT
• Do a full cost analysis to determine if debt • Don't issue bonds if you think that meeting
will be cheaper for the company than equity. regular payments to the bondholders will
• Take into account that unexpected market overstretch your cash flow.
volatility and inflation will affect the coupon
level.

Q
WD
C

en
CO MORE INFO
Books:
Brown, Patrick J. An Introduction to the Bond Markets. Hoboken. NJ: Wiley, 2006.
Choudhry, Moorad. The Bond and Money Markets: Strategy, Trading, Analysis. Oxford:
Butterworth-Heinemann, 2003.

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200
Steps for Obtaining Bank Financing
DEFINITION
A major problem for both emerging and
established companies is the cost of raising
capital. Can the owners obtain bank financing
instead of incurring dilution by giving up
additional ownership in the company? An owner
of a promising business may perceive itself as
being creditworthy, however a bank will require
"proof," for example in the form of a full quarter
or year of sustained profitability, depending on
the industry and levels of profitability. Decision
makers at the bank will judge the company on
a number of factors, including the following
ratios:
• Leverage/gearing: to guarantee the
company is sufficiently capitalized, i.e. total
liabilities divided by tangible net worth.
• Liquidity: to guarantee sufficient working
capital; measured by current ratio, i.e.
current assets divided by current liabilities.
• Debt service coverage: to guarantee the
company has sufficient operating cash flow to
cover principal and interest and any capital
leases.
Companies will need to present a written
business plan explaining business objectives in
detail, operating plans, projected earnings for
the next one to five years, marketing strategy,
and other relevant information. Marketing
strategies must be outlined in detail to lend
credence to sales projections. The first two years
of projections should be detailed by month or by
quarter to measure the projected performance
against financial ratios. These projections
should be composed of balance sheets, income
statements, and cash-flow statements. The bank
will also want to know:
• How much money do you need?
• How do you plan to use the money? (For
example, to buy new assets, to pay off debts,
or to pay operating expenses?)
• How long will it take you to repay the loan?
(Use your cash flow projections to help plan
the repayments.)
• What loan repayments can you afford to
make without damaging the business?
• What can you offer as security for the
loan? (Bankers generally require personal
guarantees from the owners.)
The bank will also want to determine whether the
management has the skills to run the business.
Typical questions include: is the manager/owner 00
talented enough to direct the company? Are the
sales team knowledgeable about the industry
and have they demonstrated successful sales
growth in other companies? Does the financial C
officer have an in depth understanding of the
financial background of the company? Do the Qrq
management team get on well together and
complement each other?
a*
ADVANTAGES
• Bank financing allows the owners to keep
a major interest in the company, instead of
diluting interest by selling shares. Looking
for bank financing will force the owners to
focus on detailed projections. In order to
present a written business plan, the owners
must concentrate on the strategic planning
that is vital to a business's survival. Building
a successful relationship with the bank will
help with future business expansion.
DISADVANTAGES
• Research, preparation, and presentation of
the details required by the bank will take
time away from the day to day functions of
running the business.
• The company will be leveraged and therefore
subject to detailed bank scrutiny during the
period of the loan.
• An unfavorable payback period.
ACTION CHECKLIST
• Prepare a detailed business plan explaining
objectives, operations, marketing strategy,
and projected earnings for the next five
years.
• Make sure you are not taking on too much
debt. There is no sense in taking out a loan
that will squeeze out your profits and bleed
your business dry. Check your leverage/
gearing and liquidity ratios and then capacity
for debt service coverage.
• Prepare answers to the bank's key questions. o
For example, how much money do you need?
How do you plan to use the money? How
long will it take you to repay the loan? What
will you use as security for the loan?
O
201
 Financing and Raising Capital

(A DOSANDDON'TS
• FN
DO DONT
• Get expert advice when preparing your • Don't go to the bank thinking that you'll get
proposal. Getting a bank loan for an the loan just because you have a good idea.
emerging company or even an established You will need to take a rigorously detailed
U business is not always simple. proposal.

Q
M
C
MORE INFO
Books:
Burk, James E., and Richard P. Lehman. Financing Your Small Business: From SBA Loans and
Credit Cards to Common Stock and Partnership Interests. Naperville, IL: Sourcebooks, 2006.
Sisson, Robert. Financing the Small Business: A Complete Guide to Obtaining Bank Loans and All
Other Types of Financing. Cincinnati, OH: Adams Media Corporation, 2002.
Timmons, Jeffry A., Stephen Spinelli, and Andrew Zacharakis. How to Raise Capital: Techniques
and Strategies for Financing and Valuing Your Small Business. Maidenhead, UK: McGraw-Hill
Professional, 2005.

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Understanding and Using Interest
Coverage Ratios
DEFINITION
An interest coverage ratio is, simply, a measure
of a company's ability to pay interest on its debt
and is thus an indicator of its safety margin when
deciding if the business is a good credit risk.
To calculate the interest coverage ratio, a
company's operating income (also known as
earnings before interest and taxes, or EBIT) is
divided by its interest charges over a defined
period, typically a quarter or half-year.
Sometimes, EBITDA (where DA is depreciation
and amortization) is used instead of EBIT in the
calculation. The ratio shows how many times
a company can cover its interest charges on a
pre-tax basis. For example, a ratio of 5x would
indicate that a company has the ability to cover
its debt costs five times over. Paying the interest
charges on the most senior debt increases the
ratio as it reduces the amount of liabilities on
that deal. The interest payments due also lessen
as the debt is cleared.
The lower the ratio, the more a company is
burdened by the cost of its debt. An interest
coverage ratio of 2.5X is a warning sign of
potential financial problems. A ratio of 1.5 x
or less should trigger serious concern about a
company's overall financial health. When the
ratio is less than ix, it means the company is
not earning enough revenues to pay its interest
charges. It may then have to honor its debt
obligations by borrowing further funds or using
MORE INFO
Books:
Duffle, Darrell, and Kenneth J. Singleton. Credit Risk: Pricing, Measurement, and Management.
Princeton, NJ: Princeton University Press, 2003.
Lando, David. Credit Risk Modeling: Theory and Applications. Princeton, NJ: Princeton University
Press, 2004.
van Deventer, Donald R., and Kenji Imai. Credit Risk Models & the Basel Accords. Singapore: Wiley,
2003.
n
sr
cash to hand. Failing to meet these obligations I
could force a company into bankruptcy. Sf
Conversely, a high coverage ratio indicates
that the company is financially secure enough to 5fi
meet its interest payments on time. However, a
high ratio may also be a sign that a company has
s.
an undesirable lack of debt or is paying off its
debt too quickly, using earnings that might be d
a
better invested in projects that could yield better
returns. Furthermore, it is sometimes cheaper
for a company to borrow more funds at a lower
cost of capital than it is currently paying for its
existing debt to meet those obligations.
ADVANTAGES
• An interest coverage ratio is a very useful
indicator of a company's general financial
health and one that can be quickly calculated
using the most up-to-date financial data
available.
DISADVANTAGES
• The interest coverage ratio metric should
never be used as the sole test of a company's
financial soundness. Only if you have access
to the current books can you know if there are
otherwise unknown changes in a company's
financial situation. Use other metrics in
conjunction, such as the debt-to-equity ratio,
to gain a fuller picture.
203
Understanding and Using Leverage
Ratios
DEFINITION
Leveraging is a way to use funds whereby most
of the money is raised by borrowing rather than
by stock issue (for a company) or use of capital
(by an individual). At its most basic, leveraging
means taking out a loan so that you can invest
the money and hoping your investment makes
more money than you will have to pay in interest
on the loan.
The leverage ratio is used to calculate
the financial leverage of a company. This
information gives an insight into the company's
financing methods, or it can be used to measure
the company's ability to meet its financial
obligations. There are a number of different
ratios, but the main factors involved are debt,
equity, assets, operating income, and interest
expenses.
The most commonly used ratio is debt to
equity (D/E, or financial leverage), which
indicates how much the business relies on debt
financing. In normal circumstances the typical
D/E ratio is 2:1, with only one-third of the debt
in the long term. A high D/E ratio might show up
possible difficulty in paying interest and capital
while obtaining extra funding. As an example,
if a company has $10 million of debt and $20
million of equity, it has a D/E ratio of 0.5 ($10
million/$20 million).
Another leveraging ratio can be used to
measure the operating cost mix. This helps to
indicate how any change in output may affect
operating income. There are two types of
operating costs: fixed and variable. The mix of
these will differ depending on the company and
the industry. A high operating leverage can lead
to forecasting risk. For example, a tiny error
made in a sales forecast could trigger far bigger
errors when it comes to projecting cash flows
based on those sales.
There is also interest coverage, which measures
a company's margin of safety and indicates how
many times the company can make its interest
payments. This figure is calculated by dividing
earnings prior to interest and taxes by the
interest expense.
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tr
ADVANTAGES
• Leveraging means borrowing money to
invest. Anyone who takes out a mortgage is
effectively leveraging. By paying a deposit (ft
W
to obtain a loan, you can buy a home that
otherwise you would not be able to afford.
Although property prices can and do fall
periodically, over the long term property
usually increases in value. If it does, you can
o
sell the property and make a profit on your ft
original mortgage loan. a*
• Leveraging enables an individual or a
company to gain access to larger capital sums
to make investments, with the aim of making
a profit by doing so.
• Strategies in leveraging run from basic
to highly sophisticated, and the degree of
risk varies in the same way. The benefits
of leveraging will depend on your financial
situation, your objectives, and your attitude to
risk.
DISADVANTAGES
• Anything that has the potential to make
money involves some risk. Gains can be
better than normal; losses can be worse. A
change in interest rates can have an effect
on your profit too. There is a risk that your
investment will not make enough profit to
pay off the interest on your loan.
• You can mitigate the risks by diversifying
your portfolio, thereby guarding against
high losses, although this will probably limit
opportunities to make spectacular gains. A
fixed-rate loan can protect against a rise in
interest rates.
ACTION CHECKLIST
• Are you comfortable borrowing money that
you might struggle to pay back?
• Are you comfortable with high risk in your
finances?
• Are you confident that interest rates will not
rise to add further risk to your borrowings?
• A r e you confident your investment will make o
more than the interest you have to pay back
on your loan?
2:
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 Financing and Raising Capital

2 DOS AND DON'TS

DO DONT
• Look at leveraging as a way of using other • Don't get involved with leveraging if you are
people's money (by way of a loan) to make uncomfortable with financial risk.
your own investments. • Don't choose an investment without a full
• Understand how your loan works and what understanding of what you are investing in.
and when you will have to pay back.
• As much research as you can. And then more
research.
Q
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C

(A
(ft

MORE INFO
Books:
Marr, Bernard. Strategic Performance Management: Leveraging and Measuring Your Intangible
Value Drivers. Oxford: Butterworth-Heinemann, 2006.
Matthaus-Maier, Ingrid, and J. D. von Pischke (eds). Microfinance Investment Funds: Leveraging
Private Capital for Economic Growth and Poverty Reduction. Berlin: Springer-Verlag, 2006.
Militello, Frederick C, and Michael D. Schwalberg. Leverage Competencies: What Financial
Executives Need to Lead. Upper Saddle River, NJ: FT Prentice Hall, 2002.

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206
Understanding Debt Cover
DEFINITION
Debt cover is defined as the ratio of a company's
total assets to its debt. It helps to assess the
amount of cash flow available to meet annual
interest and principal payments on a debt,
including sinking fund payments. Should a
company be wound up, the ratio would indicate
by how much the shareholders' redemption
value and prior charges and any future capital
charges would be covered by the assets. This
useful metric indicates how easily a company
can meet its interest and principal payments
from its revenues.
Debt cover is calculated by dividing a
company's operating income (either EBIT or
EBITDA) by the debt expenses, i.e. the interest
charges. Banks typically use debt cover as an
indicator for determining economic risk when
making loans. Typically, a bank looks for a ratio
ofbetween 1.15X and 1.35X (net operating income
divided by annual debt service) to be satisfied
that there is sufficient cash flow available on an
ongoing basis to repay the loan instalments.
However, the debt cover may sometimes be
less than ix for a loan. This does not necessarily
mean that the company is at risk of default,
although it is certainly an indicator of potential
financial problems ahead as it means there is,
at the time of calculation, a negative cash flow.
For example, a ratio of 0.9x indicates that there
is only enough net operating income to cover
MORE INFO
Books:
Duffie, Darrell, and Kenneth J. Singleton. Credit Risk: Pricing, Measurement, and Management.
Princeton, NJ: Princeton University Press, 2003.
Lando, David. Credit Risk Modeling: Theory and Applications. Princeton, NJ: Princeton University
Press, 2004.
van Deventer, Donald R., and Kenji Imai. Credit Risk Models & the Basel Accords. Singapore: Wiley,
2003.
9
90% of annual debt payments, and the company
would therefore have to repay borrowings using
cash or by taking out a further loan. Usually (ft
banks are unlikely to lend where there is negative
cashflow,but they may decide to take the risk if
the company can clearly demonstrate that this is (ft
a temporary blip. (ft
Over a period of time the debt cover should
improve as a company pays down its debts and,
e.
generally speaking, as with other metrics that
ore
measure credit risk, the higher the ratio the O
better as it means a lower risk of capital loss. §-
ADVANTAGES
• Debt cover is a useful measure of financial
strength. It can indicate not only what the
debt cover was at a particular point in time,
but also how much it has changed since it was
last evaluated. It is thus a way of assessing a
company's financial quality and associated
risk levels.
DISADVANTAGES
• Debt cover should never be used as the
sole metric test of a company's financial
soundness. Only if you have access to the
current books can you know if there are
otherwise unknown changes in a company's
financial situation. Use other metrics in
conjunction, such as the interest coverage
ratio, to gain a fuller picture.
207
Understanding Fixed-Charge Coverage
DEFINITION
Fixed-charge coverage is a financial ratio that is
used to gauge the quality of a bond issue or the
ability of a project to meet its debt repayments. It
is calculated by dividing total fixed charges into
the net income (or earnings before interest and
tax) available for these charges. Thefixedcharges
are gross interest, contractual payments under
operating leases, and preference dividends.
Thus, afixed-chargecoverage ratio would look
like this:
Fixed-charge coverage = EBIT + ———— y-
Fixed charge + Interest
where EBIT is earnings before interest and tax,
and the fixed charge is before tax.
Generally, the greatest fixed charge a
company is likely to face is the interest on its
debt. However, the fixed-charge coverage ratio
assumes particular importance if the company
you are evaluating spends heavily on leases, such
as leases on buildings and equipment. A lease
payment is effectively the same thing as a debt
payment, and it should be taken just as seriously.
The lower a company's net income, the greater
the negative impact of the lease payments on the
ratio.
Overall, the lower the ratio, the worse is the
financial position of the company. Bond issues
can contain covenants that set limits on how low
the fixed-charge coverage ratio can fall. Such
a covenant is designed to provide the lender
with protection, so that the borrower's financial
position will remain more or less the same as
it was when the loan was made. Thus, a bond
may contain a covenant that prevents the fixed-
charge coverage ratio from falling below 2.
ADVANTAGES
• Thefixed-chargecoverage ratio is readily
identifiable.
• It provides a straightforward measure of the
financial health of a company.
DISADVANTAGES
• There is no standardized procedure for
ft
(ft
determining either fixed charges or the net
income available for these charges.
• Other ratios may provide a better indicator of
a company's financial health. (ft
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c
ACTION CHECKLIST
^Identify the fixed-charge coverage ratio from era
the company's accounts.
^ I f it is less than 1, speak to the company's
o
managers immediately to ascertain how they
plan to meet their fixed-cost obligations.
8-
DOSANDDONTS
DO
• Remember that if a company has a fixed-
charge coverage of less than 1, it cannot
meet its fixed obligations through earnings
and thus must rely on other funds, such as
extra borrowings or drawing down working
capital.
• Remember that this ratio often comes into
play if you have a working-capital loan; the
lender will insist that a specific fixed-charge
coverage ratio is maintained or your loan will
be recalled.
• Remember to try to gauge the attitudes of
managers toward taking on more debt as the
existing debt matures.
DONT
• Don't just rely on the fixed-charge coverage
ratio. Other ratios that can be used to
measure a company's ability to meet its debt
obligations include the interest coverage ratio
and the debt service coverage ratio.
• Don't ignore the proforma coverage ratio. It
has essentially the same components as the
fixed-charge coverage ratio but is forward
looking. It can tell you whether this year's
earnings (if repeated) would be able to cover
what must be paid in the coming year.
D
209
 Financing and Raising Capital

to MORE INFO
i-3 Books:
*y Geddes, Ross. Valuation and Investment Appraisal. London: Financial World Publishing, 2002.
4} Holmes, Geoffrey, Alan Sugden, and Paul Gee. Interpreting Company Reports and Accounts. 10th
X" ed. Harlow, UK: FT Prentice Hall, 2008.
U The Ultimate Small Business Guide: A Resource for Startups and Growing Businesses. New York:
^L Basic Books, 2003.
£i
V Article:
H Goodacre, Alan. "Operating lease finance in the UK retail sector." International Review of Retail,
M) Distribution and Consumer Research 13:1 (2003): 99-125. Online at:
.S dx.doi.org/10.1080/0959396032000065373
<Z3 Website:
HH American Bankruptcy Institute: www.abiworld.org

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210
 Checklists
Equity Investment
Dealing with Venture Capital
Companies
DEFINITION
Small and growing businesses seeking to finance
further development, but which cannot raise
the necessary funds through a bank loan or
overdraft, or by an injection of further capital
from the current owner, may find that venture
capitalists provide the best solution to their
needs. Venture capital (VC) is the term used
for unsecured funding provided by specialist
firms in return for a proportion of a company's
shares. Venture capital investments are seen as
relatively high risk for the lender because they
are unsecured.
VC funds are often used in conjunction
with a management buyout or buyin, in which
a management team is demonstrating its
commitment to a firm's success by investing
their own money in the business.
Venture capital firms consider various
factors before committing funds to a business.
These include the track record of the business
and whether the management team has a
proven record of success; for this reason, VC
companies generally do not consider start-ups
as suitable for investment. They will seek to
determine whether the management's plans
for the business are credible. They will also
try to determine whether a viable exit strategy
can be achieved within a preferred timescale,
usually within three to five years of making their
investment. This could be executed via a trade
sale, stock market listing, refinancing by another
institution, or a repurchasing of the entire capital
by management.
In return for their investment, VC firms make
a number of demands, including the following:
• A high return (perhaps a compound return of
25% or more), largely generated by growth in
the capital value of the business.
• Representation on the company's board.
In the past, companies have approached venture
capital funds to provide seed, start-up, and
expansion financing, as well as management/
leveraged buyout financing. However, nowadays
VC companies focus almost entirely on funding
businesses that have proprietary technology or
knowledge. Thus they tend to favor businesses
with a product or service that offers a unique
selling point or other competitive advantage.
9ft
n.
ADVANTAGES en
• VC investors put money into risky or
innovative businesses and projects that might
otherwise have trouble obtaining funding.
• Apart from providing funding, a VC company •§
takes an active role in the management of
a business, to which it can bring a great
deal of administrative expertise and market
knowledge. It may also have valuable skills
and contacts, and can assist with strategy and
key decision-making.
• Having invested in a project, a VC company ft
will do all it can to ensure that it is a success. 3
• VC companies can also provide access to
funding by other VC investors.
• Investors are often prepared to provide
follow-up funding as the business grows.
DISADVANTAGES
There may be disadvantages to accepting VC
investment, and the following points should be
considered carefully.
• Is the VC company acting as a lead investor?
If so, are there complementary or competing
companies in its portfolio? Does it have
experience with similar types of investment?
• Will the VC company be able to come up with
extra financing if it becomes necessary?
• What type of role does it want in the
management of your business?
• Can your management team live up to the
conditions demanded by the VC company,
and does it have complementary skills?
• If your firm reaches the deal negotiation stage
with a VC investor, you will have to pay legal
and accounting fees whether or not you are
successful in securing funds.
DOSANDDON'TS
DO
• Seek expert legal and financial advice
when negotiating any agreement with a VC
company.
• Be aware of the significant time required to O
complete the process. t-H
• When researching venture capitalists, go for
geographic and industry specializations that
complement your own.
o
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213
 Financing and Raising Capital

DONT
3 • Don't take on venture capital unless you
(0 are sure that you can cope mentally and
physically with the provider's requirements.
Don't forget that you will lose some of your
power to make management decisions.
Don't forget that there can be legal and
regulatory issues to comply with when raising
finance.

I MORE INFO
Books:
£ Cardis, Joel, er al. Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and
Practitioners. New York: Wiley, 2001.
Gladstone, David, and Laura Gladstone. Venture Capital Handbook: An Entrepreneur's Guide to
Raising Venture Capital. Upper Saddle River, NJ: Prentice Hall, 2002.
Hill, Brian E., and Dee Power. Inside Secrets to Venture Capital. New York: Wiley, 2001.
w
Articles:
Arthur, Jeff. "Cashing in with venture capital." SaskBusiness (January-February 2008).
Iwata, Edward. "Venture capital spreads the wealth around the country." USA Today (March 11,
2008). Online at: www.usatoday.com/money/smallbusiness/2008-03-10-venture-capitaLN.htm
Websites:
British Venture Capital Association (BVCA): www.bvca.co.uk
European Private Equity & Venture Capital Association (EVCA): www.evca.eu
National Venture Capital Association (NVCA, US): www.nvca.org
vFinance directory of venture capital resources and related services: www.vfinance.com

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Investors and the Capital Structure
DEFINITION
A company's capital structure is determined by
its long-term financing arrangements, including
a combination of common stock, debentures,
preferred stock, long-term debt, and retained
earnings. The capital structure, which is also
known as the capitalization structure, differs
from the financial structure in that the latter DISADVANTAGES
reflects short-term liabilities and accounts • A company with a capital structure based
payable.
To better understand the nature of a company's
capital structure, it is worth considering the
o
the company is performing well. However,
one advantage of this structure from the k
Gfi
company's perspective is that payment of
dividends is optional, giving the company the
right to make no dividend payments during
challenging trading periods. w
•8
I
largely on debt is required to pay interest to the
debt holders, regardless of how the company
is performing. However, there may be tax
(A

I
comparative levels of equity and debt. Companies advantages associated with debt repayments.
with relatively high levels of debt are said to have • Careful thought needs to be given to capital-
higher "gearing." However, a company's gearing structure decisions, based on factors such as
outlook is not always as simple as it may appear expected rate of investment return and cost of 3
at first glance. Convertible bonds, for example, capital. Ill-judged capital-structure decisions
are classed as debt at the time of issue but can lead to serious financial problems.
could subsequently become equity. Conversely,
preference shares are by nature equity, but they
have a fixed-return element that gives them ACTION CHECKLIST
certain debt-like characteristics. \ / B e clear about the differences between capital
At a simplistic level, a company's choice of structure and financial structure—terms that
capital structure should have no impact on the are often confused. Capital structure is the
company's total value, as represented by the equity/debt balance of a company's long-term
sum of equity and debt. This theory is sometimes finances, whereas financial structure also
known as "capital structure irrelevance" or the includes short-term funding arrangements,
"Modigliani-Miller theory." Promulgated in the as represented in the current liabilities on the
1960s by Franco Modigliani and Merton Miller, company's balance sheet.
who later collected the Nobel Prize for Economics, >^Aim to understand the factors behind
the basis of the theory is that all investors in the companies' choice of capital structure.
company ultimately benefit from the total cash There are many considerations behind
flows enjoyed by the company. Changes to the these decisions, including cash flow
overall balance between equity and debt have projections, possible taxation benefits,
no effect on the cash flows, only on how they funding availability, industry factors, risk
are effectively divided up between different considerations, and cash management.
types of investor. However, more advanced
financial models subsequently demonstrated the
limitations first recognized by Modigliani and
Miller: factors of relevance include the impact DOSANDDONTS
of taxation and agency issues, i.e. conflicts of DO
interests between executives, equity investors, • Consider the benefits of buying a combination
and bondholders. of shares and debt when making an
investment in a company. This approach
ADVANTAGES would effectively lower the gearing of the
• A basic understanding of a company's capital investment opportunity relative to a shares-
structure, particularly its level of gearing, is only purchase.
a useful starting point when considering an • Bear in mind that, while differences between O
investment in the company. rival companies' capital structures can seem hrt
1—1
• Investors in companies with capital significant, research based on extensions of
structures based on equity would expect the Modigliani-Miller theory has suggested
to receive returns on their investment via that the benefits of adjustments to companies'
dividends. Capital growth is also likely when capital structures are frequently limited. O

215
 Financing and Raising Capital

DONT
• Don't ignore a company simply because of Don't ignore the possible impact of agency
•H

I
its capital structure. An investor looking for problems when analyzing companies.
a more highly geared proposition could buy Conflicts of interest can occur in many forms,
shares in the company, then lend against even between stockholders, debt holders,

6 them. and executives.

s
I MORE INFO
Books:
Kiihn, Christian. Capital Structure Decisions in Institutional Buyouts. Wiesbaden, Germany: DUV,
2006.
Riahi-Belkaoui, Ahmed. Capital Structure: Determination, Evaluation, and Accounting. Westport,
CT: Quorum Books, 1999.
Articles:
Brounen, Dirk, Abe de Jong, and Kees Koedijk. "Capital structure policies in Europe: Survey
evidence." Journal of Banking and Finance 30:5 (May 2006): 1409-1442. Online at:
dx.doi.org/10.1016/j.jbankfin.2005.02.010
Talberg, Magnus, Christian Winge, Stein Frydenberg, and Sjur Westgaard. "Capital structure across
industries." International Journal of the Economics of Business 15:2 (2008): 181-200. Online at:
dx.doi.org/10.1080/13571510802134304

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Options for Raising Finance
DEFINITION
Funding small and medium-sized enterprises
is a major part of the general business finance
market. When a budding company is growing
rapidly and needs to invest in capital equipment
or other assets, its financial capital may be
insufficient. Few emerging companies are able
to finance their expansion plans from cash flow
alone. Therefore, entrepreneurs need to consider
raising finance from external sources. Once
they have decided to raise capital, they need to
consider what source and type of finance will
suit their needs.
• Venture capital: Is intended for higher risks,
such as start up situations and development
capital for established companies.
• Joint venture: Find an individual or
organization to both invest in and work with a
company in its business project.
• Limited company: Raise capital by setting
up a limited company and selling shares to
investors.
• Banks for working capital: Short-term
finance or the working capital necessary to
fund the day-to-day running of the business.
This can take the form of an agreed overdraft,
where the interest will be calculated on your
daily outstanding balance and charged on a
monthly or quarterly basis.
• Banks for medium-term loans: A loan
paid back over an agreed term (typically three
to ten years), where principal and interest are
paid off monthly. This type of loan is used
mainly to invest in equipment, expansion, and
development.
• Banks for long-term loans: The most
common way to arrange long-term borrowing.
This type of loan is normally used to purchase
assets such as a business, land, buildings,
plant, or machinery that can be shown to
directly or indirectly add to profit over a
number of years.
• Factoring and invoice discounting: To
improve cash flow,financecan also be raised
against customer debts using factoring or
invoice discounting.
• Leasing: Providesfinancefor the acquisition
of specific assets, such as cars, equipment, and
machinery. Leasing involves a deposit and
repayments over, typically, three to ten years.
Thefinancierpurchases the equipment you
require and then leases it to you in return for
regular payments for the duration of the lease
period.
9
ft
• Personal loans: If it is impossible to
arrange a loan in your business's name,
you could consider arranging a personal
loan. However, check that the conditions do
6?
not jeopardize control of the business and
that you are very confident of being able to
repay or you may lose the assets put up as •§
collateral.
• Family and friends: To avoid any
misunderstandings and/or resolve any
%
dispute if things go wrong, it is imperative
ft
to make a written agreement, including the
timescale and interest payments.
ft
ADVANTAGES 3
• Finding the finance on the right terms allows
small and medium-sized enterprises to invest
in land, new capital equipment, R&D, etc.
Very few emergent companies are able to
finance their expansion plans from cash flow
alone.
• Raising finance helps to avoid the dilution of
business control or share capital.
DISADVANTAGES
• Venture capitalists normally want preference
shares or loan stock in addition to their
equity stake.
• Joint ventures and the setting up of limited
companies can often result in the loss of
control over aspects such as policy and
development.
• Banks have the power to place a business into
administration or bankruptcy if it defaults on
debt interest or repayments.
• Borrowing from family or friends can lead to
disputes or interference in the management
of the venture.
ACTION CHECKLIST
^Prepare a written business plan explaining
in detail your business objectives, your
operating plan, projected earnings,
marketing strategy, and other relevant
information. O
^ U s e the strategy laid out in the business plan »—i
to help you assess all the alternatives and
then negotiate terms with several financial
providers before choosing the one that suits
I
you best. o
217
 Financing and Raising Capital

2 DOSANDDON'TS

1
DO
• Consider what source and type of finance
suits your needs. Then match the method
of funding and the term of the loan to the
reason for the finance.
DONT
• Don't forget that your financing decisions
may have an impact on business cash flow
and taxation obligations.

4)

MORE INFO
Books:
Burk, James E., and Richard P. Lehman. Financing Your Small Business: From SBA Loans and
Credit Cards to Common Stock and Partnership Interests. Naperville, IL: Sourcebooks, 2006.
Lister, Kate, and Tom Harnish. Finding Money: The Small Business Guide to Financing. Chichester,
UK: Wiley, 1995.
Timmons, Jeffry A., Stephen Spinelli, and Andrew Zacharakis. How to Raise Capital: Techniques
and Strategies for Financing and Valuing Your Small Business. Maidenhead, UK: McGraw-Hill
Professional, 2005.
Articles:
Thomas, Tony. "How to raise business finance." NZ Business (June 2006).
Williams, Gary. "How to balance ownership with the need to raise capital." Deseret News (April 20,
2008). Online at: tinyurl.com/2f7llc7
Websites:
Support for small and medium-sized enterprises: www.rba.co.uk
US Chamber of Commerce: www.uschamber.com

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218
An Overview of Stockholders' Agreements
DEFINITION
The shares (or stock) issued by most limited
companies are classed as "ordinary," and each
share carries one vote. Majority shareholders will
therefore control voting in the company. Since
minority shareholders may resent not having any
say in important company decisions, conflicts
can arise. To minimize these, it is advisable
that the shareholders sign a stockholders'
agreement—which will give small shareholders a
voice in these big decisions.
Stockholders' agreements are more commonly
used in certain circumstances: for example,
when some shareholders are not directors and
thus do not have much of a role in the decisions
of the board, or in the case of equal-stake joint
ventures.
A stockholders' agreement will establish
the constitution of the board, the number of
directors, which shareholder(s) will have the
right to appoint directors (and how many), and
who will be the chairman of the board and have
the casting vote if needed. It will also decide who
will have management control and how board
meetings and voting will operate.
The agreement can also establish that certain
business issues will require the approval of
100% of the shares. These are usually only very
important issues, such as: the company entering
into a contract with directors or shareholders;
the incurring of expenditure or liability over
a certain predetermined value; the company
giving a guarantee or taking on an encumbrance
(debt) of a certain value; the sale, transfer, lease,
or licensing of any of the assets of the company
other than in the ordinary course of business;
or the altering of any provisions of the company
bylaws.
In general, a stockholders' agreement is
a contract between shareholders that can
stipulate more or less anything, as long as it
does not contravene the law or the bylaws of the
company
ADVANTAGES
• Stockholders' agreements protect minority
shareholders and allow them to participate in
decisions from which they might otherwise be
excluded.
9
• Stockholders' agreements are not regulated.
Shareholders have the flexibility to decide the I
type of contract they want.
• The stockholders' agreement can also restrict
the transfer of shares and will establish W
pre-emption rights (the right of existing
shareholders to be the first to acquire the d
shares of another shareholder).
DISADVANTAGES 3
• Assenting to a stockholders' agreement may <
involve extensive negotiations and require
professional advice. It could be expensive to
draft and put in place.
2
ACTION CHECKLIST
</ Study any shareholder agreement carefully
before signing. Be clear what you would like
to achieve from it.
• Be prepared for extensive negotiations,
which could prove time-consuming as well as
costly.
• Economize by negotiating a reasonable rate
with your legal and financial advisers, but
remember that it is better to incur costs and
understand the agreement you sign than
to enter into an agreement that you do not
understand and may not represent your
interests.
DOS AND DON'TS
DO
• Involve your lawyers in the negotiation of a
stockholders' agreement.
• Think carefully what you would like to
achieve from it.
• If necessary, request the right to appoint a
director as your representative on the board.
In this way, you can influence decisions in
the company at board level.
DONT
• Don't make the mistake of entering into a
stockholders' agreement that you do not
understand and does not represent your o
interests.
219
 Financing and Raising Capital

t§ MORE INFO
'A Books:
•^ Wilkinson, Chris (ed). Joint Ventures and Shareholders' Agreements. 3rd ed. Haywards Heath, UK:
q Tottel Publishing, 2009.
Stedman, Graham, Janet Jones, and John Cadman. Shareholders' Agreements. 4th ed. Andover,
UK: Sweet & Maxwell, 2003.

tj Articles:
4) Sisca, Eileen R., and Eckert Seamans. "Protect your investment with a shareholders' agreement."
£ Leader's Edge 2:9 (1999): 4 .
^ Waldman, Glenn J. "The shareholders' agreement—Don't leave your P.A. without it." Florida Bar
i> Journal 71:9 (October 1997): 57. Online a t : tinyurl.com/2ct3bum
>
jjjjj Websites:
^ Canadian legal resources: www.canadalegal.com
,-j-J Exile From the Herd: The Official Mark Jeftovic blog: www, private world. com
£ International Financial Law Review: www.iflr.com
Net Lawman legal documents (UK): www.netlawman.co.uk

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220
Raising Capital by Issuing Shares
DEFINITION
A company that wants to raise capital by issuing
shares has several options. If it is not yet listed on
a stock exchange, the company can prepare for
an initial public offering (IPO), in which it will
be valued and an opening price will be set for its
shares when they are released onto the market.
How much finance can be raised through an IPO
depends partly on the perceived value, and thus
share price, of the company, and partly on how
much interest there is in the shares when they
are released on the market.
For a company that is already listed on an
exchange, an alternative route is to launch an
additional share issue (also known as a seasoned
equity offering, or SEO) or a rights issue. A SEO
is a new equity issue by a company following its
IPO. A rights issue permits existing stockholders
to purchase a designated number of new shares
from a company at a specified price within a
specified time. The offer may be rejected, or
accepted in full or in part, by each stockholder.
Rights are usually transferable, meaning that
the holder can sell them on the open market.
The additional shares in a rights issue are
generally issued to stockholders on a pro rata
basis—for example, in a two-for-five rights issue
stockholders are offered two shares for every five
they already hold.
Renounceable rights are rights offered by a
company to existing stockholders to purchase
further stock, usually at a discount. These rights
have a value and can be traded. If rights are to
be issued, the company has to set the price of
the new shares, determine how many it will sell,
and assess how the current share value will be
affected as well as the effect on new and existing
stockholders. Nonrenounceable rights are not
transferable and cannot be bought or sold; these
rights must be taken up or they will lapse.
ADVANTAGES
• For a company that has reached a certain size
and has a strong reputation, an IPO can be
a good route to raising a large sum of capital
that will enable it to expand, or invest in
assets that will enable it to grow in the future.
• The company does not need to repay this
share capital, but instead agrees to distribute
future profits to stockholders in return for
their investment.
O
sr
• Once listed, a company can periodically
issue further shares via a rights issue, raising
yet more capital for expansion without (ft
running up debt. Being in a position to raise
capital from the stock markets, rather than
privately from individual investors, is a major
incentive for many companies to issue shares
on an exchange.
•8
DISADVANTAGES
• The main disadvantage of issuing shares
through an IPO is that a company's owners
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no longer have full control of the business
and become accountable to stockholders.
Stockholders can block plans if they believe
o
they pose too great a risk to their investment.
3
• Any issuance of further shares dilutes
the holdings of existing stockholders as a
proportion of the company's total shares.
This can lead to dissatisfaction from minority
stockholders, who have the most to lose.
In some jurisdictions, such as the UK,
stockholders have preemptive rights by law,
which means they have the right to purchase
new issuances first. In other jurisdictions,
such as the US, preemptive rights must
be enshrined in a company's constitution.
Stockholders who do not have preemptive
rights are most at risk of seeing their
investment diluted.
ACTION CHECKLIST
• Consider whether options for raising capital
other than a share issue might be more
suited to your investment plans.
• Consult your bank and other financial
advisers on the time scale for an IPO or
rights issues, and on the timing of the offer.
DOS AND DONTS
DO
• Issue a proper prospectus for your share offer.
• Keep stockholders informed about how much
dividend they can expect to receive each year.
O
DONT H-H
• Don't issue shares if you are not prepared to
give up a certain amount of decision-making
to stockholders.
o
221
 Financing and Raising Capital

•§ MORE INFO
^2 Books:
'•J Gregoriou, Greg N. Initial Public Offerings: An International Perspective. Amsterdam: Butterworth-
V Heinemann, 2006.
jfi Temple, Peter. First Steps in Shares. Harlow, UK: Pearson Education, 2001.
• Articles:
t* Goergen, Marc, Arif Khurshed, and Ram Mudambi. "The strategy of going public: How UK firms
qj choose their listing contracts." Journal of Business Finance and Accounting 33:1-2 (January/
g March 2006): 79-101. Online at: dx.doi.org/10.1111/j.1468-5957.2006.00657.x
•gj Loughran, Tim, and Jay R. Ritter. "Why don't issuers get upset about leaving money on the table in
V IPOs?" Review of Financial Studies 15:2 (Spring 2002): 4 1 3 - 4 4 4 . Online at:
£ dx.doi.org/10.1093/rfs/15.2.413

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Raising Capital through Private and
Public Equity
DEFINITION DISADVANTAGES
Many publicly listed companies needing to raise • Taking the equity route can lock a company on
funds for investment choose not to offer shares into an agreement over a long time frame.
or issue bonds on the open markets, but instead • The company may have to surrender a large
look for capital on the private equity markets. In stake in return for investment, possibly as
the former case, funding comes from a publicly much as 50%, and also provide seats on the
listed company looking to invest in other board.
companies that offer synergy, as well as good • Investors may interfere with the company's
financial returns. In the latter, the funds come business plan and other areas of strategic
from institutional investors who invest their importance.
I
(A
wealth indirectly through private equity funds- • With either type of equity deal, there needs
private equity being a class of assets that are not to be chemistry between the counterparties.
publicly traded on the exchanges. Institutional Lack of chemistry can lead to board
investors provide such capital with the aim of disagreements and other problems, souring
achieving risk-adjusted returns that exceed the relationship.
those possible on the stock markets. • It can be difficult for a company to extricate
In both cases, a percentage stake in the itself from an equity investment arrangement,
company is surrendered in exchange for the depending on the terms of the deal.
investment, and the deal usually includes one
or more seats on the board of directors as well.
Companies seeking equity funding may use a ACTION CHECKLIST
financial intermediary to broker the best deal for ^Look for synergies if choosing the equity
the investment. investment route, as the relationship with
Companies that raise investment capital in investors is likely to be more fruitful and less
this way can usually expect to deliver a return fraught if the counterparties feel they want
on investment through one of the following the same things for the business, and can
routes: Recapitalization, in which the company agree on essentials such as direction and
distributes dividends or cash to its stakeholders; strategy.
a merger or acquisition, in which the company V Private equity firms are more likely to be
may be absorbed by or merged with its public concerned about the long-term relationship
equity investor, or sold for either cash or in terms of ultimate financial return, whereas
shares in another company by its private equity a public equity investor may be concerned
backers; a buy-out, in which the equity investor only with the bottom line.
agrees to pull out in exchange for a cash sum
from the company, which thereupon regains
its independence; or an initial public offering
(IPO), whereby company shares are offered to DOS AND DONTS
the public on a stock exchange, which offers the DO
equity investor both an immediate partial cash • Hold talks with a range of potential investors
return on its investment, in addition to a public to compare the deals on offer.
market in which additional share issues can be • Look at other possible financing options—an
placed at a later date. equity deal may not always be the right
solution.
ADVANTAGES
• Raising capital through equity can be a good DONT
choice for companies that are not ready for • Don't enter into an equity deal if you feel
an IPO or are unwilling to finance expansion pressured to give away a greater stake in the
through debt. business than you want to. You may regret it
• An equity deal means that the company later.
has access to business experts through its • Don't be afraid to bargain hard at the
investors, who can help to steer the business
strategically as well as financially.
negotiating stage of the deal. o

223
 Financing and Raising Capital

CO
tn MORE INFO
V-* Books:
^3 Fraser-Sampson, Guy. Private Equity as an Asset Class. Chichester, UK: Wiley, 2007.
QJ Jenkinson, Tim, and Alexander Ljungqvist. Going Public: The Theory and Evidence on How
6 Companies Raise Equity Finance. 2nd ed. Oxford: Oxford University Press, 2001.
Mathonet, Pierre-Yves, and Thomas Meyer. J-Curve Exposure: Managing a Portfolio of Venture
^ Capital and Private Equity Funds. Chichester, UK: Wiley, 2007.
fi Mavrikakis, Alexis. Public Companies and Equity Finance 2009. Guildford, UK: College of Law

s
jH Publishing, 2009.

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224
Sovereign Wealth Funds—Investment
Strategies and Objectives
DEFINITION
Sovereign Wealth Funds' (SWFs) investment
decisions are typically made with one of two
goals in mind: Either the funds are seeking an
attractive rate of return in purely economic
terms, or they are hoping to generate strategic
benefits for their country. In the former case,
SWFs regularly describe themselves as passive
investors in that they do not seek to influence or
control the companies they invest in, sometimes
preferring to avoid holding voting shares at all.
In contrast to typical private equity investors,
SWFs are also frequently happy to put their faith
in existing company management, rather than
aiming to parachute their own executives onto
the board. When a SWF invests in a company
for strategic benefits, commonly in sectors such
as financial services or leisure, the objective is
usually to gain insights into the management's
operational expertise with a long-term view of
helping to develop or grow a related industry in
the fund's own country.
While many SWFs may emphasize that their
investment strategies tend to be longer term and
more "hands off" than the average private equity
investor, there are signs that some SWFs are
prepared to work more closely with these more
active investors to help achieve their investment
goals. For example, Abu Dhabi-based Mubadala's
2007 purchase of a 7.5% stake in Carlyle, and
news that China Investment Corporation (CIC)
had raised its stake in Blackstone to around
12.5% in late 2008, raised the prospect of further
cooperation between SWFs and private equity
groups.
Though many SWFs have demonstrated their
willingness to hold a geographically diverse
spread of assets, few have historically provided
much insight into the precise investment
strategies they employ to achieve their stated
objectives. However, Norway's GPF-G Fund
(Government Pension Fund—Global), the
world's second-largest SWF (after the Abu Dhabi
Investment Authority), is the notable exception,
providing regular updates on its holdings and
demonstrating a high level of commitment to
ethical investing. Nevertheless, the SWFs' general
perceived lack of investment transparency and
doubts over their commitment to high standards
of corporate governance standards have done
little to help the image of SWFs. Though political
pressure is growing in some jurisdictions for
o
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E
greater standards of transparency and improved
disclosure from SWFs with the potential to
acquire assets of significant national importance
•a
or prestige, there is evidence that many SWFs
would prefer to work within more loosely
worded "best practice" investment frameworks.
In October 2008, the International Working
Group of Sovereign Wealth Funds presented a
I
proposed set of principles guiding the operations
of SWFs to the International Monetary Fund's
(IMF) policy-focused International Monetary
and Financial Committee. Both the IMF and the
Organisation for Economic Co-operation and
Development (OECD) are set to present their 3
own proposals in reports due in 2009.
ADVANTAGES
• The long-term and "hands-off" nature
of investments by SWFs can make them
attractive shareholders for some companies.
• SWFs have been a particularly valuable
source of immediate capital injections into
financial institutions whose balance sheets
have been in urgent need of strengthening.
• High levels of investable cash give SWFs
the ability to capitalize on opportunities
generated by market swings, with the
meaning SWFs can be a stabilizing influence
during times of market volatility.
DISADVANTAGES
• Doubts persist in some quarters over the
motives behind some SWFs investments,
particularly those made for long-term
strategic reasons.
• Political concerns are frequently raised
over the prospect of key national resources
falling under the control of secretive overseas
investors, particularly in view of most SWFs'
poor disclosure standards.
ACTION CHECKLIST
^ B y moving towards the adoption of best
practice guidelines to be proposed by the
IMF and the OECD, it should be possible to
alleviate some concerns over the lack of O
transparency and disclosure of most SWFs.
^ B y taking non-voting shares only, SWFs
can help to overcome objections over the
motivation for some of their more politically
sensitive investments. o
225
 Financing and Raising Capital

CO DOSANDDON'TS
DO DONT
3 • Recognize the increasing scope for private
equity and SWF investors to cooperate on
• Don't be afraid of improved disclosure; follow
the example of Norway's pension SWF.
investment projects. • Don't overlook the role of SWFs, as cash-rich,
u • Appreciate that the generally poor level of
transparency of SWFs does little to alleviate
long-term investors, in helping to stabilize
volatile markets and recapitalize struggling
concerns over their motives when making companies.
overseas investments.

MORE INFO
Book:
Hassan, Adnan. A Practical Guide to Sovereign Wealth Funds. London: Euromoney Institutional
Investor, 2008.
Articles:
Jen, Stephen. "Sovereign wealth funds: What they are and what's happening." World Economics
8:4 (2007): 1-7. Online at: www.world-economics-journal.com/Contents/ArticleOverview.
aspx?ID=311
Raphaeli, Nimrod, and Bianca Gersten. "Sovereign wealth funds: Investment vehicles for the
Persian Gulf countries." Middle East Quarterly 15:2 (Spring 2008): 45-53. Online at:
www.meforum.org/1863/sovereign-wealth-funds-investment-vehicles-for
Websites:
International Working Group of Sovereign Wealth Funds: www.iwg-swf.org
Opalesque Sovereign Wealth Funds Briefing: www.opalesque.com/SWF_Briefing
Sovereign Wealth Fund Institute: www.swfinstitute.org
SWF Radar archive: www.swfradar.com

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226
Sovereign Wealth Funds—Profiles of the
Top 10 Players
DEFINITION
Though Sovereign Wealth Funds (SWFs) have
been around in various forms for decades, the
leading players have risen to a new level of
prominence over recent years. In particular,
since the onset of the global credit crunch,
several leading SWFs have taken full advantage
of their massive level of liquidity to secure major
stakes in financial services companies in urgent
need of capital injections.
Middle Eastern and Asian nations benefiting
from natural resources or mass manufacturing
account for the overwhelming majority of the
leading global SWFs, though Russia and several
US states such as Alaska also operate sizable
funds. The 10 leading global players are as
follows:
1 Abu Dhabi Investment Authority (ADIA).
Established by the United Arab Emirates in
1976, ADIA is by far the world's biggest SWF,
with assets estimated at $875 billion.1 As
much as 75% of ADIA's assets are thought to
be administered by external fund managers.
With a spread of investments among
industrial andfinancialfirmsin the Middle
East, ADIA caught the headlines in 2007 with
a $7.5 billion investment in US banking giant
Citigroup.
2 Norwegian Government Pension Fund.
Norway's decision to invest the proceeds of
its North Sea oil and gas operations into this
$300+ billion1 pension fund in 1990 has
created one of the world's biggest SWFs. It is
the most transparent, having created a panel
of experts to ensure that the 7,000 companies
in which the fund invests meet its strict
ethical criteria. Following the advice of this
panel, the fund famously de-invested in Wal-
Mart, citing concerns over the retail giant's
labor rights record in developing economies.
3 Government of Singapore Investment
Corporation (GIC). Thought to be among the
world'sfivebiggest SWFs, the investment
management unit of the Singaporean
government is believed to manage assets of
around $330 billion.1 Established in 1981,
GIC prefers to keep a relatively low profile,
despite delivering average investment returns
of nearly 10% per annum in dollar terms since
1982. GIC holds major stakes in Swiss bank
UBS and US energyfirmAEI.
4 China Investment Corporation (CIC). With
9
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its origins in the investment business of
China's central bank, CIC was established
in its present form as recently as 2007. CIC
oversees the investment of China's foreign w
exchange reserves, estimated to be in the c
region of $200 billion.1 CIC lifted its stake in
fund management group Blackstone to 12.5%
in 2008, and it has also recently expanded its
other interests in financial services, holding a
9.9% stake in Morgan Stanley.
5 SAMA Foreign Holdings. With assets
believed to be in the region of $300 billion,1
this Saudi Arabian SWF is generally regarded
as one of the least transparent of the major
global funds of its kind. Presently outsourcing
equity to professional asset managers, SAMA
(Saudi Arabian Monetary Agency) could soon
be overshadowed by a new SWF planned by
the Saudis to manage some of their enormous
oil-derived wealth.
6 China Development Bank (CDB). Established
in 1994, CDB has combined domestic
infrastructure investments (such as the
controversial Three Gorges Dam) with
overseas interests, acquiring stakes in banks
such as the UK's Barclays. CDB is thought to
hold assets worth around $225 billion.1
7 Kuwait Investment Authority. Run by the
Kuwait Investment Office, the country's
investment arm, which traces its roots back to
the early 1960s, it holds assets worth around
$250 billion.110% of Kuwait's annual oil
revenues are channeled into the fund, which
invests globally across a range of asset classes.
8 Temasek. The Singapore state-run investment
fund was established in 1974, with assets
recently estimated at around $160 billion.1
In common with many of its peers, Temasek
has been active in the global financial sector,
acquiring stakes in institutions such as Merrill
Lynch, Standard Chartered, and Barclays.
9 Russia National Welfare and Oil
Stabilization Funds. Dating from around
2004, the Oil Stabilization Fund has invested
exclusively in foreign government bonds.
In early 2008 the Fund was split into two: O
The Reserve Fund is thought to hold assets
of around $162 billion,1 while the National
Welfare fund, Russia's official SWF with
assets estimated at $125 billion,1 absorbs
some of the proceeds from the country's
energy industry.
o
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Financing and Raising Capital

10 Investment Corporation of Dubai. Formed
in 2006, the Investment Corporation of
Dubai is thought to have assets of at least
$13 billion,1 including its subsidiaries Dubai
International Capital (DIC) and Dubai World.
As well as a high-profile stake in HSBC, the
group also holds investments in electronics
giant Sony and automobile manufacturer
DaimlerChrysler.
ADVANTAGES
• SWFs' stated aim of investing for the long
term can lend stability to the shareholder
bases of the companies in which they invest.
• These funds have been a valuable source of
large-scale investment for some companies
in need of capital as the credit crunch has
deepened.
• Many SWFs aim to secure nonvoting shares
in their target companies, helping to alleviate
concerns in some countries over foreign
ownership of key assets.
DISADVANTAGES
• The lack of transparency associated with
SWFs can create concerns over the motives
behind some investments.
• Some proposed SWF investments can meet
with political or regulatory resistance, on
protectionist or national interest grounds. A
noted example occurred when Dubai World's
acquisition of P&O prompted US politicians
to insist that the acquirer would dispose of
several major P&O-owned US ports.
Concerns have been raised over some SWFs'
commitment to upholding high regulatory
standards.
ACTION CHECKLIST
*/k commitment to the adoption of best
practice principles proposed by the IMF can
help SWFs to overcome some concerns over
issues such as their motives, governance,
and transparency.
>/Governments should ensure that their
national SWFs manage their investments to
the economic benefit of their citizens.
DOS AND DONTS
DO
• SWFs should be sensitive to local concerns
over their investment objectives when
striking overseas deals.
• In situations where SWFs seek an active,
controlling stake in a company, SWFs can
overcome their lack of perceived expertise
in some sectors by employing acknowledged
industry experts to run their acquired
businesses more efficiently.
DONT
• Don't view SWFs as an automatic source
of funding for Western financial institutions
which find themselves in difficulty.
• Don't allow the funds to ignore the value
of effective communications and improved
investment transparency and disclosure.

MORE INFO
Books:
Carson, Thomas N., and William P. Litmann (eds). Sovereign Wealth Funds. New York: Nova, 2008.
Davis, Steven H. Inside China Investment Corp. London: McGraw-Hill, 2008.
Articles:
Elson, Anthony. "The sovereign wealth funds of Singapore." World Economics 9:3 (2008): 73-96.
Online at: www.world-economics-journal.com/Contents/ArticleOverview.aspx?ID=343
Schuette, Patrick. "Tamed tigers: Sovereign wealth funds as passive investors." Illinois Business
Law Journal (November 2008). Online at: tinyurl.com/ykj7kgp
Websites:
Abu Dhabi Investment Authority: www.adia.ae
China Investment Corporation: www.china-inv.cn/cicen
International Monetary Fund: www.imf.org
International Working Group of Sovereign Wealth Funds: www.iwg-swf.org
Organisation for Economic Co-operation and Development: www.oecd.org
Sovereign Wealth Fund Institute: www.swfinstitute.org

228
 Sovereign Wealth Funds—Profiles of the Top 10 Players

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NOTES 2
1 Asset size estimates taken from Norton Rose's 5H
June 2008 report, "Sovereign wealth funds and the ^
global private equity landscape survey" (available 2^
on www.nortonrose.com) and The Times (London), (*)
December 27, 2007. W

229
Understanding Capital Markets,
Structure and Function
DEFINITION
Capital markets provide a wide range of
products and services that are related to
financial investments. Capital markets include
the stock market, commodities exchanges, the
bond market, and just about any physical or
virtual service or intermediary where debt and
equity securities can be bought or sold. Their
primary purpose is to raise funds and channel
investors' money to areas where there is a deficit
or need for investment. They play a vital role
as intermediaries between governments and
companies, which use them to finance a myriad
of activities.
The capital markets can be broken down
into the primary market, where new stocks and
bonds are issued to investors, and the secondary
market, where existing stocks and bonds are
traded.
In the primary market, governments,
companies, or public sector organizations can
obtain funding through the sale of a new stock
or bonds. These are normally issued through
securities dealers and banks, which underwrite
the offered stocks or bonds. The issuers earn a
commission, which is built into the price of the
security offering.
In the secondary market, stocks and shares
in publicly traded companies are bought and
sold through one of the major stock exchanges,
which serve as managed auctions for stock. A
stock exchange, share market, or bourse is a
company, corporation, or mutual organization
that provides facilities for stockbrokers and
traders to trade stocks and other securities.
Stock exchanges also provide facilities for the
issue and redemption of securities, trading in
other financial instruments, and the payment of
income and dividends.
ADVANTAGES
• Capital markets provide the lubricant
between investors and those needing to raise
capital.
• Capital markets create price transparency
and liquidity. They provide a safe platform
for a wide range of investors —including
commercial and investment banks, insurance
companies, pension funds, mutual funds, and
retail investors—to hedge and speculate.
• Holding different shares or bonds allows an
investor to spread investment risk.
o
3*
• The secondary market gives important
pricing information that permits efficient use
of limited capital.
DISADVANTAGES
• In capital markets, bond prices are influenced
by economic data such as employment,
I
income growth/decline, consumer prices,
and industrial prices. Any information that
I
implies rising inflation will weaken bond
prices, as inflation reduces the income from a
bond.
• Prices for shares in capital markets can ft
be very volatile. Their value depends on a 3
number of external factors over which the
investor has no control.
• Different shares can have different levels of
liquidity, i.e. demand from buyers and sellers.
ACTION CHECKLIST
• When placing a buy or sell order, there
are two ways you can trade. Shares can
be traded at market order, which means
buying at the prevailing market price. The
alternative is the limit order, in which you set
the minimum or maximum price.
• What are interest rates going to do?
Investors who buy and sell bonds before
maturity are exposed to many risks, most
importantly changes in interest rates. When
interest rates increase, new issues will pay a
higher yield and the value of existing bonds
will fall. When interest rates decline, the
value of existing bonds will rise as new issues
pay a lower yield.
DOSANDDONTS
DO
• Before you buy, check how quickly you will
be able to sell if necessary, and at what
discount and dealing fee.
DONT o
• Don't, unless you are completely confident,
invest in only one type of bond or security.
An exchange-traded fund or an index fund
might be a much safer bet. z
o
231
 Financing and Raising Capital

t§ MORE INFO
S Books:
^ Fabozzi, Frank 3., and Franco Modigliani. Capital Markets: Institutions and Instruments. 4th ed.
« Upper Saddle River, N2: Prentice Hall, 2008.
6 Maginn, 3ohn L, Donald L. Turtle, Jerald E. Pinto, and Dennis W. McLeavey (eds). Managing
Investment Portfolios: A Dynamic Process. 3rd ed. Hoboken, N3: Wiley, 2007.
^ Mclnish, Thomas H. Capital Markets: A Global Perspective. Maiden, MA: Blackwell Publishers, 2000.
S ...
0) Articles:
Q Mehta, Nina. "TradeWeb eyes equity expansion in 2008." Traders Magazine (December 2007).
•^ Online at: www.tradersmagazine.com/issues/20_275/100087-l.html
4) Rodier, Melanie. "The massive growth of electronic bond trading." Wall Street and Technology
C
£ (April 15, 2008). Online at: www.wallstreetandtech.com/electronic-trading/showArticle.
jhtml?articleID=207200781
*J Websites:
£ FTSE Global Bond Index: markets.ft.com/markets/overview.asp
j^ Interactive Investor: www.iii.co.uk/sharedealing

u
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232
Understanding Capital Structure
Theory: Modigliani and Miller
DEFINITION
The Modigliani-Miller theorem states that,
in the absence of taxes, bankruptcy costs, and
asymmetric information, and in an efficient
market, a company's value is unaffected by
how it is financed, regardless of whether the
company's capital consists of equities or debt,
or a combination of these, or what the dividend
policy is. The theorem is also known as the
capital structure irrelevance principle.
A number of principles underlie the theorem,
which holds under the assumption of both
taxation and no taxation. The two most important
principles are that, first, if there are no taxes,
increasing leverage brings no benefits in terms
of value creation, and second, that where there
are taxes, such benefits, by way of an interest tax
shield, accrue when leverage is introduced and/
or increased.
The theorem compares two companies—one
unlevered (i.e. financed purely by equity) and
the other levered (i.e. financed partly by equity
and partly by debt)—and states that if they are
identical in every other way the value of the two
companies is the same.
As an illustration of why this must be true,
suppose that an investor is considering buying
one of either an unlevered company or a levered
company. The investor could purchase the
shares of the levered company, or purchase the
shares of the unlevered company and borrow an
equivalent sum of money to that borrowed by
the levered company. In either case, the return
on investment would be identical. Thus, the
price of the levered company must be the same
as the price of the unlevered company minus the
9
ft
V)
borrowed sum of money, which is the value of
the levered company's debt. There is an implicit
assumption that the investor's cost of borrowing
1
money is the same as that of the levered company,
which is not necessarily true in the presence of
asymmetric information or in the absence of
efficient markets. For a company that has risky
debt, as the ratio of debt to equity increases
the weighted average cost of capital remains %
ft
constant, but there is a higher required return
on equity because of the higher risk involved for
equity-holders in a company with debt. &
ft
3
ADVANTAGES
• In practice, it's fair to say that none of the
assumptions are met in the real world, but
what the theorem teaches is that capital
structure is important because one or more of
the assumptions will be violated. By applying
the theorem's equations, economists can find
the determinants of optimal capital structure
and see how those factors might affect
optimal capital structure.
DISADVANTAGES
• Modigliani and Miller's theorem, which
justifies almost unlimited financial leverage,
has been used to boost economic and
financial activities. However, its use also
resulted in increased complexity, lack of
transparency, and higher risk and uncertainty
in those activities. The global financial crisis
of 2008, which saw a number of highly
leveraged investment banks fail, has been in
part attributed to excessive leverage ratios.
D
M
233
 Financing and Raising Capital

§ MORE INFO
Books:
3
^j Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 9th ed.
V Boston,G.MA: McGraw-Hill/Irwin,
The Quest for 2008.
Value: A Guide for Senior Managers. New York:
A Stewart, Bennett.
U HarperBusiness, 1 9 9 1 .

Articles:
C
Qi Miles, James A., and John R. Ezzell. "The weighted average cost of capital, perfect capital markets,
jUj and project life: A clarification." Journal of Financial and Quantitative Analysis 15:3 (September
•§ 1980): 7 1 9 - 7 3 0 . Online at: dx.doi.org/10.2307/2330405
& Modigliani, Franco, and Merton H. Miller. "The cost of capital, corporation finance, and the theory of
£ investment." American Economic Review 48:3 (June 1958): 2 6 1 - 2 9 7 . Online at:
M www.jstor.org/stable/1809766
£» Modigliani, Franco, and Merton H. Miller. "Corporate income taxes and the cost of capital: A
•fl correction." American Economic Review 53:3 (June 1963): 433-443. Online at:
Q< www.jstor.org/stable/1809167
w

234
Understanding the Cost of Capital
and the Hurdle Rate
DEFINITION
The cost of capital is the rate of return that
an investor expects to earn on his or her
investment. If an investment is to be worthwhile,
the expected return on capital must be greater
than its cost. In other words, the risk-adjusted
return on capital (that is, incorporating not just
the projected returns, but the probabilities of
those projections) must be higher than the cost
of capital.
Cost of capital is made up of two elements:
debt and equity. The cost of debt is, in the
simplest terms, the amount of interest paid
on the debt. The interest cost is historical, but
investor expectations may also influence the
actual cost (i.e. investors may accept a higher
cost in the short term where the long-term gains
are better). Other factors may also affect the
cost of debt. The interest rate usually includes
the risk-free rate plus a risk component, which
takes into account the probability of default on
the debt.
The cost of equity is more complex. The
traditional calculation used is that of dividend
capitalization, whereby the dividends per share
are divided by the current market value of the
stock plus the dividend growth rate. Thus, the
cost of equity is equal to the compensation
demanded by the market in exchange for
ownership of the asset and bearing the risk of
ownership.
The cost of capital is often used as the discount
rate, i.e. the rate at which the projected cash
flow is discounted to determine the net present
value.
The weighted average cost of capital (WACC)
is a method of measuring a company's cost
of capital. The total capital is taken to be the
value of a company's equity (if there are no
outstanding warrants and options, this is equal
sr
to the company's market capitalization) plus the
cost of its debt (this must be continually updated
as the cost of debt changes every time there is
a change in the interest rate). When calculating
the WACC, the equity in the debt-to-equity ratio c
is the market value of all equity, rather than the
shareholders' equity on the balance sheet.
The hurdle rate is the minimum rate of return, 3
when applying a discounted cash flow analysis,
that an investor requires before they commit to
an investment. A company may apply it when
deciding whether to undertake a project, or a $
bank when extending loans. It must be equal to
the incremental cost of capital. It is known as
the hurdle rate because the amount of return
determines if the investor is "over the hurdle"
and ready to invest
ADVANTAGES
• Using a hurdle rate can help take the emotion
out of making a decision on investment by
focusing purely on the financial aspects.
When an investment looks exciting, it can
be easy to overlook the risks or a potentially
poor rate of return. A risk premium can be
appended to the hurdle rate if evaluation
of the investment shows that specific
opportunities inherently contain high levels
of risk.
DISADVANTAGES
• A major downside to using a hurdle rate is
that, inevitably, some profitable projects will
be rejected. Additionally, if the hurdle rate is
too high, a company may only favor projects
that are profitable in the short term rather
than taking a long-term view. Thus it can
make companies seem conservative and deter
them from investing in innovation where the
returns are uncertain.
oh i
M
235
 Financing and Raising Capital

Tg M O R E INFO
Tg Book:
W Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe. Corporate Finance. 9th ed. Boston,
2 MA: McGraw-Hill, 2010.
^ Articles:
• Modigliani, Franco, and Merton H. Miller. "The cost of capital, corporation finance, and the theory of
CJ investment." ^mer/can Economic Review 48:3 (June 1958): 261-297. Online at:
W www.jstor.org/stable/1809766
C Yee, Kenton K. "Aggregation, dividend irrelevancy, and earnings-value relations." Contemporary
t? Accounting Research 22:2 (Summer 2005): 453-480. Online at:
£ dx.doi.org/10.1506/GEH4-WNJR-G58F-UM0U
fl

u
I—H

236
Understanding the Weighted Average o
5T
Cost of Capital (WACC) o
&
(ft
DEFINITION financing is simply its market value (rather
Gf>
The weighted average cost of capital (WACC) than the book value, which may be significantly
measures the capital discount of a company's different) divided by the sum of the values of
income and expenditure. It is a component of all the components. The easiest component to
the formula used for calculating the expected calculate is the market value of the equity of a
cost of new capital and it represents the rate publicly traded company, as this is simply the
that a company is expected to pay to finance price per share multiplied by the number of
its assets. It is thus the minimum return that a
company must earn on its existing asset base to
satisfy its creditors, owners, and other providers
outstanding shares. Likewise, the market value
of preferred shares is easy to determine and is
calculated by multiplying the cost per share by
I
of capital. number of outstanding shares. The market value
WACC is calculated by taking into account the of a company's debt is also easy to discover if a
relative weight of each component of a company's company has publicly traded bonds. However,
capital structure. The calculation usually uses many companies have debt in the form of bank
the market values of the components, rather
loans, whose market value is not easily found.
than their book values, which may differ
significantly. Components may include equity However, the market value of debt is often fairly
(both common and preferred), debt (straight, close to the book value, at least for companies
convertible, or exchangeable), warrants, options, that have not experienced significant changes
pension liabilities, executive stock options, and in credit rating. Thus, calculation of WACC
government subsidies. More exotic sources of typically uses the book value of any debt.
financing, such as convertible/callable bonds or On the cost side, the cost of preferred shares
convertible preferred stock, may also be included is calculated by dividing the periodic payment
in a WACC calculation if they are present in by the price of the preferred shares. The cost of
significant amounts as the cost of these is usually ordinary shares is typically determined using the
different from plain vanilla financing methods. capital asset pricing model. The cost of debt is
For a company with a complex capital structure, usually the yield to maturity on the company's
calculating WACC can be a time-consuming publicly traded bonds, or the rates of interest
exercise. charged by the banks on recent loans. The cost of
The equation used to calculate WACC uses the debt can be cut further as a company can usually
cost of each capital component multiplied by its write off taxes on the interest it pays on the debt.
proportional weight as follows: Thus, the cost of debt is calculated as yield to
maturity multiplied by (1 minus the tax rate).
WACC = E/V x R. + D/V x Rd x (1 - Tc)
Because governments usually allow tax to
where Re is the cost of equity, Rd is the cost of be deducted from interest, there is an inherent
debt, E is the market value of the firm's equity, D bias towards debt financing. However, the cost
is the market value of the firm's debt, V = E + D, of financial distress, such as bankruptcy, tilts
E/V\s the percentage of financing that is equity, any bias towards equity financing. In theory,
D/V is the percentage of financing that is debt, therefore, the ideal debt-to-equity ratio in a
and Tc is the corporate tax rate. company is usually the point at which any
To determine the value of each component tax benefits accrued by debt financing are
it is assumed that the weight of a source of outweighed by the costs of financial distress.

237
 Financing and Raising Capital

(A
% MORE INFO
3W
Books:
Armitage, Seth. The Cost of Capital: Intermediate Theory. Cambridge, UK: Cambridge University
Jj Press, 2005.
rj Johnson, Hazel. Determining Cost of Capital: The Key to Firm Value. London: FT Prentice Hall,
. 1999.
4J Pratt, Shannon P., and Roger J. Grabowski. Cost of Capital: Applications and Examples. 4th ed.
§ Hoboken, NJ: Wiley, 2010.
S Website:
5C Formularium on WACC calculation: formularium.org/en/10.html?go=96.169
V

a
Pi,

238
Using Mezzanine Financing
DEFINITION
Mezzanine financing can be an ideal solution for
firms looking for a quick injection of capital to
grow their already successful business without
giving up an interest in that business.
Mezzanine financing presents a way for
publicly and privately held companies to obtain
financing without ownership of the company
being given up. It is a mixture of traditional debt
financing and equity financing that offers the
benefits of both. Mezzaninefinancing,like equity
financing, is an unsecured debt that requires no
collateral, unlike a traditional bank loan. Like
debt financing, mezzanine financing is very
flexible and does not necessarily involve giving
up an interest in the company. Likely sources
of mezzanine financing are private investors,
insurance companies, mutual funds, pension
funds, and banks.
Because mezzanine financing is normally
provided very quickly, with little due diligence by
the lender and with little or no collateral required
from the borrower, this type offinancingtends to
be expensive, with the lender seeking a return of
between 20% and 30%. Mezzaninefinancingalso
has the advantage that it is treated like equity on
a company's balance sheet, which may make it
easier to obtain standard bank financing.
To attract mezzanine financing, a company
usually must demonstrate:
• A track record in the industry, with an
established reputation and product.
• A history of profitability, or at least of
breaking even.
• A viable expansion plan for the business
through acquisition, broader penetration of
the market, etc.
• Solid management and operations planning.
• An established business plan.
In leveraged buyouts, mezzanine capital is
often used in conjunction with other securities
to fund the purchase price of the company that
is being acquired. Typically, mezzanine capital
will be used to fill a financing gap between less
expensive forms of financing (senior loans,
second-lien loans, high-yield financing) and
equity.
Due to the lack of valid collateral, as well as
the high speed of lending, mezzaninefinancingis
typically more difficult to obtain than a traditional
bank loan or equity financing. However, the
benefits are that mezzanine financiers do not
normally interfere in company management and,
o
except in the case of a default, they do not want
sr
an interest in the company. Whereas traditional n
equity investors may attempt to gain some level E
ofcompany control, mezzanine financiers will do
what they can to ensure that the debt is paid off
without resorting to default.
ADVANTAGES
•s
• Mezzanine financing often offers more
flexible financing options, such as coupons
and covenants that take into account the
business's cash flow.
• Mezzanine financing provides business
owners with the funds they may need to buy
another business or to expand.
• Little or no due diligence and collateral.
• Generally no loss of ownership control.
DISADVANTAGES
• Mezzanine financing is normally aggressively
priced, with lenders seeking returns of
between 20% and 30%.
• Financiers can include restrictive covenants
that the borrower has to endure. These can
include agreements by the lender not to
borrow more money or refinance senior debt
from traditional loans.
• Financiers might want to have a vote on the
board of directors.
• Many financial experts believe that this type
of financing has aggravated the recent credit
crunch.
ACTION CHECKLIST
• What other avenues of financing are available
that would not load the company with so
much debt?
• in return for the loan, does the company
have to cede some independence to the
lender?
• Does the loan restrict the company to
spending money in certain areas?
• Does your company have a strong market
position based on its products/technology
and a market share that will allow it to repay
the loan?
• Does your company have a focused business o
strategy and positive long-term development
prospects?
• Do you have positive, stable cash flows that
can be forecasted reliably?
o
hi
239
 Financing and Raising Capital

•H
DOSANDDONTS
DO DONT
• Check that the possibilities for funding from • Don't use mezzanine financing if there are
other resources have been exhausted or are serious underlying business problems that
insufficient. need to be addressed.

MORE INFO
Books:
Fabozzi, Frank J. (ed). The Handbook of Financial Instruments. Hoboken, NJ: Wiley, 2002.
Longenecker, Justin G., Carlos W. Moore, J. William Petty, and Leslie E. Palich. Small Business
Management: An Entrepreneurial Emphasis. 13th ed. Mason, OH: Thomson-Southwestern
Publishing, 2005.
Vance, David E. Raising Capital. New York: Springer Science+Business Media, 2005.
Article:
Bean, LuAnn. "Mezzanine financing: Is it for you?" Journal of Corporate Accounting and Finance
19:2 (January/February 2008): 33-35. Online at: dx.doi.org/10.1002/jcaf.20370
Website:
Bank of America—TriSail mezzanine finance: corp.bankofamerica.com/public/public.portal?_pd_
page_label=trisail/index

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240
Index 3
ft-
corporate finance ft
Abu Dhabi Investment Authority (ADIA) capital structure strategy 3,17, 215
sovereign wealth fund 227 cost of issuing convertible securities 53
accounts receivable debt financing 7
collateral 189 institutional investors' role 115
activist investors Modigliani-Miller capital structure
management of 165 irrelevance principle 233
Aggarwal, Reena 103 nonrecourse financing 49
Armitage, Seth 93 private and public equity 223
private equity for SMEs 123
B raising capital in global financial
bank loans markets 103
small and medium-sized enterprises raising capital in the UK 41
(SMEs) 11, 201 securitization 63
banking relationships see also funding
management of 191 corporate governance
banks and banking target for activist investors 165
rise of global banks 69 cost of capital
bond market hurdle rate 235
raising capital by issuing bonds 199 weighted average cost of capital (WACC) 237
structure and function 181 credit crunch
Booth, Lena small investors 97
173 credit derivatives 45
Bradford and Bingley
credit management
rights issue case study 93 accounts receivables 189
Brotzge, Lawrence 83 credit ratings 37
Brzeszczynski, Janusz 159 management of 187
credit risk
C debt cover 207
capital investment interest coverage ratios 203
setting hurdle rate 141 management 45
capital markets cross-listing by companies 169
structure and function 231
capital structure D
debt financing 7 de la Torre, Augusto 11
implications 31 debt cover 207
Modigliani-Miller theorem 233 debt/equity (D/E) ratio 205
perspectives 25 debt financing
strategy 3»17 capital structure strategy 3, 7,17, 215
cash flows Modigliani-Miller capital
bank lending requirements 179 structure irrelevance principle 233
China
sovereign wealth funds 227
China Development Bank emerging markets
sovereign wealth fund 227 initial public offerings (IPOs) 159
China Investment Corporation (CIC) public-private partnerships 73
sovereign wealth fund
collateral
227 entrepreneurs
assessing growth opportunities 89 o
receivables as 189 assessing venture capital funding 129
convertible securities see also small and medium-sized
cost of issuing 53 enterprises (SMEs)
• — <
corporate bonds equity financing
raising capital by issue of 199 capital structure strategy 3,17, 215

O
241
 Financing and Raising Capital

* equity financing (conf.) Government of Singapore Investment

Inde:

Modigliani-Miller capital structure Corporation (GIC)

irrelevance principle 233 sovereign wealth fund 227
raising capital through private grants
and public equity 223 raising capital in the UK 41
small and medium-sized Groth, John C. 17 2 5 , 3 1
enterprises (SMEs) 151
equity markets H
cross-listing 169 hedge funds
rights issues 93 private investments in public
equity (PIPE) 147
F Hostrup, Arne-G. 123
Fabozzi, Frank J. 45,63 Hoy, Frank 89
factoring
accounts receivables 189 I
Fayolle, Alain 129 initial public offerings (IPOs) ,
financial instruments emerging markets 159
credit derivatives 45 price discovery 135
Islamic credit ratings 37 SMEs 109
financial intermediaries underpricing 173
role 183 InkJet
financial ratios venture capital case study 123
debt cover 207 institutional investors
debt/equity (D/E) 205 corporate financing role 115
fixed-charge coverage 209 interest coverage ratios 203
interest coverage 203 Investment Corporation of Dubai
leverage 205 sovereign wealth fund 227
fixed-charge coverage ratio 209 investors
franchising activist 165
business of 185 small 97
fund managers IPOs see initial public offerings
activist 165 Islamic finance
funding credit ratings 37
bonds issue 199
capital structure strategy 3 17, 215 J
corporate debt 7 Jiang, Hao 115
Modigliani-Miller capital structure
irrelevance principle 233 K
nonrecourse financing 49 Kossoff, Leslie 165
private and public equity 223 Koveos, Peter 73
private equity for SMEs 123 Kuwait Investment Authority
private investments in public sovereign wealth fund 227
equity (PIPE) 147
raising capital in global financial L
markets 103 Lasfer, Meziane 3,169
raising capital in the UK 41 leverage ratios 205
rights issues 93 LiPuma, Joseph 129
shares issue 221 listed companies
SMEs 41, 217 rights issues 93
see also corporate finance see also public companies;
Fung, Hung-Gay 109 stock markets
[NANCE

Lister, Roger 53
G loan agreements
gearing overview 197
measurement 193 Lowe, Steven 7
ratios 205

a
1*4 globalization M
rise of global banks 69 Martinez Peria, Maria Soledad 11

242
 Index

McKaig, Thomas 49 shareholders l-H

Mekonnen, Wondimu 97 stockholders' agreements 219 g
mezzanine financing shares M*
cross-listing
n
definition 239 169 X
Microsoft raising capital by issue of 221
activist investor case study 165 rights issues 93
Mills, Lauren 41 shariah law
money markets credit ratings 37
structure and function 195 Singapore
sovereign wealth fund 227
N Sjostrom, William K., J r 147
Norwegian Government Pension Fund Skinner, Chris 69
sovereign wealth fund 227 small and medium-sized enterprises (SMEs)
assessing growth opportunities 89
P assessing venture capital funding 129
PPP see public-private partnership bank finance 11,201
price discovery corporate finance 41
initial public offerings (IPOs) 135 equity capital 151
private equity funding choices 217
raising capital through 223 initial public offerings (IPOs) 109
SMEs access to 123 private equity, access to 123
private investments in public equity small investors
(PIPE) 147 attracting 97
project finance SMEs see small and medium-sized
nonrecourse financing 49 enterprises
public companies sovereign wealth funds (SWF)
cross-listing 169 global leaders 227
price discovery in IPOs 135 investment strategies and objectives 225
private investments in public stock markets
equity (PIPE) 147 cross-listing 169
raising capital through public equity 223 stockholders' agreements 219
see also initial public offerings (IPOs); SWF see sovereign wealth funds
listed companies
public-private partnership (PPP) T
emerging markets 73 Temasek
sovereign wealth fund 227
R Terjesen, Siri 151
rating agencies 37 treasury management
managing credit rating 187 credit risk 45
receivables Tucker, Jon 141
collateral 189
risk management V
credit risk 45 van Bommel, Jos 135
interest coverage ratios 203 venture capital (VC)
Russia National Welfare and Oil assessing funding for SMEs 129
Stabilization Funds dealing with VC companies 213
sovereign wealth fund 227 SMEs access to 123
sources 83
Sabarwal, Tarun 57 W
SAMA Foreign Holdings
sovereign wealth fund
Schmukler, Sergio
227
11
weighted average cost of capital (WACC)
definition
Wyss, David
237
37
o
secondary listing by companies 169
securitization Y
corporate funding tool 63 Yahoo!
credit risk
risks and rewards
45
57
activist investor case study
Yourougou, Pierre
165
73 o
in

243