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Chapter 13

Raising Equity
Capital

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Chapter 13 Outline

13.1 Equity Financing for Private Companies


13.2 Taking Your Firm Public: The Initial Public
Offering
13.3 IPO Puzzles
13.4 Raising Additional Capital: The Seasoned
Equity Offering

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Learning Objectives

• Contrast the different ways to raise equity


capital for a private company
• Understand the process of taking a company
public
• Gain insight into puzzles associated with initial
public offerings
• Explain how to raise additional equity capital
once the company is public

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13.1 Equity Financing for Private
Companies

• Entrepreneurs usually need capital from outside


sources
• In this section, we examine:
 the sources that can provide a private company with
capital
 the effect of the infusion of outside capital on the
control of the company

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13.1 Equity for Private Companies

• Sources of Funding:
 A private company can seek funding from several
potential sources:
 Angel Investors
 Venture Capital Firms
 Institutional Investors
 Corporate Investors

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13.1 Equity for Private Companies
• Angel Investors:
 Individual investors who buy equity in small private firms
(typically invest their own funds)
 The first round of outside private equity financing is often
obtained from angels
 There is no “set amount” for angel investors, and the range can
go anywhere from a few thousand, to a few million dollars
 Angel investors bear extremely high risk and are usually subject
to dilution from future investment rounds. As such, they require
a very high return on investment.
 Professional angel investors seek investments that have the
potential to return at least 10 or more times their original
investment within 5 years, through a defined exit strategy, such
as plans for an initial public offering or an acquisition.
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13.1 Equity for Private Companies
• Angel Investors:
 Cradle Fund Sdn Bhd (Cradle), an agency under the Ministry of Finance,
Malaysia (MOF) is a not-for-profit organisation that manages the RM100
million Cradle Investment Programme since its inception in June 2003.
 Objective: to address the needs and challenges of Malaysian technology
entrepreneurs, in particular in obtaining pre-seed and seed funding.
 The first conditional grant offered entrepreneurs funding of up to RM50,000
to transform their raw technology-based ideas into commercially viable
ventures.
 In the Malaysian 2012 Budget - a tax incentive for angel investors which
would allow for an angel investor to be accorded a tax relief of up to
RM500,000 p.a, in the 3rd year (after 2 years) of his/her shareholding
 It is designed to encourage more angel investments from the private sector
into early stage companies
 CAPITAL.my was created to provide a one stop platform to bring together
Entrepreneurs with proven business models and Investors with experience
and capital to grow and nourish a business idea into a profit venture. 13-7
Copyright © 2009 Pearson Prentice Hall. All rights reserved.
13.1 Equity for Private Companies
• Angel Investors:
 CAPITAL.my was created to provide a one stop platform to bring together
Entrepreneurs with proven business models and Investors with experience and
capital to grow and nourish a business idea into a profit venture.
 HOW IT WORKS
 Entrepreneurs email Executive Summary of the proposal. This email address is
being protected from spam bots, you need Javascript enabled to view it for
evaluation or Register your capital request online.
 Upon receiving of your capital request, CAPITAL management team will assess
and review the suitability of your proposal before personally match with our
registered investor database and display a synopsis of your project on our website
for potential investor's viewing.
 If the Investor / Funder likes you proposal, he or she will then contacts you
directly to arrange to meet to ascertain if there is any possibility of a working
partnership.
 Both parties provide CAPITAL with confidential feedback so that we can monitor
progress. The feedback also assists us to match files more closely.
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13.1 Equity for Private Companies
• Venture Capital Firms:
 Specialize in raising money to invest in the private equity of
young firms
 In 2007, VC firms invested $29.4 billion in 3,811 venture capital
deals, for an average investment of about $7.7 million per deal
 VC is attractive for new companies with limited operating history
that are too small to raise capital in the public markets and have
not reached the point where they are able to secure a bank loan or
complete a debt offering.
 VC is invested in exchange for an equity stake in the business.
 As a shareholder, the venture capitalist's return is dependent on
the growth and profitability of the business. This return is
generally earned when the venture capitalist "exits" by selling its
shareholdings when the business is sold to another owner.
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Venture Capital: Financing stages

There are typically six stages of venture round financing offered in VC,
that correspond to these stages of a company's development.
• Seed funding: Low level financing needed to prove a new idea, often
provided by angel investors.
• Start-up: Early stage firms that need funding for expenses associated
with marketing and product development
• Growth (Series A round): Early sales and manufacturing funds
• Second-Round: Working capital for early stage companies that are
selling product, but not yet turning a profit
• Expansion : Also called Mezzanine financing, this is expansion
money for a newly profitable company
• Exit of venture capitalist : Also called bridge financing, 4th round is
intended
Copyright to finance
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Figure 13.1 Most Active U.S. Venture
Capital Firms in 2006

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Figure 13.2 Venture Capital Funding in
the United States

• What was the spike in 2000?


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Malaysia Venture Capital Management
Berhad (MAVCAP)
• established in 2001, the country’s largest venture capital (VC)
company with investments in the ICT sector and other high-growth
industries, a wholly owned subsidiary of the MOF Incorporated
• Objective: to realise the Government’s mission to support Malaysian
based ICT companies as well as the VC industry
• invests for a period of three to eight years in seed, start-ups and
early-stage companies.
• invest capital in the company, hold a Board position and are actively
involved in key management decisions.
• Typical Investment Size:
• RM1 million – RM10 million for seed & start-up deal stage
• RM3 million – RM15 million for early & expansion deal stage
• RM5 million – RM20 million for late-deal stage 13-13
13.1 Equity for Private Companies

• Institutional Investors:
 pension funds, insurance companies, endowments,
and foundations
 may invest directly in private firms, or may invest
indirectly by becoming limited partners in venture capital
firms

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13.1 Equity for Private Companies

• Corporate Investors:
 Many established corporations purchase equity in
younger, private companies
 Corporations might invest for corporate strategic
objectives in addition to the desire for investment returns

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13.1 Equity Financing for Private
Companies

• Securities and Valuation


 When a company decides to sell equity to outside
investors for the first time, it is typical to issue
preferred stock rather than common stock to raise
capital
 It is called convertible preferred stock if the owner can
convert it into common stock at a future date

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Example 13.1 Funding and Ownership

Problem:
• You founded your own firm two years ago. You
initially contributed $100,000 of your money
and, in return received 1,500,000 shares of
stock. Since then, you have sold an additional
500,000 shares to angel investors. You are now
considering raising even more capital from a
venture capitalist (VC).

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Example 13.1 Funding and Ownership

Problem (cont’d):
• …This VC would invest $6 million and would
receive 3,000,000 newly issued shares. What is
the post-money valuation? Assuming that this is
the VC’s first investment in your company, what
percentage of the firm will she end up owning?
What percentage will you own? What is the
value of your shares?

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Example 13.1 Funding and Ownership

Solution:
Plan:
• After this funding round, there will be a total of
5,000,000 shares outstanding:
Your shares 1,500,000
Angel investors’ shares 500,000
Newly issued shares 3,000,000
Total 5,000,000

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Example 13.1 Funding and Ownership

Plan (cont’d):
• The VC is paying $6,000,000/3,000,000=$2/share. The
post-money valuation will be the total number of shares
multiplied by the price paid by the VC. The percentage
of the firm owned by the VC is her shares divided by
the total number of shares. Your percentage will be
your shares divided by the total shares and the value of
your shares will be the number of shares you own
multiplied by the price the VC paid.

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Example 13.1 Funding and Ownership

Execute:
• There are 5,000,000 shares and the VC paid $2 per share.
Therefore, the post-money valuation would be 5,000,000($2) =
$10 million.
• Because she is buying 3,000,000 shares, and there will be
5,000,000 total shares outstanding after the funding round, the
VC will end up owning 3,000,000/5,000,000=60% of the firm.
• You will own 1,500,000/5,000,000=30% of the firm, and the
post-money valuation of your shares is 1,500,000($2) =
$3,000,000.

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Example 13.1 Funding and Ownership

Evaluate:
• Funding your firm with new equity capital, be it from
an angel or venture capitalist, involves a tradeoff—you
must give-up part of the ownership of the firm in return
for the money you need to grow. The higher is the price
you can negotiate per share, the smaller is the
percentage of your firm you have to give up for a given
amount of capital.

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Example 13.1a Funding and
Ownership

Problem:
• You founded your own firm three years ago.
You initially contributed $500,000 of your
money and, in return received 100,000 shares of
stock. Since then, you have sold an additional
50,000 shares to angel investors. You are now
considering raising even more capital from a
venture capitalist (VC).

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Example 13.1a Funding and
Ownership

Problem (cont’d):
• …This VC would invest $15 million and would
receive 1,000,000 newly issued shares. What is
the post-money valuation? Assuming that this is
the VC’s first investment in your company, what
percentage of the firm will he end up owning?
What percentage will you own? What is the
value of your shares?

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Example 13.1a Funding and
Ownership

Solution:
Plan:
• After this funding round, there will be a total of
1,550,000 shares outstanding:
Your shares 500,000
Angel investors’ shares 50,000
Newly issued shares 1,000,000
Total 1,550,000

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Example 13.1a Funding and
Ownership

Plan (cont’d):
• The VC is paying $15,000,000/1,000,000=$15/share.
The post-money valuation will be the total number of
shares multiplied by the price paid by the VC. The
percentage of the firm owned by the VC is his shares
divided by the total number of shares. Your percentage
will be your shares divided by the total shares and the
value of your shares will be the number of shares you
own multiplied by the price the VC paid.

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Example 13.1a Funding and
Ownership

Execute:
• There are 1,550,000 shares and the VC paid $15 per share.
Therefore, the post-money valuation would be 1,550,000($15) =
$23,250,000.
• Because he is buying 1,000,000 shares, and there will be
1,550,000 total shares outstanding after the funding round, the
VC will end up owning 1,000,000/1,550,000=64.5% of the
firm.
• You will own 500,000/1,550,000=32.3% of the firm, and the
post-money valuation of your shares is 500,000($15) =
$7,500,000.

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Example 13.1a Funding and
Ownership

Evaluate:
• Funding your firm with new equity capital, be it from
an angel or venture capitalist, involves a tradeoff—you
must give-up part of the ownership of the firm in return
for the money you need to grow. The higher is the price
you can negotiate per share, the smaller is the
percentage of your firm you have to give up for a given
amount of capital.

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13.1 Equity Financing for Private
Companies

• Exiting an Investment in a Private Company


 Exit Strategy
 Acquisition
 Public Offering

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13.2 Taking Your Firm Public: The
Initial Public Offering

• The process of selling stock to the public for the


first time is called an initial public offering
(IPO)
 In this section we look at the mechanics of IPOs in
two cases—the traditional set-up and recent
innovations.

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Table 13.1 Largest Global Equity Issues

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13.2 Taking Your Firm Public: The
Initial Public Offering

• Advantages and Disadvantages of Going Public


 Advantages:
 Greater liquidity
 Better access to capital
 Disadvantages:
 Equity holders more dispersed
 Must satisfy requirements of public companies
• IPOs include both Primary and Secondary offerings

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13.2 Taking Your Firm Public: The
Initial Public Offering

• Underwriters and the Syndicate


 Underwriter: an investment banking firm that
manages the offering and designs its structure
 Lead Underwriter
 Syndicate: other underwriters that help market and
sell the issue

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Table 13.2 International IPO
Underwriter Ranking Report for 2007

• The major U.S. investment and commercial banks dominate the


underwriting business.

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LEAD MANAGERS’ LEAGUE TABLE
FOR JANUARY-DECEMBER 2012
(By Value RM’ million)

No. Lead Managers Total


1 CIMB Investment Bank Berhad 10,084.2
2 Maybank Investment Bank Berhad 9,504.2
3 AmInvestment Bank Berhad 8,207.5
4 RHB Investment Bank Berhad 6,837.5
5 HSCB Amanah Malaysia Berhad 2,246.7
6 Bank Muamalat Malaysia Berhad 380.0
7 Affin Investment Bank Berhad 230.0
Total 37,490.1

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Figure 13.3 The Cover Page of
RealNetworks’ IPO Prospectus

13-36
13.2 Taking Your Firm Public: The
Initial Public Offering

• SEC Filings
 Registration Statement
 preliminary prospectus or red herring
 Final Prospectus

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The Listing Process
(Source: Investment Banking Handbook, Institut Bank-Bank Malaysia, 2010, p.127)

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13.2 Taking Your Firm Public: The
Initial Public Offering

• Valuation
 Underwriters work with the company to come up
with a price that they believe is a reasonable
valuation for the firm
 Two ways:
 estimate the future cash flows
 compute the present value
 Road Show
 Book Building

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Example 13.2 Valuing an IPO Using
Comparables

Problem:
• Wagner, Inc., is a private company that designs,
manufactures, and distributes branded consumer
products. During the most recent fiscal year,
Wagner had revenues of $325 million and
earnings of $15 million. Wagner has filed a
registration statement with the SEC for its IPO.

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Example 13.2 Valuing an IPO Using
Comparables

Problem (cont'd):
• Before the stock is offered, Wagner’s investment
bankers would like to estimate the value of the
company using comparable companies. The investment
bankers have assembled the following information
based on data for other companies in the same industry
that have recently gone public. In each case, the ratios
are based on the IPO price.

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Example 13.2 Valuing an IPO Using
Comparables

Problem (cont'd)

• After the IPO, Wagner will have 20 million shares outstanding.


Estimate the IPO price for Wagner using the price/earnings ratio
and the price/revenues ratio.

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Example 13.2 Valuing an IPO Using
Comparables

Solution:
Plan:
• If the IPO price of Wagner is based on a price/earnings ratio that
is similar to those for recent IPOs, then this ratio will equal the
average of recent deals. Thus, to compute the IPO price based on
the P/E ratio, we will first take the average P/E ratio from the
comparison group and multiply it by Wagner’s total earnings.
This will give us a total value of equity for Wagner. To get the
per share IPO price, we need to divide the total equity value by
the number of shares outstanding after the IPO (20 million). The
approach will be the same for the price-to-revenues ratio.

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Example 13.2 Valuing an IPO Using
Comparables

Execute:
• The average P/E ratio for recent deals is 21.2. Given earnings of
$15 million, we estimate the total market value of Wagner’s
stock to be ($15 million)(21.2) = $318 million. With 20 million
shares outstanding, the price per share should be $318 million /
20 million = $15.90.
• Similarly, if Wagner’s IPO price implies a price/revenues ratio
equal to the recent average of 0.9, then using its revenues of
$325 million, the total market value of Wagner will be ($325
million)(0.9) = $292.5 million, or ($292.5/20)= $14.63/share

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Example 13.2 Valuing an IPO Using
Comparables

Evaluate:
• As we found in Chapter 9, using multiples for
valuation always produces a range of
estimates—you should not expect to get the
same value from different ratios. Based on these
estimates, the underwriters will probably
establish an initial price range for Wagner stock
of $13 to $17 per share to take on the road show.

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Example 13.2a Valuing an IPO Using
Comparables

Problem:
• Wagner, Inc., is a private company that designs,
manufactures, and distributes branded consumer
products. During the most recent fiscal year,
Wagner had revenues of $200 million and
earnings of $15 million. Wagner has filed a
registration statement with the SEC for its IPO.

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Example 13.2a Valuing an IPO Using
Comparables

Problem (cont'd):
• Before the stock is offered, Wagner’s investment
bankers would like to estimate the value of the
company using comparable companies. The investment
bankers have assembled the following information
based on data for other companies in the same industry
that have recently gone public. In each case, the ratios
are based on the IPO price.

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Example 13.2a Valuing an IPO Using
Comparables

Problem (cont'd)
Company Price/Earnings Price/Revenues

Ray Products Corp. 17.5 2.1


Byce-Frasier Inc. 14.4 2.3
Fashion Industries Group 14.9 1.3
Recreation International 13.3 2.7
Average 15.0 2.1

• After the IPO, Wagner will have 30 million shares outstanding.


Estimate the IPO price for Wagner using the price/earnings ratio
and the price/revenues ratio.
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Example 13.2a Valuing an IPO Using
Comparables

Solution:
Plan:
• If the IPO price of Wagner is based on a price/earnings ratio that
is similar to those for recent IPOs, then this ratio will equal the
average of recent deals. Thus, to compute the IPO price based on
the P/E ratio, we will first take the average P/E ratio from the
comparison group and multiply it by Wagner’s total earnings.
This will give us a total value of equity for Wagner. To get the
per share IPO price, we need to divide the total equity value by
the number of shares outstanding after the IPO (30 million). The
approach will be the same for the price-to-revenues ratio.

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Example 13.2a Valuing an IPO Using
Comparables

Execute:
• The average P/E ratio for recent deals is 15.0. Given earnings of
$25 million, we estimate the total market value of Wagner’s
stock to be ($25 million)(15.0) = $375 million. With 30 million
shares outstanding, the price per share should be $375 million /
30 million = $12.50.
• Similarly, if Wagner’s IPO price implies a price/revenues ratio
equal to the recent average of 2.1, then using its revenues of
$200 million, the total market value of Wagner will be ($200
million)(2.1) = $420 million, or ($420/30)= $14.00/share

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Example 13.2a Valuing an IPO Using
Comparables

Evaluate:
• As we found in Chapter 9, using multiples for
valuation always produces a range of
estimates—you should not expect to get the
same value from different ratios. Based on these
estimates, the underwriters will probably
establish an initial price range for Wagner stock
of $12 to $15 per share to take on the road show.

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Valuing an IPO: M’sian Stock Market

• With respect to the regulation on the IPO offer price, prior to 1996, applicants for
new-issue offers are required to offer at fixed price at the time of application with
the final fixed unilaterally up or down by the SC at the time of approval of
application for listing. The final approved price tagged to new shares for public
lottery is determined without resorting to the market demand as it is illegal to
solicit applications prior to the approval of the regulators. The fixed offer price was
typically determined by the SC within a range of prospective price/earnings (P/E)
ratios set for each industry.
• In an effort to enhance transparency and efficiency of the Malaysian stock
exchange, the SC moved towards a market-based pricing mechanism in January
1996. This removal of constraints on IPO price setting permits IPO applicants and
their underwriters to have more freedom in setting the offer price. However, they
have to furnish the basis of their computation in deriving the offer price in their
prospectus. The deregulation of IPO pricing eventually allows IPO firms,
underwriters, and investors alike to make informed decisions about pricing rather
than rely on the regulator to fix prices that were often well below equilibrium
levels.
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13.2 Taking Your Firm Public: The
Initial Public Offering

• Pricing the Deal and Managing Risk


 Firm Commitment IPO: the underwriter guarantees
that it will sell all of the stock at the offer price
 Over-allotment allocation, or Greenshoe provision:
provides stability and liquidity to a public offering
 allows the underwriter to issue more stock, amounting
to 15% of the original offer size, at the IPO offer price
 In Msia: The introduction of this mechanism took effect
of the Capital Markets and Services (Price Stabilization
Mechanism) Regulations 2008 on January 11, 2008. 13-53
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13.2 Taking Your Firm Public: The
Initial Public Offering

• Other IPO Types


 Best-Efforts Basis: the underwriter does not
guarantee that the stock will be sold, but instead tries
to sell the stock for the best possible price
 Auction IPO: The company or its investment
bankers auction off the shares, allowing the market
to determine the price of the stock

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Table 13.3 Bids Received to Purchase
Shares in a Hypothetical Auction IPO (in ‘000)

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Figure 13.4 Aggregating the Shares
Sought in the Hypothetical Auction IPO

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Example 13.3 Auction IPO Pricing

Problem:
• Fleming Educational Software, Inc., is selling 500,000 shares of stock in an
auction IPO. At the end of the bidding period, Fleming’s investment bank has
received the following bids:

• What will the offer price of the shares be?

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Example 13.3 Auction IPO Pricing

Solution:
Plan:
• First, we must compute the total number of shares
demanded at or above any given price. Then, we pick
the lowest price that will allow us to sell the full issue
(500,000 shares).

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Example 13.3 Auction IPO Pricing

Execute:
• Convert the table of bids into a table of cumulative
demand:

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Example 13.3 Auction IPO Pricing

Execute (cont'd):
• For example, the company has received bids for a total of
125,000 shares at $7.75 per share or higher (25,000 + 100,000 =
125,000).
• Fleming is offering a total of 500,000 shares. The winning
auction price would be $7.00 per share, because investors have
placed orders for a total of 500,000 shares at a price of $7.00 or
higher. All investors who placed bids of at least this price will be
able to buy the stock for $7.00 per share, even if their initial bid
was higher.

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Example 13.3 Auction IPO Pricing

Execute (cont'd):
• In this example, the cumulative demand at the winning
price exactly equals the supply. If total demand at this
price were greater than supply, all auction participants
who bid prices higher than the winning price would
receive their full bid (at the winning price). Shares
would be awarded on a pro rata basis to bidders who
bid exactly the winning price.

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Example 13.3 Auction IPO Pricing

Evaluate:
• While the auction IPO does not provide the
certainty of the firm commitment, it has the
advantage of using the market to determine the
offer price. It also reduces the underwriter’s
role, and consequently, fees.

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Example 13.3a Auction IPO Pricing

Problem:
• Fleming Educational Software, Inc., is selling 1,000,000 shares of stock in an
auction IPO. At the end of the bidding period, Fleming’s investment bank has
received the following bids:
Price ($) Number of Shares Bid
20.00 250,000
19.50 225,000
19.00 175,000
18.50 200,000
18.00 150,000
17.50 125,000
17.00 75,000
• What will the offer price of the shares be?

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Example 13.3a Auction IPO Pricing

Solution:
Plan:
• First, we must compute the total number of shares
demanded at or above any given price. Then, we pick
the lowest price that will allow us to sell the full issue
(1,000,000 shares).

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Example 13.3a Auction IPO Pricing

Execute:
• Convert the table of bids into a table of cumulative
demand: Price ($) Cumulative Demand
20.00 250,000
19.50 475,000
19.00 650,000
18.50 850,000
18.00 1,000,000
17.50 1,125,000
17.00 1,200,000

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Example 13.3a Auction IPO Pricing

Execute (cont'd):
• For example, the company has received bids for a total of
725,000 shares at $19.50 per share or higher (250,000 + 225,000
= 475,000).
• Fleming is offering a total of 1,000,000 shares. The winning
auction price would be $18.00 per share, because investors have
placed orders for a total of 1,000,000 shares at a price of $18.00
or higher. All investors who placed bids of at least this price will
be able to buy the stock for $18.00 per share, even if their initial
bid was higher.

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Example 13.3a Auction IPO Pricing

Execute (cont'd):
• In this example, the cumulative demand at the winning
price exactly equals the supply. If total demand at this
price were greater than supply, all auction participants
who bid prices higher than the winning price would
receive their full bid (at the winning price). Shares
would be awarded on a pro rata basis to bidders who
bid exactly the winning price.

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Example 13.3a Auction IPO Pricing

Evaluate:
• While the auction IPO does not provide the
certainty of the firm commitment, it has the
advantage of using the market to determine the
offer price. It also reduces the underwriter’s
role, and consequently, fees.

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13.2 Taking Your Firm Public: The
Initial Public Offering

Google’s IPO
• On April 29, 2004, Google, Inc., announced plans to go public.
Breaking with tradition, Google startled Wall Street by declaring
its intention to rely heavily on the auction IPO mechanism for
distributing its shares. Google had been profitable since 2001, so,
according to Google executives, access to capital was not the
only motive to go public. The company also wanted to provide
employees and private equity investors with liquidity.

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13.2 Taking Your Firm Public: The
Initial Public Offering

Google’s IPO (cont'd)


• …One of the major attractions of the auction
mechanism was the possibility of allocating shares to
more individual investors. Google also hoped to set an
accurate offer price by letting market bidders set the
IPO price. After the Internet stock market boom, there
were many lawsuits related to the way underwriters
allocated shares. Google hoped to avoid the allocation
scandals by letting the auction allocate shares.

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13.2 Taking Your Firm Public: The
Initial Public Offering

Google’s IPO (cont'd)


• …Investors who wanted to bid opened a brokerage account with one of the
deal’s underwriters and then placed their bids with the brokerage house.
Google and its underwriters identified the highest bid that allowed the
company to sell all of the shares being offered. They also had the flexibility to
choose to offer shares at a lower price.
• On August 18, 2004, Google sold 19.6 million shares at $85 per share. The
$1.67 billion raised was easily the largest auction IPO ever. Google stock
(ticker: GOOG) opened trading on the Nasdaq market the next day at $100
per share. Although the Google IPO sometimes stumbled along the way, it
represents the most significant example of the use of the auction mechanism
as an alternative to the traditional IPO mechanism.

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Table 13.4 Summary of IPO Methods

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13.3 IPO Puzzles

• Four characteristics of IPOs puzzle financial economists, and all


are relevant to the financial manager:
1. On average, IPOs appear to be underpriced: The price at the end of
trading on the first day is often substantially higher than the IPO price.
2. The number of IPOs is highly cyclical. When times are good, the market is
flooded with IPOs; when times are bad, the number of IPOs dries up.
3. The costs of the IPO are very high, and it is unclear why firms willingly
incur such high costs.
4. The long-run performance of a newly public company (three to five years
from the date of issue) is poor. That is, on average, a three- to five-year
buy and hold strategy appears to be a bad investment.
• We will now examine each of these puzzles that financial
economists seek to understand.

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13.3 IPO Puzzles

• Underpriced IPOs
 On average, between 1960 and 2003, the price in the
U.S. aftermarket was 18.3% higher at the end of the
first day of trading
 Who wins and who loses because of underpricing?
 Money Left on the Table

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UNDERPRICED IPOs (M’sian Market)

Sample Average
Study Period Underpricing
Dawson (1987) 1978-1983 166.70%
Ismail, Abidin and Nasarudin (1993) 1980-1989 114.60%
Lougran, Ritter and Rydqvist (1994) 1980-1991 80.30%
Yong (1996) 1990-1994 72.85%
Leong, Vos and Tourani-Rad (2000) 1992-1998 107.00%
Abdullah and Taufil (2004) 1992-1998 78.44%
Chong et.al (2005) 1991-2001 90.40%
Chong et.al (2007) 1991-2003 66.50%
Yatim (2012) 1999-2008 28.00%
Che Yahya and Abdul Rahim (2012) 2000-2010 27.17
Ramlee and Ali (2012) 1998-2008 22.85%

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Underpricing Theory

• Asymmetry Information Hypothesis


• Signaling Hypothesis
• Information Cascade Hypothesis
• Prevention and Buffer against Possible Litigation
• Marketing Mechanism
• Ownership Structure Hypothesis
• Facilitate Questionable Practices
• Behavioral Theory

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13.3 IPO Puzzles

• “Hot” and “Cold” IPO Markets


 It appears that the number of IPOs is not solely
driven by the demand for capital. Sometimes firms
and investors seem to favor IPOs; at other times
firms appear to rely on alternative sources of capital

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Figure 13.6 Cyclicality of Initial Public
Offerings in the United States, (1975–2006 )

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Number of New Listings 1998-2008

Year Main Board Second Board Total


2008 7 8 15
2007 15 8 23
2006 10 8 18
2005 16 17 33
2004 15 26 41
2003 16 22 38
2002 22 22 44
2001 6 14 20
2000 12 26 38
1999 10 11 21
1998 6 22 28

Total 135
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13.3 IPO Puzzles

• High Cost of Issuing an IPO


 In the U.S., the discount below the issue price at
which the underwriter purchases the shares from the
issuing firm is 7% of the issue price. This fee is
large, especially considering the additional cost to
the firm associated with underpricing.

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Figure 13.7 Relative Costs of Issuing
Securities

13-82
13.3 IPO Puzzles
Poor Post-IPO Long-Run Stock Performance

 Newly listed firms appear to perform relatively poorly over the following
three to five years after their IPOs
 The empirical evidence on long-term returns of IPO stocks are still
inconclusive, with the majority of developed stock markets reporting
underperformance (Ritter, 1991; Loughran and Ritter, 1995 and Welch and
Ritter, 2003) whilst their developing counterparts show over-performance
(Kiymaz, 2002; Chen, Hung and Wu, 2002; and Chan, Wang and Wei, 2004).
 In the Malaysian IPO market, the literature consistently documents a positive
market adjusted long-term performance.
 Jelic et al. (2001) report that Malaysian IPOs have positive returns up to 3 years after listing.
 Corhay, Teo and Tourani-Rad (2002) found that Malaysian IPOs outperformed the market
with a mean (CAR) of 41.7% (BAHR) of 39.6% over a three year period after listing.
 Ahmad-Zaluki, Campbell and Goodacre (2007) report positive buy and hold returns of
17.86% for IPOs listed on Bursa Malaysia Main Board over the period of 1990 to 2000.
 Chong (2008) reports a meager positive equal weighted market adjusted buy-and-hold-
return of 0.66% for 132 main board samples from 1991 to 2003.
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Long-Term Return and Liquidity
Analysis by Cohort Year (Msian)

Listing No. of EW EW EW VW VW VW Mturn Mturn Mturn TV12 TV24 TV36


Year sample mabahr12 mabahr24 mabahr36 mabahr12 mabahr24 mabahr36 12 24 36
1998 20 -0.390 0.173 -0.802 -0.013 0.991 -0.699 13.05 13.24 12.60 56.92 59.10 58.81

1999 18 0.680 -0.488 0.105 -1.556 -0.960 0.351 21.15 12.19 9.34 105.13 61.62 51.84

2000 36 -1.767 -0.625 -0.607 -1.097 -0.315 -0.510 15.69 13.76 10.36 156.35 105.43 81.14

2001 20 -1.051 -1.023 -0.749 0.091 -1.136 -2.013 20.62 14.40 12.01 153.32 111.00 94.28

2002 39 -0.189 -0.441 -1.044 0.553 0.381 0.484 13.34 16.43 12.56 126.12 118.40 96.58

2003 36 -1.189 -2.212 -2.080 0.103 -0.576 -0.821 17.89 11.32 10.34 137.24 101.50 75.43

2004 40 -2.068 -2.268 -2.138 -1.012 -1.582 -1.437 9.87 6.51 6.56 139.69 88.84 73.40

2005 27 -0.576 -0.676 -1.087 -1.012 -1.582 -1.437 9.82 7.56 6.94 94.17 65.14 56.36

2006 13 1.502 0.339 -0.247 2.503 0.027 0.534 17.33 11.40 9.05 128.18 98.03 64.31

2007 19 -1.661 -1.296 -1.094 -1.672 -1.321 -1.023 7.63 4.80 4.00 109.21 42.26 34.34

2008 15 0.563 0.053 -0.392 -5.085 -0.948 -0.455 4.96 4.48 4.44 38.85 34.44 36.37

Total/ 283 -0.821 -0.966 -1.094 -1.431 -0.560 -0.490 11.54 9.06 7.85 120.64 86.78 70.49
Average

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13.4 Raising Additional Capital: The
Seasoned Equity Offering

• A firm’s need for outside capital rarely ends at


the IPO
 Seasoned Equity Offering (SEO): firms return to
the equity markets and offer new shares for sale

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13.4 Raising Additional Capital: The
Seasoned Equity Offering

• SEO Process
 When a firm issues stock using an SEO, it follows
many of the same steps as for an IPO. The main
difference is that a market price for the stock already
exists, so the price-setting process is not necessary.
 Tombstones

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1-86
13.4 Raising Additional Capital: The
Seasoned Equity Offering

• Two kinds of seasoned equity offerings exist:


 Cash offer: the firm offers the new shares to
investors at large.
 Rights offer: the firm offers the new shares only to
existing shareholders

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Example 13.4 Raising Money with
Rights Offers

Problem:
• You are the CFO of a company that has a market
capitalization of $1 billion. The firm has 100
million shares outstanding, so the shares are
trading at $10 per share. You need to raise $200
million and have announced a rights issue. Each
existing shareholder is sent one right for every
share he or she owns.

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Example 13.4 Raising Money with
Rights Offers

Problem (cont'd):
• You have not decided how many rights you will
require to purchase a share of new stock. You
will require either four rights to purchase one
share at a price of $8 per share, or five rights to
purchase two new shares at a price of $5 per
share. Which approach will raise more money?

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Example 13.4 Raising Money with
Rights Offers

Solution:
Plan:
• In order to know how much money will be
raised, we need to compute how many total
shares would be purchased if everyone exercises
their rights. Then we can multiply it by the price
per share to calculate the total amount raised.

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Example 13.4 Raising Money with
Rights Offers

Execute:
• There are 100 million shares, each with one right attached. In
the first case, 4 rights will be needed to purchase a new share, so
100 million / 4 = 25 million new shares will be purchased. At a
price of $8 per share, that would raise $8 x 25 million = $200
million.
• In the second case, for every 5 rights, 2 new shares can be
purchased, so there will be 2 x (100 million / 5) = 40 million
new shares. At a price of $5 per share, that would also raise $200
million. If all shareholders exercise their rights, both approaches
will raise the same amount of money.

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Example 13.4 Raising Money with
Rights Offers

Evaluate:
• In both cases, the value of the firm after the issue is
$1.2 billion. In the first case, there are 125 million
shares outstanding after the issue, so the price per share
after the issue is $1.2 billion / 125 million = $9.60. This
price exceeds the issue price of $8, so the shareholders
will exercise their rights. Because exercising will yield
a profit of ($9.60 – $8.00)/4 = $0.40 per right, the total
value per share to each shareholder is $9.60 + 0.40 =
$10.00.

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Example 13.4 Raising Money with
Rights Offers

Evaluate (cont'd):
• In the second case, the number of shares outstanding
will grow to 140 million, resulting in a post-issue stock
price of $1.2 billion / 140 million shares = $8.57 per
share (also higher than the issue price). Again, the
shareholders will exercise their rights, and receive a
total value per share of $8.57 + 2($8.57 - $5.00)/5 =
$10.00. Thus, in both cases the same amount of money
is raised and shareholders are equally well off.

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Example 13.4a Raising Money with
Rights Offers

Problem:
• You are the CFO of a company that has a market
capitalization of $5 billion. The firm has 250
million shares outstanding, so the shares are
trading at $20 per share. You need to raise $500
million and have announced a rights issue. Each
existing shareholder is sent one right for every
share he or she owns.

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Example 13.4a Raising Money with
Rights Offers

Problem (cont'd):
• You have not decided how many rights you will
require to purchase a share of new stock. You
will require either five rights to purchase one
share at a price of $10 per share, or ten rights to
purchase three new shares at a price of $6.67 per
share. Which approach will raise more money?

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Example 13.4a Raising Money with
Rights Offers

Solution:
Plan:
• In order to know how much money will be
raised, we need to compute how many total
shares would be purchased if everyone exercises
their rights. Then we can multiply it by the price
per share to calculate the total amount raised.

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Example 13.4a Raising Money with
Rights Offers

Execute:
• There are 250 million shares, each with one right attached. In
the first case, 5 rights will be needed to purchase a new share, so
250 million / 5 = 50 million new shares will be purchased. At a
price of $10 per share, that would raise $10 x 50 million = $500
million.
• In the second case, for every 10 rights, 3 new shares can be
purchased, so there will be 3 x (250 million / 10) = 75 million
new shares. At a price of $6.67 per share, that would also raise
$500 million. If all shareholders exercise their rights, both
approaches will raise the same amount of money.

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Example 13.4a Raising Money with
Rights Offers

Evaluate:
• In both cases, the value of the firm after the issue is
$5.5 billion. In the first case, there are 300 million
shares outstanding after the issue, so the price per share
after the issue is $5.5 billion / 300 million = $18.33.
This price exceeds the issue price of $10, so the
shareholders will exercise their rights. Because
exercising will yield a profit of ($18.33 – $10.00)/5 =
$1.67 per right, the total value per share to each
shareholder is $18.33 + 1.67 = $20.00.

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Example 13.4a Raising Money with
Rights Offers

Evaluate (cont'd):
• In the second case, the number of shares outstanding
will grow to 325 million, resulting in a post-issue stock
price of $5.5 billion / 325 million shares = $16.92 per
share (also higher than the issue price). Again, the
shareholders will exercise their rights, and receive a
total value per share of $16.92 + 3($16.92 - $6.67)/10 =
$20.00. Thus, in both cases the same amount of money
is raised and shareholders are equally well off.

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13.4 Raising Additional Capital: The
Seasoned Equity Offering

• Researcher shows on average, the market greets the news


of an SEO with a price decline (about 1.5%)
 Often the value lost due to the price decline can be a significant
fraction of the new money raised
 Lemon Principle –
 "The Market for Lemons: Quality Uncertainty and the Market
Mechanism" is a 1970 paper by the economist George Akerlof.
 It discusses information asymmetry, which occurs when the seller knows
more about a product than the buyer
 The result is that a market in which there is asymmetric information with
respect to quality shows characteristics similar to those described by
Gresham's Law: the bad drives out the good

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13.4 Raising Additional Capital: The
Seasoned Equity Offering

• SEO Costs
 In addition to the price drop when the SEO is
announced, the firm must pay direct costs as well.
Underwriting fees amount to 5% of the proceeds of
the issue

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Chapter Quiz

1. What are the main sources of funding for private


companies to raise outside equity capital?
2. What is a venture capital firm?
3. What services does the underwriter provide in a
traditional IPO?
4. Explain the mechanics of an auction IPO.

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Chapter Quiz

5. List and discuss four characteristics about IPOs that


are puzzling.
6. For each of the characteristics, identify its relevance
to financial managers.
7. What is the difference between a cash offer and a
rights offer for a seasoned equity offering?
8. What is the average stock price reaction to an SEO?

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