Chapter 15: Raising Capital

The Auction

Takes place on a single trading day, -> buyers submit their bids at pre-set prices. -> If over-subscribed, the bids are filled on a pro-rata basis until all the shares are sold.

Venture Capitalists:

- Corporate entities - Invest pooled money from range of investors. - All stages of development. - Investment may be tied to high growth opportunities, with focus on technology and innovation.

Angel Investors:

- Individual or group of individuals - Invest own money - Focus on early stages o business. - Investment may be tied to individual or group expertise.

Factors to look for when picking a financier or group of financiers include:

1) Financial strength i.e. Will the financier have the necessary funding ability to back the project until its completion? 2) Contacts: i.e. Can the financier provide valuable contacts to help the entrepreneur reach his or her goal? 3) Exit strategy: i.e. how much equity is the investor looking to acquire as a condition of providing the funding and how much of control is the entrepreneur willing to give up? **Given that there is a high probability of failure among start-ups, angel investors and financiers commonly look for 60% - 100% potential annual rates of return on their successful ventures in order to provide funding.

FIVE Sources of Capital used to grow a business:

1. Personal funds 2. Borrowed funds from family and friends. 3. Commercial bank loans 4. Borrowed funds through business start-up programs like the U.S. Small Business Administration (SBA) 5. Angel financing or venture capital

The Aftermarket: Dealer in the Shares

After completion of the auction the outstanding shares trade in the secondary market and the investment banker (functions as a dealer in the stock for a minimum of 18 months), the "green-shoe provision." The GREEN SHOE provision allows the investment banker the right to purchase up to 15% of additional shares over a thirty-day period beyond that offered to the public during the auction -> maintain inventory and fill any pent-up demand. A LOCK-UP agreement, the original owners of the firm have to maintain their shares of stock for 180 days, prevent dumping of stock and free-fall in its price due to profit-taking on part of the original owners.

Registration, Prospectus, and Tombstone

All new issues of shares have to be registered with the SEC prior to being sold in the capital markets. - 20 to 40 days (cool-off period.) - During the waiting period, the issuer can circulate a preliminary prospectus (red herring) informing potential investors of the issue. - No commitments can be obtained from buyers until after SEC approval. If information is missing, the SEC issues a comment letter, requiring corrections and a new application to be filed. - Once re-filed, the cool-off period starts again. During the waiting period the issuer and investment bank place large advertisements (tombstone ads.) in newspapers and magazines, - containing the name of the issuer, -some details about the issue, -a list of participating investment banks. There are TWO EXCEPTIONS to the usual SEC registration process requirement, 1) If the issue has a maturity of less than 270 days e.g. commercial paper issues. 2) If the issue is worth less than $5 million (Regulation A)

As a loan balance is paid down over time, that process is called __________________.

Amortization

Commercial Bank Loans through the SBA:

Available to qualified small business applicants via a variety of loan programs, the most common of which is the 7(a) Loan Guaranty Program. The 7(a) Loan Guaranty Program administers business loans to individuals or businesses that might not be eligible for a loan through the normal lending agencies. Loan proceeds can be used for working capital and fixed assets, with repayment schedules extending up to 25 years. These loans are delivered through commercial lenders and guaranteed by the SBA. The interest rates tend to be quite competitive but the major advantage of this program accrues to the banks since the loans are backed by the SBA.

Timken Company EXAMPLE (Slide 15-15)

Calculating payments and EAR of a straight loan: The Timken Company wants to borrow $2,000,000 from its local bank. The bank quotes them a rate of 8.25% (APR) on a 5-year loan with payments due monthly. How much will their monthly payment be and what is their EAR? ANSWER: PV = 2,000,000; FV = 0; N = 60 (monthly payments x 5 years); i = 8.25; P/Y = 12;C/Y = 12; PMT = 40,792.50 EAR = (1 + (.0825/12)12 - 1 = 8.569% *8.25 is annual rate, since the rate is compounding monthly, the overall rate is a bit higher, at 8.569%.

Straight Liquidation

Chapter 7 of The Federal Bankruptcy Reform Act (1978) - process that has to be followed when a firm decides to close its business and liquidate its assets. - Once a firm files for Chapter 7, the bankruptcy court judge appoints a trustee to oversee the process of liquidation, the order of which is as follows: 1) Proceeds from the sale of the collateralized assets or transfer of actual assets to secured creditors to settle their claims 2) The trustee's expenses in administering the sale of assets and payment of claims 3) Payment to claimants whose claims result from activities after the filing of Chapter 7 4) Wage earners of the company for unpaid wages (there are limits for this class of claims) 5) Claims for unpaid portions of benefit plans for employees (again, there are limits for this class of claims) 6) Unsecured claims from customer deposits (up to a certain amount) 7) Federal, state, and local unpaid taxes 8) Unfunded pension plans 9) General unsecured creditors (unsecured bank loans, bondholders, and so forth) 10) Preferred stockholders up to the par value of their stock 11) Common stockholders (all remaining funds)

OTHER Borrowing Options for a Mature Business

Commercial Paper Bankers' acceptances

STABLE & MATURE Business: Borrowing: Bank Loans

Commercial banks provide much of the short-term financing required for the operating needs of a business via straight loans, discount loans, and lines of credit with or without compensating balances.

Borrowing for a Stable and Mature Business: SELLING Stock

Common stock -> the other major source of capital for a firm to avail of Equity holders get voting rights as part owners and share in the residual profits of the firm. INITIAL PUBLIC OFFERINGS: (IPOs) when the firm first goes public and SEASONED OFFERINGS for subsequent issues.

Commercial Bank Loans

Constitute the first source that people often seek after they have run out of friends and in-laws to ask. Banks tend to be very conservative lenders often requiring substantial collateral, income history and evidence of stability. Start-ups are rarely directly funded by commercial banks.

Borrowing for a Stable & Mature Business: SELLING BONDS

Corporate bonds are a major source of long-term financing for established companies. Typically sold in $1000 units, and publicly auctioned or privately placed. Public issue is regulated by the SEC, and involves the following FIVE steps 1) Company selects an investment bank. 2) Register the bond with the SEC 3) The bond is rated by an agency such as Standard & Poor's or Moody's 4) The investment bank markets the bond to prospective buyers 5) An auction is conducted to sell the bond. There are TWO key documents required during the bond issuance process: - PROSPECTUS - INDENTURE AGREEMENT Firms that issue coupon bonds have to make periodic coupon payments and a large lump sum payment at maturity. SINKING FUNDS or reserve accounts, set up by bond issuers to put away funds every year so as to have the necessary funds available to retire the bond when it matures.

Commercial Paper

Discounted note sold by a company directly to an investor with both principal and interest repaid within 270 days (just like a treasury bill). Face value = $100,000 Out of the reach of most small investors. It is generally assumed institutions and sophisticated investors purchase commercial paper. *The reason firms issue commercial paper over other forms of borrowing: - lower rates than through commercial banks and since they mature within 270 days, -> short-form registration with the SEC.

Debt obligations get paid off ___________ in the case of bankruptcy/business closing.

FIRST

IPO Initial Public Offerings & Underwriting

Firms sell stock to the public with the help of investment banking firms, who perform due diligence and are experts in marketing the issue. - Investment banks partner with issuing firms in exchange for compensation that can be set up on a best-efforts basis or on a fixed-commitment basis. Under a BEST-EFFORTS arrangement the investment bank pledges to use its best efforts to sell all the authorized shares and takes a cut on each individual share sold, but provides no guarantee as to how many shares will be sold. The more shares sold, the higher the payoff to the investment bank. (The investment bank will collect a fee/commission for the shares sold) Under a FIXED-COMMITMENT arrangement, also known as an underwriting arrangement, the investment banker guarantees a fixed amount of proceeds to the issuer. The investment banker makes up/keeps the difference between the actual selling price and the guaranteed price. (The investment bank buys all at a discounted price, and then sell off what they bought at a higher price than they paid)

Angel Financing & Venture Capital

Generally sought by entrepreneurs and businesses that would not qualify for commercial bank or SBA-backed financing. ANGEL INVESTORS are wealthy individuals and groups that are interested in providing initial funding for high-risk ideas. They typically have very short loan investment horizons (less than 10 years) and upside limits of about $2 million. VENTURE CAPITALIST firms or funds are also willing to fund high-risk projects, but have longer time horizons and higher funding limits. They generally provide the funding in stages.

Initial start up phase is capital _____________.

Intensive

The Marketing Process: ROAD SHOW

Involves taking the issue on the road to attract interest among potential investors. Process lasts about 2 weeks and enables the investment banker to get a feel for what the price should be set at. After a successful road show and marketing campaign, a price is set and the issue proceeds forward to be auctioned off in the primary capital market.

Reorganization: Chapter 11

Is what some firms file for if their managers feel that there is a chance that they could re-structure the firm and be worth more alive than dead. In a typical re-organization the process is as follows: 1) A petition for Chapter 11 is filed by either the company or by a creditor, and a bankruptcy court judge either accepts or denies the petition. 2) If accepted, a date is set by the judge for all claimants to show proof of their claims and 3) A reorganization plan is presented to the court and must be approved by a majority of the members of a claimant class. 4) If the claimants cannot agree on the reorganization plan, the judge may issue a ruling on all or parts of a plan and thus "decree" the reorganization plan. 5) If a minority of classes does not agree to the plan, the judge may listen to their objections and alter the reorganization plan. 6) Often, the current managers continue to run the business while it operates under the reorganization plan, but the court may also appoint a trustee to oversee the operations and protect the rights of the claimants during this period of time. 7) The reorganization plan may allow the issuance of new securities and thus add another set of claimants to the firm. 8) Old debt may be restructured in terms of both maturity and rates. 9) The plan itself holds off claimants while the company tries to reorganize and come out of bankruptcy as a new operating firm. 10) If a firm fails to make the reorganization plan work, it will probably fall into Chapter 7 bankruptcy.

Discount Loan EXAMPLE (Slide 15-17)

Let's say that a firm needs $500,000 to fund the operations of its new expansion. It approaches a commercial bank, which offers it a discount loan at 9.5% per year which will have to be paid back in full in one payment at the end of twelve months. How much will the face value of the loan have to be set at and what rate of interest is the company effectively paying? ANSWER: Use formula: Loan Amt (face value) = Amount Needed/(1-discount rate) $500,000/(1 - int rate) = $552,486 $552,486 x .095 = 52,486.17 52,486.17/500,000 = 10.497%

Personal Funds & Family Loans

Limited in scope, but often good starting points for most entrepreneurs and sole proprietorships. Professional lenders like commercial banks and venture capitalists view funding by family and friends as a sign that the business has potential. ie; savings, inheritance, the lottery, etc.

Letter of Credit or Line of Credit

Line of credit is a pre-approved borrowing amount that works much like a credit card. The company can borrow money at a preset rate from bank at any time without seeking additional approval of the loan each time it needs funds. The bank, however, is compensated based on the outstanding balance of the loan. The compensation can be a fixed interest rate, but often is a floating interest rate tied to a benchmark interest rate. This borrowing style has changing balances and changing interest rates, so it is difficult to state the effective rate on the loan.

The riskier the business, the __________ return on investment the investor requires.

MORE

Unique businesses, such as, Facebook, face challenges when attempting to secure loans from the ____________.

SBA

Line of Credit is very common for ____________ business stages.

Mature

Businesses need ___________ to grow.

Money

Straight Loans

Money is lent up front. Represent the simplest of all types of bank loans. Offered with a quoted APR and pre-set payment amounts and intervals.

Prospectus

Much of the information filed in the registration and is used to inform potential buyers about the bond.

Discount Loans

Offered to firms with the interest amount being already subtracted at the start. The difference between the amount the firm can use and the amount that has to be paid back at the end is the bank's interest or discount earned. The loan amount is the amount due at maturity

The Final Phase: Closing the Business

Sometimes, successful solvent firms decide to cease operations, - they sell off their assets, - pay off all outstanding debts and expenses, - and distribute the residual value to the stockholders. When firms are unsuccessful, they may decide to cease operations, - declare bankruptcy, and liquidate their assets; - or they may decide to re-organize, attempt to re-establish themselves, and try to re-emerge as stronger firms.

FIVE Stages in the LifeCycle

Start-up Growth Maturity Decline Closing Each stage presents unique problems, opportunities, and funding requirements. Business life cycles vary considerably. *Some firms go through the early stages fairly rapidly and then settle into maturity for a long time, while others skip to the closing stage in a few years. The US Census Bureau's Business Information Tracking System estimates that roughly 60% of businesses that employ others besides the owners will close within their first 6 years. The life cycle approach is a useful way to discuss financing opportunities and sources for businesses.

Golden Corral Corporation EXAMPLE (Slide 15-23)

The Golden Corral Corporation is in the process of issuing a 30-year, 8% coupon (paid SEMI-ANNUALLY) AA1-rated corporate bond with $1000 par value. If by the time the bonds receive SEC clearance, the market yield on this bond goes to 8.35%, and the company sells 3000 of these bonds with the help of an investment banker who charges them a commission rate of 3% on the proceeds, what will the total proceeds be for the issuing company, and what is the cost of these bonds to the firm in terms of the cost of capital? What are the firm's future cash obligations? ANSWER: P/Y = 2; C/Y = 2; N = 60; PMT = 40; FV = 1000; I = 8.35 PV = $962 Gross proceeds from sale of bonds: 3000 x $962 = $2,885,058.18 Investment banker's commission: $2,885,058.18 x .03 = $86,551.75 Total proceeds received by the issuing company: $2,798,506.43 Net proceeds per bond = $962 x (1-.03) = $932.84 *Cost of Debt to Golden Corral based on NET price: Using N = 60, P/Y = 2 PV = (-)$932.84, PMT = 40, and FV = 1000, CPT -> I/Y = 8.629%

Quick Start Funding Group EXAMPLE (Slide 15-12)

The Quick Start Funding Group is looking to fund only those projects which have the potential to return $10 million dollars for every $1 million that they have invested within a 5-year period. Calculate the firm's expected rate of return on its investment. ANSWER: FV = $10 million; PV = 1 million; N=5; CPT -> I% = 58.49%

Compensating Balance

These loans work like lines of credit except that a portion of the loan is NOT available to the borrower, even though interest is paid on the full face value of the loan. EXAMPLE: For example, if a firm takes a loan of $100,000 at a rate of 7.5% per year and a compensating balance requirement of 15%, it will be able to use only $85,000 and be charge $7,500 in interest for the year. The effective rate of interest will therefore be: Use Formula: Effective Rate = Interest Paid/Amount Used 100,000 x 15% = 15,000 that is NOT available (think of this like a reserve) 100,000 - 15,000 = $85,000 $100,000 x 0.075 = 7500 amount of interest due on full line. Interest due on full line/amount of loan ACTUALLY available = 7500/85,000 = 8.823%

Indenture Agreement

formal contract for the bond between the issuing company and the eventual buyer. It includes vital information about the bond such as the: coupon rate, payment schedule, maturity date, and par value other restrictive covenants that could restrict the activities of the issuing firm to increase the safety of the bond in the eyes of potential buyers.

Small business is a _____________ part of the US Economy.

large

Commercial banks usually lend to businesses in the more ____________ stage vs. beginning stages.

mature

The SBA helps to facilitate and foster the growth of ______________ businesses.

small