Raising Capital
Class 5: Raising capital
Why Do Firms Raise Capital?
Finance is the "blood of business" — firms need financing for real investments (factories, teams, products) and for capital-structure reasons (rebalancing debt/equity).
Match the maturity of financing to the maturity of the funding need:
Working Capital
↔ Short-term debt
Long-lived Assets
↔ Long-term funding
| Feature | Debt | Equity |
|---|---|---|
| Claims | Fixed (interest/coupons) | Residual (dividends discretionary) |
| Tax Treatment | Interest tax-deductible | Dividends not deductible |
| Bankruptcy Priority | Senior | Junior (residual) |
| Maturity | Fixed end date | Perpetual |
| Control | Via covenants | Voting rights |
Primary Market
New issues — funds flow from savers → firms
Examples: IPO, SEO
Secondary Market
Trading previously issued securities (liquidity)
Purpose: Liquidity
⚠️ Common Exam Trap:
IPO/SEO issuance = Primary. Post-listing trading = Secondary.
The Financing Ladder (Pecking Order)
A common ordering: internal funds → debt → equity. Real-world constraints vary by firm maturity and market conditions.
Step 1
Internal Funds / Retained Earnings
Cheapest & easiest (if profitable)
Step 2
Debt
Bank loans or bonds
Step 3
Equity
VC/PE, IPO, SEO
Life Cycle Matters
Young/immature companies have different financing capabilities than established firms. The choice between being acquired vs doing an IPO depends on growth stage and strategic goals.
Markets keep "inventing products" — examples include:
- Convertible preferred stock
- Convertible bonds
- Mezzanine financing
Venture Capital & Private Equity
Private markets are large, and many firms delay or avoid going public as private capital deepens.
Market Reality
Private equity/VC is huge. Most companies are private, and private capital growth can reduce the need to go public early.
Limited Partners (LPs)
Supply 90–99% of capital
Pension funds, endowments, wealthy individuals
General Partner (GP)
Manages fund, small capital stake
Earns management fees + carried interest
Funded
Due Diligence
Serious Interest
Many Applications
This helps explain why founders accept harsh terms or give up control.
Ownership % = Capital Provided ÷ Estimated Value
Key Insight: High Discount Rates
Cost of capital for startups: 50–70% reflects extreme risk and uncertainty.
✓ High Return: IPO or trade sale
✗ Low Return: refinancing or liquidation
The IPO Process
A simplified map of steps, underwriting types, and key trade-offs.
1 — Select underwriter
2 — Register IPO with regulator
3 — Print prospectus
4 — Marketing + book building (roadshow)
5 — Price securities
6 — Sell securities
7 — Aftermarket activities
Firm Commitment
- Underwriter buys entire issue
- Underwriter bears selling risk
- Earns spread
- "Bought deal"
Best Efforts
- Underwriter sells what it can
- Issuer bears risk
- Offer may be pulled
- Still incur flotation costs
✓ Raise new capital / expansion
✓ Cheaper future financing
✓ Facilitate M&A
✓ Liquidity for existing holders
✓ Reputation/credibility
✓ Executive incentives
✓ Retain control (minority stake)
✗ Expensive (10–25% of proceeds)
✗ Disclosure requirements
✗ Liability/lawsuits
✗ Loss of control
✗ Short-termism pressure
✗ First-day underpricing
Dutch Auction (Google 2004)
Start high, reduce until demand clears. Still had 18% underpricing.
Direct Listing (Spotify 2018)
No roadshow/bookbuilding. Lower fees but cannot raise new capital. Higher volatility.
IPO Pricing & Underpricing
"Fair price ??? – does not exist!!!"
- Professor's key message
The Pricing Dilemma
High price = no prize. Investors overpay, underwriter reputation suffers.
Low price = no friends. Issuer leaves money on table, wealth transfer to investors.
Low price = no friends. Issuer leaves money on table, wealth transfer to investors.
Information asymmetry between informed and uninformed investors:
- Uninformed investors can't distinguish good vs bad issues
- They get allocated more shares in bad IPOs (informed investors avoid)
- Without underpricing, uninformed investors stop participating
- Demand collapses → bad for underwriters
- Solution: Underprice to compensate uninformed investors
Agency Problem:
The company hires the underwriter, but the underwriter's real customer is investors (repeat buyers).
Keeping investors happy sustains the IPO “machinery.”
Snapchat Example: money left on table, but underwriting fees ~7%
Avg. first-day return (US)
17.3%
Typical underpricing magnitude
5-year underperformance
-22%
Long-run drift
IPOs underperform
70%
Share of issues lagging
Stabilization Period
Underwriter can support price (only at/below offer price). Manipulation rules relaxed.
Quiet Period
Ends ~25 calendar days after IPO (then underwriters can publish estimates).
Lock-up Period
Typically 180 days. Stock often drops after expiration.
Announcement effect: ~-3%
Often interpreted as a signal of overvaluation or reduced debt capacity / distress risk.
"Equity issuance is informationally negative under asymmetric information."
Finance Calculators
Interactive calculators for IPO underpricing and VC ownership.
Money Left on Table = (Close Price - Offer Price) × Shares Sold
Money Left on Table
$0
Underpricing %
0.0%
Ownership % = Capital Provided ÷ Estimated Value
VC Ownership Stake
0.0%
Test Your Knowledge
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