Corporate Finance Week 5 — Raising Capital
1) Big-picture framework: how to think about raising capital
Why financing exists
- Firms need financing for real investments (factories, teams, products) and for capital-structure reasons (e.g., too much debt → raise equity to rebalance).
- Maturity matching rule: match maturity of financing to maturity of funding need:
- Working capital ↔ short-term debt
- Long-lived assets ↔ longer-term funding
Financing “ladder” (implicit pecking order logic)
- Internal funds / retained earnings
- Debt (bank loans or bonds)
- Equity (VC/PE, IPO, SEO)
Hybrid instruments (convertible preferred, convertibles) exist because markets “invent products.”
Debt vs equity: baseline distinctions you must articulate
- Fixed vs residual claims: interest/coupons vs discretionary dividends
- Tax: interest tax-deductible; dividends typically not
- Priority in bankruptcy: debt is senior
- Maturity: debt ends; equity is perpetual
- Control rights: equity votes; debt uses covenants to protect itself
These points are “default paragraphs” for exam answers comparing financing sources.
2) Private capital: Venture Capital / Private Equity (high probability for News Analysis)
Market reality (lecture emphasis)
- Private capital is large; most companies are private.
- Growth in private capital reduces incentives to go public (context for IPO decisions).
- Many consumer-facing firms are PE-owned (used as intuitive examples).
Fund structure and incentives (LP/GP)
- LPs (Limited Partners): supply most of the capital (often ~90–99% ownership stake in the fund).
- GP (General Partner): manages the fund, usually with a small capital stake; earns fees.
VC selection “pyramid”
- Many applications → few diligence processes → very few funded.
- Explains why founders accept strict terms and give up control.
What VCs/PE want and how deals are structured
- Objective: buy low, sell high in private markets.
- VC targets early-stage, high-growth firms that need money to scale.
Exam-ready deal formula:
Ownership proportion = Capital provided / Estimated value
Governance implication: PE/VC often imposes constraints on new investment and financing to protect itself.
Exit logic
- Target high returns in a medium-term horizon.
- Exit via IPO or trade sale.
- Low-return outcomes: refinancing or liquidation.
VC valuation intuition (what to say in an exam)
- VC valuation uses extremely high required returns (startup risk); discount rates can be very high early (e.g., 50–70%).
- Discount rates typically fall (but remain high) as the firm matures toward IPO.
- Translate into exam language: valuation is exit-based + high required return; terms/control rights compensate for downside and information asymmetry.
3) Capital markets mechanics: primary vs secondary (common trap)
- Primary market: new issues; funds flow from savers to firms (capital formation).
- Secondary market: trading of already-issued securities; purpose is liquidity.
IPO/SEO issuance is primary; post-listing trading is secondary.
4) IPO decision: why go public vs why avoid it (News Analysis core)
Three perspectives: raising too little vs too much
- Raise too little → cannot deliver promised performance.
- Raise too much → hold non-performing cash; fail ROI expectations (DCF logic).
- “No second chance” unless you deliver performance after raising.
Why firms go public
- Raise new capital (expansion or restructuring)
- Cheaper access and easier future financing
- M&A advantages (valuation visibility; IPO can facilitate acquisition outcomes)
- Liquidity/exit and diversification for existing holders
- Reputation/credibility; information from markets
- Executive incentives; equity as “currency”
- Control can be retained if only a minority stake is listed
Disadvantages
- Expensive: direct expenses can be ~10–25% of money raised
- Reporting burden and disclosure (competitors learn)
- Liability/lawsuits (noted as larger in the US than Europe)
- Loss of control / activist pressure
- Public pressure and short-termism (quarterly focus)
- First-day underpricing and market cycles
5) IPO process: the mechanics you should narrate cleanly
- Select underwriter
- Register IPO with regulator
- Print prospectus
- Marketing + bookbuilding (roadshow)
- Price securities
- Sell securities
- Aftermarket activities
Underwriting types
- Firm commitment: underwriter buys entire issue; bears selling risk; earns spread.
- Best efforts: underwriter sells what it can; issuer bears risk; offer may be pulled but flotation costs still incurred.
Bookbuilding + roadshow (pricing information channel)
- Roadshow targets large institutional investors.
- Bookbuilding collects orders:
- Retail typically submits market-style orders (quantity only).
- Institutions submit limit-style orders (quantity conditional on price).
6) IPO pricing: “fair price does not exist”
- Overprice → investors overpay; underwriter reputation suffers.
- Underprice → “money on the table,” dilution/wealth transfer; higher cost of capital.
- Memorable line: “High price = no prize. Low price = no friends.”
7) IPO underpricing: the Week 5 centerpiece
Definition
IPO underpricing = increase from offer price to first-day close.
Core theory: information asymmetry + winner’s curse
- Uninformed investors cannot distinguish good vs bad issues.
- Without underpricing, uninformed participation falls, demand collapses, and IPO markets function poorly.
Underwriter incentives (“dark side of underwriting” narrative)
- The company hires the underwriter, but the underwriter’s repeat customer base is investors.
- Keeping investors happy sustains the IPO machinery across deals.
- Snapchat used as an example of money left on the table; underwriting fees around ~7% referenced in lecture context.
Empirical facts (useful sentences for Section A)
- Average first-day return: ~17.3% (US figure cited).
- Long-run underperformance: about −22% over 5 years; ~70% underperform.
- Pattern: smaller and younger firms tend to be more underpriced.
8) Aftermarket mechanics
Stabilization and quiet period
- Underwriter stabilization: price support only at or below offer price.
- Normal manipulation prohibitions are relaxed during stabilization.
- Quiet period ends 25 calendar days after IPO (after which underwriters can publish estimates, per slide).
Lock-up period
- Typically 180 days.
- Rationale: align incentives; reduce selling pressure.
- Often stock price drops after lock-up expiration.
9) Alternative IPO methods: comparisons you should be able to make
Dutch auction (Google example)
- Start high, reduce price until demand clears; winners pay the clearing price.
- Google (2004) cited as major example; slides note underpricing (e.g., ~18%) and discuss trade-offs (marketing/information issues).
Direct offering / direct listing (Spotify example)
- Lists without roadshow/bookbuilding/allocation; regulatory/audit still required.
- Lower fees; but cannot raise new capital (selling existing shares only).
- Often higher post-launch volatility.
Lecture intuition: choose direct listing when the firm does not need cash (often profitable) but wants liquidity/exit; brand recognition substitutes for marketing.
10) Seasoned Equity Offering (SEO): why price drops (very testable)
- SEO = public firm raising additional equity.
- Announcement effect generally negative (about −3% cited).
- Interpreted as signal of overvaluation or financial distress / reduced debt capacity.
Exam phrasing: equity issuance is informationally negative under asymmetric information.
11) Raising debt: private bank debt vs public bonds
Bank debt
- Dominant source, especially for short-term needs.
- Short-term working capital debt often unsecured.
- Longer-term debt to finance fixed assets typically secured.
- Leases are also a financing form.
Corporate bonds
- Governed by an indenture (contract) covering:
- Terms and covenants
- Total issuance
- Collateral/security description
- Sinking fund provisions
12) What this means for the final exam
Week 5 topics flagged as likely News Analysis themes:
- IPO decision and methods
- IPO underpricing (asymmetric information + signaling / incentives)
- IPO performance
- PE / VC
Prepare adaptable “template answers” for any IPO/VC/PE article.
13) Exam-ready templates and calculations to practice
A) If the news article is about an IPO
- Why IPO now? (growth funding, liquidity, acquisitions, market timing/window, reputation)
- Costs/trade-offs (10–25% direct expenses; disclosure; loss of control; short-term pressure)
- Pricing dilemma + underpricing (no fair price; money on the table)
- Explain underpricing (winner’s curse/info asymmetry; underwriter incentives)
- Aftermarket (stabilization/quiet period; lock-up ~180 days)
Mini-calculation: “Money left on the table”
(First-day close − Offer price) × Shares sold
B) If the news article is about VC/PE funding
- Why private not public? (avoid IPO costs/pressure/disclosure; private capital is deep)
- Deal structure & dilution (Ownership = Capital / Estimated value)
- Control rights (constraints on investment/financing; active involvement)
- Exit (IPO vs trade sale; refinancing/liquidation low return)
- Valuation intuition (very high discount rates for startups; selection pyramid)