Week 11 - Firm Financial Decisions - Financing Decisions

Question 1

Equity Financing for Private Companies

Answer 1

→ A large portion of Australian businesses are small sole proprietorships and partnerships
→ In 2023, sole traders and partnerships made up 38.91% of the 2589873 actively trading businesses in Australia
→ Sole proprietorships are not allowed to access outside equity capital, so these businesses have relatively little capacity for growth
→ Sole proprietors are also forces to hold a large fraction of their wealth in a single asset - the business - and therefore are likely to be undiversified
By incorporating, businesses can gain access to capital, and founders can reduce risk of their portfolio by selling some of their equity and diversifying

Question 2

Angel Investors

Answer 2

→ Individual investors who buy equity in small private firms
For many start-ups, the first round of outside private equity financing is often obtained from ‘angels’

Question 3

Venture Capital Firms

Answer 3

→ Specialise in raising money to invest in the private equity of young firms
In return, venture capitalists often demand a great deal of control over the company

Question 4

Institutional Investors

Answer 4

→ Superannuation funds, insurance companies, investment companies, and endowments may invest:
- Directly
Indirectly by investing in venture capital firms

Question 5

Equity financing for private companies

Answer 5

→ When a company decides to sell equity to outside investors for the firm time, it is typical to issue a preferred shares rather than ordinary shares to raise capital
→ Preferences shares are issued by mature firms usually have a preferential dividend and seniority in ant liquidation, and sometimes special voting rights
→ Preference shares issued by young firms, typically do not pay a cash dividend
→ However, these preference shares usually give the owner a right to convert them into ordinary shares at a future date (called convertible preference shares)
- These shareholders have all the future rights and benefits as ordinary shareholders if things go well
On the other hand, if the firm runs into financial difficulties, the preference shareholders will have a senior claim on the assets of the firm relative to any ordinary shareholder

Question 5

Corporate Investors

Answer 5

→ Corporate strategic objectives
→ Desire for investment returns.

Question 6

Taking your firm public: the IPO

Answer 6

The process of selling shares to the public for the first time is called an initial public offering (IPO)
Advantages of going public:
→ Greater liquidity - gives private investors the ability to diversify
→ Better access to capital - in both the IPO and in subsequent offerings
→ It might be easier to attract managerial talent
Disadvantages of going public:
→ Equity holders more dispersed (many shareholders) - this reduces investors’ ability to monitor management
→ Must satisfy the requirements of public companies - compliance with regulations can be costly for public firms

Question 9

In an IPO, a firm offers a large block of shares to the public for the first time. IPOs include both primary and secondary offerings

Answer 9

→ Primary offering: new shares that raise new capital
- Secondary offering: existing shares that are sold by current shareholders (as part of their exit strategy)

Question 10

After a firm decides to go public, its managers work with an underwriter - an investment banking firm that manages the security issuance and designs its structure

Answer 10

→ Lead Underwriter: the primary banking firm responsible for managing the security issuance
→ Syndicate: a group of other underwriters that help to market and sell the issue

Question 11

Lodgement of a prospectus

Answer 11

→ A prospectus is a document issued by a company setting out the terms of its equity issue. In most cases, a prospectus or similar disclosure document is required to list
It must be lodged with both ASIC and the ASX

Question 12

Listing application with the ASX

Answer 12

→ Once the company has lodged a prospectus and has satisfied the regulators’ disclosure requirements, the company can submit a listing application with the ASX
→ The listing application and the prospectus are reviewed to ensure they satisfy the ASX Listing Rules, and once they are satisfied, the ASX approves the sale of the shares to the general public

Question 13

Once an initial price range is established, the underwriters try to determine what the market thinks of the valuation

Answer 13

→ The begin by arranging a road show: an event where senior management and the lead underwriters travel around the country (and sometimes world) promoting the firm and explaining their rationale for the offer price to be the underwriters’ largest customers
The next step is book building: the process for coming up with the offer price based on customers’ expressions of interest called book building

Question 14

Firm commitment IPO

Answer 14

the underwriter guarantees that it will sell all of the shares at the offer price

Question 15

Over-allotment allocation

Answer 15

allows the underwriter to issue more shares, amount to 15% of the origin offer size, at the IPO offer price

Question 16

Best efforts basis

Answer 16

the underwriter does not guarantee that the shares will be sold; instead they attempt to sell the shares for the best possible price

Question 17

Auction IPO

Answer 17

the company or its investment bankers auction of the shares, allowing the market to determine the price of the shares

Question 18

IPO Puzzles

Answer 18

1. Underpricing of IPOs
   → Generally underwriters set the issue price so that the av erage first-day return is positive. On average, between 1960 and 2022, the price in the US aftermarket was 17.5% higher at the end of the first day or trading (underwriter and new shareholders benefit)
   → In Australia, several studies have found that IPO’s are underpriced by 20.5%
2. 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 favour IPOS; at other times, firms appear to rely on alternative sources of capital
3. High Cost of Issuing an IPO
   → In the US, the discount below the issue price at which the underwriter purchases the shares from the issuing firm is 7% of the issue price
   → In Australia, the typical spread is 4%
   → This fee is large, especially considering the additional cost to the firm associated with underpricing
4. Poor post-IPO long-run share performance
   → Newly listed firms appear to perform relatively poor over the following 3-5 years after their IPOs
   That underperformance may not result from the issue of the equity itself, but rather from the conditions that motivated the equity issuance in the first place