Question

1. While studying feverishly in the college library, you accidentally stumbled upon the secrets of the world’s first laser can-opener. You would like to develop your idea for the betterment of mankind. You have some ideas about how to produce and market these little beauties. Initial funding for the project has been provided by venture capitalists, and initial market acceptance has been favorable. You would like to crank up production and think that perhaps it is time to go public. (Answer parts a, b, c and d)

1. Explain in detail the role of venture capitalists (who they are, how they provide funds, how they are compensated).

2. Why might entrepreneurs and venture capitalists be eager to “go public”?

3. What is the role (three functions) of underwriters in an IPO. Fully explain the difference between a firm commitment and best-efforts underwriting and describe how underwriters are compensated.

4. Also fully explain the role of Federal (who, why, how) and state regulatory agencies in the IPO process. (Hint: it looks a little “fishy” to me.)

Answer 1

(a): Venture capitalists are investors who provide capital to a firm that have high growth potential. Along with money and funding venture capitalists also prove managerial expertise. Venture capitalists provide funds by buying equity of the firm that they are funding. Venture capitalists are compensated through the increase in the value of the equity of the firm and they look for an exit by initiating a merger, an acquisition or an IPO (initial public offering).

(b): Entrepreneurs and venture capitalists are eager to go public once the firm has attained a certain size beyond which additional resources can be best obtained by listing the shares in the stock markets. Going public is feasible and recommended once a certain size is obtained and hence future funding that is obtained through listing of shares will help in reducing the cost of capital. Another reason is that entrepreneurs and venture capitalists will be looking to capitalize on the potential of the firm and exit their positions in a manner that will maximize their gains.

(c ): Three functions of underwriter are – (i): sales type activities i.e. purchase the entire IPO issue and sell it to investors. (ii): Risk assumption – As they guarantee a certain price for the IPO. (iii): Administration – i.e. administrating the public issuance and distribution of securities.

In case of firm commitment the underwriters will purchase the entire offering of shares. In case of best-efforts the underwriters will make their best effort possible to fulfill the requirements of the contract, without promising a specific outcome with regards to quantity of stocks sold and price at which it will be sold.

In case of best effort the underwriter is compensated with a flat fee. In case of firm commitment the underwriter’s compensation is the spread between the price for which the underwriter acquired the stock from the issuer (usually a discounted price) and the price for which the underwriter sells the stock to the public.

(d): The Federal agency that plays an important role in case of IPO is SEC (Securities And Exchange Commission). An initial draft registration statement has to be filed with SEC and the SEC will usually take around 30 days to do its initial review of the draft registration statement. Valuation and price range discussions will have to be done with SEC. It is usually in the 14th week that all SECs comments and amendments to the registration statement is done. State security laws also comes into picture in case of IPOs.