Question

This question is worth 10 marks in total. This is a written calculation question, and you should perform the necessary calculations/working on paper to later be scanned and uploaded. Start a new page for this question. For dollar amounts, give your answer to the nearest cent. For interest rates, give our answer as a percentage rounded to 2 decimal places.

If any parts of the question use values from earlier parts, use the EXACT values from earlier parts.

QUESTION START

a) Explain why venture capital funding is critical for start-up firms with a lot of intangible assets. (1 mark)

b) Discuss the problem of information asymmetry in venture capital funding. (1 mark)

c) Describe two ways in which venture capital firms structure their funding to reduce risk.

The following information applies for parts d), e) and f). A company makes an initial public offering of shares to raise $250 million, at an offer price of $3.90 per share. The issue is underwritten at $3.50. The costs of preparing the prospectus, legal fees, ASIC registration and other administrative costs add up to $600,000. The firm’s share price closes at $4.10 on its first day of trade.

d) Calculate the IPO underwriting spread. (1 mark)

e) Calculate the IPO underpricing. (1 mark)

Two years later, the company wants to raise another $28.3 million to finance a new investment project through a seasoned equity offering at $55 per share, and the underwriter charges a 8% spread.

f) How many shares have to be issued through the SEO?

g) Discuss two advantages for firms to raise capital through seasoned equity offerings, as compared with an IPO.

Answer 1

1. (a) Venture capital is the provision of capital for new business ventures. It supports entrepreneurial talent with funds and business skills to exploit market opportunities with an aim to obtain capital gains. Venture capital is a form of intermediation particularly to support the creation and growth of innovative, entrepreneurial companies. It specializes in financing and nurturing companies at an early stage of development (start-ups) that operate in high-tech industries. For such companies the expertise of the venture capitalist, its knowledge of markets and of the entrepreneurial process, and its network of contacts are most useful to help them grow.
The venture capital company provides some value added services in the form of management advice and contribution to overall strategy formulation of the start up firm. The relatively high risk of the venture capitalist is compensated by the possibility of high return, usually through substantial capital gains in the medium term.

The most common source of funds for entrepreneur the personal savings, credit cards, loans from friends and family and loans against property.Many start-up firms require considerable capital. Most of the entrepreneurs typically are not able to invest sufficient amounts of money in their start-ups. Even if they do, they are required to incur high costs. This is because the capital paid in by the entrepreneur is fully liable. If the entrepreneur finances with equity, the money is fully lost in the case of insolvency. If he finances with debt, many legal environments are very restrictive. The high uncertainties concerning the development of young growth companies, their missing track record concerning the repayment of credits and their inability to provide a collateral for commercial loans are factors that, lead to a situation in which debt capital for young growth companies, at least in the early stages of their development is virtually not available.
Entrepreneurial firms are characterized by significant intangible assets, expect years of negative earnings and have uncertain future prospects. Such firms are usually unlikely to receive bank loans or other debt financing. This problem is further compounded when the lending institutions are in the public sector and open to wide public scrutiny, thus they tend to be risk averse.
The major issue in the funding of early stage technology ventures is the asymmetry in the information available to the three partners - the technologist, the entrepreneur and the financier. Because of this they may have widely varying perceptions of the prospects for the enterprise. The role of the VC funding system is to devise financing and management agreements that accommodate these variations in information and perceptions.

(b) A venture capital market is crowded with low-quality ventures, where the chance of success of each venture is overstated by the entrepreneur, leading to a problem of adverse selection, a type of market failure known as the market for “lemons.” An entrepreneur developing a new product knows more than the investor about the product and its shortcomings. He/she may have an incentive to present the best information to the investor about the product and may overstate the chance of its success to obtain venture financing. It is difficult for an investor to distinguish between good-quality and poor-quality ventures. The venture capital market that is crowded with poor-quality ventures has consistent high failure rate with new ventures. Typically, five out of ten venture investments fail. Three out of ten lead to situations in which the investor might get back the principal or a part of it. Only two out of ten investments may succeed, and out of the two successes, only one may provide a high return to the investor.

Venture Capitalists (VC firms) mailnly focus on funding projects in emerging high-technology areas. Nascent technologies, domains and business models and most importantly intangibility of assets are some of the characteristics VC funded projects. This results in an extreme level of information asymmetry and thus, funding these projects requires specialized risk assessment skills.

Information asymmetry results in two distinct kinds of risks-adverse selection and moral hazard.
Adverse Selection risks are those resulting from hidden information (i.e., entrepreneurs possess certain information not known to the VCs & hold back those informations from the Venture capitalist). Moral Hazard risks are the ones emanating from hidden actions (i.e. entrepreneurs can take certain actions not observable by the VCs).

To control the adverse selection and sort out good quality ventures from poor quality ones the VCs employ intensive proposal screening and due diligence, syndication of deals (coinvesting with other VC firms) and specialization (by domain, funding size, stage of funding). For example, investors require a high hurdle rate, sometimes in excess of 70 percent, or require an investment return of ten times the investment amount, to qualify early stage ventures, especially when the entrepreneur has no track record or the venture does not have an operating history, the conditions when the adverse selection problem is at its worst. Requiring a high hurdle rate to qualify a venture is one of the mechanisms investors use to sort out and reject poor-quality ventures.
Moral hazard is overcome by staging of investments, legal contracting and extensive monitoring of the investee firms In general, presence of information asymmetry requires an extensive usage of signaling mechanisms to overcome the incoming risks.

(c) The primary ways VCs structure their funding to mitigate risks are :- (1) time diversification, (2) stage diversification, (3), sector diversification, (4) pro-rata or over pro-rata investing over time, and (5) number of investments in the portfolio.

(​​​​​1) Time diversification: Most VC funds are committed over a three to five year period. The commitment period for most funds is five years – by spreading out the commitments over a three to five year period, a fund gets time diversity and theoretically smooths out some of the macro cycles i.e. various events taking place in the macro business environement.

(2) Stage diversification:- Some funds have an early stage and late stage investing approach. The VC industry went through a phase post 2000 where there was a shift in some early stage firms to mid and later stage investing as well as a phase in the late 1990’s where early stage firms created growth funds to augment their early stage strategy. Today most of the firms that did this have settled on an integrated early / late stage approach within a single fund.

(3) Sector diversification: - A number of VC firms had broad sector diversification, investing in software and life sciences companies out of the same fund. With the rise of clean tech investing in the mid-2000’s, many software oriented VC firms started clean tech practices.

(d) & (e)

Underwriting Spread :-

Underwriter's spread =$ (3.90 - 3.50) = $0.40 per share

No. of shares outstanding = $250 million / $3.90 = 64102564

Total due to underwriter = ($0.40 * 64102564 shares) = $25641026

Out of pocket expenses = $6,00,000

Underpricing :-

Share price at the end of the day :- $4.10

First day underpricing = ($4.10 - $3.90) = $0.20 per share

Total underpricing = ($0.20 * 64102564) = $12820513

(f) Underwriter charges 8% spread for the SEO.
SEO offer price is $55 per share

i.e. the Underwriter's Spread = ($55 * 8%) = ($55 * 0.08) = $4.4 per share

The actual share price = $55 - $4.4 = $50.6 per share

Therefore, the no. of shares that have to be issued through the SEO, if the company wants to raise another $28.3 million = ($28.3 million / $50.6) = ($283,00,000 / $50.6) = 559288 shares.

(g) When an existing publicly traded company decides to raise additional capital by selling additional shares of its stock or debt instruments to the public, the share offering is considered a seasoned issue. Seasoned issues, also known as secondary offerings or subsequent offerings. Given that the company's shares already trade in the secondary market, the underwriters handling the seasoned or secondary offering price the shares at the prevailing stock market price on the day of the offering.

Companies do secondary offerings for two primary reasons. Sometimes, the company needs to raise more capital in order to finance operations, pay down debt, make an acquisition, or spend on other needs. With this type of offering, a company actually issues brand new shares, increasing its existing share count. For instance, Achillion Pharmaceuticals announced that it would raise $125 million in a stock offering, saying it plans to use the proceeds for research and development purposes. In other cases, secondary offerings happen because major shareholders want a chance to sell out.

One advantage of SEO over IPO is that the pricing of IPOs are necessarily judgemental, since a market for the stock does'nt preexist, firms conducting SEOs can usethe quoted price of the existing stock as a point of reference.

Firms conducting SEOs sell newly registered stocks publicly to raise new capital, while the equity share of existing stockholders is diluted when an SEO is conducted. However, the additional capital is expected to fuel further growth, thereby enhancing the overall equity claim. Existing stockholders won't lose anything if an SEO is fairly priced. Under the efficient capital market hypothesis, the current quoted stock price is considered a fair price.