Question

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 $210 million, at an offer price of $3.50 per share. The issue is underwritten at $3.00. The costs of preparing the prospectus, legal fees, ASIC registration and other administrative costs add up to $800,000. The firm’s share price closes at $4.20 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 $27.3 million to finance a new investment project through a seasoned equity offering at $60 per share, and the underwriter charges a 9% 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

(a)

Venture Capital

Venture Capital financial intermediaries focused on providing capital to small, innovative, fast growth start up companies that are typically high risk and not amenable to more tarditional financing alternatives.

The key challenge is the investors comparing this high risk, high reward illiquid asset class with that of the stock market, which generates anywhere between 15-30 per cent per annum without capital gains tax.

Most Venture Capital firms say it is difficult, in terms of the

* money available

*investor maturity

*government support

India is still not a mature market where high net worth individuals (HNIs) allocate their savings to VC funds

(b)

Information asymmetry results in two distinct kinds of

*Risks-adverse selection

Adverse Selection risks are those resulting from hidden information (i.e., entrepreneurs possess certain information not known to the VCs).

*Moral hazard

Moral Hazard risks are the ones emanating from hidden actions (i.e. entrepreneurs can take certain actions not observable by the VCs).

(c)

two ways in which venture capital firms structure their funding to reduce risk are as follows

* Minimizing politics. Politics can wreck returns.

Every partner needs to deploy $X per fund. But returns are rarely consistent across partners. By making sure investment decisions are as free of politics as possible, fewer Almost deals get done. The Almost deals never return much, if any, capital. Partners with little deal flow, or poor deal flow, or fewer relationships, should be doing fewer deals, or playing other roles.

* Getting really, really, really good at pricing.

The best deals are always expensive, so this is hard. So it's not as simple as being "disciplined" on price. Getting really, really, really good at pricing. The best deals are always expensive, so this is hard. So it's not as simple as being "disciplined" on price.

(d)

IPO underwriting spread = Share price - Offer price

Given that

Share price = 4.20

Offer price = 3.50

So, IPO Underwriting spread = 4.20 - 3.50

= 0.7