Question

5. Congratulations! 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)

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

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

c. 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.

d. 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

a0

Concept of Venture Capital:

Narrowly speaking, venture capital refers to the risk capital supplied to growing companies and it takes the form of share capital in the business firms. Both money provided as start-up capital and as development capital for small but growing firms are included in this definition.

In developing countries like India, venture capital concept has been understood in this sense. In our country venture capital comprises only seed capital, finance for high technology and funds to turn research and development into commercial production.

In broader sense, venture capital refers to the commitment of capital and knowledge for the formation and setting up of companies particularly to those specialising in new ideas or new technologies. Thus, it is not merely an injection of funds into a new firm but also a simultaneous input of skills needed to set the firm up, design its marketing strategy, organise and manage it.

In western countries like the USA and UK, venture capital perspective scans a much wider horizon along the above sense. In these countries, venture capital not only consists of supply of funds for financing technology but also supply of capital and skills for fostering the growth and development of enterprises.

Much of this capital is put behind established technology or is used to help the evolution of new management teams. It is this broad role which has enabled venture capital industry in the West to become a vibrant force in the industrial development. It will, therefore, be more meaningful to accept broader sense of venture capital.

Characteristics of Venture Capital:

Venture capital as a source of financing is distinct from other sources of financing because of its unique characteristics, as set out below:

1. Venture capital is essentially financing of new ventures through equity participation. However, such investment may also take the form of long-term loan, purchase of options or convertible securities. The main objective underlying investment in equities is to earn capital gains there on subsequently when the enterprise becomes profitable.

2. Venture capital makes long-term investment in highly potential ventures of technical savvy entrepreneurs whose returns may be available after a long period, say 5-10 years.

3. Venture capital does not confine to supply of equity capital but also supply of skills for fostering the growth and development of enterprises. Venture capitalists ensure active participation in the management which is the entrepreneur’s business and provide their marketing, technology, planning and management expertise to the firm.

4. Venture capital financing involves high risk return spectrum. Some of the ventures may yield very high returns to more than Compensates for heavy losses on others which may also have earning prospects.

In nut shell, a venture capital institution is a financial intermediary between investors looking for high potential returns and entrepreneurs who need institutional capital as they are yet not ready/able to go to the public.

Dimensions of Venture Capital:

Venture capital is associated with successive stages of the firm’s development with distinctive types of financing, appropriate to each stage of development. Thus, there are four stages of firm’s development, viz., development of an idea, start up, fledgling and establishment.

The first stage of development of a firm is development of an idea for delineating precise specification for the new product or service and to establish a business-plan. The entrepreneur needs seedling finance for this purpose. Venture capitalist finds this stage as the most hazardous and difficult in view of the fact that majority of the business projects are abandoned at the end of the seedling phase.

Start-up stage is the second stage of the firm’s development. At this stage, entrepreneur sets up the enterprise to carry into effect the business plan to manufacture a product or to render a service. In this process of development, venture capitalist supplies start-up finance.

In the third phase, the firm has made some headway, entered the stage of manufacturing a product or service, but is facing enormous teething problems. It may not be able to generate adequate internal funds. It may also find its access to external sources of finance very difficult. To get over the problem, the entrepreneur will need a large amount of fledgling finance from the venture capitalist.

In the last stage of the firm’s development when it stabilizes itself and may need, in some cases, establishment finance to explicit opportunities of scale. This is the final injection of funds from venture capitalists. It has been estimated that in the U.S.A., the entire cycle takes a period of 5 to 10 years.

Functions of Venture Capital:

Venture capital is growingly becoming popular in different parts of the world because of the crucial role it plays in fostering industrial development by exploiting vast and untapped potentialities and overcoming threats.

Venture capital plays this role with the help of the following major functions:

Venture capital provides finance as well as skills to new enterprises and new ventures of existing ones based on high technology innovations. It provides seed capital to finance innovations even in the pre-start stage.

In the development stage that follows the conceptual stage, venture capitalist develops a business plan (in partnership with the entrepreneur) which will detail the market opportunity, the product, the development and financial needs.

In this crucial stage, the venture capitalist has to assess the intrinsic merits of the technological innovation, ensure that the innovation is directed at a clearly defined market opportunity and satisfies himself that the management team at the helm of affairs is competent enough to achieve the targets of the business plan.

Therefore, venture capitalist helps the firm to move to the exploitation stage, i.e., launching of the innovation. While launching the innovation the venture capitalist will seek to establish a time frame for achieving the predetermined development marketing, sales and profit targets.

In each investment, as the venture capitalist assumes absolute risk, his role is not restricted to that of a mere supplier of funds but that of an active partner with total investment in the assisted project. Thus, the venture capitalist is expected to perform not only the role of a financier but also a skilled faceted intermediary supplying a broad spectrum of specialist services- technical, commercial, managerial, financial and entrepreneurial.

Venture capitalist fills the gap in the owner’s funds in relation to the quantum of equity required to support the successful launching of a new business or the optimum scale of operations of an existing business. It acts as a trigger in launching new business and as a catalyst in stimulating existing firms to achieve optimum performance.

Venture capitalists role extends even as far as to see that the firm has proper and adequate commercial banking and receivable financing. Venture capitalist assists the entrepreneurs in locating, interviewing and employing outstanding corporate achievers to professionalize the firm.

b)

Going public and offering stock in an initial public offering represents a milestone for most privately owned companies. A large number of reasons exist for a company to decide to go public, such as obtaining financing outside of the banking system or reducing debt.

Furthermore, taking a company public reduces the overall cost of capital and gives the company a more solid standing when negotiating interest rates with banks. This would reduce interest costs on existing debt the company might have.

The main reason companies decide to go public, however, is to raise money – a lot of money and spread the risk of ownership among a large group of shareholders. Spreading the risk of ownership is especially important when a company grows, with the original shareholders wanting to cash in some of their profits while still retaining a percentage of the company.

One of the biggest advantages for a company to have its shares publicly traded is having their stock listed on a stock exchange. Following are the reasons:

1. Access to Risk Capital:

Most companies will find it difficult to raise equity from venture capitalists and other big investors. It is not just about lack of availability of potential investors. There may be investors available but they may not be willing to give a fair valuation to the entrepreneurial venture. In such cases, it will be prudent to seek equity investment from the public who might be willing to value the company more generously.

1. Increased Brand Image:

The brand image of an enterprise also goes up once it has been publicly listed. It gets more recognition from suppliers and customers. Also, it becomes easier to attract companies. Moreover, banks will also be more willing to lend to listed companies than to closely held firms.

1. Stock Options:

Labour laws in India permit issuing stock to employees even in the case of private limited companies. But, the laws make it very cumbersome and procedures are not very well designed to facilitate liquidity. In the case of public limited firms, it is very easy to set up employee stock option plans and motivate your employees.

1. Facilitates Mergers and Acquisitions:

As a publicly listed company, it is much easier to carry out mergers and acquisitions. The processes get simpler and valuations are largely market driven. As such valuation does not remain an area of much concern.

1. Debt Reduction:

Company generally uses the proceeds from the IPO to pay off the loans and creditors which helps to reduce the debt burden on the company and increase its value.

1. Liquidation:

Listing gives an opportunity to entrepreneurs to liquidate a part of their holdings. Also, if the venture has accessed venture capital in the past, listing gives an opportunity to venture capitalists to liquidate all or part of their holdings.

1. Sharing Corporate Control:

The company can no longer be operated by the whims and fancies of the entrepreneur. Now, there will be a board of directors, which will be responsible to the general shareholders. Management of the company has to be carried out transparently and in the best interests of the shareholders.

1. Sharing Financial Gain:

In a proprietorship, all profits go to the entrepreneur but in a publicly listed firm, the entrepreneur cannot take all the profits home. Profits have to be shared with all other shareholders through issue of dividends and bonus shares.

1. Managing Shareholder Value:

Earlier there was no way for the entrepreneur to keep track of the daily changes in the value of his/her company. In a publicly listed firm, there is a stock price, which indicates the value of the firm, and this keeps changing throughout the trading day. The entrepreneur will have to ensure that business decisions and company performance continually serve to enhance shareholder value.

1. Sharing Strategic Information through Periodic Reporting:

Listing and reporting norms in India are amongst the strictest in the world. The publicly listed firm has to periodically share information relating to past performance and future plans. In such a scenario, competitors can track the company’s strategic intent.

c) underwriter

1)The underwriter in a new stock offering serves as the intermediary between the company seeking to issue shares in an initial public offering (IPO) and investors.

2)The underwriter helps the company prepare for the IPO, considering issues such as the amount of money sought to be raised, the type of securities to be issued, and the agreement between the underwriter and the company.

3)The underwriter then creates a draft prospectus to take on a road show to potential institutional investors. The road show seeks to create excitement for the IPO and involves conferences given to investors around the country. 4)After the road show, the underwriter and company determine of the final price for the IPO based on the orders received during the road show. Then, the syndicate allocates shares to investors. The final step is the first day of trading, when the investing public can first buy the stock on an exchange.

DIFFERENCE

Firm Commitment:

This is an arrangement whereby an investment bank enters into a written agreement, with the issuer of the securities, to make an outright purchase from the issuer of securities to be offered to the public. The underwriter, as the investment banker, is required to make its profit on the difference between the purchase price — determined through either competitive budding or negotiation — and the public offering price. Firm commitment underwritings are to be distinguished from conditional arrangements for distributing new securities, such as standby commitments and best efforts commitments.

In a firm commitment underwriting, the issuer already knows, at the time the registration statement becomes effective how much money it is going to receive from the offering. Usually, firm commitment underwriting is only done for higher quality companies or where the investment bank as obtained indications of interest, which reflect that it will be able to resell the shares that it is purchasing from the issuer.

Best Efforts:

In this type of offering, investment bankers, acting as agents, agree to do their best to sell an issue to the public. Instead of buying the securities outright, these agents have an option to buy and an authority to sell the securities. Depending on the contract, the agents exercise their option and buy enough shares to cover their sales to clients, or they cancel the incompletely sold issue altogether and forego the fee. Best efforts deals entail risks and delays from the issuer’s standpoint. For the most part, the best efforts deals that are seen today are handled by firms specializing in the more speculative securities of new and unseasoned companies.

UNDERWRITER COMPENSATION

Underwriters represent the group of representatives from an investment bank whose main responsibility is to complete the necessary procedures to raise investment capital for a company issuing securities. Underwriters do not necessarily make guarantees concerning selling an initial public offering (IPO). However, that depends on the type of underwriting that is agreed upon with the stock's issuer. Each type of underwriting varies in the amount of risk the underwriter takes on and how the underwriter is compensated. The two most common types of underwriting are bought deals and best effort deals.

In a bought deal, the underwriter purchases a company's entire IPO issue and resells it to the investing public. The amount of compensation the underwriter makes represents the spread between the price for which the underwriter acquired the stock from the issuer (usually a discounted price) and the price the for which the underwriter sells the stock to the public. In this case, the underwriter bears the entire risk of selling the stock issue, and it would be in his or her best interest to sell the entire new issue because any unsold shares then continue to be held by the underwriter.

In a best effort deal, the underwriter does not necessarily purchase any of the IPO issue, and only makes a guarantee to the company issuing the stock that it will use its "best efforts" to sell the issue to the investing public at the best price possible. Unlike a bought deal, there is no consequence for the underwriter if the entire issue is not sold, it is the issuing company that is stuck with any unsold shares. Because there is less risk involved, the underwriter's gains are limited even if the issue does sell well because in the best effort situation, the underwriter is compensated with a flat fee.

D)

The Securities Act of 1933 ("1933 Act") requires, with limited exceptions, that before securities are sold to the public that the public be provided with adequate, reliable, and timely information about the company.

The 1933 Act provides for different forms to register securities. It is important to determine which form is the proper form for the company to use. Typically, when conducting an IPO the company will file either a Form S-1 or a Form SB-2. Form S-1 is the most common registration form and the "general purpose form." Form SB-2 is available to reporting and non-reporting companies in the U.S. or Canada with revenues of less than $25 million in the last fiscal year, and which are not investment companies.

No matter which registration statement a company selects, the structure of the document will essentially be the same. The first part of the registration statement will be the prospectus, which will contain information regarding the company, the securities being offered, the manner of distribution, and the company's audited and unaudited financial statements as dictated by the 1933 Act disclosure rules.

The prospectus will be the main marketing document for the IPO. Therefore, it is important that the information in the prospectus be in plain English and be easily understandable. The prospectus should not contain statements that are ambiguous, contradicted in other sections of the registration statement, or not supportable.

Moreover, any drafter should be cautious to ensure that the document carefully reflects the risk of investing in the company and that potential investors are fully apprised of the strengths and weaknesses of the company. This includes providing the reader with information on competition, government regulation of the industry, risks associated with the company's product, and dependence on a small number of customers or contracts.

Providing this information in the prospectus should reduce the number of comments by the SEC and other regulators. Equally important, as any investment in an IPO has inherent market risks, by providing complete disclosures on the weaknesses of the company and the risks of the investment, the drafters may limit the company's, underwriter's, attorneys', and selling brokers' liability in the event that the offering does not fare well.

The other portions of the registration statement will contain required consents, exhibits (including employment agreements for key employees and material contracts), signatures, and various undertakings. These sections are not generally distributed to the prospective investor. However, they are available to the public from the SEC or on EDGAR.

After the registration statement has been completed, it will be filed with the SEC, on EDGAR, sent to the NASD and respective listing exchange(s) and the Blue Sky administrators in the states that the company and the underwriter want the IPO to be sold.

THE REVIEW PROCESS.

Once the regulators receive the registration statement, they will start a review process or comment period. The SEC, the NASD, the specific listing exchanges, and Blue Sky regulators, may all instruct the company or the underwriters to make certain changes to the disclosure in the registration statement, company's by-laws, and may designate to whom the securities may be sold. The company cannot sell any securities during this time period and must await approval from the various regulators. This is called the "waiting period."