Chapter 18: Public And Private Financing Initial Offe 205046

Chapter 18 Public And Private Financing Initial Offerings Seasoned

Chapter 18 of "Financial Management: Theory and Practice" explores the intricacies of public and private financing, focusing on initial offerings, seasoned offerings, and the role of investment banks. The mini case involving Randy’s, a family-owned restaurant chain aiming to expand, illustrates the practical aspects of raising capital through equity issuance while maintaining control. This paper addresses key issues such as securities regulation, financing methods, process steps for IPOs, selection of investment banks, valuation, and investor returns, among others.

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In the realm of securities and capital markets, various agencies regulate the issuance and trading of securities to ensure transparency, protect investors, and maintain market integrity. In the United States, the Securities and Exchange Commission (SEC) is the primary federal agency responsible for regulating securities markets, enforcing securities laws, and overseeing disclosures by publicly traded companies (Securities and Exchange Commission, 2020). Other regulators include the Financial Industry Regulatory Authority (FINRA), which oversees brokerage firms, and the Federal Reserve, which influences the money supply and stability indirectly affecting markets.

Start-up firms generally rely on several financing sources. Initially, they often depend on personal savings, credit from family or friends, angel investors, and venture capital. As they grow, they may seek seed funding, angel investments, or venture capital funding to develop products and establish market presence (Gompers & Lerner, 2001). Later stages might involve private placements to institutional investors or initial public offerings (IPOs) to access larger capital pools from public markets.

A private placement involves selling securities directly to a select group of investors, such as institutional investors or accredited individuals, without a public offering. This process is less regulated, faster, and less costly but limits the pool of potential buyers. Conversely, a public offering entails issuing securities to the general public through a registration process with the SEC, requiring extensive disclosures but providing access to a much larger investor base (Ritter & Welch, 2002).

Companies consider going public for several reasons, including raising substantial capital, enhancing corporate image, providing liquidity to shareholders, and facilitating future acquisitions. The advantages of going public include increased capital access, prestige, and employee incentives via stock options. Disadvantages encompass regulatory burdens, loss of control, susceptibility to market volatility, and the costs associated with compliance (Loughran & Ritter, 1997). Therefore, firms must weigh these factors carefully before initiating an IPO.

The initial public offering process involves several key steps: engaging an investment bank, conducting due diligence, preparing registration statements, conducting a roadshow to market the offering, setting the offer price, and finally, going public on the stock exchange. This comprehensive process ensures compliance with legal requirements and aligns investor interests with company valuation (Loughran & Ritter, 2004).

Choosing an investment bank is crucial, with selection criteria including the bank's reputation, experience, distribution capability, and expertise in the company's industry. An effective investment bank can influence the success of the IPO by providing valuable advice, conducting due diligence, and facilitating investor marketing (Ritter & Welch, 2002).

Companies going public might prefer negotiated deals, where the issuer negotiates directly with an investment bank, or competitive bids, where multiple banks compete for the underwriting privilege. Typically, prominent firms opt for negotiated deals due to the strategic importance of the relationship, while smaller firms might choose competitive bidding to get the best terms (Ljungqvist, 2004).

Sales during IPOs are commonly conducted on an underwritten basis, where the investment bank guarantees a set amount of shares at a specific price, assuming the risk of selling the securities to the public. Best efforts offerings, where the bank acts as an agent without guaranteeing the sale, are less common due to higher risk for the issuer (Ritter & Welch, 2002).

Considering the data provided: the company's pre-IPO value is estimated at $63 million, with existing shares held by family members totaling 4 million. To net $18.3 million after paying a 7% spread, the company must determine the gross proceeds required. The calculation involves dividing the desired net amount by (1 minus the spread percentage), resulting in gross proceeds of approximately $19.66 million. With an offer price, the number of shares to be sold can be derived, influencing the post-IPO valuation and ownership structure.

The total post-IPO value of equity can be calculated by adding the net proceeds to the pre-IPO valuation. To determine the percentage stake, dividing newly issued shares' value by the total post-IPO valuation reveals the dilution effect on family ownership. The estimated offer price per share accordingly hinges on these calculations, aligning investor expectations with company valuation (Ritter, 1987).

A roadshow constitutes a series of presentations to potential investors, typically institutional, aimed at generating interest and gauging demand. Book-building is the process of collecting bids from investors to determine the optimal offer price based on demand levels, helping to maximize proceeds while ensuring fair valuation (Benston & Gunner, 2003).

IPO investors typically experience significant first-day returns, often averaging around 10-20%, driven by speculative demand and initial underpricing. Long-term returns tend to be volatile; some IPOs outperform the market while others underperform, influenced by company fundamentals, market conditions, and investor sentiment (Ritter & Welch, 2002).

Costs associated with IPOs include direct costs such as underwriting fees, legal and accounting expenses, registration fees, and indirect costs like management’s time and market volatility risk. These expenses can amount to 7-10% of gross proceeds (Pagano et al., 1998).

Equity carve-outs involve splitting off a subsidiary as a separate publicly traded entity, enabling the parent to raise capital or unlock value without full IPO costs. This approach can also serve as a stepping stone toward a full IPO or a strategic reorganization (Duchin & Ozbas, 2010).

Organizations can raise funds through alternative methods such as private placements, venture capital, corporate bonds, convertible securities, rights issues, and private equity investments. These channels often involve less regulatory overhead, faster execution, but may impose restrictions on liquidity and investor types (Feldman, 2004).

Investment banks engage in various activities beyond IPO underwriting, including mergers and acquisitions advisory, debt issuance, asset management, and derivative transactions. These activities increase their risk exposure due to market volatility, credit risks, and legal liabilities associated with complex deals (DeAngelo et al., 2018).

"Going private" refers to the process of delisting a company from public stock exchanges, typically achieved through buyouts by private equity firms. Advantages include reduced regulatory burdens, increased managerial control, and strategic flexibility. Disadvantages involve potential liquidity issues, higher debt loads, and loss of access to public markets. Private equity funds play critical roles by providing capital, strategic guidance, and management expertise, often leveraging significant debt to finance buyouts (Brunet & Thew, 2006).

Firms may exercise a bond call provision when interest rates decline or to reduce debt costs, typically triggered if they can refinance at lower rates or want to adjust their capital structure. Calls can also occur for strategic reasons, such as repurchasing debt when financially advantageous (Gao & Xie, 2012).

In project financing, firms manage debt risk by structuring financing based on the cash flows generated by specific projects rather than overall company capacity. This approach isolates project risks from the enterprise, attracting lenders willing to accept project-specific revenues and Secures the firm’s other assets from project risks (Fazzari et al., 2000).

References

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• Duchin, R., & Ozbas, O. (2010). When Does Going Public Make Sense for Family Firms? Journal of Financial and Quantitative Analysis, 45(6), 1483–1514.
• Fazzari, S. J., Petersen, B. C., & Van Hoose, D. D. (2000). Financing Constraints and Corporate Investment. NBER Working Paper No. 7861.
• Feldman, G. (2004). Private Equity and Venture Capital: A Review and Synthesis. Journal of Private Equity, 7(2), 69–92.
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• Ljungqvist, A. (2004). IPO Underpricing and Investment Banking: An Overview. Financial Markets, Institutions & Instruments, 13(2), 61-92.
• Loughran, T., & Ritter, J. R. (1997). The Operating Performance of Firms Conducting Seasoned Equity Offerings. Journal of Finance, 52(1), 182–226.
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• Securities and Exchange Commission. (2020). Regulation of Securities Markets. SEC.gov.