Lecture 7 Notes.docx

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Western University
Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

Financing and Distribution BOOTSTRAPPING Initial Funding of the Firm  The process by which many entrepreneurs raise “seed” money and obtain other resources necessary to start their businesses  The initial “seed” money usually comes from the entrepreneur or other founders.  The process by which many entrepreneurs raise “seed” money and obtain other resources necessary to start their businesses  The initial “seed” money usually comes from the entrepreneur or other founders.  Other cash may come from personal savings, the sale of personal assets, loans from family and friends, use of credit cards.  The seed money, in most cases, is spent on developing a prototype of the product or service and a business plan.  Usually lasts 1 to 2 years This is the general process: The bootstrapping is early on. The seed money can come from savings, credit cards, etc. – they put their own money into this vision. It’s usually spent trying to make a prototype and come up with a business plan. Usually this lasts about a year or two. If it lasts really long, it is probably a bad idea. VENTURE CAPITAL  Venture capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing.  Individual venture capitalists or angel investors are typically wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals.  Three reasons exist as to why traditional sources of funding do not work for new or emerging businesses: 1. The high degree of risk 2. Types of productive assets. 3. Informational asymmetry problems  The venture capitalists’ investments give them an equity interest in the company.  Often in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalist. Pool funds from all sorts of places. These are the ones who help the business go past the prototype. They are critical. These entrepreneurs likely do not have access to large amounts of money Most of what they’re using as assets are intangible – “I’m creative” “I’ve got a great idea” It’s hard for the banker/lender to tell if I’m a good risk or a bad right Usually gives them an equity cheque – not lending money Preferred can be common Preferred stock doesn’t have dividends or others but if your company is going to skyrocket you’d want common shares Venture Capitalists Provide More Than Financing  The extent of the venture capitalists’ involvement depends on the experience of the management team.  One of their most important roles is to provide advice.  Because of their industry and general knowledge about what it takes for a business to succeed, they provide counsel for entrepreneurs when a business is being started and during early stages of operation. Tend to gravitate towards certain industries “only going to invest pharmaceuticals” so they become an expert in that industry and help them develop that management team – advice A lot of time these entrepreneurs have a great idea but have no business background so this is helpful How Venture Capitalists Reduce Their Risk  Venture capitalists know that only a handful of new companies will survive to become successful firms.  Tactics to reduce risk: o Funding the ventures in stages o Requiring entrepreneurs to make personal investments o Syndicating investments o In-depth knowledge about the industry Most new business fail Always ways these investors can reduce their risks: •Funding – fund you in stages “give a million today, in 6 months will see how you’re doing and give you another million” – at risk for contributing but not for the whole thing •Requiring entrepreneurs to make personal investments – if they don’t want to put they’re own money into it then it’s a bad idea •Syndicating •In-depth knowledge – go to industries they are comfortable with, expert on Syndication  It is a common practice to syndicate seed- and early-stage venture capital investments.  Syndication occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalists.  Syndication reduces risk in two ways: o It increases the diversification of the originating venture capitalist’s investment portfolio. o The willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision. Selling some of your investments Sells some of your own stuff to other venture capitalists (might have 30% equity in original contract, now 15% because sold some to other venture) If other venture capitalist funds want in – probably a good investment The Exit Strategy  Venture capitalists are not long-term investors in the companies, but usually exit over a period of three to seven years.  Every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process. o Timing (when to exit) o The method of exit o What price is acceptable  There are three principal ways in which venture capital firms exit venture-backed companies: o Sell to a strategic buyer in the private market. o Sell to financial buyer in the private market o Initial Public Offering: selling common stock in an initial public offering (IPO). Not there forever. Comes a time when they leave. Usually between 2-7 years 1999 big money came in for Google, Google went big in 2004 so it took them 4 year. This takes them from a prototype to a running business. Before exit, have to go back to original contract. Timing of when get exit, the method of exiting, and what price is acceptable. Want to have a say who they are selling it to Public market is what you see selling shares on the stock market Private market is not traded on stock exchange – can still make a lot of money Strategic buyer: Strategic purpose – like Coca Cola buying Smart Water – this company should compliment your current business Financial buyer: In the business to buy companies and sell them in about 10 years IPO: Taking it from a private to a public organization INITIAL PUBLIC OFFERING One way to raise larger sums of cash or to facilitate the exit of a venture capitalist is through an initial public offering, or IPO, of the company’s common stock.  First-time stock issues are given a special name because the marketing and pricing of these issues are distinctly different from those of seasoned offerings. Very detailed process Companies go from private to public once. IPO – primary market transaction. Never been offered by a company publicly traded Advantages Going Public  The amount of equity capital that can be raised in the public equity markets is typically larger than the amount that can be raised through private sources.  Once an IPO has been completed, additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost.  Going public can enable an entrepreneur to fund a growing business without giving up control.  After the IPO, there is an active secondary market in which stockholders can buy and sell its shares. o People who already own them can sell them as well  Publicly traded firms find it easier to attract top management talent and to better motivate current managers if a firm’s stock is publicly traded. A great way to raise money Once it’s done the first time Less expensive to go through a season stock Disadvantages to Going Public  High cost of the IPO itself.  The costs of complying with ongoing SEC disclosure requirements  The transparency that results from this compliance can be costly for some firms. Have to comply with the security commissions Cannot opt out Transparency - Have to have audits done, have to put financial statements up Investment-Banking Services  To complete an IPO, a firm will need the services of investment bankers, who are experts in bringing new securities to the market.  Investment bankers provide three basic services when bringing securities to market– o Origination, o Underwriting, o Distribution. Can’t do this by yourself. Need an investment banker to help. These are experts. Origination  Includes giving the firm financial advice and getting the issue ready to sell.  The investment banker helps the firm determine whether it is ready for an IPO.  Once the decision to sell stock is made, the firm’s management must obtain a number of approvals.  File a registration statement with the Securities Exchange Commission Early on. Work done before they go public determining when they’re ready to go public Due diligence process – protect those that don’t have the information. Confirm things. If not ready, can help them get to that point. The management has the final say on the price. Underwriting  The risk-bearing part of investment banking.  The securities can be underwritten in two ways: o On a firm-commitment basis o On a best-efforts basis Who bears the risk in this issue? Firm-Commitment Underwriting  The investment banker guarantees the issuer a fixed amount of money from the stock sale.  Investment banker’s compensation – underwriter’s spread  The underwriter bears the risk -price risk. 1) They’re going to guarantee a certain price. The compensation the investment banker gets to keep the difference. If they sell it for less, have to pay the difference. Best-Effort Underwriting  The investment banking firm makes no guarantee to sell the securities at a particular price.  Does not bear the price risk  Compensation is based on the number of shares sold. 2) Going to try my best. No guarantees. Underwriting Syndicates  To share the underwriting risk and to sell a new security issue more efficiently, underwriters may combine to form a group called an underwriting syndicate.  Participating in the syndicate entitles each underwriter to receive a portion of the underwriting fee as well as an allocation of the securities to sell to its own customers. A group of people coming together to spread that risk a little bit. Each group gets portion of their fees. Underwriting-Determining the Offer Price  One of the investment banker’s most difficult tasks is to determine the highest price at which the bankers will be able to quickly sell all of the shares being offered and that will result in a stable secondary market for the shares. If you price them too high. Coming up with the right price is very difficult. Sometimes they underprice it because it protects them a little Underwriting – Due Diligence Meeting  Before the shares are sold, representatives from the underwriting syndicate hold a due- diligence meeting with representatives of the issuer.  Investment bankers hold due-diligence meetings to protect their reputations and to reduce the risk of investors’ lawsuits in the event the investment goes sour later on. All the members of the banks meet with the issuer to protect their reputation Distribution  Once the due-diligence process is complete, the underwriters and the issuer determine the final offer price in a pricing call.  The pricing call typically takes place after the market has closed for the day.  By either accepting or rejecting the investment banker’s recommendation, management ultimately makes the pricing decision. Once it’s done, distribute it. Happens really quickly. IPO PRICING AND COST  Three basic costs are associated with issuing stock in an IPO:  Underwriting spr
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