DPBS 1170
Capital Resources
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Unit 6 Lecture:
asynchronous and
synchronous
Raising capital
• Identify
- Different types of capital resources within an organization
• Mobilise capital through various avenues of capital raising such
as
- Venture capital/private equity
- Initial Public Offering (IPO)
- Seasoned equity offering (SEO)
- Public vs. non public debt
- Trade Credit
Topics of Unit 6
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Capital Toolkit
Identify
Identify capital
needs, evaluate
possible sources
of capital and set
target capital
structure.
Mobilize
Raise capital via
• Internal sources
• Equity
• Debt
Measure
Monitor and quantify:
• Costs and benefits
• financial leverage
• financial risks
• debt maturity profile
Chief Financial Officer and Corporate Treasury
Characteristics of the firm:
Size, life cycle, nature of operations, cost structure …
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Week 6 Week 8
What are capital resources?
Identify
Identify capital
needs, evaluate
possible sources
of capital and set
target capital
structure.
The resource called capital
What is capital? – A company’s sources of financing which it can
use to buy goods, invest in projects or pay expenses.
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II) Financing decisions
(i.e. how to fund the investment e.g.
type, form, horizon)
III) Payout decisions (i.e.
what return do we give)
Current Assets:
• Cash
• Short-term investments
• A/R
• Inventory
Simplified balance sheet
Non-Current Assets:
• LT Investments
• PP&E
• Buildings
• Machinery
• Intangibles
• Goodwill
• Trademarks/patents
Liabilities:
• Short-term debt
• Long-term debt
Equity:
• Paid in capital
• Retained earnings
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Sources of capital:
External
vs.
internal
Uses of capital:
bank loans, bonds,
short-term bills
Previously issued
equity, preferred equity
(from shareholders)
Retained earnings
(profit from prior
periods)
Capital Investments
e.g. IT upgrades
Ongoing expenses
(COGS, SG&A)
e.g. Payroll
Net working capital
e.g. Inventory
Demand: Uses of capital
Supply: Sources of (fresh) capital [Week 8]
Common Equity
Short-term debt
e.g. Commercial
Paper
Long-term debt
e.g. bonds + bank
loans
Trade Credit &
Factoring
Preference Shares
Credit facilities
e.g. line of credit
Revenue generated by operations
Previously
retained cash
Debt
instruments
Equity
instruments
What are capital resources?
Mobilize
Raise capital via
• Internal sources
• Equity
• Debt
Sources of equity capital
The choice of equity financing depends in large part on the size of your company, its
recurring revenue, its stability of revenues and earnings and its level of risk. A lot of this is
correlated with the age/life cycle of the firm:
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Age/life cycle of firm Typical source of equity capital
Young, small, start-up firms (e.g. Canva)
Venture capital firms - attract the attention of investors that
are specialized in dealing with start-up companies. Unlikely to
access listed equity markets
Firms with track record of performance
(e.g. AirBnB)
Initial Public Offering (IPO) - typically eventually make the jump
onto a public exchange via IPO due to track record
performance and exciting prospects
Established firms (e.g. Tesla)
Seasoned equity offerings (SEO) or rights issue - firms that have
been listed for some time can continue to access equity by
selling some additional shares in the stock market
Venture Capital
• Venture capital (VC) is a part of the larger private (i.e. non-
public) equity market and describes early-stage, high-risk
equity financing of young firms.
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Venture Capital
What does it
involve?
Part of the larger private (i.e. non-public) equity market
How does it work? Funding is done in rounds, i.e., several points in time where outside investors pour additional funds
into the firm in exchange for equity stakes expanding valuations. Original owners diluted
Who uses it? early-stage, high-risk equity financing of young firms
Access to venture capital is very limited for start-ups without a track record.
Venture capitalists rely heavily on informal networks to help identify potential investments.
Personal connections matter.
Personalities of the founders matter!
Cost of VC Venture capital is “expensive” for the founders:
VCs extract as much as they can from the founders.
Founders regularly end up owning less than 20% of their firm after a few rounds.
The use of convertible debt protects VCs but severely dilutes existing shareholders in case of a
“down-round”.
Some VCs are hands-on, and demand say in management decisions and board seats.
Alignment of
interests
VCs’ and founders’ incentives are frequently NOT aligned
VCs have a portfolio of 20-100 “lottery tickets” and aim for “boom or bust” in the shortest time
possible.
The founders have all their human capital in ONE firm and would prefer to grow sustainably and
organically to maximize chance of survival at the expense of “moonshot growth”.
Background: Dilution in start-ups
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Founders start with a good idea and some of their own capital, build out
an idea into a business that angel investors are willing to invest $0.5m in
at a $1.5m pre-money valuation ($2m post-money).
75%
25%
Seeding Round
Founders Angel Investors
50%
17%
33%
Series A
Founders Angel Investors Institutional The business value doubles in value to $4m but will need additional
funding. Institutional investors (VC) contribute $2m at a $4m pre-money
valuation ($6m post-money).
The business grows by 50% before another capital injection is needed.
Institutional investors contribute another $4.5m at a $9m pre-money
valuation (post-money $13.5m).
The business has gone from $1.5m to $13.5m, i.e., 9X.
The founders’ dollar wealth has gone from $1.5m to $4.5m, i.e., 3X (but
they may have put in less than $1.5m before outside funding began).
33%
11%
56%
Series B
Founders
Angel Investors
Institutional
Superstar Example 1: AirBnB
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Source: www.craft.co/airbnb/funding-rounds
Initial Public Offering
• Traditionally, the goal of many founders has been to grow their
company into a size and scale that allows them to “go public”,
i.e., list on a public exchange and sell their shares to millions of
investors. This is called the initial public offering (IPO).
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Initial Public Offering (IPO)
What does it
involve?
young firms to grow enough to be able to “go public”, i.e., list on a public exchange and sell their
shares to millions of investors
How does it work? Stringent process involving approval from board of directors, appointing underwriter, prepare a
prospectus, investor road show, IPO in the primary market.
Underwriters are investment firms that act as intermediaries between a company selling securities and
the investing public during the IPO. Underwriters formulate method used to issue securities, price
securities and sell securities to their clients.
Who uses it? Established young firms with track record performance and good prospects
Cost of IPO The underwriting/IPO process is costly to the issuing firm. The fee ranges between 2.5% and 8% of the
amount of funds to be raised in Australia
Advantages and
disadvantages
Advantages:
Allows early investors to exit
Private firms can only have a certain number of shareholders
Wider access to capital markets
Shareholders benefit from the liquidity of public markets
Higher profile and status
(Probably) lower cost of capital
Disadvantages:
Dispersed ownership means loss of control by founders
Obligation to file public reports that divulge important information like key suppliers.
High regulatory, compliance costs and public scrutiny
IPOs and underpricing
On average, stock prices experience large positive returns on the first day of listing, can be
anywhere between 10 and 100%+! In other words, shares are typically underpriced relative
to the value that the public market assigns to them. Issuers are at times mad at underwriters
for “leaving money on the table”.
What are reasons for the underpricing?
• Difficult to price an IPO because there is not yet a market price.
• Additional asymmetric information associated with companies going public.
• Underwriters face a two-sided market (the issuer and the investors) and need to please
both!
• Repeat game with reputational concerns
• Preferred customers get preferred allocation (this is a legal grey area)
• Underpricing assures publicity, interest and demand
• Underpricing leads to oversubscription and rationed allocations.
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Additional ways to raise equity capital
Seasoned Equity Offering (SEO)
• similar to an IPO
• issue additional, new shares to raise new funds for company
• And/or founders and early VCs sell big blocks of their existing shares (cash out/exit)
• Typically to institutional investors.
Very common in U.S. capital markets.
Often, companies have follow-on SEOs
within 12 months of their IPO.
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Example: SEO
Your firm has 50,000 shares outstanding at $20 each. You need $200,000 in fresh capital.
Option A: SEO @ Price = $16 (20% discount to previous closing price).
Compute # shares and relevant prices after issuance?
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$200,000/$16=12,500 new shares for a new total of 62,500 shares.
Value of firm after raise = $20x50,000+$16x12,500=$1,200,000
New share price = $1,200,000/62,500=$19.20
Bad for existing investors! New investors got a discount, less money is raised, per share value drops!
Placement/SEO valuation
Before the placement/SEO, there were 0 shares outstanding. During the capital raising,
the firm issued 1 more. The pre-announcement price is and the subscription price is
.
The pre-money value of the firm is 0 = 0 × .
Total funds raised (ignoring fees) is Δ = Δ × .
The post-money value of the firm is 1 = 0 + Δ and there are 1 = 0 + Δ shares in total
now.
Then the new share price is the weighted average of the two prices:
=
1
1
=
0 × + Δ ×
0 + Δ
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Price reaction to raising additional equity
Empirical fact: Share prices tend to decline when new equity is
issued!
Theory Implication on price
Market timing theory When managers sell new shares because they believe the shares are
overvalued; managers rely on debt and retained earnings (and possibly
repurchasing shares) if they believe the shares are undervalued.
Pecking order theory Use retained earnings first ⇒ then debt ⇒ then convertible issues ⇒ equity
only as a last resort. Having to raise equity can be a bad signal!
Signalling theory of debt The use of leverage rather than equity as a way to signal good information to
investors. Reason: Interest payments are a commitment and require discipline
on spending. Therefore, if firm is doing the opposite, then it is a signal of bad
information hence share price falls
Total equity raised
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What are capital resources?
Mobilize
Raise capital via
• Internal sources
• Equity
• Debt
Debt
Non public debt Public debt
•Bank loans
Term loans (1 bank) and syndicated loans (many banks
jointly)
Direct business loans, market dominated by commercial
banks
Maturities typically 3–5 years
Often secured by specific assets, e.g., through “first lien”
(right to seize the asset)
Bonds/debentures:
Publicly traded issue of long-term debt
Requires longer process with registration, prospectus
etc.
Exception: Institutional bond issues (shortened issuance
process)
•Higher cost of issuance
•market dominated by institutional investors
•Often includes optional features, for example:
•Callable: Issuer has the right to redeem debt
before maturity.
•Convertible: Bondholder has the right to
exchange into equity at preset ratios.
•On-demand loans from a bank:
Line of Credit or Revolving Credit Facility: pay
commitment fee on the unused amount and interest on
the used amount, borrower can draw up to a maximum.
•Private debt:
private placement loans or bonds issued to institutional
investors only
Easier to renegotiate than public issues
Lower costs than public issues
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Supplier Company
(Retailer)
Inventory
Trade credit
+ A/R
Products
+ A/R + A/P
Customers
Invoice
A seller may extend trade credit to a buyer: payment some time after goods delivery.
Company in the middle (Dell Computers; small retailer)
• Buys inventory from suppliers
• Does not pay right away -> increases accounts payable
• Hold inventory -> binds capital
• Sells products to customers
• May not get paid right away -> increases accounts receivable
Excursion: Working Capital Management (WCM)
& Cash Conversion Cycle
Dell Computers has the power to force suppliers to offer
generous repayment terms; holds just-in-time inventory and
enforce fast repayment from its customers. Gets paid before
paying! => Excess cash!
Small retailer does not have the force or the credit to get good
terms from its suppliers, lacks inventory management, and gets
paid late by customers.
=> Cash deficit, requires additional financing
Dell
Computers
Small
Retailer
(1) # days for A/R to be paid 30 60
(2) # days inventory on hand 7 21
LESS (3): # days for A/P to be
paid
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Cash Conversion Cycle (CCC) =
(1)+(2)-(3)
-38 +67
Important insight:
Efficient WCM reduces capital needs. Some firms can “dictate” repayment terms
on both sides (suppliers, customers). => Competitive advantage!
Key question: How long between paying for inventory and getting paid by customers?
Seniority: Ranking in financial distress
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Common equity
Preferred equity
Senior unsecured debt
Junior/subordinated debt
Secured debt
“First lien” debt
Mortgages, bank loans
Debt secured by claims on specific assets
General claim on pool of assets
“First loss”, but also unlimited “residual cash flow”
Risk
Safe
Matching use and source of funds
“Matching principle” of capital raising:
Companies should match the cash flow profile and horizon
of the source of financing with the expected cash flow
profile and horizon of the investment/asset.
• Use short-term financing for short-term assets.
• Match long-term financing with the lifetime of long-lived
asset.
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Raising capital
• Identify
- Different types of capital resources within an organization
• Mobilise capital through various avenues of capital raising such
as
- Venture capital/private equity
- Initial Public Offering (IPO)
- Seasoned equity offering (SEO)
- Public vs. non public debt
- Trade Credit
Topics of Unit 6
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Course Reminders
• Next week is Flexibility Week! No lectures or tutorials!
• Unit 6 Asynchronous and Synchronous lecture – please complete
this by Friday 6 October 5pm (AEST)
• Interview Skills Part B due W8 Friday 20 October 4pm (AEDT)!
• You will receive your mark and feedback for ISA during Flexibility
Week. Please watch out for announcements.
Enjoy
Flexibility
Week!
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administration, please go to the Moodle
Forum.
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