RAISING EQUITY CAPITAL Types of Equity 1 Common or ordinary stock Shareholders have control rights Can elect directors and vote about certain corporate decisions Receive dividends 2 Preferred stock No voting rights Have priority over common stock in the distribution of dividends and assets In aggregate preferred makes up a very small proportion of companies financing Preferred Stock Debt or Equity Preferred stock gets a fixed payment like debt The payment is theoretically perpetual there is no final repayment date But company often buys back the preferred stock or it is converted to common stock Company can choose to not pay the preferred dividend But all cumulative dividends owed to preferred typically must be paid before company can pay any dividend to common stock In bankruptcy preferred stockholders paid after bondholders but before common stockholders Equity Financing for Private Companies The initial capital that is required to start a business is usually provided by the entrepreneur and his her immediate family internal equity A private company can seek external equity funding from several potential sources Angel Investors Venture Capital Firms Institutional Investors Corporate Investors Equity Financing for Private Companies Angel Investors Individual investors who buy equity in small private firms Usually minority investors with little direct control Venture Capital VC funds raise money from investors pension funds endowments wealthy individuals then invest that money in young companies Usually charge the investors 2 and 20 Often demand a great deal of control in the companies they invest in Examples Kleiner Perkins Draper Fisher Jurvetson Sequoia Capital Equity Financing for Private Companies Institutional Investors Pension funds insurance companies endowments and foundations May invest directly or indirectly by becoming limited partners in venture capital firms Corporate Investors Many established corporations purchase equity in younger private companies Emphasis is usually on achieving strategic objectives rather than necessarily maximizing investment returns Deciding whether to raise external equity Funding your firm with new equity capital be it from an angel or venture capitalist involves a tradeoff You must give up part of the ownership of the firm in return for the money the firm needs to grow The higher is the price you can negotiate per share the smaller is the percentage of your firm you have to give up for a given amount of capital Especially VCs often also bring connections and expertise i e more than just money An angel investor offers to invest 500 000 for a 25 stake in your company How much is your company currently worth Valuation Post money valuation Implied total value of the company after raising new equity Dollar amount of investment divided by the equity stake Pre money valuation Implied value of the company before the new money was raised Post money valuation less the newly raised cash Shark Tank example In Shark Tank the sharks usually refer to post money values but the entrepreneurs should really be thinking about pre money Example CordaRoy s asked for 200k investment for a 20 stake Post money value 1 million Typical Shark comment You think that your company is worth 1 million dollars No This valuation would mean that company is currently worth 800k pre money It s worth 1 million only after the shark has invested 200k in the business Lori Greiner offered 200k for a 58 stake in CordaRoy s Post money value 344k Pre money value 144k Which offer is better 200 000 for a 20 stake Post money 1M Pre money 800 000 600 000 for a 50 stake Post money valuation 1 2M Pre money 600 000 What s the value of the entrepreneur s stake in either case Considerations when structuring a VC deal Agreeing on the relevant numbers Management s incentives minimize principal agent problem VC wants to monitor serve on Board Funds dispersed in stages Stage Financing A start up will require a total investment of 5 million in order to grow into a viable firm VC fund decides to invest 1 million for 50 If this first stage 1 million is successful a second stage additional 4 million will be needed First Stage Market Value Balance Sheet mil Assets Liabilities and Equity Cash from new equity 1 0 New equity from venture capital 1 0 Other assets 1 0 Your original equity 1 0 Value 2 0 Value 2 0 Why use stage financing 1 2 3 Option to abandon if unprofitable Option to expand if profitable at second stage Management has incentive to work hard Stage Financing cont Suppose that the firm performance is promising after the first stage and the second stage is needed Before the second stage investment equity is worth 10 mil Entrepreneur holds of old equity 5 mil Second Stage Market Value Balance Sheet mil Assets Liabilities and Equity Cash from new equity 4 0 New equity from 2nd stage 4 0 Fixed assets 1 0 Equity from 1st stage 5 0 Other assets 9 0 Your original equity 5 0 Value 14 0 Value 14 0 After 2nd round of financing entrepreneur holds 5 14 and VCs holds 9 14 of equity Many most ventures never get to the second stage If second stage is successful then either there s a third stage or the company goes public IPO Choice of Securities Young firms typically issue preferred stock rather than common stock Convertible preferred stock is particularly common in Venture Capital deals Why VC can convert the preferred stock into common stock at a future date so the VC participates on the upside If the firm doesn t do well VC has higher priority claim than entrepreneur on the downside The option to convert makes the valuation of these securities trickier Can become even more complicated if there are convertible loans warrants and option based management incentive schemes Private Equity Private Equity funds usually buy established companies private or public with the hope of improving them If the company was public the transaction takes the company off the stock market Often engage in leveraged buyouts LBOs by doing these transactions using a lot of new debt Private equity firms are organized like venture capital firms PE firms raise money for a specific fund from investors and the fund invest in several companies Examples of PE firms Bain Capital Blackstone Kohlberg Kravis Roberts KKR Texas Pacific Group TPG Example of a Private Equity deal Leveraged buyout of Hertz Took place in September 2005 Second largest buyout by that date the largest was RJR Nabisco which is still the largest in inflation