Raising Capital: Venture Capital, Public Issues, and Rights Offerings

Posted on Jan 23, 2025 in Economics and Finance

Raising Capital

Venture Capital

Venture Capital is private financing for relatively new businesses in exchange for stock. The ultimate goal is usually to take the company public, and the venture capitalist will benefit from the capital raised in the initial public offering (IPO).

Public Issue

A public issue is the creation and sale of securities that are intended to be traded on the public markets.

Steps in Issuing New Securities to the Public

  1. Management must obtain permission from the Board of Directors.
  2. The firm must prepare and distribute copies of a preliminary prospectus (red herring) to the Ontario Securities Commission (OSC) and to potential investors. A prospectus is a final legal document describing details of the issuing company and the proposed offering to potential investors. A preliminary prospectus, or red herring, contains some of the financial information contained in the final prospectus but does not contain the price at which shares will be offered.
  3. The OSC studies the preliminary prospectus and notifies the company of required changes.
  4. When the prospectus is approved, the price is determined, and security dealers can begin selling the new issue.

Two Kinds of Public Issues

  1. General Cash Offer: New securities offered for sale to the general public on a cash basis.
  2. Rights Offer: New securities are first offered to existing shareholders.

Services Provided by Underwriters

  • Formulate the method used to issue securities.
  • Price the securities.
  • Sell the securities.
  • Price stabilization.

A syndicate is a group of underwriters that market the securities and share the risk associated with selling the issue. The spread, or profit margin, is the difference between what the syndicate pays the company issuing shares and what the security sells for in the market.

Firm Commitment Underwriting

Also called a “bought deal”, the issuer company sells the entire issue to the underwriting syndicate. The syndicate then resells the issue to the public. The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold. The syndicate bears the risk of not being able to sell the entire issue for more than the cost. Bought deals are the prevalent form of equity issue.

Best Efforts Underwriting

The underwriter must make their “best effort” to sell the securities at an agreed-upon offering price. The company bears the risk of the issue not being sold. The offer may be pulled if there is not enough interest at the offer price. In this situation, the company does not get the capital, and they have still incurred substantial flotation costs.

Dutch Auction Underwriting

The underwriter conducts an auction, and investors bid for shares. The offer price is determined based on the submitted bids.

New Equity Issues and Price

Stock prices tend to decline when new equity is issued because of:

  • Signaling and managerial information: Managers may choose to sell new shares of stock when they believe the current stock price is high (they can issue fewer shares at a higher price).
  • Signaling and debt usage: Issuing equity may send a signal that management believes the company currently has too much debt.

Issuing securities is very expensive, and the decrease in price may be partial compensation for the cost of the issue.

Rights Offerings

A rights offering is an issue of common stock first offered to existing shareholders. It allows current shareholders to avoid the dilution (loss of value) that can occur with a new stock issue. “Rights” are given to the shareholders, specifying the number of shares that can be purchased, the purchase price, and the time frame. The rights price is less than the market price.

Rights Offering Example

Suppose a company wants to raise $10 million. The subscription price is $20, and the current stock price is $25. The firm currently has 5,000,000 shares outstanding.

  1. How many shares have to be issued?
  2. How many rights will it take to purchase one share?
  3. What is the value of a right?

Ex-rights: The price of the stock will drop by the value of the right on the day that the stock no longer carries the “right”.

Standby underwriting: The underwriter agrees to buy any shares that are not purchased through the rights offering.