Who - wealthy individuals, government and universitites, venture capital firms/funds

1.Project a horizon date at which the venture will be a stable, profitable firm. Forecase earnings and earnings growth as of that date.

2. Calculate the fair value of the firm at the horizon date, using a normal discount rate, market-to-book equity ratio or P/E ratio

3. Calculate the current value of the venture by discounting the horizon-date value using an appropriate risk-adjusted discount rate (30% to 70%)

4. Use the current value to partition the venture's shares among entreprenuers and investors 

Bootstrapping - Entreprenuers tap personal savings and borrowing capacit, and may also borrow from family/friends/business associates; customer advances, lending from vendors, etc.

Angel Financiers - Wealthy individuals who are very tolerant of risk; prefer to invest in small companies that have great growth potential, investing at earliest development stategs; tend to favor common stock or partnership interests; generally wish to liquidate their investment by selling their securities at a later stage of development

Limited Liability Corporation (LLC) - hybrid business having characteristics of both a corporation and a partnership

Advantages - limited liability; favorable tax treatment

1. VCs had to devise an effective organizational form - This was resolved with legislation creating the LLC, and an IRS rule that a LLC can be treated as a partnership for tax purposes.

2. VCs had to find a way to tap large institutional capital - Three congressional acts adopted in 1979 ("Prudent Man Rule") and 1980 ("Small Business Investment Incentive Act" and "Plan Assets Safe Harbor Regulation Act") provided VCs access to the large national pool of capital help by pension funds 

- Private partnershis that obtain funds by issuing equity shares on a quasi-private basis --> Most banks and finance companies are public corporations and obtain funds by issuing debt

- Specialize in financing very young, high-risk companies, most of which are not yet profitable --> Banks and finance companies generally finance stable, profitable firms

- Generally accept equity securities, rather than debt securities

- More involved in the management of a firm that they support 

- Less regulated 

VC - screen out ventures with poor prospects; asses and work with the managemens of selected ventures to maximize the probability of success; secure a sufficient share of the failures (diversify) by reducing risk

Entreprenuer - Face a tradeoff between obtaining adequate financing and accepting substantial dilution; A VC may want protection built into the securities they purchase; Entreprenuers are often frustrated by: the discipline that a VC imposes on them; the VC's periodic demands for information; the VC's influence on development

VC - Principle; Entrepreneurs - Agent

- If entreprenuers are allowed to have complete control they might: pursue unprofitable venture for passion or fame; purse low-risk, low-value path since they are likely to have a larger fraction of their limied personal wealth tied up in the venture; strong personal incentive to continue the venture even if the prospect is gloomy 

Monitoring is costly because it gives up development time by creating reports/review

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Overinvestment - The problem here is that the outsider provides funding for the next stage of development, but the entrepreneur makes the continuation/termination decision. Thus, the entreprenuer has an incentive to continue even if it is optimal to terminate 

Underinvestment - If an inside VC provides all funding, but receives only a fraction of the ventures future payoffs

Resolution - by having both inside and outside investors, the overinvestment and underinvestment problems are balanced out, and a rational continuation or termination decision would be made at each state of deveopment

- Pre-IPO shareholders can reap the benefits of diversification by selling at least a portion of their shares and using the proceeds to invest in other securites

- Diversification among public investors results in a lower cost of capital for the firm

- By issuing new shares in the IPO: the firm can retire debt to reduce leverage, which in turn reduces the risk of the entrepreneurs' private portfolios even if they do not sell their shares in the IPO; the firm's entreprenuers can dilute to voting power, and thus influence, of other pre-IPO shareholders

- After the firm's shares are seasoned in the listing market, the firm can: establish stock/stock option plans for executives/employees; more readily issue shares to finance an acquisition 

- Underpricing: IPOs appear to be substantially underpriced

- Issuance Costs: Typical underwriter spread = 7%; Time and resources spent on prep

- Loss of Control: New equityholders may press the firm to change its policies and/or to replace management

- Agency Costs: Separation of ownership and control leads to such costs

- Information Asymmetry: Disclosure requirements may compromise the firm's strategic position in its industry

- Performance Pressures: From investors, the business press, equity research analysts, and bond rating agencies

- Distracions: Management is often distracted by time-consuming investor-relations tasks, such as press releases, personal visits from or to major shareholders, etc. 

Both principal-agent and information asymmetry problems are likely to be very severe for IPO firms.

- Mitiages principal-agent problems by: structuring the deal; recommending financial structures

- Mitigates IA problems by: becoming well informed about the operations and prospects of the issuer; having expertise in, and a reputation for determining a fair price for the issue

Institutional investors are sensitive to past treatment from an underwriter

- NASDAQ/OTC - listing requirement for NYSE are more stringent

- listing choice for smaller firms is driven by direct issue costs

- Tech firms, firms backed by VCs, and firms that subsequently raise funds through follow-on equity offerings are more likely to list on the NASDAQ

- larger and less risky firms are more likely to list on the NYSE 

- Providing procedural and financial advice

- Assisting the firm in all legal procedures

- Securing a transfer agent

- Timing the offering (to the extent possible)

- Establishing a fair price for the shares

- Either purchasing the entire issue (for resale to the public) or brokering the sale of shares

- Providing aftermarket price support 

Step 1: The underwriter establishes a range of potential offer price, considering: the firm's organizational structures, pro forma projections, the firm's risk and potential profitability, the state of the market

Step 2: The underwriter identifies and contacts interested investors: Bids taken from each investor specify the number of shares at each of a range of prices; the underwriter then deveops a demand schedule for the issue by summing shares demanded at each price; finally, the underwriter determines the offering price as the intersection of supply and demand 

Firm Commitment - In the firm commitment method, the underwriter agrees to purchase all shares at a fixed price, and then takes the risk of reselling the shares to the public. Thus, the underwriter acts as a dealer and bears the risk

Best Efforts - In the best efforts method, the underwriter makes no guarantee about the price. Instead, the underwriter only agrees to conduct a search for interested buyers.  Thus, the underwriter acts as a broker and firm bears the risk. To mitigate risk, firm retains options to: withdraw the offering if either the offer price or share committed for sale is too low, expand the offering if the price is high

Over-allotment - In a firm commitment offering, the underwriter has an over-allotment ("greenshoe") option to sell additional sharte if it is profitable to do so; By exercising this option, the underwriter increases its profits on profitable IPOs, which offsets losses on other issues

Lockup Provision - Pre-IPO shareholders (especially insiders) agree to refrain from selling their shares for a period (typically 180 days) after the IPO date

- an important aspect of insiders' commitment to continuing ownership

- a bonding mechanism that resolves information asymmetry problems between the insiders and new investors

- downside - only a minority of the firm's shares freely float in the initial secondary market, limited liability 

- Evidence indicates that IPOs are "underpriced" at offering

- Litigation Risk: The underwriter sets the issue price knowing that it will be sued if there is evidence of overpricing.  So they underprice to minimize litigation risk

- Winner's Curse: Underpricing emerges to encourage participation by uninformed traders who would otherwise suffer the "winner's curse" in trading with the informed.  That is, uninformed investors realize that they tend to be more successful in obtaining shares of overpriced IPOs.

- Signaling Models: Higher-valued firms strategically underprice their stock to encourage information production by investors that will then be revealed in the secondary market prices

- Fair risk-return trade off: Perhaps IPOs are not un 

- If underpricing is related to the level of I, the the management can reduce it by committing to a definite stated use for the proceed

 

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Empirical evidence indicate that IPO stocks exhibit poor long-run performances

- The longer-run underperformances of IPO firms in not related to their IPO status, but to their status as small firms

- IPO stocks are not "underpriced" 

Debt - Not an ownership interest; creditors do not have voting rights; Interest is considered a cost of doing business and it tax deductible; creditors have legal recourse if interest or principal payments are missed; Excess debt can lead to financial distress and bankruptcy

Equity - ownership interest; common stockholders vote for the board of directors and other issues; Dividends are not a cost of doing business and are not tax deductible; Dividends are not a liability of the the firm and stockholders have no legal recourse if dividends are not paid; a firm with no liabilitgty can not go bankrupt

- the amount and timing of future coupon interest and principal

- the security and priority status of the issue

- the trustee hired to protect bondholder's interests 

- Preference in position over other lenders

- Bonds with high seniority are called senior bonds while those with low priority are called subordinate bonds

- Secured bonds are generally senior bonds 

- Conflicts of interest between a borrowing firm and its creditorss are exacerbated in the case of a public bond because the ownership of public bonds is generally diffuse

- The interest of bondholders is protected in part by a trustee (usually a bank), charged with monitoring the firm's compliance with terms, convenants, and provisions in the contract

- If the firm fails to make timely payments (usually allowing for a 30-day grace period), the trustee declares the firm to be in default 

Restrictive covenants may be included in a bond contract to restrict the borrowing firm's: use of the proceeds of the bond offering; future operations; future financing; ability to pay dividents

Issues:

- can be costly to write and enforce

- cannot protect lender against many unforseen circumstances

- may inefficiently limit borrowers' flexibility to do business

- tradeoff between protection and bond return 

- The Call Provision allows the firm to repurchase (i.e. retire or call) a bond prior to its scheduled maturity by paying a pre-specified call price

- A "call-protected" period is generally imposed during which time the bonds cannot be called

- The borrowing firm will call the bonds when the market price of the bond is higher than the call price

- The call provision has an advantage for the corporation since it reduces the risk of a fall in interest rate

- The market value of the callable bond will be less than a comparable non-callable bond

- In an efficient market the call provision should be correctly priced and firms should be indifferent to using callable versus non-callable bonds 

- The sinking fund provision requires the firm to retire a specified percentage of the bonds each year, following a specified deferment period.

- The sinking fund is an account managed by the bond trustee

- The trustee can purchase the bonds in the open market or all the bonds by lottery at their par value

- Opposing effects on bondholders: Sinking funds provide extra protection to bondholders; sinking funds may hurt bondholders by giving the firm an attractive option 

- provides bondholders the right to redeem their bonds at any time (after a deferment period), usually at par value

- makes bond more expensive  

Seven Steps:

1. The issuing firm selects an underwriter

2. The firm decides the amount of the offering

3. The firm decides on the terms, covenants, and provisions that will be included in the contract

4. The issue is registered with the SEC

5. The firm may seek to have the bond rated by one or more credit rating agencies such as Moody's of Standard and Poor's

6. The underwriter generates a tenative price for the issue

7. The issue is marketed and sold to public investors 

- Investment banks often form a temporary alliance, alled a underwriting syndicate to to underwrite a bond issue

- One serves as the lead underwriter, undertaking the bulk of required due diligence, and receives the lion's share of the syndicate's fees

- Other syndicate members mainly assist in marketing the issue

- The firm pays underwriters a fee expressed as a percentage of the proceeds, called the underwriter spread 

- The underwriter estimates the coupon rate required to render the bond's market price equal to par or face value

- The required coupon rate depends on issuer characteristics, contract terms, and market factors

- The most important market factor is the yield on a US Treasury bond with the same maturity

- On the issue date, the underwriter fixes the coupon rate on the new issue equal to the Treasury yield plus a yield premium required to render the market price of the bond equal to par value 

- Default risk is likelihood that a borrower will not make the promised payments

- Because of default risk, corporate bonds offer higher yields than government bonds; the difference is known as the defaultr risk premium or credit/yield spread 

- Rating agencies evaluate the default risk and assign credit ratings, charging a one-time fee for their services

- Agencies: Moody's, Standard  

Investment grade: BBB to AAA

Speculative grade: C,D to BB

- Very few firms in the U.S are financially sound enough to rated AAA. AAA rated firms are very rare (6/840 in the sample)

- Number of junk bonds increased in the 1990s 

 

Promised Yield: y = [(X/P)^(1/T)] - 1

Expected Return: r = [(E(X)/P)^(1/T)] - 1

Expected Payment: E(X) = pX + (1-p)X' 

- The conversion provision allows bondholders to exchange their bonds for shares of the focal firm's stock, at a specified conversion ratio (the number of shares received for each bond)

- Approximately, the convertible bond is a portfolio consisting of an otherwise equivalent nonconvertible bond plus a call option on the firm's stock 

- At the time a convertible bond is issued, the conversion option is typically out of the money. However, the option's time to expiration ins very long, so the option has substantial value

- Thus, if at issuance a convertible bond had a coupon rate that would render its market price equal to par value if it were not convertible, then with the conversion provision the bond's market price would be substantially in excess of its par value

- Instead, the coupon rate is set much lower so that, in combination with the (setting of) the exercise price, the bond's market price will be equal to its par value. Thus, convertibles' yield spread to Treasuries are generally negative 

- substantial possibility of default/bankruptcy in the near future

- Bankruptcy/financial distress is the result of bad business conditions and the use of debt financing

- Bankruptcy proceeding is just a legal way of dividing the firm's assets when the total pie available to security holders has shruken substantially

- Bankruptcy/financial distress costs pertain to the additional shrinkage of the pie due to the bankruptcy process or incentive conflicts 

- Stock-based insolvency: value of assets < value of non-equity liabilities

- Flow-based insolvency: current available cash < current obligations 

- Liquidity and financial distress: Firms maintian liquidity to avert bankruptcy. An economic slowdown strains firms' liquidity, causing them to cut back on expenditures, furthering slowing the economy

- Monetary policy: Fed would adopt a contractionary policy when the economy is overheated. Rates rise and banks constrain short-term loans; These events, combined with the eventual slow down of the economy itself, increase financial distress for all firms particulary firms that are financially relatively weak and/or highly levered

- From diversification to focus: conglomerates of the 1960s and 1970s were relatively inefficient, and yet were sustainable because they were the norm; when the change to corporate focus began, many inefficient conglomerates because distressed; transactions such as asset sales, equity carve-outs, and spin-offswere developed to convert ineffient conglomerates to more focused and efficient enterprises

Industry Level:

- Industry competition: 5 Forces --> entry/exit barriers, bargaining power of suppliers, bargaining power of buyers, threat of substitute products, competitive rivalry 

- Industry shocks: demand, costs, technology

- Industry deregulation: airline, communication

Firm Level:

- Flaws in ownership and/or governance structures

- Operating risk

- Leverage 

- First stage: negative net cash flow and earnings; falling market equity value

- Second stage: management attempts to reduce costs through employee layoffs, temporary plant closings 

- Third stage: late payments to suppliers, employees, and creditors; financial restructuring --> cut dividends, debt renegotiation; sale of assets; acquired by a more successful firm; change of management or governance 

- Legal, administrative, and accounting costs

- Costs of shutting down operations

- Disposing of assets

- Continued operating losses while legal processes unfold

- Time and resources spent on negotiation among climants 

- Loss of comptetitiveness: ex. forced sale of valuable assets to shore up liquidity

- Concessions to various stakeholders: To compensate them for the risk of doing business with a distressed firm

- Agency costs: underinvestment, risk-shifting

- Loss of tax benefits: From debt and depreciation

- Difficulty in raising external capital: High transaction costs, low liquidity 

Chapter 11 - the goal is to determine whether and how the firm can be reorganized, with respect to both operations and financial structure, and reemerge as a going concern

Chapter 7 - the court supervises the liquidation of the firm's assets and the distribution of proceeds to claimants after which the firm ceases to exist. Relatively rare 

- claimants with higher priority must be paid in full before other claimants receive anything

- many departures from rule

- departures may be effective in controlling the risk-shifting incentive 

- deliver the penalty for failure by forcing a wrapping up when a business cannot pay its obligations

- reduces the social costs of failure 

- Firm and creditors can renegotiate debt contracts to avoid bankruptcy filling

- Creditors shoudl be willing to renegotiate if it makes them at least as well off as in bankruptcy

- Formal bankruptcy allows firms to break some rules regarding issuing new debt

- There are some tax advantages to formal bankruptcy. Interest on unsecured debt stops accruing in formal bankruptcy

- Equityholders may be able to bargain for a better deal with creditors given the special rules in bankruptcy court

- sometimes there are so many creditor classes that it is impossible to get them to all agreee to a private workout disadvantage to a complex debt structure

- creditors may not trust information supplied by the firm regarding the firm's value assume that they are being ripped offf in proposed private workout