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Bank & Other Loans
Bonds & Commercial paper
80%




60%




40%




20%




0%
United States Japan Germany




Source: Hackethal and Schmidt (1999)
There is also some evidence that firms in some emerging markets, such as Brazil
and India, use equity (internal and equity) much more than debt to finance their
operations. Some of this dependence can be attributed to government regulation that
discourages the use of debt, either directly by requiring the debt ratios of firms to be
below specified limits or indirectly by limiting the deductibility of interest expenses for
tax purposes. One of the explanations for the greater dependence of U.S. corporations on
debt issues relies on where they are in their growth life cycle. Firms in the United States,
in contrast to firms in emerging markets, are much more likely to be in the mature growth
stage of the life cycle. Consequently, firms in the US should be less dependent upon
external equity. Another factor is that firms in the United States have far more access to
corporate bond markets than do firms in other markets. Firms in Europe, for instance,
often have to raise new debt from banks, rather than bond markets. This may constrain
them in the use of new debt.


7.8. ˜: Corporate Bond Markets and the use of debt




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Companies in Europe and emerging markets have historically depended upon bank debt
to borrow and have had limited access to corporate bond markets. In recent years, their
access to corporate bond markets, both domestically and internationally, has increased.
As a result, which of the following would you expect to happen to debt ratios in these
countries?
a. Debt ratios should go up
b. Debt ratios should go down
c. Debt ratios should not change much




finUS.xls: There is a dataset on the web that has aggregate internal and external
financing, for US firms, from 1975 to 1998.



The Process of Raising Capital
Looking back at figure 7.2, we note four financing transitions, where the source of
funding for a firm is changed by the introduction of a new financing choice. The first
occurs when a private firm approaches a private equity investor or venture capitalist for
new financing. The second occurs when a private firm decides to offer its equity to
financial markets and become a publicly traded firm. The third takes place when a
publicly traded firm decides to revisit equity markets to raise more equity. The fourth
occurs when a publicly traded firms decides to raise debt from financial markets by
issuing bonds. In this section, we examine the process of making each of these
transitions. Since the processes for making seasoned equity and bond issues are very
similar, we will consider them together.

Private Firm Expansion: Raising Funds from Private Equity

Private firms that need more equity capital than can be provided by their owners
can approach venture capitalists and private equity investors. Venture capital can prove
useful at different stages of a private firm™s existence. Seed-money venture capital, for
instance, is provided to start-up firms that want to test a concept or develop a new


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product, while start-up venture capital allows firms that have established products and
concepts to develop and market them. Additional rounds of venture capital allow private
firms that have more established products and markets to expand. There are five steps
associated with how venture capital gets to be provided to firms, and how venture
capitalists ultimately profit from these investments.
1. Provoke equity investor™s interest: The first step that a private firm wanting to raise
private equity has to take is to get private equity investors interested in investing in it.
There are a number of factors that help the private firm, at this stage. One is the type
of business that the private firm is in, and how attractive this business is to private
equity investors. The second factor is the track record of the top manager or managers
of the firm. Top managers, who have a track record of converting private businesses
into publicly traded firms, have an easier time raising private equity capital.
2. Valuation and Return Assessment: Once private equity investors become interested in
investing in a firm, the value of the private firm has to be assessed by looking at both
its current and expected prospects. This is usually done using the venture capital
method, where the earnings of the private firm are forecast in a future year, when the
company can be expected to go public. These earnings, in conjunction with a price-
earnings multiple, estimated by looking at publicly traded firms in the same business,
is used to assess the value of the firm at the time of the initial public offering; this is
called the exit or terminal value.
For instance, assume that Bookscape is expected to have an initial public offering
in 3 years, and that the net income in three years for the firm is expected to be $ 4
million. If the price-earnings ratio of publicly traded retail firms is 25, this would
yield an estimated exit value of $ 100 million. This value is discounted back to the
present at what venture capitalists call a target rate of return, which measures what
venture capitalists believe is a justifiable return, given the risk that they are exposed
to. This target rate of return is usually set at a much higher level6 than the traditional
cost of equity for the firm.
Discounted Terminal Value = Estimated exit value /(1+ Target return)n



6 By 1999, for instance, the target rate of return for private equity investors was in excess of 30%.

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Using the Bookscape example again, if the venture capitalist requires a target return
on 30% on his or her investment, the discounted terminal value for Bookscape would
be
Discounted Terminal value for Bookscape = $ 100 million/1.303 = $ 45.52 million
3. Structuring the Deal: In structuring the deal to bring private equity into the firm, the
private equity investor and the firm have to negotiate two factors. First, the private
equity investor has to determine what proportion of the value of the firm he or she
will demand, in return for the private equity investment. The owners of the firm, on
the other hand, have to determine how much of the firm they are willing to give up in
return for the same capital. In these assessments, the amount of new capital being
brought into the firm has to be measured against the estimated firm value. In the
Bookscape example, assuming that the venture capitalist is considering investing $ 12
million, he or she would want to own at least 26.36% of the firm.7
Ownership proportion = Capital provided/ Estimated Value
= $ 12/ $ 45.52 = 26.36%
Second, the private equity investor will impose constraints on the managers of the
firm in which the investment is being made. This is to ensure that the private equity
investors are protected and that they have a say in how the firm is run.
4. Post-deal Management: Once the private equity investment has been made in a firm,
the private equity investor will often take an active role in the management of the
firm. Private equity investors and venture capitalists bring not only a wealth of
management experience to the process, but also contacts that can be used to raise
more capital and get fresh business for the firm.
5. Exit: Private equity investors and venture capitalists invest in private businesses
because they are interested in earning a high return on these investments. How will
these returns be manifested? There are three ways in which a private equity investor
can profit from an investment in a business. The first and usually the most lucrative
alternative is an initial public offering made by the private firm. While venture


7 Many private equity investors draw a distinction between pre-money valuation, or the value of the
company without the cash inflow from the private equity investor, and post-money valuation, which is the



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capitalists do not usually liquidate their investments at the time of the initial public
offering, they can sell at least a portion of their holdings once they are traded8. The
second alternative is to sell the private business to another firm; the acquiring firm
might have strategic or financial reasons for the acquisition. The third alternative is to
withdraw cash flows from the firm and liquidate the firm over time. This strategy
would not be appropriate for a high growth firm, but it may make sense if investments
made by the firm no longer earn excess returns.

From Private to Publicly Traded Firm: The Initial Public Offering

A private firm is restricted in its access to external financing, both for debt and
equity. In our earlier discussion of equity choices, we pointed out the hard bargain
venture capitalists extract for investing equity in a private business. As firms become
larger and their capital needs increase, some of them decide to become publicly traded
and to raise capital by issuing shares of their equity to financial markets.

Staying Private versus Going Public

When a private firm becomes publicly traded, the primary benefit is increased
access to financial markets and to capital for projects. This access to new capital is a
significant gain for high growth businesses, with large and lucrative investment
opportunities. A secondary benefit is that the owners of the private firm are able to cash
in on their success by attaching a market value to their holdings. These benefits have to
be weighed against the potential costs of being publicly traded. The most significant of
these costs is the loss of control that may ensue from being a publicly traded firm. As
firms get larger and the owners are tempted to sell some of their holdings over time, the
owner™s share of the outstanding shares will generally decline. If the stockholders in the
firm come to believe that the owner™s association with the firm is hurting rather than
helping it, they may decide to put pressure for the owner™s removal. Other costs
associated with being a publicly traded firm are the information disclosure requirements


value of the company with the cash influx from the private equity investors. They argue that their
ownership of the firm should be based upon the former (lower) value.
8 Black and Gilson (1998) argue that one of the reasons why venture capital is much more active in the
U.S. than in Japan or Germany is because the option to go public is much more easily exercised in the U.S.

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and the legal requirements9. A private firm experiencing challenging market conditions
(declining sales, higher costs) may be able to hide its problems from competitors,
whereas a publicly traded firm has no choice but to reveal the information. Yet another
cost is that the firm has to spend a significant portion of its time on investor relations, a
process in which equity research analysts following the firm are cultivated10 and provided
with information about the firm™s prospects.
Overall, the net tradeoff to going public will generally be positive for firms with
large growth opportunities and funding needs. It will be smaller for firms that have
smaller growth opportunities, substantial internal cash flows, and owners who value the
complete control they have over the firm.

Steps in an initial public offering

Assuming that the benefits outweigh the costs, there are five steps involved in an
initial public offering.
Step 1: Choose an investment banker based upon reputation and marketing skills. In most
initial public offerings, this investment banker underwrites the issue and guarantees a
specified price for the stock. This investment banker then puts together a group of several
banks (called a syndicate) to spread the risk of the offering and to increase marketing
reach.
Step 2: Assess the value of the company and set issue details: This valuation is generally
done by the lead investment bank, with substantial information provided by the issuing
firm. The value is sometimes estimated using discounted cash flow models. More often,
though, the value is estimated by using a multiple, like a price earnings ratio, and by
looking at the pricing of comparable firms that are already publicly traded. Whichever
approach is used, the absence of substantial historical information, in conjunction with
the fact that these are small companies with high growth prospects, makes the estimation
of value an uncertain one at best. Once the value for the company has been estimated, the


9 The costs are two fold. One is the cost of producing and publicising the information itself. The other is the
loss of control over how much and when to reveal information about the firm to others.
10 This may sound like an odd term, but it is accurate. Buy recommendations from equity research analysts
following the firm provoke investor interest and can have a significant impact on the stock price; sell



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value per share is obtained by dividing by the number of shares, which is determined by
the price range the issuer would like to have on the issue. If the equity in the firm is
valued at $ 50 million, for example, the number of shares would be set at 5 million to get
a target price range of $10, or at 1 million shares to get a target price range of $ 50 per
share. The final step in this process is to set the offering price per share. Most investment
banks set the offering price below the estimated value per share for two reasons. First, it
reduces the bank™s risk exposure. If the offering price is set too high and the investment
bank is unable to sell all of the shares being offered, it has to use its own funds to buy the
shares at the offering price. Second, investors and investment banks view it as a good
sign if the stock increases in price in the immediate aftermath of the issue. For the clients
of the investment banker who get the shares at the offering price, there is an immediate
payoff; for the issuing company, the ground has been prepared for future issues.
Step 3: Gauge investor demand at the offering price: In setting the offering price,
investment bankers have the advantage of first checking investor demand. This process,
which is called building the book, involves polling institutional investors prior to pricing
an offering, to gauge the extent of the demand for an issue. It is also at this stage in the
process that the investment banker and issuing firm will present information to
prospective investors in a series of presentations called road shows. In this process, if the
demand seems very strong, the offering price will be increased; in contrast, if the demand
seems weak, the offering price will be lowered. In some cases, a firm will withdraw11 an
initial public offering at this stage, if investors are not enthusiastic about it.
Step 4: Meet SEC filing requirements and issue a prospectus: In order to make a public

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