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Obtaining Capital: Methods of Long-Term Financing
Venture Capital
Finance Textbooks Boundless Finance Obtaining Capital: Methods of Long-Term Financing Venture Capital
Finance Textbooks Boundless Finance Obtaining Capital: Methods of Long-Term Financing
Finance Textbooks Boundless Finance
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Finance
Concept Version 5
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IPOs

Initial public offerings are a primary and potentially lucrative means of exit from investment for venture capitalists.

Learning Objective

  • Describe the benefits and disadvantages of an IPO


Key Points

    • An initial public offering is the first time a company's stock is sold to the general public on a securities exchange, transforming the company from private to public. Though unpredictable and potentially costly, IPOs give benefits like increased access to financial markets and more capital.
    • Venture capitalists gain both financial returns and professional reputation from successful IPOs.
    • For venture-backed companies, their VC investors often expect the company to go public within a certain time frame so that they can sell or distribute their holdings of the company and exit the investment.
    • Venture capitalists protect their ability to sell shares by contracting for registration rights prior to agreeing on funding the company. Demand rights allow the investors to initiate an IPO, while piggyback rights allow investors to sell when the company initiates an IPO.
    • If the IPO market is weak, this threatens the venture capitalists' chances of a successful exit. The VC investors may instead select a different method of exit, or they can wait and hope for the market to improve.

Terms

  • Registration rights

    A contractual agreement specifying conditions for registering shares of stock with the SEC prior to selling them on a security exchange.

  • Initial public offering

    An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public.


Example

    • For a recent example of a weak IPO market, we can look to online companies like Facebook and Zynga. Facebook's IPO launch in May 2012 was highly anticipated but ended up under-performing, losing 47% of its original offering price as of August 2012. The online game developer Zynga's IPO similarly fell flat despite high expectations. Falling values can put pressure on the VC investors to sell before they can lose any more of their returns.

Full Text

An initial public offering (IPO), also known as a stock market launch, is the first time a private company's shares are sold to the general public on a securities exchange. Allowing the general public to take up equity stakes in the company transforms it from being privately traded to publicly traded. If the company was venture-backed, the VC firms often gain their returns from IPO yields. Usually, the VC exits investments within a short time (1-3 years, normally) after the IPO is concluded either by distributing the shares to VC fund investors or selling them off on the market. Going public can also have benefits for the company, including:

Apple Computers IPO Prospectus

The Initial Public Offering (IPO) Prospectus for Apple Computer Inc. in December 1980. A total of 5 million shares were offered to the public for $22 each. The total outstanding shares after the offering were 54,215,332. The company's officers, directors and major shareholders held 32 million shares and the rest were held by the company for stock options plans and other needs. Apple's valuation after the IPO was over $1 billion. (54 million shares at $22. )

  • Increasing exposure, prestige, and public image
  • Enlarging and diversifying equity base
  • Enabling cheaper access to capital, which is particularly important for high growth companies
  • Allowing owners of the company to cash in on their efforts in a very lucrative way (if the IPO is successful).
  • Attracting and retaining better management and employees through liquid equity participation

IPOs are not without cost to the company. Disadvantages to completing an initial public offering, include:

  • Legal, accounting and marketing costs associated with the process
  • Requirement to disclose financial and business information
  • Meaningful time, effort and attention required of senior management
  • Risk that required funding will not be raised
  • Public dissemination of information which may be useful to competitors, suppliers and customers.

Prior to agreeing to provide capital, venture capitalists contract for privileges including "registration rights", which ensure their ability to sell shares into the public capital markets, thereby safeguarding their future returns. Prior to selling shares on the stock exchange, companies must register these shares with the Securities and Exchange Commission. The registration rights agreement between the company and the venture capitalists requires the company to register the offering of shares by venture capitalists under certain conditions.

These conditions may be in the form of "demand rights" or "piggyback rights".

  • Demand rights require the company itself to prepare, file and maintain a registration statement on behalf of the investors' shares, so that investors can actually initiate a public offering and sell their shares.
  • Piggyback rights require that the VC investors' shareholdings are included in a company-initiated registration, so that the investors can sell their shares when the company initiates a public offering. The number of each type of demand or piggyback rights, the percentage of investors necessary to exercise these rights, allocation of expenses of registration, the minimum size of the offering, the scope of indemnification and the selection of underwriters and brokers are all areas of potential negotiation in the registration rights agreement.
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