Lesson 7_ How Firms Raise Capital

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Western University *

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1023B

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Finance

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Jan 9, 2024

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Chapter 10: Explain what is meant by bootstrapping when raising seed financing and why bootstrapping is important. Describe the role of venture capitalists in the economy and discuss how they reduce their risk when investing in start ‐ up businesses. Discuss the advantages and disadvantages of going public and compute the net proceeds from an IPO. Explain why, when underwriting new security o±erings, investment bankers prefer that the securities be underpriced. Compute the total cost of an IPO. Discuss the costs of bringing a general cash o±er to market. Explain why a firm that has access to the public markets might elect to raise money through a private placement. And be able to review some advantages of borrowing from a commercial bank rather than selling securities in financial markets and discuss bank term loans. Chapter 11: Explain what a dividend is, and describe the di±erent types of dividends and the dividend payment process. Calculate the expected change in a stock's price around an ex ‐ dividend date. Explain what a stock repurchase is and how companies repurchase their stock. Calculate how taxes a±ect the after ‐ tax proceeds that a stockholder receives from a dividend and from a stock repurchase. Discuss the benefits and costs associated with dividend payments and compare the relative advantages and disadvantages of dividends and stock repurchases. Define stock dividends and stock splits and explain how they di±er from other types of dividends and from stock repurchases. Describe factors that managers consider when setting the dividend payouts for their firms. How Firms Raise Capital IPO: initial public offering (company) ● Companies can raise money by themselves, by merging with another firm, or by going public with their shares How New Businesses Get Started ● Usually started by an entrepreneur, not as a large corporation ● The process by which many entrepreneurs raise "seed" money and obtain other resources necessary to start their businesses is bootstrapping , which basically means to accomplish something on your own

● Initial seed money usually comes from the entrepreneur or other founders o During the starting stage of development for a business, venture capitalists or banks are not normally willing to fund the business o The deliverables at this stage are whatever it takes to satisfy investors that the new business concept can become a viable business and deserves their financial support o This stage usually lasts 1 to 2 years Venture Capital ● Venture capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing ● Angel investors: individual venture capitalists who are wealthy individuals who invest their own money in emerging businesses at the very early stages ● Individual venture capitalists or angel investors, are typically wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals ● Primary sources of funds for venture capital firms include financial and insurance firms, private and public pension funds, wealthy individuals and families, corporate investments not associated with employee pensions, and endowments and foundations ● Many venture capitalist firms manage more than one fund at a given time ● Investment activity decreased during 2007-2008, but increased again during 2009 ● 3 reasons as to why traditional sources of funding do not work for new or emerging businesses: 1. The high degree of risk : most suppliers of capital, such as banks, pension funds, and insurance companies are averse to undertaking high-risk investments, and much of their risk-averse behaviour is mandated in regulations that restrict their conduct 2. Types of productive assets - no assets to weigh risk over, most assets are not tangible, it’s easier to secure loans when tangible assets are present, so new firms whose primary assets are intangibles, like patents or trade secrets, often find it difficult to secure financing from traditional lending sources 3. Informational asymmetry problems - banks don't know about your idea as much as you, and when dealing with highly specialized technologies or companies emerging in new business areas, most investors do not have the expertise to distinguish between good and bad entrepreneurs, so they are more reluctant to invest in their firms ● The venture capitalists' investments give them an equity interest in the company ● Often in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalist ● The extent of the venture capitalists' involvement depends on the experience of the management team ● One of their most important roles it to provide advice ● Use their knowledge about industry and general knowledge to help business figure out how to succeed, provide counsel for entrepreneurs when a business is being started and during early stages of operation ● Modern venture capitalist firms tend to specialize in a specific line of business, such as clean energy, business software, hospitality, etc. ● One of the roles of a VC is to provide advice to entrepreneurs o When businesses start, the people managing it are usually good with technical skills but not as good on the skills necessary to successfully manage growth, which VCs can help advise on ● VCs may want a seat on the board of directors, and will at least want an agreement that gives them unrestricted access to info about the firm's operations and financial performance, and the right to attend and observe and board meeting

o They also want the authority to assume control over the firm if the firm's performance is poor, as well as the authority to install a new management team if necessary The Venture Capital Funding Cycle ● Bootstrap financing: entrepreneur supplies funds, prepares business plan, and searches for initial outside funding ● Seed-stage financing: venture capitalists provide funds to finish development of the concept ● Early-stage financing: VCs provide funds to finish development of the concept ● Latter-stage financing (mezzanine financing): typically includes 1-5 additional stages ● Venture capitalists then exit by selling to a strategic buyer, selling to a financial buyer, or selling stock to the public Value proposition: why consumers find your business/product attractive How Venture Capitalists Reduce their Risk ● VC's know that only a handful of new companies will survive to become successful firms ● Tactics to reduce risk o Funding the ventures in stages : not giving all of the money at once, e.g. $1 Million for 8 months, then more later if you show you are using the money properly ▪ If the performance does not meet expectations, the VCs can bail out and cut their losses, but if they still have confidence in the business, they can help management make some midcourse corrections so that the project can proceed ▪ The VCs' investments give them an equity interest in the company, which is typically in the form of preferred stock that is convertible into common stock at the discretion of the VC, which ensures that VCs have the most senior claim among the stockholders if the firm fails o Requiring entrepreneurs to make personal investments: proves commitment and confidence in business ▪ VCs want your financial rewards to come from building a successful business, not from your salary o Syndicating investments: sharing the risk with other venture capitalists o Maintaining in-depth knowledge about the industry: specializing in and understanding a business field gives the VC an advantage over other lenders who may be generalists ● Syndication o When a group of venture capitalists get together o Reduces risk in 2 ways: o Increases the diversification of the originating venture capitalist's investment portfolio, since other VCs now own a portion of the deal and the originating VC has less money invested o The willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision The Exit Strategy ● Venture capitalists are not long-term investors in the companies, but usually exit over a period of 3 to 7 years ● Every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process, including: o Timing (when to exit)

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o The method of exit o What price is acceptable ● 3 principles ways in which VC firms exit-venture backed companies: o Sell to a strategic buyer in the private market ▪ Somebody who buys the company because it helps them (e.g. Facebook buying a new tech. company to further their brand) ▪ Strategic buyer is looking to create value through synergies between the acquisition and the firm's existing productive assets o Sell to financial buyer in the private market ▪ Buy it to gain financial value, not cause they are concerned with bettering themselves through the concept ▪ This occurs when a financial group, like a private equity firm, buys the new firm with the intention of holding it for a period of time, usually 3-5 years, and then selling it for a higher price (leveraged buyout) ▪ Differs from strategic buyout because a financial buyer does not expect to gain from operating or marketing synergies ● In a financial sale, the firm operates independently, and the buyer focuses on creating value by improving operations as much as possible o Initial Public Offering: selling common stock in an initial public (IPO) ▪ To obtain the highest price possible in the IPO, a VC will not sell all of the shares he or she holds at the time of the IPO, selling everything would send a bad signal to investors ▪ The majority of VCs exit through strategic and financial sales, rather than public sales (IPOs) The Cost of Venture Capital Funding ● High cost, but also high potential rates of return ● For every 10 businesses backed by VCs, only 1 or 2 prove successful ● If a venture capital-financed new business is successful, the venture capitalists like have made a substantial contribution to creating value for the other owners ● It is estimated that a typical VC fund will generate annual returns of 15-25% on the money that it invests, compared with an average annual return of 11.82% for the S&P 500 (this is the American stock market index based on the market capitalizations of 500 large companies that have stocks listed on NYSE, NASDAQ, or the Cboe BZX Exchange IPO ● One way to raise larger sums of cash or to facilitate the exit of a venture capitalist is through an IPO, or the company's common stock ● First-time stock issues are given a special name because the marketing and pricing of these issues are distinctly different from those of seasoned offerings, MADE TO APPEAL TO INVESTORS AS THE COMPANY ENTERS THE MARKET FOR THE FIRST TIME ● Advantages of going public o You can raise much more equity capital than through private sources o Once an IPO has been completed, additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost ▪ This is because the public markets are highly liquid and investors are willing to pay higher prices for more liquid shares of public firms than for the relatively illiquid shares of private firms o Can enable an entrepreneur to fund a growing business without giving up control o After the IPO, there is an active secondary market in which stockholders can buy and sell its shares

o Publicly traded firms find it easier to attract top management talent and to better motivate current managers if a firm's stock is publicly traded o For publicly traded companies, it is easy to offer incentives tied to stock performance because market info about the value of a share of stock is readily available ● Disadvantages o High cost of the IPO itself, due to the fact that the stock is not seasoned yet, meaning it does not have an established record ▪ Out-of-pocket costs like legal fees and accounting expenses can be expensive o The cost of complying with ongoing SEC disclosure requirements ▪ Regulatory costs can be significant for small firms o The transparency that results from this compliance can be costly for some firms ▪ If firms have to publicly provide all info about the company, it might take away their competitive advantage against companies that choose to remain private o Some investors argue that the SEC's requirement of quarterly earnings estimates and quarterly financial statements encourages manager to focus on short-term profits rather than long-term value maximization ● Shares are sold on stock market a couple days after IPO day ● Seasoned public offering: a sale of securities (either sock or bonds) by a firm that already has similar publicly traded securities outstanding o Public offering means that the securities being sold are registered with the Securities and Exchange Commission and can be legally sold to the public at large o Only registered securities can be sold to the public Investment-Banking Services ● To complete an IPO, a firm will need the services of investment bankers, who are experts in brining new securities to the market ● Investment bankers provide 3 basic services when bringing securities to market o Origination o Underwriting o Distribution Origination ● Includes giving the firm financial advice and getting the issue ready to sell ● The investment banker helps the firm determine whether it is ready for an IPO o Based on the management team, historical financial performance, and the firm's expected future performance ● Once the decision to sell stock is made, the firm's management must obtain a number of approvals o Firm's BOD must approve all security sales, and stockholder approval is required if the number of shares of stock is to be increased ● File a registration statement with the Securities Exchange Commission o Includes the preliminary prospectus , which is the initial registration statement filed with the SEC by a company preparing to issue securities in the public market, and contains detailed info about the issuer and the proposed issue o Legally, no sales can be made from this document o Designed to allow investors to make intelligent decisions about investing in a security issue and the risks associated with it ● Must also decide how much money the firm needs to hold and how many shares must be sold Underwriting

● The risk-bearing part of investment banking ● The securities can be underwritten in 2 ways o On a firm-commitment basis: the IB negotiates a deal with you and says they will buy your shares at a price they agree upon, and they will then go and try to sell them in the market on IPO day ▪ The IB actually buys the stock from the firm at a fixed price and then resells it to the public ▪ The underwriter bears the risk that the resale price might be lower than the price the underwriter pays, which is called price risk ▪ The IB's compensation is called the underwriter's spread ● In a firm-commitment offering, this is the difference between the IB's purchase and the offer price o On a best-efforts basis: when the IB doesn’t guarantee a price or how many shares sell, but will try to sell as many shares as possible and try to get the highest price they possibly can, but they will take a commission (a piece of the sales) ▪ The IB does not bear the price risk associated with underwriting the issue, and compensation is based on the number of shares sold ● Most corporations issuing stock prefer firm-commitment arrangements to best-effort contracts, more than 95% are firm-commitment arrangements o Best-effort offerings arise when underwriters do not want to accept the risk of guaranteeing the offering price ● Underwriting Syndicates o To share the underwriting risk and to sell a new security issue more efficiently, underwriters may combine to form a group called an underwriting syndicate o Participating in the syndicate entitles each underwriter to receive a portion of the underwriting fee as well as an allocation of the securities to sell its own customers o To broaden the search for potential investors, underwriting syndicates may enlist other IB firms in a syndicate known as a selling group , which assists in the sale of the securities ▪ These firms receive commission for each security they sell and bear none of the risk of underwriting the issue ● Determining the Offer Price o One of the investment banker's most difficult tasks is to determine the highest price at which the bankers will be able to quickly sell all of the shares being offered and that will result in a stable secondary market for the shares o Must consider the firm's expected future cash flows, as well as the stock price implied by multiples of total firm value to EBITDA or stock price to earnings per share for similar firms that are already public o Finally, the IB conducts a road show where management makes presentations about the firm and its prospects to potential investors, which helps the IB determine the number of shares that investors are likely to purchase at different prices ● Due Diligence Meeting o Before the shares are sold, reps from the underwriting syndicate hold a due-diligence meeting with reps of the issuer o IBs hold due-diligence meetings to protect their reps and to reduce the risk of investors' lawsuits in the event the investment goes sour later on o These meetings ensure that all material issues about the firm and the offering are discovered and fully disclosed to investors Distribution

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● Once the due-diligence process is complete, the underwriters and the issuer determine the final offer price in a pricing call ● The pricing call typically takes place after the market has closed for the day ● By either accepting or rejecting the investment banker's recommendation, management ultimately makes the pricing decision ● If management finds the price acceptable, the issuer files and amendment to the registration statement with the SEC, which contains the terms of the offering and the final prospectus o Once the securities are registered with the SEC, they can be sold to investors The First Day of Trading ● Syndicate's primary concern is to sell the securities as quickly as possible at the offer price ● Speed of sale is important because the offer price reflects market conditions at the end of the previous day and these conditions can change quickly ● If the securities are not sold within a few days, the underwriting syndicate disbands, and members sell the securities at whatever price they can get The Closing ● At the closing of a firm-commitment offering, the issuing firm delivers the security certificates to the underwriter and the underwriter delivers the payment for the securities, net of the underwriting fee, to the issuer ● Closing usually takes place on the third business day after trading has started The Proceeds ● 3 questions to consider when deciding what happens with the proceeds 1. What are the total expected proceeds from the common-stock sale? 2. How much money does the issuer expect to get from the offering 3. What is the IB's expected compensation from the offering, based on the underwriter's spread IPO Pricing and Cost ● Underpricing: offering new securities for sale at a price below their true value o The lower the offering price, the more likely the securities will sell out quickly and the less likely the underwriters will end up with unsold inventory o IB's say that underpricing helps attract long-term institutional investors who help provide stability for the stock price once the secondary market for the shares is established ● If the stock is priced too high, the entire issue will not sell at the proposed offer price ● In a firm-commitment offering, the underwriters will suffer a financial loss if the offer price is set too high ● In a best-effort agreement, the issuing firm will raise less money than expected ● If the stock is priced too low, the firm's existing stockholders will experience an opportunity loss and make less money o The IB firm will also suffer a loss of reputation for failing to price the new issue correctly and raising less money for its client than it could have if the price is too low ● Data shows that the shares hold in an IPO are typically priced between 10-15% below the price at which they close at the end of the day of the first day of trading o This implies that underwriters tend to sell shares of stock in IPOs to investors for between 90-85% of their true market value o Average underpricing during the 2001-2013 years was 10.6%, and the weighted average first-day return from 1997-2013 was 11.6%, excluding 1999-2000

● 3 basic costs are associated with issuing stock in an IPO o Underwriting spread: is the difference between the proceeds the issuer receives and the total amount raised in the offering o Out-of-pocket expenses: include other investment banking fees, legal fees, accounting expenses, printing costs, travel expenses, SEC filing fees, consultant fees, and taxes ▪ All of these expenses are reported in the prospectus o Underpricing: typically defined as the difference between the offering price and the closing price at the end of the first day at the IPO ▪ The opportunity loss that the issuer's stockholders incur from selling the security below its true market value ▪ Underpricing of IPOs is more pronounced for larger issues, but there are significant economies of scale in direct costs Private Markets ● Because many smaller firms and firms of lower credit standing have limited access, (or no access) to the public markets, the cheapest source of external funding is often the private markets ● When market conditions are unstable, some smaller firms that were previously able to sell securities in the public markets no longer can ● Bootstrapping and VC financing are part of the private market as well ● Many private companies that are owned by entrepreneurs, familiars, or family foundations, and are sizable companies of high credit quality, prefer to sell their securities in the private markets even though they can access public markets ● Private Placements o Occur when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals o Private lenders are more willing to negotiate changes to a bond contract o If a firm suffers financial distress, the problems are more likely to be resolved without going to a bankruptcy court o Other advantages include the speed of private placement deals and flexibility in issue size o The biggest drawback of private placements involves restrictions on the resale of the securities Private Equity Firms ● Like VCs, private equity firms pool money form wealthy investors, pension funds, insurance companies, and other sources to make investments ● Private equity firms invest in more mature companies, and they often purchase 100% of a business ● The managers of these firms look to increase the value of the firms they acquire by closely monitoring their performance and providing better management ● Once value is increased, they sell the firms for a profit ● Profit equity firms generally hold investments for 3 to 5 years General Cash Offer By a Public Company ● If a public firm has a high credit rating, the lowest-cost source of external funds is often a general cash offer , which is a sale of debt or equity, open to all investors, by a registered public company that has previously sold stock to the public GENERAL CASH OFFER IS A SALE OF DEBT OR EQUITY, OPEN TO ALL INVESTORS, BY A REGISTERED COMPANY THAT HAS PREVIOUSLY SOLD STOCK TO THE PUBLIC

● Procedures involved in a general cash offer: 1. Type of security and amount to be raised is determined (e.g. debt, common stock, preferred stock) 2. Approval is obtained from the BOD to issue securities. If the size of a stock issue exceed the previously authorized number of shares of common or preferred stock, approval from stockholders is required as well 3. The issuer files a registration statement and satisfies all of the securities laws enforced by the SEC. For a debt issue, the registration statement must contain a bond indenture which specifies the details of the issue 4. After assessing demand, the underwriter and the issuer agree on an offer price 5. Closing: at the closing of a firm-commitment offering, the issue delivers the securities to the underwriter, and the underwriter pays for them, net of its fees. The securities are then sold to individual investors ● The issuer has flexibility in the method of sale and the way the securities are registered, and both of these factors can affect the issuer's funding cost ● Total cost on a general cash offer only includes underwriting spread and out-of-pocket expenses (does not include data on underpricing), GENERAL CASH OFFER COST DOES NOT INCLUDE DATA ON UNDERPRICING o Issuing common stock is the most costly alternative and issuing corporate bonds (nonconvertible) is the least costly o Higher costs for equity issues reflect greater underwriting risk, higher sales commissions for those involved in selling the issue, and the higher administrative expenses required to bring equity securities to market ● The cost of an IPO is significantly higher than the cost of a general cash offer of equity, even when the cost of underpricing for the IPO is not included in the total o There is usually greater risk involved in underwriting an IPO and a higher cost of distributing the shares in an IPO Competitive vs. Negotiated Sale ● Competitive sale: when the issuer specifies the type and number of securities it wants to sell and hires an IB firm to do the origination work o Once the origination work is completed, the issuer invites underwriters to bid competitively to buy the issue, and the IB firm that pays the highest price for the securities wins the bid o Winning underwriter then pays for the securities and makes them available to individual investors at the offer price ● Negotiated sale: the issuer selects the underwriter at the beginning of the origination process o At that time, the scope of the work is defined, and the issuer negotiates the origination and underwriter's fees to be charged o The issuer and underwriter then work together to design the issue and determine the most favourable time to take the securities to market o Following an assessment of demand, the offer price is set and the underwriter pays the issuer for the securities and sells them to individual investors ● For competitive bidding, the greater the number of bidders, the greater the competition for the security issue, and the lower the cost to the issuer o Negotiated sales lack competition and therefore should be the more costly method of sale o Proponents of negotiated sales argue that through this method, the IB works closely with the issuer and thus has intimate knowledge of the firm and its problems,

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meaning the IB can reduce uncertainty surrounding the issue and tell the firm's story to potential investors, resulting in a lower issue cost ▪ The potential competitors are actually the other IB's that were not chosen to underwrite the current issue but would like to underwrite the firm's next issue, so the threat of potential competition provides similar benefits to direct competition ● For debt issue, most experts believe that competitive sales are the least costly method of selling so-called vanilla bonds (bonds with not unusual features) when market conditions are stable o These securities are like commodities because market participants understand the risks of investing in them and are comfortable buying them ● In contrast, when there are complex circumstances to explain or when market conditions are unstable, negotiated sales provide the least costly method of sale for debt issues o A negotiated sale allows the underwriter to better manage uncertainty and explain the firm's situation, resulting in the lowest funding cost ● For equity securities and issues, negotiated sales generally provide the lowest-cost method of sale Shelf registration: a type of SEC registration that allows firms to register to sell securities over a two-year period and, during that time, take the securities "off the shelf" and sell them as needed ● Costs of selling the securities are reduced because only a single registration statement is required ● This statement can cover multiple securities, and there is no penalty if authorized securities are not issued ● Corporations gain greater flexibility in bringing securities to market o Securities can be taken off the shelf and sold within minutes, so firms can sell their securities when market conditions are more favourable ● Shelf registration allows firms to periodically sell small amounts of securities, raising money as it is actually needed, rather than banking a large amount of money from a single security sale and spending it over time Private vs. Equity Markets ● Firms that sell securities in the public market are usually large and well-known ● Many smaller firms and firms of lower credit standing have limited access, or no access, to the public markets PRIVATE MARKET IS MORE FOR SMALLER FIRMS o Their cheapest source of funding is often private markets ● When market conditions are unstable, some smaller firms that could previously sell securities in public markets are no longer able to do so at a reasonable price, since investors seek to hold high-quality securities rather than high-risk securities during times like this o This is called flight to quality on Wall Street, and refers to moving capital to the safest possible investments to protect oneself during unsettled periods in the market ● Some large companies with high credit quality prefer to sell their securities in private markets even though they have access to public markets o One reason is because these firms wish to avoid the regulatory costs and transparency requirements that come with public sales of securities o Others believe that their firms have intricate business structures or complex legal or financial structures that can best be explained to a small group of sophisticated investors rather than to the public at large

● Bootstrapping and venture capital financing are part of the private market as well, and are primary sources of funding for new businesses Dividends, Stock Repurchases, Payout Policy ● Any time value is distributed to a firm's stockholders, the amount of equity capital invested in the firm is reduced ● Unless the firm raises additional equity by selling new shares, distributions to stockholders reduce the availability of capital for new investments and increase the firm's financial leverage ● Payout policy: the policy concerning the distribution of value from a firm to its stockholders ● Dividend: something of value distributed to a firm's stockholders on a pro-rate basis (meaning it is in proportion to the percentage of the firm's shares that they own) o When a firm distributes value through a dividend, it reduces the value of the stockholders' claims against the firm o Read example on page 228 to understand how this works Dividends ● Dividend policy: refers to a firm's overall policy regarding distributions of value to stockholders ● A dividend is something of value that is distributed to a firm's stockholders on a pro-rata ● A dividend can involve the distribution of cash, assets, or something else, such as discounts on the firm's products that are available only to stockholders ● When a firm distributes value through a dividend, it reduces the value of the stockholders' claims against the firm ● A dividend reduces the stockholders' investment in a firm by returning some of that investment to them Types of Dividends ● Regular Cash Dividend o The most common form, it is the cash dividend that is paid on a regular basis o Are generally paid on a quarterly basis and are a common means by which firms return some of their profits to stockholders o The size of a firm's regular cash dividend is typically set at a level that management expects the company to be able to maintain in the long run, barring some major change in the fortunes of the company o Stock market investors often view a dividend reduction negatively ● Extra Dividends o Management can afford to err on the side of setting the regular cash dividend too low because it always has the option of paying an extra dividend if earnings are higher than expected o Extra dividends are often paid at the same time as regular cash dividends, and some companies use them to ensure that a minimum portion of earnings is distributed to stockholders each year o Extra money cause of a good year ● Special Dividend o One-time payment to stockholder, like an extra dividend o Larger than extra dividends and to occur less frequently

o When companies have extra money because they've done something special in the business like sold parts of the business ● Liquidating Dividend o Is a dividend that is paid to stockholders when a firm is liquidated o Can only be paid after firms use proceeds of selling its assets to pay all wages owed to employees and the companies obligations to suppliers, lenders, taxing authorities, etc. ● When companies pay dividends, the stock price goes down by the amount of the dividend ● Distribution of value to stockholders can also take the form of discounts on the company's products, free samples, etc., but these are not thought of as dividends because the value received by stockholders is not in cash and does not reflect their proportional ownership in the firm Dividend Payment Process ● First, board of directors must vote on the dividends value and type, every 3 months ● Then, company makes a public announcement about the dividends o The date on which it publicly announces the divided is known as the declaration date o Typically includes the amount of value that stockholders will receive for each share of stock that they own, as well as the other dates associated with the divided payment process o An announcement that a company will pay an unexpectedly large divided can indicate that management is optimistic about future profits, suggesting that future cash flows are higher than expected, resulting in an increase in the company's stock price ● And vice versa ● Then, there is the ex-dividend date , which is the first day that the stock trades without the right to get the dividend that's been announced o This is the date when stock prices go down after dividends have been announced o An investor who buys shares only before this date will receive a dividend o Before the ex-dividend date, a stock is said to be trading cum dividend , or with dividend, and on or after the ex-dividend date, the stock is said to trade ex-dividend o If an investor purchases the company's shares before the ex-dividend date, the investor knows that he or she will soon receive a dividend on which taxes will have to be paid ● 23.8% is the max tax that can be paid on dividends o The price of the firm's shares changes on the ex-dividend date even if there is no new info about the firm, which simply reflects the change in the value of the cash flows that the stockholders are entitled to receive before and after the ex-dividend date o E.g. if investors pay a 23.8% tax on dividends, the $10 price of a stock should include $0.762 for the dividend and $9.238 for other cash flows ($10-$0.762 = $9.24) so the stock price should drop to $9.24 on the ex-dividend date ● Then, one or two days later is the record date , which is when they try to figure out who in the world owned the shares on the ex-dividend date o By the record date, an investor must be a stockholder in order to receive a dividend, must be a stockholder of record o They have a record of everyone that is legally entitled to the dividend o Board specifies this date when it votes to make the dividend payment o Once the company informs the exchange on which its stock is traded what the record date is, the exchange sets the ex-dividend date

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o The ex-dividend date precedes the record date because it takes time to update the stockholder list when someone purchases shares o If you buy the shares before the ex-dividend date, the exchange will ensure that you are listed as a stockholder of record or that company as of the record date ● Then, they eventually pay it to everyone on the record by the record date, done on the payable date o Typically a couple weeks after the record date Dividend Payment Process at Private Companies ● It is not as well defined for private companies because o Shares are bought and sold less frequently o Fewer stockholders o No stock exchange is involved in the dividend payment process ● It is easy to inform all stockholders of the decision to pay and actually pay them, as the board knows the identities of the stockholders when they vote to authorize a dividend, since the list of stockholders is relatively short and the largest stockholders are on the board ● It is easy to actually pay it ● There is no public announcement ● No need for an ex-dividend date ● The record date and payable date can be any day on or after the day that the board approves the dividend Stock Repurchases ● Stock repurchases: the purchase of stock by a company from its stockholders, an alternative way for the company to distribute value to the stockholders ● Unlike dividends, they do not represent a pro-rate distribution of value to the stockholders because not all stockholders participate, whereas in a dividend distribution, every stockholder receives the dividend ● When a company repurchases its own shares, it removes them from circulation o This can decrease or increase the fraction of shares owned by the major stockholders and thereby diminish their ability to control the company o If a company with a relatively small number of shares in the public market distributes a lot of cash to investors through a stock repurchase, there will be less liquidity for the remaining shares ● Stock repurchases are taxed differently than dividends o When a stockholder sells shares back to the company, the stockholder is taxed only on the profit from the sale o Unlike the case with dividends, since stockholders choose whether to participate in a repurchase plan, they are able to choose when they pay taxes on the profits from selling their stock ● Investors would rather be taxed on gains from stock repurchases than dividends (talked to Barry about this) ● When a company uses cash to repurchase stock, the cash account on the assets side of the balance sheet is reduced, while the treasury stock account on the liabilities and stockholders' equity side of the balance sheet is increased (becomes more negative) o In contrast, when a company pays a cash dividend, the cash account on the assets side of the balance sheet and the retained earnings account on the liabilities and stockholders' equity side of the balance sheet are reduced How Stock is Repurchased

1. Open-market Repurchase: go into market and buy shares at whatever the price is ● Company may use repurchases to distribute some of its profits instead of paying a regular cash dividend ● There are limits on the number of shares that a company can repurchase on a given day, which hare intended to restrict the ability of firms to influence their stock price through trading activity, meaning that it could take months for a company to distribute a large amount of cash using open-market repurchases 2. Tender Offer: an open offer by a company to purchase shares ● Used when a company wants to distribute a large amount of cash at one time and does not want to use a special dividend ● Fixed Price: company announce that they want to buy back X number of shares and are willing to pay whatever the fixed price is for the share, and that offer is good for the next 30 days ● Interested stockholders then tender their shares by letting managment know how many shares they are willing to sell ● Dutch auction: investors choose the price they want to sell at, then they wait and see if someone accepts the price to buy shares or not ● Take the highest last price offered and everybody gets that price ● Firm announces the number of shares that it would like to repurchase and asks the stockholders how many shares they would sell at a series of prices, ranging from just above the price at which the shares are currently trading to some higher price ● Once these offers to sell have been collected, management determines the price that would all them to repurchase the number of shares that they want ● All of the tendering stockholders who indicate a willingness to sell at or below this price will then receive this price for their shares 3. Targeted Stock Repurchase: a stock repurchase that targets a specific shareholder ● Means a company has a set number of shares they want to rebuy, they could go into the open market to by them, make a tender offer, or see if they can find a rich person/company with a shitload of shares, then you call them and try to buy all the shares (e.g. 1 million shares) from them, makes demand go up and stock price go up in the market ● Such repurchases can benefit stockholders who are not selling because managers may be able to negotiate a per-share price that is below the current market price ● This is possible because the only alternative for a stockholder who own a large bloc of shares and wants to sell them at one time often involves offering the shares for a below-market price in the open market ● Most common way to repurchase shares is through open-market repurchases o But the average percentage of shares repurchases is smaller for this method than the other methods, confirming the managers tend to use other methods when they want to distribute a large amount of cash at once ● Almost half of the targets stock repurchases involve a purchase price that is below the stock's price in the open market ● However, a large stockholder's willingness to sell their shares may signal this investor's pessimism about the firm's prospects, causing other market participants to drive down the stock price (may think business is going down) Dividends and Firm Value

● Capital structure policy does not affect firm value if there are no taxes, no information or transaction costs, and if the real investment policy of the firm is fixed ● Dividends do not matter under these conditions because a stockholder can "manufacture" any dividends he or she wants at no cost, and the total cash flow a firm produces from tis real assets are not affected by the dividends that it pays ● Dividends only provide a signal concerning a fundamental change at the firm, meaning they are only byproducts of change Benefits of dividends ● Paying dividends attracts investors who prefer to invest in stocks that pay dividends o E.g. retiree, or institutional investor (like an endowment or foundation) o But some investors may choose to avoid stocks that pay dividends, since they might to pay taxes on the dividends and would face transaction costs when they reinvest the dividends they receive ● Many companies pay regular cash dividends on the one hand while routinely selling new shares on the other o This could be because management is trying to appeal to their investors who prefer dividends o This practice also helps to align the incentives of managers and stockholders ● If the company's BOD votes to pay dividends that amount to more than the excess cash that the company is producing from its operations, the board is effectively forcing management to sell equity periodically in the public markets (since the money to pay the dividends has to come from somewhere) ● This increases the cost to managers of operating the business inefficiently, so it aligns their incentives with the stockholders, as the process of raising new equity involves a lot of auditing ● When considering the outside certification coming from the public and auditors, paying a dividend and issuing equity rather than just keeping cash inside the firm can lead to better company performance and the willingness of investors to pay a higher price for the company's stock ● Dividends can be useful in managing the capital structure of a company, and paying dividends can help keep the firm's capital structure near its optimal mix Costs of dividends ● Dividends are taxable, which can be a hefty tax o Taxed as ordinary income, which is higher than the capital gains tax rate ● Owners of stocks that pay dividends often have to pay brokerage fees if they want to reinvest the proceeds o To eliminate this cost, some companies offer dividend reinvestment programs (DRIPs) , through which a company can sell shares, commission free, to dividend recipients who elect to automatically reinvest their dividends in the company's stock o But these do not affect taxes that must be paid on the dividends ● Total value of the assets in a company go down when a dividend is paid, paying dividends can increase the cost of debt o With less valuable assets, the debt holders face greater risk of default, and to compensate this greater risk, they will charge the company a higher rate on its debt Dividends vs. Stock Repurchases ● Stock repurchases are an alternative to dividends as a way of distributing value

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● Stock repurchases give stockholders the ability to choose when they receive the distribution, which affects the timing of the taxes they must pay as well as the cost of reinvesting funds that are not immediately needed o Stockholders who sell shares back to a company pay taxes only on the gains they realize, and historically, these capital gains have been taxed at a lower rate than dividends ● For managers, stock repurchases provide greater flexibility with distributing value o Even when a company publicly announces an ongoing open-market stock repurchase program, as opposed to a regular cash dividend, investors know that management can always quietly cut back or end the repurchases at any time ● In contrast, dividend programs represent a stronger commitment to distribute value in the future because they cannot be quietly ended ● Investors know that managers will only initiate dividends when they are quite confident that they will be able to continue them for the long run o If future cash flows are not certain, managers prefer to distribute extra cash today by repurchasing shares through open-market purchases because this enables them to preserve some flexibility ● One disadvantage of stock repurchases is that since most ongoing stock repurchase programs are not as visible as dividend programs, they cannot be used as effectively to send a positive signal about the company's prospects to investors ● Managers know more than investors so they can create repurchase programs to benefit themselves or transfer wealth from one investor to another, which isn't really in the best interest of all stockholders ● Companies in the U.S. have historically distributed more value through dividend payments than through stock repurchases, indicating manager may like dividends more o But in recent years, popularity of stock repurchases has increased o Nowadays, more companies of considering stock repurchases over dividends, and the companies that still pay dividends usually pay large dividends ● The fraction of total equity value that is being distributed to stockholders has declined Stock Dividends and Stock Splits ● Stock Dividend: a distribution of new shares to existing stockholders in proportion to the percentage of shares that they own (pro rata), the value of the assets in a company does not change with a stock dividend o One type of "dividend" that does not involve the distribution of value is known as a stock dividend ● Stock dividends do not increase a company's wealth, it's just a different distribution of money ● Companies still issue more dividends to try and lower their stock prices o When a company pays a stock dividend, it distributes new shares of stock on a pro-rata basis to existing stockholders o Value of company does not change o The stockholder is left with exactly the same value as before o All that happens when a stock dividend is paid is that the number of shares each stockholder owns increases and their value goes down proportionately ● Stockholder is left with exactly the same value as before ● Stock Split: a pro rata distribution of new shares to existing stockholders that is not associated with any change in the assets held by the firm; stock splits involve larger increases in the number of shares than stock dividends

o A stock split is quite similar to a stock dividend, but it involves the distribution of a larger multiple of the outstanding shares o Companies take your shares and split them into more o Shareholders do not have to agree to stock splits o We can often think of a stock split as an actual division of each share into more than one share o Benefit: they can send a positive signal to investors about the outlook that management has for the future and this, in turn, can lead to a higher stock price o Management is unlikely to want to split the stock of a company two-for-one or three-for-one if it expects the stock price to decline ● This is when stockholders receive one additional share for each share they already own o Reverse stock splits: opposite of stock split ● When the number of shares each investor has is reduced ● May be undertaken to satisfy exchange requirements ● E.g. NASDQ requires shares to trade for at least $1, and if there is a fear that this cannot be met by a company, the company can use a reverse stock split to keep the per-share price above the required thresholds o Companies want to make their share prices lower because shareholders think that companies splitting stock is a good thing o If a stock gets too high, less people in the market can afford it or choose to want to afford it o Similar to a stock dividend, a stockholder might own twice as many shares after the split, but because the split does not change the nature of the company's assets, those shares represent the same proportional ownership in the company as the original shares ● Stock dividends are typically regularly scheduled events, like regular cash dividends, whereas stock splits tend to occur infrequently during the life of a company Reasons for Stock Dividends and Splits ● Trading range argument: proposes that successful companies use stock dividends or splits to make their shares more attractive to investors o This is because as the price of the stock of a successful company increases over time, it might become harder for investors to afford to purchase a round lot of 100 shares, which could affect the company's stock price ● It has been more expensive for investors to purchase odd lots , which consist of less than 100 shares, than round lots, which are multiples of 100 shares ● Odd lots are less liquid because more investors want to buy round lots ● It can also be more expensive for companies to service odd-lot purchases ● Because of these disadvantages, investors tend to be less enthusiastic about purchasing odd lots and managers prefer that they do not as well o Therefore, when buying a round lot becomes too expensive, investors may choose not to invest in the company at all o Stock dividends and splits offer ways to bring the price of the stock down to the appropriate trading range, so that investors can still buy round lots o This argument is not always valid though ● One real benefit of stock splits is that they can send a positive signal to investors about management's outlook for the future, as management is unlikely to want to split the stock of a company two-fore-one if it expects the stock price to decline, it is only likely to split the stock when it is confident that the stock's current market price is not too high

Setting a Dividend Payout What Managers Tell Us ● Surveys about how managers set their firms' dividend payouts indicate that: o Firms tend to have long-term target payout ratios o Dividend changes follow shifts in long-term sustainable earnings o Managers focus more on dividend changes than on the level (dollar amount) of the dividend o Managers are reluctant to make dividend changes that might have to be reversed ● Managers tend to use dividends to distribute excess earnings and they are concerned about unnecessarily surprising investors with bad news ● More recent surveys indicate that rather than setting a target level for repurchases, managers tend to repurchase shares using cash that is left over after investment spending, and many managers prefer repurchases because repurchase programs are more flexible than dividend programs o Also because they can be used to time the market by repurchasing shares when management considers a company's stock price too low ● Also believe that these two methods of distributing value has little effect on who owns the company's stock (institutional investors do not prefer dividends over repurchases or vice versa) Practical Considerations in Setting a Dividend Policy/Payout ● A company's dividend payout is about how the excess value in a company is distributed to its stockholders ● Choosing this payout involves determining how much value should be distributed ● It is extremely important that managers choose their firm's dividend policies in a way that enables them to continue to make the investments necessary for the firm to compete in tis product markets ● Managers should consider several practical questions when selecting a dividend policy: 1. Over the long term, how much does the company’s level of earnings (cash flows from operations) exceed its investment requirements? How certain is this level? 2. Does the firm have enough financial reserves to maintain the dividend payout in periods when earnings are down or investment requirements are up? 3. Does the firm have sufficient financial flexibility to maintain dividends if unforeseen circumstances wipe out its financial reserves when earnings are down? 4. Can the firm quickly raise equity capital if necessary? 5. If the company chooses to finance dividends by selling equity, will the increased number of stockholders have implications for the control of the company? Stock price reactions to dividend announcements ● Cash flow identity o States that the sources of cash must equal the uses of cash in a firm ● Let's say a company has announced an increase in its dividend payments that investors did not expect ● If the company is not selling new equity or debt, not repurchasing stock, and its investment in fixed assets and net working capital does not change, then the cash flow identity indicates that the cash to investors from operating activity must be expected to increase ● An expected increase in the cash flow to investors from operating activity is a good signal, and investors will interpret it as suggesting that cash flows to stockholders will increase in the future, so the stock price would go up

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● Normally, when a company announces that it will increase its regular cash dividends, stock prices rise ● In contrast, when a company announces that it will reduce its regular cash dividend, stock prices tend to fall ● An announcement that a company will pay a special dividend is also associated with an average stock price increase ● These are all suggestions that have occurred in the past, but there is not absolute proof that increasing dividends results in an increase in stock prices ● Cash flow identity just shows that managers make changes in dividends when something fundamental changes in the company ● There is no evidence that it is possible to increase firm value by increasing dividends, dividend changes only provide a signal concerning a fundamental change at the firm If a discount is given in proportion to the ownership percentage, then it can be a dividend On the ex-dividend date, the stock price falls but not usually by the same amount as the dividend, usually falls by a little less than that (b/c other values in the market like supply and demand may raise it or lower it, so it's hard to predict the exact amount)

Lesson 7_ How Firms Raise Capital

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