The Private Equity Market

The previous sections of this chapter assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market. Of course, there are many firms that have not reached this stage and cannot use the public equity market. For start-up firms or firms in financial trouble, the public equity market is often not available. The market for venture capital is part of the private equity market.21

Private Placement

Private placements avoid the costly procedures associated with the registration requirements that are part of public issues. The Securities and Exchange Commission (SEC) restricts private placement issues to no more than a couple of dozen knowledgeable investors including institutions such as insurance companies and pension funds. The biggest drawback of privately placed securities is that the securities cannot be easily resold. Most private placements involve debt securities, but equity securities can also be privately placed.

17A. Hershman, "New Strategies in Equity Financing," Dunn's Business Monthly (June 1983).

18D. J. Dennis, "Shelf Registration and the Market in Seasonal Equity Offerings," Journal of Business 64 (1991).

19S. Bhagat, M. W. Marr, and G. R. Thompson, "The Rule 415 Experiment: Equity Markets," Journal of Finance 19 (December 1985).

20R. Rogowski and E. Sorenson, "Deregulation in Investment Banking: Shelf Registration, Structure, and Performance," Financial Management (Spring 1985).

21S. E. Pratt, "Overview and Introduction to the Venture Capital Industry," Guide to Venture Capital Sources, 10th ed., 1987 (Venture Economics. Laurel Avenue, Box 348, Wellesley Hills, MA 02181).

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Chapter 19 Issuing Securities to the Public

■ Figure 19.2 Corporate Equity Security Offerings: 1997

4.07

37.3

152.1

Private Rule 144A Placements

Private Non-Rule 144A Placements

Public Equity Offering

230.1 100% Total Equity Offerings

Private Rule 144A Placements

Private Non-Rule 144A Placements

Public Equity Offering

230.1 100% Total Equity Offerings

Source: Jennifer E. Bethal and Erik R. Sirri, "Express Lane or Toll Booth in the Desert: The Sec of Framework for Securities Issuance," Journal of Applied Corporate Finance (Spring 1998).

In 1990, Rule 144A was adopted by the SEC and established a framework for the issuance of private securities to certain qualified institutional investors. The rule has generated a substantial market for privately underwritten issues. Largely because of Rule 144A, companies raise about one-sixth of the proceeds from all new issues without registration with the SEC. To qualify to buy Rule 144A offerings, investors must have at least $100 million in assets under management. Most private placements are in straight bonds or convertible bonds. However, preferred stock is frequently issued as a private placement.

The Private Equity Firm

A large amount of private equity investment is undertaken by professional private equity managers representing large institutional investors such as mutual funds and pension funds. The limited partnership is the dominant form of intermediation in this market. Typically, the institutional investors act as the limited partners and the professional managers act as general partners. The general partners are firms that specialize in funding and managing equity investments in closely held private firms. The private equity market has been important for both traditional start-up companies and established public firms. Thus, the private equity market can be divided into venture equity and nonventure equity markets. A large part of the nonventure market is made up of firms in financial distress. Firms in financial distress are not likely to be able to issue public equity and typically cannot use traditional forms of debt such as bank loans or public debt. For these firms, the best alternative is to find a private equity market firm.

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Part V Long-Term Financing

Suppliers of Venture Capital

As we have pointed out, venture capital is an important part of the private equity market. There are at least four types of suppliers of venture capital. First, a few old-line, wealthy families have traditionally provided start-up capital to promising businesses. For example, over the years, the Rockefeller family has made the initial capital contribution to a number of successful businesses. These families have been involved in venture capital for the better part of this century, if not longer.

Second, a number of private partnerships and corporations have been formed to provide investment funds. The organizer behind the partnership might raise capital from institutional investors, such as insurance companies and pension funds. Alternatively, a group of individuals might provide the funds to be ultimately invested with budding entrepreneurs.

Of the early partnerships, the most well-known is clearly American Research and Development (ARD), which was formed in 1946. Though ARD invested in many companies, its success was largely due to its investment in Digital Equipment Company (DEC). When Textron acquired ARD in 1972, over 85 percent of the shareholders' distribution was due to the investment in DEC.22 Among the more recent venture capitalists, Arthur Rock & Co. of San Francisco may very well be the best known. Because of its huge success with Apple Computer and other high-tech firms, it has achieved near mythic stature in the venture-capital industry.

Recent estimates put the number of venture-capital firms at about 2,000. Pratt's Guide to Venture Capital (Venture Economics) provides a list of the names of many of these firms.23 The average amount invested per venture has been estimated to be between $1 million and $2 million. However, one should not make too much of this figure, because the amount of financing varies considerably with the venture to be funded.

Stories used to abound about how easily an individual could obtain venture capital. Though that may have been the case in an earlier era, it is certainly not the case today. Venture-capital firms employ various screening procedures to prevent inappropriate funding. For example, because of the large demand for funds, many venture capitalists have at least one employee whose full-time job consists of reading business plans. Only the very best plans can expect to attract funds. Maier and Walker indicate that only about 2 percent of requests actually receive financing.24

Third, large industrial or financial corporations have established venture-capital subsidiaries. The Lambda Fund of Drexel Burnham Lambert, Manufacturers Hanover Venture Capital Corp., Citicorp Venture Capital, and Chemical Venture Capital Corporation of Chemical Bank are examples of this type. However, subsidiaries of this type appear to make up only a small portion of the venture-capital market.

Fourth, participants in an informal venture-capital market have recently been identi-fied.25 Rather than belonging to any venture-capital firm, these investors (often referred to as angels) act as individuals when providing financing. However, they should not, by any means, be viewed as isolated. Wetzel and others indicate that there is a rich network of angels, continually relying on each other for advice. A number of researchers have stressed that, in any informal network, there is likely one knowledgeable and trustworthy individual who, when backing a venture, brings a few less experienced investors in with him.

22H. Stevenson, D. Muzka, and J. Timmons, "Venture Capital in Transition: A Monte-Carlo Simulation of Changes in Investment Patterns," Journal of Business Venturing (Spring 1987).

23Pratt, "Overview and Introduction to the Venture Capital Industry."

24J. B. Maier and D. Walker, "The Role of Venture Capital in Financing Small Business," Journal of Business Venturing (Summer 1987).

25See W. E. Wetzel, "The Informal Venture Capital Market: Aspects of Scale and Market Efficiency," Journal of Business Venturing (Fall 1987).

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The venture-capital community has unfortunately chosen to refer to these individuals as "dumb dentists." Although a number indeed may be dentists, their intelligence should not be called into question. Wetzel argues that the prototypical angel has income over $100,000, net worth over $1,000,000, and substantial business experience and knowledge. As one might expect, the informal venture capitalist is able to tolerate high risks.

Though this informal market may seem small and unimportant, it is perhaps the largest of all sources of venture capital. Wetzel argues that aggregate investments from this source total around $50 billion, about twice the amount invested by more professional venture capitalists. The size of each contribution is smaller here. Perhaps, on average, only $250,000 per venture is raised when the informal market is tapped.

Stages of Financing

A. V. Bruno and T. T. Tyebjee identify six stages in venture-capital financing:26

1. Seed-Money Stage. A small amount of financing needed to prove a concept or develop a product. Marketing is not included in this stage.

2. Start-Up. Financing for firms that started within the past year. Funds are likely to pay for marketing and product development expenditures.

3. First-Round Financing. Additional money to begin sales and manufacturing after a firm has spent its start-up funds.

4. Second-Round Financing. Funds earmarked for working capital for a firm that is currently selling its product but still losing money.

5. Third-Round Financing. Financing for a company that is at least breaking even and is contemplating an expansion. This is also known as mezzanine financing.

6. Fourth-Round Financing. Money provided for firms that are likely to go public within half a year. This round is also known as bridge financing.

Although these categories may seem vague to the reader, we have found that the terms are well-accepted within the industry. For example, the venture-capital firms listed in Pratt's Guide to Venture Capital indicate which of the above stages they are interested in financing.

The penultimate stage in venture capital finance is the initial public offering.27 Venture capitalists are very important participants in initial public offerings. Venture capitalists rarely sell all of the shares they own at the time of the initial public offering. Instead, they usually sell out in subsequent public offerings. However, there is considerable evidence that venture capitalists can successfully time IPOs by taking firms public when the market values are at the highest. Figure 19.3 shows the number of IPOs of privately held venture-capital-backed biotechnology companies in each month from 1978 to 1992. The venture-capital-backed IPOs clearly coincide with the ups and downs in the biotech market index in the top panel.

• What are the different sources of venture-capital financing?

• What are the different stages for companies seeking venture-capital financing?

• What is the private equity market?

26A. V. Bruno and T. T. Tyebjee, "The Entrepreneur's Search for Capital," Journal oof Business Venturing (Winter 1985).

27A very influential paper by Christopher Barry, Chris J. Muscarella, John W. Peavey III, and Michael R. Vetsuypens, "The Role of Venture Capital in the Creation of Public Companies: Evidence from the Going Public Process," Journal of Financial Economics 27 (1990), shows that venture capitalists do not usually sell shares at the time of the initial public offering, but they usually have board seats and act as advisors to managers.

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Part V Long-Term Financing

■ Figure 19.3 Initial Public Offerings by Venture-Capital-Backed Biotechnology Firms, January 1978 to January 1992

Number of IPOs llll iiulil_■ J.jll ■ ■■!■■ .iL

Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 Source: Joshua Lerner, "Venture Capitalists and the Decision to Go Public," Journal of Financial Economics 35 (June 1994).

Case Study:

The Decision to Do an Initial Public Offering (IPO): The Case of Medstone International, Inc.

Most firms initially raise equity financing with private placements in the venture-capital market from a small number of investor capitalists. If a firm does well and needs to raise more equity financing, it may decide to sell stock with an initial public offering.We see how this occurs with the case of Medstone International, Inc.

Medstone International, Inc., was created in 1984 to manufacture and sell medical products using the new technology of shockwave lithotripsy. Initially, Medstone raised its cash from contributions from its founders and from banks. From 1984 to 1986 Medstone spent most of its available cash on research and development of the technology of shockwave lithotripsy. Eventually, in 1986, the company developed a product called the Medstone 1050 ST.The purpose of the Medstone 1050 ST was for nonsurgical disintegration of kidney stones and gallstones.

However, it wasn't until 1987 that the company actually generated profits from the Medstone 1050 ST (as follows).

Summary of Financial Information (in thousands)

1986

1987

Revenues

Income

Assets

Liabilities

Equity

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By January 1988 Medstone International had obtained an investigative new drug permit from the Food and Drug Administration (FDA) and had entered into an agreement to sell and install the Medstone System in seven U.S. states. In early 1988 the firm's prospects seemed excellent and its founders had reason to be optimistic. But Medstone needed additional cash and its founders wanted the opportunity to cash out, so it hired the Weeden Co., a well-known investment banking firm, to arrange for an initial public offering (IPO) of common stock. In June 1988, Medstone went public with an IPO and sold 1 million shares of stock at $13 per share and raised $11,700,000. Immediately after the IPO there were 4,500,000 shares of Medstone stock outstanding. Insiders owned 3,500,000 shares, and outsiders owned 1,000,000 shares.

Price to Public

Underwriting Discount

Proceeds to Company

Per share Total

$13,000,000 13,000,000

$1,300,000 1,300,000

$11,700,000 11,700,000

Although the stock was offered at $13 per share, by the end of the first day, it was selling for $18 (this is a 38.5 percent increase).

As is typical in IPOs, the proceeds from the sale of stock had two purposes: to reduce indebtedness to banks and to cash out insiders, and to finance present and future operations and growth opportunities.

In 1984 when Medstone was formed, it was a "start-up" with no operating history and virtually no manufacturing and marketing experience. Moreover, when Medstone did its IPO, its product had not yet received final FDA approval.The company's potential was great and so were its risks of fail-ure.The company's ultimate success depended upon its ability to form a new business, introduce new products, and successfully compete in the marketplace. However, in the case of medical products, success depends on obtaining FDA approval. Obtaining FDA approval for a new product can be a time-consuming process, and there is no guarantee that final clearance will ever be granted. Unfortunately, Medstone was never able to obtain final FDA approval.

When the company announced that it would no longer try to sell the Medstone 1050 ST, the market for its stock collapsed and the firm was forced to reorganize.Were investors in Medstone too optimistic? If so, they were not alone.The stocks of many IPOs have performed poorly after the offering.

Every IPO is unique but there are some familiar themes.

1. Underpricing. Firms going through an IPO usually have their shares underpriced.This means that the initial market price is usually significantly less than their market price prevailing at the end of the first trading day.This is one of the indirect costs of IPOs, and Medstone's underpricing was typical.

2. Underperformance. The Medstone IPO did not work out very well for many of the outside investors because the firm ultimately could not sell its Medstone 1050 ST.The Medstone IPO is typical in that the average firm performs very poorly after an IPO.Three years after an IPO, the stock price of firms doing IPOs has typically fallen below the initial price. Interestingly, it is also true for seasoned equity issues.This is a puzzle and several reasons have been put forth to explain it.

3. Going Public. Many IPOs such as Medstone are to give inside equity investors an opportunity to exchange their private equity for public equity and cash out their stakes in the firm. Usually only a fraction of the inside equity is sold in the IPO. Later in subsequent common stock sales, the rest of the inside ownership is sold. ■ ■ ■ ■ ■

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Part V Long-Term Financing

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