COMM 370 - Corporate Finance
Class 11: Raising Capital
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 0
Class 11 – Raising Capital
Learning objectives:
• Describe the key differences between debt and equity financing
• Describe what types of financing firms use at different stages of their life cycles
• Discuss various types of debt and equity financing
• Describe key steps in raising public equity and debt
• Outline:
• Equity vs. debt – key differences
• Financing over a firm’s life cycle
• Financing for small, medium, and large firms
• Initial public offerings and long-term debt
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 1
Equity Financing
• Equity gives shareholders an ownership interest in the firm:
• they elect the directors/management through voting at the annual shareholder
meeting; they also vote on major corporate decisions (e.g., mergers).
• they are protected by limited liability (if the company goes bankrupt, the
creditors cannot collect from its common shareholders’ personal assets).
• in the event of a liquidation, they get paid only after creditors get paid.
• they receive dividends, which are a return on the capital they provide (in addition
to any capital gains); not a business expense → not deductible for tax purposes.
• Key Features:
• voting rights (common, no-voting, super-voting shares).
• board decides whether a dividend is paid or not and what amount.
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 2
Debt Financing
• Debt is not an ownership interest in the firm and lenders do not vote.
• Creditors are protected by the loan contract (indenture): failure to pay interest or
principal leads to default and often to bankruptcy.
• Creditors gain control in default (even if a small covenant violation), so they can
force restructurings of labor and assets or force a liquidation to collect.
• In the event of a bankruptcy, they are additionally protected by bankruptcy law.
• Creditors earn interest on the loans they provide and this interest is treated as a
business expense (not taxed at the corporate level) → it generates tax shields.
• Key features:
• principal or face value
• maturity date, payment schedule & interest
• indenture & covenants (generally tied to financial ratios)
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 3
Hybrid Securities
• Hybrids combine characteristics of debt and equity; used in private and public firms.
• Preferred shares:
• Like debt:
• they have a face value and often a maturity date (other ones are perpetual).
• they pay fixed dividends which often accumulate if the firm skips one.
• Like equity:
• they represent ownership in the firm (and can trade on the exchange).
• in a liquidation, they get paid only after creditors (but before common shares).
• Convertible debt:
• long-term debt issued with an option to be converted later into a certain # of shares.
• investors earn interest until conversion, then dividends and capital gains.
• in essence, the firm borrows and later repays the loan with its own shares.
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 4
Financing Over a Firm’s Life Cycle – Stylized Description
• Access to capital and financial contracts are shaped by frictions in capital markets:
• information asymmetry between firm insiders and investors
• investors’ limited ability to monitor managers’ discretional use of the funds
• These frictions are severe for small firms and much less severe for large firms →
financing options and financial contracts change as the firm grows and matures.
• Small and young firms are risky, lack a track record, and are informationally opaque.
• they cannot raise equity from outside investors or borrow long-term debt
• they rely on insider equity as well as on “angel” and venture capital finance
• limited and costly (capital providers demand higher returns)
• complex financial contracts to protect capital providers
• they also use trade credit and short-term debt (with covenants)
• capital structure is optimized within the limited available sources of capital
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 5
Financing Over a Firm’s Life Cycle – Stylized Description (cont.)
• Medium-size firms are safer, are building a track record, and are more transparent:
• they can access broader private equity financing and medium-term loans
• also broad use of trade credit
• still no access to public equity and long-term debt
• but less capital constrained than smaller firms
• Large firms are mature, with solid track records, and are very informationally
transparent (SEC / OSC requirements, analyst coverage, audited statements, etc).
• they have access to public equity (first go through an IPO, then SEOs as needed)
• they have access to long-term financing (syndicated loans and bonds)
• also broad use of trade credit
• much better access to capital and able to choose capital structure
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 6
Financing Over a Firm’s Life Cycle - Summary
Small / Young Firms Mid-Size / Growing Firms Large / Mature Firms
No collateral, very risky, Collateral available, less Collateral, safer business,
no track record risky, building a track record established track record
Insider Finance Private Equity Public Equity
Angel & Venture Capital Medium-term Debt Long-term Debt
Short-term Debt
Again, this is a stylized description of financing over a firm’s life cycle.
Note: profitable firms can also retain earnings – another key source of funds.
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 7
Financing for Small Firms: Equity
• Insider Financing: owner-manager (founder) personal savings deployed to the firm.
• Angel Investors: wealthy individuals (successful entrepreneurs) who are willing to
fund startups in exchange for shares in the future business.
• hard to estimate the value of the firm’s shares in the early stages → use convertible
notes or a SAFE (simple agreement for future equity)
• angels can convert into equity when the firm raises a large amount of equity, and can
convert at a discount compared to new investors (conversion privileges)
• Venture Capital: firms specialized in raising money to invest in startups, where limited
partners (LPs) are the investors and the general partners (GPs) are the managers.
• LPs diversify risk across the VC’s portfolio companies and rely on the GP’s expertise
• GPs charge a large fee to run the VC firm and also receive a large rewards upon exit
• contracts generally in the form of preferred shares convertible to common shares, and
include clauses to provide downside protection as well as upside potential for the VC
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 8
Trends in Venture Capital Financing
• The VC sector has grown enormously in the last 50 years
• The type of investor piling into VC has changed just as dramatically
• it was once niche VC firms run in Silicon Valley focused on software/tech
• VC now extends well beyond Silicon Valley and America more broadly, and is
financing enterprises working on everything from blockchains to biotech
Source: The Economist (2022). The bright new age of venture capital.
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 9
Financing for Small Firms: Debt
• Short-term debt financing from banks:
• revolving lines of credit & short-term loans
• credit agreements with covenants and frequent renegotiation
• banks effectively monitor and discipline borrowers
• Bank debt is beneficial for the firm and its owners
• bank monitoring leads to more efficient use of the funds / creates firm value
• builds long-term relationships with creditors
• debt financing avoids dilution of owners’ equity stakes
• Trade Credit:
• a key source of financing, especially when other forms are not available
• credit terms give a certain number of days to pay and a discount for early payment
• supported by trust, related operations, and shared knowledge of business situation
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 10
Financing for Medium-Size Firms: Equity
• Private equity firms
• similar to VCs but focused on already established and more mature private firms
• their size and scope is significantly larger than VC firms
• the investment is normally 100x the typical VC investment
• capital for growth, but also mezzanine (e.g., transition to IPO) and to distressed firms
• PE groups are also very active in leveraged buyouts (LBOs) of selected target firms
• Other types of investors supplying private equity:
• institutional investors: banks, pension plans, and insurance companies.
• sovereign wealth funds: state-owned pools of money that are invested in businesses
• corporate investors: invest for strategic objectives (e.g., in business partners or key
suppliers), in addition to the financial returns
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 11
Financing for Medium-Size Firms: Debt
• Still bank loans with covenants and collateral requirements, but now:
• larger amounts – firm is less financially constrained
• medium-term debt (e.g., term loans due in 3 years), in addition to lines of credit
• Improved access to debt supported by information gathered by the bank through
continuous contact with the borrower over the years:
• monitoring and repayment of prior loans (track record)
• provision of multiple financial services to the firm
• firm becomes less “opaque” to the bank → easier evaluation of credit risk
• Syndicated bank loans
• single loan that is funded by a group of banks rather than just a single bank
• a “lead bank” arranges the loan and provides a large share of the funds
• used for large loans and when banks want to spread credit risk
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 12
Advantages and Disadvantages of Going Public
• Going public – issuing publicly traded shares for the first time in an initial public
offering (IPO) – is likely the most important event in the life of corporation.
• IPOs occur when a firm is established and needs a major equity infusion to grow
based on a sound business plan (e.g., Lululemon in 2007, 9 years after founding).
• Advantages:
• Greater liquidity: private equity investors and owners can now cash out.
• Better access to capital: can now raise much larger amounts of capital as needed.
• Analyst coverage gives the firm visibility
• Disadvantages:
• Owners reduce their ownership in the firm and new investors are generally
dispersed so not good monitors → management might become less efficient.
• The firm must comply with all requirements of public companies (SEC/OSC
filings, Sarbanes-Oxley, etc.). These are very costly and create constraints.
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 13
The Mechanics of IPOs
• Company appoints a managing underwriter and co-managers (underwriting
syndicate) to market the IPO to investors.
• Regulatory filings with the provincial securities commission (OSC in Canada),
including the registration statement and the preliminary prospectus.
• Regulator reviews preliminary prospectus and approves the issue to the public.
• Firm and underwriter establish an initial price range, then go on a road show to
promote the issue, and gauge investor’s interest (the book-building process).
• Then further adjust the price and set the final offer price.
• Company files the final prospectus with all details, including # of shares and price.
Importantly, all material information must be disclosed to investors in this document.
• Once shares start trading, the market determines the share price.
• Seasoned equity offerings (SEOs) are similar, but easier as there is a price already.
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 14
Financing for Large Firms: Equity
• Common stock is the most predominant type of public equity:
• now there is a stock price quoted on the stock exchange
• this price reacts to changes in investors’ perception of the firm’s fundamentals
• Dual-class stock is more rare (common in Canada but less so in the USA)
• two classes of stock, e.g., class A and class B, with different voting power
• insiders want to raise outside capital but do not want to relinquish control
• they keep the super-voting shares (usually not traded) for themselves
• raise capital by issuing publicly traded shares with inferior voting power
• Google IPO in 2004: the class-B shares (reserved for insiders) carry 10 votes each;
the class-A shares sold to the public carry just one vote each.
• Several examples in Canada: Canadian Tire, Bombardier, Magna International,
Rogers Communications, Shopify, and Celestica (many family firms!)
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 15
Financing for Large Firms: Equity (cont.)
• Preferred shares can be publicly traded. Interestingly, it is a debt-like security (its
dividend is fixed at the time of issuance) but has no direct effect on bond ratings.
• But they are not common (used for example by large American banks, like Citigroup).
• The existence of publicly trade stock also opens the door to “derivative securities”,
which offer valuable options regarding the underlying stock – warrants in particular.
• Warrants are long-term call options on the firm’s stock issued by the firm itself:
• investors can buy shares of the firm anytime until expiration for a fixed exercise price
• used to raise capital, but also to compensate or retain employees
• Often part of a “unit offering”:
• bundle one share and one warrant (staged financing)
• bundle a bond and a warrant (convertible debt)
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 16
Financing for Large Firms: Debt
• Commercial paper
• unsecured, 1-9 months term, for short-term purposes only, e.g. working capital
• issued only by large firms with high credit ratings
• Corporate bonds (tradable fixed-income securities)
• a public bond issue is similar to a stock issue in terms of process, but bonds
trade “over the counter” (through dealers and brokers) and not on exchanges
• bond prices change due to changes in interest rates and the issuer’s default risk
• long term, with maturities of up to 30 years
• the indenture, included in a prospectus, it is a formal contract between a bond
issuer and a trust company which represents the bondholders in case of default
• most corporate bonds contain clauses restricting the company from issuing new
debt with equal or higher priority than existing debt
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 17
Relative Costs of Issuing Securities
• Total Direct Cost (all underwriting, legal, and auditing costs) of issuing a security as
a percentage of the amount of money raised
Source: Lee, I., Lochhead, S., Ritter, J., & Zhao, Q. (1996). The costs of raising capital. Journal of Financial Research,
19(1), 59-74.
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 18
Summary
• Equity gives ownership in the firm and voting rights, but debt does not; still, creditors
are protected by the debt contract and gain control when debt is in default.
• A firm’s access to capital and the types of securities available vary over a firm’s life
cycle, because information asymmetry and risk decreases as firms grow older.
• Small and young firms obtain equity from insiders, angels, and VC firms; if they can
support some debt, they obtain short-term debt from banks (lines of credit).
• Mid-size firms can obtain equity from a broader set of private equity investors and, in
addition to lines of credit, they can obtain larger and longer-term loans.
• Once firms grow larger and more mature, they can go public and this changes the
game: now can raise large amounts of equity and shares trade on the exchange.
• Public debt is rare (about 20% of public firms): the vast majority of firms rely mostly
on private debt, e.g., syndicated bank loans and lines of credit.
• Going forward, we will talk about “debt” and “equity”; our conclusions are general.
The University of British Columbia | Sauder School of Business | COMM 370 | Caren Lombard & Jose Pizarro | Do not post without permission 19
