Open Posted By: ahmad8858 Date: 04/05/2021 Graduate Assignment Writing

Go back to the Damodaran video

that we have viewed before. This time, in much more depth and financial sophistication, since we have learned a lot since the first viewing an few weeks ago, relate specific parts (identify your review of the video by the "minute" marker) of the video to concepts and examples (or charts and figures) in Chapter 13.

Please if you are only planning on writing a couple of paragraphs, you might as well leave the text box blank and take a zero. This is just about the end of the course, and you need to show that the course has created deep new understanding in your professional skillset. 

So, describe some concepts, insights, questions from the video (with the minute number). Link that with specific pages, concepts, charts, examples in Ch 13 of the book.

Category: Engineering & Sciences Subjects: Chemistry Deadline: 12 Hours Budget: $120 - $180 Pages: 2-3 Pages (Short Assignment)

Attachment 1

Chapter 13 Harvesting

Administrator (A) - fix this to all upper

Learning Objectives

Understand how early-stage investors can harvest by going public

Describe the investment banker’s role in the IPO process, including the due-diligence, certification, and marketing functions

Explain how an underwriter values a new issue and how the valuation evolves as the offering date approaches

Describe how private acquisition transactions can be structured and identify factors that affect the choice of structure

Understand when and why an entrepreneur might decide to undertake a management buy-out

Understand how an ESOP creates liquidity for owners of a non-public business and how a leveraged ESOP works

Describe how roll-up IPOs enable small companies to go public

Identify factors that affect the choice of harvesting alternatives


Harvesting Alternatives

Initial public offering (IPO)

Private sale (M&A)

Management buy out (MBO)

Roll-up IPO

Sale of the business to employees (ESOP)

Continuing to operate the venture


Public Offerings — Some Terminology

IPO (Initial Public Offering)

The first time company shares are sold to investors in a public offering

Can be primary, secondary, or combined offering

Primary Offering

Sale of newly issued shares by the company

Can be initial or seasoned offering

Secondary Offering

Sale of shares by existing investors

A means of harvesting, does not yield capital for the firm

Seasoned Offering

Public venture raises capital by issuing additional new shares


Ways Equity Investors Can Harvest

Secondary sale as part of the IPO. Existing investors sell previously issued shares as part of an IPO

Sale in the secondary market. After a public market has been established, early investors can sell small amounts of shares from time to time directly into the public market (SEC Rule 144)

Seasoned offerings of secondary shares. After a company goes public, existing investors can sell larger quantities of shares in a formal secondary public offering after the IPO

Private placement of secondary shares. Investors can make a private sale of shares of public or private companies to other investors, the entrepreneur, or the company. Usually to accredited investors and qualified institutional buyers

Approaches to Public Offering

Firm commitment general cash offering

Underwriter commits to buy all shares issued at the net offering price

Best-efforts basis

The investment banker acts more like an agent of the issuer and does not guarantee net proceeds

Rights offering

The issuer raises equity by issuing warrants to existing shareholders, which are tradable call options

The IPO Process: Selecting the Underwriter

The “bake-off” or “beauty contest”

Matching the underwriter’s capabilities with the issuer’s specific interests and objectives (e.g., retail v. institutional investors, aftermarket analyst coverage)

Underwriter duties

Due diligence


Issue pricing



Market making

The IPO Process: Due Diligence and Issue Pricing

Underwriter is the intermediary between the informed issuer and uninformed investors

Due diligence and the prospectus can mitigate the information asymmetry

Establishing the offer price also addresses the information disparity

Investors can rely on the offer price as a conservative estimate of the value of the shares compared to other firms/transactions

The reputations of underwriters and VCs can act to “certify” that the IPO value is consistent with prevailing market prices

IPO Pricing Process for Firm Commitment Underwriting

Figure 13.1

-- Figure 13.1 --

IPO issue pricing process for a firm commitment underwriting


The IPO Process: Cost

Going public is expensive

Underwriter fee: 5-7% of proceeds

Direct issuing cost: 1-5% of proceeds

Underpricing: 15-18% of proceeds

Total: 21-30% of gross proceeds

22-32% of net proceeds

The IPO Process: Cost

Underpricing (measured as initial return) is usually the most important component of total cost

Second is the “underwriter spread” or fee

In a general cash offer, the underwriter buys the shares from the issuer for a negotiated net price and tries to resell at the offer price

The difference between offer price and net price is the spread

Direct costs are out of pocket costs incurred by the issuer for lawyers, accountants, filing fees, etc.

Average IPO Underpricing (Initial Return) by Year

Figure 13.2

-- Figure 13.2 –

Average IPO underpricing by year (measured as initial return)

The figure shows equal-weighted and proceeds-weighted annual averages of IPO underpricing where underpricing is measured as the initial return from the offer price to the first aftermarket closing price. Data are from https://site.warrington.ufl.edu/ritter/ipo-data/.


Average IPO Underwriter Spread by Year

Figure 13.3

-- Figure 13.3 –

Average IPO underwriter spread by year

The figure shows equal-weighted and proceeds-weighted annual averages of IPO underwriter spreads where the spread is measured as the difference between gross and net proceeds, expressed as a percentage of gross proceeds. Data are from https://site.warrington.ufl.edu/ritter/ipo-data/.


IPO Direct Costs and Underwriter Spread by Issue Size

Issue size Total direct cost
(proceeds in $ millions) (% of proceeds)
2.0–​9.99 17.0
10.0–​19.99 11.6
20.0–​39.99 9.7
40.0–​59.99 8.7
60.0–​79.99 8.2
80.0–​99.99 7.9
100.0–​199.99 7.1
200.0–​499.99 6.5
500.0 and up 5.7
The cost of a public offering includes three components: the spread between the offer price and net proceeds to the issuer, issue costs borne directly by the issuing firm, and underpricing. This table provides estimates of the first two components (excluding underpricing) for different sizes of issues.

Table 13.1

-- Table 13.1 –

IPO direct costs and underwriter spread by issue size

Source: I. Lee, S. Lochhead, J. Ritter, and Q. Zhao, “The Cost of Raising Capital,” Journal of Financial Research 19 (1996): 59–74, Table 1.


Why Are IPOS So Expensive?

Significant fixed costs


Due diligence cost

Costs the underwriter incurs to market the issue

The underwriter’s exposure to risk after the IPO

Would auctioning be better?




Puzzles Raised by Underpricing and Underwriter Spreads

What explains underpricing?

Would auctions be better (i.e., reduce underpricing)?

Why do spreads in the U.S. tend to be uniform (i.e., 7%)?

Why are average spreads smaller in other developed countries than in the U.S.?

(The book reviews research on these topics and findings)

Methods of Valuation and Pricing of IPOs

Estimate enterprise value on a pre-money basis (excluding the IPO proceeds)

Estimates can be based on the market values of comparables, prices of recent IPOs, or other transactions, or fundamentals

Deduct the value of debt financing

Residual equity is divided by number of shares to get value per share

Methods of Valuation and Pricing of IPOs


An issuer hopes to raise $20M in net proceeds (net of spread and underpricing)

The underwriter estimates that the market value of equity is $10 per share

The underwriter targets 15% underpricing, so the venture would issue shares issues at $8.50 (gross proceeds)

The net price after a spread of 10% of gross proceeds would equal $7.65. ($8.50 x 90%)

Methods of Valuation and Pricing of IPOs

Example, cont.:

Given the target of $20M in net proceeds, the firm would issue 2.614 million shares ($20M/$7.65)

Depending on take down due diligence and market conditions, the underwriter may decide on a lower or higher issue price and sell shares of sufficient quantity to deliver the $20M net proceeds

Methods of Valuation and Pricing: Overallotment Options

Overallotment (Green Shoe) options

Allows the underwriter to offer additional shares if demand is higher than anticipated

Allows the underwriter to offer additional shares, anticipating that some investors may not honor their commitments to buy or may “flip” their shares, which would depress the price

In the U.S., the option can be up to 15% of original number of shares offered, thereby affecting supply of shares and the aftermarket price

Cost of Harvesting an IPO by Going Public

IPOs usually involves a small fraction of total shares

Selling shareholders normally harvest in the aftermarket

Existing shareholders implicitly bear the cost of the IPO

Percentage cost of IPO is less important than percentage cost of creating a public market for the shares

Cost of Harvesting an IPO by going Public


A venture seeks $30M in net proceeds

The investment bank estimates pre-money value at $120M

The target aftermarket value is $30.00 per share, implying that after the IP0 there should be 5M shares outstanding:

$120 M in pre-money + $30 M in net new proceeds=$150M

$150M/$30.00 per share= 5M shares

Cost of Harvesting an IPO by Going Public

Example, cont.:

The underwriter targets 15% underpricing compared to projected aftermarket value

So, the IPO will be priced at $25.50 per share ($30-$4.50)

The underwriter fee is 7% of the $25.50 issue price.

So the issuer nets $23.715 per share: $25.50 - .07($25.50)

To generate $30 MM the firm plans to sell 1.265 MM shares

1.265 MM = $30 MM/$23.715

Existing shareholders (VC, entrepreneur, angels) retain the balance of 3.735 MM shares

1.265 MM + 3.735 MM = 5 MM shares

Cost of Harvesting an IPO by Going Public

Example, cont.:

Estimated cost:

Total cost: total cost per share: $6.285 = ($30.00-$23.715)

$6.285 x 1.265 MM new shares issued = $7.95 MM

Percentage cost: View the total cost of $7.95 MM as the cost of harvesting the pre-money value of $120 MM

Then the cost is 6.625% = $7.95 MM/$120 MM

Cost can be thought of as the cost of creating a public market for the shares

Approaches to Public Offering

Firm commitment general cash offering

Underwriter commits to buy all shares issued at the net offering price

Best-efforts basis

The investment banker acts more like an agent of the issuer and does not guarantee net proceeds

Rights offering

The issuer raises equity by issuing warrants to existing shareholders, which are tradable call options

Administrator (A) - we might want to move this down--check text

Approaches to Public Offering: Rights Offerings

Rights offerings are more common outside in the U.S.

Existing investors receive (preemptive) rights to buy new shares

Rights are tradable warrants that give the investor the right to buy new shares at a pre-specified price, plus a certain number of warrants

An existing shareholder can either exercise the rights or sell them to others

Assuming each new share requires five warrants, the price of a new share is the exercise price plus the market value of five warrants

The issuing firm receives the exercise price

Existing shareholders receive the market value of the warrants

Approaches to Public Offering: Rights Offerings

Example: Rights Offerings

The company announces a rights offer that will increase the number of outstanding shares by 20%

The company issues warrants to existing shareholders, one warrant for each outstanding share

Warrants give shareholder the ability to buy new shares at $15 plus 5 warrants

The 5 to 1 ratio results in a 20% increase in shares

Approaches to Public Offering: Rights Offerings

Example, cont.:

Suppose this is a publicly traded company with shares trading on the exchange for $20 per share

On the rights offering date, the market price is expected to fall relative to $20 to reflect the discounted shares coming on the market at $15 + 5 warrants

Approaches to Public Offering: Rights Offerings

Example cont.:

The warrants are tradable on the same exchange as the company stock

The expected effect on share price:

Before the offering, based the market price, 5 shares would have a total vale of $100

After the offering 6 shares would have a value of $115 ($100 plus an additional $15 share)

The new value per share is $115/6 or $19.167 per share

Since the investor can either exercise the rights by paying $15 and 5 warrants, or sell the warrants, and since new share value will be $19.167, the price per warrant should be $0.833/5 or $0.167

Approaches to Public Offering: Rights Offerings

Example, cont.:

Suppose the issuer is a privately held venture

The price per share on Sharespost.com and other private equity trading sites is around $20 per share

If rights are transferrable, they will also trade over-the-counter

On the rights offering date, the price in private transactions is expected to fall relative to $20 to reflect the discounted shares coming on the market at $15 + warrant

Warrants are expected to transfer at $0.167, just as for a public company

A firm that seeks to go public and raise capital can register existing shares by direct listing and then do a rights issue

Approaches to Public Offering: Rights Offerings

Rights offerings take longer than a general cash offer or private placement

Rights offerings also can limit the implicit certification by an underwriter since the underwriter does not estimate the issue price as in a general cash offer

An additional problem is shareholders may fail to exercise or sell warrants

The ultimate shareholders of a public company may be difficult to identify and may not learn of the rights offering

Other Approaches to Public Offerings: Auctions

Auction method

In theory, auction methods have the potential to eliminate underpricing

With general cash offerings, if there is excess demand, the underwriter can respond by rationing shares and may favor preferred customers: those who are expected to refrain from “flipping” shares or those who may be sources of future business (“spinning”)

In a clean auction method offering, IPO shares go to the highest bidders

But most auction-method offerings are “dirty,” with the offer price set below the market clearing bid, so that rationing still occurs

Other Approaches to Public Offerings: Auction

Auction methods have been tried in a number of countries

In the U.S., W. R. Hambrecht originated the Open IPO where bidders submit bid prices and quantities they are willing to buy to the underwriter via an Internet site

In a clean single-price auction, demand information is matched with the quantity of shares available and the market clearing price is found

All bidders whose orders are accepted pay the same price, even if they bid higher

In a dirty single-price auction, the offer price is set lower to protect against investor fail to purchase and to enable the underwriter to allocate some shares to preferred purchasers

Other Approaches to Public Offerings: Auction

Examples: Ravenwood Winery (1999), Google (2004)

While some auction method IPOs appear to reduce or eliminate underpricing, data indicate that underpricing is not eliminated

Even without underpricing, investors may not have the information to accurately price the security

An auction method can give rise to adverse selection – investors with winning bids can pay too much

Fearing adverse selection, investors may bid too little

The underwriter may be less able to certify the price

In Japan, when both auction and bookbuilding (general cash offering) were available, bookbuilding was the clear winner

Except in emerging economies with thin markets and little institutional investing, auction is rarely observed

Other Approaches to Public Offerings: Reverse Merger

Reverse Merger(Reverse IPO)

An public company (shell) acquires shares of a private company and then may change its name to that of the private company

The acquisition can occur with an exchange of shares (no cash)

This approach does not require an underwriter, does not incur the costs of an IPO, and can be done quickly

This is not a capital raising approach, but enables eventual harvesting by existing investors

There is no certification of value, no analyst following, etc. so market cap may be lower than if an IPO were used

Other Approaches to Public Offerings: Direct Listing

Direct Public Listing

An alternative to traditional IPO in which shares held privately by existing shareholders are registered for public market trading

The firm issues no new shares and may not engage an underwriter

Shareholders can then harvest by selling their shares in a public market

Example: Spotify

Other Approaches to Public Offerings: Direct Public Offering

Direct Public Offering

The SEC consolidated its exemptions for small and private offerings into Regulation D (“Reg D”), subsequently modified by the JOBS Act

Reg D contains several exemptions from the federal registration requirements, and thereby facilitates private placements of equity

Rule 504: Companies can sell up to $1 million of their securities to “accredited investors” in any 12-month period without registration (largely superseded)

Rule 505: Companies can sell, without registration, up to $5 million of their securities in any 12-month period to an unlimited number of accredited investors and up to 35 other persons. Investors receive “restricted securities”

Rule 506: Companies can raise an unlimited amount of capital without registration, provided they sell only to accredited investors

Regulation Crowdfunding (added in 2016 with JOBS Act): Covers offerings up to $1,000,000 (adjusting up with inflation) through an SEC-registered online platform

Harvesting in the IPO

It is common for investors and founders not to sell shares during the IPO

Their shares may “locked up” for up to 180 days after the IPO

After the lock-up period, there are several ways to harvest:

Rule 144 sale: gradual sale of shares to the market

Investors can arrange a large private transaction

It is more common for existing shareholders to participate in an SEO


Exchange modes

equity for cash

assets for cash

equity or assets for equity


Choice of public or private sale

Acquisition—Equity for Cash

Buyer acquires assets and assumes liabilities

Due diligence, representations and warranties can reduce information asymmetry and bring valuations closer

Good for VCs/investors

Immediate liquidity which is easily distributed

No adverse tax impact

May not be good for entrepreneurs/founders

Potentially large tax impact

May end the entrepreneur’s involvement

Risky for buyer

Trading a safe asset (cash) for the acquired risky assets

Increase in leverage if the cash is borrowed

Acquisition—Assets for Cash

Buyer can target only the desired assets for acquisition

Buyer avoids responsibility for liabilities and unattractive capital structure, e.g., target is in financial distress

Cash price to seller will be higher without the buyer assuming the liabilities

Acquisition—Equity or Assets for Stock

Requires due diligence on both sides since the seller is getting a risky asset (the acquirer’s shares) as payment

The acquirer avoids time/cost of raising financing

May allow the seller to postpone tax liability

Issues with a private acquirer

no “market value” for shares

non-traded shares may not provide liquidity

After the Acquisition

Buyer may seek to retain key managers

employment agreements

incentives and equity (restricted shares or options)

non-compete agreements and earn-ups

Agreeing to disagree

due diligence, representations and warranties

earn-out provisions to make value contingent on future performance



Valuing Private Transactions

Motivation for studying exit by private sale:

Private markets are finding ways to provide liquidity to large firms so that firm can avoid going public or stay private longer

Both private equity and debt are growing in importance

What can explain high valuations of private firms (e.g., unicorns valued at $1B or more)?

Gornall and Strebulaev (2017) study unicorns and find valuations based on the last round of funding (using preferred shares) tend to over-value common shares by 45%, on average

Valuing Private Transactions

How much is a venture worth in a private transaction?


Opportunity cost—next best alternative use value, e.g., the next best use for a company going public is its worth to a corporate acquirer

Transactions costs—the costs of arranging a private sale, including any illiquidity discount

Non cash (stock) vs cash—if the consideration is stock and if it is restricted, then the entrepreneur will remain underdiversified

Who captures synergistic gains from an acquisition?

The seller can expect to capture more of the gain if the assets are unique and if there is competition to acquire the assets

Valuing Private Transactions

Hertzel and Smith (1993) findings based on a sample of private placements of equity by public companies:

On average, private transaction shares are priced 20.1% below public shares

Discounts are larger for smaller firms, when small amounts are raised, and when a placement is large relative to firm size

Discounts are larger when uncertainty about value is high, such as when a firm is involved in speculative product or is in financial distress

These discounts are still low compared to the total issue cost of an IPO

Private Placement Discounts Compared to Market Value

Variable   Mean discount   Variable   Mean discount
Proceeds (millions)   Market value of equity (millions)
< $1.0   43.7%   < $10.0   34.60%
$1.0 - $5.0   33.1%   $10.0 - $25.0   35.60%
$5.0 - $10.0   15.1%   $25.0 - $75.0   17.20%
$10.0 - $20.0   10.1%   > $75.0   7.60%
> $20.0   0.2%        
        Single investor
Book-to-market equity ratio   Yes   11.70%
<0.1   31.3%   No   23.30%
0.1 - 0.4   25.0%        
0.4 - 0.7   21.9%   Speculative product
0.7 - 1.0   5.0%   Yes   32.20%
1.0   3.3%   No   14.70%
        Financial distress
        Yes   34.80%
        No   16.50%

Table 13.2

-- Table 13.2 –

Private placement discounts compared to equity market value

Note: Although the study uses data from private placements of public companies, the findings capture many of the qualitative considerations that are likely to affect the costs an acquirer would incur in acquiring a private venture.

Source: Hertzel and Smith (1993)


Illustration: Estimating the Cost of a Private Transaction

A biotech venture is generating revenue but is not profitable

Book assets equal $5M and no debt

Based on public comps, market value is around $20M

Table 13.2 (“proceeds” panel) suggests an acquisition price of about $18 M, (a discount of 10.1%)

Book-to-market equity ratio of 0.25 suggests an acquisition price of $15M (25% discount)

The market value estimate of $20M suggests an acquisition price of about $13M (discount of 35.6%)

Management Buy-Out (MBO)

A harvesting event is critical to VCs and other outside investors; it may be less important for the entrepreneur/founders

An MBO might be a response to investor insistence on exercising demand registration rights or to an acquisition bid

MBOs are usually financed with debt

 venture cash flows must be sufficient to service the debt

Valuing Management Buy-out Transactions

Buyer (the management team) knows most things that are possible to know about the venture

due diligence can be completed quickly and at lower cost

Entrepreneur may place subjective value on continuing to run the business

These costs savings/benefits may be offset by the opportunity cost of the entrepreneur and management team continuing to be underdiversified

Structure of a Private Leveraged ESOP

Entrepreneur may have little desire or need for harvesting

ESOP creates liquidity by establishing an internal market for a venture’s shares

Provide cash flow to entrepreneur

Help with estate/tax planning

Provide employee compensation

Leveraged versus unleveraged ESOP

Structure of a private leveraged ESOP

Figure 13.4

-- Figure 13.4 --

Structure of a private leveraged ESOP

Black arrows designate flow of shares; grey arrows designate flow of cash; dashed arrows are other flows.


Structure of a private leveraged ESOP

Figure 13.4

-- Figure 13.4 --

Structure of a private leveraged ESOP

Black arrows designate flow of shares; grey arrows designate flow of cash; dashed arrows are other flows.


Structure of a private leveraged ESOP

Figure 13.4

-- Figure 13.4 --

Structure of a private leveraged ESOP

Black arrows designate flow of shares; grey arrows designate flow of cash; dashed arrows are other flows.


Roll-Up IPO

A company too small to go public alone combines with others to create an organization large enough to make efficient use of the public offering process

similar firms

usually profitable

IPO based on consolidated financial statements


Blockbuster (video tape rental)

Waste Management (trash collection)

Roll-up IPO

Figure 13.5

-- Figure 13.5 --

Roll-up IPO


The Harvesting Decision

Factors that bear on the exit decision

Company size

The value of a public market for the shares

Synergies with prospective acquirers

Track record and ease of valuation


Ownership and control implications


Transactions costs



The Harvesting Decision

Company size

IPO is more effective for large firms

Small firms may achieve liquidity by acquisition

The value of a public market for the shares

Disclosure and reporting requirements

As a currency for acquisitions and compensation

Increased awareness of company’s products/image enhancement

Provides flexibility over harvest timing



The Harvesting Decision

Synergies with prospective acquirers

Being public may allow entrepreneur and investors to capture more value

Track record and ease of valuation

Public investors may not provide the best valuation for new and volatile ventures


IPO volume is highly sensitive to market conditions



The Harvesting Decision

Ownership and control implications

Entrepreneur likely loses control in an acquisition

MBO allows entrepreneur to maintain control but at the expense of underdiversification

Dual class shares or nonvoting shares may affect control of the public company


Public shares give the entrepreneur timing options

Transactions costs

Private transactions are less expensive than IPO

Roll-up IPO may make public shares possible even for small firms



The Value of Being Publicly Traded

Recent evidence indicates the net benefits of being public are diminishing in importance in developed economies

Doidge, Karolyi and Stulz (2017) show the number of public firm in the U.S. peaked in l996 and has declined by about 50%,

Kalcheva, Smith and Smith (2017) find similar declines in the number of listings in other developed economies

The decline appears to be associated with growth of institutional ownership and increase in private market benefits

Gao, Ritter and Zhu (2013) argue that the increase in acquisitions relative to IPOs is associated with pressures to grow rapidly

Harvesting Choices of VC-backed Firms

Figure 13.6 shows the drop off in IPO exits of VC-backed firms after 2000

-- Figure 13.6 --

Numbers of exits of VC-backed firms via IPO and M&A and the NASDAQ Index by quarter

Sources: Ball, Chiu, and Smith (2010), Pitchbook/NVCA, Statista, and Yahoo Finance


Public Market Values and Harvesting Choices

IPO activity increases with market valuations and decreases when market values decline

Possibly because of backward looking valuation practices and asymmetric nature of canceling IPOs if market values decline

Acquisitions continue as a viable exit strategy when IPOs are not

Research shows IPOs are selected when

marketwide demand for growth capital is high

adverse selection costs of issuing equity are low

the value of protecting private information is low

Little evidence that IPO issuers can effectively “time the market”


Harvesting - Summary

Exit strategies need to be considered when investment decisions are being made

impact on valuation and deal structure

IPO transactions costs are high, but there are distinct benefits to having public shares

Other exits include acquisition, MBO, ESOP, and roll-up IPO

Key decision factors include company size, track record, potential synergies, timing, taxes, control, liquidity and diversification opportunities, and value of being public



Firm Values











and IPOs


Estimate of


Filing Range

Reported in



Issue Price

Reported in




Cash Flow




from Due



of Interest




from Issuer


down” Due



1980 1980
1981 1981
1982 1982
1983 1983
1984 1984
1985 1985
1986 1986
1987 1987
1988 1988
1989 1989
1990 1990
1991 1991
1992 1992
1993 1993
1994 1994
1995 1995