Finance I (Corporate Finance), fall 2007 - L 5
Junghun Cho, junghun.cho@cerge-ei.cz, home.cerge-ei.cz/cho, room 327 x121
Andreas Ortmann, andreas.ortmann@cerge-ei.cz, home.cerge-ei.cz/ortmann, room 332b x117
Teaching assistants: Dorota Kowalczyk, Peter Ondko (Exercise sessions when ???)
Office hours to be negotiated in class once the schedule is set.
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Reading assignments and lecture notes see … http://home.cerge- ei.cz/ortmann/corp_finance/CorpFinance.html
Please note: The lecture notes are exactly that. They are my notes (mistakes and all) for the lecture. Nothing more. They are not a transcript of the lecture.
Main financial instruments: debt and equity (and mixes of the two)
Debt - a claim to a predetermined level on the firm’s income
- a claim with concave return structure – see Figure 2.1.
Equity – a residual claim (after debt is paid) but then to all of remaining profit
• a claim with convex return structure – see Figure 2.1.
”… at best a condensed view of the stream of returns … “ (T 75)
“Debt in a highly leveraged or ‘undercaptilized’ firm (D high) resembles equity in a modestly leveraged or
‘well-capitalized’ one (D low)” (Tirole p. 76) Why?
… in both cases claim holders are basically residual claimants at all income levels. Morale: labels can be misleading from a functional point of view.
Who (insiders, outsiders; a couple of large shareholders, many smaller shareholders) holds the claim also
matters (e.g., for the governance structure which in turn might affect investments, earnings, etc.).
Shareholders usually have control rights (as long as covenants are satisfied) but debtholders acquire some control rights in case of violation of these covenants.
From www.m-w.com:
Main Entry: 1cov·e·nant
Pronunciation: 'k&v-n&nt, 'k&-v&-
Function: noun
Etymology: Middle English, from Anglo-French, from present participle of covenir to be fitting, from Latin convenire
1 : a usually formal, solemn, and binding agreement : COMPACT
2 a : a written agreement or promise usually under seal between two or more parties especially for the performance of some action b : the common-law action to recover damages for breach of such a contract
Debt – ordinary and secured, the latter can seize assets first if debt cannot fully be reimbursed
The debt-equity is misleading, rather debt and equity are the endpoints of a spectrum of claims to a firm’s income; other claims:
- senior and junior (or, subordinated debt) – see above and Fig 2.2.; return schedule is neither convex nor concave. Risk is high, correspondingly would expect higher return.
• preferred stock – essentially sub-subordinated. Holders are entitled to a fixed dividend paid every period forever (i.e., they own a perpetuity) but only after subordinated claims and ordinary and secured claims have been served. Preferred stock has priority to common stock (which however may carry voting rights, in contrast to preferred stock)
• convertible debt – debt that at some point can be converted into equity (at a predetermined strike price) – How would this modify Figure 2.2?
• all three examples above are examples of mezzanine finance (as in the mezzanine level of the Harvard economics department)
Does it matter?
Modigliani – Miller and the capital structure irrelevance results (recall earlier discussion about trade-off and pecking-order theories; see also … Table 17.7 – reproduced below -- in RWJ which shows the capital structure for various U.S. industries, as well as all of chapter 17, and particularly the “In his own words” bit by Merton H. Miller on p. 561):
M&M proposition I: It is completely irrelevant how a firm chooses to arrange its finances
M&M proposition II: A firm’s cost of equity capital is positive linear function of the firm’s capital structure (or, to be more precise: the required rate of return on the firm’s assets, the firm’s cost of debt, and the firm’s debt-equity ratio.)
Aside (drawing on chapter 17 and 15 where the WACC is defined: V = D + E where D and E are the market values of D and E that factor into the so-called capital structure weights, D/V and E/V):
WACC = (E/V) x RE + (D/V) x RD (1 – TC), or the required return on a firm’s overall assets. Ignoring taxes, WACC = (E/V) x RE + (D/V) x RD. (What is being paid = required return … .)
Solving this for the cost of equity capital, RE = RA + (RA - RD) x (D/E) [use that V = D + E] which tells us that the cost of equity capital is a function of the required rate of return on the firm’s assets (RA), the firm’s cost of debt (RD), and the firm’s debt-equity ratio (D/E) ratio. See Figure 17.3 which illustrates this: (RA - RD) is the slope of the line that relates D/E to the cost of equity capital. As leverage increases, RA remains constant (and so does RD) but (RA - RD) x (D/E) increases (and so does RE).
Example 15.4: Calculating the WACC
Example: Calculating the cost of capital for Eastman Chemical – see RWJ 489 – 493, to be assigned as part of PS # 3.
Example: Financial leverage, EPS, and ROE (the Trans Am Corporation) – see RWJ 554 – 557, to be assigned as part of PS # 3.
Example in section 17.1 of RWJ:
Market value of Company is $1,000, Company currently has no debt, its 100 shares sell for $ … . What if Company restructures itself on the … side of the … by borrowing $500 and paying out the proceeds to shareholders as an extra dividend of … ? So, the equity value (almost surely) gets reduced but (some) compensation is there in form of the dividend. Does the dividend exactly compensate for the equity value reduction? Maybe. The overall value of the firm may increase or decrease: see Tables 17.1 and 17.2. M&M proposition I says it does not. However, this is under the assumption of no taxes (and there being no effect of reducing the equity share in the compensation package of the managers, for example). In any case, the proposed restructuring acts to magnify gains and losses to shareholders (which need to be rewarded for it), as
measured by EPS and ROE. See the Trans Am Corporation example (RWJ 554 – 557).
M&M proposition I is another way of saying you can cut the pie (= the value of the firm) any way you want;
it does not matter. Tirole puts it like this:
Let VE and VD denote the values of equity and debt for debt repayment and E also denote the expectations operator, then VE + VD = E[max(0, R-D)] + E[min(R,D)] = E[R] is independent of D which in terms of Fig.
2.1 means … ? (All this assuming value maximization!) – That’s the essence of M&M proposition I.
Similarly for payout policy (dividends and share repurchases/issuance):
- Consider an all-equity firm (whose rewards structure is the 45 degree line).
- Time is discrete t = 1, 2, …
- in each period, a random net revenue Rt accrues and a dividend dt is paid
- in each period, number of shares is adjusted from nt-1 to nt
- for each t, there is a (state-contingent) investment policy It as well as a (state-contingent) choice of dividend dt and number of shares (nt-1 > nt for repurchases, nt-1 < nt for issuance)
If Pt denotes the price of the share at the end of the period (after dt ), and β is the discount factor, then
• Pt = β E[dt+1 + Pt+1 ]
• Rt + Pt (nt - nt-1) = nt-1dt + It (accounting equality between sum of revenue and amount raised in the capital market)
• Thus, Vt = E[∑τ≥1 βτ(Rt+τ - It+τ)]) derivation in Tirole, p. 78; see also Miller Journal of Finance 1977;
note that dividend and capital market choices do not matter here, only the real characteristics (Rt , It).
The key question is whether the pie is indeed determined exogenously, or whether governance configuration (as discussed) plays a role in the determination of the pie size. See the somewhat repetitive – vis a vis the discussion in the introduction -- discussion in Tirole p. 79, first column.
“Our presentation of the main stylized facts about corporate financing emphasizes informational and control issues, which we feel are central tp a good understanding of the matter. That does not mean that other considerations, such as tax or clientele effects, are irrelevant.” (Tirole p. 79)
• tax considerations – see WACC formula, also understand that junk bonds are partially issued because to avoid the corporate income tax levied on equity
• clientele effects – some potential suppliers of funds may be restricted in what they can buy
• enforcement of financial contracts – may not be what it looks like (specifically, secured debt may be less secure than it looks on paper)
For the record:
A typical debt liability specifies (Tirole p. 80)
- the principal, the term (maturity), the rate of interest, the schedule (sinking fund or not?), and possibly other conditions (indexation, call provision, etc.)
- mechanisms for transmitting timely, credible information to the lender(s)
- warranties (= guarantees about the correctness of the requested and supplied information)
- positive covenants – actions that the borrower must take to protect the interests of the lender
- negative covenants – actions that the borrower must avoid to protect the interests of the lender
- default and remedy conditions
[I assume that we do not have to review sections 2.3.1, 2.3.2, 2.3.3, and 2.3.4 which strike me as self-
explanatory but would be happy to discuss whatever you want to discuss. Just send me a message or stop by my office. Interesting is the discussion of the dichotomies on the lending and borrowing side.]
Let’s turn to equity instruments although the first that we are going to discuss – venture capital liabilities are actually a good example of the uselessness of the debt-equity dichotomy as we will see.
Guiding questions (and suggested answers) to Kaplan and Stromberg 2003, Financial contracting theory meets the real world: An empirical analysis of venture capital contracts. Review of Economic Studies 70: 281 - 315.
0. What exactly does vesting mean?
Vocabulary (from www.m-w.com):
Main Entry: 1vest Pronunciation: 'vest
Function: verb
Etymology: Middle English, from Anglo-French vestir to clothe, invest, vest, from Latin vestire to clothe, from vestis clothing, garment -- more at WEAR
transitive verb
1 a : to place or give into the possession or discretion of some person or authority; especially : to give to a person a legally fixed immediate right of present or future enjoyment of (as an estate) b : to grant or endow with a particular authority, right, or property <the plan vests workers with pension benefits after 10 years of service>
2 : to clothe with or as if with a garment; especially : to robe in ecclesiastical vestments
Main Entry: vest·ing
Pronunciation: 'ves-ti[ng]
Function: noun
: the conveying to an employee of the inalienable right to share in a pension fund especially in the event of termination of employment prior to the normal retirement age; also : the right so conveyed
Vesting
From Wikipedia, the free encyclopedia
• Find out more about navigating Wikipedia and finding information • Jump to: navigation, search
For a vested interest in the nature of supporting a particular outcome for reasons of self-interest, see Vested interest. For the garment, see Vest.
In law, vesting is to give an immediately secured right of present or future enjoyment. One has a vested right to an asset that cannot be taken away by any third party, even though one may not yet possess the asset.
When the right, interest or title to the present or future possession of a legal estate can be transferred to any other party, it is termed a vested interest. The concept can arise in any number of contexts, but the most common are inheritancelaw and retirement planlaw. In real estate to vest is to create an entitlement to a privilege or a right. For example, one may cross someone else’s property regularly and unrestrictedly for several years, and that person’s right to an easement becomes vested. The original owner still retains the possession, but can no longer prevent the other party from crossing. <snip> Ownership in startup companies
Small entrepreneurial companies usually offer grants of common stock or positions in an employee stock option plan to employees and other key participants such as contractors, board members, and major vendors.
To make the reward commensurate with the extent of contribution, encourage loyalty, and avoid spreading ownership widely among former participants, these grants are usually subject to vesting arrangements.
Vesting of options is straightforward. The grantee receives an option to purchase a block of common stock, typically on commencement of employment, which vests over time. The option may be exercised at any time but only with respect to the vested portion. The entire option is lost if not exercised within a short period after the end of the employer relationship. The vesting operates simply by changing the status of the option over time from fully unexercisable to fully exerciable according to the vesting schedule.
Common stock grants are similar in function but the mechanism is different. An employee, typically a company founder, purchases stock in the company at nominal price shortly after the company is formed. The company retains a repurchase right to buy the stock back at the same price should the employee leave. The repurchase right diminishes over time so that the company eventually has no right to repurchase the stock, i.e. the stock becomes fully vested.
Vesting periods are usually 3-5 years for employees, but shorter for Board members and others whose expected tenure at a company is shorter. The vesting schedule is most often a pro-rata monthly vesting over the period with a six or twelve month cliff.
In the case of both stock and options, large initial grants that vest over time are preferable to periodic smaller grants because they are easier to account for and administer, they establish the arrangement up-front and are thus more predictable, and subject to some complexities and limitations the value of the grants and holding period requirements for tax purposes are set upon the initial grant date, giving a considerable tax advantage to the employee.
1. What exactly is it that Kaplan and Stroemberg do? (abstract, intro, conclusion)
• study 213 VC investments in 119 portfolio companies by 14 VC firms
• Each VC firm provided contractual agreements governing each round in which the firm participated (also provided company’s business plan, internal analyses, and information of subsequent
performances). The contractual agreements were coded
• find that VCs attempt to separately allocate cash flow rights, board rights, voting rights, liquidation rights, and other control rights, all of these often contingent om observable measures of financial and non-financial performance. Board rights, voting rights, and liquidation rights are latent but used when performance is poor.
• often write non-compete or vesting provisions in contracts to increase the costs of exit for key players (to counteract the potential hold-up problem suggested by theory)
• often insure key players in case they get disabled
2. VCs keep the firms in their portfolio on a tight leash. How exactly do they do it? (Study particularly carefully Table 1 and the related narrative; it does not make much sense to worry much about the data after the third round since numbers are very small for those higher financing rounds and even medians become less robust measures.)
• VCs commit relatively small tranches to firms (median commitment is $5.4 million in the first round), of which by the end of a round $3.6 million is actually disbursed (p. 283); financing provided upfront is about 80 %.
• VCs diversify their risks in various ways (investing in portfolios, building syndicates)
3. Tirole argues that “like sophisticated creditors, venture capitalists devote much attention to the structure of the deal. Screening of firms is intense (a tiny fraction of proposals received are funded), and conditions imposed on firms are drastic.” (p. 91) Give 3 – 4 examples of such drastic conditions. You will find some inspiration in section 3. Descriptive results
• convertible preferred stock? Participating convertible preferred (= straight preferred stock and common stock)
• financings allow for allocations of cash flow, voting, board, and liquidation rights (especially when the going gets rough)
• VC typically controls roughly 50% of the cash flow rights and founders 30%. So substantial ownership of founders is maintained (obviously to create high-powered incentives) but founders give up a large chunk of ownership.
• VC stake is state-contingent (especially in earlier rounds): good (bad) performance decreases (increases) VC stake although the deviations seem small.
• (Note that the number of board seats is somewhat smaller for emerging publicly traded firms than the number reported in Boone et al. or reported in Gillette et al. [assuming that there is no systematic difference between those firms being taken public and those that do not] To some extent that seems to support the scope-or-operations hypothesis.) See panel B in Table 2. The configuration of boards varies widely: “Overall, the VC has the majority of the board seats in 25% of the cases, the founders in 14% of the cases, and neither in 61% of the cases. VC board control is less common for first VC rounds.” (pp. 289 – 290) [See p. 299 why board rights and voting rights are important in an incomplete contracting world.]
• VCs have claims that in liquidation (which they can induce in about half of the cases; see the voting rights section) are senior to the common stock claims of the founders. True for all but one of the financings. Plus claims in liquidation are almost always (98% of cases) as large as
the original investments.
• Anti-dilution protections – … almost 95% of the financings include anti-dilution protection.
• Vesting and non-compete clauses - … founder vesting in 41% of the financing rounds and (with 48%
in first VC financings) and non-compete clauses in approximately 70% of the financings.
• Almost 75% of the financings include some kind of contingency (financial performance, non- financial performance, actions). See Table 3 for percentages and types of contingencies, last row, rightmost column. “Table 3 generates two strong results. First, investors (VC) commonly write contracts in which control rights are contingent on subsequent measures of financial performance, non-financial performance, and actions. Second, there is a great deal of variation in the contingencies in these contracts.” (p. 294)
[Section 3.8, contains a good summary.]
4. Similar to the attempts of Graham and Harvey (or for that matter Gillette et al), Kaplan and Stroemberg try to relate their empirical work to (three classes of financial contracting) theories which others have written (pp. 295 – 307). What do you consider the three most interesting confirmations, or disconfirmations of theoretical predictions?
• VCs try to align incentives by giving the entrepreneur significant equity stake in the firm but also condition that stake on a multitude of financial and nonfinancial signals, “consistent with the
Informativeness Principle”. Both in line with Holmstroem (1979). See also the regressions in Table 4 and the narrative on p. 297 – 299. Interestingly, the authors also argue that they have found some support for responsiveness to multi-tasking or gaming problems. (Very important for a place like CERGE-EI!) “The contracts in high volatility, high R&D, and smaller, presumably le established industries seem to use time vesting rather than explicit performance benchmarks to induce pay performance sensitivity.” This in line with multi-tasking models such as Holmstroem and Milgrom (1991)
• The extensive use of control rights, and the shift of control rights from entrepreneurs to VCs when things go poorly, is broadly consistent with assumptions/predictions in Aghion and Bolton (1992) and Dewatripont and Tirole (1994)
• “The results on liquidation rights and claims are mixed.” (p. 304)
5. A key finding of Kaplan and Stroemberg is that “it appears that real-world contracts are more complex than the theories predict.” (pp. 308 – 309) Without going into the details in section 5.1. and 5.2. . summarize what the two key findings are. Note that this result is in interesting contrast to the findings in Prendergast (1999) which the authors cite.
- The two key findings are:
- control rights, cash flow rights, and liquidation rights are all used simultaneously. Control rights are multi- dimensional to some extent a function of performance of the founders/entrepreneurs.
- each new round involves a new set of contract terms with previous contracts potentially being renegotiated.
6. What maybe a major drawback of the study? (pp. 285) Is it of interest to know if contracts are possible if one does not know what the outcome of such contracts is? Does controlling for VC firm fixed effects
compensate for that problem?
- ” … we do not attempt to measure performance [but see pen-ultimate full paragraph on page 297, AO].
Rather, we try to characterize what contracts look like in general and, perhaps more importantly, what contracts are possible. Moreover, in our regression results, we control for VC firm fixed effects, which will pick up systematic differences in the data from the different VCs.” (p. 286)
Should they have tried to use as performance proxy which company was the lead underwriter of the IPO?
What about those companies (after all about 75 percent) that did not make it to the IPO stage? (Selection bias?)
