Issuing Securities to the Public

1
Issuing Securities to the Public

• 19.1 The Public Issue
• 19.2 Alternative Issue Methods
• 19.3 The Cash Offer
• 19.4 The Announcement of New Equity and the Value
  of the Firm
• 19.5 The Cost of New Issues
• 19.6 Rights
• 19.7 The Rights Puzzle
• 19.8 Shelf Registration
• 19.9 The Private Equity Market
• 19.10 Summary and Conclusions

2
The Public Issue

• The Basic Procedure
• Management gets the approval of the Board of
  Directors.
• The firm prepares and files a registration
  statement with the SEC.
• The SEC studies the registration statement during
  the waiting period.
• The firm prepares and files an amended
  registration statement with the SEC.
• If everything is copasetic with the SEC, a price
  is set and a full-fledged selling effort gets
  underway.

3
The Process of A Public Offering

• Steps in Public Offering Time
• 1. Pre-underwriting conferences
• 2. Registration statements
• 3. Pricing the issue
• 4. Public offering and sale
• 5. Market stabilization

Several months 20-day waiting period
Usually on the 20th day
After the 20th day 30 days after
offering
4
Alternative Issue Methods

• There are two kinds of public issues
• The general cash offer
• The rights offer
• Almost all debt is sold in general cash offerings.

5
The Cash Offer

• There are two methods for issuing securities for
  cash
• Firm Commitment
• Best Efforts
• There are two methods for selecting an
  underwriter
• Competitive
• Negotiated

6
Firm Commitment

• Under a firm commitment underwriting, the
  investment bank buys the securities outright from
  the issuing firm.
• Obviously, they need to make a profit, so they
  buy at wholesale and try to resell at retail.
• To minimize their risk, the investment bankers
  combine to form an underwriting syndicate to
  share the risk and help sell the issue to the
  public.

7
Best Efforts

• Under a best efforts underwriting, the
  underwriter does not buy the issue from the
  issuing firm.
• Instead, the underwriter acts as an agent,
  receiving a commission for each share sold, and
  using its best efforts to sell the entire
  issue.
• This is more common for initial public offerings
  than for seasoned new issues.

8
Green Shoes and Lockups

• Green Shoe provision
• Allows syndicate to purchase an additional 15 of
  the issue from the issuer
• Allows the issue to be oversubscribed
• Provides some protection for the lead underwriter
  as they perform their price stabilization
  function
• Lockup agreements
• Restriction on insiders that prevents them from
  selling their shares of an IPO for a specified
  time period
• The lockup period is commonly 180 days
• The stock price tends to drop when the lockup
  period expires due to market anticipation of
  additional shares hitting the street

9
The Announcement of New Equity and the Value of
the Firm

• The market value of existing equity drops on the
  announcement of a new issue of common stock.
• Reasons include
• Managerial Information
• Since the managers are the insiders, perhaps
  they are selling new stock because they think it
  is overpriced.
• Debt Capacity
• If the market infers that the managers are
  issuing new equity to reduce their debt-equity
  ratio due to the specter of financial distress
  the stock price will fall.
• Falling Earnings

10
Work the Web Example

• How have recent IPOs done?
• Click on the web surfer to go to the Bloomberg
  site and follow the IPO Center link
• How many companies have gone public in the last
  week?
• How have companies that went public three months
  ago done? What about six months ago?

11
The Cost of New Issues

1. Spread or underwriting discount
2. Other direct expenses
3. Indirect expenses
4. Abnormal returns
5. Underpricing
6. Green Shoe Option

12
The Costs of Public Offerings

• Equity
• Proceeds Direct Costs Underpricing
• (in millions) SEOs IPOs IPOs
• 2 - 9.99 13.28 16.96 16.36
• 10 - 19.99 8.72 11.63 9.65
• 20 - 39.99 6.93 9.70 12.48
• 40 - 59.99 5.87 8.72 13.65
• 60 - 79.99 5.18 8.20 11.31
• 80 - 99.99 4.73 7.91 8.91
• 100 - 199.99 4.22 7.06 7.16
• 200 - 499.99 3.47 6.53 5.70
• 500 and up 3.15 5.72 7.53

13
Rights

• If a preemptive right is contained in the firms
  articles of incorporation, the firm must offer
  any new issue of common stock first to existing
  shareholders.
• This allows shareholders to maintain their
  percentage ownership if they so desire.

14
Mechanics of Rights Offerings

• The management of the firm must decide
• The exercise price (the price existing
  shareholders must pay for new shares).
• How many rights will be required to purchase one
  new share of stock.
• These rights have value
• Shareholders can either exercise their rights or
  sell their rights.

15
More on Rights Offerings

• Ex-rights the price of the stock will drop by
  the value of the right on the day that the stock
  no longer carries the right
• Standby underwriting underwriter agrees to buy
  any shares that are not purchased through the
  rights offering
• Stockholders can either exercise their rights or
  sell them they are not hurt by the rights
  offering either way
• Rights offerings are generally cheaper, yet they
  are much less common than general cash offers in
  the U.S.

16
Rights Offering Example

• Popular Delusions, Inc. is proposing a rights
  offering. There are 200,000 shares outstanding
  trading at 25 each. There will be 10,000 new
  shares issued at a 20 subscription price.
• What is the new market value of the firm?
• What is the ex-rights price?
• What is the value of a right?

17
Rights Offering Example

• What is the new market value of the firm?
• There are 200,000 outstanding shares at 25
  each.There will be 10,000 new shares issued at a
  20 subscription price.

18
Rights Offering Example

• What is the ex-rights price?
• There are 110,000 outstanding shares of a firm
  with a market value of 5,200,000.
• Thus the value of an ex-rights share is

• Thus the value of a right is
• 0.2381 25 24.7619

19
The Rights Puzzle

• Over 90 of new issues are underwritten, even
  though rights offerings are much cheaper.
• A few explanations
• Underwriters increase the stock price. There is
  not much evidence for this, but it sounds good.
• The underwriter provides a form of insurance to
  the issuing firm in a firm-commitment
  underwriting.
• The proceeds from underwriting may be available
  sooner than the proceeds from a rights offering.
• No one explanation is entirely convincing.

20
Shelf Registration

• Permits a corporation to register an offering
  that it reasonably expects to sell within the
  next two years.
• Not all companies are allowed shelf registration.
• Qualifications include
• The firm must be rated investment grade.
• The cannot have recently defaulted on debt.
• The market capitalization must be gt 75 m.
• No recent SEC violations.

21
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.
• For start-up firms and firms in financial
  trouble, the public equity market is often not
  available.

22
Private Placements

• Avoid the costly procedures associated with the
  registration requirements that are a part of
  public issues.
• The SEC restricts private placement issues ot no
  more than a couple of dozen knowledgeable
  investors including institutions such as
  insurance companies and pension funds.
• The biggest drawback is that the securities
  cannot be easily resold.

23
Venture Capital

• The limited partnership is the dominant form of
  intermediation in this market.
• There are four types of suppliers of venture
  capital
• Old-line wealthy families.
• Private partnerships and corporations.
• Large industrial or financial corporations have
  established venture-capital subsidiaries.
• Individuals, typically with incomes in excess of
  100,000 and net worth over 1,000,000. Often
  these angels have substantial business
  experience and are able to tolerate high risks.

24
Venture Capital

• Private financing for relatively new businesses
  in exchange for stock
• Usually entails some hands-on guidance
• The ultimate goal is usually to take the company
  public and the VC will benefit from the capital
  raised in the IPO
• Many VC firms are formed from a group of
  investors that pool capital and then have
  partners in the firm decide which companies will
  receive financing
• Some large corporations have a VC division

25
Choosing a Venture Capitalist

• Look for financial strength
• Choose a VC that has a management style that is
  compatible with your own
• Obtain and check references
• What contacts does the VC have?
• What is the exit strategy?

26
Stages of Financing

• Seed-Money Stage
• Small amount of money to prove a concept or
  develop a product.
• Start-Up
• Funds are likely to pay for marketing and product
  refinement.
• First-Round Financing
• Additional money to begin sales and
  manufacturing.
• Second-Round Financing
• Funds earmarked for working capital for a firm
  that is currently selling its product but still
  losing money.
• Third-Round Financing
• Financing for a firm that is at least breaking
  even and contemplating expansion a.k.a.
  mezzanine financing.
• Fourth-Round Financing
• Financing for a firm that is likely to go public
  within 6 months a.k.a. bridge financing.

27
Summary and Conclusions

• Larger issues have proportionately much lower
  costs of issuing equity than small ones.
• Firm-commitment underwriting is far more
  prevalent for large issues than is best-effort
  underwriting. Smaller issues probably use best
  effort because of the greater uncertainty.
• Rights offering are cheaper than general cash
  offers.
• Shelf registration is a new method of issuing new
  debt and equity.
• Venture capitalists are an increasingly important
  influence in start-up firms and subsequent
  financing.