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 • Spread or underwriting discount • Other direct expenses • Indirect expenses • Abnormal returns • Underpricing • 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 firm’s 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 > $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.