Corporate Finance Ross  Westerfield  Jaffe

Chapter Nineteen 19 Issuing Securities to the Public Corporate Finance Ross Westerfield  Jaffe Sixth Edition Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

Executive Summary • Issuing securities involves the corporation in a number of decisions. • This chapter looks at how corporations issue securities to the investing public. • The basic procedure for selling debt and equity securities are essentially the same. This chapter focuses on equity.

Chapter Outline 19.1 The Public Issue 19.2 The Basic Procedure for a New Issue 19.3 The Cash Offer 19.4 The Announcement of New Equity and the Value of the Firm 19.5 The Cost of Issuing Securities 19.6 Rights 19.7 The Private Equity Market 19.8 Summary and Conclusions

19.1 The Public Issue • Regulation of the securities market in Canada is carried out by provincial commissions. • In the U.S., regulation is handled by a federal body (SEC). • The regulators’ goal is to promote the efficient flow of information about securities and the smooth functioning of securities’ markets. • All companies listed on the TSE come under the jurisdiction of the Ontario Securities Commission (OSC). • Other provinces have similar legislation and regulating bodies

19.2 The Basic Procedure for a New Issue Steps involved in issuing securities to the public: • Management obtains approval from the board of directors. • The firm prepares a preliminary prospectus to the OSC. • The OSC studies the preliminary prospectus and notifies the company of any changes required. • Once the revised, final prospectus meets with the OSC’s approval, a price is determined and a full-fledged selling effort gets under way.

19.3 The Cash Offer • Underwriters are usually involved in a cash offer. • Underwriters perform the following services: • Formulating the method used to issue the securities. • Pricing and selling the new securities. • The difference between underwriter’s buying price and the offering price is called the spread. • Because underwriting involves risk, underwriters combine to form an underwriting group called a syndicate

19.3 The Cash Offer (cont.) Types of Underwriting: two types of underwriting are involved in a cash offer. • Regular Underwriting • firm commitment underwriting • best efforts underwriting • Bought Deal • In a bought deal, the issuer sells the entire issue to one investment dealer or to a group.

19.3 The Cash Offer (cont.) • The selling period: while the issue is being sold to the public, the underwriting group agrees not to sell securities for less than the offering price until the syndicate dissolves. • The overallotment option: known as the Green Shoe provision gives members of the underwriting group the option to purchase additional shares at the offering price less fees and commissions. • Investment Dealers: • In 2000, RBC Dominion Securities was the leading underwriter by revenue. • TD securities was the first ranked by assets.

19.3 The Cash Offer (cont.) The offering price: • Determining the correct offering price is an underwriter’s hardest task. • The issuing firm faces a potential cost if the offering price is set too high or too low. Underpricing: • Underpricing is a common occurrence and it clearly helps new shareholders earn a higher return on the shares they buy. • In the case of an IPO, underpricing reduces the proceeds received by the original owners.

19.4 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-to-equity ratio due to the specter of financial distress the stock price will fall. • Falling Earnings

19.5 The Cost of Issuing Securities • Spread or underwriting discount • Other direct expenses • Indirect expenses • Abnormal returns • Underpricing • Green Shoe option

The Costs of Public Offerings Costs of Going Public in Canada: 1984--97 Fees 6.00 % Underpricing 7.88 % TOTAL 13.88 % • The above figures understate the total cost because they ignore indirect expenses or the overallotment option.

19.6 Rights • An issue of common stock offered to existing shareholders is called a rights offering. • Prior to the 1980 Bank Act, chartered banks were required to raise equity exclusively through rights offerings. • 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.

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.

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?

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.

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

Theoretical Value of a Right The theoretical value of a right during the rights-on period is: R0 = (M0 – S) / (N +1) Where, M0 = Common share price during the rights-on period S = Subscription price N = Number of rights required to buy one new share

Value of a Right after Ex-Rights Date • When the stock goes ex-rights, its price drops by the value of one right. Me = M0 – R0 Re = (Me – S) / N Where, Me is the common share price during the ex-rights period.

Cost of Rights Offerings • Until the early 1980s, rights offerings were the most popular method of raising new equity in Canada for seasoned issuers because of lower flotation costs. • In the late 1980s and early 1990s, with the rise of POP, bought deals replaced rights offers as the prevalent form of equity issue.

19.7 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. • There are many firms that have not reached this stage and cannot use the public equity market. • For start-up firms and firms in financial trouble, the public equity market is often not available.

Private Placements • Avoid the costly procedures associated with the registration requirements that are a part of public issues. • The OSC and SEC restrict private placement issues of 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.

Venture Capital • The limited partnership is the dominant form of intermediation in this market. • There are five types of suppliers of venture capital: • Old-line wealthy families. • Private partnerships and corporations. • Large industrial or financial corporations with established venture-capital subsidiaries. • The federal government (through crown-related firms). • 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.

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 six months; a.k.a. bridge financing.

19.10 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.

Corporate Finance Ross  Westerfield  Jaffe