Stock Offerings and Investor Monitoring

1. 10 Stock Offerings and Investor Monitoring

2. Other People’s Money OPM • As a new business grows, it will at some point likely need Other People’s Money (OPM), which could come in two forms: • 1) Debt: • - loan from the bank (doubtful unless collateral is available) • - loan from a relative or a friend, credit card debt, government loans, bonds, etc., or • 2) Equity: • - Private equity: rich uncle, venture capitalist, hedge fund, private equity firm (e.g. Blackstone, Cerberus, Bain) or- Public equity: public stock offerings (min. $50m)

3. Venture Capitalists • There are thousands of people with an idea who need OPM to develop their idea. Most of these new ideas (ventures) will fail. In fact, half of all small businesses fail in just four years. But some of those that survive can end up being spectacularly successful (e.g. eBay). • Banks and other every-day sources of capital are too risk-adverse to consider being a partner. But there are thousands of risk-tolerant venture capital firms (also wealthy individuals called angel investors) looking around for an above-normal return. (http://www.vfinance.com/) • Most of the ideas presented to VCs are not marketable and will end up in the VCs round file. The VCs get thousands of requests but are only going to consider a few. Many times, VCs rely on an informal network of professional friends (scientists, lawyers, accountants, bankers, etc.) to help identify potential investments.

4. Venture Capitalists • Venture capitalists face huge risks. In an effort to protect themselves, VCs advance just enough money for the venture to finish the first stage of development (e.g. prototype built). Based on the results, second stage money is advanced to begin manufacturing, marketing and distribution. • VCs usually specialize in various stages (e.g. seed money or ground floor vs. mezzanine or above ground floor). • To compensate for huge risks, VCs demand big returns, typically requiring 40-60% of the equity and several seats on the board. • When a start-up selects a venture capitalist, it is important to do some research ahead of time. Is the VC financially strong? What is the style of the VC? (hands-on or laizze faire? flexible or bureaucratic?) What reputation does the VC have? (check with references) What specialties does the VC have? Does the VC have a network of contacts with special skills? How and when will the VC “cash out” of the venture? • VCs usually don’t’ hold the investment very long – maybe 4-7 years or until an IPO occurs.

5. Crowd Funding • Crowd funding is when people pool their money, usually via the Internet, to support a new venture • Common examples include Internet-based organizations that help artists (musicians, film makers, etc.) raise money from their fans, or charities raise money for projects • ArtistShare, Sellaband, IndieGoGo, Kickstarter, Microventures • Global Giving, Kiva, and Wokai • In crowd funding, people usually purchase small stakes of equity in the venture. Consequently, the SEC is in the process of creating rules.

6. Venture Capitalists vs. Private Equity • Venture capitalists usually invest in start-ups only and don’t’ hold the investment very long – maybe 4-7 years or until an IPO occurs • Private equity funds usually takeover a company and manage it (e.g. www.blackstone.com, www.cerberuscapital.com, www.baincapital.com ). Private equity managers hope to manage their businesses so well that the businesses grow in value (i.e. sell their stake down the road at a profit). Private equity funds often rely heavily on debt financing.

7. Primary vs. Secondary Markets Common stock = certificate representing equity or partial ownership in a corporation Issued in PRIMARY MARKET by corporations that need long-term funds Stock is then traded in the SECONDARY MARKET, creating liquidity for investors and company evaluation for managers

8. Common Stock • Owners of common stock vote on: • Election of board of directors • Authorization to issue new shares • Amendments to corporate charter • Other major events (ratify selection of auditors, etc.) • Many investor assign their vote to management via a proxy • Individuals directly own about 25% of all common stock, the rest is owned by institutional investors • Owned 92% of common stock in 1950

9. Preferred Stock • Represents equity or ownership interest, but usually no voting rights, so a very passive owner • Preferred in the sense that it gets first rights to dividends • Heavily owned by corporate investors because of dividend tax exemption • Not an important source of L/T capital

10. Initial Public Offerings (IPOs) • First-time sale of shares to the public • Most common in bull market • Typically won’t happen until a company is big enough to sell at least $50 million of stock. • Reasons for IPOs: • The firm has maxed out its borrowing potential and needs additional funds for expansion • It’s a way for VC’s & insiders to cash in on their investment and become millionaires overnight. • A third but less significant reason is to make a splash in a news and perhaps attractive the attention of future customers

11. Steps in Initial Public Offerings (IPOs) • Steps in IPO process (not necessarily sequential): • Get financial statements in accordance with GAAP and have them audited. • Meet with lawyers and talk about charter, governance, board structure, executive compensation, etc. • Select an investment banker • Submit registration statement to SEC for approval (one month turn around) • Prepare prospectus for prospective investors (called red herring) which is like registration statement but more user friendly

12. Steps in Initial Public Offerings (IPOs) • Steps continued: • Road show presented to institutional investors in the process of bookbuilding. A tombstone announcement is prepared to advertise. Major bracket investment banking firms are listed first (see brackets on next slide) • Leftover shares go to individual investors • IPO price is set and shares sold. • A quiet period occurs after IPO for 40 days in which insiders must not talk about the IPO. All relevant information should have been in the prospectus. (Google almost violated this rule in its IPO). • Investment banker holds the firm’s hand all thru the process for a commission on amount raised (usually around 7%).

13. Tombstone Announcement (looks like a tombstone) Examples of underwriters: Goldman Sachs, Morgan Stanley, Merrill Lynch, etc. Technically, there are no major-bracket U.S. investment banks in existence anymore. Bear Stearns and Lehman Brothers went under. Merrill Lynch was purchased by Bank of America. And Goldman Sachs and Morgan Stanley switched to commercial bank charters.

14. Initial Public Offerings (IPOs) • Price must be set just right: • too high – fewer shares sold, less $$ raised. If too few shares, offer may have to be withdrawn. • too low – all shares sold but brings in less $$. • Underpricing is fairly common in order to increase the return to insiders who get in on the initial IPO. This is especially the case with smaller, more risky IPOs. • Performance of IPOs: Price generally rises on first day (almost 20% one-day returns over last 30 years) but long-term performance of IPOs usually is poor. • Lockup provision (usually 6 mo.) prevents flipping. Incentive for insiders to be more truthful about information provided before IPO • IPOs tend to occur more frequently during bullish stock markets

15. Historical Trend of IPOs

17. Recent IPO Examples: Facebook (FB), May 18, 2012, offer price $38 Groupon (GRPN), Nov. 4, 2011, offer price $20. LinkedIn (LNKD, May 19, 2011, offer price $45. General Motors (GM), Nov. 18, 2010, offer price $33. Go to http://www.renaissancecapital.com/IPOHome/Rankings/BiggestUS.aspx to see largest US IPOs.

18. Example of IPOs Recent IPO Example: Groupon (GRPN), November 4, 2011 Groupon has not been able to maintain its IPO price of $20

19. Example of IPOs Recent IPO Example: LinkedIn (LNKD), May 19, 2011 Based on the first few days of trading, this IPO was wildly successful, given that its offer price was only $45 per share.

20. Example of IPOs General Motors (GM) IPO: November 18, 2010General Motors became a public company again (ticker GM) on 11/18/10 by raising $23.1 billion in the largest IPO in global history up to that point. Most of the funds were used to pay back the government investment, bringing the government’s ownership percentage down to about 33%. The offer price was set at $33 per share, at which GM sold some 700 million shares. Although the price initially rose a few dollars on the first day, the price essentially remained close the offer price for the first couple of weeks.

21. IPOs (cont.) • Abuses in the IPO market • In 2003, regulators attempted to impose new guidelines that would prevent abuses • Spinning is the process in which an investment bank allocates IPO shares to executives • Laddering involves increasing the price above the offer price on the first day of issue in response to substantial demand • Excessive commissions are sometimes charged by brokers when there is substantial demand for the IPO

22. Google’s IPO: Aug. 19, 2004 • Dutch Auction allows ALL investors (both individual and institutional) to submit bids and all bids above a certain cutoff are accepted. • Dutch Auction resulted in more participation by non-institutional investors (the little guy) and lower costs (saved $20 million in fees because investment banks are not trying to re-sell shares to investors) • Initial price $118-135 but revised to $85 • Sold all 19.6 million shares resulting in proceeds of $1.67b (could have raised more as price was at $100 by end of day) • What is it today? (ticker GOOG) • Lot’s of flipping going on (33.3 million shares traded during first two days) • Google made available lots of info that could be easily understood by everyone

23. Google’s IPO: Aug. 19, 2004

24. Public Placement of Stock • Secondary stock offerings • New stock issued by firm that already has shares outstanding. Often occurs as part of restructuring efforts to achieve optimal capital structure • Shelf Registration • 1982 SEC rule • Allows firms to place securities (usually within two years) without the time lag associated with registering with SEC

25. Costs of IPOs

26. Costs of IPOs

27. Stock Secondary Markets Organized Exchanges • Execute secondary market transactions • Examples: NYSE, AMEX, Midwest, Pacific • NYSE is largest, controlling 80 percent of value of all organized exchanges in the U.S. • Used to own a “seat” on exchange in order to trade • Used to be 1366 seats each costing $1.5m • Now firms purchase a license to trade instead of a seat • Trading resembles an auction • Min. requirements: large company with lots of shares at least worth $1

28. NYSE

29. Stock Secondary Markets Over the Counter (OTC) • No trading floor or specific location • Telecommunications network • Nasdaq • National Association of Securities Dealers Automatic Quotations • Thousands of small firms, plus high-tech giants • OTC Bulletin Board (penny stock trading, <$1) • Pinksheets • Even tinier firms that do not meet requirements for NASDAQ (usually penny stocks of fairly risky companies with OB extensions in their tickers)

30. Nasdaq Headquarters A computer network -- no trading floor – only physical infrastructure is headquarter building in Manhattan

31. Stock Secondary Markets • Changes in technology • ECN (electronic communication networks) take out the middlemen (brokers) although still some need for market makers and specialists • http://batstrading.com • Online trading has forced fees to drop substantially • Real-time quotes in decimals • After hours trading (crazy idea?) • Oodles of company info & research (much of it free)

32. Stock Indexes • Dow Jones Industrial Average • 30 large U.S. firms • Disadvantages: (1) price-weighted, (2) only 30 stocks, (3) only represents large industrials (doesn’t represent small companies, tech companies, etc.) • Standard and Poor’s (S&P) 500 • Value-weighted • 500 leading U.S. firms • DJ Wilshire 5000 Total Mkt covers all U.S. stocks • New York Stock Exchange Indexes • Other Stock Indexes: Amex, NASDAQ, etc.

33. Categorizing the Secondary Market • In the U.S., companies and stocks are often categorized by the following approximate market capitalization values: • Small-cap: market cap below US$1 billion • Mid-cap: market cap between US$1 billion and US$5 billion • Large-cap: market cap exceeds US$5 billion • The small-cap definition is far more controversial than those for the mid-cap and large-cap classes. Typical values for the ranges are enumerated here: • Micro-cap: market cap under US$100 million • Nano-cap: market cap under US$50 million • Blue chip is sometimes used as a synonym for a large-cap, while some investors consider any micro-cap or nano-cap issue to be a penny stock, regardless of share price.

34. Types of Investors in Stock • Individuals Investors • Owned 92% of common stock in 1950 • Today, they own only 25%! • Institutional Investors • Today, institutional investors own about 3/4ths of common stock outstanding • Examples: Pension Funds, Mutual Funds, Insurance Companies, Endowment Funds, Hedge Funds, etc. • Hold huge voting power (CALPERS likely holds more stock than any other single entity)

35. Agency problem: investor actions Shareholder activism An investor who is dissatisfied with the way managers are running a firm has three choices: Sell Do Nothing Flush! Shareholder Activism– Proxy Fight

36. Corporate Actions re: Stock Value • Mgmt is under tremendous pressure to meet earnings targets (not given too many chances). • Mgmt also has personal incentive to raise stock price (stock options, etc.) • Mgmt Responses: • Stock repurchases to increase price & distribute cash • LBOs options (junk bonds) • Threat of Hostile Takeover • Stock price decline to bargain price due to poor management • Antitakeover amendments to charter (2/3 vote) • Poison pills (existing owners get 25% of all new shares) • Golden parachutes

37. Accounting Scandals • Accounting irregularities • To the extent that firms can manipulate financial statements they may be able to hide information from investors • e.g., Enron, Tyco, and WorldCom • The auditors hired to audit financial statements allowed them to use unusual accounting methods • Board members on the audit committee were not always monitoring the audit

38. SOX 2002 • The Sarbanes-Oxley Act of 2002: • Was implemented to ensure more accurate disclosure of financial information to investors • Attempts to force auditors to take their auditing role seriously. Audit firms must register with SEC and be “audited.” They can be punished for substandard work. • Prevents a public accounting firm from auditing a client whose CEO, CFO, or other employees are employed by the client firm within one year prior to the audit • Audit partner rotation every 5 years

39. SOX 2002 (cont.) • The Sarbanes-Oxley Act: • Requires that only outside board members of a firm be on the firm’s audit committee • Prevents the members of a firm’s audit committee from receiving consulting or advising fees from the firm • Requires that the CEO and CFO of firms to certify that the audited financial statements are accurate • Specifies major fines or imprisonment for employees who mislead investors or hide evidence • Allows public accounting firms to offer non-audit consulting services to an audit client only if the client pre-approves those services • Cost of SOX to many companies >$1 million.

40. Stock Markets Around the World http://www.world-exchanges.org/statistics/monthly-reports

41. http://www.world-exchanges.org/statistics/monthly-reports

43. Globalization of Stock Markets • Barriers to international stock trading have decreased • Reduction in information costs • Reduction in exchange rate risk • Correlation among markets (1987 crash) • In 2007, NYSE merged with stock exchanges in Paris, Brussels, and Amsterdam (called NYSE Euronext). Merger with German stock exchange is on hold. • Foreign co. desire to tap into US markets but SEC requirements are costly, so many will sell ADRs (American Depository Receipts). http://www.adr.com/ (e.g. Honda, ticker HMC)

44. Globalization of Stock Markets • Methods used to invest in foreign shares • Direct purchases (limited market) • American Depository Receipts (ADRs) • Advantages: Fin. Stmt. per US GAAP, lots of info by analysts, reliable quotes • Disadvantage: less liquid than US stocks • International mutual funds • World equity benchmark shares (WEBs or international iShares)