How Securities are Issued?

Complete No. 1 2 3 4 5 6 7 Name

Primary & Secondary Markets Investment Bankers Initial Public Offerings (IPOs) Private Placements Pricing an IPO Advantages of going Public Disadvantages of going Public

In chapter two, we discuss in detail the process through which securities are issued and the players involved. The process of investment banking and issuing securities in the primary market is discussed in detail. We cover the steps involved in taking a company public through an Initial Public Offering (IPO) and discuss the legal and structural aspects as well as the parties involved.

Chapter:2

How Securities are Issued?

Section :1 Primary & Secondary Markets

When businesses need to raise capital, they may choose to sell or float securities. The market for new issues of stocks, bonds, or other types of securities that are marketed to the public by investment bankers, is called the Primary Market. Hence, a primary market is where securities are sold for the first time. Purchase or sale (trading) of already-issued securities among investors occurs in the Secondary Market. There are two types of primary market issues of common stock: Initial Public Offerings, or IPOs, are stocks issued by a new business or a formerly privately owned company that is now going public i.e. offering stock to the public for the first time.
Seasoned new issues, or Seasoned Offerings, are offered by corporations that are already

publicly listed. For example, a sale of new shares by SABIC would constitute a seasoned offering. In case of bonds, we distinguish between the two types of primary market issues, a Public Offering and a Private Placement. The former refers to an issue of bonds sold to the general investing public that can then be traded in the secondary market. The latter refers to an issue that is usually sold to one or a few institutional investors and is generally held to maturity.

Chapter:2

How Securities are Issued?

Section :2 Investment Bankers

Investment bankers are firms specializing in the sale of new securities to the public, typically by advising, structuring and underwriting the issue. Just as economies of scale and specialization create profit opportunities for industrial concerns and financial intermediaries, so do these economies of scale create niches for firms that perform specialized services for businesses. Firms raise much of their capital by selling securities such as stocks and bonds to the public. Because these firms do not do so frequently, investment-banking firms that specialize in such activities can offer their services at a cost below that of maintaining an in-house security issuance division. Investment bankers such as Goldman Sachs, Merrill Lynch, or Solomon Smith Barney in US, or Gulf Investment Bank or Arab Banking Corporation in the GCC region, advise the issuing corporation on the pricing of the issue, appropriate interest rate, and so forth. Ultimately, the investment-banking firm markets the security issue to the investing public through road shows, advertisements, etc. Apart from raising capital, investment bankers can offer their expertise in a wide range of services to their clients. The fact that investment bankers are constantly in the market, assisting one firm or another in issuing securities, and depend on their reputation to generate future business, helps in creating confidence of the investing public in investment banking institutions. The investment banker will suffer along with the investors if the securities it underwrites are marketed to the public with overly optimistic or exaggerated claims; the public will not be so trusting the next time that investment banker participates in a security sale.

Chapter:2

How Securities are Issued?

Section :3 Initial Public Offerings (IPOs)

Complete

No. 1 2 3 4 5 6
Prospectus Underwriting Placement Agents Spread Road Shows Book Building

Name

When a corporation needs to raise capital, they either issue debt securities (bonds) or by equity (selling stock). Anytime a corporation issues new stock it comes from 'Authorized But Not Yet Issued Stock'. If the corporation has sold stock before, this is known as a Seasoned Offering'. A company can have many Seasoned Offerings. When a corporation offers its stock for sale for the first time, it is known as anInitial Public Offering (IPO). A company can only have one Initial Public Offering. The first step for the corporation is to hire an investment bank. The investment bank will act as the advisor, distributor and underwriter. Underwriting is the actual process of raising capital through debt or equity. The corporation seeking to raise capital is not required to hire the services of an investment banker by law and if it wanted to, it could go door to door selling its stocks or bonds. Investment bankers advise the firm regarding the terms on which it should offer the securities. A preliminary registration statement must be filed with the Securities & Exchange Commission (or whoever is the relevant regulatory authority), describing the

issue and the prospects of the company. This statement in the final form, and approved by the regulatory authority, is called the Prospectus.

Chapter:2 How Securities are Issued? Section :3 Initial Public Offerings (IPOs) Sub Section :3 Prospectus

A typical Prospectus includes a detailed description of the business, raising the money, biographical material on the officers and directors of the company, the amount of shares each insider (officers, directors, and shareholders owning more than 10% of the securities) owns, complete financial statements including existing debt and equity securities and how they are capitalized, where the proceeds of the offering are going (use of funds), and any legal proceedings involving the company including strikes, lawsuits, antitrust actions, copyright/patent infringement suits, all for the present time period or if they are aware of impending or future actions. The document also includes the price at which the security is to be offered.

Chapter:2 How Securities are Issued? Section :3 Initial Public Offerings (IPOs) Sub Section :3 Underwriting

In a typical underwriting arrangement, the investment bankers purchase the securities from the issuing company and then resell them to the public. The issuing firm sells the securities to the underwriting syndicate for the public offering less a spread that serves as compensation to the underwriters. In this procedure, which is called a firm commitment; the underwriter receives the issue and assumes full risk if the shares cannot be sold to the public at the stipulated offering price. The following flowchart depicts the relationships among the company issuing security, the lead underwriter, the underwriting syndicate, and the investors.

An alternative to the firm commitment is the best-efforts agreement. In this case, the investment banker does not actually purchase the securities but agrees to help the issuing company in selling the issue to the public. The banker simply acts as an intermediary between the public and does not bear any risk in case it is unable to resell purchased securities at the offering price. The best-efforts procedure is more common for initial public offerings (IPOs) of common stock, where the appropriate share price is less certain. There is one more variation called an All or None Underwriting. Under this type of underwriting, the underwriter agrees to do his best to sell the entire issue by a certain date. All of the proceeds go into an escrow account. If the securities are not all sold by the certain date, the money is returned to the purchasers and the issue is canceled. Corporations engage investment bankers either by negotiations or competitive bidding, although negotiation is far more common. In addition to the compensation resulting from the spread between the purchase price and the public offering price, an investment banker may receive shares of common stock or other securities of the firm.

Chapter:2 How Securities are Issued? Section :3 Initial Public Offerings (IPOs) Sub Section :3 Placement Agents

Placement agents are typically the brokerage firms and securities dealers that specialize in buying and selling of securities. They have a dedicated sales and trading team that is an expert in selling securities to individual and institutional investors and have strong relationships with them. Underwriters either decide to sell to the investors directly or they might opt to utilize the expertise of placement agents. The dealer agreement or selling agreement is the agreement in which securities dealers/brokers, who are not part of the syndicate, are contracted to purchase some of the securities from the issue. The underwriters may not be able to locate enough purchasers for the issues. They may then approach other securities dealers and see if they may want to participate. These other securities dealers may have even been offered a chance to participate as an underwriter but chose not to. What these other securities dealers can do is help move the product (the securities) to the general public. Basically, they provide another distribution channel. However, these securities dealers don't have any risk at all as the Dealer Agreement or selling agreement will allow these dealers to purchase the securities at a discount from the offering price in order to fill order they may have gotten after the effective date from their clients.

Chapter:2 How Securities are Issued? Section :3 Initial Public Offerings (IPOs) Sub Section :3 Spread

The underwriters and dealers get paid out of the proceeds of the issue offering. The public offering price is what the general public pays. This is the amount on the face of the prospectus. However, the issuing corporation receives a lower price than that from the managing underwriter. The difference between these two prices is the Spread. Any firm participating in the underwriting is compensated out of the spread. The amount of the spread is determined through a negotiation between the managing underwriter and the corporate issuer. However, at times there are certain parameters that are known to have taken place in previous underwriting and the negotiations take place around those. All members of the syndicate are paid out of the spread. The managing underwriter receives a fixed amount, called the managers fee, for each share that is sold. In addition, each member of the underwriting syndicate also keeps a portion of the spread, referred to as the underwriting or syndicate allowance. This compensates each member of the underwriting syndicate for their expenses and the risk they incur. The selling group that sells the securities is also allocated a portion of the spread known as the selling concession.

Chapter:2 How Securities are Issued? Section :3 Initial Public Offerings (IPOs) Sub Section :3 Road Shows

Once the regulatory authority has commented on the registration statement and a preliminary prospectus has been distributed to interested investors, the investment bankers organize Road Shows in which they travel around the country to publicize the

imminent offering. These road shows serve two purposes. First, they generate interest among potential investors and provide information about the offering. Second, they also provide information to the issuing firm and its underwriters about the price at which they will be able to market the securities.

Chapter:2 How Securities are Issued? Section :3 Initial Public Offerings (IPOs) Sub Section :3 Book Building

Large investors communicate their interest in purchasing shares of the IPO to the underwriters prior to the issuance of the prospectus. These indications of interest are called a Book and the process of polling potential investors on their interest in the upcoming issue offering is called Book Building. These indications of interest provide valuable information to the issuing firm because institutional investors often will have useful insight about both the market demand for the security as well as the prospects of the firm and its competitors.

Chapter:2

How Securities are Issued?

Section :4 Private Placements

Private Placements are the direct sale of an issue of securities to large institutional investors and large private investors. These are not offered to the general public and it is not permitted to advertise these issues. Also, there is no registration statement, the purpose of which is to protect the general investing public. Typically, a private placement investor is either an institution such as banks, mutual funds or insurance companies, brokers/dealers purchasing for their own accounts, employee benefit plans etc. A Purchaser Representative must represent a non-sophisticated investor. This person must be an attorney, accountant, or financial planner, etc. There are also restrictions on the resale of the securities.

Chapter:2

How Securities are Issued?

Section :5 Pricing an IPO

The part of an IPO that every company wants to know is how much money they are going to get. The company, its advisors, and the underwriter will determine the amount of money that can be raised. Once the amount of money that needs to be raised is determined, the price per share is going to determine the amount of shares that will be offered to the public. The first part of the pricing analysis includes comparing the company with other companies that are similar and are in the same industry. The impact

of the added capital from the IPO also needs to be evaluated with respect to its impact on the financial condition of the company and operating results. Other factors that need be evaluated include current trends, timing of the issue, investor confidence levels, central bank policy, industry trends, and national/international developments. In addition to these, the following items should be looked at:
Financial results

Accounting polices and their impact on reporting Assets Back orders (or the pipeline) Cost of capital General and administrative expenses as a percentage of sales Historical and projected growth rate of sales and earnings Long-term debt Profit margins Receivables Stockholders equity Off balance sheet financing
The company itself

Cost of production Experience and quality of management Growth opportunity in geographic or technological terms Industry outlook Is it a regional or national company? Market share Percentage of sales the largest customers account for out of the total sales New product development from conception to production as opposed to the rest of the industry Raw material suppliers The scope of the product line as compared to the industry leaders Years the company has been in operation
Legal considerations

Environmental considerations Liabilities and lawsuits National, state, or local legislation, both positive or negative Patents, trademarks, licensees or proprietary knowledge Last but not the least, a fair market value of the companys equity will be determined using the appropriate inputs. All of the factors mentioned above will help in arriving at a realistic estimate of the companies future earning and cash flow potential. Based on the projection, and the discount rate, a fair market value for the equity will be determined. In later chapters, we discuss in detail how to determine the fair market value of a companys total equity or an individual stock.

Chapter:2

How Securities are Issued?

Section :6 Advantages of going Public

There are a number of advantages for companies to go public and get listed on the market:

Listed companies can raise relatively large sums of funds either through equity or debt issue. Listing provides a ready market place for the shareholders to dispose their shares or acquire more shares as they wish. Public companies tend to have higher profile than private companies. Provides a ready value for the shares of the company compared to a privately held company. Provides an opportunity for employees to also become shareholders. Merger and acquisitions are made easier when the company is listed. Issuing new capital is relatively easier for a listed corporation. Higher bargaining power with financiers compared to a private company. A public offering generally nets a higher price for securities than do private placements or other forms of equity financing. Going public can serve as the most attractive exit strategy.

Chapter:2

How Securities are Issued?

Section :7 Disadvantages of going Public

There are a number of disadvantages for companies to go public:

The initial and ongoing costs of going public are substantial. Going public requires time. Disclosure requirements increase for a public company. If more than 50% of your shares are sold to the public, you may be faced with losing control of your company. You can no longer make all decisions unilaterally or on an immediate basis. Once the company goes public, there is a performance pressure to provide reasonable returns to the shareholders. External economic factors and overall stock market fluctuations can affect the value of a company.

After an initial public offering, insiders shares are usually held in escrow for a period of several months to several years. Levels of compensation, benefits and related-party transactions that may work for a private company may not be appropriate for a public one.

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