Capital Markets Chap-4 IPO Process

Why Need Public Capital

1. Lack of other financing choices 1. Private financing unavailable 2. Too much debt, so firm optimizes capital structure Allow current investors to cash out 1. Founders demand liquidity, want to sell stake in firm 2. Issue seasoned equity secondary share offering 3. Firm is valued by the market, shares sold get market price Future source of capital 1. Establish the firm in public capital markets for future capital raising 2. Lowers the cost of capital (cost of equity mitigates cost of debt) 3. Diversification / Risk sharing 4. Increases transparency of firm actions Employee compensation 1. Firm can offer incentive contracts stock options

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Problems with Public Capital

1. 2. Going public is costly and may not be appropriate for all firms, even when they are in need of additional financing Ownership is diluted 1. Decision making is delegated to an increased number of owners 2. Founder (entrepreneur) loses control Public monitoring increases 1. SEBI filing requirements (Disclosure) 2. Competitors benefit from transparency 3. Regulators have increased authority (legal restrictions to public firms) Direct financial costs 1. Filing costs of prospectus and subsequent federal filings requires additional staff 2. Investment banks and new investors charge the firm via large transactions costs 1. Shares are under priced (can be greater than 15%) 2. Underwriters collect fees (7% of gross proceeds)

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4.

Securities Underwriting
Underwriting: To assume financial responsibility
and guarantee against public issue failure
Underwriter an investment banker/intermediary 1. 1. Insurance underwriters create contracts that indemnify (protect against loss) their customers (auto liability, life insurance, flood protection etc.) 2. 2. Securities underwriters guarantee the placement of new debt or equity with public financial markets in case of under subscription

The IPO Process

1. Firm selects an underwriter who also acts as the
advisor, based on 1. The reputation and expertise of the underwriter 2. Follow-on products like research coverage 3. Prior relationships between the firm owners (often VCs) and investment banks 4. Distribution channels available to underwriter (institutional clients) 5. The investment banks willingness to take on the firm (high reputation underwriters may not risk their reputation on a firm with uncertain prospects

The IPO Process

2. Firm and underwriter agree on the offering method:
1. Firm commitment: firm sells the entire issue to the underwriter who then attempts to sell it to the public (insured) Although the underwriter fully commits to purchasing the issue, the price is not agreed (or committed to) until later in the issuance process. 2. Best effort: underwriter makes no promise about the price, but makes a best effort to sell at the agreed price (uninsured) 3. Rights offering: securities are first offered to existing shareholders

4. Rights offer can be insured or uninsured

The IPO Process

3. Valuing the offer: Underwriter performs its duediligence and provides a value of the firm
Firm provides all information and books to underwriter the underwriter is the agent that reduces asymmetric information Method such as Discounted cash flow method, and different financial metrics (PE, Mkt-book, ROA etc.) are used to arrive at value of offer (Price band)

4. SEBI - filing: The underwriter files a registration statement with the SEBI that gives specific information on the offering, firm history, financials and future plans.
1. SEC spends up to certain period reviewing the filing 2. The exact length of the waiting period can change, based on additional filings desired by SEBI 3. The intended exchange (NSE/BSE) reviews the filing as well 4. The filing contains that information which forms part of public (prospectus) 5. red herring prospectus covering potential and risks is published

The IPO Process

The IPO Process

5. Syndication: The underwriter arranges a syndicate to help with the distribution (ENAM DLF)
1. The primary (original) underwriter is designated the lead underwriter 2. Underwriter may take on a co-manager (co-lead) to help with the underwriting 3. The lead underwriter allocates portions of the offering to syndicate members with the primary purpose of a syndicate to risk share 4. Securities underwriting syndications is similar in nature to loan syndication by banks 6. Road show: Begins a few weeks prior to the IPO to create a market

1. The lead underwriter visits large investors (institutional) to solicit interest and build a demand schedule

The IPO Process

7. Offer: Underwriter sells the issue and an exchange begins trading the issue in a primary market. Usually remains open for 3-5 days 1. Depending on demand underwriter may have to rationing proportionate/lottery basis 2. Shares are sold to investors prior to trading in secondary markets 3. After the shares are allocated listed market maker begins trading the shares

4. New investors who didnt get an allocation of the primary shares can now buy shares in the open market
5. Investors who received an initial allocation of shares can begin selling them to new investors