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

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.

The Process of A Public Offering

Steps in Public Offering
1. Pre-underwriting conferences
2. Registration statements
3. Pricing the issue
4. Public offering and sale
5. Market stabilization

Time
Several months
20-day waiting period
Usually on the 20th day
After the 20th day
30 days after offering

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.

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

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.

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.

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

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

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?

The Cost of New Issues

1.

2.
3.
4.
5.
6.

Spread or underwriting discount

Other direct expenses
Indirect expenses
Abnormal returns
Underpricing
Green Shoe Option

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%

Rights

If a preemptive right is contained in the firms

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.

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.

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.

$25
$20
$5,200,000 200,000 shares
10,000 shares
share
shares

Rights Offering Example

What is the ex-rights price?

There are 210,000 outstanding shares of
a firm with a market value of $5,200,000.
Thus the value of an ex-rights share is:
$5,200,000
$24.7619
210,000 shares

Thus the value of a right is

$0.2381 = $25 $24.7619

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.

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.

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.

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.

Venture Capital

The limited partnership is the dominant form of

intermediation in this market.
There are four types of suppliers of venture capital:
1.
2.
3.

4.

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.

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

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?

Stages of Financing
1.

Seed-Money Stage:
Small amount of money to prove a concept or develop a product.

2.

Start-Up
Funds are likely to pay for marketing and product refinement.

3.

First-Round Financing
Additional money to begin sales and manufacturing.

4.

Second-Round Financing
Funds earmarked for working capital for a firm that is currently
selling its product but still losing money.

5.

Third-Round Financing
Financing for a firm that is at least breaking even and
contemplating expansion; a.k.a. mezzanine financing.

6.

Fourth-Round Financing
Financing for a firm that is likely to go public within 6 months;
a.k.a. bridge financing.

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.