How Securities are Issued

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How Securities are Issued

• Topics Covered
• Venture Capital
• The Initial Public Offering (IPO)
• IPOs and Underpricing
• Market Reaction to Security Issuance
• Private Placement
• Rights Issue

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Venture Capital

• Considerations in Structuring the Deal
• Agreeing on the relevant numbers
• Managements incentives (minimize principal/agent
  problem)
• VC wants to monitor (serve on Board)
• Funds dispersed in stages

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Venture Capital (background)

• Tremendous growth in venture capital financing in
  late 1990s (is an important source of funds)
• VC funds raise money from investors, then
  distribute that money to young companies
• Venture capital provided by pension funds,
  endowments, very wealth individuals (angels), and
  increasingly by corporations (way to hedge risk?)

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Sources of Venture Funds
Source 2001 data from 2002 NVCA Yearbook,
prepared by Venture Economics, page 23
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VC Financing (source Venture Economics)
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Proceeds from IPO(Source Renaissance Capital)

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Venture Capital
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Stage Financing

• If first stage is successful, second stage will
  be needed.
• Why use stage financing?
• Option to abandon if unprofitable
• Option to expand if profitable at second stage
• Management has incentive to work hard

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Venture Capital
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Venture Capital

• Before 2nd round of financing, equity worth 10
  mil
• Entrepreneurs held ½ of old equity 5 mil
• After 2nd round of financing, entrepreneur holds
  5/14, and VCs holds 9/14 of equity
• Many (most) ventures never get to the second
  stage!
• If second stage is successful, then either
  theres a third stage or the company goes public
  (IPO).

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Private Equity Returns
As of 09/30/2002 - Source VentureXpert Database
by VE NVCA
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Five Year Performance TrendsFirst Quartile Funds
US Venture v. Buyouts v. stocks
Source VentureXpert Database by VE NVCA
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Initial Offering - terms

• Initial Public Offering (IPO) - First offering of
  stock to the general public.
• Underwriter - Firm that buys an issue of
  securities from a company and resells it to the
  public.
• Spread - Difference between public offer price
  and price paid by underwriter (typically 7 for
  IPO).
• Prospectus - Formal summary that provides
  information on an issue of securities.
• Underpricing - Issuing securities at an offering
  price set below the true value of the security.

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The IPO Process

• Choose underwriter(s) that provides the company
  with financial procedural advice, sells issue
  to the public
• Registration statement filed with SEC gives info
  on the proposed offering, firms history,
  financials, existing business, and plans for the
  future
• Conduct road show where talk to potential
  investors to size up demand for the issue
• Set a fixed price for issue and allocate shares
  among interested investors (typically big
  institutions) determine underwriters spread

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IPO Markets Require More Maturity -- AgainDeja
IPO?
Source VentureXpert Database by VE NVCA
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IPOs and Underpricing

• On the first day the stock is publicly-traded,
  the price rises significantly above its issue
  price.
• Þ company is leaving cash on the table by
  underpricing its offering (66B 1999-2000)
• Average first-day return for nonfinancial U.S.
  IPOs
• 1980s 7
• 1990-98 15
• 1999-2000 65
•  

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Explanations for Underpricing

• Good taste in the mouth firms want to create
  momentum for stock price because may want to
  return to market again to sell more equity
• Underwriters want to be sure offering is fully
  subscribed (sufficient demand for shares) and
  that clients are pleased quid pro quos (Credit
  Suisse First Boston)
• Winners curse underpricing compensates
  uninformed investors for potential losses due to
  asymmetric information
• (Historically IPOs underperform a peer group of
  stocks following the offering)

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Final Thoughts on IPOs

• Important to remember that the float (fraction of
  a firms shares sold to public) is typically
  around 15
• Lock-up period after IPO during which time
  insiders cannot sell their shares (typically six
  months after IPO)
• Þ thin trading during lock-up period,
  difficult to short stock given limited supply
  of share (generally see fall in price when
  lock-up expires)

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General Cash Offers - terms

• Seasoned Offering - Sale of securities by a firm
  that is already publicly traded.
• Shelf Registration - A procedure that allows
  firms to file one registration statement for the
  same security that is good for two years.
• Private Placement - Sale of securities to a
  limited number of investors without a public
  offering.

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Underwriting Spreads
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Market Reactions to Security Offerings

• Market Reactions
• Equity Issues -3 (30 of money raised)
• Convertibles -2
• Public Bonds 0
• Bank Loans 2
• Why?

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More Evidence of Market Timing

• Historically, gross equity issuance (IPOs and
  SEOs) has comprised roughly 25 of total issuance
  (equity and gross bond issuance).
• Some evidence that the fraction of total issuance
  comprised of equity sales is a (negative)
  predictor of future stock returns.
• Same story with convertible bonds
• 1994 to third quarter 1999, convertible debt
  comprised 5-10 of total public debt issuance
  for nonfinancial corporations (jumped to 20-25
  fourth quarter of 1999 and first quarter 2000
  when NASDAQ soared)

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The Private Placement Market

• Avoids Registration Requirements
• Accounts for ½ of all new corporate debt
• Lower transactions costs to issue
• Easier to customize and renegotiate
• Investors demand a premium for lack of liquidity
• Rule 144a, passed in 1990, allows qualified
  buyers (large financial institutions) to trade
  unregistered securities.
• Increased liquidity (thus issuer has lower costs
  and can offer lower rates)
• Increased foreign issuers in the U.S.

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Rights Issue

• Rights Issue - Issue of securities offered only
  to current stockholders.
• Example - AEP Corp currently has 11 million
  shares outstanding. The market price is 24/sh.
  AEP decides to raise additional funds via a 1 for
  11 rights offer at 22 per share. If we assume
  100 subscription, what is the value of each
  right?

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Rights Issue
Example - AEP Corp currently has 11 million
shares outstanding. The market price is 24/sh.
AEP decides to raise additional funds via a 1 for
11 rights offer at 22 per share. If we assume
100 subscription, what is the value of each
right?

• Current Market Value 11 mil x 24 264 mil
• Total Shares 11 mil 1 mil 12 mil
• Amount of new funds 1 mil x 22 22 mil
• New Share Price (264 22) / 12 23.83/sh
• Value of a Right 23.83 - 22 1.83
• What is the payoff to a shareholder with 11
  shares?

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Rights Issue (not fully subscribed)

• Suppose the previous rights offer is only 50
  subscribed.
• What is the value of the right now?
• Suppose you had 11 shares (pre-rights offer).
• What is your gain/loss if you exercised the
  right?
• What if you did not exercise the right?