Initial Public Offerings

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Initial Public Offerings
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IPO

• Process by which a previously private company
  offers shares to the public at large for the
  first time.
• Also known as going public

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Advantages

• Current and future access to capital
• Increased liquidity and market value
• Prestige, reputation and public image
• Mergers/acquisitions shares as currency
• Opportunities for employee ownership
• Diversification of owners portfolio

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Disadvantages

• Dilution
• Control
• Value (later)
• Public disclosure
• Investor pressure (dividends performance)
• Investor relations costs
• Volatility in value (overall market)

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Disadvantages

• Expenses one time
• Underwriting compensation (7 avg)
• Legal fees (100,000 600,000)
• Accounting fees (50,000 225,000)
• Printing and engraving (50,000 - 250,000)
• Management time (priceless)
• Capitalize unless offering unsuccessful

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Disadvantages

• Expenses ongoing
• Investor relations
• Annual reports
• Proxy material
• Other administrative
• Management time (priceless)

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Hidden Legal Costs

• Preparing for IPO
• Operate company formally, as-if public
• Regular board meetings, minutes, S/H
  communication, etc.
• Due Diligence housecleaning
• Preparing company for public scrutiny
• Registration process
• Periodic reporting ongoing compliance

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Preparing for U/W Due Diligence

• Address potential problems early
• Excessive compensation
• Weak management team
• Nepotism
• Problems with intellectual property
• Bad business model

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Legal Audit

• As an approach to preparing for due-diligence
• Choice and structure of entity
• Protection of intellectual property
• Employment policies, practices compensation
• Regulation (Securities law other)
• Other threatened or potential litigation

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Not Ready for IPO Because

• 53 not documented FMV of stock options
• 31 not established regularly meeting BOD
• 23 lacked business plan
• 20 lacked proper accounting system and controls
• 16 lacked history of audited financials
• 12 did not produce quarterly financials

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Additional Tips

• Formalized management structure (again, act as if
  you are already public)
• People select skilled persons carefully
• Products protected, with scalable distribution
  and production
• Profits preferable (late 1990s exception)

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Deal Breakers

• Incomplete management team
• Weak business model or revenue stream
• Low barriers to entry weak customers
• Self-dealing among directors or mgmt
• Inadequate corporate records
• Poor earnings history
• Unaudited financial statements

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Underwriting

• Lead underwriter negotiates the process and forms
  a syndicate
• Syndicate is simply a group of investment banks
  that share in the offering of shares to the
  public
• Tombstone pecking order from most to least
  important

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Two Types of Underwriting

• Best efforts U/W offers to sell as many shares
  as possible at offering price
• Usually used on more speculative issues
• Usually an all-or-none deal if minimum amount
  of capital not raised, deal is off
• Price risk is on company U/W essentially acting
  as a broker

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Two Types of Underwriting

• Firm Commitment U/W purchases all securities at
  agreed price, less costs, and resells to the
  public
• U/W effectively acting as a dealer
• Company is guaranteed proceeds
• Price risk is borne by U/W
• Letter of intent spells out terms

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Choice of U/W

• Reputation, reputation, reputation
• Size of offering some U/W have minimum
• Industry specialization
• Research coverage aftermarket support, and
  quality of analysts
• Personal chemistry staffing issues
• References others going public

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Underwriting Costs

• Legal fees
• Accounting fees
• Other consultant fees
• Underwriting fixed fees
• Spread (commission)
• Underpricing (later)
• Significant economies of scale

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Costs Summarized

• Average gross spread 7.31
• Other direct expenses 3.69
• Total direct costs 11.0
• Underpricing 12.05
• See tables

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Choice of Exchange

• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• NASDAQ National Market
• NASDAQ small cap issues
• NASDAQ bulletin board (pink sheets)
• AMEX Emerging Company Marketplace
• Does it matter?

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Entry Requirements
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Listing Fees
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Alternatives to Traditional IPOs

• Direct Public Offerings (DPOs) issuer sells
  shares to public without U/W and syndicate
• Easier w/ simplified SEC registration
• Internet Spring Street Brewery
• Rise of internet commerce
• Rise of internet investor

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DPOs

• Regulation A can raise as much as 5M over 12
  month period
• Registration statement not required
• Must comply with anti-fraud and personal
  liability provisions of the Act
• Must file an offering circular (same as
  prospectus, but financials not audited)

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DPOs

• SCOR Small Corporate Offering Registration
• 1M over 12 month period
• Must comply with anti-fraud and personal
  liability provisions of the Act
• Offering circular not required
• File a Form U-7

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DPO Advantages Disadvantages

• Avoid costs of hiring U/W
• Less due diligence time and money
• Small investors get a shot
• Stock may be illiquid and difficult to trade
• U/W performs a valuable certification function
  that is absent in DPOs

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Internet IPOs

• On-line Auction
• OpenIPO acts as U/W
• Fees 3 - 5
• Uses Dutch Auction
• Shares sold at lowest price which sells all
• Same as Treasury auction

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Mechanics of an IPO

• Organizational meeting
• Prepare and file Registration Statement
• Waiting Period
• Road Show
• SEC Approval
• Final pricing amendment closing

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Organizational Meeting

• Structure of offering
• Size, price range, symbol, lock-up, U/W agreement
• Time and responsibilities
• Accounting and financial issues
• Historical and Pro-forma F/S auditor letters
• Corporate governance issues
• Legal issues

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Registration Statement

• Document filed with SEC consists of offering
  prospectus and exhibits and additional
  information
• 33 Act v. 34 Act
• ? Investor reliance
• Several drafts perhaps 4 or 5 created over a 30
  to 45 day period grueling
• File officially with SEC, or hold pre-filing
  conference

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Registration Statement, cont.

• Officially filed with SEC
• SEC sends comment letter
• 50 to 200 paragraph document
• Key ? quality of disclosure
• NASD and state securities laws must also be
  satisfied before the registration statement is
  effective

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Registration Statement Contents

• Description of company and business
• Risk factors
• Use of proceeds
• Capitalization
• Management and principal shareholders
• Litigation

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Registration Statement Contents

• Managements discussion
• Discussion of business plan by management
• Financial information
• Underwriting arrangements and characteristics of
  securities offered
• Identity of experts

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Waiting Period

• Time between filing of registration stmt and
  final SEC approval
• U/W syndicate is engaged in road shows see next
  slide
• Marketing activities are limited distribution
  of catalogs, brochures, TV ads and articles about
  issuer prohibited

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Road Show

• Allows members of the U/W syndicate to learn more
  about your company
• Presentations to major financial markets
• solicitations of interest not binding
• Trying to estimate the demand curve
• Use preliminary prospectus, also known as red
  herring
• Disclaimer in red down the side

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IPO Calendar (aside)

• List of IPOs an investment bank is associated
  with
• Lists company, estimated size of offering and
  estimated price range
• Range will change depending on market and
  offering prospects

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Valuation and Pricing

• U/W in unique role
• Corporate clients who raise money
• Retail clients who are investors (institutional
  and individual)
• Price too low ? benefits retail clients, but
  harms issuer (dilution in value)
• Price too high ? benefits issuer, but harms
  retail clients who may lose money

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Valuation and Pricing

• Price is normally set the day (night) before the
  offering becomes effective
• Perhaps not as much risk as first thought in
  firm commitment
• U/W will have a good feel for the demand for the
  securities

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Other IPO Terms

• A hot issue is one that is oversubscribed one
  for which there is significantly more demand than
  shares being offered
• Green Shoe Provision allows U/W to purchase
  more shares at offering price
• Lock-up provision restricts selling of shares
  by insiders normally 180 days

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Underpricing

• Underpricing closing price first day -
  offering price
• Offering price price the investor who receives
  shares in the offering will pay
• Underpricing has been significant, on average
  see handout (12)
• Krispy Kreme, April 2000 OP 21 Closed 37

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Underpricing

• Underpricing is a windfall to an investor who
  receives shares in the offering and sells them
  the first day
• Not all issues are underpriced some are
  overpriced
• Underpricing creates dilution for the issuer
  issuer sells shares for less than full value

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Reasons for Underpricing

• U/W Bias corporate issuer v. retail customers
• Primarily with smaller, more speculative issues
  (see handout)
• Informed v. uninformed Investor story
• Allocation of shares winners curse
• Prospect theory
• IPOs under-perform market longer term

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Ongoing Reporting

• 10K (10KSB) annual report with F/S
• 10Q (10QSB) quarterly report F/S
• Form 8K disclosure of material information
• Proxy solicitation statutory voting rules
• Beneficial ownership officers, directors
  owners of at least 10

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Ongoing Reporting

• Short-swing transactions officers, directors,
  employees or other insiders must return any
  profit
• Tender offer special rules anyone acquiring
  more than 5 must file Schedule 13D

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Insider Trading

• Governed by Rule 10B-5
• Unlawful for persons, directly or indirectly
• Employ any device, scheme or artifice to defraud
• Make an untrue statement of material fact, or
  omit to state a material fact
• Engage in any act that would operate as fraud in
  connection with sale of security