Chapter 19 Issuing Securities to the Public

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Chapter 19Issuing Securities to the Public
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Objectives

• Understand how corporations issue securities to
  the investing public.
• Process
• Costs
• The IPO Story
• Alternative issue methods
• Venture Capital

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Public Issues The Basic Procedure

• Obtain approval from the Board of Directors.
• Select investment bankers and contract.
• File registration statement with the SEC.
• Distribute preliminary prospectus (red herring)
  to investors
• After the SEC approves the registration,
• Set final offering price and begin selling
  securities

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The Process of A Public Offering

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

Several months 20-day waiting period
Usually on the 20th day
After the 20th day 30 days after
offering
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Top 10 U.S. Investment Banking Firms

• Merrill Lynch
• Salomon Smith Barney (Citigroup)
• Morgan Stanley Dean Witter
• Goldman Sachs
• Lehman Brothers
• JP Morgan / Chase
• Credit Suisse First Boston
• Bear Sterns
• Donaldson Lufkin Jenrette (bought out by CSFB)

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An Example of a Tombstone Advertisement
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Two Methods for Selecting an underwriter

• Competitive
• Negotiated

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Two Alternative Public Issue Methods

• The general cash offer
• The rights offer
• Publicly placed debt is sold in general cash
  offerings.
• Debt issues are often privately placed.

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Two Methods for Issuing Securities

• Firm Commitment
• Best Efforts

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Fraction of IPOs Issued Using Best Efforts
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The Cost of New Issues

• Spread or underwriting discount
• Other direct expenses
• Indirect expenses
• Abnormal returns (SEOs)
• Underpricing (IPOs)
• Green Shoe Option

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Direct Costs of IPOs
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Direct Costs of SEOs
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Direct Costs of Issuing Convertible Bonds
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Direct Costs of Issuing Straight Debt
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A Comparison of Total Direct Costs
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Summary of Direct Costs of Issuance

• Economies of scale
• Gross spread is the larger of the two direct
  costs
• For a given size issue, direct costs are ordered
  as follows
• IPOs
• SEOs
• Convertible debt
• Straight debt

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Abnormal Returns for SEOs

• Abnormal returns of -3 to -4 when firms
  announce a new equity issue (SEO).
• Why do we observe these abnormal returns?

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Initial Public Offerings

• Average total direct costs (1990 1994) 11
• Average underpricing (1990 1994) 12

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Average First Day IPO Returns
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Top 10 First Day Returns
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The Internet Bubble Bursts!
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Long-Run IPO Returns
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Money Left on the Table
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UPS left 1.6 BILLION on the table!

• Offer date November 10, 1999
• Shares offered 87,520,000
• Offer price 50 per share
• First closing market price 68.25
• Price run-up 18.25
• How much money did UPS leave on the table?

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Underpricing is a Global Phenomenon!
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Why are IPOs Underpriced?

• If offer price is set too low, issue is
  oversubscribed and shares must be allocated
  proportionally.
• The Winners Curse model from economics is one
  explanation for the underpricing of IPOs.

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Winner Curse Example

• Suppose there are 2000 shares to be sold in each
  case.

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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 firm cannot have recently defaulted on debt.
• The market capitalization must be gt 75 m.
• No recent SEC violations.

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Rights Offerings

• 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.
• About 10 of all new stock issues are through
  rights offerings.
• This method required in some foreign countries.
• Generally, one right is issued for each share
  outstanding.

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Mechanics of Rights Offerings

• The management of the firm must decide
• How much capital they want to raise
• The exercise price (the price existing
  shareholders must pay for new shares).
• These rights have value
• Rights can be detached from the shares and sold,
  OR
• Shareholders can exercise their rights and
  purchase additional shares in the firm.

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Rights Offering Example

• Lefty Tools, Inc. (LTI) has 2M shares currently
  outstanding, trading at 30 each.
• LTI wants to raise 10M through a rights
  offering.
• One right per existing share. The firms
  management has set the exercise price at 20.
• Find the value of each right, and the ex-rights
  price of each existing share.

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A Short-Cut Formula

• V Value of one right
• Pon Rights-on price
• PS Subscription or exercise price of right
• N number of old shares required to purchase one
  new right

In our example, Pon 30, PS 20 and N 4.
This yields V 2
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Shareholder Wealth and Rights Offerings

• Your position before rights offering
• Own 1,000 shares valued at 30 each
• Have 5,000 in cash
• Total wealth 1,00030 5,000 35,000
• You receive 1,000 rights.
• Since it takes 4 rights (plus 20) to buy one new
  share, you can buy a maximum of 250 new shares
  (unless you buy additional rights in the market
  for 2 each).

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Wealth Effects of Shareholder Actions

• Should you
• Exercise all rights?
• Sell all rights?

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Do On Your Own (at home)

• Verify on your own that if you sold 500 rights at
  their fair market value, and exercised the
  remaining 500, you wealth total would still be
  35,000.
• Rework the entire LTI rights offering example
  assuming that LTIs management sets the
  subscription price at 25 instead of 20.
• Verify that this change does NOT affect your
  total wealth of 35,000, regardless of whether
  you exercise all rights, sell all rights, or sell
  some and exercise the rest.

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Implications

• Either exercise your rights or sell them.
• Dont let them expire!
• The exercise price doesnt really matter (much)
• As long as it is set well below the current
  market price.
• What would happen if stock price falls below the
  exercise price?
• Standby agreements

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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.

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Private Placements

• Avoid the costly procedures associated with the
  registration requirements that are a part of
  public issues.
• The SEC restricts private placement issues to 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.
• Also, amount raised may be limited

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Venture Capital

• The limited partnership is the dominant form of
  intermediation in this market.
• There are four types of suppliers of venture
  capital
• 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.

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Stages of Financing

• Seed-Money Stage
• Start-Up
• First-Round Financing
• Second-Round Financing
• Third-Round Financing
• Fourth-Round Financing
• After fourth-round financing, its time for an IPO!