Initial public offerings (IPO) Types of stock Going public and listing Securities regulation Investment banking

1. Schematic CHAPTER 19 Investment Banking: Common Stocks • Initial public offerings (IPO) • Types of stock • Going public and listing • Securities regulation • Investment banking

2. How are start-up firms usually financed? • Founder’s resources • Angels • Venture capital funds • Most capital in fund is provided by institutional investors (limited partners) • Managers of fund are called venture capitalists (general partners) • Venture capitalists (VCs) sit on boards of companies they fund

3. Differentiate between a private placement and a public offering. • In a private placement,such as to angels or VCs,securities are sold to a few investors rather than to the public at large. • In a public offering, securities are offered to the public and must be registered with SEC. (More...)

4. Privately placed stock is not registered, so sales must be to “accredited” (high net worth and officers) investors. • Send out “offering memorandum” with 20-30 pages of data and information, prepared by securities lawyers. • Buyers certify that they meet net worth/income requirements and they will not sell to unqualified investors. • Limited unaccredited investors o.k.

5. Advantages of Going Public • Current stockholders can diversify holdings. • Liquidity is increased. Owners can sell some shares. • Easier to raise capital in the future. • Going public establishes a value for the firm. • Makes it more feasible to use stock as employee incentives.

6. Disadvantages of Going Public • Must file numerous reports. • Operating data must be disclosed. • Officers must disclose holdings. • Special “deals” to insiders will be more difficult to undertake. • A small new issue will not be actively traded, so price may not reflect true value.

7. How would the decision to go public affect key employees? The advantages of public ownership would be recognized by key employees, who would most likely have stock or stock options. They would know what their stock and options were worth, and would like the liquidity.

8. When is a stock sale an initial public offering (IPO)? • A firm goes public through an IPO when the stock is offered to the public for the first time. • Later offers are called Secondary offerings (not identical to Secondary Market) • Selling stock to the public would make the company publicly held. • Insert: How an IPO is done.

9. What criteria are important in choosing an investment banker? • Reputation and experience in this industry • Existing mix of institutional and retail (i.e., individual) clients • Support in the post-IPO secondary market • Reputation of analyst covering the stock • Financial strength

10. What is “book building?” • Investment banker asks investors to indicate how many shares they plan to buy, and records this in a “book”. • Investment banker hopes for oversubscribed issue. (Green Shoe Clause) • Based on demand, investment banker sets final offer price on evening before IPO. (See Accenture article)

11. Describe how an IPO would be priced. • Since the firm is going public, there is no established price. • The banker would examine market data on similar companies. • Price set to place the firm’s P/E, M/B, price/margin ratios in line with publicly traded firms in the same industry, with similar risk and growth characteristics.

12. On the basis of all relevant factors, banker would determine a ballpark equilibrium price. • The offering price would be set somewhat lower to increase demand and to insure that the issue will sell out.

13. There is an inherent conflict of interest, because the banker has an incentive to set a low price • to make brokerage customers happy. • to make it easy to sell the issue. • Firm would like price to be high. • However, the original owners generally sell only a small part of their stock, so if price increases, they benefit. • Later offerings easier if first goes well. • Controversy over “spinning”

14. Suppose a firm issued 1.5 million shares at $10 per share. What would be the approximate flotation costs on the issue? • Gross proceeds: $15 million. • But, flotation costs of IPO would be about 18% or $2.7 million.(See insert) • The firm would net about $12.3 million from the sale.

15. What are typical first-day returns? • For 75% of IPOs, price goes up on first day. • Average first-day return is 14.1%. • About 10% of IPOs have first-day returns greater than 30%. • For some companies, the first-day return is well over 100%.

16. What are the long-term returns to investors in IPOs? • Two-year return following IPO is lower than for comparable non-IPO firms. • On average, the IPO offer price is too low, and the first-day run-up is too high.

17. What are the direct costs of an IPO? • Underwriter usually charges a 7% spread between offer price and proceeds to issuer. • Direct costs to lawyers, printers, accountants, etc. can be over $400,000.

18. What would be the flotation costs on the issue if the firm were already publicly owned? • If the firm were already publicly owned, the flotation costs would be much less (about 9%) because a market price for the stock would already have been established.

19. What are equity carve-outs? • A special IPO in which a parent company creates a new public company by selling stock in a subsidiary to outside investors. • Parent usually retains controlling interest in new public company. • What is the purpose of an equity carve-out?

20. How are investment banks involved in non-IPO issuances? • Shelf registration (SEC Rule 415), in which issues are registered but the entire issue is not sold at once, but partial sales occur over a period of time. • Public and private debt issues • Seasoned equity offerings (public and private placements)

21. What’s listing? Would a small firm likely be listed? • A listed stock is traded on an organized exchange (NYSE, American, Pacific Coast, etc.) • Transition between exchanges • It’s unlikely that a small firm’s stock would be listed. Small firms trade in the OTC market.

22. What is a rights (or privileged or preemptive) offering? Why would a firm use a rights offering? • A rights offering occurs when current shareholders get the first right to buy new shares. • Prevents dilution of current holders • Would not make sense for a firm that is going public. If current stockholders wanted to buy shares, they wouldn’t go public.

23. WAYS TO SELL COMMON STOCK • Rights offering • Private Placement • Public offering • IPO • Secondary • Dividend Reinvestment Plan. • Employee Purchase Plan • ESOP, Stock options, etc. Slide 15-38

24. What is meant by going private? • The reverse of going public. • E.G. In an LBO, the firm’s managers team up with a small group of outside investors with equity capital and purchase all of the publicly held shares of the firm. • The new equity holders usually use a large amount of debt financing. • Called a leveraged buyout or MBO.

25. Leverage Buyout (LBO) Steps: • Repurchase by Management and associated groups • Funds provided by management and associated groups & HEAVY DEBT • Change operations/incentives and/or sell some assets • Later go public again, at tidy profit

26. Advantages of Going Private • Gives managers greater incentives and more flexibility in running the company. • Removes pressure to report high earnings in the short run. • After several years as a private firm, owners typically go public again. Firm is presumably operating efficiently and sells for more.

27. Disadvantages of Going Private • LBO firms are normally leveraged to the hilt, so it’s difficult to raise new capital. • A difficult period that could normally be weathered might bankrupt the company.

28. Would a company that is going public be likely to sell its new stock by itself or through an investment banker? • Would be likely to use an investment banker. • Would use a negotiated deal rather than a competitive bid.

30. Why would companies that are going public not use a competitive bid? • The competitive bid process is only feasible for large, well-established firms, on large issues, and even here, the use of bids is rare for equity issues. • It would cost investment bankers too much to learn enough about the company to make an intelligent bid carrying out “due diligence”.

31. If a company goes public, in a negotiated deal would it be on an underwritten or best efforts basis? • Most offerings are underwritten. • In very small, very risky deals, the investment banker may insist on a best efforts basis.

32. Would there be a difference in costs between a best efforts and an underwritten offering? • The investment bankers are exposed to more risk on underwritten deals, and they will charge a price for assuming this risk. (Don’t overstate) • If the firm absolutely has to have the money to meet a commitment, and hence it needs a guaranteed price, it will use an underwritten sale.

33. REGULATION OF SECURITY OFFERINGS • Securities Act of 1933 • Sale of new securities • Securities Act of 1934 • regulation of outstanding securities • Establishes SEC

34. REGULATION OF SECURITY OFFERINGS • Registration statement • The disclosure document filed with the SEC in order to register a new security issue. • Prospectus: • Part 1 of the registration statement.

35. CONTENTS OF PROSPECTUS • Prospectus • nature and history of company • use of proceeds • certified financial statements • names of management and holdings • competitive conditions • risk factors • legal opinions • description of security being offered

36. REGULATION OF SECURITY OFFERINGS • Red Herring • The preliminary prospectus. Contains red lettered statement that registration statement has not yet become effective • Tombstone

37. REGULATION OF SECURITIES • SHELF REGISTRATION (Rule 415) • A procedure whereby a company is permitted to register securities it plans to sell over the next two years. These securities then can be sold piecemeal whenever the company chooses. • Blue Sky laws • State laws regulating the offering and sale of securities.

38. Registration Process 20 days 40 Days

39. VENTURE CAPITAL • NO LIQUIDITY • PROBABILITY DISTRIBUTION OF RETURNS • SOURCES OF FUNDS • HIGH INCOME INDIVIDUALS • PARTNERSHIPS INCLUDING PENSION FUNDS, INSURANCE FUNDS, UNIVERSITY ENDOWMENTS, ETC. • STAGED FINANCING • Rule 144A

40. Prob. Distribution of Returns for single VC investment Prob. Return 0%

41. CHAPTER 19 Investment Banking: Long-Term Debt • Bonds vs. term loans • Types of loans • Calls and sinking funds • Bond ratings • Advantages/disadvantages of LT debt

42. Bonds vs. Term Loans • Bonds • Not amortized • Sold to public through investment bankers; can be traded fairly easily • Used by larger companies • Term loans • Amortized • Directly placed with institutions • Not traded after placement • Shorter maturity than bonds

43. Advantages of Term Loans • Speed • Flexibility • Can tailor terms • Can be renegotiated if problems arise • “Story loans.” Easier for small companies to sell one lender a “story” • Lower issue costs

44. A BOND RATHER THAN A LOAN WILL BE CHOSEN IF: • WELL KNOWN • STRONG • NOT IN A GREAT HURRY • DON’T EXPECT TO CHANGE TERMS • LIKELY TO REISSUE

45. ORDER OF INTEREST RATES LEVELS: • JUNK BONDS • JUNIOR • SENIOR • BANK LOANS • BOND ISSUES

46. How do companies manage the maturity structure of their debt? • Maturity matching • Match maturity of assets and debt • Information asymmetries • Firms with strong future prospects will issue short-term debt

47. Suppose a company issues a bond using a building as collateral. What type of bond would this be? • Mortgage bond, because real property is pledged as collateral. Probably first mortgage, but could be second mortgage bonds secured by the same building.

48. If the company had issued debentures instead of mortgage bonds, would the interest rate be affected? • Yes. Debentures are not securedby specific assets. Therefore, bondholders face more risk in debentures than in secured bonds, so higher interest rates must be set on debentures.

49. What’s a bond’s indenture? • An indenture is the formal agreement between the issuer and investors. Trustee is assigned. • Designed to insure that issuer does nothing to cause the quality of bonds to deteriorate after bonds are sold. (More...)

50. An indenture contains restrictive covenants that constrain the issuer’s actions. Included are: • Refunding or call conditions. • Sinking fund requirements. • Levels at which key financial ratios must be maintained. • Earnings level necessary before dividends can be paid.