Types of public security issuances • IPO Issuances: • IPO = Initial Public Offering. The first sale of stock by a company to the public • This the most visible type of security issuance with respect to exposure in financial publications • Consider the Google IPO of 2005, ICBC in 2006 and the news surrounding the issuance events • IPO firms are being valued by the “market” for the first time, and establishing the initial valuation (based on firm private information) and finding public market investors willing to pay that valuation is the specialization of an investment bank
SEO Issuances: • SEO = Seasoned equity offering. An already traded firm issues new shares. • Market values are already established, so placing these securities is generally less difficult than an IPO since there is less asymmetric information. • Types of SEO’s • Follow-on offering: Is an SEO in which new shares are issued to the public • Secondary offering: Is an SEO in which existing shares held by current owners (like the founder of the firm – Bill Gates of Microsoft for instance) are sold to the market
Why go Public? • Lack of other financing choices • Private financing unavailable • Too much debt, so firm optimizes capital structure • Allows current investors to cash out • Founders demand liquidity, want to sell stake in firm • Issue seasoned equity – “secondary share offering” • Firm is valued by the market, shares sold get market price
Future source of capital • Establish the firm in public capital markets for future capital raising (SEOs, bond issuances) • Diversification / Risk sharing • Increases transparency of firm actions • Employee compensation • Firm can offer incentive contracts – stock options
Why not go Public? • Going public is costly, time consuming and may not be appropriate for all firms, even when they are in need of additional financing • Ownership is diluted • Decision making is delegated to an increased number of owners • Founder (entrepreneur) loses control • Public monitoring increases • Competitors benefit from transparency • Regulators have increased authority (legal restrictions to public firms)
Direct financial costs • Filing costs of prospectus and subsequent filings • Investment banks and new investors charge the firm via large transactions costs • Shares are underpriced (can be greater than 15%) • Underwriters collect fees (7% of gross proceeds) • Short-term performance pressures • Change in accounting practices
The IPO Process • Firm selects an underwriter (investment bank) who also acts as the advisor, basing the decision on: • The reputation and expertise of the underwriter (the advisor must be credible) • Follow-on products like research coverage • Prior relationships between the firm owners and investment banks • Distribution channels available to underwriter (institutional clients) • The investment banks willingness to take on the firm (high reputation underwriters may not risk their reputation on a firm with uncertain prospects)
Firm and underwriter agree on the offering method: • Firm commitment: firm sells the entire issue to the underwriter who then attempts to sell it to the public (insured) – Although the underwriter fully commits to purchasing the issue, the price is not agreed (or committed to) until later in the issuance process. • Best effort: underwriter makes no promise about the price, but makes a best effort to sell at the agreed price (uninsured) • Rights offering: securities are first offered to existing shareholders (not common in the U.S.)
Valuing the offer: Underwriter provides a value of the firm. • Firm opens its books to the underwriter so that they have full information for determining value – the underwriter is the agent that reduces asymmetric information • Discounted cashflow analysis is one valuation method, but more commonly, underwriters identify a peer group of publicly traded firms and use multiples of different financial metrics to provide a range of values. • Firm and underwriter agree and set an offer range, which may change once the underwriter has a better assessment of market interest in the offering. • Six to 8 weeks have passed from the selection of the underwriter until the end of the due diligence.
Road show: Begins a few weeks prior to the IPO. • The lead underwriter visits large investors (institutional) to solicit interest and build a demand schedule (book building) • Book building occurs with “special” clients of the underwriter, including institutions (Fidelity, Janus etc.) and wealthy private investors. • Book building is also spreading to smaller clients through electronic road shows, aided by the internet. • Only once the waiting period is over, can the investment bank/underwriter solicit specific pricing and demand information from investors. • The waiting period usually ends a few days prior to the IPO, allowing investment banks to reach what they think will be an equilibrium (final) offer price.
Offer: Underwriter sells the issue and an exchange begins trading the issue in a secondary market. • Depending on demand for shares, the underwriter may have to ration shares to investors. • Shares are sold to investors prior to trading in secondary markets • New investors who didn’t get an allocation of the primary shares can now buy shares in the open market • Investors who received an initial allocation of shares can begin selling them to new investors • Investors who are allocated shares and immediately turn around and sell them in the market are not viewed favorably by investment bankers and may be cut off from future allocations.
Fees: Underwriters charge issuing firms for their services • Fees are earned for reducing the asymmetric information between investors and the firm • Investment banks (underwriters) use their reputation in a repeated game setting (they do this over and over with different firms) to convince investors of the firm’s type • For firm commitment offerings, fees come from the following sources • Gross spread: price sold to market – price bought from firm. Typically this is 7% of gross proceeds • Underpricing = closing price at end of first trading day – the offer price. Underwriters generally under price the offer by as much as 15%, and much more in certain cases.