Ch 15. Raising Capital
Part 1. Selling Securities
Hello everyone. This is Ch 15, raising capital.
This chapter, we will see how companies’
new stocks are issued and sold.
When a firm decides to sell securities to
public, the first step is to obtain permission
from the Board of Directors of the company.
Then, the firm files a registration statement
with the Securities and Exchange Commission,
SEC. SEC examines this registration for 20
days, called 20-day waiting period. During
this period, stocks may not be sold, but a
preliminary prospectus called a red herring
is distributed. If there are problems, then
the company may amend it. If so, the waiting
period starts over. After the waiting period,
price per share determined on the effective
date of the registration and the selling effort
begins.
The stocks may be sold as a public issue or
a private issue. If a firm wants to sell its
shares to more than 35 investors, it should
file registration with SEC as we saw. If stocks
are sold to general public, it is called general
cash offer. If the offer is only for current
shareholders, it is called right offer. When
a firm publicizes its stocks for the first
time, this offer is called initial public
offerings, IPO. Only one IPO per firm is possible.
After IPO, any equity offerings are called
seasoned equity offering, SEO.
If stocks are sold to fewer than 35 investors,
it is called private issue. Private issues
do not have to be filed to SEC.
Since an issuing firm is not an expert to
sell new stocks, it hires investment banks
to underwrite offerings. The underwrites formulate
method to issue securities, price the securities,
sell the securities, and stabilize price in
the aftermarket. The investment banks form
a syndicate which makes underwriters share
the risk associated with selling the issues.
And, they receive spread, which is difference
between what the syndicate pays the company
and what the security sells for in the market.
There are three typical ways to underwrite.
First one is firm commitment underwriting.
Firm commitment underwriting is that an issuer
sells entire shares to a syndicate, and the
syndicate resells issue to the public. Underwriter
makes money on the spread between the price
paid to the issuer and the price received
from investors when the stock is sold. The
syndicate bears the risk if it is not able
to sell the entire issue for more than the
cost. This is the most common type of underwriting
in the United States.
Second way is called best efforts underwriting.
Underwriter makes the best effort to sell
the securities at an agreed-upon offering
price. So, an issuing company bears the risk
of the issue not being sold. Offer may be
pulled if not enough interest at the offer
price. The risk is that a company does not
get the capital and they have still incurred
substantial flotation costs. So, it is not
as common as it used to be.
Third way is Dutch or uniform price auction.
It is a bidding system. Buyers bid a price
and number of shares. Then, a seller works
down the list of bidders and determines the
highest price at which they can sell the desired
number of shares. All successful bidders pay
the same price per share, which may encourage
aggressive bidding. For example, the company
wants to sell 1,500 shares of stocks. There
are five bidders and bid a price and number
of shares as shown in the table. If you cumulate
quantity by the order of higher bid price,
Bidder A, B, C, D can get the stocks. The
price they pay is $15, which is the lowest
bid price among winners.
This is called Tombstone. This is for World
Wrestling Federation Entertainment, Inc. It
shows number of shares that a syndicate sells,
11.5 million shares, and offer price, $17.
9.2 million shares are offered in the U.S.
and 2.3 million shares are offered in international
markets. Investment banks in the syndicate
divided into brackets. And firms listed alphabetically
within each bracket. The investment banks
in higher bracket has greater prestige since
underwriting success built on reputation.
The lead underwriters of U.S. offering are
Bear Sterns, Credit Suisse, Merill Lynch and
Wit Capital. In international offering, there
are three underwriters.
To avoid the risk, IPO often has overallotment
option, called green shoe provision. It allows
the syndicate to purchase an additional 15%
of the issue from the issuer. By doing so,
it provides some protection for the lead underwriter
as they perform their price stabilization
function. We can find it in all IPO and SEO
offerings.
There is also the agreement that insiders
are prohibited to sell IPO shares for a specified
time period, commonly 180 days. It is called
lockup agreement. Stock price tends to drop
when the lockup period expires due to market
anticipation of additional shares sold in
the market.
One of the most critical functions that underwriters
do is to find right offer price. IPO pricing
is very difficult because there is no current
market price available. Many cases, we can
see underpricing IPOs. On first day of IPO,
price immediately rises. It means that the
company does not raise this difference, often
called leave money on the table. Dutch auction
is designed to eliminate the underpricing.
To minimize the opportunity costs of underpricing,
during SEC registration, a company will set
a “file price range.” And, just before
the IPO, the final price is determined. The
final price can be below, inside, or above
the file price range. Historically, IPOs with
a final price above the file range have been
far more underpriced than those with a final
price below or inside the file range.
Why are IPOs generally underpriced? The best
possible explanation is underwriters want
offerings to sell all shares out. Reputation
for successful IPO is critical. And underpricing
is basically an insurance for underwriters.
There's called winners curse. Investors have
different information about the fair value
of the shares. So, informed investors only
buy new shares if the issue price is less
than fair value. for uninformed investors,
sure must be offered at a discount because
none of the investors group have enough money
to observe the initial public offerings. Therefore,
IPOs are generally underpriced. Especially,
smaller or riskier IPOs underpriced attract
investors. Since IPO underpricing generate
the opportunity cost to the firm, this would
be one of the most expensive costs to raise
capital through IPOs.
Pop quiz. If the company wants to sell 1,000
shares, find how many shares each bidder can
get and how much each bidder will pay per
share.
Bidder A will get all 500 shares, and B will
get 400. And, C still get the shares, but
not 250 because the company is selling only
1,000 shares. C will get 100 shares. Now,
since C is the winner who bid the lowest price,
$16 will be an offer price.
This is the end of Ch 15. Thank you.
