Case Study 2: S&S Air Goes Public

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Raising Capital

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Key Concepts and Skills

Understand:

• How securities are sold to the public, and the role of investment bankers

• Initial public offerings, and the costs of going public

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Selling Securities to the Public

• Management must obtain permission from the Board of Directors.

• Firm must file a registration statement with the SEC.

• The SEC examines the registration during a 20-day waiting period. ▪ A preliminary prospectus, called a red herring, is distributed during

the waiting period.

▪ If there are problems, the company is allowed to amend the registration and the waiting period starts over.

• Securities may not be sold during the waiting period.

• The price is determined on the effective date of the registration and the selling effort begins.

Process for issuing securities:

1. Obtain approval from the Board of Directors 2. File registration statement with the SEC 3. SEC requires a 20-day waiting period

• Company distributes a preliminary prospectus called a red herring • Cannot sell securities during waiting period

4. The price is set when the registration becomes effective and the securities can be sold

Registration Statements

• contains many pages (50 or more) of financial information, including a financial history, details of the existing business, proposed financing, and plans for the future.

• does not initially contain the price of the new issue. • does not have to be filed if the loan will mature in less than nine months or the issue involves less than

$5 million.

SEC examines the registration statement during a waiting period. During this time, the firm may distribute

copies of a preliminary prospectus to potential Investors.

• The preliminary prospectus is sometimes called a red herring because bold red letters are printed on the cover.

• Prospectus: shows potential investors and describes a new security offering

SEC makes no statement about the financial strength of the firm, it simply indicates that the registration is

in order.

A registration statement becomes effective on the 20th day after its filing unless the SEC sends a letter of

comment suggesting changes. In that case, after the changes are made, the 20-day waiting period starts

again.

The company cannot sell these securities during the waiting period. However, oral offers can be made

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Issue Methods

• Public Issue • General cash offer—securities offered for sale to the general public on a cash basis

• Rights offer—public issue in which securities are first offered to existing shareholders on a pro-rata basis

• Initial Public Offering (IPO)—a company’s first equity issue made available to the public

• Seasoned equity offering—a new equity issue of securities by a company that has previously issued securities to the public

• Private Issue – Sold to fewer than 35 investors

– SEC registration not required

When a company decides to issue a new security, it can sell it as a public issue or a private Issue. In the

case of a public issue, the firm is required to register the issue with the SEC.

Rights offers are fairly common in other countries, but they are relatively rare in the United States,

particularly in recent years. We therefore focus primarily on cash offers in this module.

IPO is also called an unseasoned new issue.

A seasoned equity offering of common stock can be made by using a cash offer or a rights offer.

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Methods of Issuing New Securities

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Underwriters

• Underwriters: investment firms that act as intermediaries between the issuer and the public

• Underwriting services: – Formulate method to issue securities

– Price the securities

– Sell the securities

– Price stabilization by lead underwriter in the aftermarket

• Syndicate = group of investment bankers (Underwriters) that market the securities and share the risk associated with selling the issue

• Spread = difference between what the syndicate pays the company (buying price) and what the security sells for in the market (offering price)

If the public issue of securities is a cash offer, underwriters are usually involved. Underwriting is an

important line of business for large investment firms such as Merrill Lynch.

Some of the services provided by underwriters include:

• Help in determining the type of security to issue • Help in determining the method used to issue the securities • Pricing of the securities • Selling the securities • In the case of an IPO, stabilizing the price in the aftermarket

Price stabilization is an important component of the lead underwriter’s job for IPOs.

Underwriters usually combine to form an underwriting group called a syndicate to share the risk and to

help sell the issue, managed by a lead underwriter

Spread—the difference between the underwriter’s buying price and the offering price; it is the

underwriter’s main source of compensation and for IPOs in the range of $20 to $80 million the spread is

typically 7%. For penny stock IPOs, the spread is generally 10%. Spread is also called gross spread.

Sometimes, on smaller deals, the underwriter will get noncash compensation in the form of warrants and

stock in addition to the spread.

Ethics Note: The regulatory process attempts to ensure that investors receive enough information to make

informed decisions; this is the role of the prospectus. However, this is not always the case. Brokers have

been known to sell securities based on sales scripts that have little to do with the information provided in

the prospectus. Also, investors often make investment decisions before receiving (or reading) the prospectus.

While the behavior of the brokers is hardly ethical, it reinforces the point that you should take what the

broker says with a grain of salt and always read the prospectus before making a purchase decision.

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Tombstone

Tombstones—large

advertisements used by

underwriters to let

investors know that new

securities are coming to

market.

Tombstone advertisements (or, simply, tombstones) are used by underwriters during and after the 20 days

waiting period. The tombstone contains the name of the issuer (the World Wrestling Federation, or WWF,

in this case.

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Tombstone Figure 15.1

• Investment banks in

syndicate divided into

brackets

•Firms listed alphabetically

within each bracket

•“Pecking order”

•Higher bracket = greater

prestige

•Underwriting success

built on reputation

Tombstone lists the investment banks (the underwriters involved with selling the issue). The investment

banks on the tombstone are divided into groups called brackets based on their participation in the issue

The brackets are often viewed as a kind of pecking order. In general, the higher the bracket, the greater is

the underwriter’s prestige.

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Firm Commitment Underwriting

• Issuer sells entire issue to underwriting syndicate

• 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

• Syndicate bears the risk of not being able to sell the entire issue for more than the cost

• Most common type of underwriting in the United States

This is a good place to review the difference between primary and secondary market transactions.

Technically, the sale to the syndicate is the primary market transaction, and the sale to the public is the

secondary market transaction.

Three basic types of underwriting are involved in a cash offer: firm commitment, best efforts, and Dutch

auction.

Firm commitment underwriting – the underwriting syndicate purchases the shares from the issuing

company and then sells them to the public. The syndicate’s profit comes from the spread between the prices,

and it bears the risk that the actual spread earned will not be as high as anticipated (or may not even cover

costs). This is the most common type of underwriting in the United States.

For a new issue of seasoned equity, more than 95 percent of all such new issues are firm commitments.

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Best Efforts Underwriting

• Underwriter makes “best effort” to sell the securities at an agreed-upon offering price

• Issuing company bears the risk of the issue not being sold

• Offer may be pulled if not enough interest at the offer price

– Company does not get the capital and they have still incurred substantial flotation costs

• Not as common as it used to be

Best efforts underwriting – the underwriters are legally bound to make their “best effort” to sell the

securities at the offer price, but do not actually purchase the securities from the issuing firm. In this case,

the issuing firm bears the risk of the market being unwilling to buy at the offer price.

The underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer.

This form of underwriting has become uncommon in recent years.

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Dutch Auction Underwriting

• Underwriter accepts a series of bids that include number of shares and price per share.

• The price that everyone pays is the highest price that will result in all shares being sold.

• There is an incentive to bid high to make sure you get in on the auction but knowing that you will probably pay a lower price than you bid.

• The Treasury has used Dutch auctions for years.

• Google was the first large Dutch auction IPO.

Dutch auction underwriting (also known by the uniform price auction) – the underwriter does not set the

offer price. Instead, a series of bids is solicited from potential investors and the price that is paid by everyone

is the price that will result in all shares being sold. The incentive is to bid high to guarantee that you get in

on the offer price, knowing that you will only pay the lowest accepted price. The U.S. Treasury has sold

bills, bonds, and notes using the Dutch auction process for many years. Google is the highest profile Dutch

auction IPO to date.

Buyers:

• Bid a price and number of shares

Seller:

• Work down the list of bidders

• Determine the highest price at which they can sell the desired number of shares

All successful bidders pay the same price per share.

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Dutch or Uniform Price Auction Example

The company wants to sell 1,500 shares of stock.

The firm will sell 1,500 shares at $15 per share.

Bidders A, B, C, and D will get shares.

Bidder Quantity Bid

A 500 $20

B 400 18

C 250 16

D 350 15

E 200 12

Bidder Quantity Bid Σ Qty

A 500 $20 500

B 400 18 900

C 250 16 1,150

D 350 15 1,500

E 200 12 1,700

With Dutch auction underwriting, the underwriter does not set a fixed price for the shares to be sold.

Instead, the underwriter conducts an auction in which investors bid for shares. When the auction closes,

bidders are listed in descending order of price bid.

Bidder A is willing to buy 500 shares at $20 each.

Bidder B is willing to buy 400 shares at $18 each.

Bidder C is willing to buy 250 shares at $16 each.

Bidder D is willing to buy 350 shares at $15 each.

Bidder E is willing to buy 200 shares at $12 each.

$15 is the highest price at which the company can sell the desired number of shares.

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Green Shoe Provision

• “Overallotment Option”

• Allows syndicate to purchase an additional 15% of the issue from the issuer

• Allows the issue to be oversubscribed

• Provides some protection for the lead underwriter as they perform their price stabilization function

• In all IPO and SEO offerings but not in ordinary debt offerings

The Aftermarket - Trading period after a new issue is initially sold to the public.

Many underwriting contracts contain a Green Shoe provision (sometimes called the overallotment option),

which gives the members of the underwriting group the option to purchase additional shares from the issuer

at the offering price (i.e. the stated reason for the Green Shoe option is to cover excess demand and

oversubscriptions).

The term Green Shoe provision sounds quite exotic, but the origin is relatively mundane. The term comes

from the name of the Green Shoe Manufacturing Company, which, in 1963, was the first issuer that granted

such an option.

The Green Shoe provision allows the underwriters to purchase additional shares (up to 15% of the issue) at

the original price up to 30 days after the initial sale. This provision is used primarily when an offering goes

well and the underwriters need to cover their short positions created by overallotment of the issue. See the

references provided above for more information.

In practice, usually underwriters initially go ahead and sell 115 percent of the shares offered. If the demand

for the issue is strong after the offering, the underwriters exercise the Green Shoe option to get the extra 15

percent from the company.

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Lockup Agreements

• Not legally required but common

• Restricts insiders from selling IPO shares for a specified time period

– Common lockup period = 180 days

• Stock price tends to drop when the lockup period expires due to market anticipation of additional shares hitting the Street

The lockup agreement prevents insiders from selling their shares for some period after the IPO, usually 180

days. The stock price often drops right before the lockup period expires in anticipation of a large number

of shares flooding the market (excess supply causes the price to drop). This is the time that venture

capitalists and other early-stage investors will be able to exercise their “exit” strategy.

Such agreements specify how long insiders must wait after an IPO before they can sell some or all of their

stock.

The Quiet Period - The quiet period is a period of time around the IPO when company employees and the

underwriters must limit communications with the public to “ordinary announcements and other purely

factual matters.” This is done to prevent too much hype in the hope of increasing demand for the stock.

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IPO Underpricing • IPO underpricing: a large increase above the offer price the

first day of trading

• IPO pricing may be difficult to price an IPO because there isn’t a current market price available – Private companies tend to have more asymmetric information than

companies that are already publicly traded.

– Underwriters want to ensure that, on average, their clients earn a good return on IPOs.

• Dutch Auctions designed to eliminate first day IPO price “pop”

• Underpricing causes the issuer to “leave money on the table”

• Degree of underpricing varies over time

Determining the correct offering price is the most difficult thing an underwriter must do for an initial public

offering. The issuing firm faces a potential cost if the offering price is set too high or too low. If the issue

is priced too high, it may be unsuccessful and have to be withdrawn.

Underpricing: too low offering price < market closing price in the first day of trading

Underpricing (a large increase above the offer price the first day of trading) is fairly common. It obviously

helps new shareholders earn a higher return on the shares they buy. However, the existing shareholders of

the issuing firm are not helped by underpricing. To them, it is an indirect cost of issuing new securities.

Consider the Visa IPO. The stock opened at $44 and rose to a first-day high of $69, before closing at $56.50,

a gain of about 28 percent. Based on these numbers, Visa was underpriced by about $12.50 per share, which

means the company missed out on an additional $5.6 billion or so, the largest dollar amount “left on the

table” in history.

Such young firms can be very risky investments. Arguably, they must be significantly underpriced, on

average, just to attract investors, and this is one explanation for the underpricing phenomenon.

Furthermore, when the price is too low, the issue is often “oversubscribed.

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IPO Underpricing

The underpricing (there is a large increase above the offer price the first day of trading) of IPOs is very

common. Empirical evidence suggests that it has gotten worse in recent years. As Table 15.2 points out,

the average underpricing has been higher from 2000 to 2007, even with a down market, than any other

period in time. The record year, though, is still 1999 with an average first day return of almost 70 percent.

How have recent IPOs performed?

Hoovers.com’s “IPO Central”

Use the “IPO Calendar” to determine how many companies went public during the last week

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IPO Underpricing Reasons

• Underwriters want offerings to sell out

▪ Reputation for successful IPOs is critical

▪ Underpricing = insurance for underwriters

▪ Oversubscription & allotment

▪ “Winner’s Curse”

• Smaller, riskier IPOs underprice to attract investors

Why Does Underpricing Exist?

Possible explanations include:

• most are driven by smaller, speculative issues • oversubscription of issues due to a limited number of shares • investment banks need to be sure they can clear an issue • a reward to institutional investors for helping in the book building process

To illustrate, consider this tale of two investors. Smith knows very accurately what the Bonanza Corporation

is worth when its shares are offered. She is confident that the shares are underpriced. Jones knows only that

prices usually rise one month after an IPO. Armed with this information, Jones decides to buy 1,000 shares

of every IPO. Does he actually earn an abnormally high return on the initial offering?

The answer is no, and at least one reason is Smith. Knowing about the Bonanza Corporation, Smith invests

all her money in its IPO. When the issue is oversubscribed, the underwriters have to somehow allocate the

shares between Smith and Jones. The net result is that when an issue is underpriced, Jones doesn’t get to

buy as much of it as he wanted. Smith also knows that the Blue Sky Corporation IPO is overpriced. In this

case, she avoids its IPO altogether, and Jones ends up with a full 1,000 shares. To summarize this tale,

Jones gets fewer shares when more knowledgeable investors swarm to buy an underpriced issue and gets

all he wants when the smart money avoids the issue. This is an example of a “winner’s curse,” and it is

thought to be another reason why IPOs have such a large average return. When the average investor “wins”

and gets the entire allocation, it may be because those who knew better avoided the issue. Another reason

for underpricing is that the underpricing is a kind of insurance for the investment banks. Conceivably, an

investment bank could be sued successfully by angry customers if it consistently overpriced securities.

Underpricing guarantees that, at least on average, customers will come out ahead.

Ethics Note: Traditionally, IPOs have been reserved for the syndicates’ best customers, but the investment

bankers have to be careful how they allocate those shares. In July, 2004, Piper Jaffray was fined $2.4

million for selling shares of “hot” IPOs to the executives of firms that they have either recently done

business with or with whom they were trying to gain business.

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New Equity Issues and Price

• Stock prices tend to decline when new equity

is issued

• Possible explanations for this phenomenon:

▪ Signaling explanations:

• Equity overvalued: If management believes equity is

overvalued, they would choose to issue stock shares

• Debt usage: Issuing stock may indicate firm has too

much debt and can not issue more debt

▪ Issue costs

• equity is more expensive to issue than debt

from a straight flotation cost perspective.

It seems reasonable to believe that new long-term financing is arranged by firms after positive net present

value projects are put together. As a consequence, when the announcement of external financing is made,

the firm’s market value should go up. Interestingly, this is not what happens. Stock prices tend to decline

following the announcement of a new equity issue (a seasoned equity offering).

Why? A number of researchers have studied this issue.

Much of the decline may be due to the private information known by management (called asymmetric

information) and the signals that the choice to issue equity sends to the market.

• Managerial information concerning value of the stock (Equity Overvalued) – expectation that managers will issue equity only when they believe the current price is too high

• Equity Overvalued - This will benefit existing shareholders. However, the potential new shareholders are not stupid, and they will anticipate this superior information and discount it in

lower market prices at the new-issue date.

• Debt usage – issuing equity may send a signal that management believes the company currently has too much debt.

• Issue costs – equity is more expensive to issue than debt from a straight flotation cost perspective

Since the drop in price can be significant, and much of the drop may be attributable to negative signals, it

is important for management to understand the signals that are being sent and try to reduce the effect when

possible.

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The Cost of Issuing Securities

Issuing securities to the public isn’t free, and the costs of different methods are important determinants of

which is used. These costs associated with floating a new issue are generically called flotation costs.

The cost of issuing securities can be broken down into the following main categories:

• Spread • Other direct expenses – legal fees, filing fees, etc. • Indirect expenses – opportunity costs, i.e., management time spent working on issue • Abnormal returns – price drop on existing stock • Underpricing – below market issue price on IPOs • Green Shoe option – cost of additional shares that the syndicate can purchase after the issue has gone

to market

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IPO Cost – Example

• The Faulk Co. has just gone public under a firm commitment agreement. Faulk received $32 for each of the 4.1 million shares sold. The initial offering price was $34.40 per share, and the stock rose to $41 per share in the first few minutes of trading. Faulk paid $905,000 in legal and other direct costs and $250,000 in indirect costs. What was the flotation cost as a percentage of funds raised?

• The net amount raised is the number of shares offered times the price received by the company, minus the costs associated with the offer, so:

• Net amount raised = (4,100,000 shares)($32) – 905,000 – 250,000 = $130,045,000

The company received $130,045,000 from the stock offering

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IPO Cost – Example

• Next, we can calculate the direct costs. Part of the direct costs are given in the problem, but the company also had to pay the underwriters. The stock was offered at $34.40 per share, and the company received $32 per share. The difference, which is the underwriters’ spread, is also a direct cost.

• Total direct costs = $905,000

+ ($34.40 – 32)(4,100,000 shares) = $10,745,000

• We are given part of the indirect costs, but the underpricing is another indirect cost.

• Total indirect costs = $250,000

+ ($41 – 34.40)(4,100,000 shares) = $27,310,000

Now we can calculate the direct costs. Part of the direct costs are given in the problem, but the company

also had to pay the underwriters. The stock was offered at $25 per share, and the company received

$23.25 per share. The difference, which is the underwriters spread, is also a direct cost.

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IPO Cost – Example

• Total costs = $10,745,000 + 27,310,000 = $38,055,000

• The flotation costs as a percentage of the amount raised is the total cost divided by the amount raised, or:

• Flotation cost percentage = $38,055,000 / $130,045,000

• Flotation cost percentage = .2926, or 29.26%

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Rights Offerings: Basic Concepts

• Issue of common stock offered to existing shareholders

• Allows current shareholders to avoid the dilution that can occur with a new stock issue

• “Rights” are given to the shareholders ▪ Specify number of shares that can be purchased

▪ Specify purchase price

▪ Specify time frame

• Rights may be traded OTC or on an exchange 15-23

Privileged subscription – issue of common stock offered to existing stockholders.

Offer terms are evidenced by warrants or rights.

Rights are often traded on exchanges or over the counter.

If a preemptive right is contained in the firm’s articles of incorporation, the firm must first offer any new

issue of common stock to existing shareholders.

In a rights offering, each shareholder is issued rights to buy a specified number of new shares from the

firm at a specified price within a specified time

Rights offerings have some interesting advantages relative to cash offers. For example, they appear to be

cheaper for the issuing firm than cash offers. In fact, a firm can do a rights offering without using an

underwriter.

Rights offerings are fairly rare in the United States.

The Mechanics of a Rights Offering

Early stages are the same as for a general cash offer, i.e., obtain approval from directors, file a registration

statement, etc. The difference is in the sale of the securities. Current shareholders get rights to buy new

shares. They can subscribe (buy) the entitled shares, sell the rights, or do nothing.

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• Dilution is a loss in value for existing shareholders.

▪ Percentage ownership – shares sold to the general public without a rights offering

▪ Market value – firm accepts negative NPV projects

▪ Book value and EPS – occurs when market-to-book value is less than one

Dilution

Dilution of Proportionate Ownership

This occurs when the firm sells stock through a general cash offer and new stock is sold to persons who

previously weren’t stockholders. For many large, publicly held firms this simply isn’t an issue, since there

are many different stockholders to begin with. For some firms with a few large stockholders it may be of

concern.

Eg. If Joe does not participate in the new issue, his ownership will drop. Notice that the value of Joe’s

shares is unaffected; but he will own a smaller percentage of the firm.

Dilution of Value: Book versus Market Values

A stock’s market value will fall if the NPV of the project being financed is negative and rise if the NPV is

positive. Whenever a stock’s book value is greater than its market value, selling new stock will result in

accounting dilution (but not necessarily result in market value dilution)

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• Permits a corporation to register a large issue with the SEC and sell it in small portions over a two-year period

• Reduces the flotation costs of registration

• Allows the company more flexibility to raise money quickly

• Requirements

▪ Company must be rated investment grade.

▪ Cannot have defaulted on debt within last three years

▪ Market value of stock must be greater than $150 million.

▪ No violations of the Securities Act of 1934 in the last three years

Shelf Registration

Shelf registration – SEC Rule 415 allows a company to register all securities that it expects to issue

within the next two years in one registration statement. The firm can then issue the securities in smaller

increments, as funds are needed during the two-year period. Both debt and equity can be registered using

Rule 415.

Qualifications:

-Securities must be investment grade

-No debt defaults in the last three years

-Market value of stock must be greater than $150 million

-No violations of the Securities Act of 1934 within the last three years