THE COST OF SELLING STOCK TO THE PUBLIC
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. In this section, we take a closer look at the
flotation costs associated with equity sales to the public.
The cost of selling stock to the public
The costs of selling stock are classified in the following table and fall into six
categories: (1) the gross spread, (2) other direct expenses, (3) indirect expenses, (4)
abnormal returns (discussed previously), (5) underpricing, and (6) the Green Shoe option.
1. Gross Spread: The gross spread consists of direct fees paid by the issuer to the
underwriting syndicate—the difference between the price the issuer receives
and the offer price.
2. Other direct expenses: These are direct costs, incurred by the issuer, that are
not part of the compensation to underwriters. These costs include filing fees,
legal fees, and taxes—all reported on the prospectus.
3. Indirect expenses: These costs are not reported on the prospectus and include
the costs of management time spent working on the new issue.
4. Abnormal returns: In a seasoned issue of stock, the price of the existing stock
drops on average by 3 percent upon the announcement of the issue. This drop
is called the abnormal return.
5. Underpricing: For initial public offerings, losses arise from selling the stock
below the true value.
6. Green shoe option: The Green Shoe option gives the underwriters the right to
buy additional shares at the offer price to cover overallotments.
The underwriting arrangements
Rights offerings are typically arranged using standby underwriting. In standby
underwriting, the issuer makes a right offering, and the underwriter makes a firm
commitment to “take up” (that is, purchase) the unsubscribed portion of the issue. The
underwriter usually gets a standby fee and additional amounts based on the securities
taken up.
Standby underwriting protects the firm against undersubscription, which can occur
if investors throw away rights or if bad news causes the market price of the stock to fall
below the subscription price.
In practice, only a small percentage (less than 10 percent) of shareholders fail to
exercise valuable rights. This failure can probably be attributed to ignorance or vacations.
Furthermore, shareholders are usually given an oversubscription privilege, which
enables them to purchase unsubscribed shares at the subscription price. The
oversubscription privilege makes it unlikely that the corporate issuer would have to turn
to its underwriter for help.
Right offers: The case of time-warner
Rights offers have become less and less common in the United States. However, as
media giant Time-Warner’s 1991 $2.76 billion offer indicates, they are far from dead. The
Time-Warner offer was the largest equity sale of any type in U.S. history, and it was the
largest rights offer since AT&T’s $1.4 billion issue in the 1970s. The offer was controversial
when it was originally proposed because the subscription price varied depending on what
percentage of the issue actually sold. This feature was later dropped, and the stock was
sold using straight rights offer.
In the Time-Warner deal, the stock was trading in the $90 range just before the offer
became effective, and each right entitled the holder to purchase .6 new shares. The
subscription price was $80 per share, so 34.5 million shares were sold. Approximately 56
percent of the stockholders in Time-Warner exercised their options directly and
purchased stock. Another 42 percent sold their rights on the open market; these rights
were subsequently exercised by the purchasers. As is typical of rights offers, about 2
percent of the rights were neither exercised nor sold, so some stockholders apparently
did not act to protect their interests. Only about 586,000 shares were initially unsold, and
subscribers sought more than five times that amount in oversubscription rights, so none
of the stock ultimately went unsold.
The underwriters, led by Salomon Brothers, earned substantial fees for their
services. For managing the offer and promising to buy unsold shares (of which there were
none), the basic compensation was 3 percent of the amount of the issue, or $82.8 million.
Furthermore, the underwriters were given the right to buy stock at a 3 percent discount
on the subscription price, or $77.60 per share. By purchasing rights in the open market,
exercising the rights and buying the stock at a discount, and then reselling the stock, the
underwriters earned an additional profit of roughly $27.6 million. The total compensation
was thus approximately $110 million, or about 4 percent of the issue proceeds. Because
this was somewhat high for such a large deal, Time-Warner and its chairman, Stephen
Ross (no relation to the noted financial economist and textbook author of the same
name), were criticized by various groups.
Motion picture giant Metro-Goldwyn-Mayer (MGM) has been one of the more active
users of rights offerings in the United States. MGM completed rights offerings of $200
million in 1988, another $100 million in 1992, and $700 million in October 1998. In
November 1999, MGM completed a $721 million rights offering resulting in the issuance
of about 50 million new shares. Under the terms of the offer, each shareholder received
.328 transferable subscription rights for each common share; each right had an exercise
price of $14.50 per share. About 99.3 percent of MGM’s shareholders exercised their
rights, and the offer was oversubscribed by nearly 3.9 million shares. Outside the United
States, large rights offerings are not uncommon. For example, in September 2000,
Spanish Internet portal Terra Networks raised $2 billion in rights offer to help finance its
planned merger with Lycos. In June 2001, British Telecommunications completed the
largest rights offering ever when it raised $8.3 billion.
