Chapter 10.3 Flashcards
Initial Public Offering
If a business is very successful, what will it outgrow at some point?
The ability of private sources of equity, such as family and friends and venture capitalists, to fund its growth
What activities is additional money needed by a business once it outgrows the ability of private sources of equity to fund its growth?
- Investments in plat and equipment
- Working capital
- Research and development (R&D)
What is one way to raise larger sums of cash/facilitate the exit of a venture capitalist?
Through an initial public offering, or IPO, of the company’s common stock
What is an IPO?
A company’s first sale of common stock in the public market
Why are first-time stock issues given a special name?
Because the marketing and pricing of these issues are distinctly different from those of seasoned offerings: they’re publicly traded securities
What is a publicly traded security?
Term public offering means that the securities being sold are registered w/ the Securities and Exchange Commission and, thus, can legally be sold to the public
What kind of securities can only be sold to the public?
Registered securities
Alternatively to being sold publicly, what other ways can securities be sold?
Directly to institutional investors in the private market
Rather than the sale of the business to a strategic/financial buyer, why may the entrepreneur and the venture capitalist decide that an IPO is the appropriate way to achieve their goals?
When large sums of capital are necessary to fund a business or when the entrepreneur or venture capitalists are ready to sell some or all of their investment in a business
What does the decision to go public depend on?
An assessment of whether the advantages outweigh the disadvantages
What are the advantages of going public?
- Access to larger amounts of equity capital
- Ability to raise additional funds through follow-on offerings
- Fund growth without giving up full control
- Active secondary market for shares (liquidity and diversification)
- Exit opportunities for early investors (e.g., venture capitalists)
- Easier to attract and motivate top management with stock-based incentives
How is the amount of equity capital that can be raised in the public equity markets typically larger than the amount that can be raised through private sources
There are millions of investors in public stock markets, and it is easier for firms to reach these investors through public markets.
After a firm has completed an IPO, how can additional equity capital usually be raised through follow-on seasoned public offerings at a low cost?
The public markets are highly liquid and investors are willing to pay higher prices for more liquid shares of public firms than for the relatively illiquid shares of private firms
How can going public enable an entrepreneur to fund a growing business w/o giving up control?
Entrepreneur doesn’t have to sell the entire business but only what’s needed to raise the necessary fumds
What is the benefit of there being an active secondary market in which stockholders can buy and sell its shares, once it has gone public?
Enables the entrepreneur and other managers to more easily diversify their personal portfolios or to just sell shares in order to enjoy some of the rewards of having built a successful business
What is particularly advantageous to venture capitalists about a company going public?
Provides a way for venture capitalists to sell their shares
How does a company having an active market for a firm’s shares (going public) make it easier for the firm to attract top management talent and to better motivate current managers?
Senior managers generally own equity in the firm, and some part of their compensation is tied to the firm’s stock performance
How does equity ownership align management behaviour with the objective of maximizing stockholder value?
When senior managers own equity and their compensation depends on stock performance, they are motivated to maximize stockholder value.
Why is stock-based compensation easier in public companies than it is in private ones?
Public: easy to offer incentives tied to stock performance bc market info about the value of a share of stock is readily available
Private: market transactions are infrequent, and thus the market value of a firm’s equity must be estimated
What are the disadvantages of going public?
- High cost of the IPO
- Lower initial stock price
- Ongoing SEC compliance costs
- Loss of confidentiality
- Short-term market pressure
How does going public have a high cost of the IPO/lower initial stock price?
Cost partly due to stock not being seasoned. The likely liquidity of a stock that’s sold in an IPO is less well known than for a seasoned one, and its value is more uncertain. Because of this, investors less comfy buying stock sold in IPO and thus will not pay as high price for it as for similar seasoned stock.
Out-of-pocket costs adding on to cost of IPO: legal fees, accounting expenses, printing costs, travel expenses, SEC filing fees, consultant fees, and taxes can add
What is a seasoned stock?
A seasoned stock, which is traded in a public secondary market, has an established record which investors can observe how many shares trade on regular basis (measure of the liquidity for the shares) and the prices at which the trades take place.
How does going public have ongoing costs of complying with SEC disclosure requirements?
Once firm goes public, must meet lots of filing and other requirements imposed by SEC. For larger firms, these regulatory costs aren’t that important bc they represent relatively small fraction of total equity value. But for small firms costs can be significant
How can the transparency that results from complying with SEC requirements be costly for some firms?
Requirement that firms provide public w/ detailed financial statements, detailed info on executive compensation, info about firm’s strategic initiatives, + more can put firm at competitive disadvantage relative to private firms that aren’t required to disclose such info
How does going public encourage managers to focus on short-term profits rather than long-term value maximizations?
Some investors argue that the SEC’s requirement of quarterly earnings estimates and quarterly financial statements encourages managers to focus on short-term rather than long-term.
Managers who fail to meet their quarterly earnings projections often see their firm’s stock price drop significantly
Why will investors pay higher prices (or accept lower yields) for a seasoned stock than for otherwise similar stock from an IPO?
Investors View Seasoned Securities as Less Risky Than Unseasoned Securities. Liquidity and value of a seasoned stock are better known. The same is true for other types of securities, such as bonds
Why do firms need the services of investment bankers to complete an IPO?
They’re experts in bringing new securities to market
What are the 3 basic services investment bankers provide when bringing securities to market?
- Origination
- Underwriting
- Distribution
What is the service of “origination” that investment bankers provide firms when bringing securities to market?
Give the firm financial advice and getting the issue ready to sell
What is the service of “underwriting” that investment bankers provide firms when bringing securities to market?
Risk-bearing part of investment banking
What is the service of “distribution” that investment bankers provide firms when bringing securities to market?
Involves reselling the securities to the public
Why will smaller firms probably use the full range of services provided by the investment banker?
Because they have little or no experience in issuing new securities
Why will larger firms probably use less of the services provided by investment bankers?
Go to the seasoned public markets on a regular basis have experienced financial staffs and may provide some or all of the origination services themselves
Why is identifying the investment banking firm that will manage the IPO process an important task for the management of a firm?
Because not all investment banks are equal. Some are better than others
Why does securing the services of an investment banking firm w/ a reputation for quality and honestly improve the market’s receptivity and help ensure a successful IPO?
Top investment banking firms do not want to tarnish their reputation by bringing bad deals to market. Their willingness to underwrite a firm’s IPO is an implicit seal of approval
Are the steps a business takes in bringing a common-stock IPO to market the same for debt issues as well?
Yes
How does the investment banker help during the origination phase?
Helps management determine whether the firm is ready for an IPO
What does an investment banker helping management determine whether the firm is ready for an IPO require?
Determining whether the management team, the firm’s historical financial performance, and the firm’s expected future performance are strong enough to merit serious consideration by sophisticated investors
What happens if the answer to any of the questions asked by investment bankers during the origination phase is a no?
The investment banker might help the firm find private capital to see through until all of the answers are yes
What are some issues relating to $ that must be decided by the firm during the origination phase?
- How much money the firm needs to raise
- How many shares must be sold
Once the decision to sell stock is made, what kind of approvals must the firm’s management obtain?
Number of approvals: Firm’s board of directors must approve all security sales, and a stockholder approval is required if the number of shares of stock is to be increased
Since the securities sold to the public must be registered in advance with the SEC, what is the first step in this process?
To file a registration statement with the SEC
What is a portion of the registration statement with the SEC called and what does it contain?
The preliminary prospectus:
- Detailed info about the type of business activities in which the firm is engaged and its financial condition
- Description of the management team and their experience
- Competitive analysis of the industry
- Range within which the issuer expects the initial offering price for the stock to fall
- The # of shares that the firm plans to sell
- Explanation of how the proceeds from the IPO will be used
- Detailed discussion of the risks associated w/ the investment opportunity
What is a preliminary prospectus?
The initial registration statement filed with the SEC by a company preparing to issue securities in the public market; it contains detailed information about the issuer and the proposed issue
While the SEC is reviewing the preliminary prospectus, what may the firm distribute to its potential customers?
Copies, but by law no sales can be made from this document
How is the info in a prospectus designed to help investors?
Allow investors to make intelligent decision about investing in a security issue and the risks associated w/ it
Is the SEC approval an endorsement of the wisdom or desirability of making a particular investment? Why or why not?
No, approval means only that the firm has followed various rules and regulations required to issue securities and that the information is complete and accurate
What happens once the origination work is complete?
The security issue can be sold to investors
What 2 ways can the securities be underwritten in?
- On a firm-commitment basis
- On a best-effort basis
What is a firm-commitment underwriting?
Underwriting agreement in which the underwriter purchases securities for a specified price and resells them
What is in the typical underwriting arrangement called firm-commitment underwriting?
The investment banker guarantees the issuer a fixed amount of money from the stock sale. The investment banker actually buys the stock from the firm at a fixed price and then resells it to the public
What risk does the underwriter bear?
Price risk: the risk that the resale price might be lower than the price the underwriter pays
What is price risk?
The risk that the resale price might be lower than the price the underwriter pays
How can the resale price be lower than the underwriter?
If the underwriter overestimates the value of the stock when determining how much to pay the firm
OR
if the value of the stock declines before its resold to the public
What is underwriter’s spread?
The investment banker’s compensation
In a firm-commitment offering, how is the spread calculated?
The difference between the investment banker’s purchase price and the offer price
How many % is the underwriter’s spread in the vast majority of initial public stock offerings in the U.S.?
7%
What does the spread cover?
The investment banker’s expenses, compensation for bearing risk, and profit
Suppose an investment banker buys a firm’s stock for $46.50 per share and the offer price is $50.00, how much is the gross underwriter’s spread per share?
If the underwriter’s total expenses for the offering are $1.50 per share, how much is the underwriter’s net profit per share?
$3.50 per share ($50.00 − $46.50 = $3.50), or 7 percent of the offer price
$2.00 per share ($3.50 − $1.50 = $2.00)
What is best-effort underwriting?
Underwriting agreement in which the underwriter (investment banking firm) doesn’t agree to purchase/sell the securities at a particular price but promises only to make its “best effort” to sell as much of the issue as possible above a certain price
What are the key features of a best-effort offering particularly about the investment banker’s compensation and responsibility for price risk?
Investment banker doesn’t bear the price risk associated with underwriting the issue, and compensation is based on the number of shares sold
Which type of underwriting do most corporations prefer when issuing stock: firm-commitment or best-effort, and why?
Most prefer firm-commitment arrangements because the investment banker guarantees the sale by purchasing the entire issue, reducing risk for the corporation.
How many % of all underwritten offerings involve firm-commitment contracts?
More than 95%
When do best-effort offerings arise?
When underwriters do not want to accept the risk of guaranteeing the offering price
What might underwriters do to share the underwriting risk and to sell a new security issue more efficiently?
Underwriters may combine to form a group called an underwriting syndicate
What is an underwriting syndicate?
A group of underwriters that joins forces to reduce underwriting risk
What is each member of an underwriting syndicate responsible for?
Selling some of the securities being issued
What does participating in the syndicate entitle each underwriter to?
To receive a portion of the underwriting fee as well as a proportionate allocation of the securities to sell to its own customers
What might underwriting syndicates do to broaden the search for potential investors?
Enlist other investment banking firms in a syndicate known as a selling group, which assists in the sale of the securities
How do firms in selling groups receive commissions and what risks do they bear?
Commission for each security they sell and bear none of the risk of underwriting the issue
What is one of the investment banker’s most difficult tasks?
To determine the highest price at which:
- the bankers will be able to quickly sell all of the shares being offered
AND
- that will result in a stable secondary market for the shares
What does considering the value of the firm’s expected future cash flow help the firm determine?
Used to help determine a firm’s IPO price
What market-based methods do investment bankers use to help set an IPO price?
Consider the stock price implied by multiples of total firm value to EBITDA or stock price to earning per share for similar firms that are already public
What is a road show?
The investment banker conducts it, in which management makes presentations about the firm and its prospects to potential investors
Why is the road show the key marketing and info gathering event for an IPO?
Generates interest in the offering and helps the investment banker determine the number of shares that investors are likely to purchase at different prices
What meetings are held before shares are sold?
Representatives from the underwriting syndicate hold a due diligence meeting w/ representatives of the issuer
What is the purpose of due diligence meetings before shares are sold?
To list, gather, and authenticate matters such as articles of incorporation, by-laws, patents, important contracts, and corporate minutes
When do investment bankers have a final opportunity to ask management questions about the firm? What kinds of questions do they ask?
During due diligence meeting.
Questions about the firm’s financial integrity, intended use of the proceeds, and any other issues deemed relevant to the pending security sale
In terms of risk, why do investment bankers hold due diligence meetings?
To protect their reputations and to reduce the risk of investors’ lawsuits in the event the investment doesn’t go well later on
Why are the due diligence meetings serious?
They ensure that all material issues about the firm + offering are discovered and fully disclosed to investors
Once the due diligence process is complete, what do the underwriters and the issuer determine?
The final offer prince in a pricing call
When does the pricing call typically take place
After the market has closed for the day
What happens during the pricing call?
Lead underwriter makes its recommendation concerning the appropriate price, and the firm’s management decides whether that price is acceptable
Why is the lead underwriter in a pricing call also known as the book runner?
Because this underwriting assembles the book of orders for the offering
How does management ultimately make the pricing decision?
By either accepting or rejecting the investment banker’s recommendation from the pricing call
What happens if management finds the price recommended by the lead underwriter acceptable?
The issuer files an amendment to the registration statement with the SEC, which contains the terms of the offering and the final prospectus
What happens once the securities are registered with the SEC?
They can be sold to investors
What happens when the market opens the day after the ultimate pricing decision is made?
The underwriter typically sells the shares to investors
What is the syndicate’s primary concern on the first day of trading?
To sell the securities as quickly as possible at the offer price
Why is the speed of sales important?
Because the offer price reflects market conditions at the end of the previous day and these conditions can change quickly
In successful offerings, how quickly will securities be sold?
Most of the securities will have been presold to investors prior to delivery, and if the issue isn’t entirely presold, it will be sold out within a few hours
What happens if the securities aren’t sold within a few days?
The underwriting syndicate disbands, and members sell the securities at whatever price they can get
At the closing of a firm-commitment offering, what does the issuing firm deliver?
The security certificates to the underwriter and the underwriter delivers the payment for the securities, net of the underwriting fee, to the issuer
What does the closing usually take place?
On the third business day after the trading has started
Suppose a small manufacturing firm is doing a stock IPO with an investment banking firm on a firm-commitment basis. The firm plans to issue 2 million shares of common stock, and the gross underwriting spread is 7 percent. Following the road show, the CFO accepts a $20 per-share offering price that has been proposed by the underwriter.
How much money does the issuer expect to get from the offering?
IPO’s offer price: $20/share
Underwriter’s spread: 7%
Thus, the issuer’s expected net proceeds are $18.60 per share [$20 per share − ($20 per share × 0.07) = $18.60 per share]
What is the best approach to calculating amounts related to how much money the firm and underwriter make from the sale of the new stock?
First work through the funding allocations on a per-share basis and then compute the total dollar amounts
Suppose a small manufacturing firm is doing a stock IPO with an investment banking firm on a firm-commitment basis. The firm plans to issue 2 million shares of common stock, and the gross underwriting spread is 7 percent. Following the road show, the CFO accepts a $20 per-share offering price that has been proposed by the underwriter.
What are the total expected proceeds from the common-stock sale?
Total proceeds from the sale of the stock are expected to = $40 million ($20 per share x 2 million shares = $40 million)
Suppose a small manufacturing firm is doing a stock IPO with an investment banking firm on a firm-commitment basis. The firm plans to issue 2 million shares of common stock, and the gross underwriting spread is 7 percent. Following the road show, the CFO accepts a $20 per-share offering price that has been proposed by the underwriter.
Who will the total proceeds be shared by and what is each of their expected proceeds in $
The total proceeds will be shared by:
1. the firm, with $37.2 million ($18.60 per share × 2 million shares = $37.2 million)
2. the underwriter, with $2.8 million ($1.40 per share × 2 million shares = $2.8 million)
Suppose a small manufacturing firm is doing a stock IPO with an investment banking firm on a firm-commitment basis. The firm plans to issue 2 million shares of common stock, and the gross underwriting spread is 7 percent. Following the road show, the CFO accepts a $20 per-share offering price that has been proposed by the underwriter.
What is the investment bank’s expected compensation from the offering?
$2.8 million
[ ($20/share x 0.07) x 2 million shares] = $2.8 million
When will the sale be deemed successful?
If the syndicate sells stock at the offering price (expected price), and both the underwriter and the issuer will receive their expected proceeds
