Equity financing Flashcards
sponsor/underwriter
- financial institution that buys the shares of a company at issuance then sells them on.
- Acts as a middleman
- Assumes the risk as they need to keep any unsold shares
- may insist on lower share price to ensure demand
methods of IPO
- offer for sale
- offer for sale by tender
- offer for subscription
- placing
SEO
- Seasoned equity offering
- secondary issues of shares made by companies already listed on the stock market
offer for sale
- Shares are offered at a fixed price set by issuer
- institutional and individual investors are invited to subscribe
- Sponsor underwrites the shares
Offer for Sale by tender
A method of selling shares to the public through a bidding process.
pros of offer for sale by tender
- Useful when the value of the company and the demand are unknown.
- Can be used as valuation/demand gauge
- Allows for more diverse investor base
cons of offer for sale by tender
- More expensive for issuing company
- investors may undervalue company
Example of offer for sale by tender
- Google IPO in 2004
- chose this method to allow for more diverse investor base
- expected to raise 3 - 4 billion, only raised approx 1.67 billion
- misestimated demand/ investor sentiment
offer for tender process
- investors make bids on the share (can submit multiple at varying prices)
- once all bids posted, sponsor orders them from highest to lowest
- lowest accepted bid is the strike price
- shares will be allocated to highest bidders first
- all investors pay this regardless of their bid
offer for subscription
- partially underwritten
- cheaper than offers for sale/by tender
- share issues can be aborted if not enough capital is raised
- particularly attractive for new companies
possible reasons for google IPO failure
- offer for sale by tender process was too complex (unlikely as the same process doesn’t usually have the same disparity)
- investor sentiment/industry weakness post .com crash could’ve impacted the share price
types of SEO
- Rights issues/offerings (usually deep discounted issues)
- Placings
- open offers
Placings (IPO)
- Shares are placed with specific clients of sponsor/underwriter
- cheaper than other equity financing options
- however, secondary market is less liquid, lowering the share price
Rights issue
- Firm offers existing shareholders the right to buy additional shares at a discount
- the right can be exercised or sold
Features of rights issue
- share holders have pre-emption rights
- shares offered to existing shareholders based on their percentage of ownership
- shares are offered at a discount, usually 15% to 20%
- most rights issues are underwritten
- if share holders exercise rights they maintain ownership %
- if the sell rights their control is diluted
1 for 4 rights issue means?
for every 4 existing shares owned the shareholder can buy 1 share of new issue
How to calculate number of new shares issued with a rights issue
number of shares outstanding * rights issue
i.e.
2m * 1 to 4 = 500k
Rights price
- discounted price to which a company offers it’s new share to shareholders
- how much you want to raise divided by number of new issued shares
Ex rights price
- theoretical weighted average of the share price after the issue has taken place
- (total value of existing shares + total value of new issue ) divided by the total number of shares
What is the value of the right
value of right = ex rights - rights price
cum rights
- a stock that is sold with the rights attached to it.
why is shareholder wealth always unaffected by a rights issue
-exercising shareholder can buy new shares at disscount = value of right but share value drops proportionately with value of the right
- selling shareholders gain the value of the right but lose share value = to the value of right
Deep discounted issues
- Shares are offered at a huge discount to market value to ensure demand
- usually underwritten despite ensured demand
rights issue paradox
- in Theory rights issues should not affect shareholder wealth, in practice, share prices often decline after a rights issue announcement
Theoretical explanations for the use of underwritten offerings
According to smith paper 1977
- insurance
- distribution of ownership
- timing
- increase share price
- consulting advice
Smiths Hypothesis on the explanation for underwritten offering preferences
- underwriters send positive signal to the market by certifying the company
- Managers gain personal benefit from using underwriter (i.e. Lunches, Day trips, when arranging offering)
- Costs to shareholders of monitoring managers financing decisions exceeds underwriting costs (i.e underwriters monitor managers for shareholders)
- in practice only the worst companies don’t use an underwriter simply because they can’t secure one
open offers
- Existing shareholders can buy new shares in proportion to their existing shareholding
- No rights to sell ( share holders lose value if they don’t exercise rights)
- restricted to maximum discount of 10%
- No limits to offer size
positives of pre-emption rights (Myners)
According to Myners report 2005
- pre-emption rights viewed as major strength of UK/European Law
- provides protection from dilution of monetary value and control
- rights issues are cheaper than other equity issuance methods (no book building, advertising costs, roadshows)
- Theoretically avoid underwriting fees through deep discounted issues but this is rarely practiced
- shareholders are possibly prepared to finance the company at a lower cost than new investors.
issues with pre-emption rights (Myners)
- companies cannot tap investors on demand, therefore they may miss investment opportunities due to the unnecessarily lengthy and cumbersome process
- Guidelines suggest that when a company is seeking to raise more than 5% of share capital, pre-emption rights will not be dis-applied (treated as a rule, more emphasis needed on that it is a guideline)
- as a result companies may be constrained in their ability to raise finance
US position on pre-emption rights
- Either opt in (no preemption rights) or opt out (preemption rights) for individual states
- most states are opt in
- suggests value of pre-emption rights are lower in the us than in the uk
why are pre-emption rights less popular in the US?
- Development of different types of securities make it difficult to determine which shares have pre-emption rights (i.e restricted shares)
- protection through US common law on fiduciary duty (shareholders can sue if in breach)
- US shareholders have less power than in the UK, rely on disciplining power of the market
Placings (SEO)
- Shares sold at discounted fixed rate to specific clients of the underwriter e.g. FIs, insurance companies, pension funds, other banks
- Legal maximum discount is 5% of current MV
- legal maximum placing of 5% market cap per year, 7.5% max over three years
insurance (underwritten offerings)
- underwriters offer insurance as if the existing shareholders don’t buy the new issues then the underwriter has to
Distribution of ownership (underwritten offerings)
- The underwriter ensures these new shares are distributed to a broad pool of investors, not just existing shareholders,
- useful if the company doesn’t want control in the hands of a few shareholders
- in practice 50-80% of shareholders don’t exercise rights (smith 1977)
Timing (underwritten offerings )
proceeds of an underwritten offer are available sooner
Consulting advice (underwritten offerings)
issuing company receives speciality advice from underwriters
pre-emption rights
Existing shareholders have the right to buy their pro rata amount of new issue shares at a discount before outsiders
litigation culture UK vs US
- UK: uncommon for shareholders to take legal action against directors
- US: regular occurence
pre-emption group reformation
- Board must be independent
- Board should publish annual report with case study examples of best practice
- Group must have a broad representation from Academia, corporate lawyers, fund managers, small company representatives etc
Summary of Myners
- pre-emption rights are valuable and shouldn’t be removed
- suggests a greater need for dialogue between shareholders and directors
- directors must aim to keep shareholders informed and maintain high standards of corporate governance to build trust
- revive pre-emption group to renew and improve existing guidelines
