Raising Capital

Dribble Program

A company registers the stock with the SEC through a variety of different methods and sells the shares in dribbles as it sees fit. Thus, the company sells the stock on the secondary market.

Initial Public Offering (IPO)/ Unseasoned New Issue

A company's first equity issue made available to the public. These are cash offers.

In the aggregate, debt offerings are much more common than equity offerings and typically much larger as well. Why?

A company's internally generated cash flow provides a source of equity financing, and this source of equity financing has no flotation costs. Therefore, establishing firms are likely to obtain equity via retained earnings rather than via equity issues. However, theses firms will have to issue debt to obtain additional debt financing or to replace debt that matures. Hence, debt offerings will be more common than equity offerings. Debt issues are also likely to be larger than equity issues because large establishing companies issue debt but may never issue equity, while smaller start up companies are likely to comprise a large portion of equity issues.

Green Shoe Provision/Overallotment Option

A contract provision giving the underwriter the option to purchase additional shares from the issuer at the offering price. This is done in order to cover excess demand and oversubscriptions. It provides some protection for the underwriters as they perform their price stabilization function. Usually lasts for about 30 days and involve no more than 15% of the newly issued shares.

Syndicate

A group of investment bankers that market the securities and share the risk associated with selling the issue.

Preliminary Prospectus

A legal document describing details of the issuing corporation and the proposed offering to potential investors.

Seasoned Equity Offering (SEO)/ Secondary/Follow - on Offering

A new equity issue of securities by a company that a previously issued securities to the public. Can be made by using a cash offer or a rights offer.

Red Herring

A preliminary prospectus distributed to prospective investors in a new issue of securities.

Rights Offer (Rights Offering)

A public issue of securities in which securities are first offered to existing shareholders. Avoids dilution. "Rights " are given to shareholders: a) Number of shares b) Prices specified c) Certain time frame "Rights" may trade separately: OTC or in an exchange.

Registration Statement

A statement filed with the SEC that discloses all material information, such as, financial history, details of existing business, proposed financing and plans for the future, concerning the corporation making a public offering.

General Cash Offer

An issue of securities offered for sale to the general public on a cash basis. "First come, First served"

Securities Exchange Act of 1934

Basis of regulating securities already outstanding.

Firm Commitment Cash Offer/Firm Commitment Underwriting Syndicate

Buys the entire issue of securities, assuming full financial responsibility for any unsold shares. - The company negotiates an agreement with a syndicate to underwrite and distribute the new shares. - A specified number of shares are bought by a syndicate and sold at a higher price. - The underwriter makes money on the spread between the price paid to the issuer and the price received from the investors when the stock is sold. - This is the most common type of underwriting in The United States.

Spread / Discount

Compensation to a syndicate, determined by the difference between what the syndicate pays the company and what the security sells for initially in the market.

Floatation Costs/What are the different costs associated with security offerings?

Costs associated with issuing new stocks or bonds. a) Spread: Consists of direct fees paid by the issuer to the underwriting syndicate (difference between the price the issuer receives and the offer price). b) Other direct expenses: Direct costs incurred by the issuer that are not part of the compensation to underwriters. Eg: Filing fees, legal fees, and taxes - all are reported on the prospectus. c) Indirect expenses: Costs that are not reported on the prospectus and include the cost of management time spent working on the new issue. These can be considered as opportunity costs. d) Abnormal returns: In a seasoned issue of stock, the price of the existing stock drops, on average, by 3% upon the announcement of the issue. e) Underpricing: For IPOs, losses arise from selling the stock below the true value. f) Green Shoe option: Gives the underwriter the right to buy additional shares at the offer price to cover overallotments.

A private placement is likely to have a higher interest rate than a public issue. Why?

Due to the more flexible arrangements in the event of financial distress, and the lower costs associated with private placements. Additionally, the floatation costs associated with selling debt is much lower than that of equity.

Why are the costs of selling equity so much larger than the costs of selling debt?

Economies of scale are part of the answer. Debt issues are also simply easier and less risky to sell from an investment bank's perspective. Very large amounts of debt securities can be sold to a relatively small number of buyers (pension funds & insurance companies), and debt securities are much easier to price.

Private Equity

Equity financing for nonpublic companies.

Quiet Period

From the time a company begins to seriously consider an IPO until 40 calendar days following an IPO, the SEC requires that a firm and its managing underwriters observe a "quiet periods", during which all communications with the public must be limited to ordinary announcements and other purely factual matters.

IPO Underpricing

IPO pricing is very difficult as no current market price is available. Dutch Auctions designed to eliminate first day IPO price pop. Private companies tend to have more asymmetric information than companies that are already publicly traded. Underwriters want their clients, on average, to earn a good return on IPOs. Underpricing causes the issuer to "leave money on the table". Degree of underpricing varies over time.

Why is an IPO necessarily a cash offer?

If the firm's existing shareholders wanted to buy the shares, the firms wouldn't have to sell them publicly in the first place.

Why is underpricing a cost to the issuing firm?

If the issue is priced below the market value, the issuer's existing shareholders will experience an opportunity lost when they sell their shares for less than what they are worth.

Underwriters

Investments firms that act as intermediaries between a company selling securities and the investing public: a) Formulating the method used to issue the securities b) Pricing the new securities c) Selling the new securities d) Price stabilization by lead underwriter Typically, underwriters buy the securities for less than the offering price and accept the risk of not being able to sell them.

Suppose a stockbroker calls you up out of the blue and offers to sell you "all the shares you want" of a new issue. Do you think the issue will be more or less underpriced than average?

It will probably be less underpriced because otherwise it would have been oversold and there would be no need for the broker to try to sell it to you.

Dilution

Loss in value for existing shareholders. a) Percentage ownership: Shares sold to the general public without a rights offering. b) Market Value: Firm accepts negative NPV projects. c) Book Value and EPS: Occurs when market - to - book value < 1.

Securities Act of 1933

Origin of federal regulations for all new interstate securities issues.

Venture Capital (VC)

Private financing for relatively new, often high-risk ventures in exchange for equity. Usually entails some hands - on guidance. Many VC firms are formed from a group of investors that pool capital and then have partners in the firm decide which companies will receive financing. Some large corporations have a VC division.

Methods of issuing securities/ Types of underwriting

Public a) Traditional, negotiated cash offer: i) Firm commitment cash offer ii) Best efforts cash offer iii) Dutch auction cash offer b) Privileged subscription: i) Direct rights offer: - The company offers the new stock directly to its existing shareholders. ii) Standby rights offer: - The net proceeds are guaranteed by the underwriters. c) Non - traditional cash offer: i) Shelf cash offer: - Qualifying companies can authorize all the shares they expect to sell over a 2 - year period and sell them when needed. ii) Competitive firm cash offer: - The company can elect to award the underwriting contract through a public auction. Private: Direct placement: - Securities are sold directly to the purchaser, who, at least until recently, generally could not resell the securities for at least 2 years.

Bonds

Public issue of long - term debt.

Shelf Registration

Registration permitted by SEC Rule 415, which allows a company to register all issues it expects to sell within 2 years at one time, with subsequent sales at any time within those 2 years. Reduces the floatation costs of registration. Allows the company to be more flexible to raise money quickly.

What is the difference between a rights offer and a cash offer?

Right offer is securities offered first to existing shareholders and a cash offer is an issue of securities to the public on a cash basis.

Dutch Auction cash offer/ Uniform Price Auction/ Dutch Auction Underwriting Syndicate

Th type of underwriting in which the offer price is set based on competitive bidding by investors. - Underwriter accepts a series of bids that include number of shares and PPS. - 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 company has investment bankers auction shares to determine the highest offer price obtainable for a given number of shares to be sold. - The Treasury has used Dutch Auctions for years. - Google was the first large Dutch Auction IPO.

Lockup Agreement

The part of the underwriting contract that specifies how long insiders must wait after an IPO before they can sell stock. It prevents selling after IPO for a specified time. Commonly, lasts for 180 days. Stock price tends to drop when the lockup period expires.

Aftermarket

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

Best efforts cash offer/ Best Efforts Underwriting Syndicate

The underwriter sells as much of the issue as possible (at an agreed - upon offering price), but can return any unsold shares to the issuer without financial responsibility. - The underwriter must make their "best efforts" to sell the securities at an agreed upon offering price. - But, ultimately, the company bears the risk of the issue not being sold. - The company has investment bankers sell as many of the new shares as possible at the agreed - upon price. - There is no guarantee concerning how much cash will be raised. - The offer may be pulled if there is not enough interest at the offer price. In this case, the company doesn't get the capital, and they have still incurred substantial financial costs. - Some firms do not use an underwriter. - Not as common as it previously was.

Why do noninvestment - grade bonds have much higher direct costs than investment - grade issues?

They are riskier and harder to market from an investment bank's perspective.

Reasons for IPO Underpricing

Underwriters want offerings to sell out: a) Reputation for successful IPOs is critical. b) Underpricing = Insurance for underwriters. c) Oversubscription & allotment d) Winner's curse Smaller and more speculative IPOs must be significantly underpriced, on average, to attract investors. To counteract the winner's curse and to attract the average investor, underwriters underprice issues.

Tombstone advertisement

Used by underwriters to announce a public offering.

The Value of a Right

Usually, Price < Market Price Share Price will adjust based on the number of new shares issued. Value of old share price < "new" share price.

Why is VC often provided in stages?

VCs take risk by investing their money in start - up firms. But, all firms may not succeed. Hence, in order to limit the financial risk, VC generally provide financing in stages, because many or even most new ventures will not fly, but the occasional one will. Thus, VC invest only the required amount as per the stage in which the particular company falls. The main stages are: a) First - stage (First "Round") Financing: The companies which fall under this category need funds just to get a model and the plan of manufacturing process. b) Second - stage (Second "Round") Financing: Companies falling under this stage require huge investments because it is a stage where the firms start the actual manufacturing process followed by marketing the products or services and then distributing the final products. c) Mezzanine Level: Under this level, the companies go public, i.e., prior to the initial public offering, then expanding companies are financed for the growth.

Why is underpricing not a great concern with bond offerings?

Yields on comparable bonds can usually be readily observed, so pricing a bond issue accurately is much less difficult.

What are the differences between private and public bond issues?

a) A direct long - term loan avoids the cost of SEC's registration. b) Direct placement is likely to have more restrictive agreements. c) It is easier to renegotiate a term loan or a private placement in the event of a default. It is harder to renegotiate a public issue because several holders are usually involved. d) The costs of distributing bonds are lower in the private market.

Choosing a Venture Capitalist

a) Financial Strength: The VC needs to have the resources and financial reserves for additional financing stages should they become necessary. b) Style: Choose a VC that has a management style that is compatible with your own. c) References: Obtain and check for these. Has the VC been successful with similar firms? How has the VC dealt with situations that didn't work out? d) Contacts: VC firms frequently specialize in a few particular industries, and such specialization could prove quite valuable. e) Exit strategy is very important: i) Sell the company: VC benefits from proceeds of the sale. ii) Take the company public: VC benefits from IPO.

Types of Underwriting

a) Firm Commitment Underwriting b) Best Efforts Underwriting c) Dutch Auction Underwriting

Selling securities to the public

a) Management must obtain permission from the Board of Directors. b) The firm must file a registration statement with the SEC. c) The SEC examines the registration statement during a 20 - day waiting period: i) A preliminary prospectus, called red herring , is distributed during this period. ii) If there are problems, the company is allowed to amend the registration and waiting period starts over. d) The company can't sell the securities during the waiting period. But, oral offers can be made. e) The price is determined on the effective date of the registration. A final prospectus is required.

What are some possible reasons the price of a stock drops on the announcement of a new equity issue?

a) Signaling and managerial information: Management may attempt to issue new shares of stock when the stock is over-valued, that is, the intrinsic value is lower than the market price. Investors learn that firm is overvalued and thus price drops. b) Signaling and debt usage: When there is an increase in the possibility of financial distress, a firm is more likely to raise capital through equity than debt. The market price drops because the market interprets the equity issue announcement as bad news. Equity issues might indicate that the firms has too much debt or is suffering from liquidity issues. Its risk maybe higher and again the manager signals this poor financial health by trying to seek out equity investors. c) Issue costs: There are substantial costs associated with selling securities. 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.

Direct Private Long- term Financing

a) Term Loans: Direct business loans. Typically, their maturities lasts for about 1 to 5 years. Most are repayable during their life. Lenders: Commercial banks, Insurance companies, Specialized in corporate finance. Commercial banks are significant participants in the term - loan market. b) Private Placements: Business loans. Usually, long - term in nature. Provided directly by a limited number of investors. Life insurance companies and pension funds dominate the private - placement segment of the bond market.

Qualifications for Shelf Registration

a) The company must be rated investment grade. b) The firm can't have defaulted on its debt in the past 3 years. c) The market value of the firm's outstanding stock must be > $150 million. d) The firm must not have had a violation of the Securities Act of 1934 in the past 3 years.

What are the arguments against shelf registration?

a) The costs of new issues might increase because underwriters might not be able to provide as much current information to potential investors as they would otherwise, so investors would pay less. Thus, the selling of the issue piece by piece might be higher than selling it all at once. b) Market Overhang: The possibility that a company could increase the supply of stock at any time will have a negative impact on the current stock price.

What lessons do we learn from studying issue costs?

a) With the possible exception of straight debt offerings, there are substantial economies of scale. The underwriter spreads costs fall sharply as a % of the amount raised, a reflection of the mostly fixed nature of such costs. b) The costs associated with selling debt are substantially less than the costs of selling equity. c) IPOs have higher expenses than SEO's, but, the difference is not that significant. d) Straight bonds are cheaper to float than convertible bonds. e) Comparing the total direct costs to the underpricing, the direct costs are only about half of the total for small issues. Across all size groups, the total direct costs amount to 10% and underpricing amounts to 24% of the capital raised.