Initial Public Offerings

Why do companies go public?

1. Facilitate future acquisitions: going public raises capital that can be used to invest (acquire other companies). For example, a listed company can acquire another company and pay in share of their company instead of in cash. The target company can then own a piece of the acquiring company and in turn, still own a piece of their own company. 2. Establish market value 3. Enhance reputation 4. Broaden ownership 5. Diversification 6. Minimize cost of capital

Explain the two other important features of IPOs: 1. Overallotment 2. Lockup Agreement

1. Overallotment: allows the IPO to be over-subscribed, underwriters borrow additional shares (usually up to 15%) from existing shareholders and place then to investors. Within the first 30 days of trading, underwriters can either (i) pay back the shares to existing shareholders at the offer price (greenshoe option), or (ii) give back the shares by repurchasing them in the after market (price stabilization) 2. Lockup Agreement; prevents existing shareholders from selling their shares for a specified time period following the IPO. Stock price tends to drop when the lockup period expires.

What are the five steps in the IPO process?

1. Select an underwriter 2. Register with SEC and print prospectus 3. Present roadshow 4. Price the shares 5. Place the shares

Explain the IPO process: present roadshow

A roadshow is a series of meetings with institutional investors around the country. Intended to generate excitement and interest in the IPO, often critical to the success of the offering. Important to gather information about potential purchasers willingness to pay for the firm's shares.

What is an IPO?

An IPO is a public and disintermediated way of equity financing. It is the company's first equity issue made available to public investors involving a sale k of the firm's shares.

Explain selection and treatment in terms of stock exchanges.

Increased competition between stock exchanges led to acquisitions and today there are less stock exchanges than there used to be. Selection: stock exchanges engage in extensive due diligence. Documents are vetted by national agencies (such as SEC). Treatment: ongoing listing requirements by stock exchanges. Vigilance by national agencies and international information intermediaries.

Explain the indirect costs of going public. Explain underpricing and it's effects.

Proprietary disclosure costs, management time, underpricing (UP). UP is the difference between closing price on the first day of trading and offer price. UP is considered as money left on the table. Example: Twitter set the price at $26 per share but closes at $44.90 per share, leaving $1.25 billion on the table. UP has consequences on the wealth and ownership of existing shareholders.

Explain the IPO process: place the shares How can the shares be allocated? What are the two types of offering shares?

Shares are delivered to investors. Allocation can be divided between: - institutional investors: mutual funds, insurance - retail investors: individuals - employees Offered shares can be two types: 1. Primary — Newly issued shares pursuant to the IPO — Better way to raise new funds — Dilutes value of existing shares 2. Secondary — An example: Before IPO: company has 100,000 shares and 100% of the company belongs to one person. IPO structure: the company places 10% of newly issued shares (primary) and 5% of existing (secondary) shares on the market. After IPO: there are 110,000 shares (10,000 newly issued, primary) and 95,000 still belonging to the person. 15,000 shares total on the market.

Explain the decline in IPO activity. Why are small firms suffering?

Sharp decline in IPO activity after the dot com bubble (late 1990s) particularly in small firms (<$50 million in pre-IPO sales) due to: - conventional wisdom: regulation becoming too heavy, pushing firms to stay private - selling out to a larger firm has become more attractive than growing independently This predicts that small firms are suffering because of: - compliance costs: fixed component is more burdensome for small firms - being a small firm is suboptimal: inability to benefit from economies of scale and scope

Explain the IPO process: register with SEC and print prospectus

The firm must prepare a registration statement with all material information and file it with the Securities and Exchange Commission (SEC), or the equivalent in other countries such as CONSOB in Italy. The prospectus is a publically available legal document describing details of the firm and the equity issue.

Explain the IPO process: select and underwriter What is an underwriter? What are the two underwriting methods?

The underwriter is the investment firm that acts as an intermediary between the company selling securities and the investing public. The underwriter advises the firm on the type of security to issue, helps with pricing, marketing, and registration of the shares on an organized exchange. Underwriting methods: 1. Firm commitment: the underwriter buys the entire issue, assuming responsibility for any unsold shares. 2. Best effort: the underwriter sells as much of the issue as possible at a pre-declared price, but can return any unsold shares to the issuer.

Explain the direct costs of going public. Compare the direct cost gross spread between US and Europe.

Underwriter commission or gross spread (7% in US), legal fees, auditor fees, printing fees, advertising costs... Direct costs are on average 11% of capital raised (mostly fixed, ranging from 6% for larger firms up to 17% for smaller firms). European gross spreads are less clustered than US. They are more efficient and collusion (underwriters adopt strategic pricing). European gross spreads also have lower quality of underwriting services, lower risk of litigation/legal/marketing costs, and different levels of competition. US has higher fees.

Explain the IPO process: price the shares How is valuation determined?

Valuation is critical because the IPO is the first time the market value of the firm is assessed. The underwriter usually offers a preliminary price range and sets the final offer price after the roadshow.