Chapter 15 Raising Capital

Green Shoe Provision

(sometimes called the overallotment option), which gives the members of the underwriting group the option to purchase additional shares from the issuer at the offering price.7 Essentially all IPOs and SEOs include this provision, but ordinary debt offerings generally do not. The stated reason for the Green Shoe option is to cover excess demand and oversubscriptions. Green Shoe options usually last for 30 days and involve 15 percent of the newly issued shares.

Costs of Selling Stock to the Public

: (1) the gross spread, (2) other direct expenses, (3) indirect expenses, (4) abnormal returns (discussed previously), (5) underpricing, and (6) the Green Shoe provision.

Debt Usage

A company's decision to issue new equity may reveal that the company has too much debt or too little liquidity. One version of this argument says that the equity issue is a bad signal to the market. After all, if the new projects are favorable ones, why should the firm let new shareholders in on them? It could just issue debt and let the existing shareholders have all the gain.

Issue costs:

As we discuss next, there are substantial costs associated with selling securities.

Dilution refers to a loss in existing shareholders' value. There are several kinds:

Dilution of percentage ownership. Dilution of market value. Dilution of book value and earnings per share.

Costs of Selling Stock to the Public: Underpricing

For initial public offerings, losses arise from selling the stock below the true value.

Underwriters perform services such as the following for corporate issuers:

Formulating the method used to issue the securities. Pricing the new securities. Selling the new securities.

The difference between the underwriter's buying price and the offering price is called the

Gross Spread

Managerial information:

If management has superior information about the market value of the firm, it may know when the firm is overvalued. If it does, then it will attempt to issue new shares of stock when the market value exceeds the correct value. This will benefit existing shareholders. However, the potential new shareholders are not stupid, and they will anticipate this superior information and discount it in lower market prices at the new-issue date.

Costs of Selling Stock to the Public: Abnormal returns

In a seasoned issue of stock, the price of the existing stock drops on average by 3 percent on the announcement of the issue. This drop is called the abnormal return.

Steps in Issuing securities to the Public

Management's first step in issuing any securities to the public is to obtain approval from the board of directors. In some cases, the number of authorized shares of common stock must be increased. This requires a vote of the shareholders. The firm must prepare a registration statement and file it with the SEC. The registration statement is required for all public, interstate issues of securities, with two exceptions: Loans that mature within nine months. Issues that involve less than $5 million. 3 The SEC examines the registration statement during a waiting period. During this time, the firm may distribute copies of a preliminary prospectus. The prospectus contains much of the information in the registration statement, and it is given to potential investors by the firm. The preliminary prospectus is sometimes called a red herring, in part because bold red letters are printed on the cover. On the effective date of the registration statement, a price is determined and a full-fledged selling effort gets under way. A final prospectus must accompany the delivery of securities or confirmation of sale, whichever comes first.

The Quiet Period

Once a firm begins to seriously contemplate an IPO, the SEC requires that a firm and its managing underwriters observe a "quiet period." This means that all communications with the public must be limited to ordinary announcements and other purely factual matters. The quiet period ends 40 calendar days after an IPO (for most IPOs).

LOCKUP AGREEMENTS

Such agreements specify how long insiders must wait after an IPO before they can sell some or all of their stock. Lockup periods have become fairly standardized in recent years at 180 days. Following an IPO, insiders can't cash out until six months have gone by, which ensures that they maintain a significant economic interest in the company going public. Lockup periods are also important because it is not unusual for the number of locked-up shares to exceed the number of shares

Costs of Selling Stock to the Public:Green Shoe option

The Green Shoe option gives the underwriters the right to buy additional shares at the offer price to cover over allotments.

Dutch auction cash offer

The company has investment bankers auction shares to determine the highest offer price obtainable for a given numb

Best efforts cash offer

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 primary qualifications of shelf registration are these:

The company must be rated investment grade. The firm cannot have defaulted on its debt in the past three years. The aggregate market value of the firm's outstanding stock must be more than $150 million. The firm must not have violated the Securities Act of 1934 in the past three years.

Firm commitment cash offer

The company negotiates an agreement with an investment banker to underwrite and distribute the new shares. A specified number of shares are bought by underwriters and sold at a higher price.

Costs of Selling Stock to the Public: 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.

Costs of Selling Stock to the Public: 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. Indirect expenses These costs are not reported on the prospectus and include the costs of management time spent working on the new issue.

tombstone advertisement

advertisements (or tombstones) are used by underwriters during and after the waiting period.

Shelf Registration

permits a corporation to register an offering that it reasonably expects to sell within the next two years and then sell the issue whenever it wants during that two-year period. For example, in March 2017, cargo ship operator DryShips announced a shelf registration of $2 billion in securities, including debt, preferred stock, common stock, and warrants. Not all companies can use Rule 415.

Because underwriting involves risk, underwriters usually combine to form an underwriting group called a

syndicate

In firm commitment underwriting

the issuer sells the entire issue to the underwriters, who then attempt to resell it.

Dutch Auction Underwriting

the underwriter does not set a fixed price for the shares to be sold. Instead, the underwriter conducts an auction in which investors bid for shares. The offer price is determined based on the submitted bids. A Dutch auction is also known by the more descriptive name uniform price auction. This approach to selling securities to the public is relatively new in the IPO market and has not been widely used there, but it is very common in the bond markets

Best Efforts Underwriting

the underwriter is legally bound to use "best efforts" to sell the securities at the agreed-upon offering price. Beyond this, the underwriter does not guarantee any particular amount of money to the issuer. This form of underwriting has become uncommon in recent year