AFM 371 Winter 2008 Chapter 20 - Issuing Equity Securities

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1 AFM 371 Winter 2008 Chapter 20 - Issuing Equity Securities 1 / 18

2 Outline Background Public Equity Issues Rights Offerings Private Equity and Venture Capital 2 / 18

3 Background the procedures for selling debt and equity securities are basically the same we will focus only on equity here securities market regulation in Canada is handled by provincial commissions (in the U.S. this is handled by the federal SEC) regulators want to protect investors against fraud, promote efficient flow of information about securities, and the smooth functioning of securities markets all firms listed on the TSX are under the jurisdiction of the Ontario Securities Commission (OSC) other provinces have similar laws and regulatory agencies regulation is coordinated by the Canadian Securities Administration 3 / 18

4 Background Cont d firms typically follow a financing pattern over their lifetimes: Firm Sales Start-up insider financing, angel investors, venture capital Growth private debt and equity, bank debt, venture capital Maturity mostly public financing (traded debt and equity) Firm Age 4 / 18

5 Public Equity Issues the first issue of public equity is called an initial public offering (IPO) a subsequent issue is called a seasoned equity offering in a cash offer, securities are sold to the general public in a rights offer, existing shareholders have a pre-emptive right to purchase new shares typical steps involved in an offering: management obtains approval from board/shareholders a preliminary prospectus (a.k.a. red herring ) is prepared and sent to the OSC and some potential investors (no price information yet) OSC studies the preliminary prospectus and notifies the company of any required changes once the revised, final prospectus is approved by the OSC, a price range is determined a marketing effort commences ( road show ), where informal orders are taken the offering price is set (a three way bargain between the issuer, the investment bank(s), and major buyers) trading begins 5 / 18

6 Public Equity Issues Cont d an underwriter is an investment bank that buys an issue of a security from a firm and resells it to the public underwriters are usually involved in a cash offer; they determine the method used to issue the securities, price the securities, and sell them the difference between the underwriters buying price and the offering price is called the spread since underwriting involves risk, underwriters combine to form an underwriting group called a syndicate (with the lead underwriter in a dominant decision-making role) with regular underwriting, the syndicate buys the securities from the issuer and resells to the public includes an out clause, which gives the syndicate the right to back out of the deal if the price drops substantially firm-commitment underwriting is like regular underwriting without the out clause 6 / 18

7 Public Equity Issues Cont d best-efforts underwriting is commonly used in IPOs underwriter has a legal obligation to use best efforts to sell the securities at the offering price which was agreed upon, but does not guarantee an amount of money to the issuer a bought deal is like firm-commitment underwriting where the underwriter has pre-sold the entire issue to large institutional investors the selling period: while the issue is being sold to the public, the syndicate agrees not to sell securities for less than the offering price the lead underwriter is allowed to buy shares if the market price drops to stabilize the price from downward pressure if the issue remains unsold after a period (e.g. 30 days), the syndicate dissolves and members can sell their shares for whatever price they can get the green shoe option (a.k.a. overallotment option) gives syndicate members the right to buy additional shares from the issuer at the offering price 7 / 18

8 Public Equity Issues Cont d setting the offering price is the underwriter s hardest task in an IPO if the issue is priced too high, it may have to be withdrawn if the issue is priced too low, then the issuing firm s existing owners are selling the shares for less than their true worth underpricing is a common occurrence in IPOs extent of underpricing (i.e. first day return) varies across countries (about 6% on average in Canada, 18% in U.S.), but is present to some degree in just about every market in the world among the possible reasons for underpricing are: underwriters want to minimize the risk of the issue being withdrawn and to avoid potential legal action if the share price falls key investors may be able to influence the offering price the winner s curse 8 / 18

9 Public Equity Issues Cont d it is usually very difficult to establish short positions in stocks immediately after an IPO the syndicate and institutional investors generally agree not to make shares available for borrowing until some time after the IPO price stabilization makes shorting less desirable some recent IPO scandals (most of these were made public in legal cases in New York in the early 2000s): spinning - allocating hot IPOs to the personal brokerage accounts of favoured clients in return for future investment banking business laddering - requiring the purchase of additional shares in the aftermarket in return for participation in IPOs analysts employed by underwriters often had the incentive to issue buy recommendations in return for future investment banking business underwriters were found to allocate IPOs primarily to investors who generated a lot of commissions on other trades 9 / 18

10 Public Equity Issues Cont d what is the stock market reaction to an SEO? we might expect the price to rise, since the firm could be needing financing to take advantage of new investment opportunities however, exactly the opposite happens on average, the market price of existing shares drops (approximately 3%) upon the announcement of an SEO why are SEOs bad news? managerial information debt capacity insufficient earnings 10 / 18

11 Public Equity Issues Cont d the POP system allows large firms to file annual and semi-annual statements with the OSC whether or not they are issuing securities in a given year, and then to use a shorter prospectus so as to speed up seasoned issues similar to a U.S. system called shelf registration the MJDS system is an agreement between the U.S. and Canada which allows large issuers to sell securities in both countries while complying with home country regulatory bodies flotation costs (i.e. costs of floating a new security issue) include direct and indirect costs direct costs of security issuance include the spread and administrative expenses such as filing fees, accounting and legal fees, etc. (reported on the prospectus) indirect costs (not reported on the prospectus) include management time, underpricing and the green shoe option (in IPOs), and the typical drop in price in an SEO 11 / 18

12 Public Equity Issues Cont d flotation costs in the U.S. ( ): Proceeds Direct Costs Underpricing ($ millions) SEOs IPOs IPOs % 16.96% 16.36% % 11.63% 9.65% % 9.70% 12.48% % 8.72% 13.65% % 8.20% 11.31% % 7.91% 8.91% % 7.06% 7.16% % 6.53% 5.70% 500 and up 3.15% 5.72% 7.53% average costs of going public in Canada ( ) were fees of 6% plus underpricing of 7.88% the figures here understate the total costs because they ignore indirect expenses 12 / 18

13 Rights Offerings an issue of common stock offered to existing shareholders is called a rights offering regulation (prior to 1980) used to force chartered banks in Canada to raise equity only via rights offerings; the POP system has lead to most issues being bought deals now, so rights offerings have declined in importance if a pre-emptive right is contained in the firm s articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders this allows shareholders to maintain their percentage ownership if they want to shareholders receive one right for each share owned gives the shareholder the option to buy a specified number of shares at a specified price within a specified time management must determine the subscription price and the number of rights needed to buy one new share shareholders can either exercise their rights or sell them to other investors 13 / 18

14 Rights Offerings Cont d example: a firm has 10 million shares which are trading at $15 per share. The firm wants to raise $50 million via a rights offering. Let the subscription price be set at $10 per share. (a) How many rights are needed to buy one share? (b) What is the value of a right? (c) What will the price per share be ( rights-on and ex-rights )? (d) Does the subscription price matter? 14 / 18

15 Rights Offerings Cont d a couple of formulas: theoretical value of a right during the rights-on period is R o = M o S N + 1 where M o is the rights-on share price, S is the subscription price, and N is the number of rights needed to buy one share when stock goes ex-rights, its price drops by the value of one right, so M e = M o R o R e = M e S N rights offerings usually use standby underwriting - an underwriter makes a firm commitment to take up the unsubscribed portion of the issue in practice, most shareholders ( 90%) exercise their rights 15 / 18

16 Private Equity and Venture Capital so far we have assumed that a company is large enough to raise capital in public capital markets, but there are many firms that are too small to do so for start-up firms (and firms in financial trouble), public capital markets are often unavailable private placements avoid the costly procedures arising from registration requirements associated with public issues traditionally, private placements were mostly debt, but private equity is becoming more common (especially with hedge funds) regulators restrict private placements to a couple of dozen knowledgeable investors (insurance companies, pension funds) the biggest drawback is that privately placed securities cannot easily be resold 16 / 18

17 Private Equity and Venture Capital Cont d venture capital is a part of the private equity market suppliers of venture capital include wealthy individuals ( angels ) and families, private partnerships and corporations, industrial and financial firms with established venture capital subsidiaries, endowments and foundations, and governments venture capitalists provide not just financing, but also advice on strategic planning and operational decisions venture capital is typically structured as a limited partnership general partners put up about 2% of the money and do all of the work limited partners put up the remaining 98% of the money 17 / 18

18 Private Equity and Venture Capital Cont d most venture capitalists focus on particular industries and/or stages of financing (e.g. seed money, money to finance production, money to finance growth) venture capitalists profit by liquidating successful investments through: sale back to management, to a buyout firm, or to a large corporation an IPO general partners keep 20% of the profits, use the rest to repay the limited partners a typical venture capital investment is preferred equity the salient features of venture capital contracts are converts to equity at the time of an IPO restrictions on entrepreneurs the majority of entrepreneurs wealth must be invested in the firm, and entrepreneurs usually receive relatively small salaries 18 / 18