Issuing Securities to the Public

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

CHAPTER

19 Issuing Securities to

the Public

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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin

Group F Members:

1. Adelaide Cornelius (802615)

2. Monaliza Lee (803737)

3. Borhan Siangau (802081)

4. Julin Marusid (803735)

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Key Concepts and Skills

1.Understand how securities are sold to the public and the role of investment bankers

2.Understand initial public offerings and the costs of going public

3.Understand the venture capital market and its role in financing new businesses

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Issuing Securities To The Public

Definition of Securities? The generic term for any instrument traded

on a stock exchange (eg: any shares listed in KLSE)

In general, any evidence of an interest in corporate stock or stock rights or an interest in any note, bond, debenture or other evidence of indebtedness issued by a government or corporation.

For certain tax purposes, however, the definition is more limited.

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19.1 The Public Issue• The Basic Procedure

Management gets the approval of the Board.The firm prepares and files a registration statement

with the SEC (SEC is a Security Exchange Commision). Under the SEC is The Security Act 1933 & Security Exchange Act 1934.

The SEC studies the registration statement during the waiting period.

(* Waiting period is a time for the firm may distribute copies of a preliminary prospectus.)

The companies cannot sell the securities during the period.

.

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Key Concepts and Skills

The firm prepares a files an amended registration statement with the SEC.

If everything is copasetic with the SEC, a price is set and a full-fledged selling effort gets underway

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The Process of a Public Offering

Steps in Public Offering Time

1. Pre-underwriting conferences

2. Registration statements

3. Pricing the issue

4. Public offering and sale

5. Market stabilization

Several months

20-day waiting period

Usually on the 20th day

After the 20th day

30 days after offering

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An Example of a Tombstone

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19.2 What is the alternative securities method to issue new securities?• Two type of public issues:

i). The General Cash Offer

- What is cash offer? - Stock that sold to all interested investor by cash term.

- Cash Offer are sold to all invested investors

(eg: Investment banking houses- Wong Kwok Group)

ii). The Rights Offer

- What is Rights Offer? - The right price offered during the public issue.

- Rights Offer are sold to existing shareholders• Almost all debt is sold in general cash offerings.

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Table 19.2 - a

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Table 19.2 – bThe methods of issuing new securities:

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19.3 The Cash Offer• There are three methods for issuing securities for cash:

i. Firm Commitmentii. Best Efforts iii. Dutch Auction

• There are two methods for selecting an underwriteri. Competitive offer - The issuing firm can offer its

securities to the underwriter bidding highestii. Negotiated offer – The issuing firm work with one

underwriter• (Underwriter- An organization, normally a merchant bank

or a brokerage firm, that usually guarantees a minimum level of subscriptions to a share of debt issue. If public subscriptions fail to reach the minimum level the underwriter takes up the shortfall. Underwriters often have

Sub-underwrites who share the risk).

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Firm Commitment Underwriting• Example: CIMB Bank• The issuing firm sells the entire issue to the

underwriting syndicate.• The syndicate (underwriting group) then

resells the issue to the public.• The underwriter makes money on the spread

between the price paid to the issuer and the price received from investors when the stock is sold.

• The syndicate bears the risk of not being able to sell the entire issue for more than the cost.

• This is the most common type of underwriting in the United States.

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Best Efforts Underwriting• Underwriter must make their “best effort” to sell

the securities at an agreed-upon offering price.• The company bears the risk of the issue not

being sold.• The offer may be pulled if there is not enough

interest at the offer price. The company does not get the capital, and they have still incurred substantial flotation costs.

• This type of underwriting is not as common as it used to be.

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Dutch Auction Underwriting• Underwriter accepts a series of bids that

include number of shares and price per share.• 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 Treasury has used Dutch auctions for years.

• Eg: Google was the first large Dutch auction IPO (Initial Public Offering) in 2004.

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IPO Underpricing• IPO (Initial Public Offering) define as the first

public equity issue that is made by a company.• May be difficult to price an IPO because there is

not a current market price available.• Private companies tend to have more

asymmetric information than companies that are already publicly traded.

• Underwriters want to ensure that, on average, their clients earn a good return on IPOs.

• Underpricing causes the issuer to ‘leave money on the table’.

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19.4 The Announcement of New Equity and the Value of the Firm

• What is equity? Equity is a ownership interest in a firm. Also, the

residual dollar value of a future trading account, assuming liquidation is at the going trade price.

Example:

a. In real estate – dollar difference between what a property could be sold for & debts claimed against it.

b. In a brokerage – equity equal to the value of the account’s securities minus any debit balance in a margin account.

Stockholders Equity = Assets - liabilities Equity is also shorthand for stock markets investment.

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19.4 The Announcement of New Equity and the Value of the Firm

The market value of existing equity drops on the announcement of a new issue of common stock.

* Reasons include:

i. Managerial Information – When the managers have superior info about the firm’s market value , they know when the firm overvalued. They might attempt to issue new share of stock when market value exceed the correct value. However, the potential shareholders will infer overvaluation from the new issue, bidding down the stock price on the announcement date.

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Cont: The Announcement of New Equity and the Value of the Firm

ii. Debt Capacity – the firm choose a debt-equity ratio to balances the tax shield from the debt with the cost of financial distress. If the managers have info that financial distress has risen, the firm might raise stock capital than debt. If the market infer that the managers are issuing new equity, the stock price will fall.

iii. Falling Earnings – when managers unexpectedly raise large capital in amount (unanticipated financing), and if investors have reasonable fix on firm’s upcoming investment and dividend payouts, the unanticipated financings equal to shortfalls in earnings, therefore, an announcement of new stock issue will reveal a future earnings shortfall (Eg: Proton )

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19.5 The Cost of New Issues Issuing securities to the public is not free. Cost of

different issuing methods are important. The cost fall into 6 categories:

1. Spread or underwriting discount

-Is the difference between the price the issuer receives & the price offered to the public.

2. Other direct expenses

-Include filing fees, legal fees, taxes – all reported in the prospectus.

3. Indirect expenses

-Include management time spent on the new issue.

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Cont: The Cost of New Issues3. Abnormal returns

-Upon the announcement of the issue, the price drop by 3-4%. The drop, protects new shareholders against the firm selling overpriced stock to new shareholders.

4. Underpricing

-Cost to the firm when stock is sold for less than its efficient price in the aftermarket.

5. Green Shoe Option

-Right for underwriters to buy additional shares at the offer price to cover overallotments.

(* overallotment- The allocation of new securities to an applicant for a new issue.)

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19.6 Rights• Rights – is a term of the option are evidenced by

certificates, or can be called as ‘Share Warrants’

• Rights have value. Companies raise additional capital by offering to existing shareholders the right, to subscribe for new shares, at a price which is usually below the current market price.

• If a preemptive 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 % ownership.

* (Preemtive- A right or provision that allows current common stockholders to purchase any additional shares offered by the firm before they are offered to outsiders)

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Mechanics of Rights Offerings

What is Right Offering?

A popular means of raising capital by offering shareholders the opportunity to buy additional shares of the same stock at a price below the current market value.

Eg: Low-cost Airlines in Malaysia, Air Asia is planning a RM500 million rights offering as it expects debt level to climb in year 2009.

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Mechanics of Rights Offerings

The process of issuing rights is differ from the process of issuing shares of stock for cash.

Existing stockholders are notified that they have been given one right for each share of stock they own.

Exercise occurs when a shareholder send payment to the firm’s subscription agent (bank) and turns in the required number of rights.

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Mechanics of Rights Offerings• The management of the firm must decide:

i. The exercise price (the price existing shareholders must pay for new shares).

ii. How many rights will be required to purchase one new share of stock.

Eg: Number of rights needed to buy a share of stock:

Old Share = ? Rights

New Share

iii. What effect will the rights offering have on the existing price of the stock.

• These rights have value:– Shareholders can either exercise their rights or sell

their rights.

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Rights Offering Example Rights Offering is an issue of common stock to

existing stockholders.

Calculation Example: Telekom proposing a rights offering. There are 200,000 shares outstanding trading at RM25 each. There will be 10,000 new shares issued at a RM20 subscribtion price.

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What is the new market value of the firm?

shares

20shares 000,10

share

25shares 000,200000,200,5

RMRMRM

There are 200,000 outstanding shares at

RM25 each.

There will be 10,000 new shares issued at a RM20

subscription price.

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What Is the Ex-Rights Price?

There are 210,000 outstanding shares of a firm with a market value of RM5,200,000.

Thus the value of an ex-rights share is:

= RM24.7619RM5,200,000

210,000 shares

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What Is the Ex-Rights Price?

• Thus, the value of a right is:

RM0.2381 = RM25 – RM24.7619

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19.7 The Rights Puzzle Over 90% of new issues are underwritten, even

though rights offerings are much cheaper.

A few explanations:– Underwriters increase the stock price. There is not

much evidence for this, but it sounds good.– The underwriter provides a form of insurance to the

issuing firm in a firm-commitment underwriting.– The proceeds from underwriting may be available

sooner than the proceeds from a rights offering.

• No single explanation is entirely convincing.

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19.8 Shelf Registration

It is a registration of a new issue (prepared up to 2 yrs in advanced), so that the issue can be offered quickly as soon as funds are needed or market condition are favourable.

It is a new method of issuing new debt and equity.

The direct costs of self issues substantially lower than those of traditional issues.

Not all companies are allowed shelf registration.

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19.8 Shelf Registration

Qualifications:

i. The firm must be rated investment grade.

ii. They cannot have recently defaulted on debt.

iii.The market capitalization must be > $75 m in US

iv. No recent SEC violations

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19.9 The Private Equity Market

Private equity is an umbrella term for large amounts of money raised directly from accredited individuals and institutions and pooled in a fund that invests in a range of business ventures. Eg: In Malaysia 2009,our PM Najib has set up a private equity fund, called Ekuiti Nasional Berhad (Ekuinas), to boost the local markets, with an initial capital of RM500 million to invest in private sector funds, to promote genuine partnerships and a fully commercial approach.

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Cont: The Private Equity Market

In previous sections, we assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market

The public equity market is often not available for start-up firms and firms that in financial trouble.

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Private Placements

Avoid the costly procedures associated with the registration requirements that are a part of public issues.

The SEC restricts private placement issues to not more than a couple of dozen knowledgeable investors (include institutions such as insurance companies and pension funds - eg: Etiqa & EPF)

Securities cannot be easily resold.

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Venture Capital Venture capital is financing provided by wealthy

independent investors, banks, and partnerships to help new businesses get started, reach the next level of growth, or go public.

In return for the money they put up, also called risk capital, the investors may play a role in the company's management as well as receive some combination of equity, profits, or royalties.Eg; MSC Venture Corporation- A premier venture capital organization in Malaysia specialising in funding innovative companies in the Information Communication Technology (ICT) industry.

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Venture Capital The limited partnership is the dominant form of

intermediation in this market There are 4 types of suppliers of venture

capital:1. Old-line wealthy families

2. Private partnerships and corporations

3. Large industrial or financial corporations (have established venture-capital subsidiaries).

4. Individuals (incomes in excess of $100,000 and net worth over $1,000,000). Usually, these “angels” have substantial business experience and are able to tolerate high risks.

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Corporate Equity Security Offerings

17.7%

16.2%

66.1%

Private Rule 144A placements

Private non-Rule 144A placements

Public equity offering

Source: Jennifer E. Bethal and Erik R. Sirri, “Express Lane or Toll Booth in the Desert: The Sec of Framework for Securities Issuance,” Journal of Applied Corporate Finance (Spring 1998).

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Stages of Financing1. Seed-Money Stage A small amount of financing needed to prove a

concept or develop a product. Marketing is not included in this stage.

2. Start-Up Financing for firms that started within the past

year. Funds are likely to pay for marketing and product development expenditures.

3. First-Round Financing Additional money to begin sales and

manufacturing after a firm has spent its start-up funds.

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Stages of Financing

4. Second-Round Financing Funds earmarked for working capital for a firm that

is currently selling its product but still losing money.

5. Third-Round Financing Financing for a company that is at least breaking

even and is contemplating an expansion. This is also known as mezzanine.

6. Fourth-Round Financing Money provided for firms that are likely to go public

within half a year. This round is also known as bridge financing.

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Summary & Conclusions:1. Firm commitment underwriting prevalent

use for larger issues, while best effort use for smaller issues.

2. Rights Offerings are cheaper than General Cash Offer.

3. Shelf registration is a new method of issuing new debt and equity.

4. Venture Capital are increasingly importance influence in start-up firms and subsequent financing.

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Issuing Securities to the Public

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