10Stock Offerings and Investor Monitoring

Other People’s MoneyOPM

As a new business grows, it will at some point likely need Other People’s Money (OPM), which could come in two forms:

1) Debt:

- loan from the bank (doubtful unless collateral is available)

- loan from a relative or a friend, credit card debt, government loans, bonds, etc.,- loan from the governments (e.g. Small Business Admin.)

2) Equity:

- Private equity: rich uncle, venture capitalist, hedge fund, private equity firm (e.g. Blackstone, Cerberus, Bain) or- Public equity: public stock offerings (min. $50m)

Venture Capitalists There are thousands of people with an idea who need OPM to

develop their idea. Most of these new ideas (ventures) will fail. In fact, half of all small businesses fail in just four years. But some of those that survive can end up being spectacularly successful (e.g. eBay).

Banks and other every-day sources of capital are too risk-adverse to consider being a partner. But there are thousands of risk-tolerant venture capital firms (also wealthy individuals called angel investors) looking around for an above-normal return. (http://www.vfinance.com/)

Most of the ideas presented to VCs are not marketable and will end up in the VCs round file. The VCs get thousands of requests but are only going to consider a few. Many times, VCs rely on an informal network of professional friends (scientists, lawyers, accountants, bankers, etc.) to help identify potential investments.

Venture Capitalists Venture capitalists face huge risks. In an effort to protect themselves,

VCs advance just enough money for the venture to finish the first stage of development (e.g. prototype built). Based on the results, second stage money is advanced to begin manufacturing, marketing and distribution.

VCs usually specialize in various stages (e.g. seed money or ground floor vs. mezzanine or above ground floor).

To compensate for huge risks, VCs demand big returns, typically requiring 40-60% of the equity and several seats on the board.

When a start-up selects a venture capitalist, it is important to do some research ahead of time. Is the VC financially strong? What is the style of the VC? (hands-on or laizze faire? flexible or bureaucratic?) What reputation does the VC have? (check with references) What specialties does the VC have? Does the VC have a network of contacts with special skills? How and when will the VC “cash out” of the venture?

VCs usually don’t’ hold the investment very long – maybe 4-7 years or until an IPO occurs.

Crowd Funding Crowd funding is when people pool their money, usually

via the Internet, to support a new venture Common examples include Internet-based organizations

that help artists (musicians, film makers, etc.) raise money from their fans, or charities raise money for projects ArtistShare, Sellaband, IndieGoGo, Kickstarter, Microventures Global Giving, Kiva, and Wokai

In crowd funding, people usually purchase small stakes of equity in the venture. Consequently, the SEC is in the process of creating finalized rules.

Venture Capitalists vs. Private EquityVenture capitalists usually invest in start-ups only and don’t’ hold the investment very long – maybe 4-7 years or until an IPO occursPrivate equity funds usually takeover a company and manage it (e.g. www.blackstone.com, www.cerberuscapital.com, www.baincapital.com ). Private equity managers hope to manage their businesses so well that the businesses grow in value (i.e. sell their stake down the road at a profit). Private equity funds often rely heavily on debt financing.

Primary vs. Secondary MarketsCommon stock = certificate

representing equity or partial ownership in a corporation

Issued in PRIMARY MARKET by corporations that need long-term funds

Stock is then traded in the SECONDARY MARKET, creating liquidity for investors and company evaluation for managers

Common Stock Owners of common stock vote on:

Election of board of directors Authorization to issue new shares Amendments to corporate charter Other major events (ratify selection of auditors, etc.)

Many investor assign their vote to management via a proxy

Individuals directly own about 25% of all common stock, the rest is owned by institutional investors

Owned 92% of common stock in 1950

Preferred Stock Represents equity or ownership interest, but usually no

voting rights, so a very passive owner Preferred in the sense that it gets first rights to dividends Heavily owned by corporate investors because of dividend

tax exemption Not an important source of L/T capital

Initial Public Offerings (IPOs)First-time sale of shares to the publicMost common in bull marketTypically won’t happen until a company is big enough to sell at least $50 million of stock.

Reasons for IPOs: The firm has maxed out its borrowing potential and

needs additional funds for expansion It’s a way for VC’s & insiders to cash in on their

investment and become millionaires overnight. A third but less significant reason is to make a splash in

a news and perhaps attractive the attention of future customers

Steps in Initial Public Offerings (IPOs)Steps in IPO process (not necessarily sequential): Get financial statements in accordance with GAAP and

have them audited. Meet with lawyers and talk about charter, governance,

board structure, executive compensation, etc. Select an investment banker Submit registration statement to SEC for approval.

Usually take about one month, during which the company/bankers are barred from promoting the IPO. (Google almost violated the quiet period rule.)

Steps in Initial Public Offerings (IPOs)Steps continued:

Prepare prospectus for prospective investors (called red herring) which is like registration statement but more user friendly

Road show presented to institutional investors in the process of bookbuilding. A tombstone announcement is prepared to advertise. Major bracket investment banking firms are listed first (see brackets on next slide)

Leftover shares go to individual investors IPO price is set and shares sold. Investment banker holds the firm’s hand all thru the

process for a commission on amount raised (usually around 7%).

TombstoneTombstoneAnnouncement Announcement (looks like a tombstone)(looks like a tombstone)

Examples of underwriters: Goldman Sachs, Morgan Stanley, Merrill Lynch, etc. Technically, there are no major-bracket U.S. investment banks in existence anymore. Bear Stearns and Lehman Brothers went under. Merrill Lynch was purchased by Bank of America. And Goldman Sachs and Morgan Stanley switched to commercial bank charters.

Initial Public Offerings (IPOs) Price must be set just right:

too high – fewer shares sold, less $$ raised. If too few shares, offer may have to be withdrawn.

too low – all shares sold but brings in less $$. Underpricing is fairly common in order to increase the return to

insiders who get in on the initial IPO. This is especially the case with smaller, more risky IPOs.

Performance of IPOs: Price generally rises on first day (almost 20% one-day returns over last 30 years) but long-term performance of IPOs usually is poor.

Lockup provision (usually 6 mo.) prevents flipping and ensures price stability. Incentive for insiders to be more truthful about information provided before IPO.

Underwriters can also discourage flipping by rewards non-flippers with more shares and barring flippers from future IPOs

IPOs tend to occur more frequently during bullish stock markets

Historical Trend of IPOs

Go to http://www.renaissancecapital.com/IPOHome/Rankings/BiggestUS.aspx to see largest US IPOs.

Recent IPO Examples:Alibaba, Sept/14, offer price $68Facebook (FB), May/12, offer price $38Groupon (GRPN), Nov./11, offer price $20.LinkedIn (LNKD, May/11, offer price $45.General Motors (GM), Nov/10, offer price $33.

Example of IPOsExample of IPOs

IPO Example: Groupon (GRPN), November 4, 2011Groupon has not been able to maintain its IPO price of $20

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Example of IPOsExample of IPOs

IPO Example: LinkedIn (LNKD), May 19, 2011Based on the first few days of trading, this IPO was wildly successful, given that its offer price was only $45 per share. 

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Example of IPOsExample of IPOsGeneral Motors (GM) IPO: November 18, 2010General Motors became a public company again (ticker GM) on 11/18/10 by raising $23.1 billion in the largest IPO in global history up to that point. Most of the funds were used to pay back the government investment, bringing the government’s ownership percentage down to about 33%. The offer price was set at $33 per share, at which GM sold some 700 million shares. Although the price initially rose a few dollars on the first day, the price essentially remained close the offer price for the first couple of weeks.

IPOs (cont.)

Abuses in the IPO market In 2003, regulators attempted to impose new guidelines that would

prevent abuses Spinning is the process in which an investment bank allocates IPO

shares to executives Laddering involves increasing the price above the offer price on

the first day of issue in response to substantial demand Excessive commissions are sometimes charged by brokers when

there is substantial demand for the IPO

Google’s IPO: Aug. 19, 2004 Dutch Auction allows ALL investors (both individual and

institutional) to submit bids and all bids above a certain cutoff are accepted.

Dutch Auction resulted in more participation by non-institutional investors (the little guy) and lower costs (saved $20 million in fees because investment banks are not trying to re-sell shares to investors)

Initial price $118-135 but revised to $85 Sold all 19.6 million shares resulting in proceeds of

$1.67b (could have raised more as price was at $100 by end of day)

What is it today? (ticker GOOG) Lot’s of flipping going on (33.3 million shares traded

during first two days) Google made available lots of info that could be easily

understood by everyone

Google’s IPO: Aug. 19, 2004

Public Placement of Stock Secondary stock offerings

New stock issued by firm that already has shares outstanding. Often occurs as part of restructuring efforts to achieve optimal capital structure

Shelf Registration 1982 SEC rule Allows firms to place securities (usually within two years) without

the time lag associated with registering with SEC

Costs of IPOs

Costs of IPOs

Stock Secondary Markets

Organized Exchanges Execute secondary market transactions Examples: NYSE, AMEX, Midwest, Pacific NYSE is largest, controlling 80 percent of value of all organized

exchanges in the U.S. Used to own a “seat” on exchange in order to trade

Used to be 1366 seats each costing $1.5m Now firms purchase a license to trade instead of a seat

Trading resembles an auction Merged with markets in France, Belgium, and the Netherlands Min. requirements: Minimum # of shares, minimum revenue, earnings,

cash flow $$; share price > $1.

NYSENYSE

Stock Secondary MarketsOver the Counter (OTC)

No trading floor or specific location Telecommunications network Nasdaq

National Association of Securities Dealers Automatic Quotations Thousands of small firms, plus high-tech giants

OTC Bulletin Board (penny stock trading, <$1) Pinksheets

Even tinier firms that do not meet requirements for NASDAQ (usually penny stocks of fairly risky companies with OB extensions in their tickers) Firms don’t register with SEC. Risky!!

Nasdaq HeadquartersNasdaq Headquarters

A computer network -- no trading floor – only physical infrastructure is headquarter building in Manhattan

Stock Secondary MarketsChanges in technology

ECN (electronic communication networks) take out the middlemen (brokers) although still some need for market makers and specialists

http://batstrading.com Online trading has forced fees to drop substantially Real-time quotes in decimals After hours trading (crazy idea?). Allows investors to

trade on new after-hour information but not much trading volume so poor liquidity exists

Oodles of company info & research (much of it free)

Stock Indexes Dow Jones Industrial Average

30 large U.S. firms Disadvantages: (1) price-weighted, (2) only 30 stocks, (3)

only represents large industrials (doesn’t represent small companies, tech companies, etc.)

Standard and Poor’s (S&P) 500 Value-weighted 500 leading U.S. firms

Wilshire 5000 Total Mkt covers all U.S. stocks (originally 5000 stocks traded in U.S.)

New York Stock Exchange Indexes Other Stock Indexes: Amex, NASDAQ, etc.

Categorizing the Secondary Market In the U.S., companies and stocks are often categorized by the

following approximate market capitalization values: Small-cap: market cap below US$1 billion Mid-cap: market cap between US$1 billion and US$5 billion Large-cap: market cap exceeds US$5 billion The small-cap definition is far more controversial than those for

the mid-cap and large-cap classes. Typical values for the ranges are enumerated here:

Micro-cap: market cap under US$100 million Nano-cap: market cap under US$50 million Blue chip is sometimes used as a synonym for a large-cap,

while some investors consider any micro-cap or nano-cap issue to be a penny stock, regardless of share price.

Types of Investors in Stock Individuals Investors

Owned 92% of common stock in 1950 Today, they own only 25%!

Institutional Investors Today, institutional investors own about 3/4ths of common stock

outstanding Examples: Pension Funds, Mutual Funds, Insurance Companies,

Endowment Funds, Hedge Funds, etc. Hold huge voting power (CALPERS likely holds more stock than any

other single entity)

Analysts Experts in certain companies who sell their ratings Scandalous analysts would recommend certain stocks (POS) because

of the kickback not because of a good analysis

Agency problem: investor actions

Shareholder activismAn investor who is dissatisfied with the way managers are running a firm

has three choices:

Sell

Do Nothing

Flush!

Shareholder Activism– Proxy Fight

Corporate Actions re: Stock Value

Mgmt is under tremendous pressure to meet earnings targets (not given too many chances).

Mgmt also has personal incentive to raise stock price (stock options, etc.)

Mgmt Responses: Stock repurchases to increase price & distribute cash LBOs options (junk bonds) Threat of Hostile Takeover

Stock price decline to bargain price due to poor management Antitakeover amendments to charter (2/3 vote) Poison pills (existing owners get 25% of all new shares) Golden parachutes

Accounting Scandals

Accounting irregularities To the extent that firms can manipulate financial

statements they may be able to hide information from investors e.g., Enron, Tyco, and WorldCom

The auditors hired to audit financial statements allowed them to use unusual accounting methods Board members on the audit committee were not always

monitoring the audit

SOX 2002The Sarbanes-Oxley Act of 2002:

Was implemented to ensure more accurate disclosure of financial information to investors

Attempts to force auditors to take their auditing role seriously. Audit firms must register with SEC and be “audited.” They can be punished for substandard work.

Prevents a public accounting firm from auditing a client whose CEO, CFO, or other employees are employed by the client firm within one year prior to the audit

Audit partner rotation every 5 years

SOX 2002 (cont.)The Sarbanes-Oxley Act:

Requires that only outside board members of a firm be on the firm’s audit committee

Prevents the members of a firm’s audit committee from receiving consulting or advising fees from the firm

Requires that the CEO and CFO of firms to certify that the audited financial statements are accurate

Specifies major fines or imprisonment for employees who mislead investors or hide evidence

Allows public accounting firms to offer non-audit consulting services to an audit client only if the client pre-approves those services

Cost of SOX to many companies >$1 million.

Stock Markets Around the World

http://www.world-exchanges.org/statistics/monthly-reports

Equity - 1.1 - Domestic market capitalization (USD millions)

2014

DecemberAmericasBermuda SE 1 601.5 9.2% 9.2%BM&FBOVESPA 843 894.2 -17.3% -6.8%Buenos Ai res SE 60 142.0 13.3% 47.1%Colombia SE 146 745.7 -27.6% -10.9%Lima SE 78 839.9 -2.6% 3.6%Mexican Exchange 480 245.3 -8.7% 2.7%NASDAQ OMX 6 979 172.0 14.7% 14.7%NYSE 19 351 417.2 7.8% 7.8%Santiago SE 233 245.5 -12.0% 1.6%TMX Group 2 093 696.8 -1.0% 8.0%Total region 30 269 000.0 7.0%

Asia - PacificAustra l ian SE 1 288 708.3 -5.7% 3.1%BSE India 1 558 299.7 36.8% 39.6%Bursa Malays ia 459 004.4 -8.3% -2.1%Colombo SE 23 665.1 25.8% 26.2%GreTai Securities Market 84 822.5 8.7% 15.3%HoChiMinh SE 46 067.0 15.0% 16.6%Hong Kong Exchanges 3 233 030.6 4.3% 4.3%Indones ia SE 422 127.0 21.8% 23.9%Japan Exchange Group - Osaka NA - -Japan Exchange Group - Tokyo 4 377 994.4 -3.6% 9.9%Korea Exchange 1 212 759.5 -1.8% 2.3%National Stock Exchange India 1 520 925.1 36.7% 39.5%New Zealand Exchange 74 415.7 12.8% 18.8%Phi l ippine SE 261 840.7 20.5% 21.4%Shanghai SE 3 932 527.7 57.5% 61.4%Shenzhen SE 2 072 420.0 42.7% 46.3%Singapore Exchange 752 831.0 1.1% 6.1%Ta iwan SE Corp. 850 943.1 3.4% 9.7%The Stock Exchange of Thai land 430 426.6 21.5% 21.6%Total region 21 081 883.2 13.8%

Europe - Africa - Middle EastAbu Dhabi SE 113 740.0 3.7% 3.7%Amman SE 25 554.9 -0.8% -0.8%Athens Exchange 55 154.3 -33.2% -24.0%BME Spanish Exchanges 992 913.6 -11.1% 1.3%Borsa Is tanbul 219 762.6 12.3% 22.2%Budapest SE 14 513.3 -26.7% -11.3%Casablanca SE 52 746.8 -2.0% 8.8%Cyprus SE 4 031.0 91.5% 118.1%Deutsche Börse 1 738 539.1 -10.2% 2.3%Dubai Financia l Market 87 858.9 - -Egyptian Exchange 70 083.7 13.7% 17.0%Euronext 3 319 062.2 -7.4% 5.5%Iri sh SE 143 465.8 -15.7% -4.0%Johannesburg SE 933 930.7 -0.9% 9.4%Kazakhstan SE 22 973.4 -12.4% 3.6%Ljubl jana SE 7 519.4 5.5% 20.1%Luxembourg SE 63 167.5 -19.7% -8.5%Malta SE 3 641.7 - -Mauritius SE 8 751.0 -2.1% 3.4%Moscow Exchange 385 926.7 -49.9% -8.6%Muscat Securities Market 37 830.5 2.9% 2.9%NASDAQ OMX Nordic Exchange 1 196 725.4 -5.7% 7.4%Oslo Børs 219 369.7 -17.3% 2.2%Qatar Stock Exchange 185 860.3 21.8% 21.8%Saudi Stock Exchange - Tadawul 483 115.5 3.4% 3.4%SIX Swiss Exchange 1 495 314.2 -2.9% 8.4%Tel Aviv SE 200 525.0 -1.4% 10.6%Wiener Börse 96 790.3 -17.7% -6.3%Total region 12 178 867.4 -8.7%

WFE Total 63 529 750.7 5.6%

Exchange% change /

Dec 13 (in USD)

% change /Dec 13

(in local cur)

http://www.world-exchanges.org/statistics/monthly-reports

Equity - 1.1 - Domestic market capitalization (USD millions)

2014

DecemberAmericasBermuda SE 1 601.5 9.2% 9.2%BM&FBOVESPA 843 894.2 -17.3% -6.8%Buenos Ai res SE 60 142.0 13.3% 47.1%Colombia SE 146 745.7 -27.6% -10.9%Lima SE 78 839.9 -2.6% 3.6%Mexican Exchange 480 245.3 -8.7% 2.7%NASDAQ OMX 6 979 172.0 14.7% 14.7%NYSE 19 351 417.2 7.8% 7.8%Santiago SE 233 245.5 -12.0% 1.6%TMX Group 2 093 696.8 -1.0% 8.0%Total region 30 269 000.0 7.0%

Asia - PacificAustra l ian SE 1 288 708.3 -5.7% 3.1%BSE India 1 558 299.7 36.8% 39.6%Bursa Malays ia 459 004.4 -8.3% -2.1%Colombo SE 23 665.1 25.8% 26.2%GreTa i Securities Market 84 822.5 8.7% 15.3%HoChiMinh SE 46 067.0 15.0% 16.6%Hong Kong Exchanges 3 233 030.6 4.3% 4.3%Indones ia SE 422 127.0 21.8% 23.9%Japan Exchange Group - Osaka NA - -Japan Exchange Group - Tokyo 4 377 994.4 -3.6% 9.9%Korea Exchange 1 212 759.5 -1.8% 2.3%National Stock Exchange India 1 520 925.1 36.7% 39.5%New Zealand Exchange 74 415.7 12.8% 18.8%Phi l ippine SE 261 840.7 20.5% 21.4%Shanghai SE 3 932 527.7 57.5% 61.4%Shenzhen SE 2 072 420.0 42.7% 46.3%Singapore Exchange 752 831.0 1.1% 6.1%Ta iwan SE Corp. 850 943.1 3.4% 9.7%The Stock Exchange of Tha i land 430 426.6 21.5% 21.6%Total region 21 081 883.2 13.8%

Europe - Africa - Middle EastAbu Dhabi SE 113 740.0 3.7% 3.7%Amman SE 25 554.9 -0.8% -0.8%Athens Exchange 55 154.3 -33.2% -24.0%BME Spanish Exchanges 992 913.6 -11.1% 1.3%Borsa Is tanbul 219 762.6 12.3% 22.2%Budapest SE 14 513.3 -26.7% -11.3%Casablanca SE 52 746.8 -2.0% 8.8%Cyprus SE 4 031.0 91.5% 118.1%Deutsche Börse 1 738 539.1 -10.2% 2.3%Dubai Financia l Market 87 858.9 - -Egyptian Exchange 70 083.7 13.7% 17.0%Euronext 3 319 062.2 -7.4% 5.5%Iri sh SE 143 465.8 -15.7% -4.0%Johannesburg SE 933 930.7 -0.9% 9.4%Kazakhstan SE 22 973.4 -12.4% 3.6%Ljubl jana SE 7 519.4 5.5% 20.1%Luxembourg SE 63 167.5 -19.7% -8.5%Malta SE 3 641.7 - -Mauritius SE 8 751.0 -2.1% 3.4%Moscow Exchange 385 926.7 -49.9% -8.6%Muscat Securities Market 37 830.5 2.9% 2.9%NASDAQ OMX Nordic Exchange 1 196 725.4 -5.7% 7.4%Oslo Børs 219 369.7 -17.3% 2.2%Qatar Stock Exchange 185 860.3 21.8% 21.8%Saudi Stock Exchange - Tadawul 483 115.5 3.4% 3.4%SIX Swiss Exchange 1 495 314.2 -2.9% 8.4%Tel Aviv SE 200 525.0 -1.4% 10.6%Wiener Börse 96 790.3 -17.7% -6.3%Total region 12 178 867.4 -8.7%

WFE Total 63 529 750.7 5.6%

Globalization of Stock Markets Barriers to international stock trading have decreased

Reduction in information costs Reduction in exchange rate risk

Correlation among markets (1987 crash) In 2007, NYSE merged with stock exchanges in Paris,

Brussels, and Amsterdam (called NYSE Euronext). Merger with German stock exchange is on hold.

ADRs Foreign co. desire to tap into US markets but SEC requirements

are costly, so many will sell ADRs (American Depository Receipts). See http://www.adrbnymellon.com/dr_directory.jsp (e.g. Honda,

ticker HMC)

Globalization of Stock Markets Methods used to invest in foreign shares

Direct purchases (limited market) American Depository Receipts (ADRs)

Advantages: Fin. Stmt. per US GAAP, lots of info by analysts, reliable quotes

Disadvantage: less liquid than US stocks International mutual funds World equity benchmark shares (WEBs or international iShares)