How Corporations Issue Securities

• Financial Institutions• Student Presentations• Venture Capital• Initial Public Offering• Other New Issue Procedures• Subsequent Security Sales• Private Placements

Financial Institutions• Types of institutions

– Banks– Insurance companies– Pension funds– Mutual funds– Hedge funds

• Payment mechanism

• Borrowing and lending

• Pooling risk

Venture Capital• First stage financing• Advantages

– Deep pockets– Contacts– Experience with start-up companies– Partnership in operations and financial success

• Incentives– For managers

• Fully committed financially• Will reap payoff only if successful

– For venture capitalist• Downside protection• Upside potential

Venture Capital - 2• Second (and third or more) stage financing

– May include additional venture capitalists– Ties funding to meeting objectives

• Most companies funded by venture capital do not succeed– Open Prairie Ventures

• 2 of 15 start-ups actually considered successes

• Payoffs on successes provide enough to offset the losses on the rest of the investments

Venture Capital Market• Venture capital investment trends

– 1995 $8 billion– 2000 $105 billion– 2006 $26 billion

• Generally organized a limited private partnerships– Management company

• Fixed fee and share of profits (2% plus 20%)

– Limited partners• Insurance companies or pension plans• Wealthy investors• Share in gains/losses

• Exit strategy for venture capitalist– Selling firm– Going public

Initial Public Offering1. Select managing underwriter and form

underwriting syndicate2. Arrange spread and greenshoe option3. Register with SEC and issue prospectus4. Roadshow to interest potential investors and build

book of demand5. SEC approval and issue price set6. Underwriters allocate stock7. Trading starts8. Managing underwriter makes liquid market

Underwriting a New Issue• Role of underwriter and underwriting syndicate

– Financial advisors– Buy the issue– Resell it to the public

• Alternatives for underwriting syndicate– Buy entire issue and resell it– Best-efforts basis– All-or-none arrangement

• Primary offering– New shares

• Secondary offering– Shares held by management, venture capitalist or other investors

Financial Terms for IPO

• Spread– Difference between what underwriter pays and the

offering price– Typically 7% for $20 – 80 million IPOs– Split among managing underwriter, syndicate and

sales force

• Registration costs• Greenshoe option

– Allows underwriter to buy and sell additional shares

Prospectus• Number of shares

– Primary offering– Secondary offering

• Price– To public– To underwriter– Proceeds to company and other sellers

• Registration expenses• Use of proceeds• Company information• Considerations – Warnings• Management and compensation• Prior transactions• Selling stockholders• Underwriting agreement• Legal matters

Underpricing of IPOs• IPOs often end the first day of trading above the

offering price• Average first day returns approximately 19% over

1963-2003• Long term, IPOs underperform the market• Why are IPOs underpriced?

– To assure selling entire issue– To entice investors to IPOs of underwriter– To reward favored clients

• Individual investors do not get favorable returns by bidding for each IPO

New Issue Procedures

• Bookbuilding– Typical in US

• Fixed price offer

• Auction– Google– Discriminatory auction– Uniform price auction– Impact of winner’s curse

Subsequent Security Sales• General cash offers

– Shelf registration• More common for debt than equity• Allows company to time market

• Spreads– IPOs - around 7%– Seasoned equity - around 5%– Debt – around 1%

• Market reaction to stock issues– US stocks approximately a 3% decline when stock issue is

announced– Signaling issue

• Rights issues

Private Placements

• Limits on number and type of investors

• Advantages– Lower cost– May deal directly with buyer

• Disadvantages– No active market to determine price– Hard to resell

• Example– State Farm and debt issues

Summary• Companies can raise capital in a variety of ways• Venture capital is a stepping stone to more long term

financing• Initial public offerings are a complex process• Issuing equity is more costly than issuing debt• Underwriters play an important role in raising capital• Underpricing of IPOs is typical• Signaling inside information impacts stock price• Beware of the winner’s curse in investing

Next Class

• Payout Policy

• Read Chapter 16