How corporations issue securities

God Himself could not sink this ship”– Titanic deckhand April 10, 1912

Venture Capital

Since success of a new firm is highly dependent on the effort of the managers, restrictions are placed on management by the venture capital company and funds are usually dispersed in stages, after a certain level of success is achieved.

Venture Capital

Money invested to finance a new firm

U.S. Venture Capital Investments

7.910.8

14.620.7

53.5

104.4

40.5

21.7 19.6 21.8 22.4

0

20

40

60

80

100

120$

Mil

lion

s

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Venture Capital:Performance

• SIGNALING Words are cheap but you are more likely to trust an entrepreneur who puts his money where his mouth is.

• Venture Capital Performance [Huntsman and Hoban (1980), Barry ( 1994)]

Initial Offering

Initial Public Offering (IPO) - First offering of stock to the general public.

Underwriter - Firm that buys an issue of securities from a company and resells it to the public.

Spread - Difference between public offer price and price paid by underwriter.

Prospectus - Formal summary that provides information on an issue of securities.

Underpricing - Issuing securities at an offering price set below the true value of the security.

Motives For An IPOPercent of CFOs who strongly agree with the reason for an IPO

Return from Investing in Initial Public Offerings (IPOs)

• Deliberate underpricing?

• Large Initial Returns of 16.4% during first day. [Ibbotson, Sindelar and Ritter (1988)

– Who gets this? [Barry and Jennings (1993)

• What is the long Run Performance? [Levis(1993)]

New Equity Issues Winners' Curse(or why issues may be underpriced)

• Underpriced issues are generally oversubscribed & overpriced issues are

undersubscribed.

• Investors who apply for every issue, will tend to receive a small allocation of

underpriced issues & a large allocation of overpriced issues.

• If issues are on average fairly priced, then uninformed investors will not

apply for new issues.

• Therefore a discount may be needed to attract uninformed investors.

IPOs (Unseasoned Issues) in U.S. A couple of examples..

April 1996 Optical Cable Corp. was sold at $10 a share. After 1 month price hit a high of $136 before falling to $57 three days later.

July 1995 underwriters indicated that Netscape would sell 3.5 million shares at $12 - $14 each. A few days later they increased shares available to 5 million and upped price range to $21 - $24.

That evening they set the final price at $28. Next morning trading opened 1 1/2 hours late at a price of $71, valuing the firm at $2 billion.

Costs of Microsoft IPO

Combined primary and secondary issue.

Underwriters acquired 2.8m shares at $19.69 and resold them at $21

Legal and other costs = $.5m

Initial market price = $35

Direct expenses:Spread 2.8m x $1.31 = $3.7mOther expenses .5Total direct expenses $4.2mProceeds 2.8m x $19.69 = $54.6mExpenses as % of proceeds 4.2/54.6 = 7.1%

Cost of underpricing 2.8m x ($35 - $21) = $39.2mTotal expenses $43.4mMarket value of issue 2.8m x $35 = $98 mExpenses as % of market value 43.4/98 = 44%

Average expenses of going public (USA)Value of Direct Average initial Total

Issue ($m) costs % return % costs %

2 - 10 17.0 16.4 25.2 10 - 20 11.6 9.7 18.2 20 - 40 9.7 12.5 18.2 40 - 60 8.7 13.7 18.0 60 - 80 8.2 11.3 16.4 80 - 100 7.9 8.9 14.1 100 - 200 7.1 7.2 12.8 200 - 500 6.5 5.7 11.1 > 500 5.7 7.5 10.4 All issues 11.0 12.1 18.7

Note: Direct costs and initial return are % of issue price. Total costs are % of market priceSource: Ritter (1996)

IPO Proceeds

• IPO Proceeds and First Day Returns

Average Initial IPO Returns

0 20 40 60 80 100

return (percent)

DenmarkCanadaNetherlandsSpainTurkeyFranceAustraliaNorwayHong KongUKUSAItalyJapanSingaporeSwedenTaiwanGermanySwitzerlandKoreaBrazilIndiaChina

256 %

U.S. direct issue costs 1990-1994

2 to 10 20 to 40 60 to 80 100 to 200 500 +

Bonds

Convs

Second eqs

IPOs

05

101520

2 to 10 20 to 40 60 to 80 100 to 200 500 +

Bonds

Convs

Second eqs

IPOs

Proceeds $m

Costs %

Price Falls For Seasoned Issues

Avg. 2-day abnormal return (%)Type of security* Industrials Utilities

Equity -3.1 -0.8

Convertible bonds -2.0 na

Convertible pref. -1.4 -1.4

Preferred -0.8 0.1

Straight bonds -0.3 -0.1

*Firm commitment offers

Source: US evidence summarized in Eckbo & Masulis (1993)

Why stock issues cause a fall in the share price: a possible explanation (Myers & Majluf)

• Managers have better information than investors

• Suppose managers believe stock is overpriced (It may be a good time to sell)

• If stock is overpriced, old shareholders get good deal. • Investors know managers are more likely to issue stock when it is overvalued and therefore mark down the price