cb 00 et ae) Public and Private Financing: Initial Offerings, Seasoned Offerings, Investment Banks On May 18, 2012, Facebook went public in one of the most eagerly anticipated initial public offerings (IPO) of the decade. Facebook and some of its founders/investors sold about 421 million shares for $38 each, but subsequent trading on NASDAQ was delayed for 30 minutes due to technological problems. When trading did begin, the price quickly went up to over $42. Although the price rose to $45 during the day, most new investors were selling the stock, putting downward pressure on the price. Morgan Stanley, one of the underwriters, kept the price from plunging by purchasing enough shares itself to create artificial demand, By the end of the day, the price was down to $38.23, barely above the initial price. During the following two weeks, the price fell below $26, and finger-pointing and blaming ensued First, analysts and investors complained that shortly before its IPO, Facebook had increased the number of shares it planned to sell and then sold them ata higher-than- expected price. This combination, they said, reduced demand for the stock and hurt the per share value. Second, there was pandemonium during the day when traders were unable to confirm their trades. For example, UBS (a large Swiss financial institution) claimed it suffered $350 million in losses due to the interruption in information. NASDAQ offered $40 million in compensation to brokerage firms that lost money due to the information interruption, but that is unlikely to satisfy all the traders. Third, some investors sued Facebook and its underwriters, alleging that they concealed a reduction in projected sales revenues from all but a few favored clients. We will have more to say about Facebook's IPO later in the chapter, so keep these events in mind. ‘Sources: ShayndiRaice, Ryan Dexember, and Jacob Bunge, “Facebook's Launch Sputtes,” The Wal Street Journal, May 18,2012, p. A; Jonathan Stempel and Dan Levine, www.reuters.com, May 23,2012 a7ource textbook eb ite fon xc fet |gudeyouthrough the Pscacuatons fil forthe chopter Toolkits onde yutoopenthe ‘ond folow along 2+ reodthechoptr. Part 8 Tactical Financing Decisions Previous chapters described how a company selects projects, chooses its capital struc ture, and implements its dividend policy. These activities determine the amount of new capital a company must raise and the debt/equity mix of that new capital. In this chapter, ‘we describe the actual process of raising capital from the public markets (such as selling stock in an initial public offering) and private markets (such as selling stock to a private investor like a pension fund). We also describe the roles investment banks and regulatory agencies play in raising capital. 18-1 The Financial Life Cycle of a Start-Up Company ‘Most businesses begin life as proprietorships or partnerships, and if they become suc- cessful and grow, at some point they find it desirable to become corporations. Initially, most corporate stock is owned by the firms’ founding managers and key employees. Even start-up firms that are ultimately successful usually begin with negative free cash flows because of their high growth rates and product development costs; hence, they ‘must raise capital during these high-growth years, If the founding owner-managers have invested all of their own financial resources in the company, then they must turn to outside sources of capital. Start-up firms generally have high growth opportunities, and they suffer from especially large problems due to asymmetric information. There fore, as we discussed in Chapter 15, they must raise external capital primarily as equity rather than debt. To protect investors from fraudulent stock issues, in 1933 Congress enacted the Secu: rities Act, which created the Securities and Exchange Commission (SEC) to regulate the financial markets.’ The Securities Act regulates interstate public offerings, which wwe explain later in this section, but it also provides several exemptions that allow com- panies to issue securities through private placements that are not registered with the SEC. The rules governing these exemptions are quite complex, but in general they restrict the number and type of investors who may participate in an issue, Accredited investors include the officers and directors of the company, high-wealth individuals, and institu- tional investors. In a nonregistered private placement, the company may issue securities to an unlimited number of accredited investors but to only 35 nonaccredited investors. In addition, none of the investors can sell their securities in the secondary market to the general public. For most startups, the first round of external financing comes through a private placement of equity to one or two individual investors, called angel investors. In return for a typical investment in the range of $50,000 to $400,000, the angels receive stock and pethaps also a seat on the board of directors. Because angels can influence the strategic direction of the company, itis best when they bring experience and industry contacts to the table in addition to cash As the company grows, its financing requirements may exceed the resources of indi- vidual investors, in which case it is likely to turn to a venture capital fund, A venture capital fund is a private limited partnership established to invest in start-up companies. It is managed by its general partners, who are often called venture capitalists (VCs). The VCs are usually very knowledgeable and experienced in a particular industry, such as health care, information technology, or biotechnology. They screen hundreds of start-ups and ultimately make equity investments in around a dozen, called portfolio companies. ‘The VCs or their employees sit on the companies’ boards of directors. Some portfolio Tn addition to federal statutes, which affect transactions that cross state borders, states ave “blue sky” awe ‘hat regulate securities sold jst within the state. These laes were designed to prevent unscrupulous dealers from selling something of ite worth, such asthe blue sk, to naive investorsCChapter 18 Public and Private Financing: Initial Offerings, Seasoned Offerings, Investment Banks 749 companies and other start-up companies are called unicorns because they have an esti- ‘mated valuation greater than $1 billion dollars, which is rare among start-ups. Current (carly 2018) examples are Uber Technologies, Airbnb, and Reddit. ‘A fund typically raises around $300 million from a relatively small group of individual and institutional investors, including pension funds, college endowments, and corpora- tions. The general partner usually contributes a relatively modest amount of cash but acts, as the fund’s manager. In return, the general partner normally receives annual compensa- tion equal to 1% to 2% of the fund's assets plus a 20% share of the fund’s eventual profits As we write this in early 2018, a VC's eventual profits are called carried interest and are taxed at the capital gains tax rate, which usually is lower than the ordinary income tax rate. This is a contentious political issue because the VC's original investment is so much smaller than the limited partners’ investments, causing some people to regard carried interest as ordinary income rather than capital gains. Individual venture capital funds may be part of a larger investment firm that serves as the funds’ general manager. Such investment firms can be quite large, such as Andreessen, Horowitz, with ownership stakes in Airbnb and Pinterest. Some start-up “funds” are divisions or subsidiaries of publicly traded companies. For example, GV (originally named Google Ventures) isa subsidiary of Alphabet, Inc. (which also owns Google). GV has ownership stakes in Uber and SurveyMonkey. PEyeeEe TE What is a private placement? What isan angel investor? What i @ venture capital fund? VC? 18-2 The Decision to Go Public Going public means selling some of a company's stock to outside investors in an initial public offering (IPO) and then letting the stock trade in public markets. For example, Snap, Inc, (the owner of Snapchat), Roku, Inc., and Stitch Fix Inc, all went public in 2018, ‘There are advantages and disadvantages for going public, as explained next. 18-2a Advantages of Going Public ‘The advantages to going public include the following: 1. Increases liquidity and allows founders to harvest their wealth. The stock of a private, or closely held, corporation illiquid. It may be hard for one of the owners who wants to sell some shares to find a ready buyer, and even if a buyer is located, there is no established price on which to base the transaction. 2. Permits founders to diversify. As a company grows and becomes more valuable, its founders often have most of their wealth tied up in the company. By selling some of, their stock in a public offering, they can diversify their holdings, thereby reducing the riskiness of their personal portfolios. 3. Facilitates raising new corporate cash. If a privately held company wants to raise cash by selling new stock, it must either go to its existing owners, who may not have any money or may not want to put more eggs in this particular basket, or else shop around for wealthy investors. However, itis usually quite difficult to get outsid- ers to put money into a closely held company: If the outsiders do not have voting control (more than 50% of the stock), then the inside stockholders/managers can take advantage of them. Going public, which brings with it both public disclosure750 Part 8 Tactical Financing Decisions of information and regulation by the SEC, greatly reduces this problem and thus makes people more willing to invest in the company, which makes it easier for the firm to raise capital. 4, Establishes a value for the firm. Ifa company wants to give incentive stock options to key employees, itis useful to know the exact value of those options. Employees much prefer to own stock, or options on stock, that is publicly traded and therefore liquid. Also, when the owner of a privately owned business dies, state and federal tax apprais- crs must set a value on the company for estate tax purposes. Often these appraisers set «higher value than that ofa similar publicly traded company. 5. Facilitates merger negotiations. Having an established market price helps when a com- pany either is being acquired or is seeking to acquire another company in which the payment will be with stock, 6. Increases potential markets. Many companies report that itis easier to sell their prod- ucts and services to potential customers after they become publicly traded. 18-2b Disadvantages of Going Public “The disadvantages associated with going public include the following: 1. Increases reporting costs. A publicly owned company must file quarterly and annual reports with the SEC and/or various state agencies. These reports can be a costly bur- den, especially for small firms. In addition, compliance with the Sarbanes-Oxley Act often requires considerable expense and manpower. 2. Increases disclosure requirements. Management may not like the idea of reporting operating data, because these data will then be available to competitors. Similarly, the ‘owners of the company may not want people to know their net worth. But because @ publicly owned company must disclose the number of shares its officers, directors, and major stockholders own, itis easy enough for anyone to multiply shares held by price per share to estimate the net worth of the insiders, 3. Increases risk of having an inactive market and/or low price. Ifthe firm is very small and ifits shares are not traded frequently, then its stock will not really be liquid and so the market price may not represent the stock’s true value. Security analysts and stockbrokers simply will not follow the stock, because there will not be sufficient trading activity to generate enough brokerage commissions to cover the costs of following it. 4, Reduces owner/manager control. Because of possible tender offers and proxy fights, the managers of publicly owned firms who do not have voting control must be concerned about maintaining control. Further, there is pressure on such managers to produce annual earnings gains, even when it might be in the shareholders’ best long-term interests to adopt a strategy that reduces short-term earnings but raises them in future years. These factors have led a number of public companies to “go private” in leveraged buyout deals, where the managers borrow the money to buy out the nonmanagement stockholders. We discuss the decision to go private in a later section, 5. Increases time spent on investor relations. Public companies must keep investors abreast of current developments. Many CFOs of newly public firms report that they spend 2 full days a week talking with investors and analysts. Perens rns What are the major advantages of going public? What are the major disadvantages?CChapter 18 Publicand Private Financing: Initial Offerings, Seasoned Offerings, Investment Banks 751 18-3 The Process of Going Public: An Initial Public Offering An initial public offering is complicated, expensive, and time-consuming, as the follow- ing explains. 18-3a Selecting an Investment Bank After a company decides to go public, it faces the problem of how to sell its stock to alarge number of investors. Although most companies know how to sell their products, few have ‘experience in selling securities. To help in this process, the company will interview a num- ber of different investment banks, also called underwriters, and then select one to be the lead underwriter. To understand the factors that affect this choice, it helps to understand ‘exactly what investment banks do in an IPO. First, the investment bank helps the firm determine the preliminary offering price, ‘or price range, for the stock and the number of shares to be sold. The investment bank’s reputation and experience in the company’s industry are critical in convincing potential investors to purchase the stock at the offering price. In effect, the investment bank implic- itly certifies that the stock is not overpriced, which obviously comforts investors. Second, the investment bank actually sells the shares to its existing clients, which include a mix of institutional investors and retail (that is, individual) customers. Third, the investment bank, through its associated brokerage house, will have an analyst “cover” the stock after itis issued. This analyst will regularly distribute reports to investors describing the stock’s prospects, which will help to maintain an interest in the stock. Well-respected analysts, increase the likelihood that there will be a liquid secondary market for the stock and that its price will reflect the company’s true value. Some activities in finance involve as much marketing skill as finance expertise. For ‘example, the selection of an underwriter often is described as a bake-off in which the com- peting investment banks woo the company with their best sales pitch, much like a cake- baking contest in which bakers vie for first prize. scebook chose Morgan Stanley to be its lead underwriter, but other investment banks were also involved, as we explain next 18-3b The Underwriting Syndicate ‘The firm and its investment bank must next decide whether the bank will work on a best, efforts basis or will underwrite the issue. In a best efforts sale, the bank does not guaran- tee that the securities will be sold or that the company will get the cash it needs, only that, it will put forth its “best efforts” to sell the issue. In contrast, in an underwritten issue, the company does get a guarantee: The bank agrees to buy the entire issue from the company at a set price per share. The investment bank will then try to sell the newly issued stock to investors. Notice that the company receives the cash it needs even if the investment bank is unable to sell the stock at a price that is high enough to be profitable. Hence, an underwritten offer shifts risk from the company to the investment bank. However, the company pays for this protection because the price per share that it receives from the investment banker is less than the price per share that the investment bank expects to receive when it sels the stock. The following sections explain IPO pricing in more detail. Except for extremely small issues, virtually all IPOs are underwritten. Investors are required to pay for securities within 10 days, and the investment bank must pay the issuinglows ferany 1S See er Part 8 Tactical Financing Decisions firm within 4 days ofthe official commencement of the offering. Typically, the bank sells the stock within a day or two after the offering begins, but on occasion the bank miscalcu- lates, sets the offering price too high, and thus is unable to move the issue. At other times, the market declines during the offering period, forcing the bank to reduce the price of the stock. In either instance, on an underwritten offering the firm receives the price that was agreed upon, so the bank must absorb any losses that are incurred. Because they are exposed to large potential losses, investment banks typically do not handle the purchase and distribution of issues single-handedly unless the issue is very small. If the sum of money involved is large, then investment banks form underwriting syndicates in an effort to minimize the risk each individual bank faces. The banking house that sets up the deal is called the lead underwriter or the managing underwriter. Syndicated offerings are usually covered by more analysts, which contribute to greater liquidity in the post-IPO secondary market. Thus, syndication provides benefits to both, underwriters and issuers. In addition to the underwriting syndicate, on larger offerings still more investment banks are included in a selling group, which handles the distribution of securities to individual investors. The selling group includes all members of the underwriting syn- dicate plus additional dealers who take relatively small percentages of the total issue from the members of the underwriting syndicate. Thus, the underwriters act as whole salers while members of the selling group act as retailers. The number of brokerage houses in a selling group depends partly on the size of the issue, but it is normally in the range of 10 to 15. For example, the lead underwriter for Facebook’s IPO was Morgan Stanley, and the sales syndicate included over 30 firms, including Goldman Sachs, Merrill Lynch, Barclays, Citigroup, Credit Suisse Securities, Deutsche Bank Securities, and Wells Fargo. A new selling procedure has recently emerged that takes advantage of the trend toward institutional ownership of stock. In this type of sale, called an unsyndicated offering, the managing underwriter—acting alone—sells the issue entirely to a group of institutional investors, thus bypassing both retail stockbrokers and individual inves tors. In recent years, about 50% of all stock sold has been by unsyndicated offerings. Behind this phenomenon is a simple motivating force: money. The fees that issuers pay on a syndicated offering, which include commissions paid to retail brokers, can run a full percentage point higher than those on unsyndicated offerings. Moreover, although total fees are lower in unsyndicated offerings, managing underwriters usually come out ahead because they do not have to share the fees with an underwriting syndicate. How: ever, some types of stock do not appeal to institutional investors, so not all firms can use unsyndicated offers. 18-3c Regulation of Securities Sales Sales of new securities, and also sales in the secondary markets, are regulated by the Secu: rities and Exchange Commission and, to a lesser extent, by each of the 50 states. There are four primary elements of SEC regulation. 1. Jurisdiction. The SEC has jurisdiction over all interstate public offerings in amounts of $1.5 million or more. 2. Registration. Newly issued securities (stocks and bonds) must be registered with the SEC at least 20 days before they are publicly offered. The registration statement, called Form $-1, provides financial, legal, and technical information about the com- pany to the SEC. A prospectus, which is embedded in the S-1, summarizes this infor- ‘mation for investors, The SEC's lawyers and accountants analyze both the registrationCChapter 18 Public and Private Financing: Initial Offerings, Seasoned Offerings, Investment Banks 753 statement and the prospectus; ifthe information is inadequate or misleading, the SEC will delay or stop the public offering? Among its disclosures, the S-1 document and subsequent amendments (S-1/A) show the proposed number of shares to be sold (including a breakdown between shares sold by the company and shares sold by current stockholders, including the founders and investors) and a range of possible offering prices (the prices at which the first investors may purchase the stock). For example, Facebook’s S-1 filing on Febru- ary 1, 2012, did not specify either the number of shares or price range, but its amended statement on May 3, 2012, stated that Facebook would offer 337 million shares (180 million from the company and 157 million shares from its current stockholders) at @ price between $28 and $35 per share. Prospectus. After the SEC declares the registration to be effective, new securities may be advertised, but all sales solicitations must be accompanied by the prospectus, The preliminary prospectus, which is also called a red herring prospectus, may be dis- tributed to potential buyers during the 20-day waiting period after the registration is effective, but no sales may be finalized during this time. The “red herring” prospectus Go called because it has a standard legal disclaimer printed in red across its cover) contains all the key information that will appear in the final prospectus except the final price, which is generally set after the market closes the day before the new secu: rities are offered to the public. 4, Truth in reporting. Ifthe registration statement or prospectus contains misrepresen tations or omissions of material facts, then any purchaser who suffers a loss may sue for damages. Severe penalties may be imposed on the issuer or its officers, directors, accountants, engineers, appraisers, underwriters, and all others who participated in the preparation of the registration statement or prospectus. 18-3d The Roadshow and Book-Building18-3f The First Day of Trading ‘The first day of trading for many IPOs can be wild and exciting. For example, in 2017 Roku’ stock increased by 68% on its first day of trading, but Allena Pharmaceuticals, Inc. was down by over 29%, Professor Jay Ritter of the University of Florida reported that the average first-day return in 2017 was about 12%, abit lower than the 2000-2017 return, 0f 13.9%." In one of the most famous IPOs of the recent past, Facebook broke even on the first day, May 18, 2012, and would have fallen if the underwriters had not created artificial demand by purchasing the falling shares. On the second day, Facebook fell by 11%. Face book’s amended filings in the week before its IPO may have contributed to its weak first day performance. On May 15, 2012, Facebook filed an amended $-1/A increasing the range of prices from $28-$35 to $34~$38. On May 16, Facebook filed another amendment increasing by 84 million shares the amount to be sold by insiders. On May 17, Facebook announced that the offer price would be $38 per share, at the very top of the already higher range. Facebook's stock began trading the next day. ‘Many analysts were surprised by these increases in the offer price and the number of shares to be sold, especially the proportion of shares from insiders, which rose to 57% of the total sold in the IPO. To put this in perspective, Google's insiders represented about 28% of its IPO, but some insiders don’t sell any of their shares in an IPO, like the insiders at Amazon in 1994, Itis possible that this increase in supply and cost drove down demand, for the stock. ‘The relation between the ranges in the initial and the final offer prices isan important indicator of first-day returns. During the period 2000-2017, higher-than-expected demand in the roadshows caused about 21% of IPOs to have a final offer price that exceeded the ‘See Jay R. Rite, hutpsste warrington. afedu/itterlipo-datal and select the fst link for "IPO Statistics {or 2017 and Farlier Years”"The reported data are sn Table 1Part 8 Tactical Financing Decisions top of the initial range.* On average, these stocks subsequently went up on the first day by about 37%! For the 35% of IPOs with an offer price below the bottom of the initial range, the average first-day return was about 3%. However, a large percentage of these actually hhad negative returns. About 44% of IPOs had an offering price within the initial range of the initial filing, For such companies, the average first-day return was about 11%. You're probably asking yourself two questions. First, how can I get in on these deals? Second, why is the offering price so low on average? Unfortunately, you probably can’t get the chance to buy an IPO at its offering price, especially not a “hot” one. Virtually all sales go to institutional investors and preferred retail customers, A few Web-based investment banks are trying to change this, such as the OpenlPO of W. R. Hambrecht & Co., but right, now itis difficult for small investors to get in on the first day for hot IPOs. Various theories have been put forth to explain IPO underpricing. As long as issuing companies don’t complain, investment banks have strong incentives to underprice the issue. First, underpricing increases the likelihood of oversubscription, which reduces the risk to the underwriter. Second, most investors who get to purchase the IPO at its offering price are preferred customers of the investment bank, and they became preferred custom- ers by generating lots of commissions in the investment bank's sister brokerage company. Therefore, the IPO is an easy way for the underwriter to reward customers for past and future commissions. Third, the underwriter needs an honest indication of interest when building the book prior to the offering, and underpricing is a possible way to secure this, information from the institutional investors. But why don't issuing companies object to underpricing? Some do, and they are seek- ing alternative ways to issue securities, such as OpenIPO. However, most seem content to leave some money on the table. The best explanations scem to be that: (1) The company wants to create excitement, and a price run-up on the first day does that. (2) Only a small percentage of the company’s stock generally is offered to the public, so current stockhold- ers lose less to underpricing than appears at first glance. (3) IPO companies generally plan to have additional offerings in the future, and the best way to ensure future success is to hhave a successful IPO, which underpricing guarantees. Although IPOs on average provide large first-day returns, their long-term returns over the following 3 years are below average. For example, if you could not get in at the IPO price but purchased a portfolio of IPO stocks on their second day of trading, your 3-year return would have been lower than the return on a portfolio of similar but seasoned stocks. In summary, the offering price appears to be too low, but the first-day run-up is generally too high. 18-3g The Costs of Going Public How much does it cost to go public? Suppose RipleyTech (RT) goes public by selling § million shares atan offer price of $20 per share. Investment banks usually charge a 7% spread between the price they pay the issuing company and the price at which they sell shares to the public, although it can be lower for very large IPOs. For RT, the underwriting spread is 7%, and the underwriting fee is $1.40 per share: $20(0.07) = $1.40. Therefore, RT receives only $18.60 per share: $20.00 ~ $1.40 = $18.60, In total, RI receives $93 million: $18,60(5 million) = $93 million, The total underwriting fee is $7 million: $1.40(6 million) = $7 million, ‘There are other direct costs as well, with fees for lawyers, external auditing, printing, engraving stock certificates, registration, and filing. For IPOs with gross proceeds less “Ror the source of data in this paragraph, sce the source cited in footnote 5, For information on the offer price relative othe range in the initial filing see Table 7in footnote 5 sourceCChapter 18 Public and Private Financing: Initial Offerings, Seasoned Offerings, Investment Banks 759 than $50 million, the direct costs average over 7% of the gross proceeds.’ For IPOs rais. ing $50-$100 million, the direct costs are about 4.5% of the proceeds. For larger IPOs, the direct costs are between 1% and 2.5%, Assuming that RT's direct costs are similar to those ‘of other firms its size, the direct costs are $4.5 million: 4.59%($100 million) = $4.5 million. Last but not least are the indirect costs. First, there is the money left on the table, ‘which is equal to the number of shares multiplied by the difference in the first-day closing price and the offering price (assuming the price goes up). During 2017, the average IPO left $34 million on the table, which is about 24% of the average proceeds of SI41.* RI's stock had a typical first-day return of 15% and was up at closing by $3: 159($20) = $3. ‘This suggests that the offer price could have been $23. With an offer price increased by $3, RT could have raised on additional $15 million: $365 million shares) = $15 million. In other words, RT left $15 million on the table because its offer price was too low. In our example, the total of the underwriter fee, direct costs, and money left on the table is $26.5 million: $7 million + $4.5 million + $15 million = $26.5 million. In addi- tion, senior managers spend an enormous amount of time working on the IPO rather than ‘on managing the business, which certainly carries a high cost even if it cannot be easily measured. As you can see, an IPO is quite expensive.’ 18-3h The Importance of the Secondary Market An active secondary market after the IPO provides the pre-IPO shareholders with a chance to convert some of their wealth into cash, makes it easier for the company to raise additional capital later, makes employee stock options more attractive, and makes it easier for the company to use its stock to acquire other companies. Without an active secondary market, there would be little reason to have an IPO. Thus, companies should try to ensure that their stock will trade in an active secondary market before they incur the high costs of an IPO. As part of the IPO process, the stock will be listed on a stock exchange, usually the NYSE or the NASDAQ. To belisted, a company must apply to an exchange, pay a relatively small fee, and meet the exchange's minimum requirements regarding net income, total market value, and “float,” which is the number of shares outstanding and in the hands of outsiders (as opposed to the number held by insiders, who generally do not actively trade their stock). Also, the company must agree to disclose certain information to the exchange and to help the exchange track trading patterns and thus ensure that no one is, attempting to manipulate the stock’s price. [As part of its IPO duties, the investment bank (or its parent company) usually agrees to make a market in a company’s stock by holding an inventory of the shares and meeting, “These estimates are based on survey results ina PWC publication, “Considering an 1PO? The Costs of Goi and Being Public May Surprise You.” See httpeliwwwstrategyand.pwe.com/mediafielStrategyand ‘Considering-an-IPO.paf, "Ror the source of data this paragraph, se the soure cited in footnote 5, For information on the money left ‘onthe table, ce‘Table lain that source, ‘Bor more on IPOs, see Roger G. Ibbotson, Jody 1, Sindela, and Jay R. Rite, “the Market's Problems with the Pricing of Inital Public Offerings,” Journal of Applied Corporate Finance, Spring 1994, pp. 65-74; Chris J. Mascarella and Michael R.Vetsuypens, “Ihe Underpricing of Second’ Initial Public Oferings” Journal of Financial Research, Fal 1989, pp. 183-192; Jay R. Ritter, "The Long-Run Performance of Initial Pubic Otler- Ings" Journal of Finance, March 1891, pp. 3-27; and Jay R. Ritter, “Tastial Pubic Offerings,” Contemporary Pinance Digest, Spring 1998, pp 5-30. "Gor additional discussion on the benefits of listing, see H. Kent Baker and Richard B. Bdelman, “AMEX. to-NYSE Transfers, Market Microstructure, and Shareholder Wealth,” Financial Management, Winter 1992, ‘pp. 60-72; and Richard B. elman and H. Kent Bake, "Liguidty ad Stock Exchange Listing,” The Financial Review, May 1980, pp. 231-288.760 Part 8 Tactical Financing Decisions demand in the secondary market by offering to buy or sell the stock. The diligence with ‘which it carries out this task can have a huge effect on the stock’s liquidity in the second- ary market and thus on the success of the IPO. 18-3i Regulating the Secondary Market ‘As we stated earlier, a liquid and crime-free secondary market is critical to the success of an IPO or any other publicly traded security. So, in addition to regulating the process for issuing securities, the Securities Exchange Commission also has responsibilities in the secondary markets, The primary elements of SEC regulation are set forth next 1. Stockexchanges. The SEC regulates all national stock exchanges, and companies whose securities ae listed on an exchange must file annual reports similar to the registration statement with both the SEC and the exchange. Insider trading. The SEC has control over trading by corporate insiders, Officers, directors, and major stockholders must file monthly reports of changes in their hold- ings of the stock of the corporation, Any short-term profits from such transactions ‘must be turned over to the corporation. 3. Market manipulation. The SEC has the power to prohibit manipulation by such devices as pools (large amounts of money used to buy or sell stocks to artificially affect prices) or wash sales (sales between members of the same group to record arti ficial transaction prices). 4, Proxy statements. The SEC has control over the proxy statement and the way the com- pany uses it to solicit votes. 2, Control over credit used to buy securities is exercised by the Federal Reserve Board through margin requirements, which specify the maximum percentage of the purchase price someone can borrow. If a great deal of margin borrowing has persisted, then a decline in stock prices can result in inadequate coverages, This could force stockbrokers {o issue margin calls, which require investors either to put up more money or have their rmargined stock sold to pay off their loans. Such forced sales further depress the stock market and thus can set off a downward spiral. The required “initial margin” at the time a stock is purchased has been 50% since 1974; required “maintenance margin’ after the initial purchase is lower than the initial margin and is set by the individual lender. ‘The securities industry itself realizes the importance of stable markets, sound broker- age firms, and the absence of stock manipulation." Therefore, the various exchanges work closely with the SEC to police transactions and to maintain the integrity and credibility of the system, Similarly the Financial Industry Regulatory Authority (FINRA) cooperates with the SEC to police trading and broker conduct. These industry groups also cooper- ate with regulatory authorities to set standards for securities firms, to develop insurance programs to protect the customers of failed brokerage houses, and to provide resolution of complaints made by investors regarding brokers. In general, government regulation of securities trading, as well as industry self-regula- tion, is designed to ensure that: (1) Investors receive information that is as accurate as pos- sible. (2) No one artificially manipulates the market price of a given stock. (3) Corporate insiders do not take advantage of their position to profit in their companies’ stocks at the ‘Tete egal for anyone to attempt to manipulate the price of stock, During the 1920s and earlie, syndicates ‘would buy and sll stocks back and forth a rigged prices so the pubic would believe thata particular stock was ‘worth more o less than is trv val. he stock exe encouragement and support ofthe SEC utilize sophisticated computer programe to help spot any iregularties that suggest manipulation, and they require disclosures to help identify manipulators, Ths aystem also helps to identify legal insider trading, Its nowillegel to manipulate a stock's prie by spreading false news onthe Internet.CChapter 18 Publicand Private Financing: Initial Offerings, Seasoned Offerings, Investment Banks 761 expense of other stockholders. The SEC, the state regulators, and the industry itself can’t prevent investors from making foolish decisions or from having “bad luck,” but they can and do help investors obtain the best data possible for making sound investment decisions. 18-3j Questionable IPO Practices Among the many revelations to come out during 2002 regarding investment banking was the practice by some investment banking houses of letting CEOs and other high-ranking. corporate executives in on “hot” IPOs, In these deals, the demand for the new stock was, far greater than supply atthe offering price, so the investment banks were virtually certain that the stock would soar far above the offering price. Some investment banks systematically allocated shares of hot IPOs to executives of ‘companies that were issuing stocks and bonds—and thus generating fees to the banks who underwrote the deals. Bernie Ebbers, the chairman and CEO of WorldCom—one of the biggest sources of underwriting fees for investment banks—was given huge allocations in hot IPOs, and he made millions on these deals. Ebbersis just one example; alot of this was going on in the late 1990s, atthe height of the tech/dot-com bubble. Government regulators investigated this practice, called “spinning,” and corporate ‘executives and investment bankers were charged with something that amounts to a kick- back scheme under which those executives who favored particular investment banks were rewarded with allocations in hot IPOs. Indeed, in 2003 ten Wall Street securities firms agreed to pay $1.4 billion in fines to settle charges of investor abuse, including spinning. ‘The corporate executives were paid to work for their stockholders, so they should have turned over any 1PO profits to their companies—not kept those profits for themselves. ‘This practice was found to be a form of bribery by the New York Supreme Court and was ruled to be illegal in 2006. ‘This kind of unethical and illegal behavior may help to explain past IPO underpric- ing and money left on the table if executives allowed their IPOs to be underpriced in exchange for allocations of similarly underpriced shares in other IPOs. Whether or not similar activities take place now remains to be seen. In summary, we have a hard time justifying IPO underpricing during the late 1990s on rational economic grounds. Researchers and analysts have come up with explanations for ‘why companies let their investment banks price their stocks too low in IPOs, but those rea- sons seem rather weak. However, when coupled with what may have been a kickback scheme, the underpricing is less puzzling (but still ethically troubling). Before closing, we should ‘make it clear that relatively few corporate executives were corrupt, However, just as one rot- ten apple can spoil an entire barrel, a few bad executives—when combined with lax regula- tion—can help a bad practice become “the industry standard,” and thus become widespread, SEreeee Tey What is the difference between best efforts and underwriting? What are some SEC regulations regarding sales of new securities? What isa roadshow? What is book building? What is underpricing? What is leaving money on the table? What are some of the costs of going public? Aprivately held company has an estimated value of equity equal to $100 million. The founders ‘awn 10 millon shares. Ifthe company goes public and sells 1 milion shares with no underwriting costs, how much should the per share offer price be? ($10.00) ifinstead the underwriting spread 157%, what should the offer price be? ($8.83)