McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved CHAPTER 19 Issuing Securities to the Public

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Executive Summary This chapter looks at how corporations issue securities to the investing public. As the basic procedure for selling debt and equity securities are essentially the same. This chapter focuses on equity. This chapter looks at how corporations issue securities to the investing public. As the basic procedure for selling debt and equity securities are essentially the same. This chapter focuses on equity.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Chapter Outline 19.1 The Public Issue 19.2 Alternative Issue Methods 19.3 The Cash Offer 19.4 The Announcement of New Equity and the Value of the Firm 19.5 The Cost of New Issues 19.6 Rights 19.7 The Rights Puzzle 19.8 Shelf Registration 19.9 The Private Equity Market Summary and Conclusions 19.1 The Public Issue 19.2 Alternative Issue Methods 19.3 The Cash Offer 19.4 The Announcement of New Equity and the Value of the Firm 19.5 The Cost of New Issues 19.6 Rights 19.7 The Rights Puzzle 19.8 Shelf Registration 19.9 The Private Equity Market Summary and Conclusions

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Public Issue The Basic Procedure Management gets the approval of the Board of Directors. The firm prepares and files a registration statement with the SEC. The SEC studies the registration statement during the waiting period. The firm prepares and 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. The Basic Procedure Management gets the approval of the Board of Directors. The firm prepares and files a registration statement with the SEC. The SEC studies the registration statement during the waiting period. The firm prepares and 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.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Process of A Public Offering Steps in Public OfferingTime 1. Pre-underwriting conferences 2. Registration statements 3. Pricing the issue 4. Public offering and sale 5. Market stabilization Steps in Public OfferingTime 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

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved An Example of a Tombstone Advertisement

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Alternative Issue Methods There are two kinds of public issues: The general cash offer The rights offer Almost all debt is sold in general cash offerings. There are two kinds of public issues: The general cash offer The rights offer Almost all debt is sold in general cash offerings.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Cash Offer There are two methods for issuing securities for cash: Firm Commitment Best Efforts There are two methods for selecting an underwriter Competitive Negotiated There are two methods for issuing securities for cash: Firm Commitment Best Efforts There are two methods for selecting an underwriter Competitive Negotiated

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Firm Commitment Under a firm commitment underwriting, the investment bank buys the securities outright from the issuing firm. Obviously, they need to make a profit, so they buy at “wholesale” and try to resell at “retail”. To minimize their risk, the investment bankers combine to form an underwriting syndicate to share the risk and help sell the issue to the public. Under a firm commitment underwriting, the investment bank buys the securities outright from the issuing firm. Obviously, they need to make a profit, so they buy at “wholesale” and try to resell at “retail”. To minimize their risk, the investment bankers combine to form an underwriting syndicate to share the risk and help sell the issue to the public.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Best Efforts Under a best efforts underwriting, the underwriter does not buy the issue from the issuing firm. Instead, the underwriter acts as an agent, receiving a commission for each share sold, and using its “best efforts” to sell the entire issue. This is more common for initial public offerings than for seasoned new issues. Under a best efforts underwriting, the underwriter does not buy the issue from the issuing firm. Instead, the underwriter acts as an agent, receiving a commission for each share sold, and using its “best efforts” to sell the entire issue. This is more common for initial public offerings than for seasoned new issues.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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 Managerial Information Since the managers are the insiders, perhaps they are selling new stock because they think it is overpriced. Debt Capacity If the market infers that the managers are issuing new equity to reduce their debt-equity ratio due to the specter of financial distress the stock price will fall. Falling Earnings The market value of existing equity drops on the announcement of a new issue of common stock. Reasons include Managerial Information Since the managers are the insiders, perhaps they are selling new stock because they think it is overpriced. Debt Capacity If the market infers that the managers are issuing new equity to reduce their debt-equity ratio due to the specter of financial distress the stock price will fall. Falling Earnings

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Cost of New Issues 1. Spread or underwriting discount 2. Other direct expenses 3. Indirect expenses 4. Abnormal returns 5. Underpricing 6. Green Shoe Option 1. Spread or underwriting discount 2. Other direct expenses 3. Indirect expenses 4. Abnormal returns 5. Underpricing 6. Green Shoe Option

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Costs of Public Offerings Equity Proceeds Direct CostsUnderpricing (in millions)SEOsIPOsIPOs %16.96%16.36% %11.63%9.65% %9.70%12.48% %8.72%13.65% %8.20%11.31% %7.91%8.91% %7.06%7.16% %6.53%5.70% 500 and up3.15%5.72%7.53% Equity Proceeds Direct CostsUnderpricing (in millions)SEOsIPOsIPOs %16.96%16.36% %11.63%9.65% %9.70%12.48% %8.72%13.65% %8.20%11.31% %7.91%8.91% %7.06%7.16% %6.53%5.70% 500 and up3.15%5.72%7.53%

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Rights 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 percentage ownership if they so desire. 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 percentage ownership if they so desire.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Mechanics of Rights Offerings The management of the firm must decide: The exercise price (the price existing shareholders must pay for new shares). How many rights will be required to purchase one new share of stock. These rights have value: Shareholders can either exercise their rights or sell their rights. The management of the firm must decide: The exercise price (the price existing shareholders must pay for new shares). How many rights will be required to purchase one new share of stock. These rights have value: Shareholders can either exercise their rights or sell their rights.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Rights Offering Example Popular Delusions, Inc. is proposing a rights offering. There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new shares issued at a $20 subscription price. What is the new market value of the firm? What is the ex-rights price? What is the value of a right? Popular Delusions, Inc. is proposing a rights offering. There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new shares issued at a $20 subscription price. What is the new market value of the firm? What is the ex-rights price? What is the value of a right?

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved What is the new market value of the firm? shares 20$ shares 000,10 share 25$ shares 000,200000,200,5$  There are 200,000 outstanding shares at $25 each. There will be 10,000 new shares issued at a $20 subscription price.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved What is the Ex-Rights Price? There are 110,000 outstanding shares of a firm with a market value of $5,200,000. Thus the value of an ex-rights share is: There are 110,000 outstanding shares of a firm with a market value of $5,200,000. Thus the value of an ex-rights share is: = $ $5,200, ,000 shares

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved What is the Ex-Rights Price? Thus the value of a right is $ = $25 – $ Thus the value of a right is $ = $25 – $

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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 one explanation is entirely convincing. 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 one explanation is entirely convincing.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Shelf Registration Permits a corporation to register an offering that it reasonably expects to sell within the next two years. Not all companies are allowed shelf registration. Qualifications include: The firm must be rated investment grade. The cannot have recently defaulted on debt. The market capitalization must be > $75 m. No recent SEC violations. Permits a corporation to register an offering that it reasonably expects to sell within the next two years. Not all companies are allowed shelf registration. Qualifications include: The firm must be rated investment grade. The cannot have recently defaulted on debt. The market capitalization must be > $75 m. No recent SEC violations.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Private Equity Market The previous sections of this chapter assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market. For start-up firms and firms in financial trouble, the public equity market is often not available. The previous sections of this chapter assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market. For start-up firms and firms in financial trouble, the public equity market is often not available.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Private Placements Avoid the costly procedures associated with the registration requirements that are a part of public issues. The SEC restricts private placement issues ot no more than a couple of dozen knowledgeable investors including institutions such as insurance companies and pension funds. The biggest drawback is that the securities cannot be easily resold. Avoid the costly procedures associated with the registration requirements that are a part of public issues. The SEC restricts private placement issues ot no more than a couple of dozen knowledgeable investors including institutions such as insurance companies and pension funds. The biggest drawback is that the securities cannot be easily resold.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Venture Capital The limited partnership is the dominant form of intermediation in this market. There are four 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, typically with incomes in excess of $100,000 and newt worth over $1,000,000. Often these “angels” have substantial business experience and are able to tolerate high risks. The limited partnership is the dominant form of intermediation in this market. There are four 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, typically with incomes in excess of $100,000 and newt worth over $1,000,000. Often these “angels” have substantial business experience and are able to tolerate high risks.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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).

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Stages of Financing 1. Seed-Money Stage: Small amount of money to prove a concept or develop a product. 2. Start-Up Funds are likely to pay for marketing and product refinement. 3. First-Round Financing Additional money to begin sales and manufacturing. 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 firm that is at least breaking even and contemplating expansion; a.k.a. mezzanine financing. 6. Fourth-Round Financing Financing for a firm that is likely to go public within 6 months; a.k.a. bridge financing. 1. Seed-Money Stage: Small amount of money to prove a concept or develop a product. 2. Start-Up Funds are likely to pay for marketing and product refinement. 3. First-Round Financing Additional money to begin sales and manufacturing. 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 firm that is at least breaking even and contemplating expansion; a.k.a. mezzanine financing. 6. Fourth-Round Financing Financing for a firm that is likely to go public within 6 months; a.k.a. bridge financing.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Summary and Conclusions Larger issues have proportionately much lower costs of issuing equity than small ones. Firm-commitment underwriting is far more prevalent for large issues than is best-effort underwriting. Smaller issues probably use best effort because of the greater uncertainty. Rights offering are cheaper than general cash offers. Shelf registration is a new method of issuing new debt and equity. Venture capitalists are an increasingly important influence in start-up firms and subsequent financing. Larger issues have proportionately much lower costs of issuing equity than small ones. Firm-commitment underwriting is far more prevalent for large issues than is best-effort underwriting. Smaller issues probably use best effort because of the greater uncertainty. Rights offering are cheaper than general cash offers. Shelf registration is a new method of issuing new debt and equity. Venture capitalists are an increasingly important influence in start-up firms and subsequent financing.