© 2000 John Petroff
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© 2000 John Petroff |
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When a corporation sells its stock for the first time, this is called an initial public offering. For the sale to generate the desired number of purchases and volume of funds, many aspects must be carefully planned: timing, subscription price, documents to filed and distributed to the public, marketing, distribution of prospectus and shares, and mechanics of the subscription. If the date of the offering happens to coincide with a series of negative events in the stock market, the subscription may fail: no one will buy the stock, and that in itself will mark the stock negatively. For instance, in the first half of year 2000, two thirds of IPO's were held back as NASDAQ index shrank from over 5,000 to close to 3,000.
Setting the date cannot be done at the last minute: an IPO requires several months of preparations in filings documents with local authorities and SEC (for stock offered in more than one state), and receiving registration certificates after a statutory waiting period (for a complete review of legal requirements one should consult a text on securities laws and regulations). Consequently, forecasting of market trends must be part of planning the IPO. Technical analysis described in Chapter 5 can be helpful for that purpose. An investment banker familiar with market trends can offer the most knowledgeable advise.
The subscription price has little to do with book value or par value. What investors will pay depends on expectations of future earnings (as demonstrated in Chapter 3). Thus, the information contained in the prospectus is crucial for convincing prospective buyers, but it is also scrutinized by the SEC for any possible misleading disclosure, and must therefore, be very conservative so as not to lead to any unjustified expectation. Setting the price too high will discourage buyers, setting too low will not generate the expected amount of capital. The subscription price is also depended on the proportion of equity control retained by the founders of the corporation. By issuing the new shares, the founders are essentially leveraging their own investment in the firm. Setting a low price for the issued shares may result in dilution of their interest in the business, and at the extreme, loss of control. The need for the presence of a professional investment banker is again apparent. Required expertise must extent from corporate finance in order to satisfy the expectations of the founders, to SEC requirements so that the prospectus is not rejected.
An underwriter's role becomes even more obvious in the aspects of marketing and distribution. Unless, the company is written and talked about in the media, potential investors must be made aware of the IPO. The clientele of an underwriter may not be enough, and a syndicate of several brokers and dealers is often formed to approach a wider public. The syndicate is also prepared to answer the flood of questions on the "red herring" (the prospectus for which the corporation has not yet SEC registration certificate), and to handle the subscription forms. For all these reasons, corporations have been relying of underwriters to manage new stock issues. If the commitment of the underwriter is only one of best effort, the commission can be as little as half of one percent on issues of $20 million dollars of more, but for issues of less than $1 million the commission can exceed 5%. If the underwriter guarantees the amount of the sale, the commission is higher because the underwriter assumes risk in promising to buy the shares if investors don't, and to maintain an orderly market after the stock is issued. Both of these can very costly.
With the increased trading of shares on-line in the beginning of this century, several internet companies have given the hope of linking investors to corporations issuing new shares directly without the need for underwriter or syndicate. Finding information about IPO's has indeed become much easier with such sites as Hoover (at http://www.hoovers.com/) and Edgar (at http://www.edgar-online.com/). Marketing, distribution and subscription mechanics seem to be facilitated, but other aspects of timing, pricing and proper disclosure still have to be dealt with.
Some IPO's are resounding successes. Witness the oversubscription of privatized companies such as Air France or Deutshe Telekom. But these are world famous entities. For the majority of IPO's, it is well known that there is a period of euphoria immediately following the subscription, which fades away by the time (possibly one year) most firms start experiencing difficulties in carrying out the plans stated in the prospectus. One will recall that the majority of firms will fail. Investors know that and are wary of new issues. This is why, some new businesses have no chance of finding takers for their shares in the stock market with or without underwriter and syndicate. The only alternative is to find venture capital, but that may imply relinquishing a large portion of stock, as well as control over the company.
In the United States, since 1982, the SEC allows shelf-registration. This saves on underwriter's fees because the company can file the registration documents, and more importantly, the company can take up to two years to sell the new issue. The corporation can sell the new shares little by little, and take advantage of best market conditions.
See review questions Q-12B1.1 through Q-12B1.14.
See research assignments R-12B1.1 through R-12B1.3.
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