© 2000 John Petroff
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© 2000 John Petroff |
2)- Subsequent new issues of common stock
Over the life of a prosperous corporation, the board of directors will have to ask from time to time existing shareholders at annual general assemblies to authorize new shares to be issued either in stock splits or new subscriptions. As noted earlier, a stock split does not change the fractional ownership of each shareholder in the corporation, it only reduces the market price to make it easier to trade in the stock. A stock split is an indication that the corporation has been growing, but it does not generate additional capital for the corporation. Subscription to newly issued stock will generate capital, but it will also reduce the fractional ownership of existing shareholders if the new stock is sold to outsiders, and may make the existing shareholders unhappy. So, a new subscription must be arranged so that the existing shareholders stay happy. There are several avenues that we consider next.
A new subscription will usually not be approved by shareholders if their fractional ownership is diminished. Indeed, if Company Y has 1,000,000 shares outstanding, and sells another 1,000,000 shares to outsiders, each original shareholder will see his/her participation in the earnings of the corporation reduced by half. To avoid this dilution of existing shareholders interest, the corporation must give the existing shareholders a preemptive right to subscribe to new shares. As explained in Chapter 3, the exercise price for the subscription is set below the current market stock price, and consequently each right has a value. For instance, a share selling at $100 in the stock market can be subscribed with 10 rights for $80; each right is worth
($100 - $80)/11 = $1.82
A shareholder can sell the rights and derive some income in addition to any dividend, or exercise the rights to acquire new shares. With the issue of one right for each share of the 1,000,000 shares outstanding, the corporation would raise
$80 x 1,000,000/10 = $8,000,000
Many large American corporations have ongoing share acquisition plans for their shareholders: rights are sent with annual reports and proxy solicitation statements. The rights have an expiration date, but to allow all shareholders to exercise their rights the deadline is often set at a sufficiently distant date (up to two months). Sometimes, the rights are sent to shareholders with a dividend reinvestment plan to encourage them to put their dividend income back into a larger stock ownership.
Another strategy management can use is to set the subscription price well below the market price. In this case the preemptive right has a substantial value. Let us say that one share quoted in the market at $100 is subscribed with one right to purchase one additional share at the subscription price of $10. After exercising the right, the owner of each initial share owns two shares worth $100 plus $10, equal $110, or $55 each. If there were 1,000,000 shares initially, the company raises $10,000,000 of new capital (i.e. 1,000,000 new shares at $10 each). For shareholders, the effect is mostly one of a stock split with its likely positive message of corporate growth which usually pushes the market price up. This strategy is quickest and least costly for the company because the corporation does not have to rely on an underwriter to sell the shares. Each right is worth $45 which corresponds to the difference between the value of the share subscribed $55 and the price paid of $10. This substantial value that each right represents, should be a strong enough inducement to force shareholders to take advantage of the transaction immediately. The downside is that some shareholders will suffer a substantial loss (i.e. $45 per share) and dilution if they fail to exercise their rights (as some always do). Because of that, the exercise price is usually not set so low as to reduce the value of a right to less than 8% of the market value of a stock.
See review questions Q-12B2.1 through Q-12B2.7.
Corporations that are smaller, less prestigious or with unstable markets have not been successful raising new capital with preemptive rights. Indeed, as mentioned above, the value of rights is usually a small fraction of the market value of the stock, and can become negligible if the market price of the stock drops. In addition, the use of rights does not prevent some dilution to take place anyway because, even when the value of rights is not negligible, some shareholders neglect to either exercise or sell them; (the shares to which the neglectful shareholders were entitled, are sold to other shareholders who then use their oversubscription privileges). The use of rights is also an administrative burden for the corporation, and an inconvenience for potential outside investors. As a result, charters of many corporations have been modified to revoke preemptive rights clauses in states where preemptive rights are not mandated by law. Existing shareholders have voted this change to give management flexibility in raising new capital effectively, and to recognize that dilution of their fractional ownership is usually very small.
When preemptive rights need not be issued, the corporation can go directly to an investment banker to issue new shares, just as for an initial public offering, but in this case it is referred to as seasoned new issue. The offer of a substantial volume of new shares will usually depress the price of the stock in the market (because supply exceeds demand), but the price should return to or rise above its previous level if the prospects of corporate growth with the new capital are sound. To avoid the dip in market price, an underwriter can buy a substantial portion of the new issue. Later when market conditions are more propitious the underwriter sells the stock at a gain. When a large block of previously issued shares is sold it is known as secondary offering.
While this method of raising new capital is more expedient for management, it is also more costly. As indicated previously, the fees charged by investment banks can add 5% to the cost of a new issue, when compared to the use of rights. On top of additional cost, the method is also potentially harmful for shareholder relations. But, when management encounters shareholders' apathy and must find a way of selling shares, any method is better than missing opportunities. This is where on-line marketing can be especially beneficial for a corporation selling additional shares: as opposed to IPO's, investors have historical data to judge the corporation by.
c)- Warrants and conversion rights
A corporation can use a deferred method of selling new shares by issuing preferred stock or bonds that are convertible into common stock. The key idea in these hybrid securities is that a fixed income security may be converted into common stock if certain conditions occur. Financing with bonds and preferred stock will be further discussed later for their own merits; what is studied here is the common share acquisition feature. It is undeniable that corporations are constantly seeking additional ways for increasing equity because of internal needs and resistance of investors to take on the risk of the corporation. Packaging the sale of shares together with a fixed income security, can be an effective way of making a potential investor acquainted with the company. When a corporation needs to attract new funds for its capital projects, but does not know if it needs permanent or temporary funds because that depends on the success or failure of its projects, then the use of convertible securities is most appropriate. As will be explained later, the use of a call provision can be combined with the conversion right to assure that the share will be purchased by holders of warrants (provided conditions make exercise of warrants economically beneficial to warrant holders). If projects do not turn out to require permanent funds, the convertible security can be retired at maturity, or purchased in the market. The conversion right is looked upon as a sweetener to encourage investors to buy the convertible security by giving them the hope for a gain if the conversion turns out to be beneficial.
The use of warrants separates the title to acquire common stock from the bond or preferred stock itself. It gives rise to a receipt of funds by the corporation when the warrant is exercised. When a bond itself is convertible, this means that when the bond is converted debt is reduced and capital is increased, no new funds are generated for the corporation. On the contrary, when a warrant is exercised, the holder of the warrant must purchases common shares at the stated exercise price from the corporation: this generates new capital. Warrants and preemptive rights are very similar. They are autonomous titles to acquire common stock, and they can be traded. But there are several differences: warrants are not issued to shareholders but attached to bonds or preferred stocks; the exercise price stated in warrants is usually 10 to 20% above market price (not below market price); and warrants have a longer life, sometime several years or no termination date at all. This makes warrants conditional deferred options to buy stock. They are likely to be exercised if the stock price rises, and to lapse if it doesn't. Sometime the exercise price has a step-up at the end of given period. For instance, a company stock is currently selling for $100, the warrant attached to a bond can have an exercise price of $120 until the end of the first year, then an exercise price of $130 the following year, and $140 the third year.
To end our discussion of warrants let us take a quick look at the decision of using warrants attached to a bond or preferred stock, as opposed to convertible security.The choice between using a convertible security or a warrant depends primarily on anticipated outcomes of the projects undertaken with the funds. The future need can be either for increased equity only, increase in both equity and debt, or neither. If anticipation of excellent results make sense to increase both (equity and debt), the warrant alternative is best. If the possibility of poor results would justify to raise neither equity nor debt, callable convertibles are best (i.e. to avoid warrants that would remain outstanding). If increasing equity is the real long term objective, then a convertible security would work fine, or, alternatively, a warrant with low exercise price attached to a callable bond or preferred stock. The problem with the warrant is that it may not be exercised even when beneficial to the holder.
See review questions Q-12B2.8 through Q-12B2.17.
See research assignments R-12B2.1 through R-12B2.4.
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