All About Initial Public
Stock Offering (IPO's)
The
question is often asked how to go about purchasing an Initial
Public Offering (IPO). Unfortunately, it's not so easy. However,
to understand why, we will explain how a company goes from the
point A where they decide they want to go public, to point B where
they actually go public and their stock shares are sold publicly.
When companies are considering an IPO they
must first evaluate the financial issues to decide whether it
is a viable financing option, and they must identify which means
they wish to use to sell the Initial Stock Offering.
During recent years there's been a growth
in Internet companies, run by online investment bankers, or "e-managers"
where companies and investors can buy and sell initial public
offerings (IPO's) for corporate stock. Companies have a choice
of using an traditional investment banker, or an online investment
banker, when selling their IPO.
In this report we focus on the second decision.
The issue that arises from this choice is to identify the differences
between the traditional IPO process and the new information technology
enabled process. Based on an analysis of several online investment
banking firms, we identify the implications this new market has
for companies making a stock offering, traditional investment
bankers, the new online intermediaries, and both larger and smaller
investors.
TRADITIONAL IPO PROCESS
The traditional IPO process
involves the company selling the IPO, an investment banker that
acts as an intermediary between the seller and buyers, and a select
group of typically larger investors. This process has been used
for IPOs for well over a century, but some inefficiencies have
evolved during that time.
The traditional investment banker receives
a commission on the amount of money raised in the IPO. Besides
transaction costs, there is the practice of "spinning."
Spinning involves investment bankers giving out shares to favored
or potential customers in hopes of winning future business.
Several firms have been investigated by
the SEC for such practices. Theoretically, companies should be
able to make more money on their IPO by receiving a price closer
to the price at which the shares begin trading on.
The regular investment banker provides
services such as pricing the initial offering and providing access
to a select group of large investors.
The initial trade of some IPOs can be sharply
above their offering price, enabling the investors to pocket a
quick profit that might otherwise have gone to the company. Because
of high transaction costs and a less than open market, a new information*technology
enabled IPO process has emerged in the past few years.
NEW IPO PROCESS ENABLED BY INTERNET MARKETS
The new IPO process involves
the same seller, but a different form of intermediary. The new
online investment banker provides an Internet-based IPO market
with access to a more open market including a larger number of
smaller investors. The primary goal is to level the Wall Street
playing field by giving the little guy, who are the individual
investors, a chance to invest in a company when it first offers
shares to the public and before the stock actually begins trading
in the markets.
IMPLICATIONS
Implications for Companies
Selling Initial Public Stock Offering. Since firms now can do
IPO's online they seem to have more risk in comparison to using
online investment banker. If they use the new online process they
can reduce their commissions and sell their IPO to a larger number
of smaller investors which shifts profits to them and away from
the investment banker and the larger investors. Their choice is
the classic risk versus return scenario.
Initial Public Stock Offering
Trader Implications. The first implication for I.P.O. investors
is that large investors will, in many cases, lose their protected
status that allowed them the first chance to purchase a new stock
offering. The market will be more competitive from the buyer side.
The second implication is that smaller investors will now have
a better chance to buy stock through IPOs.
Traditional Investment Banker
Implications. The first implication for traditional investment
bankers is that they can expect competition from online firms
for public stock offering's with the result being less demand
for their services. This is especially true for new Internet-based
companies that wish to maximize the revenues they receive from
their IPO. The second implication is a more competitive market
will reduce the percentages paid by companies for the investment
banking services. Even when their services are preferred it will
be difficult to demand the traditional higher commission rates
they commanded in the past.
Implications for Online
Investment Bankers. The first implication for online investment
bankers is that they should expect an increase in the number of
IPO offerings being made through the Internet because transaction
fees are lower. Lower transaction fees, and access to a larger
market, provide financial benefits to both IPO sellers and buyers.
The second implication is these companies
have 2 strategic options in this new "e-manager" market.
To enter the IPO intermediary market, companies will likely have
to initially compete on price, by offering their services for
a low commission rate. The online investment bankers who succeed
in the long run will be the ones that are an early market entrant
and become a trusted intermediary.
Once the intermediary company has gained
a reputation as a trusted broker for IPO sales, they can increase
their fees as they differentiate themselves from late market entrants.
CONCLUSIONS
The overall conclusion of this Initial Public
Stock Offering special report is IPO sellers and buyers are better
off with more investment banking options. IPO sellers now have a
choice of 2 alternatives each with their own strengths and weaknesses.
When a corporation needs to raise capital,
they either issue debt securities (bonds) or by equity (selling
stock). Anytime a corporation issues new stock it comes from 'Authorized
But Not Yet Issued Stock'. If the corporation has sold stock before,
this is known as a 'Primary Offering'.
Assuming the company is using an investment
bank, there are several things the parties need to discuss, negotiate,
and agree on. They need to agree on the amount of capital needed
by the corporation, the type of security to be issued, the price
of the security, any special features of the security, and the
cost to the firm to issue the securities. If they can agree on
these things, the investment bank will act as the middleman between
the corporation and the general public.
A firm may have many Primary Offerings.
If the corporation has never sold stock before it is known as
an 'Initial Public Stock Offering'. A company can only have one
Initial Public Stock Offering. The first step for the corporation
is to hire an investment bank. The investment bank will act as
the advisor and the distributor. This firm is also known as the
'Underwriter'.
'Underwriting' is the actual process of
raising capital through debt or equity. The corporation seeking
to raise capital doesn't necessarily need to use an investment
bank. There are no rules to say that they have to. If they wanted
to, they could go door to door selling their bonds or stock!
There are two different types of agreements
between the investment bank and the corporation. The first of
these is the 'Firm Commitment'. With a 'Firm Commitment' the investment
bank agrees to purchase the entire issue from the corporation
and then re-offer them to the general public.
With this type of an agreement, the investment
bank has guaranteed to provide a certain amount of money to the
corporation. The risk of the issue falls entirely upon the investment
bank. If it fails to re-sell the amounts of securities it purchased,
the investment bank still has to pay the agreed upon sum of money
to the corporation.
The second type of agreement is known as
a 'Best Effort' agreement. With a Best Effort agreement, the investment
bank agrees to sell the securities for the corporation but does
not guarantee the amount of capital raised by the issue.
When a company makes a public offering
it must comply with the Act of Full Disclosure. This is in The
Securities Act. They must file a 'Registration Statement'. The
investment bank will file the registration statement with the
SEC.
The day the investment bank turns in the
registration statement with the SEC is known as the filing date.
Contained in this registration statement will be a description
of the business raising the money, biographical material on the
officers and directors of the company, the amount of shares each
insider (officers, directors, and shareholders owning more than
10% of the securities) owns.
Also, complete financial statements including
existing debt and equity securities and how they are capitalized,
where the proceeds of the offering are going (use of funds), and
any legal proceedings involving the company including strikes,
lawsuits, antitrust actions, copyright/patent infringement suits,
all for the present or if they are aware of impending or future
actions.
After the registration statement is filed
by the investment bank on behalf of the issuing corporation, the
SEC requires a 'Cooling Off Period'. During the Cooling Off Period,
the issue is considered as 'In Registration'. During the Cooling
Off Period, while the issue is in registration, the SEC will investigate
and make sure that 'Full Disclosure' has been made.
During the cooling off period the investment
bank will try to drum up interest in the issue. They do this by
distributing a 'Preliminary Prospectus'. The preliminary prospectus
is also known as a 'Red Herring'. It has red printing across the
top and in the margins. The investment bank pays for the printing
of the red herring.
Contained in the red herring is much of
the information from the registration statement including a description
of the company, a description of the securities to be issued,
the company's financial statements, the company's current activities,
any regulatory bodies over-seeing the firm, nature of the company's
competition, who the management of the company is, and planned
use of funds from the issue.
Assuming the new issue is approved by the
SEC, the stock will be offered to the general public. This date
is the 'Effective Date'. If the SEC does not approve the issue,
a 'Letter of Deficiency' is issued. The letter of deficiency will
notify the company what was wrong. Thus, the effective date will
be postponed.
The public offering price is determined
on the effective date. That way, the issue can be prices in accordance
with current market conditions.
If clients are interested in the new stock
offering, the client will give his stock broker an 'Indication
of Interest'. The stockbroker can't take an order for the issue
from the client. All the client is allowed to do is indicate that
he is interested. The higher the indication of interest is from
clients, the better for the offering. In fact, it will probably
aid the investment bank in making pricing decisions.
While the issue is in registration (during
the cooling off period) the investment bank may not provide any
other information to its clients other than what is contained
in the red herring. They can't provide research reports, recommendations,
sales literature, or anything from any other firm about the company.
They can only provide the client with the red herring.
Just before the effective date the investment
bank will sit down with their client (the issuing corporation)
and have a 'Due Diligence' meeting. They will iron out any last
minute things which have come up. And they will make sure that
there are no material changes which have taken place between the
registration date and the effective date.
Once the effective date arrives, the security
can be sold and money collected. Also, the 'Final Prospectus'
is issued. This will be very similar to the Red Herring. Except
it will have the missing numbers for the public offering price
and the effective date filled in. It also won't have any red writing
on it.
Many times investment banks don't want
to take on all the risk of an issuing all by themselves. Instead
they form 'Syndicates'. A syndicate is a group of investment bankers
(underwriters) who will participate in selling the issue. Usually,
the 'Syndicate Manager or Underwriting Manager' is the head of
the syndicate.
The underwriting manager will then sign
a letter of intent with the issuing corporation. This formalizes
the relationship. However, it is a non-binding arrangement. Once
the SEC has approved the issue, all parties to the agreement sign
a binding contract which binds the parties to the letter of intent.
There are three primary underwriting contracts. These are the
'Agreement Among Underwriters', the 'Underwriting Agreement',
and the 'Dealer Agreement'.
The 'Underwriting Agreement' is a contract
which is what establishes the relationship between the corporate
issuer of the securities and the underwriters comprising the syndicate.
Or it might be just with one underwriter if there is no syndicate.
The UA is executed by the managing underwriter based on the authority
it has been given.
Finally we get to the so called 'Dealer
Agreement'. The dealer agreement or selling agreement, is the
agreement in which securities dealers who are not part of the
syndicate, are contracted to purchase some of the securities from
the issue. The underwriters may not be able to locate enough purchasers
for the issues. They approach other securities dealers and see
if they might want to participate.
These other securities dealers may have
even been offered a chance to participate as an underwriter but
chose not to. What these other securities dealers can do is help
move the product (the securities) to the general public. Basically,
they are another distribution channel. However, these securities
dealers don't have any risk at all. The Dealer Agreement or selling
agreement will allow these dealers to purchase the securities
at a discount from the offering price in order to fill order they
may have gotten after the effective date from their clients.
All of what we have discussed so far has
been if there was a firm commitment to the corporate issuer by
the syndicate. However, with a 'Best Efforts Underwriting', there
will be no syndicate. The underwriters don't make a commitment
to purchase the securities. They merely agree to do the best that
they can in selling the issue. The underwriters form a 'Selling
Group'. Each participant in the underwriting does his best to
sell his allotted share of the issue.
There is one last variation. That is called
an 'All Or None Underwriting'. Under this type of underwriting
the underwriter agrees to do his best to sell the entire issue
by a certain date. All of the proceeds go into an escrow account.
If the securities are not all sold by the certain date, the money
is returned to the purchasers and the issue is canceled.
The underwriters and dealers get paid out
of the proceeds of the issue offering. The public offering price
is what the general public pays. This is the amount on the face
of the prospectus. However, the issuing corporation receives a
lower price than that from the managing underwriter. The difference
between these two prices is the 'Spread'.
Any firm participating in the underwriting
is compensated out of the spread. The amount of the spread is
determined through a negotiation between the managing underwriter
and the corporate issuer. However, there are certain parameters
which are known to have taken place in previous underwritings
and the negotiations take place around these. All members of the
syndicate are paid out of the spread. The managing underwriter
receives a fixed amount for each share which is sold. This is
referred to as the managers fee.
Also, a portion is kept by each member
of the underwriting syndicate. This is referred to as the underwriting
or syndicate allowance. This compensates each member of the underwriting
syndicate for their expenses and the risk they incur. The selling
group which sells the securities is also allocated a portion of
the spread. This is known as the selling concession. A reallowance
is paid to securities firms which contacts one of the members
of the syndicate to purchase part of the issue to fill its own
customer orders after the effective date. Because this firm has
incurred no risk and made virtually no effort in the underwriting,
this is the smallest fee earned by any firm.
On the hot issues which go through an initial
public stock offering, the shares are limited and the demand might
be high. Generally, a firm which has shares to sell (perhaps one
of the underwriting syndicate) will allocate shares to its top
performing stockbrokers. It's a sort of reward. Each broker will
then call his best customers (assuming they're profile is right
for this particular issue) and see if they are interested in the
issue. If they are, on the effective date the broker will allocate
a portion of the issue to this customer. It's also a reward.
Here's the catch. Most brokerage firms
don't compensate their brokers on these issues unless their client
has held the security for a certain period of time. What they
don't want is for the customer to sell the issue the same day
or a few days later. They want them to hold the security for a
while. The longer the better. If the client wishes to sell quickly,
the probability is that the broker won't get paid his commission
on the sale. Expect the broker to try to talk the client out of
selling the security too soon. And if you do sell the security
quickly, don't expect the broker to call you back with another
hot IPO too soon.
'Private Placements' are the direct sale
of an issue of securities to large institutional investors and
large private investors. There is no public offering. Also, there
is no registration statement. The registration statement's purpose
is to protect the public. Regulation D covers Private Placements.
Under Reg. D. an accredited investor is either an institution
such as banks or insurance companies, Broker/Dealers purchasing
for their own accounts, Employee benefit plans and non-individual
entities with net worth of at least $5,000,000.
Also, Insiders of the issuer, Individuals
with a net worth of at least $1,000,000 (spouse may be included);
or individuals with $200,000 in earnings for each of the past
2 years as well as this year (if spouse is included then $300,000).
Also, the maximum number of non-accredited purchases is limited
to 35. No advertising is permitted. A non-sophisticated investor
must be represented by a 'purchaser representative'. This person
must be an attorney, accountant, or financial planner, etc. There
are also restrictions on the resale of the securities.
Public traders access to initial public
stock offering's are not easy. Not everyone can get the shares
until they hit the secondary market. Also, many IPO's pull back
in price a short time after their effective date. Sometimes patience
pays off. Also, these can be risky securities that are highly
volatile. One should be quite careful when evaluating the purchase
of a new initial public stock offering.
For people who want to purchase shares
of an IPO, it's suggested they call their stock broker. First
see if they are the underwriter or they can tell you who the underwriter
is. Also, find out which firms are part of the underwriting syndicate
- if there is one. Contact those stock market trading firms.
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Initial Public Stock
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