Chapter 3: Capital Markets - Issuing Securities PDF

# Chapter 3: Capital markets - Issuing Securities ## Capital Markets - Issuing Securities - **From the time the issuance of new securities is approved to the point where proceeds have been received on the sale of these securities, there are seven key steps that are required to be followed.**...

# Chapter 3: Capital markets - Issuing Securities ## Capital Markets - Issuing Securities - **From the time the issuance of new securities is approved to the point where proceeds have been received on the sale of these securities, there are seven key steps that are required to be followed.** 1. The board of directors must approve the issuance of securities and determine whether to sell the securities through a private placement or a public offering. If a public offering is chosen, to be listed on a stock exchange, the listing requirements must be met. In general, companies must meet a threshold of revenues and/or assets to qualify for listing. These listing requirements vary by exchange. 2. The next step is to hire an investment bank to act as the company's underwriter. An underwriter assists with the issuing process by advising on the offer price and helping to market and sell the new securities. 3. If a private placement is to be completed, the investment bank will prepare an offering memorandum and help sell the issue to interested private investors. 4. For a public share offering, the company must decide on the method of issue to be used. Generally, there are two methods of public issues: a cash offer and a rights offer. In a cash offer, the securities are offered to the public as part of a public offering. In a rights offer, the securities are offered to existing shareholders in proportion to their current share holdings. Rights offerings are further discussed in the Sources of Financing - Equity chapter. 5. If a cash offer is being made, the company must decide on the type of underwriting arrangement: a firm commitment or bought deal, a best efforts arrangement, or in rare cases, a Dutch auction. These arrangements are described in Section 3.5 below. 6. The next step is to prepare, finalize, and file the necessary documents, including the prospectus. The prospectus is described in more detail below. 7. The last step is for the underwriter to advise on the final offer price. Once this is known, the prospectus is finalized, the regulators give their final approval, and the shares can start to trade. **Public Offering** - The sale of securities on an exchange to the general public. Once issued, these shares trade on a stock exchange (or bond exchange, depending on the nature of the security). The issuer is required to publish a prospectus to provide information about itself and the securities to be sold and to distribute the prospectus to all potential buyers. A prospectus is a written document prepared by the issuer outlining the amount of funds to be raised in the offering, the nature and terms of the securities to be issued, the use of the funds, a description of the issuer's business and strategy, and historical financial statements. - When initially released, the prospectus is referred to as a preliminary prospectus because the share price is not yet known and therefore has been left blank. The preliminary prospectus is also called a red herring. The share price will be determined and assessed by the underwriters after they have visited large institutional investors to get an understanding of what price might be acceptable for the issue. Once the price is set, the final prospectus with this share price is then issued. This occurs just before the date the shares are available for sale in the market. - If a company is issuing public equity for the first time, this is referred to as an initial public offering (IPO). This is also known as an unseasoned offering. If an entity is issuing new securities, but the company is already traded on the public stock exchange, this is known as a seasoned offering. **Private Placement** - In a private placement, the securities issue is sold to a group of institutional investors, such as an insurance company, pension plan, or mutual fund. The issuer is not required to publish and distribute a prospectus, but instead provides an offering memorandum that describes the proposed terms of the security and provides information regarding the issuer. The majority of bonds and preferred shares are sold through private placements. - **Advantages** - The flotation costs of a private placement are generally less than those of a public placement of similar size. Flotation costs are all the costs incurred to complete a new issue of shares or bonds. Private placements do not have to pay the costs of registration, prospectus printing and distribution expenses, or credit rating fees. There are also no sales commissions, management fees, or underwriting fees because the deal is negotiated directly with investors. As well, if a private company is able to secure a private placement, it will not have the ongoing annual costs associated with being a publicly listed entity. - Private issues can be finalized more rapidly than a public offering. Registration and approval of a prospectus generally takes more time. - Private placements provide more flexibility in issue size than public offerings. While the flotation costs for small public issues are usually prohibitively high, in private placements most of the transaction costs are eliminated through direct negotiations between investors and issuers. This makes small issues economically feasible. - Private placements provide greater flexibility regarding the terms of the issue because they are not bound by the rules of the public exchanges. Also, dealing exclusively with institutional investors makes it easier to change the terms of an issue should the need arise.  - **Disadvantages** - Despite the lower flotation and administrative costs, private placements generally have a higher financial cost than a public offering. Because privately sold securities lack liquidity (that is, cannot be easily sold), investors are likely to demand higher returns. Thus, private investors will buy the securities at deeper discounts than what might be obtained in a public offering. This will provide the investor with a higher expected return given the higher risk.  - Depending on the percentage of ownership the equity investment gives the private investor, the investor may demand representation on the board and involvement in the day-to-day decisions of the company. - Private investors in bonds are also likely to demand tighter covenants on the issuer. Complying with tighter constraints creates additional costs, which increase the overall cost of funds from private placements. ## Role of the Investment Banker - Public offerings generally involve one or more investment bankers, and normally a syndicate (group) of bankers. The investment banker serves as an intermediary between the issuer and the purchasers of the securities, providing advice regarding the type and terms of the securities to be issued and the market in which the securities are to be sold (private or public, foreign or domestic). **Compensation to the Investment Banker** - Compensation to the investment banker or syndicate represents a significant portion of the issuer's cost. In a public offering, the fee can range from 4% to 12% of the aggregate sale price of the issue. In a best-efforts arrangement, the fee will be a fixed percentage of the total proceeds received on issuance of the shares. Under a firm commitment arrangement, the underwriting group (investment banker or syndicate) charges a gross underwriting spread, which is the difference between the sale price (the price listed on the exchange) and the underwriter's purchase price. ## Types of Underwriting Arrangements - The role of the underwriter is very important, as is the type of underwriting arrangement that has been agreed on. Depending on the type of arrangement, the risks and costs for the company issuing the securities will be different. - For a cash offering, there are a variety of underwriting arrangements that can be used. The two most common arrangements used are firm commitment (bought deal) and best efforts, each of which is described below. **Firm Commitment (Bought Deal)** - In a firm commitment underwriting arrangement, also known as a bought deal, the investment bank syndicate offers to buy the entire issue at a guaranteed price. If there is a group of investment bankers, the issuer selects a securities firm to act as the lead investment banker and underwriter. After accepting the job, the lead underwriter invites others to participate in the underwriting and selling of the security. - The underwriter (or syndicate) buys the securities from the issuing company and then resells them to the public market at the purchase price plus the underwriting spread. In this case, the issuer is guaranteed a price per share and the underwriter takes on the risk of selling the shares. - Under this arrangement, the underwriting group bears the risk that the security will not sell in the market as expected. For example, the syndicate may agree to purchase shares for $10 per share from the issuer, hoping to sell them later at $11 per share. The issuer receives $10 per share and the underwriter takes on the risk of selling the shares for more than this. Suppose that, immediately after the agreement, the market turns downward, making it difficult for the underwriting group to sell the shares as expected. In this case, the underwriting group may be forced to sell the shares at a loss. However, the underwriter may also have included a clause in the agreement allowing it to withdraw and decline to sell the issue if the price of the shares drops dramatically. **Best Efforts** - Under a best efforts underwriting arrangement, securities dealers do not purchase shares for sale; instead, they use their best efforts to sell the issue on behalf of the issuer at the highest possible price. Alternatively, the syndicate may buy the issue with an option to return shares to the issuer if the market price drops significantly from the offering price before the sale of the entire issue. In this case, the issue will likely be withdrawn from the market. Normally, private placements, issues of lesser-known companies, and small issues are sold on a best efforts basis. In this case, the issuer takes on the risk of selling the entire issue since any shares not issued can be returned. **Overallotment Option** - The underwriting arrangement may allow for an overallotment option, which gives the underwriter the right to purchase additional shares within a specified time after the initial trade date. The underwriter may purchase these shares from the issuer for the issue price less commissions and fees (or some agreed-on price). The overallotment option is also called the Green Shoe provision. Underwriters will invoke this clause if the issue has been successful, with oversubscription and increasing share prices. The underwriter will then sell these extra shares at the current market price, which is higher than the original offer price, providing the underwriter with higher profits. - This overallotment option comes at a cost to the issuing company since it will only receive the original offer price. For example, suppose that under the agreement, the underwriter purchased the shares for $14 per share, and the underwriter has a 15% overallotment option. Assume that the underwriter exercises its option within the limited time period and receives its overallotment of 150,000 shares when the share is now trading at $25 per share. The company will still only receive $14 per share for these additional shares, but the underwriter can now sell to the public and receive $25 per share. The company has lost the opportunity (resulting in an opportunity cost) to sell its shares at a higher price, and the underwriter has made a higher profit. The company has in effect lost a possible $11 ($25 - $14) per share (ignoring commission fees) on the sale of the 150,000 additional shares. **Lockup Agreements** - Usually, underwriting arrangements also have lockup agreements. These lockup agreements stipulate how long insiders must hold their shares before they can sell them in the public market. Generally, these agreements are for 180 days after the initial trade date. These stipulations avoid the market being flooded with the shares owned by insiders who are now interested in "cashing out" and realizing the increased value of the shares owned in the company. Without this lockup period, the number of shares available for sale could significantly increase, causing the share price to fall – an occurrence that the underwriter is trying to avoid. ## Let's look at an example **Lakers Ships Inc. (Lakers) is considering issuing one million shares to the public for the first time. Management has met with an underwriter that has suggested a firm commitment arrangement. The underwriter has offered a price of $13 per share to the company but believes that the shares can be sold on the market for $14.50 per share. This agreement also has an overallotment option of 15% and a **lockup period of 180 days.** **Required:** 1. Discuss the underwriter's proposal. As part of this discussion, describe the impact on Lakers and the risks that the underwriter and Lakers will have. 2. Independent of part (a), assume that on the first day of trade, the share price opened at $15 but dropped throughout the day, eventually closing at $10. The underwriter was only able to sell the following: - 400,000 shares at $15 per share - 200,000 shares at $14 per share - 150,000 shares at $13 per share - 250,000 shares at $10 per share - Calculate the amount of cash actually received by Lakers under this firm commitment underwriting arrangement. **Solution** 1. In this situation, the underwriter agrees to purchase all one million shares for $13 per share. This will give Lakers immediate cash of $13 million. The 15% overallotment allows the underwriter to purchase another 150,000 shares (one million shares x 15% overallotment provision) at $13 per share to sell in the market. The underwriter will do this if the demand for the new offer is higher than the one million shares and the underwriter knows it can sell these extra shares. Generally, this occurs when demand is high and the share price has increased above the initial offer price. This overallotment allows the underwriter to make a higher profit, but Lakers does not share in these higher share prices because the extra shares are purchased by the underwriter from the company for the original agreed-on price of $13 per share. The lockup period prevents insiders from selling their shares into the public market for 180 days and potentially causing the share price to fall. - The advantage for Lakers in this arrangement is that it is guaranteed $13 million for the issue of its shares. The underwriter takes on all the risk to sell the shares above $13 per share to make a profit. A drawback is that the company loses out on any additional cash that might be raised with the 15% overallotment clause. For example, if Lakers' share price rises to $20, it would sell the shares to the underwriter for only $13 per share under the overallotment clause rather than $20 per share, the now-current market price. This results in an opportunity cost of $7 per share. Additionally, if the price rises on opening day, Lakers may have agreed to too low an offer price with the underwriter and may have been able to raise more funds in total by setting the price higher. - Under the arrangement, the minimum net cash proceeds after all costs (assuming no overallotment occurred) is $13,000,000 - $800,000 = $12,200,000. 2. Under the firm commitment underwriting arrangement, the overallotment will not be taken by the underwriter since the share price has fallen. Lakers will receive the offer price of $13 per share for the sale of one million shares, representing cash of $13,000,000 from the underwriter (before direct costs of $800,000). ## Let's look at an example **Kettle Cookers Inc. (Kettle) is considering issuing one million shares to the public for the first time. Management has met with one underwriter that has recommended a best efforts deal. The underwriter will charge a fee of 5% and there will be no overallotment and no lockup period. The expected initial trading price is $15 per share. **Required:** 1. Discuss the underwriter's proposal. As part of this discussion, describe the impact of the arrangement on Kettle and the risks that the underwriter and Kettle will have. 2. Independent of part (a), assume that on the first day of trade the share price opened at $15 but dropped throughout the day, eventually closing at $10. The underwriter was only able to sell the following: - 400,000 shares at $15 per share - 200,000 shares at $14 per share - 150,000 shares at $13 per share - 250,000 shares at $10 per share - Calculate the amount of cash actually received by Kettle under this best efforts underwriting arrangement. **Solution** 1. Under this arrangement, the underwriter will try its best to sell the shares, but there is no guarantee that all one million shares will be sold. The risk for Kettle is that there might not even be enough shares sold to allow the public offering to proceed and, in the worst-case scenario, the company does not issue any shares. In the best-case scenario, all shares are sold at $15 per share and the underwriter receives a commission of 5% on each sale. Assuming all shares are sold at $15, the company would receive net proceeds of $15,000,000 × (1 - 0.05) - $800,000 = $13,450,000. - The disadvantage of this arrangement is that Kettle is assuming all the risk to sell the shares. If less than one million shares are sold, then less cash is raised and available for Kettle's working capital and capital project investments. This may have a detrimental effect on the company if the capital projects must be undertaken for future viability. 2. Under the best efforts underwriting arrangement, Kettle will pay 5% for a successful sale of the shares. In this case, the underwriter was not able to sell all the shares at $15 per share, as the underwriter would have liked, and the shares were sold at various prices to a number of investors. The total amount of cash is calculated as follows: - 400,000 shares at $15 per share = $6,000,000 - 200,000 shares at $14 per share = $2,800,000 - 150,000 shares at $13 per share = $1,950,000 - 250,000 shares at $10 per share = $2,500,000 - Total gross cash received on sale by underwriter = $13,250,000 - 5% commission = $662,500 - Net cash received by Kettle (before direct costs of $800,000) = $12,587,500 ## IPOs and Underpricing - One of the most difficult acts by the underwriter is to determine the "right" price at which to offer the shares of a company for the first time to the market. To get some input into this decision, the underwriter presents the company's story to institutional investors who provide feedback on the price they would be willing to pay for the shares. With this information, the underwriter then decides on the initial offer price for the issue. If the price is too high, then all the shares that the company wanted to sell may not be sold and less cash would be received. If the share price is set too low, then the company would lose additional cash it could have received with the higher price. - In reviewing the history of IPOs, underpricing appears to happen often. Underpricing occurs when the share price increases on its first day of trading. For example, take a share that had an initial offer price of $15, but by the end of the first day it is trading at $35. Could the company have issued at a price of $35 instead? If so, the company has an opportunity cost of the additional $20 per share. - In summary, underpricing is an opportunity cost for the issuer. If it occurs, then the company may have been able to raise more capital for the same number of shares issued or, alternatively, have issued fewer shares to raise the same amount of capital. ## *Practice Problem 1* **FitEquip Ltd. (FEL) is a manufacturer of fitness equipment. It has three product lines, but its rowing machine represents 75% of total revenues. As a result of the COVID-19 pandemic and the continuously growing number of in-home gyms, FEL's sales have continued to increase, and the company has decided to raise $30 million for a large expansion plan that it wants to start within the next few months.** - FEL is a private company owned equally by four shareholders who all work in key management roles and are directors for the company. There are 2 million shares currently issued and outstanding. - Sheryl Kinrade is the CEO and she has recently met with an advisor to assist FEL with raising capital. Sheryl indicated that she had been approached by a large private investor, HGI Corp., (HGI) that would be willing to invest the funds as a private placement. Sheryl met with the representatives of HGI and was impressed with their knowledge of FEL and its industry. However, the shareholders of FEL have also been thinking of going public to raise this capital. - Sheryl wants to understand the advantages and disadvantages of raising funds, using a private placement compared to a public offering. **Required:** - Prepare a memo to Sheryl with the information she has requested and make a recommendation. **Solution:** **To: Sheryl Kinrade, CEO, FitEquip Ltd. (FEL)** **Re: Advantages and disadvantages of private placement versus a public offering** **You have asked for the advantages and disadvantages of a private placement versus a public offering of shares. I have provided the discussion compared to a public offering include:** - **Advantages of a private placement:** - The flotation costs are lower with a private placement. In FEL's case, you would deal directly with the representatives of HGI Corp. to complete the transaction. In contrast, a public offering would include registering with the securities commission, preparation and distribution of documents including the prospectus, and paying underwriting fees and other professional legal and accounting fees. In addition, as a publicly traded entity, there are ongoing annual costs to be incurred. - A private placement can be completed much more quickly. You indicated that the company needs these funds in the next few months to start the expansion. A public offering will take much longer and will not be completed in that short time period. - There is more flexibility with a private placement. You might consider offering HGI a different class of shares or a bond, instead of common shares. Different terms and conditions of the securities can be customized to what FEL and HGI mutually agree to. For a public offering, there is less flexibility in terms of the type of securities and their terms and conditions offered, since they must appeal to the general public. - **Disadvantages of a private placement:** - In a private placement, the securities are illiquid, meaning that they are not easily disposed of or sold, thereby increasing HGI's risk in this investment. As a result, HGI will demand a higher return, which will increase the cost for FEL, to compensate for this higher risk. In a public offering, the required returns will be lower since investors can sell the shares in the stock market when they are no longer interested in being an investor in the company. - Depending on the number and class of shares issued to HGI to raise the $30 million, HGI could own a large percentage of the company. With this level of ownership, HGI could demand representation on the board of directors and input in the day-to-day decisions of running FEL. The percentage ownership of each of the four existing shareholders will fall as a result of issuing these new shares, and it is possible that HGI will end up having the highest proportionate ownership. With a public offering, the issued shares will be held by many shareholders, with each holding only a small percentage of ownership. **Recommendation** - Based on how quickly FEL requires the funds, a private placement is the best option at this point.