Chapter 17Chapter 17IPOs, Investment BankingIPOs, Investment Banking

Mini-Case Presentation

(Randy’s Restaurants)

Animesh Bhattacharya

Alexander Kap

(1) Which Agencies Regulate?(1) Which Agencies Regulate?

Issue is regulation of secondary markets

Securities & Exchange Commission (SEC)– Interstate public offerings: >1 state (usually nationwide)– National stock exchanges: SEC regulates all of them– Insider trading: major stakeholders required to file monthly trading reports– Proxy Process: rules apply to method used to collect shareholder voting

Federal Reserve Board – Margin requirements: Fed specifies maximum percentage of purchase price that

can be borrowed; if left unchecked, may trigger downward spiralling selloff

(1) Which Agencies Regulate? (cont’d)(1) Which Agencies Regulate? (cont’d)

States – Control the issuance of securities within their boundaries– EG: New York State, atty gnrl Eliot Spitzer

Securities Industry – Exchanges (NYSE, AMEX, NASDAQ, etc) and National Association of

Securities Dealers (NASD) – Duty is to maintain the integrity and credibility of overall trading system– EG: NYSE flap over fmr CEO Richard Grasso

(2) How are startups usually financed?(2) How are startups usually financed?

Founder’s resources– Most businesses begin as proprietorships, partnerships– Usually financed by individuals involved

“Angels”: hypothetical first round– Provide some initial seed or growth money ($50 000 - $400 000)– Receive stock, seat on board in return for support– May influence decisions, should have knowledge of industry / experience

Venture capital funds– Funds usually set up as private limited partnerships; $30 - $80 million is typical pool– Institutional investors: have large sums to invest; eg, pension funds, endowments, corp’ns– Venture capitalists (VCs): managers of these funds, sit on boards of companies they fund– Portfolio companies: the companies a particular fund eventually comes to manage (avg 12)– Usually dissolved after pre-specified life elapses (usually 7-10 yrs)

(3) Private Placements vs Public Offerings(3) Private Placements vs Public Offerings

Private Placements– Not required to be registered with SEC– Usually limited to angels / VCs / Institutional Investors – Unlimited for accredited investors (officers, directors, institutional investors), but

limit of 35 to nonaccredited investors (anyone else)– (1) Offering Memorandum: 20-30pp data/information, lawyers prepare– (2) Buyers certified of requirements (net worth, income), promise not to sell to

others who are unqualified

Public Offerings– Basically means allowing the sale of company stocks to outside investors, then

letting these trade on secondary markets– Heavily regulated by SEC (gov’t), NYSE / NASDAQ / major world exchanges– There are many pros and cons to this….

(3) Pros / Cons of “Going Public”(3) Pros / Cons of “Going Public”

The Highlights– Diversification: founders can spread out wealth among other investments– Liquidity: hard to raise cash with illiquid private stock; trading hassles eliminated – Raising Funds Easier: easier for investors to buy (liquidity), public disclosure boosts

investor trust (SEC rules), firm can now raise capital w/o wasteful searching– Establishes Firm Value: can change hands without trouble, stock options– Merger Negotiations: can now pay for acquisitions with reliably-valued stock– Potential Markets: easier to sell products once “public”

The Drawbacks– Reporting Costs: SEC requires disclosure, may be large cost on smaller firms– Disclosure: data available to competitors, data about officers and company now open– Self-Dealings: harder to arrange semi-legal/illegal activities (nepotism, salaries, taxes)– Price Stagnation/Fall: few shares = low real liquidity, lack of coverage– Loss of Control: management may get ousted, pressure for earnings growth

(4) Steps of an IPO (Overview)(4) Steps of an IPO (Overview)

Selection of Primary Banker Creation of Underwriting Syndicate Compliance with Regulations Roadshow / Bookbuilding Day of IPO Ongoing Costs

(4a) Selecting an Investment Banker(4a) Selecting an Investment Banker

Reputation and Experience– Must convince investors that stock isn’t overpriced– If stock nosedives on opening, it will be a disaster for both bank and firm

Must get right mix of investors– Institutional – Retail (individuals)

Secondary market “coverage” after IPO– If well-reputed analysts give good ratings, will boost stock prices– Often, IBs have associated brokerage arms– Serious conflicts of interest may arise without ethical safeguards

(4b) Sealing the Deal(4b) Sealing the Deal

Methods of the Deal– Best Efforts: no guarantee of sale at agreed price, IB “will do best” for fee; most risk is therefore

on firm whose stock is being issued Usually not done unless deals are very risky, involve small firms

– Underwriting: banker guarantees purchase of stock at agreed price, then turns around and sells in secondary market next day (margin = profit)

Bankers bear significant risks if stock tanks next day Best method for firms: will get guaranteed amount of financing IBs have high risk: oral commitments and investor interest carefully assessed before price set!

Negotiation vs Bidding– Competitive bidding: only used for large issues by major firms; even for them, rarely used when

dealing with stocks– Costs are too high for competitive bidding to be so widely used (huge costs involved learning

about involved companies to make good guesses)

(4b) Sealing the Deal (cont’d)(4b) Sealing the Deal (cont’d)

Underwriting Syndicates– Due to huge risks involved, bankers try to work together to minimise (10-15)– Lead Underwriter(s): house setting up deal, working with firm– Selling Group: houses that handle distribution to individual investors; include syndicate members

plus additional dealers

Unsyndicated Offerings: just the opposite– Lead underwriter sells entire issue to institutional investors alone– Make more money from deal (up to full percentage point in some cases)– Fee structure (ie, others involved) greatly reduced– Relatively new, growing in popularity

(4c) The Regulators(4c) The Regulators

SEC is the main regulator– Interstate Public Offerings: SEC handles everything over $1.5 million– Registration: at least 20 days before offering; reviewed before release

Registration Statement (form S-1): financial, legal, technical information Prospectus: summarizes such information for investors

– Red Herring Prospectus: solicitations must be accompanied by this, contains all information to be included in real offering except declared price

If any misrepresentations or omissions on real info, all involved parties are liable

States– Each state can regulate securities sales– More limited than SEC, however– Certain states (NY, NJ, CA, DE) are more important

(4d) Road-show, Bookbuilding, Pricing(4d) Road-show, Bookbuilding, Pricing

“Roadshow”: making the sale to potential investors– Management team often makes several presentations daily to promote new issue– Typically lasts 10-14 days, 10-20 cities (fairly gruelling!)– Quiet Period: certain questions cannot be answered until 25 days after trading starts

Supposed to create level playing field for retail investors– Violation of rules and/or ethical guidelines may force SEC to delay IPO

“Bookbuilding”: racking up interest on issue– IBs records number of shares institutional investors willing to buy after roadshow– “Book” shows how demand for offering is evolving, growing– Oversubsription can occur if investors wish to purchase more shares than are available

High demand may mean that offer price is increased later on– Important to time things correctly, as even good companies may lose out during downturns

(4d) Road-show, Bookbuilding, Pricing(4d) Road-show, Bookbuilding, Pricing

Pricing: lots and lots of research!!!– No established price, even if a privately placed company!– IB and firm must project future earnings and cash flows– Similar companies within industry can be used for fair comparisons

Criteria for Pricing: “rules of thumb” used– Key ratios (eg, Price/Earnings, Market/Book) are set in line with overall industry expectations– Ballpark Price: relevant factors can be used to establish a possible range of possible price (eg,

“$10 - $12”); put on prospectus

(4e) The Big Day: IPO Trading Begins(4e) The Big Day: IPO Trading Begins

First Day Trading: where the real money is– “Wild and Exciting,” even according to (otherwise dry) textbook– Some stocks appreciate to unimaginable (and usually unsustainable) levels

Examples: eBay, Palm, JetBlue, Pets.com For 75% of IPOs, price goes up on first day. Average first-day return is 14.1%. About 10% of IPOs have first-day returns greater than 30%. For some companies, the first-day return is well over 100%.

– Investment banks, institutional investors, insiders, and VCs all make a killing here– Many conflicts of interest centre around these gains

IPO Underpricing: why does it happen?– Strong incentive for IBs to do this, can ensure that they make a killing

Increases chances of oversubscription Commissions generated from brokerage arm Way to ensure interest by investors

– Issuing Companies also don’t object Creates excitement around stock issue at very low cost to existing stockholders Successful IPO generates momentum for future offerings

(5) Direct and Indirect Costs(5) Direct and Indirect Costs

Direct Costs– Spread (ie, between offer price and proceeds) of 7% spread usually charged

by underwriters– Direct costs: lawyers, printers, accountants, etc; can be substantial (over half

a million dollars)

Indirect Costs– Can be very time-consuming for management during months before– On average, raises $70 million, leaves $9 mil on table– “Left on Table” = (# Issued Shares) * (Ending First Day Price – Offer Price)