Stock and Bond Offerings

Stock and Bond Offerings

Initial Public Offerings:

An initial public offering (IPO) is the process by which a private company

transforms itself into a public company. The company offers, for the first

time, shares of its equity (ownership) to the investing public. These shares

subsequently trade on a public stock exchange like the New York Stock

Exchange (NYSE) or the Nasdaq.

The first question you may ask is why a company would want to go public.

Many private companies succeed remarkably well as privately owned

enterprises. One privately held company, Cargill books more than $60

billion in annual revenue. And until 1999, Wall Street’s leading investment

bank, Goldman Sachs, was a private company. However, for many large or

growing private companies, a day of reckoning comes for the owners when

they decide to sell a portion of their ownership in their firm to the public.

The primary reason for going through the rigors of an IPO is to raise cash

to fund the growth of a company and to increase the company’s ability to

make acquisitions using stock. For example, industry observers believe

that Goldman Sachs’ partners wished to at least have available a publicly

traded currency (the stock in the company) with which to acquire other

financial services firms.

While obtaining growth capital is the main reason for going public, it is not

the only reason. Often, the owners of a company may simply wish to cash

out either partially or entirely by selling their ownership in the firm in the

offering. Thus, the owners will sell shares in the IPO and get cash for their

equity in the firm. Or, sometimes a company’s CEO may own a majority

or all of the equity, and will offer a few shares in an IPO in order to diversify

his/her net worth or to gain some liquidity. To return to the example of

Goldman Sachs, some felt that another driving force behind the partners’

decision to go public was the feeling that financial markets were at their

peak, and that they could get a good price for their equity in their firm. It

should be noted that going public is not a slam dunk. Firms that are too small, too stagnant or have poor growth prospects will – in general – fail to

find an investment bank (or at least a top-tier investment bank, known as a

“bulge bracket” firm) willing to underwrite their IPOs.

From an investment banking perspective, the IPO process consists of these

three major phases: hiring the mangers, due diligence, and marketing.

Hiring the managers. The first step for a company wishing to go public is

to hire managers for its offering. This choosing of an investment bank is

often referred to as a “beauty contest.” Typically, this process involves

meeting with and interviewing investment bankers from different firms,

discussing the firm’s reasons for going public, and ultimately nailing down

a valuation. In making a valuation, I-bankers, through a mix of art and

science, pitch to the company wishing to go public what they believe the

firm is worth, and therefore how much stock it can realistically sell. Perhaps

understandably, companies often choose the bank that predict the highest

valuation during this beauty contest phase instead of the best-qualified

manager. Almost all IPO candidates select two or more investment banks

to manage the IPO process. The primary manager is known as the “lead

manager,”while additional banks are known as “co-managers.”

Due diligence and drafting. Once managers are selected, the second

phase of the IPO process begins. For investment bankers on the deal, this

phase involves understanding the company’s business as well as possible

scenarios (called due diligence), and then filing the legal documents as

required by the SEC. The SEC legal form used by a company issuing new

public securities is called the S-1 (or prospectus) and requires quite a bit of

effort to draft. Lawyers, accountants, I-bankers, and of course company

management must all toil for countless hours to complete the S-1 in a timely

manner. The final step of filing the completed S-1 usually culminates at

“the printer” (see sidebar in Chapter 8).

Marketing. The third phase of an IPO is the marketing phase. Once the

SEC has approved the prospectus, the company embarks on a roadshow to

sell the deal. Aroadshow involves flying the company’s management coast

to coast (and often to Europe) to visit institutional investors potentially

interested in buying shares in the offering. Typical roadshows last from two

to three weeks, and involve meeting literally hundreds of investors, who

listen to the company’s canned PowerPoint presentation, and then ask

scrutinizing questions. Insiders say money managers decide whether or not

to invest thousands of dollars in a company within just a few minutes into

a presentation.

The marketing phase ends abruptly with the placement and final “pricing”

of the stock, which results in a new security trading in the market.

Investment banks earn fees by taking a percentage commision (called the

“underwriting discount,” usually around 8 percent for an IPO) on the

proceeds of the offering. Successful IPOs will trade up on their first day

(increase in share price). Young public companies that miss their numbers

are dealt with harshly by institutional investors, who not only sell the stock,

causing it to drop precipitously, but also quickly lose confidence in the

management team.

Follow-on Offerings of Stock:

A company that is already publicly traded will sometimes sell stock to the

public again. This type of offering is called a follow-on offering, or a

secondary offering. One reason for a follow-on offering is the same as a

major reason for the initial offering: a company may be growing rapidly,

either by making acquisitions or by internal growth, and may simply require

additional capital.

Another reason that a company would issue a follow-on offering is similar

to the cashing out scenario in the IPO. In a secondary offering, a large

existing shareholder (usually the largest shareholder, say, the CEO or

founder) may wish to sell a large block of stock in one fell swoop. The

reason for this is that this must be done through an additional offering

(rather than through a simple sale on the stock market through a broker), is

that a company may have shareholders with “unregistered” stock who wish

to sell large blocks of their shares. By SEC decree, all stock must first be

registered by filing an S-1 or similar document before it can trade on a

public stock exchange. Thus, pre-IPO shareholders who do not sell shares

in the initial offering hold what is called unregistered stock, and are

restricted from selling large blocks unless the company registers them.

(The equity owners who hold the shares sold in an offering, whether it be

an IPO or a follow-on, are called the selling shareholders.)

Market reaction. What happens when a company announces a secondary

offering indicates the market’s tolerance for additional equity. Because

more shares of stock “dilute” the old shareholders, and “dumps” shares of

stock for sale on the market, the stock price usually drops on the

announcement of a follow-on offering. Dilution occurs because earnings

per share (EPS) in the future will decline, simply based on the fact that more

shares will exist post-deal. And since EPS drives stock prices, the share

price generally drops.

The process. The follow-on offering process differs little from that of an

IPO, and actually is far less complicated. Since underwriters have already

represented the company in an IPO, a company often chooses the same

managers, thus making the hiring the manager or beauty contest phase

much simpler. Also, no real valuation work is required (the market now

values the firm’s stock), a prospectus has already been written, and a roadshow presentation already prepared. Modifications to the prospectus and the roadshow demand the most time in a follow-on offering, but still can usually be completed with a fraction of the effort required for an initial offering.

Bond Offerings:

When a company requires capital, it sometimes chooses to issue public

debt instead of equity. Almost always, however, a firm undergoing a public

bond deal will already have stock trading in the market. (It is relatively

rare for a private company to issue bonds before its IPO.)

The reasons for issuing bonds rather than stock are various. Perhaps the

stock price of the issuer is down, and thus a bond issue is a better

alternative. Or perhaps the firm does not wish to dilute its existing

shareholders by issuing more equity. Or perhaps a company is quite

profitable and wants the tax deduction from paying bond interest, while

issuing stock offers no tax deduction. These are all valid reasons for issuing

bonds rather than equity. Sometimes in down markets, investor appetite for

public offerings dwindles to the point where an equity deal just could not

get done (investors would not buy the issue).

The bond offering process resembles the IPO process. The primary

difference lies in: (1) the focus of the prospectus (a prospectus for a bond

offering will emphasize the company’s stability and steady cash flow,

whereas a stock prospectus will usually play up the company’s growth and

expansion opportunities), and (2) the importance of the bond’s credit rating (the company will want to obtain a favorable credit rating from a debt rating

agency like S&P or Moody’s, with the help of the “credit department” of

the investment bank issuing the bond; the bank’s credit department will

negotiate with the rating agencies to obtain the best possible rating). As

covered in Chapter 5, the better the credit rating – and therefore, the safer

the bonds – the lower the interest rate the company must pay on the bonds

to entice investors to buy the issue. Clearly, a firm issuing debt will want

to have the highest possible bond rating, and hence pay a lower interest rate

(or yield).

As with stock offerings, investment banks earn underwriting fees on bond

offerings in the form of an underwriting discount on the proceeds of the

offering. The percentage fee for bond underwriting tends to be lower than

for stock underwriting. For more detail on your role as an investment banker

in stock and bond offerings, see Chapter 8.