From Private to Publicly Traded Firm: The Initial Public Offering
A
private firm is restricted in its access to external financing, both for debt
and equity. In our earlier discussion of equity choices, we pointed out the
hard bargain venture capitalists extract for investing equity in a private
business. As firms become larger and their capital needs increase, some of them
decide to become publicly traded and to raise capital by issuing shares of
their equity to financial markets.
Staying Private versus Going Public
When
a private firm becomes publicly traded, the primary benefit is increased access
to financial markets and to capital for projects. This access to new capital is
a significant gain for high growth businesses, with large and lucrative
investment opportunities. A secondary benefit is that the owners of the private
firm are able to cash in on their success by attaching a market value to their
holdings. Thus, owners can become very wealthy individuals overnight. To
illustrate, in a well publicized stock offering, Netscape, a company servicing
the Internet, was valued at $2.1 billion on the day it went public. Jim Clark,
the CEO and co-founder of the firm, who owned about 25% of the outstanding
shares in the firm, found his stake valued at $565 million, while Marc
Andreesen, the then 24-year old programmer who co-founded the firm, found his
million shares to be worth $58.25 million.
These
benefits have to be weighed against the potential costs of being publicly
traded. The most significant of these costs is the loss of control that may
ensue from being a publicly traded firm. As firms get larger and the owners are
tempted to sell some of their holdings over time, the ownerÕs share of the
outstanding shares will generally decline. If the stockholders in the firm come
to believe that the ownerÕs association with the firm is hurting rather than
helping it, they may decide to put pressure for the ownerÕs removal. In the
case of Apple Computers, for instance, the two founders, Steve Jobs and Steve
Wozniak, were eventually removed from management positions, largely as a
consequence of stockholder disapproval with their actions. In an ironic twist,
Steve Jobs returned as AppleÕs CEO in 1998 and engineered a turn around in its
fortunes.
Other
costs associated with being a publicly traded firm are the information
disclosure requirements and the legal requirements[1].
A private firm experiencing challenging market conditions (declining sales,
higher costs) may be able to hide its problems from competitors, whereas a
publicly traded firm has no choice but to reveal the information. Yet another
cost is that the firm has to spend a significant portion of its time on
investor relations, a process in which equity research analysts following the
firm are cultivated[2] and provided
with information about the firmÕs prospects.
Finally,
firms may not be able to go public if they do not meet the minimum listing
requirements for the exchange on which they want to be traded. The listing
requirements vary across exchanges, with the New York Stock Exchange imposing
the strictest requirements [pre-tax income of at least $ 2.5 million, tangible
assets of at least $ 18 million and 2000 or more stockholders]. Most small
firms, therefore, choose to get listed on the NASDAQ, which has far fewer
restrictions on listing. While some of these firms move on to the NYSE as they
become larger, firms like Intel and Microsoft have chosen to stay on the
NASDAQ.
Overall,
the net tradeoff to going public will generally be positive for firms with
large growth opportunities and funding needs. It will be smaller for firms that
have smaller growth opportunities, substantial internal cash flows, and owners
who value the complete control they have over the firm.
Choosing an Investment Banker
Once
the decision to go public has been made, a firm generally cannot approach
financial markets on its own. This is so because it is largely unknown to
investors and does not have the expertise to go public without help. Therefore,
a firm has to pick intermediaries to facilitate the transaction. These
intermediaries are usually investment bankers, who provide several services.
First, they help the firm meet the requirements of the Securities and Exchange
Commission (SEC) in preparing and filing the necessary registration statements
needed for the public offering. Second, they provide the credibility a small
and unknown private firm may need to induce investors to buy its stock. Third,
they provide their advice on the valuation of the company and the pricing of
the new issue. Fourth, they absorb some of the risk in the issue by
guaranteeing an offer price on the issue; this guarantee is called an underwriting
guarantee. Finally, they help sell the
issue by assembling a group called an underwriting syndicate, who try to place
the stock with its clients. The underwriting syndicate is organized by one
investment bank, called the lead investment bank.
There
are three costs associated with an initial public offering. First, the firm
must consider the legal and administrative cost of making a new issue,
including the cost of preparing registration statements and filing fees. Second,
the firm should examine the underwriting commission ÐÐ the gross spread between
the offering price and what the firm receives per share, which goes to cover
the underwriting, management, and selling fees on the issue. This commission
can be substantial and decreases as the size of the issue increases. Figure
17.9 summarizes the average issuance and underwriting costs for issues of
different sizes, reported by Ritter (1998).
Source:
Ritter
The third cost is any underpricing on the issue, which provides a windfall to the investors who get
the stock at the offering price and sell it at the much higher market price.
Thus, for Netscape, whose offering price was $29 and whose stock opened at $50,
the difference of $21 per share on the shares offered, is an implicit cost to
the issuing firm. While precise
estimates vary from year to year, the average initial public offering seems to
be underpriced by 10-15%. Ibbotson, Sindelar, and Ritter (1993), in a study of
the determinants of underpricing, estimate its extent as a function of the size
of the issue. Figure 17.10 summarizes the underpricing as a percent of the
price by size of issue.
Source: Ibbotson, Sindelar and Ritter
If
the only task for the issuing company were to find the investment banker who
could deliver the lowest combined cost, including both underwriting commission
and underpricing costs, the whole process could be opened up to auction and the
investment banker that promised to deliver the highest net proceeds to the firm
would be chosen. There are several problems with this ideal scenario, however.
First, the proceeds from the issue, based upon the offering price, may not be
delivered, and the investment bank may not have the capital to back up its
guarantee. Second, a bungled initial public offering ÐÐ one whose offering
price is set too high ÐÐ can create lasting damage to the issuing firmÕs
reputation and affect its ability to make future issues. Third, the investment
banker of choice may not have the specialized expertise[3],
say in biotechnology or software development, to provide the advice needed to
help the issuing company decide on the particulars of the issue. Fourth, given
that this is a private firm, no investment banker may be willing to estimate an
offering price without receiving more information from the firm. Finally, the
presumption that there will be a large number of investment bankers contending
for the issue may not hold true. A number of private firms have to seek out and
convince an investment banker to take them public and do not have the luxury of
choosing between multiple bidders.
Given
these problems, private firms tend to pick investment bankers based upon
reputation and expertise, rather than price. A good reputation provides the
credibility and the comfort level needed for investors to buy the stock of the
firm; expertise applies not only to the pricing of the issue and the process of
going public but also to other financing decisions that might be made in the
aftermath of a public issue. The investment banking agreement is then
negotiated, rather than opened up for competition.
Valuing the Company and Setting Issue Details
Once
the firm chooses an investment banker to take it public, the next step is to
estimate a value for the firm. This valuation is generally done by the lead
investment bank, with substantial information provided by the issuing firm. The
value is sometimes estimated using discounted cash flow models, similar to
those described in chapter 5. More often, though, the value is estimated by
using a multiple, like a price earnings ratio, and by looking at the pricing of
comparable firms that are already publicly traded. Whichever approach is used,
the absence of substantial historical information, in conjunction with the fact
that these are small companies with high growth prospects, makes the estimation
of value an uncertain one at best.
The
other decision the firm has to make relates to the size of the initial issue
and the use of the proceeds. In most cases, only a portion of the firmÕs stock
is offered at the initial public offering; this reduces the risk on the under
pricing and enables the owners to test the market before they try to sell more
stock. In most cases, the firm uses the proceeds from the initial stock issue
to finance new investments.
The
next step in this process is to set the value per share for the issuer. To do
so, the equity in the firm is divided by the number of shares, which is
determined by the price range the issuer would like to have on the issue. If
the equity in the firm is valued at $ 50 million, for example, the number of
shares would be set at 5 million to get a target price range of $10, or at 1
million shares to get a target price range of $ 50 per share.
The
final step in this process is to set the offering price per share. Most
investment banks set the offering price below the estimated value per share for
two reasons. First, it reduces the bankÕs risk exposure, since it ensures that
the shares will be bought by investors at the offering price. (If the offering
price is set too high and the investment bank is unable to sell all of the
shares being offered, it has to use its own funds to buy the shares at the
offering price.) Second, investors and investment banks view it as a good sign
if the stock increases in price in the immediate aftermath of the issue. For
the clients of the investment banker who get the shares at the offering price,
there is an immediate payoff; for the issuing company, the ground has been
prepared for future issues.
In setting the offering price,
investment bankers have the advantage of first checking investor demand. This
process, which is called building the book,
involves polling institutional investors prior to pricing an offering, to gauge
the extent of the demand for an issue. It is also at this stage in the process
that the investment banker and issuing firm will present information to
prospective investors in a series of presentations called road shows. In this process, if the demand seems very strong,
the offering price will be increased; in contrast, if the demand seems weak,
the offering price will be lowered. In some cases, a firm will withdraw[4]
an initial public offering at this stage, if investors are not enthusiastic
about it.
SEC Requirements
In
order to make a public offering the United States, firms have to meet several
requirements. First, they have to file a registration statement and prospectus
with the SEC, providing information about the firmÕs financial history, its
forecasts for the future and how it plans for the funds it raises from the
initial public offering. The prospectus provides information about the
riskiness and prospects of the firm for prospective investors in its stock. The
SEC reviews this information and either approves the registration or sends out
a deficiency memorandum asking for more information. While the registration is
being reviewed, the firm may not sell any securities, though it can issue a
preliminary prospectus, titled a red herring, for informational purposes only.
Once
the registration has been approved by the SEC, the firm can place a tombstone
advertisement in newspapers and other
publications. This ad contains details of the issue, the name of the lead
investment banker, and the names of other investment bankers involved in the
issue. The order in which the investment bankers are listed is significant. At
the top is the lead investment banker and the co-managers of the issue,
followed by the major bracket investment bankers. The categorization is based both upon reputation
and national focus. Then comes the mezzanine bracket, which includes smaller investment banks that
operate nationally, and at the bottom are the regional investment bankers
involved with the issue. Figure 17.11 shows a typical tombstone advertisement
for an initial public offering.
Figure 17.11:
Tombstone Advertisement
The Issue
Once
the offering price has been set and the tombstone advertisement published, the
die is cast. If the offering price has indeed been set below the true value,
the demand will exceed the offering, and the investment banker will have to
choose a rationing mechanism to allocate the shares. On the offering date ÐÐ
the first date the shares can be traded ÐÐ there will generally be a spurt in
the market price. If the offering price has been set too high, as is sometimes
the case, the investment bankers will have to discount the offering to sell it
and make up the difference to the issuer, because of the underwriting
agreement.
In Practice 17.1: The Initial Public Offering for United Parcel Service
On
July 21, 1999, United Parcel Service, the worldÕs largest private package
company, announced plans to sell its shares to the public. The company, which
was wholly owned by its managers and employees, announced that it was going
public in order to raise capital to make acquisitions in the future. UPS
reported revenues of $ 24.8 billion and net income of $ 1.7 billion in 1998 and
at that time employed about 330,000 people.
UPS followed the initial
announcement by filing a prospectus with the SEC on the same day, announcing
its intention of creating two classes of shares. Class A shares, with 10 votes
per share, would be held by the existing owners of UPS, and class B shares,
having one vote per share, would be offered to the public.
The
firm chose Morgan Stanley as its lead investment banker, and Morgan Stanley put
together a syndicate that included Goldman Sachs and Merrill Lynch as senior
co-managers. Other co-managers included Credit Suisse, Salomon Smith Barney and
Warburg Dillon Read. On October 20, 1999, UPS filed a statement with the SEC
(called an S-1 registration statement) announcing that it planned to issue
109.4 million shares (about 10% of the outstanding shares) at a price range[5]
of $ 36 to $ 42, and that the initial public offering would occur sometime in
early November.
Based
upon the strong demand from institutional investors, gauged in the process of
building the book, the investment banking syndicate increased the offering
price to $ 50 per share on November 8, 1999, and set the offering date at
November 10, 1999. At that time, it was the largest initial public offering
ever by a U.S. company.
On
November 10, 1999, the stock went public. The stock price jumped to $ 70.1325
from the offering price of $ 50. At the end of the trading day, UPS shares were
trading at $ 67.25. Based upon this price and the total number of shares
oustanding, the market value of UPS was assessed at $ 80.9 billion.