19-1

CHAPTER
19
Issuing Securities
to the Public

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Executive Summary
This chapter looks at how corporations issue
securities to the investing public.
As the basic procedure for selling debt and
equity securities are essentially the same. This
chapter focuses on equity.

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Chapter Outline
19.1 The Public Issue
19.2 Alternative Issue Methods
19.3 The Cash Offer
19.4 The Announcement of New Equity and the Value of the Firm
19.5 The Cost of New Issues
19.6 Rights
19.7 The Rights Puzzle
19.8 Shelf Registration
19.9 The Private Equity Market
19.10 Summary and Conclusions

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19.1 The Public Issue

The Basic Procedure
Management gets the approval of the Board of
Directors.
The firm prepares and files a registration statement
with the SEC.
The SEC studies the registration statement during the
waiting period.
The firm prepares and files an amended registration
statement with the SEC.
If everything is copasetic with the SEC, a price is set
and a full-fledged selling effort gets underway.
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The Process of A Public Offering

Steps in Public Offering Time

Several months
1. Pre-underwriting conferences
20-day waiting period
2. Registration statements
Usually on the 20th day
3. Pricing the issue
After the 20th day
4. Public offering and sale
30 days after offering
5. Market stabilization

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19-6

An Example of a Tombstone Advertisement

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19.2 Alternative Issue Methods

There are two kinds of public issues:
The general cash offer
The rights offer
Almost all debt is sold in general cash offerings.

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19.3 The Cash Offer

There are two methods for issuing securities for
cash:
Firm Commitment
Best Efforts
There are two methods for selecting an
underwriter
Competitive
Negotiated

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Firm Commitment
Under a firm commitment underwriting, the
investment bank buys the securities outright from
the issuing firm.
Obviously, they need to make a profit, so they
buy at “wholesale” and try to resell at “retail”.
To minimize their risk, the investment bankers
combine to form an underwriting syndicate to
share the risk and help sell the issue to the
public.
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Best Efforts
Under a best efforts underwriting, the
underwriter does not buy the issue from the
issuing firm.
Instead, the underwriter acts as an agent,
receiving a commission for each share sold, and
using its “best efforts” to sell the entire issue.
This is more common for initial public offerings
than for seasoned new issues.
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19.4 The Announcement of New Equity

and the Value of the Firm
The market value of existing equity drops on the
announcement of a new issue of common stock.
Reasons include
Managerial Information
Since the managers are the insiders, perhaps they are selling
new stock because they think it is overpriced.
Debt Capacity
If the market infers that the managers are issuing new equity to reduce
their debt-equity ratio due to the specter of financial distress the stock
price will fall.
Falling Earnings

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19.5 The Cost of New Issues

1. Spread or underwriting discount
2. Other direct expenses
3. Indirect expenses
4. Abnormal returns
5. Underpricing
6. Green Shoe Option

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The Costs of Public Offerings

Equity
Proceeds Direct Costs Underpricing
(in millions) SEOs IPOs IPOs
2 - 9.99 13.28% 16.96% 16.36%
10 - 19.99 8.72% 11.63% 9.65%
20 - 39.99 6.93% 9.70% 12.48%
40 - 59.99 5.87% 8.72% 13.65%
60 - 79.99 5.18% 8.20% 11.31%
80 - 99.99 4.73% 7.91% 8.91%
100 - 199.99 4.22% 7.06% 7.16%
200 - 499.99 3.47% 6.53% 5.70%
500 and up 3.15% 5.72% 7.53%
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19.6 Rights
If a preemptive right is contained in the firm’s
articles of incorporation, the firm must offer any
new issue of common stock first to existing
shareholders.
This allows shareholders to maintain their
percentage ownership if they so desire.

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Mechanics of Rights Offerings

The management of the firm must decide:
The exercise price (the price existing shareholders
must pay for new shares).
How many rights will be required to purchase one
new share of stock.
These rights have value:
Shareholders can either exercise their rights or sell
their rights.

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Rights Offering Example

Popular Delusions, Inc. is proposing a rights
offering. There are 200,000 shares outstanding
trading at $25 each. There will be 10,000 new
shares issued at a $20 subscription price.
What is the new market value of the firm?
What is the ex-rights price?
What is the value of a right?

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What is the new market value of the firm?

$25 $20
$5, 200,000  200, 000 shares  10, 000 shares 
share shares

There are 200,000 There will be 10,000 new

outstanding shares at shares issued at a $20
$25 each. subscription price.

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What is the Ex-Rights Price?

There are 110,000 outstanding shares of a firm
with a market value of $5,200,000.
Thus the value of an ex-rights share is:

$5,200,000
= $24.7619
210,000 shares

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What is the Ex-Rights Price?

Thus the value of a right is

$0.2381 = $25 – $24.7619

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19.7 The Rights Puzzle

Over 90% of new issues are underwritten, even though
rights offerings are much cheaper.
A few explanations:
Underwriters increase the stock price. There is not much
evidence for this, but it sounds good.
The underwriter provides a form of insurance to the issuing
firm in a firm-commitment underwriting.
The proceeds from underwriting may be available sooner than
the proceeds from a rights offering.
No one explanation is entirely convincing.
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19.8 Shelf Registration

Permits a corporation to register an offering that
it reasonably expects to sell within the next two
years.
Not all companies are allowed shelf registration.
Qualifications include:
The firm must be rated investment grade.
The cannot have recently defaulted on debt.
The market capitalization must be > $75 m.
No recent SEC violations.
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19.9 The Private Equity Market

The previous sections of this chapter assumed
that a company is big enough, successful enough,
and old enough to raise capital in the public
equity market.
For start-up firms and firms in financial trouble,
the public equity market is often not available.

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23

Private Placements
Avoid the costly procedures associated with the
registration requirements that are a part of public
issues.
The SEC restricts private placement issues ot no
more than a couple of dozen knowledgeable
investors including institutions such as insurance
companies and pension funds.
The biggest drawback is that the securities
cannot be easily resold.
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Venture Capital
The limited partnership is the dominant form of
intermediation in this market.
There are four types of suppliers of venture capital:
1. Old-line wealthy families.
2. Private partnerships and corporations.
3. Large industrial or financial corporations have established
venture-capital subsidiaries.
4. Individuals, typically with incomes in excess of $100,000
and newt worth over $1,000,000. Often these “angels” have
substantial business experience and are able to tolerate high
risks.
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Corporate Equity Security Offerings

17.7% Private Rule 144A placements

16.2% Private non-Rule 144A placements

66.1% Public equity offering

Source: Jennifer E. Bethal and Erik R. Sirri, “Express Lane or Toll Booth
in the Desert: The Sec of Framework for Securities Issuance,” Journal of
Applied Corporate Finance (Spring 1998).

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Stages of Financing
1.Seed-Money Stage:
Small amount of money to prove a concept or develop a product.
2.Start-Up
Funds are likely to pay for marketing and product refinement.
3.First-Round Financing
Additional money to begin sales and manufacturing.
4.Second-Round Financing
Funds earmarked for working capital for a firm that is currently selling its
product but still losing money.
5.Third-Round Financing
Financing for a firm that is at least breaking even and contemplating expansion;
a.k.a. mezzanine financing.
6.Fourth-Round Financing
Financing for a firm that is likely to go public within 6 months; a.k.a. bridge
financing.
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19.10 Summary and Conclusions

Larger issues have proportionately much lower costs of
issuing equity than small ones.
Firm-commitment underwriting is far more prevalent for
large issues than is best-effort underwriting. Smaller
issues probably use best effort because of the greater
uncertainty.
Rights offering are cheaper than general cash offers.
Shelf registration is a new method of issuing new debt
and equity.
Venture capitalists are an increasingly important
influence in start-up firms and subsequent financing.
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