Series 79
Limited Representative—
Investment Banking Exam
3RD EDITION
This material is protected under US copyright law. Each book is intended for only
one end user. Any attempt to distribute or resell this material is strictly prohibited.
Copyright © 2019, 2022 by Financial Training Services, Inc. All rights reserved
Published by Financial Training Services, Inc., New York, NY
Printed in the United States of America
Designed and composed at Hobblebush Design (www.hobblebush.com)
Editorial services provided by Pure Text (www.pure-text.net)
Edited by:
Elizabeth Streiff
Harvey Knopman
Brian Marks
David Meshkov
Ian Franklin
Kris Dudchak
Contents
Series 79 Exam Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
What Is the Series 79 Exam About? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Eligibility Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Exam Specifications. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
How to Make an Exam Appointment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
On the Day of Your Exam. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Knopman Marks Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Section 1: Corporate Valuation & Corporate Strategy . . . . . 7
1. Evaluating the Corporate Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.1 Types of Organizational Structures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.1.1 Subchapter C Corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.1.2 Subchapter S Corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.1.3 Limited Liability Companies (LLCs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.1.4 Limited Partnerships (LPs) and Master Limited Partnerships (MLPs). . . . . . . 12
1.1.5 Real Estate Investment Trusts (REITs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.1.6 Hedge Funds and Private Equity Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.2 The Life Cycle of a Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.2.1 Angel Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.2.2 Bank and SBA Financing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.2.3 Venture Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.2.4 Initial Public Offerings (IPOs). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.2.5 Follow-On Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.2.6 Rights Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.2.7 Spin-Offs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.2.8 NYSE and Nasdaq. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.2.9 Private Placements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
1.3 Types of Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
1.3.1 Individual Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
1.3.2 Insiders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
1.3.3 Conduit Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
1.3.4 Institutional Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
iii
Contents
1.4 Investment Strategies and Objectives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
1.4.1 Growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
1.4.2 Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1.4.3 Growth at a Reasonable Price (GARP). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1.4.4 Capital Appreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.4.5 Aggressive. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.4.6 Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.4.7 Deep Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.4.8 Distressed Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.4.9 Momentum. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1.4.10 Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1.4.11 Quantitative. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1.4.12 Arbitrage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1.4.13 Risk Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
1.4.14 Special Situation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
1.4.15 Sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
2. Corporate Financial Statements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.1 Financial Statements Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.2 Financial Statements and Accounting Standards . . . . . . . . . . . . . . . . . . . . . . . . 36
2.3 The Income Statement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.3.1 Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.3.2 Cost of Goods Sold (COGS). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.3.3 Gross Profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.3.4 Calculating COGS and Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.3.5 Operating Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2.3.6 Earnings Before Interest and Taxes (EBIT). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
2.3.7 Earnings Before Interest, Taxes, Depreciation, and Amortization
(EBITDA). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
2.3.8 Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.3.9 Income Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
2.3.10 Net Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2.4 The Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.4.1 Current Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.4.2 Non-Current Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.4.3 Current Liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.4.4 Long-Term Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.4.5 Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.4.6 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.5 The Cash Flow Statement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
iv
3. Foundational Valuation Concepts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Contents
3.1 Valuation Fundamentals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.1.1 Significance of Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.1.2 The Art and Science of Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3.1.3 Price Versus Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3.1.4 The “Football Field”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
3.2 Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
3.2.1 Capital Structure Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
3.2.2 Valuation of Companies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
3.3 Equity Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.3.1 Aggregate Value Versus Share Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.3.2 Basic Shares Outstanding. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
3.3.3 Diluted Shares Outstanding. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.3.4 Treasury Stock Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.4 Enterprise Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
3.4.1 Net Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
3.4.2 Noncontrolling Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
3.4.3 Enterprise Value Independent of Changes to Capital Structure. . . . . . . . . . . . 71
3.5 Converting Between Enterprise Value and Equity Value. . . . . . . . . . . . . . . . . . 72
4. Relative Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.1 Selection of Comparables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
4.1.1 Key Qualitative Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
4.2 Key Financial Characteristics and Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
4.2.1 Business Life Cycle. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
4.2.2 Profitability Ratios. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
4.2.3 Leverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
4.2.4 Shareholder Distribution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
4.3 Normalizing Financial Statements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
4.3.1 Adjustments for One-Time Items. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
4.3.2 Adjustments for Recent Events. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.4 Valuation Multiples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
4.4.1 Equity Value Multiples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
4.4.2 Enterprise Value Multiples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
4.5 Comparable Companies Analysis: Step by Step. . . . . . . . . . . . . . . . . . . . . . . . . . 113
4.5.1 Step 1: Select a Universe of Comparable Companies. . . . . . . . . . . . . . . . . . . . . . 113
4.5.2 Step 2: Spread Comps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.5.3 Step 3: Establish Valuation Range . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.5.4 Pros and Cons of a Trading Comps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
v
Contents
4.6 Precedent Transactions Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
4.6.1 Step 1: Select a Universe of Comparable Transactions . . . . . . . . . . . . . . . . . . . . 118
4.6.2 Step 2: Spread Comps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
4.6.3 Step 3: Establish Valuation Range. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
4.6.4 Pros and Cons of a Transaction Comps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
5. Fundamental and Fixed-Income Valuation. . . . . . . . . . . . . . . . . . . . 129
5.1 Discounted Cash Flow (DCF). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
5.2 Weighted Average Cost of Capital (WACC). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
5.2.1 Cost of Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
5.2.2 Cost of Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
5.2.3 Capital Structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136
5.3 Projecting Free Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
5.3.1 Income Statement Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
5.3.2 Net Capital Expenditure Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
5.3.3 Changes in Net Working Capital Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
5.3.4 Calculating Present Value of Free Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
5.4 Terminal Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
5.4.1 Perpetuity Growth Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
5.4.2 Exit Multiple Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
5.4.3 Calculating Enterprise Value and Equity Value Using a DCF. . . . . . . . . . . . . . 146
5.4.4 Pros and Cons of a Discounted Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
5.5 Other Uses of Discount Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147
5.5.1 Perpetuity Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
5.5.2 Dividend Discount Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
5.5.3 Economic Value Added (EVA). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
5.5.4 Pension Plan Obligations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
5.6 Fixed-Income Valuation and Characteristics. . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
5.6.1 Par Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
5.6.2 Coupon. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
5.6.3 Bond Pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
5.6.4 Basis Points. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
5.6.5 Callable Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
5.6.6 Bond Yields and Yield Calculations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
5.6.7 Yield Curve. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
5.7 US Government and Agency Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
5.7.1 Treasury Bills. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
5.7.2 Treasury Notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
5.7.3 Treasury Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
5.7.4 Federal Agency Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
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6. Mergers and Acquisitions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
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6.1 Participants in an M&A Transaction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
6.1.1 Target Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
6.1.2 Potential Buyers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
6.1.3 Advisers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
6.2 M&A Deal Types. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
6.2.1 Equity Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
6.2.2 Asset Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
6.2.3 Section 338(h)(10) Election. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
6.2.4 Leveraged Buyouts (LBOs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
6.3 First Round. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
6.3.1 First-Round Marketing Materials. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
6.3.2 Accretion/(Dilution) Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
6.4 Second Round. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
6.4.1 Second-Round Due Diligence Activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
6.4.2 Final Bid Procedures Letter and Final Bids. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
6.4.3 Fairness Opinion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
6.4.4 Definitive Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
6.4.5 Second-Round Timeline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
6.5 Closing a Merger. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.5.1 Regulatory Approval. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.5.2 Shareholder Approval. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.5.3 Bring-Down Due Diligence and Closing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
6.6 M&A Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Section 2: Capital Markets Activities . . . . . . . . . . . . . . . . . . . 219
7. Preparing the Prospectus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
7.1 Requirements of the Securities Act of 1933. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
7.1.1 Submitting the Registration Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
7.1.2 Deficiencies in the Registration Filing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
7.1.3 Non-Financial Statement Content of Registration. . . . . . . . . . . . . . . . . . . . . . . . 224
7.1.4 Financial Statements Included with Registration. . . . . . . . . . . . . . . . . . . . . . . . . 224
7.1.5 Forms of Registration Statements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .225
7.2 Categories of Issuers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
7.2.1 Well-Known Seasoned Issuers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
7.2.2 Seasoned Issuers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
7.2.3 Unseasoned Issuers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
7.2.4 Ineligible Issuers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
7.2.5 Non-Reporting Issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
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7.3 Effectiveness of Registration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .229
7.3.1 Pre-Filing Period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
7.3.2 Cooling-Off Period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
7.3.3 Post-Effective Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
7.3.4 Initial Public Offering (IPO) Timeline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
7.4 Shelf Registrations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
7.4.1 Refreshing Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
7.5 Audit Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
7.6 Free Writing Prospectus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
7.6.1 FWPs for WKSIs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
7.6.2 FWPs for Seasoned, Unseasoned, and Non-Reporting Issuers. . . . . . . . . . . . . 236
7.6.3 FWPs for Ineligible Issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
7.6.4 Disclosures Required in an FWP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
7.7 Graphic Communication. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
7.7.1 Electronic Road Shows. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
7.8 Prospectus Content and Filing Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . 241
7.8.1 Filing Copies of the Prospectus (Rule 424). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
7.8.2 Prospectus for Use Prior to Effective Date (Rule 430). . . . . . . . . . . . . . . . . . . . . 241
7.8.3 Registration Statement Inclusion after the Effective Date (Rule 430B). . . . . 241
7.9 Exemptions and Safe Harbors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
7.9.1 Tombstone Advertisements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
7.9.2 Pre-Registration Communications. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
7.9.3 Factual and Forward-Looking Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
7.10 Research Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
7.11 Liabilities in Communicating Securities Offerings . . . . . . . . . . . . . . . . . . . . . 246
7.11.1 Errors or Omissions in Registration Statements—Burden of Proof. . . . . . . 246
8. Reporting Requirements Under the Securities Exchange
Act of 1934. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
8.1 Reporting Requirements for Issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
8.1.1 Annual Report—Form 10-K. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253
8.1.2 Quarterly Report—Form 10-Q. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
8.1.3 Current Report—Form 8-K. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
8.1.4 Filing Categories and Deadlines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
8.1.5 Proxy Statements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
8.2 Sarbanes–Oxley Act Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
8.2.1 Enhanced Conflict of Interest Disclosures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
8.2.2 Disclosures of Transactions Involving Management and Principal
Stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
8.2.3 Management Assessment of Internal Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
8.3 Regulation FD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
8.4 Reporting and Trading Requirements for Corporate Insiders. . . . . . . . . . . . 265
8.4.1 Form 3—Initial Statement of Beneficial Ownership. . . . . . . . . . . . . . . . . . . . . . . 265
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8.4.2 Form 4—Statement of Changes in Beneficial Ownership . . . . . . . . . . . . . . . . . 265
8.4.3 Form 5—Annual Statement of Changes in Beneficial Ownership. . . . . . . . . . 265
8.4.4 Restrictions on Short-Swing Profits by Insiders. . . . . . . . . . . . . . . . . . . . . . . . . . . 266
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8.5 Large Shareholder Filings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
8.5.1 Beneficial Ownership Reports. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
8.5.2 Schedule 13F—Institutional Investment Managers. . . . . . . . . . . . . . . . . . . . . . . 268
9. Syndication of Securities Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . 273
9.1 Types of Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
9.2 Identifying Current Trends and Competitive Offerings . . . . . . . . . . . . . . . . . . 274
9.2.1 Initial Public Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
9.2.2 Follow-On Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
9.3 Types of Underwriting Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
9.3.1 Rules Regarding a Best Efforts Underwriting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
9.4 Participants in an Underwriting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
9.4.1 Formation of the Syndicate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
9.5 Underwriting Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
9.5.1 Components of the Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
9.6 Building the Book. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
9.6.1 Returned Shares and Short-Selling. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
9.7 Identifying Shareholders of the Issuer and Comparable Companies. . . . . . 287
9.8 Allotments and Directed Orders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
9.8.1 Fixed Pot Arrangement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
9.8.2 Jump Ball Pot Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
9.9 Pricing and Scheduling the Offering. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
9.10 Managing an Over-Allotment Option (Greenshoe) . . . . . . . . . . . . . . . . . . . . . 290
9.11 Lock-Up Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
9.12 Books and Records Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
9.13 Direct Listings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
9.14 Recommendations to Customers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
9.14.1 Regulation Best Interest (BI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
9.14.2 Suitability for Institutional Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
9.14.3 Suitability Requirements for New Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
10. Syndicate Settlement and Regulations. . . . . . . . . . . . . . . . . . . . . . . 301
10.1 Delivering the Red Herring. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
10.1.1 Prospectus Delivery Requirements in Corporate Transactions. . . . . . . . . . . 301
10.2 Setting Deal Terms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
10.2.1 The Underwriting Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
10.2.2 The Agreement Among Underwriters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
10.3 Rules on Underwriting Terms and Arrangements. . . . . . . . . . . . . . . . . . . . . . 304
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10.3.1 Underwriting Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
10.4 Preparing and Delivering the Road Show. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
10.5 Coordinating Communications with the Issuer. . . . . . . . . . . . . . . . . . . . . . . . 307
10.6 Regulations Concerning the Marketing of Securities Offerings. . . . . . . . . . 308
10.6.1 Offerings “At the Market”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
10.6.2 Exemptions from State Registration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
10.7 Fixed-Price Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
10.8 Marketing Timeline (Fully, One-Day, Overnight) . . . . . . . . . . . . . . . . . . . . . . . 310
10.9 Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
10.10 Restrictions on IPO Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
10.10.1 Restricted Persons. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
10.10.2 Permitted Purchases. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
10.10.3 Authorization to Purchase an IPO. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
10.11 Interests in Distribution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
10.12 Equity Research. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
10.12.1 Inducements and Retaliation for Research. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
10.12.2 Research Quiet Periods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
10.12.3 Equity Versus Debt Research Analysts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
10.13 Fiduciary Use of Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
10.14 Regulation M. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
10.14.1 Rule 101—Activities by Distribution Participants. . . . . . . . . . . . . . . . . . . . . . 323
10.14.2 Rule 102—Activities by Issuers and Selling Security Holders
During a Distribution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
10.14.3 Rule 103—Nasdaq Passive Market-Making. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
10.14.4 Rule 104—Stabilization and Penalty Bids. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
10.14.5 Rule 105—Short-Selling During the Restricted Period. . . . . . . . . . . . . . . . . . 329
10.15 Settlement of Syndicate Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
10.15.1 Key Terms for Syndicate Settlement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
10.16 Direct Participation Programs (DPPs) and Unlisted REITs . . . . . . . . . . . . 333
10.16.1 Underwriting Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
10.16.2 Due Diligence Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
10.16.3 Liquidity Disclosures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
11. Private Placements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
11.1 Offeree and Purchaser Restrictions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
11.2 The Private Placement Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
11.2.1 Capitalization Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
11.2.2 The Private Placement Memorandum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
11.3 Offering Commencement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .341
11.3.1 Placement Agent Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
11.3.2 The Subscription Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
11.3.3 Termination of the Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
x
11.4 Special Rules for Private Placements by Member Firms . . . . . . . . . . . . . . . . 343
11.4.1 Requirements of FINRA Rule 5122. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
Contents
12. Exempt Transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
12.1 Exempt Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
12.2 Regulations A and A+. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
12.2.1 Regulation A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
12.2.2 Regulation A+ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
12.3 Rule 147—Intrastate Offering Exemption. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
12.4 Regulation D—Private Placements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
12.4.1 Accredited Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
12.4.2 More on Rule 506 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
12.4.3 Bad Actor Provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
12.5 Rule 144A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
12.6 Regulation S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
12.6.1 Resale of Regulation S Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
12.7 Rule 144. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
12.7.1 Restricted Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
12.7.2 Control Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
12.7.3 Removal of the Legend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
12.8 Crowdfunding. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
12.8.1 Intermediaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
12.8.2 SEC Filing Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
12.8.3 Investment Limitations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
12.8.4 Risks of Equity Crowdfunding. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
12.9 Exempt Transactions Review. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
13. Tender Offers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
13.1 Tender Offers by Issuer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
13.1.1 Filing Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
13.1.2 Disclosure Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
13.1.3 Dissemination of the Offer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
13.1.4 Other Required Terms of Issuer Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
13.1.5 Dutch Auction Issuer Share Repurchase Programs. . . . . . . . . . . . . . . . . . . . . . 373
13.2 “Going Private” Transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
13.3 Other Tender Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
13.3.1 Pre-Commencement Communications. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
13.3.2 Equal Treatment of Securities Holders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
13.3.3 Unlawful Tender Offer Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
13.3.4 Purchases by Covered Persons Outside a Tender. . . . . . . . . . . . . . . . . . . . . . . . 379
13.4 Issuer Buybacks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
13.4.1 SEC Rule 10b-18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
13.4.2 Accelerated Share Repurchase Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
xi
Contents
Section 3: Rules & Regulations. . . . . . . . . . . . . . . . . . . . . . . . . . 387
14. Corporate Finance Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
14.1 Fairness Opinions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
14.1.1 Necessity of Fairness Opinions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
14.1.2 Factors to Consider in Preparing Fairness Opinions. . . . . . . . . . . . . . . . . . . . . 391
14.1.3 Preparing the Fairness Opinion Letter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
14.1.4 FINRA Rule 5150. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
14.2 Registration of Business Combinations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
14.2.1 Form S-4 Requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
14.2.2 Exemption for Business Combination Offers. . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
14.2.3 Proxy Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
15. Liquidation and Restructuring. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
15.1 Types of Bankruptcy Filings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
15.1.1 Chapter 7 Bankruptcy Filing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
15.1.2 Chapter 11 Bankruptcy Filing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
15.2 Priority of Claims in a Bankruptcy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
15.2.1 Summary of Priority of Claims in a Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . 417
15.3 Terms of Loan Documents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418
15.3.1 Financial Covenants and Key Ratios. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
xii
Series 79 Exam Introduction
Welcome to your Knopman Marks FINRA Series 79 study materials. We’re pleased
to have you as one of our students and wish you well as you follow our proven
study method for achieving exam success. Before you begin to study, you should
have some general knowledge about the Series 79 Exam.
What Is the Series 79 Exam About?
The Series 79 is primarily concerned with a candidate’s ability to understand the
basic functions of an investment banker. Imagine sitting behind a first- or second-year investment banking analyst and watching what he or she does during
the course of the day—that mindset will set you up for success.
The objective of this textbook is to help you prepare for the exam by reviewing the
Series 79 subject matter through the typical scenarios under which an investment
banker would apply these concepts. The scenarios include:
◆ Reviewing company financials and SEC filings
◆ Valuation of a subject company through various methodologies
◆ Mergers and acquisitions (M&A) sale process
◆ Syndication of equity and debt offerings
It is important to keep in mind that this is not an exam about Microsoft Excel.
The Series 79 will test your understanding of many of the outputs that would
result from a valuation exercise, but does not require any knowledge of “technical” valuation skills you may have learned (keyboard shortcuts, formatting,
etc.). During the preparation process, it is much more important to focus on the
methodologies.
Eligibility Requirements
All candidates must be associated with and sponsored by a FINRA member firm
to be eligible to take the Series 79 Examination and register as an investment
banker.
To obtain registration as an investment banker, candidates must pass both the
1
Introduction
Series 79 Exam and a general knowledge co-requisite, the Securities Industry
Essentials (SIE) Exam. The SIE Exam does not require sponsorship by a FINRA
member firm. Also, the Series 79 and SIE Exams can be taken in any order.
Exam Specifications
The Series 79 Exam is a 75-question, multiple-choice test. In addition, each exam
includes 10, unidentified pre-test questions that are ungraded and do not count
toward the final score. Thus, the total exam length is 85 questions (75 scored and
10 unscored). You are given two hours and 30 minutes to complete the exam. The
passing score on the Series 79 is 73%.
Each candidate’s exam is uniquely generated from a large question bank, but all
exams will evaluate a candidate’s understanding of three major content areas.
The topics covered in the Series 79, and the number of questions to expect from
each major job function, are identified in the following table. Some chapters
will cover multiple job functions, but the list below shows the primary function
discussed in each chapter.
Major Job
Function
Description
Number of
Questions
Percentage of
Exam
Chapters
1
Collection, Analysis, and Evaluation
of Data
37
49%
1–5
2
Underwriting and New Financing
Transactions, Types of Offerings, and
Registration of Securities
20
27%
7–12
3
Mergers and Acquisitions, Tender
Offers, and Financial Restructuring
Transactions
18
24%
6, 13, 14, 15
Total
75
100%
You should expect to use the entire time to complete the exam. You may find the
actual exam questions to be longer, with more extraneous information, than the
practice questions. As such, it is important to check the timer periodically to
ensure you are on target to finish the exam.
How to Make an Exam Appointment
Before you can take the exam, you must work with your broker-dealer to file your
paperwork and fingerprints with FINRA. At that point, you will be provided with
instructions on the necessary steps to complete and file your form and the exam
fees with FINRA. After FINRA has reviewed your form and found it complete and
accurate, it will open an exam window for you. You must take your exam during
this period. If you do not, your broker-dealer must open a new window and pay
additional fees.
After your window has been opened, you or your broker-dealer may make an exam
2
appointment. The Series 79 Exam is offered at Prometric testing centers. You may
either register online or call the testing center to make your appointment:
Introduction
◆ Prometric
Call (800) 578-6273 or visit www.prometric.com/finra.
Examination appointments are offered daily, including weekend availability.
To get your desired date, we suggest scheduling your test as far in advance as
possible.
If needed, you may cancel an exam appointment before the scheduled session.
To avoid fees, candidates must cancel or reschedule a minimum of 10 business
days in advance. Appointments cancelled or rescheduled within 10 business days
will result in the assess­ment of one of the following fees:
Three- to Ten-Business-Day Cancellation/Reschedule Fee: Individuals who
cancel or reschedule an appointment within three to 10 business days of a scheduled session will be assessed a fee equal to half the cost of the examination.
Two-Business-Day Cancellation/Reschedule Fee: Individuals who cancel or
reschedule an appointment within two business days of a sched­uled session, or
who fail to show up for an exam, will incur a fee equal to the fee of the examination.
On the Day of Your Exam
Plan to arrive at your exam location 30 minutes before your scheduled appointment time. To gain admission, you must provide a valid government-issued form
of ID with your signature and your picture. Acceptable forms of ID include your
driver’s license, passport, or military ID.
The exam is closed-book, and you cannot bring your notes, books, or other personal items into the testing center. Any personal effects (e.g., phones, laptops,
watches, etc.) must be left in a locker or in another location provided by the
testing center. The center’s staff will provide candidates with scratch paper—
typically laminated paper with a dry-erase marker—and a basic, four-function
calculator. Do not bring your own calculator with you for your exam—you will
not be allowed to use it.
Some students find the resources provided at the testing centers to be of a poorer
quality than those they used while studying for the exam. Specifically, the calculator
may be quite small, with few digits available on the screen. This will require you to
abbreviate numbers when doing calculations—for example, 14.7 instead of 14,700,000.
It is a good idea to practice using a similarly small, four-function calculator.
3
Introduction
Likewise, you may want to purchase a dry erase marker and a small erasable pad
to practice on, in order to simulate test conditions as closely as possible.
Before the exam clock begins, an online tutorial will familiarize you with how
the system operates. The system is easy to use—no prior experience is necessary,
though you can review the tutorial as much as needed before you begin the exam.
Among the features of the exam are:
◆ A clock display that can be turned on/off so you can track the time
remaining
◆ A confirmation box that appears each time you answer a question so you
can confirm your answer before proceeding to the next question
◆ The ability to mark questions you wish to review later so you can easily
go back to them
◆ The ability to view exhibits for certain questions
◆ The exam is designed so that the questions at the beginning and the end
are easier than the questions in the middle
At the end of the allowed testing time, or when you voluntarily stop your exam,
your score will be calculated and a score report will be displayed. The score report
will show whether you passed the exam, and you will be given a copy of this
report when you leave the center.
Knopman Marks Method
We are excited to help you get started, prepare for, and ultimately pass the Series
79 exam!
Start by reviewing our step-by-step Action Plan. The Action Plan is found on
our Training Center at www.knopman.com and is the best approach to get on
the path to success. The Action Plan is critical: following each step as listed is key
and it is our recommended plan of attack.
Below are some helpful tips that you should keep in mind as you start the Series
79 study process:
◆ Make the exam a high priority: set aside study time each day, including
weekends—even if it’s just 45 minutes or an hour. Limiting your
preparation to weekends only is often counterproductive and inefficient,
as you will forget much of what you studied if you go four or five days
without reviewing the information.
◆ Be sure to study in a quiet, well-lit place to maximize your productivity.
Minimize all distractions and dedicate yourself to focused, productive
studying.
◆ Keep in mind that the goal of reading this textbook is general
understanding, rather than retention. We do not recommend taking
notes while you read (though highlighting is fine). The retention will
come later when you watch our online lectures and work through the
practice exams.
4
◆ If you are familiar with financial statements and valuation, feel free
to start by reading Chapter 6 onward.
Introduction
◆ When watching the online lectures on the Knopman.com Training
Center, take detailed notes by hand. This results in better retention and
recollection than typing. These lectures focus on the most heavily tested
and difficult concepts on the exam.
◆ As you complete our practice exams, use only new questions from
the question bank to ensure that you are grasping and mastering the
concepts, rather than simply memorizing previously seen questions.
Read the answer and rationale for each practice question so that you can
understand why you got the question right or wrong.
◆ Although our practice questions are similar to the questions you will see
on the exam, they are not exact replicas. You may even see questions on
your exam that cover information you don’t feel prepared for. Remain
confident—if you have prepared well and followed our Action Plan, you
will be successful on the exam.
Throughout this book, certain heavily tested concepts are identified
as Knopman Notes with a gray outline and bold text. Please be sure
to pay special attention to these callouts, as they highlight important
testable points.
We are mindful that everyone learns differently, but we ask that you stick to the
Action Plan when starting off. Whether on a tight timeline or not, your studying
methods will naturally evolve as you progress through the steps in the Action
Plan and you will find some resources more useful than others.
Lastly, our materials are consistently being updated to reflect new content and
rule changes. To account for that, please make sure to enter your exam date in
the Training Center once it is confirmed with Prometric so that we can send you
any important updates leading up to your exam.
Knopman Note: Many additional supplements are available in your
Training Center. Be sure to log in and spend significant time reviewing
these supplements.
If you have any questions about logging in to our website or accessing your study
resources, please email support@knopman.com. Good luck with your studying!
5
Section 1
Corporate Valuation &
Corporate Strategy
One of the core functions of an investment banker is to help clients draw
conclusions about the value of their businesses and explore strategic alternatives. In order to provide an informed opinion, a banker must understand the various valuation methodologies, have the experience, and know
how to help the client implement a chosen strategy. This section will cover
corporate valuation and the process of running a corporate sale.
Chapter 1: Evaluating the Corporate Structure
Chapter 2: Corporate Financial Statements
Chapter 3: Foundational Valuation Concepts
Chapter 4: Relative Valuation
Chapter 5: Fundamental and Fixed-Income Valuation
Chapter 6: Mergers and Acquisitions
1. Evaluating the
Corporate Structure
This chapter covers the information investment bankers use in analyzing client
companies and advising them on financing strategies. It includes:
◆ Types of organizational structures and their characteristics
◆ Types of investors participating in corporate financings
◆ The corporate capital structure and types of securities used in financings
◆ Mergers and acquisitions
◆ Other considerations in advising companies on financing transactions
1.1 Types of Organizational Structures
Investment bankers must be familiar with different types of business entities,
including:
◆ Subchapter C corporations
◆ Subchapter S corporations
◆ Limited liability companies
◆ Limited partnerships
◆ Trusts
◆ Master limited partnerships (MLPs)
◆ Real estate investment trusts (REITs)
◆ Hedge funds
◆ Private equity funds
As you will learn in this chapter, each type of business entity has different characteristics in terms of tax treatment, management structure, liabilities, and sharing
of profits and losses.
1.1.1 Subchapter C Corporations
A subchapter C corporation (C corp) is a state-chartered business with its
own legal entity apart from that of its owners or managers. A C corp can survive
beyond the careers or lifetimes of its owners and is assumed to exist in perpetuity.
A C corp can enter contracts, open financial accounts, and hire managers and
9
Chapter 1
Evaluating the
Corporate Structure
employees. It can also centralize management control and decisions within an
executive team.
A C corp is owned by its shareholders, who elect a board of directors. The board
is responsible for governing the corporation, hiring and overseeing its officers,
and setting major policies.
C corps raise capital through the sale of stock (ownership) and bonds (debt obligations). Most shareholders, except some officers of the company, have limited
liability. They can only lose amounts they have invested in the company, and they
are not responsible for its other debts, judgments, or liabilities. The corporation
itself is liable for most debts, judgments, or liabilities, and corporate officers
can be personally liable for some actions, such as mismanagement of corporate
benefit plans or failure to remit payroll taxes.
In most cases, corporate shareholders can freely transfer their ownership interests (stock) in a C corp.
A C corp files its own federal income taxes using IRS Form 1120 or 1120-A, the
Corporate Income Tax Return. Profits are taxable at the corporate level. Dividends
of C corps are said to be “double taxed,” because the same profits are taxed once
at the corporate level and again at the shareholder level. Put another way, C corps
do not pass through gains and losses.
A C corporation is eligible to claim a “dividends received deduction” for corporate
dividends received from other corporations in which it owns equity.
C corps can issue multiple classes of stock and can have an unlimited number of
shareholders, including institutional investors.
1.1.2 Subchapter S Corporations
Subchapter S corporations (S corps) share many characteristics with C corps,
with a few major exceptions. The first exception is that S corps make a tax election that enables them to avoid having their income double taxed. Under this
election, profits are not taxed at the corporate level but rather are passed directly
through to shareholders. Each shareholder then pays all tax on these profits,
which are not considered “qualified dividends” for purposes of federal income
taxation and are therefore taxed at the shareholder’s ordinary income tax rate.
The second major exception is that S corps are not eligible to be listed on a stock
exchange or have their shares publicly traded.
Example
An investor owns stock in a C corp and an S corp, and both entities pay $10,000
in dividends. The C corp dividends, which are subject to tax at the corporate
level, are qualified dividends, subject to a special low federal income tax rate
(usually 15%). The S corp dividends are not qualified dividends and are taxed
at the shareholder’s ordinary income tax rate.
10
When shareholders are employed by S corps, they are not allowed to receive
dividends instead of “reasonable compensation” for the work performed. If reasonable compensation is not paid to an S corp shareholder, the IRS may reclassify
dividend payments as wages to ensure compensation is subject to payroll taxes.
Chapter 1
Evaluating the
Corporate Structure
In addition, S corps are not eligible to claim a “dividends received deduction”
for corporation dividends paid by other corporations in which they own equity.
To qualify for the subchapter S election, a corporation must meet the following
requirements:
◆ The company must be a domestic corporation, or a domestic entity
eligible to be treated as a corporation, with only one class of common
stock. Generally, a company can meet this requirement if all shares of
stock confer identical rights to distributions and liquidations.
◆ The company must not have more than 100 shareholders. For this
purpose, a husband and wife (and their estates) are treated as one
shareholder.
◆ All shareholders must be individuals or other qualified entities (such as
estates, exempt organizations, or certain trusts).
◆ No shareholder may be a nonresident alien.
◆ All shareholders must consent to the subchapter S election.
◆ The company must adopt a qualifying tax year.
Knopman Note: Typically, all investors in a subchapter S corporation
must be individuals. However, certain types of trusts can invest,
though a charity remainder trust cannot (the definition of this trust is
not important for the exam).
One aspect that S corps and C corps have in common is that capital gains for
shares held in either are eligible for a favorable rate upon sale, provided an investor holds the shares for at least one year.
Knopman Note: A husband and wife who each own stock in the same
subchapter S corporation are considered to be one shareholder for
purposes of the 100-shareholder limit.
1.1.3 Limited Liability Companies (LLCs)
A limited liability company (LLC) is a hybrid structure that blends characteristics of partnerships and corporations. It is not considered an incorporated entity
and does not have a perpetual life. Like a corporation, it offers its owners limited
liability. Like a partnership or an S corp, it avoids double taxation of dividends.
Knopman Note: An LLC that wished to go public would likely have to
re-organize to do so.
11
Chapter 1
Evaluating the
Corporate Structure
The laws of each state determine the specific liabilities of an LLC’s owners, who
are called members. In most states, members enjoy a shield against personal
liability for debts and judgments against the entity.
The entity is governed under the terms of an operating agreement, which can
specify the duration of the business, how it is to be managed, and the conditions
under which members’ interests may be exchanged or transferred.
An LLC may choose to be taxed as a partnership, a sole proprietorship, a C corp,
or an S corp, and uses the corresponding tax forms. To choose non-corporate
taxation, however, an LLC must not have more than two of the following characteristics that define corporations:
◆ Limited liability of owners (to the extent of assets invested)
◆ Continuity of life
◆ Centralized management, or
◆ Free transferability of owners’ interests
Example
An LLC wishes to be taxed as a partnership. Its operating agreement specifies a limited lifespan of 20 years for the entity and conditions under which
owners’ interests are not transferable. Since only two of the four conditions
are met, the entity will not be treated as a corporation for tax purposes. (Note:
At the end of 20 years, members may agree to renew the LLC and operating
agreement for a new term of years.)
1.1.4 Limited Partnerships (LPs) and Master Limited Partnerships (MLPs)
A limited partnership (LP) is a business structure commonly used by companies established for investing in industries such as oil and gas drilling and
real estate development or leasing. Limited partnerships are authorized under
state laws, most of which follow the Revised Uniform Limited Partnership Act
(RULPA).
One or more general partners are responsible for organizing and managing the
business. The passive investors, who have no say in business management, are
limited partners.
The partnership does not pay income tax at the entity level. All profits and losses
are distributed to individual partners and are reported to the IRS on personal
income tax returns. The partnership itself files an annual Schedule K-1, an information return, with the IRS.
Each general partner has unlimited personal liability for the partnership’s debts
and obligations. However, the liability of limited partners is confined to the assets
they invest in the partnership plus any debts they personally incur. To enjoy this
liability shield, limited partners are not permitted to have any control over the
business or serve on its board of directors.
One drawback to the limited partnership structure is the requirement to either
12
disband the partnership or file an amendment to the limited partnership certificate
upon the admission or withdrawal of any general partner. This requirement serves
to provide public notice to any entities that do business with the limited partnership so that they will clearly know who is responsible for its management, debts,
and liabilities. Many states also require limited partnerships to file annual reports.
Chapter 1
Evaluating the
Corporate Structure
The partnership agreement may specify the ability of each limited partner to
transfer or redeem ownership interests. For example, it may state that units of
ownership must be offered first to the general partner(s) under a right of first
refusal before they may be transferred to an outsider. Limited partnership interests are considered securities, subject to both SEC registration requirements and
state blue sky securities laws. Some private limited partnership interests may
only be offered to accredited investors, defined under the SEC’s Regulation D,
which is discussed in detail in a later chapter.
Master limited partnerships (MLPs) are limited partnerships offered to the
public and traded on exchanges. They may have hundreds of limited partner
investors, and they provide investors with the advantage of freely transferable
interests and limited liability—much like a corporation, but without their dividends being subject to double taxation.
An investor establishes a tax basis by buying units of MLPs on an exchange. Most
MLPs pay quarterly distributions representing the investor’s pro rata share of
the partnership’s income. The partnership may distribute any losses to limited
partners, which reduces tax basis.
Any distribution in excess of taxable income decreases the investor’s basis in the
partnership. This would be considered a non-taxable return of capital.
Although the partnership files an annual Schedule K-1 to report distributions and
taxable income or losses, each investor is responsible for tracking the tax basis
of his MLP units.
Knopman Note:
Q: How is an MLP best described?
A: A master limited partnership (MLP) is a limited partnership
that is publicly traded on an exchange. It combines the tax
benefits of a limited partnership with the liquidity of publicly
traded securities.
1.1.5 Real Estate Investment Trusts (REITs)
Real estate investment trusts (REITs) were authorized by Congress in the early
1960s as a structure for enabling investors to participate directly in the ownership
and financing of large real estate portfolios and projects. Most REITs are listed
on exchanges, and their shares may be purchased and transferred conveniently
through open market transactions. The total volume of listed US REITs has grown
to represent more than $200 billion in market value.
13
Chapter 1
Evaluating the
Corporate Structure
Equity REITs are involved primarily in owning and managing commercial real
estate. Mortgage REITs provide financing to real estate projects through either
temporary (construction) or permanent loans. Hybrid REITs participate in both
ownership and lending.
As a form of investment company, REITs avoid double taxation by claiming a
federal deduction for any dividends paid to shareholders, provided they meet
the following IRS requirements:
◆ REITs must invest at least 75% of their total assets in real estate (for
equity REITs)
◆ REITs must realize at least 75% of their gross income from real estaterelated activities (for mortgage REITs)
◆ At least 90% of the taxable income must be distributed to shareholders
annually (for both equity REITs and mortgage REITs)
If a REIT fails these tests, it is treated as a corporation and its income is taxed at
the corporate and individual levels.
Because of the pass-through rule, REITs generally pay large dividends. This is
what makes them popular investment vehicles.
Knopman Note:
Q: What kind of investment objective would make REITs suitable?
A: A REIT is appropriate for an investor pursuing current income
because REITs generally pay dividends.
Example
A REIT distributes 95% of its taxable income to its shareholders during a
given tax year. It meets the “90% test” to qualify as a REIT, so it may claim a
deduction for the 95% of taxable income distributed to shareholders, paying
tax at the company level only on the other 5%.
1.1.6 Hedge Funds and Private Equity Funds
Hedge funds and private equity funds are not business structures. Instead, they
are labels commonly assigned to entities created for raising investment capital
and managing assets. Although they may be organized in virtually any structure,
most of these funds are set up as LLCs or limited partnerships. Both hedge funds
and private equity funds are frequently described as “alternative” investments,
because they offer investors a way to diversify some of the risks in traditional
asset classes, such as stocks, bonds, and cash.
Knopman Note: Private funds, including hedge funds and private
equity funds, that are exclusively owned by qualified purchasers are
exempt from certain SEC regulations. Qualified purchasers are those
that own at least $5 million in investments.
14
1.1.6.1 Hedge Funds
Hedge funds are private investment funds that typically engage in several (or all)
of the following activities:
Chapter 1
Evaluating the
Corporate Structure
◆ Pursuing creative investment strategies based on active trading and
combinations of long- and short-term investments.
◆ Using leverage (borrowed money) in an attempt to increase investment
gains.
◆ Paying general partners performance-based incentive allocations. For
example, a hedge fund may allocate to its general partner 20% of the
gains it achieves annually above the highest net asset value previously
achieved (i.e., the high water mark).
◆ Limiting investor transfers or redemptions. In general, hedge funds are
not as liquid as most other investment structures. General partners can
impose restrictions (gates) on redemptions that would adversely impact
other investors. They also may prohibit redemptions in the first year or
two and require advanced notice for redemptions at all times.
1.1.6.2 Private Equity Funds
Private equity funds invest in companies that are not publicly registered or
traded. They may invest in any of the following scenarios:
◆ Venture situations—Start-ups or relatively young companies that have
the potential to be acquired or go public
◆ Leveraged buyouts—Public companies that are “taken private” by their
own management teams or through acquisitions, using borrowed money
for a significant percentage of the deal financing
◆ Distressed situations—Companies that are undervalued by the stock
market and have the potential to be revived with more capital, new
business plans, or restructured management teams
Private equity funds tend to involve longer investor commitments and even less
liquidity than hedge funds. In some cases, it takes a private equity fund several
years to invest all of its assets, and investors’ money may be locked up for as many
as 10 years until the investments can be liquidated. For this reason, participation
in private equity funds tends to be dominated by institutions and ultra high-networth investors.
Knopman Note: A private equity buyer would likely prefer investments
that have stable cash flows. This provides the firm cash to service the
debt used to make the acquisition. For this reason, a company with
low growth but stable cash flows would be a more attractive target
than a high-growth company with limited cash flow.
15
Chapter 1
Evaluating the
Corporate Structure
Knopman Note: Review the following characteristics of the various
corporate forms.
C Corp
Types of
Securities
Eligible
Investors
Max
Shareholders
• Multiple stock
classes
• Bonds
• Individuals
• Institutional
• Unlimited
Master Limited
Partnership (MLP)
Real Estate
Investment Trust
(REIT)
• One class of
stock
• Investment units
(these trade like
shares in a C corp)
• Stock
• Individuals
• N/A for exam
purposes
• N/A for exam
purposes
• Unlimited
• Unlimited
• Can exchange-list
• Can exchange-list
• Pass-through gains
and losses
• 100 shareholders
max (husband
and wife count
as a single
shareholder)
• No institutional
investors (e.g.,
an LLC could not
invest in an S
corp)
Exchange
Listing
• Can exchange-list
• Cannot list
on exchanges
(Nasdaq min.
shareholder
requirement is
400; max for S
corp is 100)
Taxes
• Does not pass
through (i.e., pays
corp income tax)
• Pass-through
gains and losses
Capital
Gains
• Eligible for
preferred capital
gains tax rate if
shares are held
for more than
one year
• Eligible for
preferred capital
gains tax rate if
shares are held
for more than
one year
• N/A for exam
purposes
• An S corp may
return principal
to investors,
which represents
a return of
the initial
investment.
This return of
principal would
reduce an
investor’s cost
basis, rather than
being considered
taxable income.
To qualify, a firm
To qualify, a REIT
must earn 90% of its
must meet the
income through natural following criteria:
resources, commodities,
1. 75% of the assets
or real estate.
must be invested
MLPs have two
in real estate
partners:
2. 75% of the
income must
• General partner
be derived
(runs day-to-day
from real estate
business; i.e., acts like
investments, and
management)
3.
90% of the gains
• Limited partner
must be passed
(contributes
through to
capital; i.e., acts like
investors
shareholder)
• The largest issuer
of SEC-registered
common stock
Note
16
S Corp
• Most large
corporations
are organized
as subchapter C
corporations
• Pass-through gains
• Does not pass
through losses
• Eligible for
preferred capital
gains tax rate if
shares are held for
more than one year
Chapter 1: Evaluating the Corporate Structure
Progress Check
1. A company or an organization with no
more than 100 shareholders that elects to
pass corporate income and losses to its
shareholders is known as:
A.
B.
C.
D.
An S corporation
A C corporation
A limited liability company
A limited partnership
2. Which two of the following are examples of
types of organizational structures?
I.
II.
III.
IV.
A.
B.
C.
D.
C corporation
Preferred stock
Limited liability company
American depositary receipt
I and III
I and IV
II and III
II and IV
4. REITs are required to distribute what
percentage of their taxable income to
shareholders to receive favorable tax
treatment?
A.
B.
C.
D.
100%
90%
75%
50%
5. For how long must an investment in a
subchapter S corporation be held before it is
eligible for a favorable capital gains tax rate?
A.
B.
C.
D.
Three months
Six months
12 months
Investments in S corps are never eligible
for a favorable capital gains tax rate
3. Members of a limited liability company:
A. Are not personally liable for its debts
B. Are personally liable for its debts
C. Must elect one chief member to manage
the business
D. Cannot manage the business
17
Chapter 1: Evaluating the Corporate Structure
Progress Check—Solutions
1.
(A)
S corporations pass income and losses, as well as deductions and credits, to their
shareholders. Shareholders report these line items, which are taxed at their respective
personal rates, on their individual income statements.
2. (A)
An American depositary receipt (ADR) is a certificate issued by a US bank that
represents shares of a foreign company traded on a US exchange. Preferred stock would
be issued by a corporation, but is not a type of organizational structure.
3. (A)
Members of a limited liability company (LLC) are not liable for its debts. LLCs must be
managed by one or more members, which can include a person, corporation, or
partnership.
4. (B)
To qualify as a REIT, a US company must distribute at least 90% of its taxable income to
shareholders as dividends.
5. (C)
Investments held in S corps and C corps are eligible for a favorable capital gains tax rate
as long as the shares are held for at least one year.
18
1.2 The Life Cycle of a Company
To provide advice and financing services, investment bankers must understand a
company’s corporate capital structure and the types of financing transactions
available for clients.
Chapter 1
Evaluating the
Corporate Structure
One way to understand these concepts is by viewing the typical life cycle of a
public company, and how it raises capital at various phases of development.
Let’s imagine a hypothetical company that begins its life in an inventor’s garage.
The first financing that the founder or promoter is likely to receive comes from
“friends, family, and MasterCard.” If the company is able to create a plausible
product and plan, it may then move on to the angel round of financing.
1.2.1 Angel Investors
Angel investors represent the first outside financing that many start-up companies receive. An angel is typically a wealthy individual who is willing to take risk
and knows something about start-up companies, as well as, perhaps, the specific
industry in which the start-up is competing. Often, angels have been successful
entrepreneurs themselves.
Angels typically demand between 20% and 50% equity ownership in a company,
and their involvement may help establish the first valuation of the company’s
worth. For example, if an angel contributes $200,000 to take a 20% equity stake
in a company, the company’s valuation would be $1 million ($200,000/20%).
Many successful angels will only participate in new ventures that offer a return of
five to 10 times their investment over five years. Angels often serve on a start-up
company’s board, or even as part of its management team, to help guide the
company’s success and watch over its investments.
1.2.2 Bank and SBA Financing
Often, new companies look to establish bank financing relationships early in
their development, particularly to finance working capital. Banks may be willing
to extend a line of credit to a new company, especially if an owner provides a personal guarantee. The Small Business Administration (SBA) facilitates several
programs designed to help start-up businesses access financing through banks
and other commercial lenders. The SBA’s role is to establish lending guidelines
and then guarantee that loans will be repaid.
The SBA provides venture capital to new businesses through Small Business
Investment Companies (SBICs). SBICs are privately owned investment funds that
are licensed and regulated by the SBA and make debt and equity investments in
qualifying small businesses.
19
Chapter 1
Evaluating the
Corporate Structure
1.2.3 Venture Capital
Venture capital is provided by private investment funds that specialize in scouting and evaluating promising start-up companies in their early phases. Venture
capitalists normally become interested in companies after they have developed
attractive products, patents, technologies, intellectual properties, or trade secrets
that have high growth potential. They also may be attracted to companies with
strong management teams and business plans.
Knopman Note: A venture capital firm could invest in a young private
company and purchase shares from the company’s CEO and founder,
in order to provide the CEO some liquidity.
A venture capitalist typically takes a patient, long-term approach to a portfolio
company, and does not demand liquidity or dividend distributions in the early
years. Many start-ups go through several rounds of venture capital, with some
investors participating in each round to avoid diluting their equity. In a successful, growing company, the price of entry normally increases with each venture
round. Although most venture capital is equity-based, financing may include
some debt. Venture capitalists often ask for warrants to leverage their potential
upside if the business is successful.
Knopman Note: Although some venture capital firms do lend money,
the majority make equity investments. Therefore, a venture capital
firm is less likely to perform a leveraged buyout (LBO) analysis,
discussed later, when looking at an opportunity.
Knopman Note: An investment bank advising a start-up, which is
looking to raise capital, would most likely recommend the start-up
take on a greater equity investment and less debt in order to minimize
the amount of cash flow being used to for debt service.
1.2.4 Initial Public Offerings (IPOs)
A company’s initial public offering (IPO) of stock generally produces a number
of important results:
◆ It provides a liquidity event for the founders, promoters, and early
investors, giving them a public market in which to sell some shares.
◆ It creates a broad-based valuation of the company by exposing the stock
to a large pool of investors. The valuation established by angels and
venture capitalists in early rounds may not be as meaningful as the one
established later by the public market.
◆ It raises permanent equity capital to fund the company’s ongoing needs.
A successful IPO can enable a promising company to grow more rapidly
because capital becomes more plentiful and less expensive to obtain.
◆ It exposes the company to the underwriting process, the resources of
20
syndicate members in broadening interest in the company, and the
requirements for registration and ongoing SEC reporting.
◆ It creates stock that can be used to tie executives and employees to
the company through option grants, employee stock ownership plans,
matching retirement plan contributions of stock, and other means.
Chapter 1
Evaluating the
Corporate Structure
1.2.5 Follow-On Offerings
Any public offering of company stock after the IPO is called an additional or
follow-on offering. Follow-ons are useful for raising new permanent capital,
refinancing debt, and “cashing out” shares of founders, promoters, angels, and
venture capital investors.
1.2.6 Rights Offerings
A rights offering raises new equity capital for a company by giving existing
shareholders the right to acquire additional shares, proportionate to their current holdings, at a stated price. The price may be discounted from the market
value of shares.
Rights offerings expand the public float, or total number of shares held by the
public. Any shareholders who do not exercise rights will have their stake in the
company diluted.
A rights offering can be useful in financing a corporate acquisition or expansion
program without having to bring in new investors.
To gauge potential interest in a rights offering, an investment banker would
generally study the makeup of the company’s current shareholders. Specifically,
public companies will generally publish the percentage of company shares held
by institutions and insiders.
1.2.7 Spin-Offs
A spin-off occurs when a company distributes shares of a subsidiary, subsequently creating a separate, independent company. The shares may be distributed to the existing shareholders or sold to a third-party purchaser.
The newly formed, independent company may be able to produce enhanced
results or additional value without the constraints or challenges it faced as part
of a larger company. This smaller, more focused company could create more competition in the sector, as the new managers are often highly incentivized to focus
on their core products.
Knopman Note: If a large company is trying to spin off a business, the
sell-side adviser would likely be tasked with calculating the value of
the spin-off, including the benefit of expected synergies.
21
Chapter 1
Evaluating the
Corporate Structure
1.2.8 NYSE and Nasdaq
Companies that choose to go public will generally apply to have their stock listed
on either the NYSE or Nasdaq. Transactions in new issues are considered primary-market transactions and will be discussed in detail in later chapters.
1.2.8.1 The New York Stock Exchange (NYSE)
The New York Stock Exchange (NYSE) or “Big Board” was founded in 1792. In
order to trade on the New York Stock Exchange, securities must meet initial and
ongoing listing requirements and pay required fees.
The initial listing requirements of the New York Stock Exchange include:
◆ Minimum of 400 shareholders
◆ Minimum of 1,100,000 shares outstanding, and
◆ Minimum stock price of $4 per share
The NYSE features an auction market where the current price is the highest
amount any buyer is willing to pay and the lowest price at which someone is
willing to sell. Some of the trading is done face-to-face on a trading floor, although
many trades are communicated electronically to designated market makers, or
DMMs (formerly called specialists). DMMs are responsible for matching buyers
and sellers and maintaining an orderly trading market in the securities they represent. Once a trade has been made, the details are sent back to the broker-dealer,
which then notifies the investor who placed the order.
1.2.8.2 The Nasdaq Stock Market
For many years, large companies sought the prestige of listing only on the
NYSE, while second-tier stocks traded on other exchanges. This practice has
changed, and Nasdaq is now home to several large technology companies, such
as Microsoft, Cisco, Intel, Google, and Amazon.
On Nasdaq, broker-dealers act as market makers for various stocks. A market
maker requests regulatory approval to offer continuous bid and ask prices for
shares for which they are designated to make a market. They may match up buyers and sellers directly, but usually they maintain an inventory of shares to meet
investor demand. In acting as market makers, broker-dealers participate in secondary-market transactions in one of two ways:
◆ As principals they hold securities for sale in their own inventory and
take on financial risk, or
◆ As agents they act on behalf of a buyer or seller, but do not own the
security at any point during the transaction, limiting their financial risk
When a broker-dealer acts as a principal, it charges customers a mark-up or
mark-down. When a broker-dealer acts as an agent, it charges customers a
commission.
22
Knopman Note:
Q: Can an issuer pay a firm to make a market in its stock?
A: No. A broker-dealer cannot accept any form of compensation
from an issuer to incentivize the firm to make a market in the
company’s stock.
Chapter 1
Evaluating the
Corporate Structure
Q: What happens if a market maker has a technical problem and
cannot continue to trade the security?
A: If a Nasdaq market maker’s ability to enter or update quotes
is impaired, the market maker immediately contacts Nasdaq
Market Operations to request the withdrawal of its quotations.
Nasdaq market makers are required to maintain firm (i.e., bona fide) quotes. A
firm quote is one where the market maker is required to execute a trade at its
quoted price. For example, a market maker bidding $10.50 on 5,000 shares would
be required to buy up to 5,000 shares at that price. Also, all Nasdaq quotes are
required to be two-sided quotes. A two-sided quote has both a bid and an offer
for the stock.
Knopman Note: If a market maker is quoting “27.10–27.20,” that means
the market maker must buy (bid) at 27.10 and must sell (offer or ask) at
27.20.
Strict rules govern the communications permitted between market
makers. Market makers are prohibited from discussing where to
price a security, as that would constitute market manipulation and
potentially a violation of the Securities Exchange Act of 1934.
Like the NYSE, the Nasdaq has initial listing requirements and ongoing standards. Top-tier Nasdaq companies are part of the Nasdaq Global Market. The
top third of Nasdaq Global Market securities comprise the Nasdaq Global Select
Market; this subset of Nasdaq has its own index and is positioned to attract
greater global investment in Nasdaq securities.
The Nasdaq Capital Market targets smaller, less capitalized companies. Listing
standards for the Nasdaq Capital Market are less stringent than those for the
Nasdaq Global Market.
All Nasdaq issuers, regardless of the tier, are required to have a $4 bid price and
at least three market makers for initial listing, and are required to maintain a $1
bid price and at least two market makers for continued listing. Listing criteria
differ between the three tiers with respect to the following financial and liquidity
requirements:
◆ Revenue
◆ Pre-tax earnings
◆ Cash flow
23
Chapter 1
Evaluating the
Corporate Structure
◆ Market capitalization
◆ Total assets
◆ Stockholders’ equity
◆ Round-lot shareholders (i.e., own at least 100 shares) and/or total
shareholders
◆ Number of publicly held shares
◆ Market value of publicly held shares
Knopman Note: It is important to be familiar with what Nasdaq
requires and does not require of listed companies.
Required (Initial)
Required (Continued)
• $4 bid
• $1 bid
• 3 market makers
• 2 market makers
• 400 shareholders
• A minimum book value (i.e.,
shareholders’ equity)
Not Required
• A minimum price-to-book value
requirement
• A minimum daily trading volume
• A seasoning period, i.e., a period
of time before a company is
eligible to list on the exchange
• A minimum monthly trading volume
Knopman Note: Canadian companies can directly list their common
stock on US exchanges. They do not issue american depositary
receipts (ADRs).
1.2.8.3 Delisting from an Exchange
Companies that are unable to sustain ongoing listing requirements are delisted.
Delisting from Nasdaq, the NYSE, or another exchange occurs when a company
has fallen out of compliance with that exchange’s requirements. These requirements typically involve the company’s market capitalization, share price, and/or
number of outstanding shares. Although a company is not necessarily in bankruptcy when it is delisted, it has typically lost some of its financial strength, credibility, and/or stability.
1.2.9 Private Placements
Private placements may be sold to accredited investors under the provisions
of Regulation D to raise capital through the sale of equity, debt, preferred, or
convertible securities.
Private placements may be offered to an unlimited number of accredited investors. The offering is made through a private placement memorandum (PPM),
which normally includes the following information:
◆ The structure and terms of the deal
◆ Brief information about the issuer and its operations
24
◆ Information about the company’s management
◆ Financial statements
◆ Risks and required disclosures
Chapter 1
Evaluating the
Corporate Structure
◆ Use of proceeds
◆ The subscription agreement and sales contract
Private placements are discussed in detail in Chapter 11.
1.2.9.1 Private Investment in Public Equity (PIPE)
A private investment in public equity (PIPE) describes a public company offering securities in a private placement to an investment fund or an accredited
investor (e.g., an institution or a high-net-worth individual) by a public company.
The securities are not registered with the SEC and remain “restricted” from resale
until registered. PIPEs have become a meaningful source of capital for small-cap
and micro-cap public companies, some of which have had trouble raising capital
through other means.
Knopman Note: A PIPE is when a public company raises capital
privately.
Large public companies that are well known to accredited investors can also
use private placements to raise equity capital and avoid the costs and delay of a
registered offering.
Example
During the 2008 financial crisis, Goldman Sachs, a public company, raised
capital privately by selling $5 billion of preferred stock to Warren Buffet’s
Berkshire Hathaway. This is an example of a PIPE offering.
PIPEs can sell a variety of securities, including common stock, preferred stock,
convertible bonds, unsecured debt, and debt secured by specific corporate assets
(such as receivables and equipment). PIPE investors often receive warrants to
increase upside participation in the issuer’s growth. In many cases, PIPE investors are offered stock at a discount to the market value of the shares.
Knopman Note: In a PIPE offering, investors commit to purchase a
certain number of restricted (i.e., unregistered) shares from a public
company at a specified price.
In some cases, PIPEs line up investors and then delay the closing of the financing
until securities are registered. This gives PIPE investors the ability to immediately
resell the securities acquired. In other cases, the registration is delayed until after
closing, in which case a blackout period applies during which shares may not
be resold.
25
Chapter 1
Evaluating the
Corporate Structure
Knopman Note: In a PIPE transaction, the issuer will often file a resale
registration statement, which allows investors in the PIPE to sell the
securities immediately. An issuer may be obligated to make penalty
payments to PIPE investors if they fail to file the resale registration
statement within an allotted time period or if they fail to use their best
efforts to have the registration statement declared effective within a
defined period.
1.3 Types of Investors
In evaluating the financing needs of client companies, it is important to consider
the types of investors who may be sources of capital.
1.3.1 Individual Investors
Surveys have shown that more than half of all US households own equities (stocks)
either directly or through mutual funds. Suitability considerations are crucial for
individual investors. A registered representative must thoroughly examine a customer’s investment profile before making a specific recommendation.
Many investment firms target high-net-worth, very high-net-worth, and ultra
high-net-worth investors. There is no standard definition for these tiers, but
many financial institutions identify them as follows:
◆ High net worth (HNW)—Financial assets exceeding $1–$2 million
◆ Very high net worth (VHNW)—Financial assets ranging from about
$5–$50 million
◆ Ultra high net worth (UHNW)—Financial assets exceeding $50 million
1.3.2 Insiders
Insiders have a direct connection to the company in whose securities they invest,
often serving as directors, officers, or managers of the company or holding controlling interest in its shares. In the US, corporate insiders are defined for
SEC-reporting purposes as a company’s officers and directors, and anyone with
beneficial ownership of more than 10% of a company’s voting shares.
Insiders are required to file Forms 3, 4, and 5 with the SEC to report transactions
in the issuer’s securities.
1.3.3 Conduit Investors
Conduit investors pool capital from many investors into funds or accounts that
the conduits manage. They include mutual funds, closed-ended funds, exchangetraded funds (ETFs), hedge funds, private equity funds, registered investment
advisers (RIAs), and broker-dealers.
Mutual funds and money market funds together are significant conduits for US
securities holdings across all three asset classes—equities, corporate/foreign
26
debt, and municipal securities. In recent years, ETFs have become important
conduits for corporate equities as well. ETFs are publicly traded portfolios that
generally mirror an index or a specific sector.
Chapter 1
Evaluating the
Corporate Structure
1.3.4 Institutional Investors
Institutional investors include commercial banks, savings institutions, credit
unions, insurance companies, private pension funds, state and local retirement
funds, federal government retirement funds, and private endowments and
foundations.
Life insurance companies, private pension funds, and state/local retirement
funds are important holders of corporate equity securities, while commercial
banks and life insurance companies are big owners of corporate and foreign debt.
Some institutional investors fall under the definition of qualified institutional
buyers (QIBs) under Rule 144A of the ’33 Act. They include insurance companies,
investment companies, employee benefit plans, investment advisers, and trust
funds holding at least $100 million in discretionary assets. QIBs can participate
in restricted and unregistered securities offerings marketed under Rule 144A of
the ’33 Act.
Knopman Note: Companies typically disclose the following
classifications of their shareholder base: 1) insiders and 2)
institutions.
1.4 Investment Strategies and Objectives
Now that you have examined many of the standard types of securities offerings
and investors, it is important to understand investor objectives and the strategies
employed to achieve those objectives.
1.4.1 Growth
Growth investors are interested in finding companies that have a high potential
for earnings and expansion. Investors that follow this investment strategy bet on
young, up-and-coming companies evolving into industry leaders. Theoretically,
high growth leads to high stock prices and to high profits.
Growth investors generally seek out companies that trade at a higher price-toearnings (P/E) multiple (discussed in greater detail later) than their peers.
27
Chapter 1
Evaluating the
Corporate Structure
Knopman Note:
Q: What is organic growth?
A: Organic growth describes business expansion due to increasing
market share in existing product lines (e.g., by increased
advertising) or in new product lines (e.g., by introducing a
new niche product). Growth achieved through mergers or
acquisitions is inorganic growth.
Companies that operate in perfectly competitive markets have no ability
to control prices, so lowering prices could not result in organic growth.
1.4.2 Value
Value investing involves searching for stocks that are underpriced by the market.
A value investor anticipates that the market will become aware of the worth of
the company and its stock price will rise.
Value stocks tend to trade at a lower P/E multiple than their peers.
Proponents of this theory may use fundamental analysis, or thorough evaluation of company-specific and economic financial data and trends, to determine
whether a company is underpriced or overpriced.
Knopman Note:
Q: What ratio might a fundamental analyst review when
considering an investment decision?
A: A fundamental analyst will review company-specific data,
such as the P/E multiple, earnings per share (EPS), and a firm’s
current ratio (discussed in Chapter 15).
Q: What does a technical analyst evaluate when considering an
investment decision?
A: A technical analyst makes predictions based on trading data,
such as the moving average and average daily trading volume.
1.4.3 Growth at a Reasonable Price (GARP)
Growth at a reasonable price (GARP) is an equity investment strategy that
attempts to combine key theories of both growth investing and value investing
to find stocks. GARP investors attempt to find companies that have potential
for consistent earnings growth that exceeds that of the rest of the market (a key
growth investing concept) while excluding companies that have overly high valuations (value investing). The main objective is to avoid the extremes of either
growth or value investing.
28
1.4.4 Capital Appreciation
Capital appreciation focuses on long-term growth. Proponents of this theory
follow a buy-and-hold strategy, and plan to hold the stocks they purchase for
many years. Day-to-day stock fluctuations are not of concern; greater importance is placed on the fundamentals of the company that could affect long-term
growth.
Chapter 1
Evaluating the
Corporate Structure
A typical capital appreciation strategy involves regular purchases of additional
shares and reinvestment of dividends.
1.4.5 Aggressive
An aggressive investment strategy attempts to use portfolio management and
asset allocation techniques to achieve maximum return. The chief objective of
this strategy is capital growth; investors place a higher percentage of their assets
in equities rather than in safer debt securities. Because aggressive investors typically build portfolios that carry a high degree of risk, they should have a correspondingly high degree of risk tolerance.
1.4.6 Income
Income investors search for companies that consistently pay high dividends,
typically focusing on larger, well-recognized companies. This strategy is often
favored by investors who are in or near retirement.
1.4.7 Deep Value
Deep value refers to a style of investing that involves purchasing the securities of
companies that have been compromised in some way, perhaps because of financial problems, business obsolescence, or negative litigation. The market assumes
that these companies will not survive, so the deep value investor is taking great
risk.
Although highly risky, this investment strategy can lead to extraordinary rewards,
even though it is not uncommon for many deep value companies to fail.
1.4.8 Distressed Securities
Distressed securities investors take equity positions in businesses experiencing financial, operational, or cyclical problems. Investors following this strategy
believe these companies have potential which can be realized with improved
management or through restructurings, reorganizations, mergers, or acquisitions.
Investing in distressed securities is generally an institutional strategy. Private
investment partnerships, such as hedge funds, have been the largest buyers of
distressed securities in recent years. Other buyers include broker-dealers, mutual
funds, and private equity firms.
29
Chapter 1
Evaluating the
Corporate Structure
1.4.9 Momentum
A momentum investor likes to invest only when the stock price is moving. These
investors believe that once a stock’s price has begun to rise, it is likely to stay on
that path. Momentum investors are likely to pick stocks from the “new high” list
and will generally sell off the stock when the price starts to fall.
Knopman Note:
Q: What kind of stocks would a price momentum trader seek out?
A: A momentum investor would seek out stocks that have seen
substantial gains over the past year or longer.
1.4.10 Index
Index investing involves replication of a group of stocks that closely tracks an
index. Designed for low turnover, accurate tracking, and low costs, this strategy involves a buy-and-hold philosophy and a purchase or sale of securities only
when there is a change to the composition of the index.
Many investors find it hard to beat the performance of a broad-market index, so
index funds or an index investment philosophy can offer strong performance for
minimal effort.
1.4.11 Quantitative
Quantitative investing uses financial analysis to determine whether a proposed
investment is worthwhile or appropriate. Quantitative investors use programs
to analyze historic patterns of price behavior and statistics to employ what they
consider a disciplined and objective approach to investment trading.
A quantitative investor would look at trading data, such as a 10-day moving average or resistance levels, to identify securities poised for a breakout.
1.4.12 Arbitrage
Arbitrage is the practice of taking advantage of a price differential between two
or more markets. Persons who engage in this practice are called arbitrageurs.
They profit from finding price differences in financial instruments, such as bonds,
stocks, derivatives, commodities, and currencies, between different markets.
Knopman Note: Credit arbitrage (aka carry trade) occurs when an
investor borrows money at a low rate (short-term liabilities) and
invests it to earn a higher return (long-term assets).
30
1.4.13 Risk Arbitrage
Risk or merger arbitrage is an investment or trading strategy often associated
with hedge funds. In a situation where an acquisition is pending, the target company’s stock typically trades below the proposed acquisition price. Arbitrageurs
will buy the stock of the target and profit if the acquisition closes. The risk arises
from the possibility of a deal failing to go through. Obstacles may include either
party’s inability to satisfy conditions of the merger, failure to obtain shareholder
approval, failure to receive required regulatory clearances, or a change in the
acquirer’s desire to complete the transaction.
Chapter 1
Evaluating the
Corporate Structure
1.4.14 Special Situation
Special situation investing involves finding a unique set of circumstances
involving a security that would compel investors to trade it. Examples of special
situations are:
◆ A large public company spinning off one of its smaller business units into
its own public company
◆ A tender offer
◆ A bankruptcy proceeding
◆ A large lawsuit
Any of these events could cause a flurry of market activity, which is what the
special situation investor is seeking.
Knopman Note:
Q: If a company were to retract its earnings guidance, what types
of investors would be most interested in the company’s stock?
A: Distressed company investors and special situation investors.
1.4.15 Sector
Investing in a sector involves focusing on investing in a specific industry.
Common areas of sector investing include technology, natural resources, and
defense. Sector investing offers great potential for reward if the right area of concentration is chosen at the right time.
31
Chapter 1: Evaluating the Corporate Structure
Unit Exam
1. A private offering of stock by a publicly traded
company is known as a:
A.
B.
C.
D.
Hybrid security
PIPE
Secondary offering
Primary offering
2. A transaction in which the acquirer and target
combine into one surviving entity is known as:
A.
B.
C.
D.
A stock sale
An asset sale
A merger
A material adverse effect
3. Publicly traded REITs refer to which of the
following?
A. REITs that do not file with the SEC and
whose shares trade on a stock exchange
B. REITs that do not file with the SEC and
whose shares do not trade on a stock
exchange
C. REITs that file with the SEC and whose
shares do not trade on a stock exchange
D. REITs that file with the SEC and whose
shares trade on a stock exchange
4. REITs must invest what percentage of their
total assets in real estate to qualify for
favorable tax treatment?
A.
B.
C.
D.
32
100%
90%
75%
50%
5. Shares offered in a public equity offering
that provide proceeds directly to selling
shareholders are referred to as:
A.
B.
C.
D.
Primary shares
Secondary shares
Dilutive shares
Issuer shares
6. All of the following are examples of organic
growth except:
A. An increase in market share through
advertising
B. Expansion of product line
C. Takeover by strategic acquirer
D. Operational enhancements
7. A private equity company recently raised
new capital to fund the acquisition of a
target business. Which of the following
characteristics would the private equity
company prioritize the most in the target?
A.
B.
C.
D.
High amounts of existing leverage
Stable cash flows
High growth potential
Successful management team
8. A young, high-growth, and minimally leveraged
start-up company would be most likely to seek
investment from which type of investor?
A.
B.
C.
D.
Venture Capital
Private Equity
Strategic Buyer
Investment Bank
Chapter 1: Evaluating the Corporate Structure
Unit Exam (Continued)
9. All of the following are benefits of an IPO
except:
A. It provides an opportunity for founders to
sell their shares
B. It raises capital to fund the company’s
growth
C. It exposes a company to more
sophisticated valuation opportunities
D. It saves a company time, resources, and
flexibility
10. Following a PIPE transaction, an issuer will
most likely do which of the following:
A. File a private placement memorandum
B. Sign a subscription agreement to sell the
restricted shares at a future date
C. Allow the investor to exercise their
warrants after the next quarterly filing
D. File a resale registration statement
33
Chapter 1: Evaluating the Corporate Structure
Unit Exam—Solutions
(B)
A private investment in public equity (PIPE) refers to a transaction in which investors
buy securities directly from a public company via a private placement. These securities
are classified as restricted by the SEC and cannot be resold to the public market
immediately after purchase.
2. (C)
In a basic merger transaction, the acquirer and target merge into one surviving entity.
More often, a subsidiary of the acquirer is formed, and that subsidiary merges with the
target, with the resulting entity becoming a wholly owned subsidiary of the acquirer.
3. (D)
For a REIT to be publicly traded, it must file with the SEC and must meet exchangelisting criteria. Many REITs are listed on the New York Stock Exchange.
4. (C)
An equity REIT must invest at least 75% of total assets in real estate. For a mortgage
REIT, at least 75% of gross income must be derived from real-estate-related investments.
5. (B)
Secondary shares are sold by existing shareholders seeking to cash in their holdings.
Issuing secondary shares does not have a dilutive effect on existing shareholders, nor
does it increase the number of shares outstanding.
6. (C)
Organic growth is characterized as business expansion due to an increase in market
share through existing product lines, new product lines, or general operational
enhancements. Growth that is derived through mergers or acquisitions is inorganic.
1.
7.
(B)
A private equity buyer would place priority over investments that have stable cash
flows. This is because it provides the private equity firm with cash to service debt
that is used to fund the acquisition. Although a successful management team is a
positive characteristic, it is not the most important.
8. (A)
A young and fast-growing company would most likely consider an equity investment
from a venture capital fund in order to prioritize the need for cash. A private equity
company would be unlikely to invest in an early-stage start-up due to a lack of cash
flows.
9. (D)
An IPO is typically a long, drawn-out process requiring significant resources. It also
requires a company to make ongoing reports to the SEC which requires further
resources and time commitment.
10. (D)
In a PIPE transaction an issuer will often file a resale registration statement that will
allow the investors to sell the securities immediately.
34
2. Corporate Financial
Statements
Many of the valuation concepts tested on the Series 79 Exam presume understanding of the three primary financial statements and how they interact with
one another. For those who are new to corporate finance, it is essential to understand these concepts.
Knopman Note: If you are comfortable with the line items of financial
statements, we suggest reading only the Knopman Notes in this
chapter.
2.1 Financial Statements Overview
Public companies are required to include audited financial statements in their
annual and quarterly reports. Detailed financial statements can be found on
company websites, usually under the “Investor Relations” tab. They are also
posted online in public filings in the SEC’s EDGAR system.
The three primary financial statements are:
◆ The income statement reports a company’s revenues, expenses,
and net profits over a quarter or full year. It is also called a profit and
loss statement, or a P&L. The income statement drives a company’s
reported quarterly earnings per share (EPS). It may be accompanied by
a statement of comprehensive income, which reconciles the P&L to
account for investments made by, and distributions made to, owners of
the company.
◆ The balance sheet reports a company’s assets, liabilities, and
shareholders’ equity at a particular point in time, usually the last day of a
quarter or year. It is also called the statement of financial position. The
balance sheet drives a company’s book value per share.
◆ The cash flow statement reflects the cash generated or used by
operating, investment, and financing activities. This statement
summarizes changes in the company’s cash position (without regard to
non-cash accounting events) during a period.
When viewed and evaluated together, these three statements provide a picture of
a company’s financial health at a given point in time. When multiple subsidiaries
35
Chapter 2
Corporate Financial
Statements
or affiliates are controlled by a common parent company (or holding company),
accounting standards require the parent to publish a set of consolidated financial statements encompassing the entire organization.
2.2 Financial Statements and Accounting Standards
To evaluate public companies, investors need uniform financial standards that
are accurate, reliable, understandable, relevant, and complete. Thus, public
accounting organizations around the world have agreed on a global accounting
standard called the International Financial Reporting Standards (IFRS). This
standard is gradually replacing country-specific standards, such as the Generally
Accepted Accounting Principles (GAAP) developed by the Financial Accounting
Standards Board (FASB) in the US. As of now, however, the SEC recognizes GAAP
as the accounting standard for US public company financial statement reports.
2.3 The Income Statement
The income statement is useful in reporting as well as in comparing revenues,
expenses, and profits for the current period with one or more prior periods. For
example, a current quarter’s results can be compared to the two prior quarters or
to the same quarter from the previous year (year over year or YoY). The income
statement contains many important financial items.
2.3.1 Revenue
Sales (or revenue) is the first line item, also known as top line, on an income
statement. Sales represents the total dollar amount realized by a company
through the sale of its products and services during a given period. Revenues
may be itemized by product or division.
2.3.2 Cost of Goods Sold (COGS)
Cost of goods sold (COGS) summarizes the direct costs of producing the goods
that generate top line revenue. COGS may include raw materials, labor, and other
manufacturing inputs. Any net increases in inventory value may also be captured.
COGS captures expenses that are variable, based on sales volume or units sold.
For service businesses, advertising may fall under COGS.
Knopman Note: The use of the term direct when describing costs (e.g.,
direct labor costs, direct materials costs) indicates that the costs
are variable and should be recorded as COGS. Depreciation and
amortization costs, however, could be fixed and may not be included.
36
2.3.3 Gross Profit
Gross profit equals revenues minus COGS. Gross profit margin is calculated
by dividing gross profit by revenue. The following table compares a hypothetical
company’s gross profits over three consecutive quarters.
All data in $000s
Revenue
COGS
Gross Profit
Gross Profit Margin
Chapter 2
Corporate Financial
Statements
Q4 2011
Q3 2011 Q2 2011
$82,476.0 $77,940.0 $72,651.0
36,511.0
30,997.0
39,139.0
$43,337.0 $41,429.0 $41,654.0
52.54%
53.15%
57.33%
The company above has increased revenues in each of the past two quarters.
But the trend is not toward higher profitability, because COGS has increased at
a faster rate than revenues in each quarter. Although gross profit has increased,
gross profit margin has declined.
2.3.4 Calculating COGS and Inventory
For companies selling physical goods, the assignment of a sale to specific inventory can significantly impact the company’s COGS and, subsequently, its gross
profit. Companies may elect to use first-in, first-out (FIFO) or last-in, first-out
(LIFO) accounting. There are other methods for calculating COGS, but the Series
79 focuses on these two.
Under FIFO accounting, the company presumes that it is selling its older inventory first; under LIFO, it presumes that newer inventory is being sold first. In an
inflationary environment, older inventory would have been cheaper to build, thus
leading to lower COGS and higher gross profit. The unsold inventory remains on
the company’s balance sheet.
Example
Company A builds inventory and sells products as indicated below.
Date
Units Built
Units Unit Cost
Total Cost
2/1/2013
50
$28
$1,400
2/8/2013
2/15/2013
80
60
$32
$37
$2,560
$2,220
Total
190
Date
2/20/2013
Units Sold
Units Price Revenue
90 $60
$5,400
$6,180
Under FIFO accounting, the company will determine COGS by first selling its earliest (i.e., oldest) inventory production. If any units sold remain
unassigned, the next oldest inventory will be sold, until all the sold units
are accounted for. From there, gross profit can be calculated. The remaining, unsold units make up the firm’s ending inventory. These calculations are
shown below.
37
Chapter 2
Corporate Financial
Statements
COGS under FIFO
Production Date
Units Unit Cost
Total Cost
2/1/2013
50
$28
$1,400
2/8/2013
40
$32
$1,280
Total
90
$2,680
Gross Profit under FIFO
Revenue
$5,400
Ending Inventory under FIFO
Beginning Inventory
$6,180
Less: COGS
Less: COGS
$2,680
$2,720
$2,680
$3,500
Under LIFO accounting, the company will determine COGS by first selling
its newest inventory production. If any units sold remain unassigned, the
next newest inventory will be sold, until all the sold units are accounted for.
From there, gross profit can be calculated. Since the company appears to be
operating in an inflationary environment, as the newer inventory is more
expensive, LIFO results in higher COGS and less gross profit than FIFO. The
remaining, unsold units make up the firm’s ending inventory.
COGS under LIFO
Production Date
Units Unit Cost
Total Cost
2/15/2013
60
$37
$2,220
2/8/2013
30
$32
$960
Total
90
$3,180
Gross Profit under LIFO
Revenue
$5,400
Ending Inventory under LIFO
Beginning Inventory
$6,180
Less: COGS
Less: COGS
$3,180
$2,220
$3,180
$3,000
It is likely that questions relating to these FIFO and LIFO calculations will be
on the exam.
38
Knopman Note: Candidates should understand LIFO and FIFO
accounting conventions. Here are some Q&As to review:
Q: In an inflationary environment, what can a company expect if it
adopts FIFO accounting?
Chapter 2
Corporate Financial
Statements
A: Using FIFO accounting will generally lead to lower COGS,
higher gross profit, more taxes, and higher net income. This
is considered to be more “aggressive” from an accounting
perspective because it leaves the more expensive inventory
on the balance sheet and inflates earnings on the income
statement. The opposite is true in a deflationary environment:
LIFO leads to higher gross profit and net income.
Q: What would happen if a company switched from FIFO to LIFO?
A: If a company using FIFO shifted to LIFO accounting, COGS
would increase, likely leading to less profit and lower taxes.
Q: What other names might be used to refer to taxes on an income
statement?
A: Taxes may be referred to on the income statement as a
“provision for income tax.” If a firm changes from FIFO to LIFO
for inventory accounting, the provision for income tax will fall.
2.3.5 Operating Expenses
Operating expenses include the fixed costs of operating the company that are
not directly related to number of units sold. Operating expenses are also referred
to as selling, general, and administrative (SG&A) expenses. SG&A includes
administrative costs, distribution, marketing, and research (for some companies) and development. Depreciation and amortization are non-cash accounting
expenses that are usually reported under SG&A.
2.3.5.1 Depreciation
Depreciation represents the portion of tangible property, or equipment, claimed
as an expense during the period due to a decline in value or wear-and-tear.
Companies use depreciation on an income statement to reduce taxes, as it is a
tax-deductible expense. As a result, when depreciation increases, a company’s
cash flow will also increase, due to the lower tax bill. Conversely, when depreciation falls, a company will pay more taxes, resulting in less cash flow.
39
Chapter 2
Corporate Financial
Statements
2.3.5.2 Amortization
Amortization is a comparable expense to depreciation, but it is claimed on
intangible assets.
2.3.6 Earnings Before Interest and Taxes (EBIT)
EBIT is also referred to as operating income, operating profit, or income from
operations. It measures a firm’s profit excluding interest expenses and income
tax expenses.
Knopman Note: If a company sells (i.e., divests) a key line of business,
it would present this on their income statement as income from
discontinued operations.
2.3.7 Earnings Before Interest, Taxes, Depreciation, and Amortization
(EBITDA)
EBITDA is a measure of a company’s profit that is calculated by adding back
depreciation and amortization (D&A) to EBIT. It is commonly used to estimate
a company’s operating cash flow, as D&A are non-cash expenses incurred by the
company. Although these expenses offer the benefit of reducing taxes owed by
the company, they do not actually represent a payment (or use) of cash.
Knopman Note:
Q: What are ways to calculate EBIT and EBITDA?
A:
• EBIT = Net Income + Taxes + Interest
• EBITDA = EBIT + D&A
• EBITDA = Net Income + Taxes + Interest + D&A
When thought about as the last iteration, net income is “part”
of EBITDA.
Q: What type of deal might negatively impact EBITDA?
A: An example of a transaction that would negatively impact
EBITDA is a sale leaseback. In a sale leaseback, a company
sells an asset to another company, and then leases (i.e., rents)
it. This will impact rent expense and reduce depreciation,
since the issuer no longer owns the asset. As a result, EBITDA
will decline. Also, any ratios involving EBITDA—for example,
interest coverage—will be negatively impacted.
40
2.3.7.1 Operating Leverage
The term operating leverage refers to the ratio of a company’s fixed costs (i.e.,
SG&A) to its variable costs (i.e., COGS). A company with greater operating leverage is able to squeeze more profit out of its sales growth. As a result, as sales
increase, the company’s profit margin will improve more than it would with an
equivalent sales increase for a company with less operating leverage. This formula is below.
Operating Leverage
=
Chapter 2
Corporate Financial
Statements
Fixed Costs
Fixed Costs + Variable Costs
The following table shows the subject company from Sales through EBIT.
Although the company’s sales have improved quarter to quarter, the reduction
in operating leverage has squeezed the company’s operating profit margin.
All data in $000s
Q4 2011
Q3 2011
Q2 2011
Sales
$82,476.0
$77,940.0
$72,651.0
COGS
Gross Profit
SG&A
Other Expense/(Income)
Operating Income (EBIT)
39,139.0
36,511.0
30,997.0
$43,337.0
$41,429.0
$41,654.0
10,290.0
10,555.0
10,722.0
1,015.0
(767.0)
1,265.0
$32,032.0
$31,641.0
$29,667.0
Operating Leverage
20.8%
22.4%
25.7%
Operating Profit Margin
38.8%
40.6%
40.8%
Knopman Note: Companies with lower COGS and higher fixed
expenses (i.e., selling, general, and administrative expenses, or SG&A)
have higher operating leverage. The benefit of higher operating
leverage is that higher sales will lead to higher profit margins.
Q: What else can improve a firm’s profit margins?
A: Industry consolidation would likely lead to long-term earnings
growth and improved profit margins due to less competition.
Q: What might reduce profit margins?
A: Increased competition, via new entrants or a spin-off by a large
company, would likely lead to reduced prices, revenues, and
profit margins.
41
Chapter 2
Corporate Financial
Statements
2.3.8 Interest Expense
Interest expense reports the cost of interest paid on long-term and short-term
debt, net of any interest received on cash.
When interest rates fall, a company may seek to refinance its outstanding debt to
reduce interest expense on the income statement, thereby increasing profitability.
Since interest is a tax-deductible expense, the reduction in interest expense does
not produce a dollar-for-dollar increase in net income. This is due to the fact that
increased profitability will require the company to pay higher taxes. The formula
to calculate the increase in net income after refinancing debt can be seen below.
Increase in Net Income
=
Reduced Interest Expenses × (1 – Marginal Tax Rate)
If the marginal tax rate is not provided, the effective tax rate (discussed shortly)
is calculated and used.
Knopman Note:
Q: When do borrowers refinance their outstanding debt, and how
does this impact annual interest expense, semiannual coupon
payments, and net income?
A: In the case of declining interest rates, a company might choose to
refinance existing debt to a lower rate to reduce interest expense.
This would increase net income by the tax-effected amount.
Example: A company with a 40% tax rate refinancing $100MM in
debt from 7% to 5% would see the following changes: $100MM ×
2% = $2MM in Annual Savings. (Note: This is equivalent to $1MM
in savings per semiannual interest payment.)
Q: What is the impact on net income?
A: $2MM × (1 – 40% Tax Rate) = $1.2MM
Included under interest expense could be any payment-in-kind interest, referred
to as PIK interest. When a company pays PIK interest, rather than paying cash
to investors to cover interest expense, it increases the principal due at maturity.
Although this does not impact the company’s net income, it alleviates pressure
on the company’s cash flow caused by debt service payments.
Although investors who receive PIK interest don’t actually receive the cash until
maturity, PIK interest is still generally taxed in the year it is accrued and is treated
as ordinary income.
42
Knopman Note:
Q: How does PIK interest work?
A: PIK interest is paid by increasing the principal due to the lender
at maturity.
Chapter 2
Corporate Financial
Statements
For example, a $1,000 loan with 5% PIK interest would add
approximately $50 to the principal due at maturity instead of
requiring a $50 cash payment each year.
Q: How does paying in PIK impact the issuer (i.e., borrower)?
A: For the issuer (borrower), PIK interest is treated in the same manner
as cash interest; it is included as an interest expense line item.
Q: How does paying in PIK impact the lender (i.e., investor)?
A: Lenders receiving PIK interest still pay tax each year as though
the interest were received in cash. Investors are not permitted
to defer taxes on the interest until maturity.
2.3.9 Income Taxes
On an income sheet, the income tax line reports the amount the company has
reserved for the period to meet income tax payments. It may be adjusted for
taxes actually paid in prior periods. Later chapters will discuss the process of tax
adjusting one-time or non-recurring items. In scenarios where the company’s
marginal or corporate tax rate is not provided, an analyst could use the effective
tax rate. The calculation for the effective tax rate is shown below.
Effective Tax Rate
=
Income Taxes
Earnings Before Tax (EBT)
Knopman Note: A firm will generate net operating losses (NOLs) if
its allowable tax deductions are greater than its taxable income. Put
differently, NOLs are created when a firm has negative taxable income.
If a company has NOLs, it can carry forward those NOLs indefinitely
and deduct them against taxes in future years.
Knopman Note: The Tax Cuts and Jobs Act of 2017 reduced the federal
corporate tax rate from 35% to 21%. Companies in most jurisdictions
will pay more than 21% due to state and local taxes. The exam will
either provide the marginal tax rate or expect you to calculate the
effective tax rate. Certain practice questions will use the older,
marginal tax rate, around 35%–40%. It is not necessary to memorize
the current corporate tax rate.
43
Chapter 2
Corporate Financial
Statements
2.3.10 Net Income
Net income is the bottom line of the income statement, summarizing the
accounting profits earned or lost during the period after all expenses (including
COGS, SG&A, interest, and tax) have been paid. As discussed above, EBITDA
is one measure that can be used as an estimate or proxy of a firm’s cash flow.
An alternative way to estimate a firm’s cash flow is to add depreciation (D) and
amortization (A) back to net income.
Cash Flow Proxy
=
Net Income + Depreciation + Amortization
In the press and in analyst coverage, net income is typically expressed as earnings per share (EPS). The calculation of earnings per share is shown below.
Earnings per Share (EPS)
=
Net Income
Total Shares Outstanding
Later chapters will review the difference between basic earnings per share and
diluted earnings per share. Below is the subject company’s full income statement,
including the effective tax rate and earnings per share.
All data in $000s, except per share data
Sales
COGS
Gross Profit
SG&A
Other Expense/(Income)
Operating Income (EBIT)
Interest Expense
Earnings Before Tax (EBT)
Q3 2011
Q2 2011
$82,476.0
$77,940.0
$72,651.0
39,139.0
36,511.0
30,997.0
$43,337.0
$41,429.0
$41,654.0
10,290.0
10,555.0
10,722.0
1,015.0
(767.0)
1,265.0
$32,032.0
$31,641.0
$29,667.0
1,350.0
1,300.0
1,200.0
$30,682.0
$30,341.0
$28,467.0
Income Taxes
12,610.3
12,743.2
11,443.7
Net Income
$18,071.7
$17,597.8
$17,023.3
41.1%
42.0%
40.2%
4,575.0
4,550.0
4,325.0
$3.95
$3.87
$3.94
Effective Tax Rate
Total Shares Outstanding
Basic Earnings per Share
44
Q4 2011
Knopman Note: It is important to understand the relationship between
the items on the income statement and changes in a firm’s profitability
or margins.
Chapter 2
Corporate Financial
Statements
Q: What would happen to a firm with revenues (sales) increasing
by 5%, and COGS (variable costs) increasing by 10%?
A: The firm’s gross profit margin (Gross Profit/Sales) would fall
despite the increased revenue. This would also likely result in
lower EBIT margins (i.e., Operating Margins = EBIT/Sales).
For example, increased revenues (sales) do not necessarily
result in increased profit margins. If a firm has revenues (sales)
increasing by 5%, but COGS (variable costs) increasing by 10%,
the firm’s gross profit margin (Gross Profit/Sales) would fall
despite the increased revenue. This scenario—assuming stable
fixed costs—would likely result in lower EBIT margins (i.e.,
operating margins).
Income Statement
Year 1
Year 2
Sales
100
105 (up 5%)
COGS
60
66 (up 10%)
Gross Profit
40
39
Gross Profit Margin
40% = 40/100
37% = 39/105
(down 3%)
However, if COGS decreases more than operating expenses
increase that would be a more plausible reason for an increase
in a company’s operating margin.
Knopman Note: If a company is looking to raise capital to fund a
project but does not want the financing to impact net income, it
would likely seek an investment from a venture capital (VC) firm. This
is because VC firms generally make equity investments, while any debt
financing (i.e., interest expense) would have an impact on net income.
2.4 The Balance Sheet
Unlike the income statement, which measures company performance over a
quarter or year, the balance sheet is a snapshot of the company’s assets and
liabilities, taken at a moment in time. This moment is usually on the last day of
a quarter or year. It is referred to as a balance sheet because, if the accounting is
done properly, the balance sheet equation (as shown below) will always hold true.
Assets
=
Liabilities + Shareholders’ Equity
45
Chapter 2
Corporate Financial
Statements
Shareholders’ equity measures the amount by which a company’s assets exceed
its liabilities, at a moment in time. Shareholders’ equity is also referred to as the
net worth or book value of equity, and is discussed later in this chapter.
The following is an example of a balance sheet. You will notice that total assets
equals total liabilities plus shareholders’ equity, so the balance sheet equation
holds true.
Consolidated Balance Sheet
($ in millions)
Current Assets
Cash & Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses and Other Current Assets
Total Current Assets
Plant, Property & Equipment
Gross PP&E
Accumulated Depreciation
Net PP&E
$1,645.4
436.7
$1,208.7
Goodwill
Other Intangible Assets, net
Other Assets
Total Assets
$1,076.4
1,425.3
277.9
$5,421.2
Current Liabilities
Accounts Payable
Notes Payable
Accrued Liabilities
Other Current Liabilities
Total Current Liabilities
Long-Term Debt
Deferred Income Taxes and Other Liabilities
Total Liabilities
$392.2
350.0
69.1
$811.3
$731.8
75.8
$1,618.9
Shareholders’ Equity
Common stock: $0.01 par value;
100,000,000 Shares Outstanding
Paid-In Capital
Preferred Stock
Retained Earnings
Treasury Stock
Noncontrolling Interest
Total Shareholders’ Equity
$1.0
2,525.8
1,403.6
(674.2)
546.1
$3,802.3
Total Liabilities & Shareholders’ Equity
46
December 31, 2012
$762.3
271.0
344.4
55.2
$1,432.9
$5,421.2
Later chapters will review key calculations from the balance sheet, while this unit
will review the key ledgers on the balance sheet.
Knopman Note: A company with a strong balance sheet and no debt
would likely seek funding from an asset-backed lender, secured by the
assets on its balance sheet.
Chapter 2
Corporate Financial
Statements
2.4.1 Current Assets
Current assets include assets that are the equivalent of cash (e.g., cash and
short-term investments) or can be expected to convert into cash within one year
(e.g., accounts receivable, inventory, and supplies). It can also include prepaid
expenses not yet due, such as insurance premiums.
2.4.2 Non-Current Assets
The largest category of non-current assets is usually property, plant, and equipment (PP&E). These assets, which sustain company operations and cannot easily be converted to cash, are carried on the balance sheet at their book value (i.e.,
purchase price less accumulated depreciation). The balance sheet ignores any
appreciation in asset value, or the fact that some assets may be worth far more
than their book value.
Other categories of non-current assets include intangible assets, goodwill,
deferred income tax assets, and long-term investments.
2.4.2.1 Goodwill
Goodwill is created when one company acquires another company (or specific
divisions or assets of a company) for a price greater than fair market value. The
difference between the acquisition price and market value is recorded as goodwill. Although goodwill is an intangible asset, it is usually listed separately on the
balance sheet from other intangibles, such as the value of copyrights, patents,
and trademarks.
Example
If public company Acme acquires public company Beta, the goodwill generated is calculated as the difference between the purchase price and the
market value of the net assets of Beta Company.
47
Chapter 2
Corporate Financial
Statements
Knopman Note: Acme purchases Beta for $300 million; debt is $20
million, equity is $160 million, and the market value of the net assets is
$190 million; acquisition goodwill will be $110 million (the difference
between the purchase price of $300 million and the market value of
the net assets of $110 million).
Acquisition Goodwill = Purchase Price − Market Value of Net Assets
Acquisition Goodwill = $300 million − $190 million
Acquisition Goodwill = $110 million
2.4.2.2 Deferred Tax Assets
Deferred tax assets (DTAs) are created when companies depreciate property
faster on SEC filings than they do on their tax returns. A DTA reflects the fact that
the company paid more tax than was actually shown on its most recent SEC filing.
This asset will eventually depreciate to zero, as the company will offset the asset
by paying less tax in future years. Other expenses may create deferred tax assets,
but depreciation is the most common. Deferred tax assets can also be created
when the company pays taxes early by accelerating recognition of revenue for
tax purposes, even though it is not reported in SEC filings. The amount of the
deferred tax asset is calculated using the marginal tax rate, when possible.
Knopman Note: If a company’s taxable income is higher than its bookreported income, it generates a deferred tax asset.
2.4.3 Current Liabilities
Current liabilities captures payments, debts, and obligations due within one
year, such as wages and accounts payable, notes or interest payable, and taxes.
Prepaid revenues that have already been booked on the income statement, but
have not yet been earned, are considered a current liability, if they will be earned
within one year.
2.4.4 Long-Term Liabilities
Long-term liabilities records the principal due in a company’s long-term debt
structure, including loans, mortgages, notes, or bond principal repayable beyond
one year. It may also include unfunded pension and retiree healthcare obligations, deferred revenue (e.g., customer prepayment for goods and services), and
deferred tax liabilities.
48
2.4.5 Shareholders’ Equity
Shareholders’ equity records the difference between the firm’s assets and liabilities. It is a measure, at any moment in time, of the capital represented by a
company’s common and preferred stock (at par value) plus cumulative retained
earnings. The value of any treasury stock (stock the company has repurchased)
will reduce shareholders’ equity.
Chapter 2
Corporate Financial
Statements
Shareholders’ equity is also referred to as book value of equity or simply book
value.
A related concept, tangible book value, can be calculated from the balance
sheet as follows:
Tangible Book Value
=
Shareholders’ Equity – Goodwill
A number of different ledgers comprise shareholders’ equity.
2.4.5.1 Preferred Stock
Preferred stock allows a company to raise additional equity without diluting the
ownership of common shareholders. Any reference to book value of common
equity requires that preferred stock be subtracted from shareholders’ equity.
2.4.5.2 Common Stock
A company’s common stock account on the balance sheet represents the proceeds received from the issuance of common stock, less the amount paid to
repurchase any treasury shares. On a balance sheet, two different accounts comprise common stock.
Par Value of Common Stock
Par value of common stock, unlike par value for a bond, has little significance
as far as financial statement analysis is concerned. Par value is an accounting
entry solely for bookkeeping purposes. Par value is typically $0.01 per share, or
possibly $1 per share. Any time a company issues stock in the market, the par
value account will increase by par value per share × the number of issued shares.
Knopman Note:
Q: Does the par value of a company’s stock have any relation to the
stock’s market value or the firm’s equity value?
A: No. Par value of common stock is purely an accounting entry
and has no influence on the market value of the stock.
49
Chapter 2
Corporate Financial
Statements
Additional Paid-In Capital (APIC)
Additional paid-in capital (APIC), also referred to as capital surplus, represents the money raised by a company from a stock issuance, in excess of par
value. As a result, the balance in a company’s APIC ledger is generally far greater
than that in the par value account.
Example
NeedsSomeEquity, Inc., (NSE) issues eight million shares of $0.10 par value
for $14 per share. Assuming the syndicate receives a spread of $0.70 per share,
what is the increase to par value and the increase to capital surplus as a result
of the transaction?
NSE receives $13.30 per share ($14.00 Public Offering Price − $0.70 Underwriting
Spread). Of the $13.30 received, $0.10 per share is credited to par value for a
total of $800,000 (8MM Shares × $0.10 per Share). The remaining $13.20 per
share is credited to APIC, for a total increase to APIC of $105.6 million ($13.20
× 8MM Shares).
If the exam were to ask about the increase to net worth, the answer would
be: 8MM Shares × $13.30 = $106.4MM. Net worth is the same as shareholders’
equity, so the division between par value and capital surplus would not be
relevant.
In many cases, public companies will combine par value accounts and APIC
accounts under one account simply titled “Common Stock,” but for the Series 79
Exam it is important to make the distinction between these two accounts.
2.4.5.3 Treasury Stock
Treasury stock represents shares that have been issued but repurchased by the
company. There are two ways of accounting for treasury stock. If the company
plans to permanently retire the repurchased stock, then the amount repurchased
will reduce both par value and capital surplus (assuming the repurchase price is
above par value) on the balance sheet.
If, however, the company might re-issue the stock in the future, treasury stock
will be set up as a separate account within shareholders’ equity. Treasury stock
is a contra-equity account, meaning it reduces common stock and shareholders’
equity. Excluding for the moment preferred stock, retained earnings, and noncontrolling interest (which will be discussed later), the calculation of treasury
stock can be seen below.
Treasury Stock
50
=
Common Stock
–
Shareholders’ Equity
Knopman Note:
Q: How does a company repurchase its own stock?
A: When a company repurchases stock, it will typically do so as
a negotiated transaction with a broker-dealer rather than by
purchasing its shares in the open market. This type of deal
is referred to as an accelerated share repurchase, and will be
discussed later in the text. As a result, shareholders’ equity will
be reduced by the actual acquisition cost, not the current market
price.
Chapter 2
Corporate Financial
Statements
Q: How does a stock repurchase impact the balance sheet?
A: A stock repurchase will always reduce cash and shareholders’
equity on the balance sheet.
Within shareholders’ equity, the company can choose to:
• Reduce par value and capital surplus (the par value method), or
• Increase the contra-equity treasury stock account (the cost
method)
2.4.6 Retained Earnings
Net income can be used to pay dividends to common shareholders. Any portion of net income not used to pay dividends becomes part of retained earnings, reported on the balance sheet under shareholders’ equity. Put another
way, retained earnings (and shareholders’ equity) increase by the amount of net
income, and are reduced by the amount of dividends declared.
Knopman Note: When a company declares a dividend, this creates
a dividend payable liability, which is balanced out by a decrease to
shareholders’ equity.
When a company pays a dividend, assets fall (as the company is
paying out cash), which is offset by the dividend payable liability being
reduced.
Negative net income (losses) reduces retained earnings. The following shows how
retained earnings are cumulatively reported on the balance sheet.
($ in millions)
2007
2008
2009
2010
Retained Earnings at Start of Year $318.0 $349.5 $222.1 $183.6
Plus: Net Income
45.2 (118.9)
(28.0)
67.4
Less: Dividends Declared
13.7
8.5
10.5
12.5
Retained Earnings at End of Year $349.5 $222.1 $183.6 $238.5
51
Chapter 2
Corporate Financial
Statements
As the example shows, it is possible for companies to continue paying dividends
even in years when they lose money (have negative net income). In this case, both
the dividends declared and the net losses reduce retained earnings.
The same logic applies to calculating changes in shareholders’ equity (i.e., add
net income, subtract dividends), assuming there are no other equity activities
throughout the year.
Knopman Note: If a company pays dividends that are greater than its
net income, shareholders’ equity will fall.
Later chapters will review a full balance sheet and important calculations on the
balance sheet, but the ledgers described in this chapter are of high importance
on the examination.
Knopman Note: The declaration of a dividend reduces a company’s
retained earnings and shareholders’ equity regardless of when the
dividend is actually paid. For example, a dividend declared in 2020
reduces shareholders’ equity even if the dividend is not actually paid
until 2021.
2.5 The Cash Flow Statement
Like the income statement, the cash flow statement measures performance
over a defined period, such as a quarter or year. However, it focuses on the actual
cash generated or spent by the business. It seeks to reconcile the company’s net
income to cash flow by adjusting for non-cash expenses (e.g., depreciation) and
changes to net working capital accounts (discussed later).
The cash flow statement also reflects the fact that companies receive and spend
cash through means other than their primary business function. Examples of this
include a company spending money to purchase new PP&E (i.e., capital expenditures), or a company issuing a bond in the open market.
Companies’ cash positions can change (up or down) for many reasons that are
not directly related to operating health. For example, a company may see an
opportunity to prepay or refund outstanding debt. This decision would result
in a cash outflow even though cash may be positive for the company over time
because of reduced debt. Analysts and investors may need to study public companies’ financial reports, such as quarterly 10-Qs and annual 10-Ks, to interpret
changes in cash flow.
The bottom line of this statement is the cash (and equivalents) available at the
end of the period, and this same entry is found on the balance sheet for the same
period. Financial analysts monitor the changes in “cash available” from period to
period to evaluate a company’s ability to meet current obligations.
52
The cash flow statement has three primary sections, which will be discussed in
detail in later chapters:
◆ Cash flows from operating activities
◆ Cash flows from investing activities
Chapter 2
Corporate Financial
Statements
◆ Cash flows from financing activities
Knopman Note: Interest income and interest expense are both
considered part of cash flows from operating activities, not cash
flow from financing activities. If a banker wanted to learn if a
company could cover its operating expenses, they could calculate the
company’s operating cash flow.
53
Chapter 2: Corporate Financial Statements
Unit Exam
1. A company’s marginal tax rate refers to which
of the following?
A. The rate at which a company is required
to pay federal, state, and local taxes on its
last dollar earned
B. The actual tax amount paid by a company
during a given year
C. The rate at which a company’s
shareholders pay taxes on dividends
received
D. The actual tax amount paid by a company
on the sale of long-term investments
2. NewPublicCo sells 100,000 shares of $0.50 par
value stock for $12 per share. Which of the
following is true about the money raised in
excess of par value?
A. It is paid entirely to the SEC as a
registration fee
B. It represents a credit to retained earnings
C. It represents a credit to capital surplus
D. It represents a liability that must
eventually be returned to shareholders
3. GoodValueCo (GVC) declares a dividend in
excess of its net income. How is this dividend
reflected on GVC’s balance sheet?
A.
B.
C.
D.
It reduces capital surplus
It reduces retained earnings
It increases long-term liabilities
Public companies are prohibited from
paying dividends in excess of their net
income
4. BJM Company, Inc., shows $700 million in
shareholders’ equity as of the beginning of
2016. During the course of 2016, BJM earns
$80 million in net income and declares $5
million in dividends. Assuming no additional
financing activities during 2016, what is BJM’s
shareholders’ equity as of the end of 2016?
A.
B.
C.
D.
5. Which of the following is true regarding the
accounting for an issuer’s repurchase of its
own stock in the open market?
A. It is reflected on the balance sheet at the
acquisition cost
B. It is reflected on the balance sheet at the
current market value
C. It is reflected on the cash flow statement
as an operating activity
D. It is reflected on the cash flow statement
as an investing activity
6. What does the colloquial term “bottom line”
refer to?
A.
B.
C.
D.
EBITDA
Revenue
Operating profit
Net income
7. A company’s profitability for a particular
period is best measured by which of the
following financial statements?
A.
B.
C.
D.
54
$620 million
$695 million
$775 million
$780 million
Income statement
Balance sheet
Cash flow statement
Statement of shareholders’ equity
Chapter 2: Corporate Financial Statements
Unit Exam (Continued)
8. Given the information below, calculate gross
profit.
($ in millions)
Sales$1,000
Cost of Goods Sold
$600
Interest Expense
$50
Taxes$10
A.
B.
C.
D.
340 million
350 million
400 million
460 million
10. The cash flow statement includes which of the
following sections?
I. Operating activities
II. Shareholders’ equity
III. Investing activities
IV. Retained earnings
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
9. Where in a company’s financial statements can
one find its depreciation and amortization?
A.
B.
C.
D.
Balance sheet
Cash flow statement
Debt schedule
Shareholders’ equity schedule
55
Chapter 2: Corporate Financial Statements
Unit Exam—Solutions
1.
(A)
The marginal tax rate for US corporations is the rate at which a company is required
to pay federal, state, and local taxes. The highest federal corporate income tax rate
for US corporations is 21%, with state and local taxes typically adding another 2% to
5% (depending on the state). Most public companies disclose their federal, state, and
local tax rates in their 10-Ks in the notes to their financial statements.
2. (C)
When a company sells stock to the public, capital raised in excess of par value is
represented as an increase to capital surplus on the issuer’s balance sheet. Capital
surplus is also referred to as additional paid-in capital (APIC).
3. (B)
When a company declares a dividend, this is reflected on the balance sheet as an
increase to current liabilities (dividends payable) and a reduction to retained earnings.
The fact that the dividend is in excess of its net income does not impact the accounting
treatment of this transaction.
4. (C)
Shareholders’ equity increases by the amount of net income during a given period
and decreases by the amount of any dividends declared. Therefore, $700 million
beginning shareholders’ equity + $80 million net income − $5 million dividends = $775
million ending shareholders’ equity.
5. (A)
When an issuer repurchases its own stock, cash is reduced by the amount of the
acquisition cost, and the treasury stock account (which is a contra-equity account)
increases by an equivalent amount. On the cash flow statement, a repurchase of shares
is considered a financing activity.
6. (D)
Net income is also referred to as the bottom line due to its position at the bottom of the
income statement. It is the residual profit after all of a company’s expenses have been
netted out.
7. (A)
The income statement offers the best overview of a company’s profitability for a
particular period. Meanwhile, the balance sheet displays a company’s financial position
at a point in time—it lists the assets, liabilities, and shareholders’ equity balances as of
the fiscal quarter or year end. The cash flow statement records the company’s cash
inflows and outflows for a particular time period. The statement of shareholders’ equity
breaks down the company’s net worth at a moment in time.
8. (C)
Gross profit is the profit remaining after deducting the direct costs associated with
producing a product. It is calculated as sales less cost of goods sold, so $1 billion – $600
million = $400 million. The pre-tax profit is $350 million, while $340 million is the net
income.
9. (B)
Depreciation and amortization can always be located in a company’s cash flow statement.
10. (A)
The cash flow statement comprises three primary sections: 1) operating activities, 2)
investing activities, and 3) financing activities, which are summed and added to
a beginning cash balance to produce an ending cash balance for a particular period.
Shareholders’ equity is a component of the balance sheet and retained earnings is a
component of shareholders’ equity.
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3. Foundational Valuation
Concepts
The previous chapter covered a company’s three primary financial statements
and how they interact with one another. The next three chapters will focus on
how this information is further used to determine the value of a business.
Valuation refers to the process of calculating an estimate for the value of a company, business unit, or asset. This chapter will discuss foundational concepts
that help to build an understanding of the context and terminology surrounding
valuation as well as some of its general mechanics.
The subsequent two chapters will delve into more detail on the three main valuation methodologies: 1) comparable companies analysis, 2) precedent transactions analysis, and 3) discounted cash flow (DCF) analysis.
3.1 Valuation Fundamentals
This section will explore the framework of valuation and some of the core concepts candidates must be familiar with.
3.1.1 Significance of Valuation
Valuation is a large component of the expertise that investment bankers provide
for their clients. In fact, most investment banking activities involve valuation
work.
When a client engages an investment bank to attempt to buy another company
(the “target”), the investment bankers are typically responsible for providing an
estimate of the target’s value. As the bankers negotiate a deal with the target,
they use their valuation analysis as a guide to ensure they are securing a good
deal for their client.
Similarly, when a company engages an investment bank to attempt to sell itself,
the investment bankers are typically responsible for estimating the value they
think the company will command in the market. As the bankers negotiate a deal
with potential buyers, they use their valuation analysis as a guide to ensure they
are securing the best possible price and deal for their client.
Valuation is also important when bankers help companies raise money. In IPOs,
follow-on offerings, private placements, and other capital-raising events, bankers
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act as intermediaries between the client and investors. For example, they advise
clients as to how much they believe can be raised based on the valuation, or, in
marketing a company’s securities to potential investors, they suggest the price at
which the company should sell its securities. This is crucial when raising capital
for a private company where no public market price exists to serve as a baseline.
3.1.2 The Art and Science of Valuation
To calculate the value of a company, there are many common techniques, which
will be discussed more in later chapters. They involve varying degrees of data
collection and analysis as well as the application of economic and financial principles. Part of an investment banker’s core competence is the intimate understanding of this knowledge and its applications. However, valuation is not all
science. In fact, it is just as much an art.
Notice that valuation is referred to as an “estimate.” This is because different
investors will have varying perceptions on the value of a company. This discrepancy is due to the reliance on different techniques by various investors; contrasting methodologies for projecting the future performance of a company;
and heavy use of judgment in the valuation process, as market participants may
hold differing beliefs about key metrics that “drive” the valuation. Furthermore,
economic conditions that may have nothing to do with the company or asset in
question can loft or depress valuations in general.
For example, based on research and knowledge about the company, its industry,
and broader economic factors, one person might believe revenue will grow by
3% per year, whereas another might believe revenue will grow by 4% per year. All
other things being equal, the second person would have a higher value for the
company.
There is no single measure of the value of a company at any given point in time.
Instead, valuation is an expression of an inherently subjective process that is
intricately tied to the beliefs of the practitioner.
3.1.3 Price Versus Value
The anecdote below illustrates the distinction between price and value and the
fact that different investors might value the same asset differently.
Imagine the market for a new car—a brand new minivan—and consider what
various types of people might pay for that car.
A family of six with four young children living in the suburbs would likely derive
more value from a minivan than a single individual living in a city with limited
parking. The family might be willing to pay $20,000 for that minivan, whereas the
individual might only be willing to buy it if it were very cheap, say $5,000.
In other words, these potential buyers have differing perceptions of the car’s
value. A trip to the auto dealer will reveal the car’s price. If the price of the car is
$15,000, only the family will make the purchase, as the price is less than what the
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family perceives the car’s value to be. If the price is $25,000 neither the family of
six nor the single person will buy the car.
Similar principles apply to the stock of a company. The many participants in
the market each have different views on the value of the company and, thus, its
stock. (The stock price merely represents the most recent value at which a trade
occurred.) If an investor is interested in buying shares of a company, she will
compare the price at which she can buy the stock with her perceived value of the
company and buy shares only if the price is less than her perception of its value.
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For companies with highly liquid stock, it is likely that a modestly sized transaction will occur near the price of the most recent transaction. As the size of a
transaction increases, the quoted market price might not be an accurate enough
reflection of the stock’s perceived value for the transaction to be consummated.
For instance, if an investor wants to buy a large amount of stock, he might be
required to pay a premium price above the current market value to entice many
other stockholders to sell their shares. This is precisely what happens when a
company wishes to buy another public company. Thus, the acquiring company
needs to perform its own, independent valuation of the target company to determine how much more than the market price it is willing to pay.
3.1.4 The “Football Field”
Investment bankers are hired to achieve the best outcome for a client. This
requires estimating what various investors in the market are willing to pay in
a given deal, resulting in a range of potential values. Investment bankers create
these estimates by:
◆ Applying different valuation techniques
◆ Experimenting with different values for key metrics that drive the
valuation, and
◆ Considering what different types of investors would pay for the company
This variety establishes a more complete picture of the range of valuation possibilities rather than merely a single estimation of value. Investment bankers
commonly present the entire range of valuation possibilities in a chart called
a “football field” that includes the high and low estimates from each valuation
methodology used. The chart below is an illustration of this.
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Implied Equity Value per Share
Current share price: $137.15
52-week range
Comparable companies
Precedent transactions
Leveraged buyout
$0
$50
$100
$150
$200
$250
Price per Share
The football field chart provides an easy way to visualize the results of various
valuation techniques. In the example above, the company’s current stock price
is shown in relation to the valuation ranges that resulted from four different
techniques: 52-week range, comparable companies, precedent transactions, and
leveraged buyout.
This chart suggests that the company is currently priced at the low end of the
valuation ranges established. If the company that is the subject of this analysis
is a banker’s client, these results can be used to suggest that the company is
undervalued by the market and lead the banker to recommend that the company
consider selling itself to unlock its full value. Alternatively, this undervalued company could make an attractive acquisition target for a different client.
3.2 Capital Structure
Building upon the framework of what valuation is, it is important to understand
enterprise value and equity value, which are two of the main components of how
one values a business. First, though, it is necessary to review a company’s capital
structure, which is the way it finances its growth and continuing operations
through different funding sources.
3.2.1 Capital Structure Overview
To explain capital structure, let’s use the analogy of an individual purchasing
a home. In this example, an individual buys a home for $100,000. To fund the
purchase, she decides to borrow $80,000 from a bank in the form of a mortgage,
which is a type of debt instrument, and contribute the remaining $20,000 herself,
which is equity.
The capital structure represents how the value of the house (or any other asset)
is split up into the various forms of capital. In this example, the house is capitalized, meaning funded, with $80,000 of debt and $20,000 of equity.
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The capital structure is typically visualized as a stacked column referred to as a
cap stack:
Equity
$20,000
Debt
$80,000
}
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Total invested capital
$100,000
This same asset can be capitalized in a number of ways. For example, if the bank
is only willing to lend $60,000, then a different capital structure will result, involving $60,000 of debt and $40,000 of equity. Notice, as illustrated below, that the
purchase price remains $100,000, and only the makeup of the capital structure
changes.
Equity
$40,000
Debt
$60,000
3.2.1.1 How Changes in Asset Values Affect Capital Structure
The capital structure of an asset changes as its value increases or decreases.
However, as the value of the asset changes, the amount owed to debt holders
remains constant. Put differently, just because the value of the asset increases or
decreases does not mean the size of the loan changes. Therefore, a change in the
value of the asset only results in changes to the value of the equity.
For instance, suppose that the value of the house from the prior example increases
to $110,000:
◆ The $80,000 mortgage would still be owed on the house.
◆ The value of the equity would be the remaining $30,000
($110,000 − $80,000).
The $10,000 increase in the value of the house is experienced only by the equity
holders, resulting in a $10,000 increase in the value of the equity. Note that the
$10,000 appreciation in the value of the house accounts for only a 10% increase
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in total value ($10,000/$100,000). However, that appreciation results in a 50%
increase in the value of the equity ($10,000/$20,000).
10%
Equity
$20,000
*
*
50%
Debt
$80,000
Equity
$30,000
Debt
$80,000
Conversely, suppose that the value of the house in our example instead decreased
to $90,000:
◆ The $80,000 mortgage would still be owed on the house.
◆ The value of the equity would be the remaining $10,000 ($90,000
− $80,000).
The $10,000 loss in the value of the house is experienced only by the equity
holders, resulting in a $10,000 decrease in the value of the equity. Here, the
$10,000 depreciation in the value of the house accounts for only a 10% decrease
in total value ($10,000/$100,000) but a 50% decrease in the value of the equity
($10,000/$20,000).
This illustrates why equity has the highest risk and highest upside potential of all
positions in the capital structure. Whereas more “senior” positions such as debt
have protection against loss of value to the asset, equity does not. However, only
equity participates fully in increases in asset value.
Upon sale of the home, the homeowner would owe the bank the amount of principal remaining on the mortgage and then be entitled to whatever amount of
money is leftover, i.e., the residual value. Because equity holders are only entitled
to what’s left after paying off everyone else, they occupy the most junior position
in the capital structure.
3.2.2 Valuation of Companies
With our house example, we looked at total value and equity value. Corporations
have two analogous values: enterprise value and equity value.
Enterprise value is analogous to the total value of a home—it represents the
total value of the company. If you look at the picture of a company’s capital structure, the enterprise value is what results when you add up all the components,
including all the debt and equity. Similarly, the total value of the home includes
the mortgage as well as the amount of the homeowner’s equity that the homeowner experiences.
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Like homes, companies have equity value—it represents the residual value, or
what is left over for the company’s shareholders after all of the “senior” claimants
(i.e., debt holders) are paid off. Similarly, equity value is the amount left over for
a homeowner after paying off the mortgage.
Equity
$20,000
Equity
$20,000
Debt
$80,000
Debt
$80,000
Purchase price of house
$100,000
Enterprise value of company
$100,000
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Investors often describe a company’s value based on its stock price, which is the
equity value divided by total shares outstanding. This is how a company’s value
is typically quoted in the stock market. However, it is important to recognize that
this determination of value is based only on the company’s equity value and not
the value of the company in its entirety, which includes the rest of the capital
structure.
Enterprise value and equity value are both commonly used figures, so it is crucial
to understand them and to be able to use them in the correct context. Confusing
the two is like confusing the purchase price of a house (equivalent to enterprise
value) with the down payment (equivalent to equity value).
3.3 Equity Value
As mentioned above, equity value is the value of the company available to its
owners. It is also referred to on the exam as market capitalization, market
cap, market capital, or market value of equity. This section will discuss some
important concepts and calculations relating to equity value.
3.3.1 Aggregate Value Versus Share Price
Equity value is distributed to owners in the form of divisible shares. Because of
this, the most common expression of the value of a company is its share price. This
is the market price of a single share of the company. The market value of the entire
company comes from adding up all the shares of stock. In other words, to calculate equity value, multiply the stock price by the number of shares outstanding.
Market Value of Equity, i.e., Equity Value = Number of Shares Outstanding × Share Price
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Conversely, if both equity value and the number of shares outstanding are known,
that information can be used to calculate a share price, as illustrated below.
Share Price
=
Equity Value
Number of Shares Outstanding
Similarly, if both equity value and share price are known, the number of shares
outstanding can be calculated.
Number of Shares Outstanding
=
Equity Value
Share Price
Knopman Note: Candidates need to be able to manipulate formulas to
solve for an unknown variable.
As will be illustrated in the next chapter, calculations performed on a per share
basis can also be done on an overall company basis and vice versa.
Knopman Note: Treasury stock and the authorized share count, which
is the maximum number of shares that a company can legally sell to
investors, are not relevant when calculating a company’s market cap.
3.3.2 Basic Shares Outstanding
As indicated above, one must know the number of shares outstanding to calculate equity value. Obtaining this information is not always straightforward. There
are three main reasons for this:
◆ Companies disclose this information relatively infrequently
◆ Companies can take actions that change this number in between
disclosures
◆ Many companies issue options, warrants, and convertible securities that
might affect total share count if exercised or converted
Candidates must be familiar with two different versions of share count: basic
shares outstanding and diluted shares outstanding.
Basic shares outstanding refers to the actual number of shares the company
has issued and that are currently owned by shareholders. Companies disclose the
number of basic shares outstanding on the front page of their quarterly (10-Q)
and annual (10-K) financial reports.
Take note, there is a lag between the end of a company’s fiscal period and when
they are required to file their reports. However, even though most of the information in the 10-Q or 10-K is reported as of the end of the fiscal period, the number
of shares outstanding is reported as of the filing date. As illustrated in the below
10-K filing, Home Depot’s fiscal year ended on January 18, 2018, but the company
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is reporting 1,157,269,522 shares outstanding as of the March 2, 2018 date that it
submitted its filing to the SEC.
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Keep in mind that the information from the most recent 10-Q or 10-K will not
always be precisely accurate, as companies can engage in transactions in between
filing dates that may alter the number of outstanding shares. For example, company employees may exercise stock options, the company may engage in stock
buybacks, or the company may conduct a follow-on offering. In these situations,
a proxy statement or 8-K might be used to find more updated information on the
share count in between quarterly filings.
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3.3.3 Diluted Shares Outstanding
Diluted shares outstanding accounts for the fact that companies often issue
various securities, such as employee stock options, warrants, and convertible
debt, that can potentially increase the number of shares outstanding and thus
dilute the ownership of current shareholders. This is because these securities can
convert into new shares of common equity at some future date. Upon conversion, each investor’s ownership is diluted as the company’s equity value spreads
amongst more shares.
Example
Assume the following information about Company A:
Equity Value
$1,100MM
Basic Shares Outstanding
100MM
Exercisable Warrants
10MM
As shown below, calculating share price using basic shares outstanding
results in a share price of $11.
$11 Share Price
=
$1,100MM Equity Value
100MM Basic Shares Outstanding
However, including the additional 10MM warrants results in the lower share
price of $10. Note that the warrants can be included in the calculation, as they
are exercisable, meaning they allow investors to exercise them to purchase
new shares in the company. The inclusion of options and warrants will be
discussed more in the treasury stock method section below.
$10 Share Price
=
$1,100MM Equity Value
(100MM Basic Shares Outstanding + 10MM Warrants)
The example above illustrates the impact of the dilution of the value of each
share. In practice, the market value of the equity is typically calculated based on
its diluted share count, not basic shares, to account for this impact, though the
exam will specify which one to work with.
3.3.4 Treasury Stock Method
The most common way to adjust for the dilutive effects of stock options and
warrants is the treasury stock method (TSM). TSM involves the following conceptual steps:
1. All in-the-money employee stock options and warrants are exercised
and converted into shares of the company. In-the-money options are
those where the strike price, or exercise price, of the option is less than
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the current share price of the company. For instance, if a company’s
share price is $30:
a. An option with a $29 strike price is in-the-money (because an
employee would love to pay $29 to purchase shares worth $30)
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b. An option with a $31 strike price is out-of-the-money (because
an employee would not want to pay $31 to purchase shares only
worth $30)
2. Exercising options and warrants means that they convert into actual
shares of the company. This causes the number of basic shares
outstanding of the company to increase—diluting ownership on a per
share basis.
3. Exercising options also means that the option or warrant holders (e.g.,
company employees) pay money to the company in exchange for shares
of stock. This generates cash proceeds for the company.
4. The company uses the proceeds of the exercise of those options and
warrants to repurchase shares in the open market at the current market
price. This somewhat offsets the dilutive effect of the option and warrant
exercise.
Companies disclose information about the number of stock options and warrants
as well as their weighted average exercise prices in the notes to their financial
statements, though the exam will provide a chart with the necessary information.
Once the number of in-the-money options and warrants are sourced, the steps
below can be followed to find the diluted share count.
Step 1: Calculate the proceeds that the company receives from employees by the
exercise of their in-the-money options.
Option Proceeds to Company = Number of In-the-Money Options × Weighted Average Exercise Price
Step 2: Calculate the number of shares the company can repurchase in the open
market at the current stock price using the options proceeds.
Number of Shares
Repurchased
=
Options Proceeds
Current Stock Price
Step 3: Calculate the amount of net new shares (i.e., the dilution) by subtracting
the number of shares repurchased from the number of options exercised.
Net New Shares = Number of In-the-Money Options − Number of Shares Repurchased
Step 4: Calculate the diluted share count by adding the net new shares to the
company’s basic shares outstanding.
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Diluted Shares = Basic Shares Outstanding + Net New Shares
Example
Assume the following information about Company B:
Current Share Price
$50
Basic Shares Outstanding
2,000,000
Options
125,000
Weighted Average Exercise Price
$40
Step 1: Options are in-the-money (since the exercise price of $40 is below the
current stock price of $50); therefore assume that the options are exercised.
Option Proceeds to Company = 125,000 Shares × $40 = $5,000,000
Step 2:
Number of Shares Repurchased
=
$5,000,000
$50
= 100,000
Step 3:
Net New Shares = 125,000 – 100,000 = 25,000
Step 4:
Diluted Shares = 2,000,000 Basic Shares + 25,000 Net New Shares = 2,025,000
3.4 Enterprise Value
Enterprise value reflects a company’s total capital structure. While the earlier
examples involved capital structures that only included debt and equity, companies typically have more complicated capital structures with several additional
layers. In addition to debt and equity, a company’s capital structure may include
preferred stock, noncontrolling interest (NCI), and cash and cash equivalents.
The enterprise value formula is below:
Enterprise Value = Equity Value + Total Debt + Preferred Stock +
Noncontrolling Interest − Cash and Cash Equivalents
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Knopman Note: Many companies on the exam will have only common
stock, debt, and cash. Therefore, expect to use the simplified version of
the enterprise value formula frequently:
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Equity Value + Total Debt – Cash
3.4.1 Net Debt
To calculate enterprise value, each layer of a company’s capital structure is added
together with the exception of cash and cash equivalents, which are subtracted.
Cash equivalents include highly liquid, short-term investments such as Treasury
bills and other money market securities.
Here’s the rationale: if a company has excess cash, it can be used to pay down
debt. In effect, the amount of debt that a company truly has is overstated if they
are making a conscious decision to hold on to extra cash rather than use that cash
to decrease their debt. In practice, the amount of total debt less cash is referred
to as net debt, i.e., debt net of cash.
Net Debt = Total Debt − Cash and Cash Equivalents
Thus, using this net debt calculation, enterprise value can be rewritten as:
Enterprise Value = Equity Value + Net Debt + Preferred Stock + Noncontrolling Interest
A company might prefer to hold on to excess cash rather than use it to pay down
debt for many reasons. For example, the company might want the security of
having a cushion of cash, or there might be other purchases that the company
wishes to make with that cash that are not as easily financed with debt.
Example
Cola Co.’s capital structure consists of $10MM of equity, $3MM of debt, and
$1MM of excess cash. ABC Co. wishes to purchase 100% of Cola Co. and pay
down all the target’s outstanding debt. Therefore, the acquirer will have to
pay $10MM for the equity and $3MM to pay off the debt—a total of $13MM.
However, upon taking ownership of Cola Co., ABC will now own the $1MM of
excess cash that the target was carrying. Therefore, ABC Co. only really paid
$12MM for the target: $10MM in Equity + $3MM in Debt − $1MM in Cash. Put
differently, because cash is being subtracted, the enterprise value of ABC Co.
is $12MM.
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3.4.1.1 Negative Net Debt
It is possible for a company’s excess cash to exceed its outstanding debt or for a
company to have zero debt. In this situation, a company will have negative net
debt. Having negative net debt is preferable from a credit quality perspective, as
it indicates that the company has the necessary cash to pay off all its debt if it
so chooses. For example, if a company has negative net debt of $50 million, this
would indicate that the company could repay all of its debt and still have $50
million of excess cash remaining.
3.4.2 Noncontrolling Interest
It is not uncommon for a company to have ownership stakes of less than 100%
in a variety of different entities. For instance, this would occur when a company
sells part of a division or purchases a stake in another company.
When a company owns more than 50%, but less than 100% of a company, the
accounting treatment involves two steps:
1. The parent company “consolidates” the subsidiary, meaning it includes
100% of the subsidiary’s information in its own financial statements, even
though it does not own 100% of the subsidiary.
2. The parent company reports the amount that is not owned by the parent
company as a noncontrolling interest (also called minority interest).
In short, if a parent company owns 90% of a subsidiary, it will include all of the
subsidiary’s information in its financial statements and then separately report
the 10% of the subsidiary that is owned by others as noncontrolling interest. This
noncontrolling interest would appear on the income statement as the amount
of net income attributable to the other owners of the subsidiary. Noncontrolling
interest would also appear on the balance sheet as the amount of equity attributable to the other owners of the subsidiary.
Example
In 2012, Anheuser-Busch InBev and Grupo Modelo (maker of Corona) reached
an agreement whereby InBev would acquire the remaining 50% of Grupo
Modelo that it did not already own. Prior to the merger, the two beer companies were strategic partners with Grupo Modelo maintaining a controlling
vote. Because Grupo Modelo was the controlling partner, Grupo Modelo
accounted for InBev’s investment on its balance sheet as a noncontrolling
interest. After the merger closed in 2013, InBev took full ownership of Grupo
Modelo and consolidated Grupo Modelo onto its own balance sheet, reflecting 100% of the company.
Although accounting treatment can get quite complicated, for exam purposes,
the important thing to know is that noncontrolling interest is one of the components of enterprise value:
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Enterprise Value = Equity Value + Net Debt + Preferred Stock + Noncontrolling Interest
Noncontrolling interest is added to all the other capital items to derive enterprise value. This may seem counterintuitive: If noncontrolling interest includes
amounts owned by a third party, why would it be added?
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Remember that enterprise value includes all stakeholders that have supplied
capital. Equity value reflects the amount of capital supplied by and owned by
the shareholders, while all the other components reflect capital supplied by
non-common stockholders. That is, debt, preferred stock, and noncontrolling
interest reflect the amount of capital supplied by all other stakeholders. If a
company wanted to buy an entire enterprise, inclusive of the parent company’s
operations and all the operations of its subsidiaries, it would have to pay off the
noncontrolling interests for its share in the subsidiaries.
Knopman Note: Many of the companies listed on the exam will have no
preferred stock or noncontrolling interest in their capital structure.
Assuming that is the case, enterprise value can be calculated as:
Enterprise Value = Equity Value + Debt − Cash
or
Enterprise Value = Equity Value + Net Debt
3.4.3 Enterprise Value Independent of Changes to Capital Structure
As discussed, enterprise value reflects a company’s total capital structure. One
benefit of this is that enterprise value is capital-structure neutral, meaning that
enterprise value remains constant regardless of changes to capital structure.
Example
Assume the following information about Company C:
Equity Value
$500MM
Total Debt
300MM
Cash
100MM
Enterprise Value = $500MM Equity + 300MM Debt − 100MM Cash = $700MM
Now assume that Company C issues additional debt of $100MM. This would
increase its total debt by $100MM to $400MM but would also increase its cash
by $100MM to $200MM. Therefore, Company C’s net debt and thus enterprise
value would remain unchanged.
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Because it is independent of capital structure, enterprise value is a useful figure
when comparing companies that have different capital structures. For example,
two publicly traded companies might have the same market value of equity (i.e.,
equity value), but one might have much more debt than the other. Comparing
two such companies using only the market value of equity might not be the best
apples-to-apples comparison, given the different amounts of leverage for these
businesses. The differing leverages will have important impacts on each company, such as on riskiness, credit quality, and borrowings costs. For that reason, equity value is best used to compare companies that have similar capital
structures, potentially those in the same industry for example. For businesses
that have different capital structures, enterprise value generally provides a better
overall comparison, as it takes all aspects of capital structure into account.
Example
Suppose the following information is given about two companies:
Company A
Company B
Equity Value
$2,974.8MM
$2,950.2MM
Plus: Net Debt
$512MM
−$329.8MM
Plus: Preferred Stock
$10.2MM
$0.0MM
Plus: Noncontrolling Interest
$0.0MM
$51.1MM
Equals: Enterprise Value
$3,497MM
$2,671.5MM
As can be seen above, the equity values of Company A and Company B are
nearly the same, but the enterprise values are substantially different due to
Company A having significantly more net debt than Company B. This illustrates the importance of comparing companies on an apples-to-apples basis
to capture the full picture of the business.
3.5 Converting Between Enterprise Value and Equity Value
As discussed, if all components of a company’s capital structure are known, they
can be summed together to calculate enterprise value. Similarly, if a company’s
enterprise value is known along with all components of capital structure except
for one, the enterprise value calculation can be rewritten to calculate the missing
value. For example, if a company’s enterprise value, net debt, preferred stock, and
noncontrolling interest are known, equity value can be calculated, as illustrated
below:
Equity Value = Enterprise Value − Net Debt − Preferred Stock − Noncontrolling Interest
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Put differently, if enough data is provided, the enterprise value formula can be
reversed to solve for equity value. Keep in mind that many of the companies on
the exam will have no preferred stock or noncontrolling interest, and therefore,
other ways to find equity value (depending on what information is provided)
include:
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Equity Value = Enterprise Value − Net Debt
Equity Value = Enterprise Value – Debt + Cash
These calculations are in addition to the calculation discussed earlier for equity
value of shares outstanding multiplied by the share price.
Market Value of Equity = Number of Shares Outstanding × Share Price
Knopman Note: For the exam, it’s crucial to know the calculations
for enterprise value and equity value and to be able to rewrite the
formulas to solve for what is missing.
Example
Given the following information about a company, it is important to be able
to use the formulas that have been discussed to calculate both an equity value
and share price.
Enterprise Value
$1,200MM
Total Debt
$500MM
Cash
$100MM
Shares Outstanding
10MM
Equity Value = $1,200MM Enterprise Value − $500MM Debt + $100MM Cash = $800MM
Share Price
=
Equity Value
Number of Shares Outstanding
=
$800MM
10MM
= $80 per Share
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Chapter 3: Foundational Valuation Concepts
Unit Exam
1. Diluted shares outstanding are greater than
basic shares outstanding in all of the following
scenarios except:
A. All exercisable options are in-the-money
B. All unexercisable options are in-themoney
C. A convertible bond is in-the-money
D. A convertible bond is in-the-money and all
unexercisable options are in-the-money
2. A company’s basic shares outstanding are
typically sourced from the front page of the
company’s latest:
A.
B.
C.
D.
8-K
DEFM14A
S-4
10-Q
3. A company has an equity value of $200MM,
total debt of $100MM, cash of $40MM,
preferred stock of $25MM, and noncontrolling
interest of $10MM. Calculate the company’s
enterprise value.
A.
B.
C.
D.
$260MM
$295MM
$340MM
$375MM
4. Company XYZ has an enterprise value of
$900MM, a net debt of $400MM, and 20MM
shares outstanding. What is the company’s
share price?
A.
B.
C.
D.
74
$10
$25
$45
$65
5. Assuming a company has a market cap of
$750MM, total debt of $250MM, and a current
stock price of $37.50, how many shares does the
company have outstanding?
A.
B.
C.
D.
20MM
26.55MM
40MM
53MM
6. Company ABC currently has a market cap of
$600MM, total debt of $400MM, and cash of
$200MM. If the company issues an additional
$200MM in debt, what is the impact to the
company’s enterprise value?
A.
B.
C.
D.
Enterprise value decreases by $200MM
Enterprise value increases by $200MM
Enterprise value does not change
The impact cannot be determined from
the information provided
7. Which of the following statements regarding
noncontrolling interest is not true?
A. It is sometimes referred to as minority
interest
B. It is added when calculating enterprise
value
C. It reflects the amount of a subsidiary
company that is owned by a parent
company
D. It is created when a parent company owns
more than 50%, but less than 100% of a
subsidiary
Chapter 3: Foundational Valuation Concepts
Unit Exam (Continued)
8. Company DEF has a market cap of $550MM,
total debt of $50MM, cash of $75MM, and
preferred stock of $25MM. Which of the
statements below is correct?
A. The company’s enterprise value is
$700MM
B. The company has a negative net debt of
$25MM
C. The company would prefer a positive over
a negative net debt
D. Net debt is calculated as cash minus total
debt
10. DEF Co. has net debt of $100MM, cash of
$60MM, and 20MM shares outstanding.
Assuming the company is trading at $32 per
share, what is DEF’s enterprise value?
A.
B.
C.
D.
$580MM
$640MM
$680MM
$740MM
9. Using the information below about Company
XYZ, calculate its diluted shares outstanding
using the treasury stock method.
Current Share Price
Basic Shares Outstanding
Options
Weighted Average Exercise Price
A.
B.
C.
D.
$30
1,000,000
100,000
$20
1,000,000
1,033,333
1,066,667
1,100,000
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Chapter 3: Foundational Valuation Concepts
Unit Exam—Solutions
1.
(B)
Unexercisable options are not accounted for in the calculation of diluted shares
outstanding in accordance with the treasury stock method.
2. (D)
The 10-Q for the most recent quarter is typically the source for basic shares outstanding.
In the event that the most recent quarter is the fourth quarter of the company’s fiscal
year, then the 10-K serves as the source for basic shares outstanding.
3. (B)
Enterprise Value = Equity Value + Total Debt + Preferred Stock + Noncontrolling
Interest − Cash
Enterprise Value = $200MM + $100MM + $25MM +$10MM − $40MM = $295MM
4. (B)
Equity Value = $900MM Enterprise Value − $400MM Net Debt = $500MM
Share Price = $500MM Equity Value/20MM Shares Outstanding = $25
5. (A)
Number of Shares Outstanding = Equity Value/Share Price
Number of Shares Outstanding = $750MM/$37.50 = 20MM
6. (C)
7.
(C)
Enterprise value is independent of changes to capital structure and thus would remain
unchanged. This is because, although debt would increase by $200MM, the issuance
of debt would also generate $200MM cash for the company, which would have a net
effect of zero.
Noncontrolling interest, also referred to as minority interest, reflects the amount of a
subsidiary that is not owned by the parent company. It occurs when a company owns
more than 50%, but less than 100% of a subsidiary. The enterprise value formula is
Equity Value + Net Debt + Preferred Stock + Noncontrolling Interest.
8. (B)
Company DEF has a negative net debt of $25MM, calculated as total debt of $50MM
minus cash of $75MM. A negative net debt is preferable from a credit quality
perspective, as it indicates that the company has the necessary cash to pay off all its
debt.
9. (B)
Options Proceeds to Company = 100,000 Options Shares × $20 Exercise Price = $2,000,000
Number of Shares Repurchased = $2,000,000 Proceeds/$30 Current Share Price = 66,667
Net New Shares = 100,000 Options Shares − 66,667 Shares Repurchased = 33,333
Diluted Shares = 1,000,000 Basic Shares + 33,333 Net New Shares = 1,033,333
10. (D)
Equity Value = Stock Price × Shares Outstanding
Equity Value = $32 × 20MM = $640MM
Enterprise Value = Equity Value + Net Debt
Enterprise Value = $640MM + $100MM = $740MM
Note that because the cash of $60MM is already included in net debt, it does not have to
be subtracted separately.
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4. Relative Valuation
Suppose an individual is selling a house and needs to decide at what price to list
the house in the market. How would the individual determine the sale price?
One approach would be to look at the prices of similar, or comparable, houses
currently for sale in the market and base the price off those reference points.
Alternatively, the individual could review the prices of similar, or comparable,
houses previously sold and use those transactions as the reference points for
pricing the house.
Both approaches are considered relative value methodologies because they
derive their valuations in relation to similar assets with observable prices.
A different methodology would be to estimate the amount of money an investor
could generate from the house, say by renting it out. This approach is considered
a fundamental value methodology, as it is based primarily on the intrinsic worth
of the asset’s ability to generate a return, in this case the total amount of rental
income that can be generated over the life of the house, with little consideration
given to the value of other assets.
As will be discussed, both methodologies have their merits and shortcomings.
To balance the different methodologies, strengths and tradeoffs, multiple ones
are typically used in a valuation scenario. They are often visualized in a football
field, and the valuation ranges are used to guide decision-making.
In the above house sale example, the football field would help to determine at
which price to list the house. An individual could list the house for sale at the
low end of the range, which would possibly shorten the time on the market or
stimulate multiple bids that could drive the price up. Alternatively, the owner
could decide to price it at the high end of the range or above that, if he or she
believes that the house is more desirable or more valuable in some material way
than comparable homes.
Finally, if the fundamental valuation methodology resulted in a higher value than
the relative value methodologies, the individual may decide that it is worthwhile
to focus on marketing the house to investors as opposed to individuals intending
to use it as a primary residence.
77
Chapter 4
Relative Valuation
This chapter will focus on the two relative value methodologies:
1. Comparable companies analysis
2. Precedent transactions analysis
The financial ratios and valuation multiples that candidates must be familiar
with will also be discussed.
4.1 Selection of Comparables
As illustrated in the house example above, relative valuation involves the use of
other prices that are observable in the market as benchmarks for the value of
the company or investment being considered. Comparable companies analysis involves comparing similar companies that have similar characteristics.
Precedent transactions analysis bases valuation on prior transactions involving similar companies. These methodologies conceptually rely on the same two
high-level exercises:
◆ Selecting a group for comparison, be it a group of comparable companies
or a group of comparable prior transactions, and
◆ Applying valuation multiples
Choosing which companies and/or transactions to include in the analysis is
essential to the valuation exercise. Just as houses have features, such as size and
location, that can be used as a basis for comparison, companies have characteristics that can be used as a basis for comparison. The act of selecting comparables,
or “comps,” is both an art and science. It involves:
◆ The calculation of key financial metrics
◆ A deep understanding of the operations of potentially similar businesses
(e.g., companies in the same sector or industry), and
◆ A high degree of judgment to determine what constitutes “similarity.”
Judgment comes from experience and training, which is why senior
bankers typically make the final determination of which companies and/
or transactions to include in the “universe of comps”
Selecting the wrong comparables skews the information being used to value the
business and therefore leads to an inaccurate valuation.
The following sections focus on key qualitative and quantitative features that
help form the basis for comparison.
4.1.1 Key Qualitative Characteristics
One primary objective in establishing a comps universe is to identify companies
with similar business drivers, meaning companies that have the same types of
exposures to various aspects of the economy.
At a high level, companies in the same sector tend to have similar exposures.
For instance, telecommunications companies will share certain characteristics,
and energy companies will share others. Political unrest in the Middle East is
78
likely to impact energy companies in a similar way, whereas the same political
event would likely impact telecommunications companies differently. Thus, the
starting point for selecting comps typically involves screening for companies in
the same sector.
Chapter 4
Relative Valuation
That being said, often a sector is still too broad of a category, and more refinement is necessary. For instance, companies in the oil and gas industry are very
different from companies in the power utility industry even though both are in
the energy sector. Thus, refining companies to narrower industry categories is
often advisable, when practical.
As the universe becomes narrower, companies may start to look more and more
similar to the one being valued. However, if the analysis becomes too narrow, two
problems can arise. First, the universe of companies may become more focused
than the subject company. For instance, the subject company may be involved in
five lines of business, whereas the companies in the narrowed universe of comparables operate in just one or two main activities. For example, even though
Apple has a music and video streaming service called Apple Music, it would be
inappropriate to use Spotify in the universe of comparables when valuing Apple,
as Apple has numerous product lines beyond Apple Music.
Alternatively, the group may get too small to provide valuable information. Only
having one or two companies in a “universe” fails to provide enough reference
points for comparison.
Knopman Note: Firms within a specific sector or industry may be
compared using industry-specific metrics based on the nature of these
businesses and their business cycles.
For example, when valuing biotech or pharmaceutical companies, it is
often useful to value them using metrics such as:
a. Comparable clinical trial phases, and
b. A new drug’s target disease
Internet and technology companies may be valued using metrics such
as number of unique monthly site visits or app downloads.
Additionally, within an industry, many different paths can be followed to create
and deliver a product or service to customers. The chain of events that starts with
a raw material and ends with a product or service being delivered to a customer
is known as a value chain.
Some companies are considered “vertically integrated,” which means that they
occupy every position along the value chain.
For instance, consider a vertically integrated oil and gas company. This company
would be involved in every step along the process that ends with delivering a
final, oil-based product to a customer, such as selling gasoline to an automobile
owner. This includes exploring for oil wells, drilling oil wells, pumping oil out of
wells, transporting oil around the world in tankers, refining oil into gasoline and
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Chapter 4
Relative Valuation
other end products, distributing gas via truck to retail gas outlets, and operating
retail gas outlets.
Some companies are involved in just one or a few parts of a value chain. For
instance, some companies just explore for oil wells or just transport oil around
the world in tankers. Depending on their position in a value chain, companies
will produce and/or deliver different products and services in different ways,
interface with different customers and end markets, and distribute through different channels. These particulars factor into not only how companies perform
but also into how differently companies may perform.
Since the goal of this exercise is to group similar companies, it is relevant to consider where companies are positioned within their respective value chains when
selecting a universe of comps.
Knopman Note:
Q: What is a niche market?
A: A niche market is a focused, targetable portion of a market. If a
new company enters an established industry and the company’s
competitors have no discernible loss of revenue or market
share, it is likely that the company found a new niche market to
target with its product.
Q: If a banker is modeling a client that operates in a niche market,
what other comparables might the banker reasonably include
in the analysis?
A: Investment bankers serving clients in niche markets can
expand the universe of comparables by looking at suppliers that
distribute manufacturing products in the same line of business
or at other companies manufacturing in niche markets, even if
the markets are different from the subject company’s.
Geography can sometimes play a role in differentiating companies. Companies
operating in completely different countries can have very different economic
exposures. Companies with a high concentration of operations in underdeveloped countries or in countries with political instability might not be appropriate
comps for companies operating in developed economies. For instance, a mining
company with all of its mines in Australia will have different risks than a mining
company that operates primarily in Tanzania.
Regional differences can sometimes play a role as well, depending on the industry, as some regions can have different economic climates or different weather
conditions that influence certain types of businesses. For instance, retail companies tend to perform differently in Alaska due to lower population density and
weather that makes it difficult to travel to stores than in Texas, which has larger
cities and better shopping weather.
80
4.2 Key Financial Characteristics and Ratios
While, when determining the best comparables, business drivers, such as sector,
services, products, and geography, are all relevant, it is also essential to understand a company’s key financial characteristics and metrics, which are discussed
in this section.
Chapter 4
Relative Valuation
4.2.1 Business Life Cycle
Companies near the beginning of their life cycle exhibit different characteristics
than mature companies. In early stages, companies will tend to be less profitable,
as they have yet to reach efficient operating scale. Put differently, new businesses
must spend a lot of money on fixed assets and fixed costs that are necessary to
operate and build the company.
Additionally, earlier-stage companies tend to have higher growth rates than
established businesses. For example, a company with $100 million of revenue
that operates in a large, multi-billion-dollar market might be able to grow annual
sales by 50% or more in the first few years. However, for a company with $100
billion of revenue, growth of a few percentage points is more typical.
The calculation of revenue growth rate is illustrated below.
Revenue Growth Rate
=
Year 2 Revenue
Year 1 Revenue
−1
As an early company matures, its margins tend to improve, as the company reaps
the benefits of its early investments and must spend less money in relation to its
size. This facilitates earnings growth, measured as:
Earnings Growth Rate
=
Year 2 Net Income
Year 1 Net Income
−1
Example
ABC Co. generated $85 million of net income in its first full year of operations
and $130 million of net income in its second year. To find ABC’s earnings
growth rate:
Earnings Growth Rate
=
$130 million Year 2 NI
$85 million Year 1 NI
= 1.53 − 1 = 0.53 (i.e., 53%)
A similar calculation can be used to find growth rates in EBITDA, EBIT, or
gross profit.
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Chapter 4
Relative Valuation
Companies at different stages in their life cycle tend to be valued quite differently
from each other. Investors anticipate that early stage companies will grow faster
and expect that current earnings will not be representative of what the company
will be able to earn in the future, once it matures. As a result, early stage companies tend to have much higher valuation multiples. Put differently, investors are
often willing to pay a higher price for companies in their growth phase given their
future earnings potential. This contrasts with more mature companies, which
are less likely to have significant changes in future earnings growth and, thus, for
which investors will typically pay a lower valuation multiple.
In selecting a universe of comps, it is important to understand what stage each
company is in and the implications of comparing companies that are in different
stages.
4.2.1.1 P/E Ratio
One ratio that may help reflect where a company sits within its life cycle is the
price-to-earnings ratio or P/E ratio. P/E measures how much an investor is
willing to pay for $1 of a company’s earnings. Generally, a higher P/E ratio indicates high optimism for future growth of the business. Alternatively, companies
with lower growth expectations will typically have a lower P/E.
For example, in June 2013, a year after Facebook’s IPO, the company’s P/E ratio
was about 108×, reflecting investors’ optimism for enormous growth. In April
2019, Facebook’s P/E ratio was 24×, reflecting an expectation of more modest
growth as the company continues to mature.
While P/E can be a useful metric for profitable companies that generate earnings, one limitation is that it is not relevant for companies with zero or negative
earnings, as the formula uses earnings per share in the denominator.
There are two ways to calculate P/E. The first is:
P/E Ratio
=
Stock Price
Earnings per Share
Example
XYZ Co. has a stock price of $20 and an EPS of $2. The company’s P/E ratio
is calculated as:
P/E Ratio
=
$20 Stock Price
$2 EPS
= 10×
A P/E ratio of 10× indicates that investors are willing to pay $10 for every $1
of XYZ Co.’s earnings.
82
As discussed in the prior chapter, candidates must be able to manipulate the
formulas to solve for the missing variable. For example, if both the P/E ratio and
a company’s earnings per share are known, an implied stock price can be calculated using the formula below.
Chapter 4
Relative Valuation
Implied Stock Price = P/E Ratio × Earnings per Share
The above formula is an alternative to calculating share price by dividing equity
value by shares outstanding, which was discussed in the previous chapter.
Example
XYZ Co. has a P/E ratio of 10× and an EPS of $2. The company’s implied stock
price is calculated as:
Implied Stock Price = 10× P/E × $2 EPS = $20
Note that the calculation of P/E above is done on a per share basis.
Alternatively, if both stock price and earnings per share are multiplied by
a company’s outstanding shares, P/E can also be calculated on an overall
company basis, as illustrated below.
P/E Ratio
=
Equity Value
Net Income
Example
XYZ Co. has a market capitalization of $200 million and a net income of $20
million. The company’s P/E ratio is calculated as:
P/E Ratio
=
$200 million Equity Value
$20 Net Income
= 10×
Remember, market capitalization is used synonymously with market cap,
market capital, and market value of equity.
Just as the per share calculation of P/E can be manipulated to solve for an implied
stock price, the same methodology can be used in the second calculation of P/E
to solve for an implied equity value.
Implied Equity Value = P/E Ratio × Net Income
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Chapter 4
Relative Valuation
It’s important to note that the above formula is a third method that has been discussed to calculate a company’s equity value. The prior two methods, discussed
in Chapter 3, were:
1. Share price multiplied by outstanding shares, and
2. Enterprise value minus debt plus cash
All three methods are important, and candidates will typically be forced into
using a particular formula based on the information provided in a given question.
This will be discussed more later in this chapter.
Example
XYZ Co. has a P/E ratio of 10× and a net income of $20 million. The company’s
implied equity value is calculated as:
Implied Equity Value = 10× P/E × $20 million NI = $200 million
Knopman Note:
Q: What are the two ways to calculate a P/E ratio?
A: A company’s P/E multiple can be calculated either on a
per share basis or on an overall company basis. These two
calculations will produce the same multiple for a given
company.
Calculation Method
Formula
Outcome
Per Share Basis
Stock Price/EPS
Overall Company Basis
Equity Value/Net Income
Same Multiple
Q: How can the P/E ratio be used to determine a stock price or
market cap (equity value)?
A: P/E can be used to calculate an implied stock price, as EPS ×
P/E, or to calculate an implied equity value, as Net Income ×
P/E.
Calculation Method
Formula
Implied Stock Price
EPS × P/E
Implied Equity Value
Net Income × P/E
Q: When is P/E a useful metric? When is it less meaningful?
A: P/E is a useful multiple for established companies with
consistent profitability. It is not as useful for companies with
negative net income or with significant earnings volatility.
84
4.2.1.2 PEG Ratio
The price-to-earnings growth ratio or PEG ratio measures valuation based
on expected earnings-per-share growth. It compares a company’s P/E ratio with
its projected annual rate of growth in EPS. The PEG ratio is useful in helping to
compare and normalize between companies that have different growth rates. It
is calculated as:
PEG Ratio
=
Chapter 4
Relative Valuation
P/E
Annual EPS Growth Rate
When plugging the EPS growth rate into a calculator, it is necessary to use the
whole number rather than the percentage—this is important.
Example
ABC Co. has a P/E of 12× and an expected EPS growth rate of 6%. The company’s PEG ratio is calculated as:
PEG Ratio
=
12× P/E Ratio
6% EPS Growth Rate
= 2×
When plugging the numbers into a calculator, you would divide 12 by 6. Do
not divide by the percentage of 6%.
Knopman Note: If a question asks which company is most likely a
growth company, look for the highest multiple. Alternatively, if the
question asks you to determine the company with the best value,
look for the lowest multiple. Low multiples correlate with cheaper,
undervalued companies.
GARP (growth at reasonable price) investors would seek a PEG ratio
under 1 (which requires a lower PE Ratio). For example, for a company
with a growth rate of 15%, a GARP investor would look for a low PE
ratio, and especially one below 15x.
4.2.2 Profitability Ratios
Companies are ultimately valued based on their ability to generate returns for
investors. Thus, it is relevant to compare companies based on their profitability. The most common profitability ratios are margin ratios and return ratios.
While margins, including gross profit margin, operating margin, and net income
margin, were discussed in Chapter 2, this section will focus on the return ratios,
which help to measure a company’s capital efficiency.
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Chapter 4
Relative Valuation
Capital efficiency measures the effectiveness of a company’s investments and
deployment of resources; it is a natural extension of profitability. For example,
suppose that two companies each earn $10MM of net income on $25MM of sales,
but one company required a $50MM investment to generate those profits while
the other company required a $500MM investment. Despite both companies having the same sales, net income, and net income margins, one was able to perform
more efficiently because it required less capital.
Investors focus on capital efficiency to connect profits with the investment
required to generate those profits. This measures a company’s ability to provide
a return on the investment, or ROI, in the company. All other things being
equal, companies with greater capital efficiency are considered higher-quality
companies since they generate more profits for the same amount of investment.
Most capital efficiency metrics are ratios that involve a numerator related to
profitability (e.g., EBIT, EBIAT, or net income) and a denominator related to capital (e.g., shareholders’ equity, total assets, or invested capital). The numerator is
typically the most recent figure, while the denominator is typically the average
of the past two years.
The reason for averaging the denominator is that profitability occurs over the
course of a year whereas capital is represented at a single point in time. For
example, suppose a company began last year with $100 in “capital,” earned $20
over the course of the year, and ended the year with $110 in capital. The numerator
should clearly be $20. What about the denominator—should it be $100 or $110?
Since the $20 was earned over the course of the entire year, the convention is to
take the average of the beginning and ending periods, which would be $105 in
this example.
When constructing a universe of comps, including some of the capital efficiency
metrics discussed below can help to illuminate differences in valuation among
otherwise similar companies.
Knopman Note: For the profitability ratios discussed below, always use
averages of the past two years for the balance sheet figures when given
enough information to do so.
4.2.2.1 Return on Invested Capital
Return on invested capital, or ROIC, measures capital efficiency at the enterprise level. In other words, it measures the company’s ability to turn the capital
invested from all capital sources, such as equity and debt, into profits that can
be distributed to those capital providers.
Invested capital is calculated as:
Invested Capital = Average Shareholders’ Equity + Average Net Debt
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Knopman Note: Invested capital is similar to the enterprise value
formula, except it uses shareholders’ equity (i.e., book value) instead
of market cap for the equity piece.
Chapter 4
Relative Valuation
Since the denominator relates to both debt and equity holders, the numerator
needs to be a metric of profitability available to both debt and equity holders,
or put differently, a pre-interest profit measure. (This is analogous to enterprise
value multiples, discussed later in this chapter, which require that the denominator be a metric that relates to all capital providers rather than just to equity
holders.)
Typically, ROIC uses either EBIT or EBIAT in the numerator. Both calculations
are below:
Return on Invested Capital
=
EBIT
Invested Capital
or
Return on Invested Capital
=
EBIAT
Invested Capital
EBIAT is earnings before interest after taxes and is sometimes also referred to
as net operating profit after tax or NOPAT. EBIAT is essentially a company’s net
income excluding the impact of interest expense. As the name suggests, EBIAT
can be calculated by subtracting taxes from EBIT.
EBIAT = EBIT − Taxes
If only the tax rate is known rather than the dollar amount of taxes paid, then
alternatively, EBIAT can be calculated as:
EBIAT = EBIT × (1 − Tax Rate)
As illustrated above, the big difference between EBIT and EBIAT is that EBIT represents earnings before taxes whereas EBIAT explicitly accounts for taxes. Often,
both calculations are done as a means of comparison to analyze the impact of
taxes on profitability.
Note that, for companies with zero debt or interest expenses, net income is sometimes used as a substitute for EBIAT. This is because after-tax EBIT is the equivalent of net income for companies with no leverage. In that case, ROIC can be
calculated as:
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Chapter 4
Relative Valuation
Return on Invested Capital
=
Net Income
Invested Capital
Knopman Note: ROIC might be calculated on the exam using either
EBIT, EBIAT, or net income in the numerator. However, only one of
three will be an answer choice, so candidates will not have to choose
between them.
4.2.2.2 Return on Assets
Return on assets, or ROA, measures the efficiency with which the company’s
assets generate profits for equity investors. Note that, while ROIC measured
returns to all capital providers, ROA and ROE involve returns to shareholders
only. ROA is calculated as:
Return on Assets
=
Net Income
Average Total Assets
Knopman Note: The measure of return on assets (ROA) can be used
when considering the liquidation of a company. For example, a
company whose ROA is less than the interest rate Treasuries pay
might consider liquidating and returning those assets to investors.
This would more likely be the case for a distressed company.
4.2.2.3 Return on Equity
Return on equity, or ROE, is a shareholder-centric capital efficiency ratio that
measures the amount earned on just the equity capital invested in the company.
It is calculated as:
Return on Equity
=
Net Income
Average Shareholders’ Equity
Expect to see questions on the exam that tie together the ROE calculation with
the balance sheet concepts that were discussed in Chapter 2, as illustrated below.
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Example
Company ABC has $400 million in shareholders’ equity as of December 31,
2018. During 2019, the company generates $70 million of net income and
declares $30 million of dividends. What is Company ABC’s return on equity
for 2019?
Chapter 4
Relative Valuation
The first step is to calculate the company’s ending shareholders’ equity for
2019:
Ending Shareholders’ Equity = Beginning SE + Net Income − Declared Dividends
Ending Shareholders’ Equity = $400MM Beginning SE + $70MM NI − $30MM Declared Dividends*
Ending Shareholders’ Equity = $440MM
*Note: A declaration of dividends reduced shareholders’ equity.
Keep in mind that ROE uses average shareholders’ equity and therefore the
beginning balance of $400MM and ending balance of $440MM need to be
averaged, which in this case results in $420MM.
Finally, plug the numbers into the ROE formula:
Return on Equity
=
$70MM NI
$420MM Average SE
= 16.7%
4.2.3 Leverage
Leverage relates to how much debt a company has. It can be measured in relation to other forms of capital in a company’s capital structure and in relation to
the company’s ability to support payment of its debt obligations. All other things
being equal, more leveraged companies operate with greater risk and have more
volatile earnings.
Knopman Note: Advantages of convertible bonds for an issuer include
lower borrowing costs and the tax deductibility of the interest
expense. However, issuing convertibles would cause a company’s
leverage to increase.
Common leverage metrics are discussed below.
Knopman Note: Increased regulation of the banking sector results in
lower financial leverage and decreased return on equity.
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Chapter 4
Relative Valuation
4.2.3.1 Debt-to-Equity
Debt-to-equity measures how much debt a company has relative to how much
equity it has. It is calculated as:
Debt-to-Equity
=
Total Debt
Shareholders’ Equity
A high debt-to-equity ratio indicates a company is highly leveraged and that a
downturn in the company’s performance could theoretically push it into bankruptcy. A company with a lower ratio can generally weather more bad times
before running into such risks.
Knopman Note:
Q: What financial ratio may be negatively impacted by a sale
leaseback transaction?
A: If a firm does a sale leaseback and then distributes the proceeds
from the sale as a dividend, its debt-to-equity ratio will be
negatively impacted (meaning the percentage of debt to equity
will rise), as the company’s shareholders’ equity will fall due to
the dividend.
4.2.3.2 Debt-to-Total Capitalization
Debt-to-total capitalization is a similar calculation, but it instead measures
a company’s debt as compared to its total capitalization rather than just to its
equity. It is calculated as:
Debt-to-Total
Capitalization
90
=
Total Debt
(Total Debt + Shareholders’ Equity)
Knopman Note:
Q: How can a banker determine total debt?
Chapter 4
Relative Valuation
A: Total debt requires the sourcing and summation of multiple
line items from the liabilities section of the balance sheet,
including:
1. Short-term debt
2. Current maturities of long-term debt
3. Long-term debt
4. Bonds
5. Notes
6. Debentures
7. Loans
8. Capital leases
9. Revolver (i.e., revolving line of credit)
The sum of these figures represents a firm’s outstanding debt.
Note: A firm may only have some, and not all, of these debt
items on its balance sheet.
Q: What is not considered debt?
A: Neither preferred stock nor accounts payable are included in
the calculation of long-term debt.
Q: After calculating the total debt figure, how can a banker
determine debt-to-total capitalization?
A: Debt-to-total capitalization is calculated as Total Debt/Total
Capitalization or Total Debt/(Total Debt + Shareholders’
Equity).
A company’s total capitalization is calculated as Total Debt +
Shareholders’ Equity (i.e., book value of equity). Book value may
also be referred to as “net worth” or, possibly, just “equity.” Do
not use market cap on the exam when calculating debt-to-cap.
Note that all information needed to calculate debt-to-cap can
be sourced from the company’s balance sheet.
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Chapter 4
Relative Valuation
4.2.3.3 Debt-to-EBITDA
Debt-to-EBITDA measures approximately how long it takes a company to pay
off its debt using the earnings it generates. A company with a 4× debt-to-EBITDA
ratio can pay off its debt more quickly than one with a 5× ratio and thus would be
safer from a credit quality perspective. The formula is below:
Debt-to-EBITDA
=
Total Debt
EBITDA
Since this ratio compares debt against the operating performance of the company, it serves as a good apples-to-apples comparison of companies across industries. For this reason, debt-to-EBITDA is a commonly used statistic.
Knopman Note: A company with a lower debt-to-EBITDA ratio than
other companies in its sector would generally have a higher credit
rating and therefore be able to issue comparable bonds at a lower
yield.
There are different variations of this ratio, including using net debt in place of
total debt. Additionally, in some industries, a version of this ratio uses EBITDAR
instead of EBITDA. EBITDAR is earnings before interest, taxes, depreciation,
amortization, and rent expense and is used in industries where companies
operate a large amount of leased real estate. The retail industry is an example.
Debt-to-EBITDA is also frequently used to determine how much could be paid
for a company given the acquirer’s credit quality.
Example
GoodTech, with $2.3MM debt outstanding, intends to acquire BetterTech
in a cash transaction. After closing, the combined company will have
$3MM EBITDA. The maximum leverage GoodTech can incur is 6× EBITDA.
Furthermore, GoodTech just generated $1.5MM in cash from a recent asset
sale. What is the most it can offer to acquire BetterTech?
GoodTech can have up to $18MM of outstanding debt, calculated as 6 × $3MM
EBITDA. However, it already has $2.3MM outstanding. Therefore, it can borrow up to $15.7MM more to purchase BetterTech. Additionally, it can use
the $1.5MM cash on hand, leading to a maximum purchase price of $17.2MM
($15.7MM + $1.5MM).
4.2.3.4 Coverage Ratio
The coverage ratio, or interest coverage ratio, measures a company’s margin
of safety when it comes to using the earnings it generates to make interest payments. It can be calculated as:
Coverage Ratio
92
=
EBITDA
Interest Expense
or
Coverage Ratio
=
EBIT
Chapter 4
Relative Valuation
Interest Expense
Companies with a higher coverage ratio are safer from a credit quality perspective, as a higher ratio indicates that the company has more earnings to pay its
interest or has less payable interest. If a company’s coverage ratio falls below 1.0×,
it is not generating enough earnings to pay off the interest on its debt and is in
danger of default. Additionally, a coverage ratio that is only slightly higher than
1.0× indicates that the company may have trouble paying principal payments in
addition to interest payments.
Knopman Note:
Q: Would a lender prefer to lend to a company with a high or low
net debt? A high or low coverage ratio?
A: Borrowers with low (or, even better, negative) net debt and
a high coverage ratio are deemed to have a stronger credit
quality.
Q: What ratio is less useful in evaluating creditworthiness?
A: An EV/EBITDA multiple is not generally used to evaluate credit
quality.
Q: What other types of coverage ratios are available to evaluate
creditworthiness?
A: A fixed-charge coverage ratio is an effective way to
calculate a company’s ability to take on more debt (i.e., its
creditworthiness). It is calculated as:
Fixed Charge Coverage Ratio
=
(EBIT + Fixed Charges)
(Fixed Charges + Interest Expense)
Fixed Charges can include, for example, lease expense.
Q: How would additional cash flow, such as government subsidies,
affect a borrower’s creditworthiness?
A: A government subsidy to a company generally improves the
company’s ability to cover interest expense. When the subsidy
ends (say the subsidy has a 10-year sunset provision), coverage
ratios will be negatively impacted, as there will be less ability to
make interest payments.
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Chapter 4
Relative Valuation
4.2.3.5 Credit Ratings
When a company issues debt, the company is typically evaluated by one or more
of the three major credit rating agencies: Standard & Poor’s, Moody’s, and Fitch.
These agencies evaluate the company’s ability to pay its debt obligations by examining a variety of risk factors, including the leverage metrics discussed in this
section. The result is a credit rating that helps in comparing a company’s default
risk with that of other companies.
Although the credit rating agencies focus on a company’s ability to pay its debt
obligation, this analysis has a large impact on the company as a whole. For example, the credit rating impacts the interest rate at which a company can borrow
and thus is relevant to a company’s overall valuation.
Knopman Note: An investment banker could contact a credit ratings
analyst from a nationally recognized ratings agency to obtain
information on comparable debt issuances. These conversations
would not require a chaperone from legal or compliance.
4.2.4 Shareholder Distribution
Shareholder distribution refers to the way a company returns cash to shareholders, typically through dividend payments, though also through share buybacks. It is at the discretion of a company’s board of directors whether to pay a
dividend to shareholders, though dividends are more typical for mature companies as opposed to newer companies, which reinvest their net income into the
business to fund growth.
Common shareholder distribution metrics are discussed below.
4.2.4.1 Dividend Yield
Dividend yield expresses an investor’s rate of return from dividends as a percentage of the company’s stock price. It is calculated as:
Dividend Yield
=
Annual Dividends per Share
Stock Price
If you are provided a quarterly dividend (dividends are typically paid on a quarterly basis), multiply the quarterly figure by four to annualize the dividend. For
example, a quarterly dividend of $0.30 per share would equate to $1.20 on an
annual basis ($0.30 × 4 Quarters).
Note that if a question specifies implied dividend yield, you should multiply the
most recent quarterly dividend by four to annualize the dividend. This applies
even if the question provides the cumulative dividends over the past four quarters. This is distinct from dividend yield, where you would just use the cumulative
dividends over the past year.
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Example
XYZ Co.’s stock is trading at $30. Over the past 12 months, it has paid $0.60
per share in dividends, though the most recent quarterly dividend was $0.20.
To calculate implied dividend yield:
Implied Dividend Yield
=
(4 × Most Recent Quarterly Dividend of $0.20)
$30 Stock Price
Chapter 4
Relative Valuation
= 2.7%
In addition to being expressed on a per share basis as described above, dividend
yield can be expressed on an aggregate basis by multiplying both the annual dividend per share and the stock price by the number of shares outstanding:
Dividend Yield
Total Annual Dividends
=
Equity Value
In this equation, the numerator is the total amount of dividends paid rather than
the dividends paid per share. Similarly, the denominator is the market value of
all shares rather than the market value per share.
Knopman Note: It is also possible to calculate a company’s stock price
using its dividends and dividend yield. For example, given an annual
dividend of $0.20 and a dividend yield of 2%, we can calculate the
stock price as:
Stock Price = Annual Dividend/Dividend Yield
Stock Price = $0.20/2% =$0.20/0.02 = $10
4.2.4.2 Dividend Payout Ratio
The dividend payout ratio is the percentage of a company’s earnings paid out
to shareholders as a dividend. It is calculated as:
Dividend Payout Ratio
=
Annual Dividends per Share
Reported Earnings per Share
Knopman Note: For dividend payout ratio, always use reported
EPS, never diluted EPS. This is because companies pay dividends
on actual shares outstanding, not on diluted shares outstanding.
Remember, diluted shares outstanding takes into account employee
stock options, which will only be paid dividends once the options are
exercised.
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Chapter 4
Relative Valuation
Similar to dividend yield, the payout ratio can also be calculated on an aggregate
basis as:
Dividend Payout Ratio
=
Total Annual Dividends
Net Income
4.3 Normalizing Financial Statements
Since valuation is a forward-looking exercise aimed at determining how much
value an investment will deliver in the future, it is important to ensure that the
historical data used as a baseline for evaluation provides an accurate representation of the company’s performance. In some cases, the information that a company presents in its financial statements fails to provide the most accurate view
of the company’s performance on an ongoing basis because they either include
one-time items that are not expected to occur again, or they exclude important
information, such as events that happened after the most recent quarterly report.
To determine the most accurate picture of a company’s performance, investment
bankers will normalize, or scrub, the company’s financials. This means they will
make necessary adjustments to create financial statements that exclude onetime items and non-recurring items and include any recent events as appropriate. Put differently, investment bankers adjust the financials to determine how
much money a company would have made if a one-time or non-recurring event
never happened.
Each adjustment flows through and affects the different line items of the financial
statements. For instance, a one-time restructuring charge will be added back to
EBIT and EBITDA to reflect the fact that the company would have made more
money if the expense had never occurred. The full amount of the adjustment
will be reflected in adjusted EBIT and EBITDA, as these are pre-tax metrics, and
therefore there is no need to account for taxes. However, if the company made
more money, it would have to pay taxes on the incremental revenue, which would
be reflected in the company’s adjusted net income, as net income is an after-tax
metric. It is important to keep in mind that the increased earnings will be somewhat offset by an increase in taxes.
Knopman Note: Assume that one-time items are provided on a pre-tax
basis unless the item is explicitly listed as “after-tax” or “net.”
Example
Company A’s reported income statement is below. What would the adjusted
EBIT and adjusted net income be if the company reports a one-time $50MM
restructuring charge, assuming a 35% tax rate?
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Income Statement ($ in millions)
Sales
$800
Cost of Goods Sold
$250
Gross Profit
$550
Selling, General & Administrative
$300
Operating Income (EBIT)
$250
Interest Expense
$50
Pre-Tax Income
$200
Income Taxes
$70
Net Income
$130
Chapter 4
Relative Valuation
To calculate adjusted EBIT, the $50MM restructuring charge can be added
back to the reported EBIT of $250, to get an adjusted EBIT of $300. Note that,
because both the restructuring charge and EBIT are pre-tax, they can simply
be added together, and no tax adjustment is required.
To find adjusted net income, the restructuring charge must be tax-effected.
Of the additional $50MM in profits, 35% will be paid to taxes, and therefore
only 65% hits the company’s bottom line. So, to find the additional net income,
take $50MM × (100% − 35% Tax Rate), which equals $32.5MM, and add that
to the reported net income of $130MM for an adjusted figure of $162.5MM.
If an after-tax or “net” item is provided, it cannot be directly added back to EBIT
or EBITDA since those are pre-tax metrics. Instead, the item will first need to be
grossed up to find its pre-tax impact by dividing the figure by (100% − Tax Rate)
and then adding it back to EBIT or EBITDA. However, when calculating adjusted
net income, a “net” item can be added back with no additional tax adjustments,
since both figures will already be after-tax.
Example
Company B’s reported income statement is below. What would the adjusted
EBIT and adjusted net income be if the company reports a one-time, net
restructuring charge of $30MM, assuming a 30% tax rate?
Income Statement ($ in millions)
Sales
$600
Cost of Goods Sold
$215
Gross Profit
$385
Selling, General & Administrative
$200
Operating Income (EBIT)
$185
Interest Expense
$35
Pre-Tax Income
$150
Income Taxes
$45
Net Income
$105
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Chapter 4
Relative Valuation
Because the restructuring charge is given on a “net” basis, the $30MM expense
can be added back to the reported net income of $105MM, for an adjusted
net income of $135MM. Note that, because net income and the restructuring
charge are after-tax, they can simply be added together, and no tax adjustment is required.
Because the restructuring charge is provided on a net basis, it cannot simply
be added back to EBIT since EBIT is a pre-tax metric. Instead, the charge
needs to first be grossed up to calculate its pre-tax impact by dividing the
$30MM expense by (100% − 30% Tax Rate), which is $42.9MM. From there, the
grossed-up charge of $42.9MM can be added to EBIT of $185MM to calculate
adjusted EBIT of $227.9MM.
4.3.1 Adjustments for One-Time Items
It is important to examine historical financial performance to identify items that
are not expected to continue into or happen again in the future. Such items are
often explicitly referenced by the company in its financials as “one-time charge,”
“one-time gain,” “non-recurring,” “extraordinary,” or “unusual.” Companies typically provide details on one-time items in their 10-Ks and 10-Qs. This can include
commentary in the MD&A section and information in the notes to the financial
statements.
Restructuring expenses are a typical example of one-time charges. When companies undergo restructurings, they incur various expenses related to closing
stores, shutting down plants, severing with employees, and hiring consultants.
Since companies tend to perform restructurings rarely, these expenses may not
reflect the ongoing financial performance of the company. Thus, when evaluating a company, it is important to “back out” such one-time charges to produce
adjusted financial information that reflects what the company’s performance
would be if the one-time expense had never happened. Other examples of typical,
one-time items include asset sales, inventory write-offs, goodwill impairments,
lawsuit expenses, and accounting changes.
Knopman Note: Impairment charges are an example of a one-time
item added back when calculating adjusted EBIT or EBITDA.
Sometimes, however, an item that appears to be a one-time event is actually a
recurring item. For instance, a company that is in natural decline may be looking
to sell off its assets on a regular basis over an extended period. A review of recent
financial statements may reveal a gain from the sale of an asset that, for another
company, would likely be considered a one-time gain subject to an adjustment,
but that for a company that is expected to sell its assets on a continual basis,
it would be better to not adjust for. Investment bankers must use their experience and judgment to determine what items require an adjustment versus what
should be considered part of a company’s normal operations.
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4.3.2 Adjustments for Recent Events
It is also important to monitor a company’s activity between quarterly financial
reports for events that materially impact its performance. A company’s 8-K filings are typically a great place to find material recent events such as entry into
a merger, completion of acquisitions and dispositions, material impairments,
capital raisings, stock splits, share repurchases, layoffs, and plant shutdowns.
Companies tend to announce important events in press releases that can usually
be accessed on their websites.
Chapter 4
Relative Valuation
Sometimes, even if the information necessary to make an adjustment is included
in a press release or the 8-K, it might not be clear exactly what adjustments
should be made. Take the case of a plant shutdown or asset disposition. Further
research and the guidance of senior bankers would be needed to make informed
estimates. In particular, M&A events require comprehensive adjustments to
combine the financial performance of the merging entities and incorporate the
financing details of the deal.
Knopman Note: When adjusting EBITDA, a banker might add back
excessive executive compensation to more accurately reflect what
an average executive would earn. EBITDA could also be adjusted for
a corporate jet expense or restructuring charges but would not be
adjusted for a special stock dividend. This is because a dividend has
no direct impact on the income statement.
Q: If a banker adjusts for one-time expenses, will EBITDA or net
income be more impacted?
A: Adding back a one-time expense would impact EBITDA more
than net income, because EBITDA is pre-tax while net income is
post-tax.
Q: When calculating pro forma EPS in connection with an
acquisition, what important adjustment should a banker
consider?
A: For a banker calculating pro forma EPS after an acquisition, it
would be important to adjust the operating expenses that will
be eliminated after the merger.
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Chapter 4: Relative Valuation
Progress Check
1. Which of the following companies would be
deemed the most creditworthy?
A. A company with EBIT interest coverage of
4× and net debt of -50 million
B. A company with EBIT interest coverage of
5× and net debt of -50 million
C. A company with EBIT interest coverage of
4× and net debt of -100 million
D. A company with EBIT interest coverage of
5× and net debt of -100 million
2. A company has $150 million of EBITDA, $50
million of net income, and a 40% tax rate.
Assuming the company reports a one-time,
pre-tax restructuring charge of $20 million,
what are adjusted EBITDA and adjusted net
income, respectively?
A.
B.
C.
D.
$150MM EBITDA, $62MM net income
$170MM EBITDA, $70MM net income
$170MM EBITDA, $62MM net income
$130MM EBITDA, $38MM net income
3. A ratio of earnings before interest, taxes,
depreciation, and amortization to interest
expense would be referred to as a:
A.
B.
C.
D.
100
Leverage ratio
Liquidity ratio
Capitalization ratio
Coverage ratio
4. A company has sales of $2 billion in 2018 and
an EBITDA margin of 15%. Assuming a 10%
sales growth rate and a 50 bps improvement in
EBITDA margin, what is 2019 EBITDA?
A.
B.
C.
D.
$300 million
$330 million
$310 million
$341 million
5. Company XYZ has $650 million in
shareholders’ equity as of December 31, 2018.
During 2019, the company generates $150
million of net income and declares $100
million of dividends. What is Company XYZ’s
return on equity for 2019?
A.
B.
C.
D.
20.7%
21.4%
22.2%
23.1%
Chapter 4: Relative Valuation
Progress Check—Solutions
(D)
A company with a high coverage ratio and low net debt would be the most creditworthy.
High interest coverage indicates sufficient profit to pay off interest, while negative net
debt indicates that a company has more cash than debt.
2. (C)
The entire pre-tax amount of $20 million is added back to $150 million of EBITDA,
resulting in adjusted EBITDA of $170 million. For net income, however, the
restructuring charge of $20 million must be tax-effected at a 40% tax rate ($12 million)
before being added to the $50 million of net income, resulting in $62 million of adjusted
net income.
3. (D)
EBITDA-to-interest expense is a standard interest coverage ratio measuring the amount
of cash flow available to cover interest obligations. Leverage is most often captured by
the debt-to-EBITDA ratio, while capitalization is captured by the debt-to-total
capitalization ratio. The current ratio is a common liquidity ratio, calculated as current
assets divided by current liabilities.
4. (D)
Assuming a 10% sales growth rate, 2018 sales of $2 billion would grow to $2.2 billion
in 2019. Adding 50 bps to the 2018 EBITDA margin of 15% provides a 2019 EBITDA
margin of 15.5%. When multiplied by 2019 sales of $2.2 billion, a 15.5% EBITDA margin
provides 2019 EBITDA of $341 million.
5. (C)
Return on Equity = Net Income/Average Shareholders’ Equity
1.
Ending SE = Beginning SE + NI − Declared Dividends
Ending SE = $650MM + $150MM − $100MM = $700MM
Average SE = (Beginning SE of $650MM + Ending SE of $700MM)/2 = $675MM
Return on Equity = $150MM Net Income/$675MM Average Shareholders’ Equity = 22.2%
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Chapter 4
Relative Valuation
4.4 Valuation Multiples
When valuing real estate (e.g., a house or apartment), one metric commonly
quoted about the property is the price per square foot. Since size is one of the
most important features of real estate properties, it is essential for buyers to
understand how much they are paying in relation to a property’s size.
Metrics like price per square foot, which include a price in the numerator and
some other numerical attribute in the denominator, are called valuation multiples, and they help investors value and compare a variety of assets, such as real
estate properties and companies.
For example, assume Property A, which is 2,000 square feet, is listed at a price
of $125,000. Therefore, it is being offered at $62.50/square foot ($125,000/2,000
square feet). The price per square foot would be useful information if a buyer
wanted to compare Property A with other properties to determine whether it is
cheap, expensive, or fairly priced.
Suppose Property B is priced at $75/square foot, making it more expensive on a
square-foot basis than Property A. With just two data points, it would be difficult
to determine whether Property A is cheap, whether Property B is expensive, or
both. If, however, it is also known that Property C is priced at $76/square foot,
then a buyer might conclude that Properties B and C are fairly priced, while
Property A is indeed cheap.
However, size is not the only important feature when it comes to valuing a property. For instance, Property B and Property C, from our previous example, might
be in better locations or be in better condition than Property A, facts that could
account for the premium pricing.
With this in mind, one use for valuation multiples is to compare a set of assets
and their relative values based on a common attribute. Another is to establish a
range of valuation multiples that can be applied to a target asset to establish a
valuation or valuation range for that target asset.
For instance, the example above created a valuation range of $62.50/square foot
at the low end and $76/square foot at the high end. Suppose a buyer is now trying
to value Property D, which is 3,000 square feet. Using the range of valuation multiples from above, it can be estimated that Property D’s value might be between
$187,500 and $228,000, as calculated below:
Low Estimated Value = 3,000 square feet × $62.50/square foot = $187,500
High Estimated Value = 3,000 square feet × $76.00/square foot = $228,000
The buyer is using the values of Properties A, B, and C to derive the estimated
value of Property D. This illustrates why these metrics are called “multiples.” They
allow an investor to calculate the total value by multiplying the metric (price per
square foot) by the numerical attribute (square feet) of the asset in question.
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The concept is nearly identical when applying valuation multiples to companies,
though the specifics of the valuation multiple will depend on whether equity
value or enterprise value is being calculated, as discussed below.
Knopman Note: While the example above illustrated a valuation range,
exam questions may instead ask for a mean, which is the average, or
they may ask for the median.
Chapter 4
Relative Valuation
The median is the number that is halfway into a set of numbers.
If the set has an even number of items, use the average of the two
middlemost numbers.
6
6.2
6.4
7.1
8.3
6.4
Median
6
6.2
6.4
7.1
Median = (6.2 + 6.4)/2
Median = 6.3
The mean (i.e., the average) is calculated as below:
6
6.2
6.4
7.1
8.3
Mean = (6 + 6.2 + 6.4 + 7.1 + 8.3)/5
Mean = 6.8
4.4.1 Equity Value Multiples
Equity value multiples use market capitalization or share price in the numerator. Since equity value reflects the value due to shareholders, the denominator
of an equity value multiple must be an attribute of the company that only relates
to shareholder value and not to the other layers of the capital structure, such as
to debt holders.
For example, when calculating equity value multiples, one would never use sales,
EBIT, or EBITDA in the denominator, as they are all pre-interest measures and
therefore do not account for the interest expense that will be paid to debt holders,
and thus, which is not available for equity holders. Instead, an investor would
use a metric such as net income or earnings per share, which are post-interest,
and thus fully reflect what is available to the company’s shareholders after all
other expenses have been paid. P/E, discussed earlier in this chapter, is the most
common equity value multiple.
Earnings-based multiples, such as P/E, can use earnings from different periods
of time: Price/LTM Net Income compares the company’s current equity value to
its earnings over the last twelve months, while Price/FY1 Net Income compares
equity value to the company’s expected next twelve months’ earnings and is often
sourced from analyst estimates.
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Chapter 4
Relative Valuation
4.4.1.1 Application of Equity Value Multiples
The application of equity value multiples, especially P/E, is one of the core fundamental concepts on the exam. Candidates must be able to use P/E to derive the
valuation of a company. This section covers a few common examples of types of
questions you will see.
As illustrated in the real estate examples above, candidates need to be able to
use the multiples of similar businesses or transactions to calculate an implied
valuation for a target company.
Example
Company XYZ is a manufacturing company that expects to earn $400 million
in net income next year. If all comparable companies in its sector trade at an
average of 12× FY1 net income, what is Company XYZ’s implied equity value?
If all of Company XYZ’s competitors are worth 12× their next year’s net income,
then the assumption can be made that Company XYZ is also worth 12× its own
expected net income of $400 million. Therefore, to calculate implied equity
value:
Implied Equity Value = 12× P/E × $400 million Net Income = $4.8 billion
Another common way this concept will be applied on the exam is when pricing
an IPO.
Example
A private company earned $150 million in net income in its most recent fiscal
year. Public companies in the sector trade at a multiple of 14×−16× earnings.
If the owners decide to float 40% of the company’s common equity by selling
20 million shares, what would be the range of per share proceeds generated
in the offering?
Low End of Valuation Range = $150 million Net Income × 14× PE
= $2.1 billion Implied Equity Value
Low End of Proceeds Range = $2.1 billion Implied Equity Value × 40% Float = $840 million
Low End of Proceeds Range per Share = $840 million/20 million Shares = $42
High End of Valuation Range = $150 million Net Income × 16× PE
= $2.4 billion Implied Equity Value
High End of Proceeds Range = $2.4 billion Implied Equity Value × 40% Float = $960 million
High End of Proceeds Range per Share = $960 million/20 million Shares = $48
Overall range of per share proceeds: $42–$48
104
Note that in this example even though the implied valuation range of the
company is between $2.1bn–$2.4bn, they are only selling 40% of the business,
valued at between $840MM–$960MM. This is because most companies in
practice only sell a percentage of their equity in their IPO (40% in this example), while the remaining shares (60% in this example) remain privately held
and in the hands of the founders, employees, and other early investors.
Chapter 4
Relative Valuation
Knopman Note: It is very important to be able to calculate a company’s
stock price by multiplying P/E and net income to find implied equity
value and then dividing by outstanding shares.
Multiples can also be used to compare a particular transaction to other deals
in the sector to see whether the price paid reflects a premium or a discount to
transactions in recent history.
Example
Company K is purchased for $80MM. The company had LTM net income of
$6MM and expects FY1 net income of $7MM. Recent transactions in the sector have been executed at 12× LTM earnings and 14× FY1 earnings. Does the
purchase price for Company K reflect a premium or discount to precedent
transactions on an LTM basis? Also, is it a premium or discount on a FY1
basis?
Answering this requires a calculation of the purchase price implied by the
data of both the LTM (last twelve months) and the FY1 (next forward year),
and then comparing each of these prices to the actual price paid of $80MM.
1. Purchase price implied by LTM data: $6MM LTM Net Income × 12
(LTM multiple) = $72MM. The actual purchase price is $80MM, representing a premium to the implied purchase of $72MM.
2. Purchase price implied by FY1 data: $7MM FY1 Net Income × 14 (FY1
multiple) = $98MM. The actual purchase price is $80MM, representing a
discount to the implied purchase of $98MM.
Therefore, the answer is that there was a premium paid relative to LTM data
and a discount paid relative to forward data.
4.4.1.2 Sector-Specific Equity Multiples
In addition to P/E, some industries employ alternative equity value multiples
specific to their sector. One such metric is price-to-book value, which is calculated as:
Price-to-Book
=
Equity Value
Book Value of Equity
105
Chapter 4
Relative Valuation
Or on a per share basis as:
Price-to-Book
=
Stock Price
Book Value per Share
Because book value, which is shareholders’ equity from the balance sheet, reflects
equity investment in the company plus the retained earnings that have accumulated over the life of the company, it is an after-interest expense figure that can
be safely paired with market capitalization in the numerator.
An alternative to price-to-book is price-to-tangible book value. Tangible book
value subtracts intangible assets, specifically goodwill, that may be difficult to
liquidate in the case of a bankruptcy. It is calculated as:
Price-to-Tangible Book
=
Equity Value
Book Value of Equity − Goodwill
Or on a per share basis as:
Price-to-Tangible Book
=
Stock Price
Tangible Book Value per Share
Knopman Note:
Q: What types of firms can be meaningfully valued using book
value multiples?
A: Financial firms, including insurance companies, banks, brokerdealers, and depository institutions, may use book value (from
the balance sheet) to derive an equity valuation or a share price
because these firms mark their books to market. This may be
expressed as a price-to-book valuation or price-to-tangible
book valuation.
Example
Company F has assets of $900MM, goodwill of $150MM, equity of $650MM,
100MM outstanding shares, and a current stock price of $15. What is the company’s price-to-tangible book value?
Equity Value = $15 × 100MM Shares = $1,500MM
Tangible Book Value = $650MM Equity − $150MM Goodwill = $500MM
Price-to-Tangible Book = $1,500MM Equity Value/$500MM Tangible Book Value = 300%
Note that, because the market value of equity can be calculated as $1,500MM,
the equity of $650 given in this question can only be assumed to be book value
of equity.
106
Knopman Note: Another ratio related to tangible book value is Debtto-Tangible Book Value, which is calculated as Total Debt divided by
(Shareholders’ Equity - Goodwill). When a company issues debt, this
ratio will increase.
Chapter 4
Relative Valuation
4.4.2 Enterprise Value Multiples
Enterprise value is calculated as equity value plus net debt, meaning it reflects
the claims of all of a company’s stakeholders. Therefore, for enterprise value
multiples, which use enterprise value in the numerator, the denominator must
be an attribute of the company that is relevant for both debt and equity holders.
This includes sales, EBIT, and EBITDA, as these are all pre-interest metrics. For
enterprise value multiples, never use net income: Bondholders do not care about
net income, as they have already received their interest.
Knopman Note: The full enterprise value formula also includes
preferred stock and non-controlling interest. It is rare to see
companies with these types of capital on the exam, so this section
will use the simplified formula of Equity + Debt – Cash for enterprise
value.
Enterprise Value-to-Sales
Enterprise value-to-sales, or EV/Sales, is a valuation multiple that compares
a company’s enterprise value to its sales as illustrated below:
EV/Sales
=
Enterprise Value
Sales
One issue with using sales as a metric is that, although it can provide an indication of a company’s size, it does not necessarily provide a sense of a company’s profitability or cash flow, as it does not account for any of the company’s
expenses. Therefore, it is often most meaningful for companies that have zero or
negative earnings.
As will be illustrated in the next section, it is important to note that if both a
target company’s sales and the EV/Sales multiple of comparable companies in
the sector are known, they can be multiplied together to calculate the target
company’s implied enterprise value:
Implied Enterprise Value = EV/Sales × Sales
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Chapter 4
Relative Valuation
Enterprise Value-to-EBITDA
Enterprise value-to-EBITDA, or EV/EBITDA, is a valuation multiple that compares a company’s enterprise value to its EBITDA:
EV/EBITDA
=
Enterprise Value
EBITDA
EV/EBITDA is the most widely used enterprise value multiple because EBITDA
provides an estimate for a company’s earnings without accounting for differences
in depreciation and amortization, which may vary widely between companies on
a year-to-year basis. Furthermore, since D&A are non-cash expenses, EBITDA
provides a better proxy for cash flow.
Please note that, if both a target company’s EBITDA and the EV/EBITDA multiple of comparable companies in the sector are known, they can be multiplied
together to calculate the target company’s implied enterprise value:
Implied Enterprise Value = EV/EBITDA × EBITDA
Knopman Note: As a general principal, when valuing a firm, EV/
EBITDA will provide the “best” valuation range if these figures are
available.
Enterprise Value-to-EBIT
Enterprise value-to-EBIT, or EV/EBIT, is a valuation multiple that compares
a company’s enterprise value to its EBIT as illustrated below:
EV/EBIT
=
Enterprise Value
EBIT
EV/EBIT is an alternative to EV/EBITDA that is most often used in situations
where information on depreciation and amortization is not available or for companies that operate capital-intensive businesses, where it is important to account
for the utilization and wear and tear on the equipment.
It is important to note that, if both a target company’s EBIT and the EV/EBIT
multiple of comparable companies in the sector are known, they can be multiplied together to calculate the target company’s implied enterprise value:
Implied Enterprise Value = EV/EBIT × EBIT
108
Knopman Note:
Q: Can EBIT ever be larger than EBITDA?
Chapter 4
Relative Valuation
A: No. EBITDA will always be greater than or equal to EBIT. It is not
possible for EBITDA to be less than EBIT because D&A cannot
be negative.
Q: What is the relationship between an EBIT and EBITDA
multiple?
A: A company’s EBITDA multiple will always be lower than (or
equal to, if D&A is zero) its EBIT multiple.
For example, consider a company with:
• Enterprise value of $100MM
• EBITDA of $25MM, and
• EBIT of $20MM
The company is worth 4× EBITDA and 5× EBIT (notice the
EBITDA multiple is lower than the EBIT multiple). If the EBIT
multiple were lower than the EBITDA multiple, a typographical
or data entry error must have occurred. Similarly, a company’s
EBITDA margin (EBITDA/Sales) will always be higher than its
EBIT margin (EBIT/Sales).
Q: How might a firm using an EBITDA multiple increase its
valuation?
A: A company seeking to increase its valuation based on an
EBITDA or EBIT multiple would increase EBITDA or EBIT to
do so. This could be accomplished through either increased
revenue (higher sales) or reduced expenses (e.g., lower SG&A).
Example: A firm with $100MM in EBITDA is using a 4× EBITDA
multiple for a $400MM valuation. If it were to reduce its fixed
costs by 5% so that EBITDA increased to $110MM, the firm’s new
valuation would be $440MM.
Knopman Note: An early-stage biotech firm will likely have no
earnings, so a banker would not use a P/E multiple or EBITDA
multiple to value the business. More relevant would be a liquidity
analysis as it is important for the company to have enough cash to
fund its operations.
109
Chapter 4
Relative Valuation
4.4.2.1 Application of Enterprise Value Multiples
The application of enterprise value multiples is another core fundamental concept on the exam. It is essential for candidates to be able to use the EV/Sales,
EV/EBIT, and EV/EBITDA multiples to derive the valuation of a company. This
section covers a few common examples of types of questions you will see.
Similar to the P/E examples above, it is essential for candidates to be able to
calculate an implied enterprise value and ultimately solve for a company’s equity
value or stock price, as illustrated in the examples below.
Example 1
Company XYZ is in the same sector as the companies described in Exhibit
1. Given XYZ’s financial data in Exhibit 2, and using the mean from Exhibit 1,
calculate XYZ’s implied equity value.
Exhibit 1
($ in millions)
EV/Sales
EV/EBITDA
EV/EBIT
Price/EPS
Company A
1.5×
8.0×
9.7×
15.5×
Company B
1.6×
7.7×
8.4×
16.9×
Company C
1.3×
8.3×
9.9×
16.6×
Exhibit 2
Company XYZ Financial Information ($ in millions)
LTM EBITDA
$400
Cash
$274
Total Debt
$874
For these types of questions, the first step is to determine which information
to use from Exhibit 1 (the comparables) to value Company XYZ. The quickest
way to calculate an implied equity value is by using the P/E multiple. However,
since Exhibit 2 does not provide XYZ’s net income, P/E cannot be used.
Because Exhibit 2 provides XYZ’s LTM EBITDA, it can be assumed that the
EBITDA multiple from Exhibit 1 must be used in this exercise. Note that the
sales and EBIT multiples from Exhibit 1 cannot be used, as Company XYZ’s
sales and EBIT are not provided.
Mean EBITDA Multiple = (8.0 + 7.7 + 8.3)/3 = 8.0×
Implied Enterprise Value = EV/EBITDA × EBITDA
Implied Enterprise Value = 8.0 × $400MM = $3.2 billion
Implied Equity Value = Enterprise Value – Debt + Cash
Implied Equity Value = $3.2 billion – $874MM + $274MM = $2.6 billion
110
Note that if Company XYZ’s outstanding share count was provided, the
implied equity value could be divided by that figure to determine an implied
stock price for the company.
Example 2
What is the difference in the equity value of Company A that is implied by
Companies X and Z?
Chapter 4
Relative Valuation
Exhibit 1
($ in millions)
EV/Sales
EV/EBITDA
Company X
1.8×
8.4×
Company Y
1.9×
8.1×
Company Z
1.6×
9.1×
Exhibit 2
Company A Financial Information ($ in millions)
LTM EBIT
$20
Depreciation & Amortization
$3
Net Debt
$30
Net Income
$12
This question is asking you to 1) calculate the equity value of Company A
using Company X’s information, 2) calculate the equity value of Company A
using Company Z’s information, and then 3) take the difference between the
two equity values.
The quickest way to calculate equity value is to take Company A’s net income,
which is given, and multiply it by the P/E ratios of Companies X and Z.
However, because the P/E multiples of the comparables are not provided,
that method will not work.
The exhibit does provide the EBITDA multiple for Companies X and Z. In
order to use it, Company A’s EBITDA must be provided. Although EBITDA
itself is not provided, it can be calculated as shown below:
Company A EBITDA = $20MM EBIT + $3MM D&A = $23MM
Company A Enterprise Value (based on Company X) = 8.4 × $23MM = $193.2MM
Company A Equity Value (based on Company X) = $193.2MM − $30MM Net Debt = $163.2MM
Company A Enterprise Value (based on Company Z) = 9.1 × $23MM = $209.3MM
Company A Equity Value (based on Company Z) = $209.3MM − $30MM Net Debt = $179.3MM
Difference in Equity Value = $179.3MM − $163.2MM = $16.1MM
111
Chapter 4
Relative Valuation
Another important application is the calculation of the synergies-adjusted multiple, also referred to as the effective multiple. The effective multiple helps to
assess how much an acquirer is paying for a target, after factoring in any synergies, such as cost savings, from the transaction. It is calculated as:
Effective Multiple
=
Profit × Purchase Multiple
Profit + Synergies
Note that profit in the above formula could be sales, EBIT, EBITDA, or net income.
Example
Company A, with $8MM of EBITDA, is the target of a takeover by Company
B. Company B can pay up to 8.5× EBITDA for Company A. In addition, it can
recognize $1.2MM in expense synergies resulting from the business combination. What is the effective EBITDA multiple for the transaction?
Effective Multiple
=
$8.0MM EBITDA × 8.5 EBITDA Multiple
$8.0MM EBITDA + $1.2MM Synergies
= 7.4×
Knopman Note:
Q: How do a firm’s EV/EBIT and EV/EBITDA ratios relate to its P/E
ratio?
A: The enterprise value compared to the pre-interest and pre-tax
earnings of the firm may look very different than the equity
value compared to the net income (equity value divided by net
income).
Consider: If two companies have similar EBIT or EBITDA
multiples, but their P/E ratios are different, this might be
explained by differences in the firms’ interest expenses or taxes.
Why? Both EBIT and EBITDA are profit measures prior to
interest expenses and taxes on the income statement, and
any differences in interest expense or tax are not reflected in
EBITDA and EBIT multiples. They are, however, reflected in a
P/E multiple, which is based on net income.
Example: When comparing a foreign firm and a domestic firm
that have dissimilar EV/EBIT ratios but similar P/E ratios, one
possible reason is the different tax rates the two firms face.
112
4.5 Comparable Companies Analysis: Step by Step
As previously discussed, comparable companies analysis, or trading comps,
is used to value a company using the financial metrics of similar, publicly traded
businesses in its sector as the basis for comparison.
Chapter 4
Relative Valuation
Publicly traded companies provide current and easily accessible information that
reflects market sentiment. They also disclose detailed financial information in
their annual and quarterly reports that enables investors to compare the companies across a variety of attributes. The group of similar companies used for comparison is often called a “universe of comps.” The universe of comps establishes
a range of trading multiples, such as P/E and EV/EBITDA, that are then used to
estimate the value of the target company, as illustrated in the previous section.
Comparable companies analysis is used in a variety of contexts. When a company is preparing for an IPO, because it does not have any public trading history,
investment bankers can use a trading comps to estimate what investors would
be willing to pay for shares of the company. A trading comps is also useful when
valuing a division of a company. The division will not have its own public price,
but publicly traded companies that are similar to the division may be used as a
benchmark for valuation. This can inform a company looking to sell or spin off a
division or a company looking to buy a division from another company.
Example
In 2005, Lenovo acquired IBM’s personal computer division in a deal valued
at $1.75 billion. To determine the purchase price for IBM’s PC unit, Lenovo
analyzed technology companies and other PC companies with similar characteristics to IBM’s PC division.
Trading comps can also be useful in valuing a public company. Companies that
are valued lower than peer companies may be undervalued or penalized by
investors for a particular reason. This knowledge can lead to insights on how to
improve the company’s performance or to motivate a value-creating transaction.
Comparable companies analysis involves these steps, which will be discussed in
the following sections:
1. Selecting a universe of comps
2. Spreading comps, and
3. Establishing a valuation range
4.5.1 Step 1: Select a Universe of Comparable Companies
The first step in a trading comps is to study the target company and select a
universe of comparable companies. A full analysis of the universe of comparable
companies will include evaluating all the factors about each company discussed
in this chapter, including their business model, life cycle, profitability, capital
efficiency, leverage, and payout policy.
Bankers develop deep insight and knowledge about the companies in their area
113
Chapter 4
Relative Valuation
and industries of expertise. For a particular target company, a senior banker can
typically determine an appropriate universe of comps quickly. For lesser-known
or unique companies, deeper analysis may be required.
The end goal is to define a group of companies that bears close resemblance to
the target company so that their prices can be used as accurate estimates for the
price of the target company.
Example
If the hamburger chain Five Guys, which is currently a private company, at
some point decides to do an IPO, analysts would likely look at the valuation
multiples of publicly traded fast food companies such as Shake Shack, Jack
in the Box, and Chipotle to help determine its value and expected proceeds.
Example
If Foursquare, currently a private company, at some point decides to do an IPO,
analysts would likely look at the valuation multiples of Yelp and TripAdvisor,
which are both publicly traded companies. This is because all three businesses
are online platforms that provide reviews and recommendations to consumers, while earning revenue via advertising.
Knopman Note: An LBO valuation model is least valuable when pricing
an IPO.
4.5.2 Step 2: Spread Comps
Spreading comps is the process of collecting data about a universe of comparables, calculating relevant ratios, and presenting them in a table so that the companies can be easily compared. The data incorporated depends on the industry,
but it typically includes such fundamental financial statistics as sales, EBITDA,
net income, profit margins, growth rates, ROI measures, leverage, and credit ratings. This data can be found in SEC filings, research reports, consensus research
estimates, press releases, and financial software tools.
The financial information is typically adjusted to account for one-time or recent
events and is usually calculated on a last twelve months (LTM) basis. Most importantly, the trading multiples for the universe of comps are included in addition to
financial statistics to provide the basis of the valuation range.
4.5.3 Step 3: Establish Valuation Range
A valuation range typically includes a target valuation that is supplemented with
both a high and low estimate. If the universe of comps bears close resemblance to
the target company and the trading multiples are close to one another, then the
target valuation will likely be determined by either the mean or median trading
multiple, and the valuation range will be determined by the high and low trading
multiples across the entire selection of comparable companies.
It is often the case that the universe of comps contains outliers. Some of the
114
companies might have some significant differences from the target company or
might be valued at a multiple that is much different from the rest of the companies in the set. In such a case, a senior banker will often evaluate the comps to
determine how to refine the range. In some cases, the outliers will be ignored,
and the remaining comps will be used. Alternatively, the banker may select very
few comps as the basis of the valuation range. The banker may also choose not to
use means or medians but to select a particular comp as the basis for the target
valuation, a different comp to determine the high end of the valuation range, and
another particular comp to determine the low end of the valuation range. This
is yet another example of how valuation involves as much art as science, with
experience and industry knowledge playing a critical role.
Chapter 4
Relative Valuation
Example of Comparable Companies Analysis
The chart below is an example of a trading comps output page that an investment banker would prepare when valuing a target company using a comparable
companies analysis. The output page below includes eight companies that can be
assumed in this example to all be in the same sector as the business being valued
in the analysis. From left to right, the data provided for each comparable includes:
◆ Company name
◆ Ticker (the stock symbol used to identify public companies on the
exchange)
◆ Percentage of 52-week high (each company’s current stock price as a
percentage of its high from the past 52 weeks)
◆ Sales
◆ LTM EBITDA margin
◆ Enterprise value
◆ LTM EBITDA
◆ EV/EBITDA multiple
◆ LTM net margin (another way of saying net income margin)
◆ Equity value
◆ LTM EPS
◆ P/E multiple
◆ Credit rating
◆ Debt/EBITDA
◆ LTM EPS growth rate
Additionally, the mean, median, low-end, and high-end figures are also provided
for each of the metrics.
As discussed, once all this information is spread on the output page, the banker
can then take the appropriate metric (for example, an EBITDA multiple or P/E)
and use it to value the target. Note that if any of the comparable companies is an
outlier, for example if one company has a P/E multiple or EPS growth rate that
highly deviates from the other companies (e.g., double that of the other comparables), it will likely be excluded from the analysis as to not skew the data.
115
94%
11,900
Note: all figures as of most recently public filing.
1) Shares outstanding denoted in millions
1,033
11,900
3,906
60%
17.36
293.22
1,033
6,461
Low
5.00
35.43
91%
76%
95%
CPYH
Company H
6.29
117.03
1,929
5,887
High
CPYG
Company G
6.96
18.92
80%
60%
4,667
CPYF
Company F
12.41
69.81
2,316
78%
CPYE
Company E
8.09
16.12
95%
Sales
$2,880
79%
CPYD
Company D
13.90
68%
Mean
CPYC
Company C
27.05
$62.66
Median
CPYB
Company B
8.73
% of
52-week
high
4,931
CPYA
Company A
Current
Share Price
70%
Ticker
Company
Name
Shares 1)
Outstanding
Comparison of selected peers
116
($ in millions)
15%
25%
18%
19%
16%
16%
18%
18%
17%
15%
25%
25%
LTM
EBITDA
Margin
1,321
14,090
4,412
5,403
4,576
14,090
1,321
8,374
1,706
4,857
4,053
$4,248
Enterprise
Value
186
1,904
755
819
789
1,904
186
1,163
328
883
579
$720
LTM
EBITDA
5.2x
7.4x
6.5x
6.4x
5.8
7.4
7.1
7.2
5.2
5.5
7.0
5.9x
EV/
EBITDA
10%
19%
12%
13%
12%
12%
12%
13%
10%
10%
16%
19%
LTM
Net Margin
119
1,466
556
588
615
1,466
119
814
200
565
376
$547
Equity
Value
0.45
19.29
2.75
5.15
1.32
19.29
0.45
8.48
0.93
5.54
1.01
$4.18
LTM
EPS
P/E
12.6x
15.2x
13.8x
13.9x
13.2
15.2
14.0
13.8
13.3
12.6
13.8
15.0x
BBB
BBB-
BBB-
BBB
A
A-
BBB
BBB
Credit
Rating
4.7x
7.0x
5.9x
5.9x
5.1
6.7
7.0
6.6
4.7
5.0
6.5
5.2x
Debt/
EBITDA
Debt
1,302
12,757
3,894
4,903
4,024
12,757
1,302
7,676
1,542
4,415
3,764
$3,744
36
133
94
88
63
133
100
116
36
123
87
$43
Cash
8%
15%
11%
11%
12%
15%
12%
9%
10%
8%
15%
9%
LTM
EPS Growth
Rate
Chapter 4
Relative Valuation
4.5.4 Pros and Cons of a Trading Comps
The main advantage of a comparable companies analysis is that it is relatively
straightforward to implement, as current data for public companies is readily
available. Additionally, it is considered a relatively objective approach since it
uses third-party prices from the public markets as the main provider of information. This contrasts with a discounted cash flow (DCF), discussed in the next
chapter, which relies significantly on assumptions and projections. A trading
comps is not a judgment-free approach, however, since it does involve selecting
a universe of comps and analyzing the data to determine the ultimate valuation
range.
Chapter 4
Relative Valuation
One disadvantage of a trading comps is that it can be challenging to find appropriate companies for comparison, especially for companies in a niche sector. For
example, the target company may have a narrow focus compared to other public
companies in the industry. Alternatively, the target company may be new and
small, while other companies in the industry are large and established.
Additionally, the analysis may reflect market aberrations. For example, if a banker
was valuing an internet company during the peak of the dot-com bubble in the
late 1990s, the banker may have derived a price for that business that was overvalued compared to its actual worth.
Furthermore, a trading comps is not always consistent with cash flow. For example, a company may generate a ton of sales, but because its expenses or interest
expense is high, it may still be bleeding cash. A trading comps would not necessarily reflect that.
Finally, a trading comps also fails to consider the control premiums and synergies
associated with owning a controlling stake of a company. Public share prices
reflect the value of owning a small piece of a company, but owning enough of a
company to direct its operations carries additional value. For instance, if a company can take over a competitor, additional value is created by the transaction—a
competitor is taken out of the market, and some cost synergies are likely created.
A precedent transactions analysis, discussed in the next section, better accounts
for these factors.
Knopman Note:
Q: When is a trading comps analysis most useful? Least useful?
A: A trading comps analysis is useful when there is a clear universe
of comparable companies in a particular sector or industry.
It is less useful for a company with no clear competitors or
comparables. Also, it is not useful to compare companies with
substantial differences in net working capital—discount cash
flow analysis is more useful in that case.
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Chapter 4
Relative Valuation
4.6 Precedent Transactions Analysis
Like a trading comps, a precedent transactions analysis, also referred to as a
comparable transactions analysis or a transaction comps, involves making
comparisons to similar investments. However, whereas a comparable companies
analysis relies on current prices of publicly traded peers, precedent transactions
relies on information from similar acquisitions.
The key benefit of a transaction comps is that the price paid in a transaction
includes control premiums, which is the amount paid above the target’s market
price to acquire a controlling stake in the business, as well as part of the value of
any expected synergies. This makes a precedent transactions analysis most useful
in an M&A context, helping to value a company that is for sale.
Example
In the Microsoft-LinkedIn merger, although LinkedIn was trading at a price
of $131 per share, Microsoft agreed to purchase LinkedIn for $196 per share,
at a 50% premium to the current market price. The additional $65 per share
reflected a control premium as well as potential synergies Microsoft would
realize from the merger. A transaction comps analysis reflects the premium
paid.
Knopman Note: A transactions comps is less relevant when pricing an
IPO, because in an IPO, there is no control premium.
Precedent transactions analysis involves these steps, which will be discussed in
the following sections:
1. Selecting a universe of comparable transactions
2. Spreading comps, and
3. Establishing a valuation range
4.6.1 Step 1: Select a Universe of Comparable Transactions
The first step in precedent transactions analysis is to study the target company
and select a universe of comparable acquisitions. The best comps are recent
acquisitions of companies in the same industry, of similar size, with a similar
type of buyer, and with similar motivation for selling.
118
Example
Since 2010, the airline industry has seen several mergers. Examples include
United Airlines’ 2010 merger with Continental, American Airlines’ 2013 purchase of US Airways, and Alaska Airlines’ 2016 acquisition of Virgin America.
If an investment banker was trying to value a potential airline merger coming
down the pipeline, the banker could review these past transactions to better understand valuation within the sector. Transaction information can be
found in a variety of sources, including press releases, merger proxies, 8-Ks,
and 10-Ks. Since this information can be time-consuming to collect, investment banks typically maintain their own internal transaction lists, which they
supplement with secondary sources, such as third-party M&A databases,
research reports, and trade publications.
Chapter 4
Relative Valuation
The buyer might either be a financial sponsor or a strategic buyer, and the
type of buyer is an important factor, as each approaches acquisitions differently.
As will be discussed in a later chapter, a financial buyer (e.g., private equity firm)
typically uses a high degree of leverage, has a medium-term investment horizon,
and will not necessarily be able to capture synergies, since it generally will not
have an existing operation into which to merge the target. In contrast, a strategic
buyer, which is a competitor of the target, will tend to purchase with less leverage,
be fulfilling a specific strategic need, and thus be capable of capturing synergies.
The seller’s motivation can also be important. In many cases, the goal is to maximize shareholder value. However, there can be exigent circumstances, such as
bankruptcy, a liquidity crisis, or a restructuring.
Since transactions occur relatively infrequently and deal information is often
inaccessible, constructing a robust universe of transaction comps is often even
more difficult than constructing a robust universe of trading comps. It is often
necessary to include companies in adjacent industries or those that serve similar
end markets as the target company. It may also be necessary to include older
transactions. When doing so, however, since valuation multiples can vary widely
at different points in the macroeconomic and industry business cycles, it is critical to qualify the circumstances of older transactions. For example, if a sector
is much different today than it was prior to 2011, any transactions that occurred
prior to that date would need to be excluded from the analysis.
The ultimate goal is to define a set of transactions that bear close resemblance
to the transaction being considered so that their prices can be used as accurate
estimates for the price of the target company.
4.6.2 Step 2: Spread Comps
The process for spreading transaction comps is similar to that of spreading trading comps—it involves collecting data, calculating relevant ratios, and presenting
them in a table so that companies can be easily compared. Spreading transaction
comps also involves a similar set of financial information as spreading trading
comps: Typically, the target’s LTM sales, EBITDA, and net income in addition to
the equity and enterprise values. In this case, the equity and enterprise values represent the purchase price of the target, which includes control premiums, rather
119
Chapter 4
Relative Valuation
than the market price of the target. Other financial information, such as EBITDA
margins or growth rates, may be included as appropriate to the circumstance.
Transaction comps are typically sorted by the date the deal was announced,
with the most recent transaction at the top. This is because more recent transactions will best reflect current market conditions. Each deal typically includes
an important set of information not included when spreading trading comps:
◆ The identities of the acquirer and target and whether the parties are
public, private, or financial sponsors
◆ The purchase consideration, which is the form of payment for the target
(cash, stock, or a mix of both)
◆ The premium paid over the target’s stock, if the target was publicly
traded
4.6.3 Step 3: Establish Valuation Range
As with comparable companies analysis, the valuation range generated by a precedent transactions analysis includes a target valuation alongside a high estimate
and a low estimate. Once a refined list of transactions has been set, then the target valuation is determined by either the mean or median trading multiple and
the valuation range is determined by the high and low trading multiples. Those
multiples are then applied to the financial information of the target company to
imply a valuation.
Example of Precedent Transactions Analysis
The chart below is an example of a transaction comps output page that an
investment banker would prepare when valuing a company that is for sale. The
output page below includes eight completed transactions that can be assumed to
be similar to the one being valued. From left to right, the data provided for each
precedent transaction in this example includes:
◆ Announcement date of transaction
◆ Target
◆ Acquirer
◆ Whether the target is a public or private company
◆ Whether the acquirer is a financial sponsor, public strategic buyer, or
private strategic buyer
◆ The purchase consideration (cash, stock, or a mix of both)
◆ Equity value
◆ Enterprise value
◆ EV/EBITDA multiple
◆ EV/Sales multiple
◆ Equity Value/Net Income multiple (P/E)
120
◆ The percentage premium that the purchase price represented compared
to the target’s stock price one week and one month prior to the
announcement respectively. Note that this data is only relevant for target
companies that had publicly traded stock
Chapter 4
Relative Valuation
Additionally, the mean, median, low-end, and high-end figures are also provided
for each of the metrics.
As discussed, once all this information is spread on the output page, the banker
can then take the appropriate metric and use it to imply a purchase price for the
target company.
121
122
Announcement
date
($ in millions)
Target
name
Acquirer
name
Target
type
Acquirer type
Purchase
consideration
Equity
value
Enterprise
value
EV/LTM
EBITDA
EV/LTM
sales
Equity/LTM
net income
1 week prior to
announcement
1 month prior to
announcement
Premium paid to market price
Chapter 4
Relative Valuation
4.6.4 Pros and Cons of a Transaction Comps
Precedent transactions analysis shares two main advantages with comparable
companies analysis—it is easy to implement and it is objective. Implementing it
requires compiling a set of data, performing fairly straightforward calculations,
and making comparisons. It also relies on valuations based on past transactions,
limiting, but not eliminating the practitioners’ judgment and bias.
Chapter 4
Relative Valuation
Additionally, the analysis is based on recent, practical transactions. Especially
for industries in which a lot of recent consolidation has occurred, a banker can
easily put together a relevant sample set of transactions to base valuation on.
However, acquisitions are relatively infrequent events—finding enough relevant
recent transactions to establish a meaningful reference for comparison can be
challenging. Furthermore, transactions and valuations are highly affected by the
business climate. Thus, temporary changes in market or economic conditions
can have a significant impact on valuation ranges.
Another challenge is that acquisition information is not always available, particularly when the target is private or a division of a company. This includes key deal
facts, such as the price paid and the recent financial performance of the target.
Finally, each transaction has its own unique circumstances that can skew or
alter valuation. For example, the types of synergies that are recognized can be
inconsistent across deals. Just because one buyer was able to capture significant
synergies when purchasing a similar company in the past does not mean that a
different buyer will be able to extract the same amount of synergies by acquiring
a similar target company.
Knopman Note:
Q: When is a transaction comps analysis most useful? Less useful?
A: A transaction comps analysis is useful when there have been
a number of mergers or acquisitions in a sector. In particular,
recent transactions are more useful than older transactions.
It is less useful when transactions may have occurred in a
different stage of the industry life cycle. For example, in a
mature industry where companies are routinely sold for 4×–5×
EBITDA, using a transaction comps from 10 years ago when the
industry was in its growth phase and companies were selling for
15×−25× EBITDA would not be useful.
Knopman Note: Be familiar with which valuation methodology is used
for each of these types of transactions.
Deal Type
Appropriate Valuation Methodology
IPO
Comparable companies
Acquisition
Precedent Transactions
123
Chapter 4: Relative Valuation
Unit Exam
1. Coverage ratios are so named for their ability
to measure the company’s capacity to:
A. Cover equity holders in the event of
bankruptcy
B. Cover the return of principal to lenders in
the debt security’s maturity year
C. Cover annual interest expense and
potentially other fixed charges
D. Cover liabilities in the event of a lawsuit
2. Which criteria are useful for determining
whether a given precedent transaction is
relevant for valuing the target company in an
M&A scenario?
A.
B.
C.
D.
I. Target company sector
II. Period during which the transaction
took place
III. Size of target company
IV. Target company domicile
I and III
II and IV
I, II, and III
I, II, III, and IV
3. What does the control premium refer to in a
transaction comps?
A. The right for the acquirer to control
decisions regarding the target’s business
B. The right for the acquirer to control the
premium paid to target shareholders
C. Premium for controlling the process’s
timing
D. The acquirer’s attempt to control target
shareholders
4. Company ABC has a P/E of 12×, total debt of
$130MM, cash of $50MM, and a net income of
$30MM. What is the company’s implied equity
value?
A.
B.
C.
D.
5. Company F has assets of $500MM, goodwill
of $50MM, equity of $250MM, 100MM
outstanding shares, and a current stock price
of $7. What is the company’s price-to-tangible
book value?
A.
B.
C.
D.
2.5×
2.8×
3.5×
3.8×
6. AcquirerCo wants to purchase TargetCo. It can
pay 11.3× EBITDA. Assuming that AcquirerCo
will recognize $2.7MM in synergies and that
TargetCo has an EBITDA of $14MM, what is
the effective EBITDA multiple?
A.
B.
C.
D.
7.94×
8.95×
9.47×
11.3×
7. JonesCo, with $3.8MM debt outstanding,
intends to acquire Acme in a cash transaction.
After closing, the combined company will
have $6.2MM EBITDA. The maximum leverage
JonesCo can incur is 5× EBITDA. Furthermore,
JonesCo has $2.5MM in cash after completing
a recent asset sale. What is the most it can
offer to acquire Acme?
A.
B.
C.
D.
124
$360MM
$440MM
$540MM
$600MM
$27.2MM
$29.7MM
$31MM
$33.5MM
Chapter 4: Relative Valuation
Unit Exam (Continued)
8. Company DEF pays a quarterly dividend
of $0.60 and has a dividend yield of 5%, a
dividend payout ratio of 25%, and a book value
of $36 per share. What is the company’s priceto-book value multiple?
A.
B.
C.
D.
0.33×
0.75×
1.33×
2.43×
10. A banker has identified an EBITDA multiple
as the best way to value a business. How could
the company increase its valuation?
A. Change the company’s capital structure to
reduce its interest expense
B. Decrease the company’s gross profit
C. Decrease the company’s operating
expenses
D. Decrease the company’s sales
9. SPC is a company in the manufacturing sector.
It has total debt of $500MM, cash of $280MM,
and 175MM shares outstanding. Assuming the
company generated $450MM in EBITDA in the
last twelve months, calculate a mean offering
price per share for SPC given the information
about its comparable companies below:
EV/
Sales
EV/
EBITDA
EV/
EBIT
Price/
EPS
Company A
1.5×
8.0×
9.7×
15.5×
Company B
1.6×
7.7×
8.4×
16.9×
Company C
1.1×
6.3×
7.7×
14.2×
A.
B.
C.
D.
$15.91
$17.51
$18.54
$18.77
125
Chapter 4: Relative Valuation
Unit Exam—Solutions
1.
(C)
Leverage ratios measure a company’s debt level, while coverage ratios determine the
company’s ability to service its debt interest expense.
2. (D)
All of these factors are important for determining whether a given precedent
transaction is appropriate.
3. (A)
Acquirers are expected to pay target shareholders a premium for the right to control
decisions at the company. Therefore, the price for buying all the shares of the target
company exceeds the price expected to be paid for buying a single share, for example.
4. (A)
Implied Equity Value = P/E Ratio × Net Income
Implied Equity Value = 12× P/E Ratio × $30MM Net Income = $360MM
5. (C)
Price-to-Tangible Book = Market Value of Equity/Tangible Book Value
Market Value of Equity = $7 Stock Price × 100MM Outstanding Shares = $700MM
Tangible Book Value = $250MM Book Equity − $50MM Goodwill = $200MM
Price-to-Tangible Book = $700MM Market Value of Equity/$200MM Tangible Book
Value = 3.5×
6. (C)
Effective EBITDA = Purchase Price/(EBITDA + Synergies)
Purchase Price = 11.3 × $14MM EBITDA = $158.2MM
Effective EBITDA = $158.2MM/($14MM + $2.7MM) = 9.47×
7.
(B)
Maximum Leverage = 5 × $6.2MM EBITDA = $31MM
Additional Leverage = $31MM Max Leverage − $3.8MM Existing Debt = $27.2MM
Maximum Offer = $27.2 Debt + $2.5MM = $29.7MM
8. (C)
Price-to-book can be calculated in two ways: Market Value of Equity/Book Value of
Equity or Stock Price/Book Value per Share. Because book value per share is provided
in the question, the per share calculation can be used in this example.
Stock Price = $2.40 Annual Dividend/5% Dividend Yield = $48
Note that the annual dividend is calculated as the quarterly dividend of $0.60 multiplied
by four.
Price-to-Book = $48/$36 = 1.33×
126
Chapter 4: Relative Valuation
Unit Exam—Solutions (Continued)
9. (B)
In this question, because SPC’s EBITDA is provided, the EBITDA multiple of the
comparable companies must be used. The average EBITDA multiple is 7.3× (calculated
as the sum of 8.0, 7.7, and 6.3 divided by 3).
Implied Enterprise Value = 7.3 × $450MM EBITDA = $3,285MM
Implied Equity Value = $3,285MM Enterprise Value − $500MM Total Debt + $280MM
Cash = $3,065MM
Implied Offer Price per Share = $3,065MM Equity Value/175MM Shares Outstanding =
$17.51
10. (C)
Companies seeking to increase their valuation based on an EBITDA multiple would
aim to increase EBITDA. Put differently, a higher EBITDA, which is a profit measure for
the company, helps increase the value of the business. Of these choices, only reduced
operating expenses (SG&A) would increase EBITDA. Note that lowering interest
expense has no impact on EBITDA since EBITDA is a pre-interest measure.
127
5. Fundamental and
Fixed-Income Valuation
While relative valuation methodologies value a company based on similar businesses and transactions, fundamental valuation methodologies directly measure
how much cash a specific company will return to an investor over time as well as
the present value of those cash flows.
The various fundamental valuation methodologies differ in the type of cash
flow used as well as the interest rate and rate of return used. This chapter will
focus on the following methodologies:
◆ Discounted cash flow (DCF)
◆ Dividend discount model, and
◆ Perpetuity methods
This chapter will also review basic fixed-income valuation and relevant bond
characteristics that candidates must be familiar with.
5.1 Discounted Cash Flow (DCF)
The idea behind a discounted cash flow analysis, or DCF, is that the enterprise
value of a company is equal to the present value of its future free cash flows (FCF).
That is, an investor is estimating how much free cash flow a company will generate today, tomorrow, and into the future, and then discounting all those cash
flows to what they are worth right now. This discounting accounts for the time
value of money, which is the idea that a dollar earned today is worth more than
a dollar earned tomorrow due to its earnings potential.
To calculate enterprise value, two distinct periods will be summed: 1) The present
value of cash flows during a projection period, and 2) the present value of terminal value, which reflects everything that occurs after the company’s projection
period. To discount the future cash flows to today’s present value, an appropriate
discount rate must be used, which is typically the weighted average cost of
capital, or WACC.
129
Chapter 5
Fundamental and
Fixed-Income
Valuation
Knopman Note:
Q: What are the two stages in a DCF?
A: The analysis consists of a projection period and a terminal
value.
Q: Which two financial statements are most relevant when
conducting a DCF?
A: The income statement and cash flow statement.
As mentioned, a DCF results in a company’s enterprise value, which can then be
used to determine the company’s equity value and share price.
The steps involved in a DCF will be discussed in the next few sections. A completed DCF is pictured below to guide you during the DCF discussion.
130
WACC
9.31%
10% % equity
90%
9.91%
Cost of equity
Capital structure
% debt
2.15%
1.15
6.75%
Weighted average cost of capital
Cost of debt
Cost of equity
Tax rate
35% Risk-free rate
Pre-tax cost of debt
6% Beta
3.90% EMRP
After-tax cost of debt
($ in millions)
Example discounted cash flow analysis
3
0.77
$145.2
$184.0
2
0.84
$154.5
$169.0
1
0.91
$153.8
$103.3
Unlevered free cash flow
Discount period
Discount factor
Present value of free cash flows
$188.5
$107.44
35%
$199.5
$17.0
-$20.0
-$8.0
$15.0
-$30.0
-$10.0
$108.75
35%
$202.0
$16.0
-$25.0
-$9.0
$14.0
-$32.0
-$12.0
tax rate
17%
$17.0
$307.0
$324.0
Plus: Depreciation & amortization
Less: Capital expenditure
Less: Increase in net working capital
EBIAT
Taxes
EBIT
Depreciation & amortization
19%
$16.0
$310.7
$326.7
$1,905.8
5%
$104.48
35%
$194.0
$313.5
$219.0
$1,815.0
10%
$71.75
35%
$133.3
$1,650.0
10%
$1,500.0
2015
Projection period
2016
2017
19%
$15.0
$298.5
% margin
% growth
Last year
2014
20%
$14.0
$205.0
EBITDA
Sales
Free cash flow projection
$141.0
4
0.7
$201.4
$112.76
35%
$209.4
$18.0
-$19.0
-$7.0
17%
$18.0
$322.2
$340.2
$2,001.0
5%
2018
$136.2
5
0.64
$212.8
$118.36
35%
$219.8
$19.0
-$19.0
-$7.0
17%
$19.0
$338.2
$357.2
$2,101.1
5%
2019
Implied equity value
Debt
Cash
Net debt
Preferred stock
Noncontrolling interest
Equity value
Shares outstanding
Share price
Enterprise value
Present value of terminal value
Terminal value
Terminal year free cash flow
Long-term growth rate
Terminal value as of year 5
Sum of present value of free cash flows
Enterprise value
$64.7
$2,265.2
35.0
$326.0
$28.0
$12.0
$400.0
$74.0
$2,631.2
$1,900.5
$212.8
2.0%
$2,969.6
$730.7
Chapter 5
Fundamental and
Fixed-Income
Valuation
131
Chapter 5
Fundamental and
Fixed-Income
Valuation
Knopman Note:
Q: What is a DCF analysis? How does it determine valuation?
A: A discounted cash flow analysis values the company based on
its expected future free cash flows discounted to present value.
It is useful in industries in which companies have significant
earnings volatility but more stable cash flows.
5.2 Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is typically used as a proxy for
the discount rate. WACC is the weighted average of a company’s cost of debt and
cost of equity. It reflects the required rate of return that a company is expected
to pay its investors to finance its capital. It is calculated as:
WACC = (After-Tax Cost of Debt × % of Debt in Capital Structure) +
(Cost of Equity × % of Equity in Capital Structure)
or
WACC = After-Tax Cost of Debt ×
(
Debt
Debt + Equity
)
+ Cost of Equity ×
Equity
( Debt + Equity )
Because a company can be financed with a mix of debt and equity, the discount
rate must reflect both. Therefore, WACC measures the appropriate discount rates
for debt holders and equity holders and weights them by their proportion in
the capital structure of the company. The various components of WACC will be
discussed below.
Knopman Note:
Q: In a DCF, how are the future cash flows discounted to present
value?
A: Those cash flows are discounted to present value using the
company’s WACC.
Q: What is a Sum Of The Parts analysis?
A: Sum Of The Parts is a valuation method used to value a firm
by assessing the value of separate business segments or
subsidiaries, and then adding them up to get the total value of
the firm. This type of valuation method can be most suitable for
firms that report different business divisions, conglomerates
with many different companies, and companies with distinct
assets. It is sometimes used in conjunction with DCF modeling
and comparable company analysis.
132
5.2.1 Cost of Debt
The cost of debt, also referred to as the current discount rate on debt, is the
interest rate a company pays on its borrowings. For exam purposes, the company’s cost of debt is estimated as its current yield of debt in the open market.
Current yield is calculated as:
Current Yield
=
Chapter 5
Fundamental and
Fixed-Income
Valuation
Annual Interest
Market Price
Always assume par value is $1,000 unless told otherwise. Therefore, if given a
bond quote of 95, that would indicate the bond is trading at 95% of par (which is
$1,000), or at a market price of $950.
Remember, the interest expense paid by the company is tax-deductible and therefore must be accounted for when calculating the cost of debt. This is because the
interest expense acts as a tax shield, which reduces the effective cost of debt and,
in turn, the overall cost of capital. The after-tax cost of debt is calculated as:
After-Tax Cost of Debt = Current Yield × (1 − Tax Rate)
Knopman Note: An issuer’s cost of debt is the rate at which it can
currently borrow money. Alternatively, it could be referred to as the
current discount rate on debt.
Example
Company ABC, which has outstanding bonds, is paying 8% interest and currently trading at $985. Assuming a marginal tax rate of 40%, calculate the
company’s after-tax cost of debt.
Current Yield
=
Annual Interest of $80
Market Price of $985
= 8.12%
After-Tax Cost of Debt = 8.12% Current Yield × (1 − 40% Tax Rate) = 4.87%
5.2.2 Cost of Equity
Cost of equity is the annual rate of return that a company’s equity investors
expect to receive, including dividends. It is typically calculated using the capital
asset pricing model (CAPM), which states that equity investors expect compensation for systemic risk. Also referred to as market risk, systemic risk reflects
the fact that the performance of a company’s stock will be impacted by the performance of the overall market. The formula for cost of equity is:
Cost of Equity = Risk-Free Rate + (Beta × Market Risk Premium)
133
Chapter 5
Fundamental and
Fixed-Income
Valuation
Knopman Note: When calculating cost of equity, a size premium may
be added to a small firm’s cost of capital to address the added risk
caused by less liquidity. Increasing the small firm’s cost of equity and
therefore WACC lowers its DCF valuation.
5.2.2.1 Risk-Free Rate and Market Risk Premium (MRP)
The risk-free rate reflects the rate of return on a theoretical investment that
carries zero risk of financial loss. On the exam, the risk-free rate may be provided.
Alternatively, the interest rate on a US Treasury security, e.g., a Treasury note or
Treasury bond, can be used due to the unlikelihood of a potential default by the
US government.
The market risk premium (MRP) reflects the difference between the rates of
return for equities and the risk-free rate. It reflects the additional return that an
investor expects from making an equity investment in exchange for the risk above
and beyond a risk-free investment. If an investment is very risky, an investor will
require a higher rate of return as compensation for that risk. If an investment has
little risk, an investor will require a lower rate of return.
In this context, “equity returns” means a diversified portfolio of equities that represents the equivalent of investing in the entire stock market. Practically, this is
considered an investment in the S&P 500. Thus, the MRP can be thought of as the
spread between the S&P 500 and the risk-free rate, as illustrated below:
Market Risk Premium (MRP) = S&P 500 Index Expected Return − Risk-Free Rate
5.2.2.2 Beta
Systemic risk is measured by beta, which reflects the volatility of a security in
response to changes in the overall market. The S&P 500 is typically used as a
proxy for the overall market, and therefore, beta measures the sensitivity of a
security’s performance compared to the S&P 500.
The S&P 500 has a beta of 1.0. A stock that has a beta of 1.0 is expected to move
in line with the market. For example, if the S&P 500 increases by 1%, that stock
would also be expected to increase by 1%.
A stock that has a beta of greater than 1.0 is more volatile than the overall market,
experiencing both higher highs and lower lows. For example, a stock with a beta
of 1.5 is 1.5 times more volatile than the S&P 500. If the S&P 500 increases by 1%,
the stock would be expected to increase by 1.5%. If the S&P decreases by 2%, that
same stock would be expected to fall by 3%.
A stock that has a beta of between 0 and 1.0 is less volatile than the overall market.
For example, a stock with a beta of 0.5 will only move half as much as the S&P 500. If
the S&P 500 increases by 4%, the stock would only be expected to increase by 2%. If
the S&P 500 decreases by 3%, that same stock would only be expected to fall by 1.5%.
The additional volatility and market risk exhibited by high-beta stocks is captured by CAPM; and the corresponding companies will have a higher cost of
equity. The opposite is true for companies with low-beta stocks.
134
For public companies, beta can be calculated by comparing the historical returns
of the security to the returns of the S&P 500. This beta can usually be sourced
from financial information resources such as Bloomberg.
Sourcing beta for a private company presents similar challenges as sourcing
other types of information for private companies. Betas are derived from historical performance, which is not available for private companies. Thus, a banker
must identify similar companies and “blend” their betas together to estimate the
beta for the company in question.
Chapter 5
Fundamental and
Fixed-Income
Valuation
When blending betas of different companies, it is important to account for the
difference in the companies’ capital structures. A company with significant leverage is riskier and will tend to trade with more volatility, resulting in a higher beta.
If that same company had no leverage, then its beta would be lower. A process
known as unlevering beta is used to strip out the impact of debt on the betas of
the comparable companies and offset the effects of differing capital structures.
Once the unlevered betas of the comparable companies are calculated they can
be blended, or averaged, together to find a representative unlevered beta. This
figure is then relevered to arrive at a levered beta that reflects the amount of
debt of the company that is being evaluated.
On the exam, candidates will not have to go through the process of unlevering
beta. Unlevered beta will be provided, and candidates will have to use it to calculate levered beta using the formula below:
Levered Beta = Unlevered Beta × [1 + (1 − Tax Rate) × Debt/Equity]
Knopman Note: Be sure to know how to determine an issuer’s cost of
equity using CAPM with a levered beta:
CAPM = Risk-Free Rate + (Levered Beta × Market Risk Premium)
Levered Beta = Unlevered Beta × [1 + (1 − Tax Rate) × Debt/Equity]
Example
Calculate a company’s cost of equity using the data provided below:
◆
◆
◆
◆
◆
Risk-Free Rate: 2.75%
Unlevered Beta: 1.32
S&P 500 Return: 7.96%
Debt/Equity: 40%
Tax Rate: 35%
Market Risk Premium (MRP) = 7.96% S&P 500 Return − 2.75% Risk-Free Rate = 5.21%
Levered Beta = 1.32 Unlevered Beta × [1 + (1 − 35% Tax Rate) × 40% Debt/Equity] = 1.66
Cost of Equity = 2.75% Risk-Free Rate + (1.66 Beta × 5.21% Market Risk Premium) = 11.40%
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5.2.3 Capital Structure
In addition to calculating cost of debt and cost of equity, a company’s capital
structure must be determined. Capital structure is essential to figure out the
weightings of the cost of debt and cost of equity in the WACC calculation.
On the exam, the capital structure will be determined in one of two ways:
Candidates might be provided a debt-to-equity ratio. For example, a 40% debtto-equity ratio. Please note that this does not mean that a company has 40% debt
and 60% equity in its capital structure. Instead, it indicates that the company has
40% debt compared to 100% equity in its capital structure. Therefore, to determine the actual percentage of debt in the capital structure, you must take the 40%
debt divided by the 140% debt plus equity, which equals 28.57%. Conversely, to
determine the actual percentage of equity in the capital structure, take the 100%
equity divided by the 140% debt plus equity, which equals 71.43%.
If the debt-to-equity ratio is not provided, candidates will be required to calculate
it. It’s important to note that, when determining the proportion of debt-to-equity,
you must always compare the total debt from the balance sheet to the company’s
market value of equity (i.e., Total Shares Outstanding × Stock Price). Never use
book value of equity from the balance sheet.
Example
Calculate a company’s WACC using the data provided below:
◆ After-Tax Cost of Debt: 4.87%
◆ Cost of Equity: 11.40%
◆ Debt/Equity: 40%
WACC = After-Tax Cost of Debt ×
WACC = 4.87% ×
Debt
(
)
Debt + Equity
(
40
40 + 100
)
+ Cost of Equity ×
+ 11.4% ×
(
100
40 + 100
Equity
( Debt + Equity )
)
WACC = 9.53%
Knopman Note: A company with preferred stock in its capital
structure must include this when calculating its WACC. Add to
the WACC formula the cost of the preferred stock (i.e., its current
yield) multiplied by the percentage of preferred stock in the capital
structure.
5.3 Projecting Free Cash Flows
136
Once WACC has been determined, it is used to discount a company’s free cash
flows to their present values. Specifically, for a DCF analysis, it is necessary to
project unlevered free cash flow, which is the company’s cash flow before taking
interest payments into account. It is the cash generated by the company after
paying all its operating expenses and taxes, but prior to making any interest payments, and therefore it is a calculation that is independent of capital structure.
Unlevered free cash flow is calculated as:
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Earnings Before Interest and Taxes (EBIT)
− Taxes
= Earnings Before Interest After Taxes (EBIAT)
+ Depreciation and Amortization (D&A)
− Capital Expenditures (Capex)
− Increase/(Decrease) in Net Working Capital (NWC)
= Unlevered Free Cash Flow
Creating these projections requires knowledge, research, and, possibly, management guidance. Estimating the future performance of a company and its impact
on free cash flow is as much an art as a science and often involves consultation
with senior bankers. Projections commonly extend for five to 10 years, though
the exact number depends on the company, industry, and context. Typically, the
projection period lasts long enough for the company’s financial performance to
reach a steady state.
This section will discuss the various projections that need to be made as well as
how the information is then used to find the present value of the company’s cash
flows during the projection period.
Knopman Note: Sometimes on the exam net income plus D&A is used
as a proxy for free cash flow.
5.3.1 Income Statement Projections
Free cash flow projections often begin by estimating the data from the income
statement during the projection period. This includes forecasting the company’s
sales, cost of goods sold, gross profit, operating expenses, EBIT, and taxes during
the projection period. These projections are typically based on a combination of
the company’s historical results, the historical performance of similar businesses,
equity research estimates, and other assumptions about long-term performance
of the company and industry dynamics.
Ultimately, once EBIT and taxes are projected out, this information can then be
used to find the company’s projected EBIAT, which is earnings before interest
after taxes. EBIAT, discussed in a prior chapter, is essentially a company’s net
income excluding the impact of interest.
5.3.2 Net Capital Expenditure Projections
Once projected EBIAT has been derived, other projections, including capital
expenditures, depreciation and amortization, and net working capital, need to
be made to calculate unlevered free cash flow.
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Capital expenditures (capex) are the funds used by a company to purchase,
expand, or upgrade its physical assets, such as property, buildings, factories, or
equipment. Because these expenditures represent cash being paid out by the
company, capex will reduce the company’s unlevered free cash flow.
Depreciation and amortization (D&A) are expenses that reflect the loss
of value of tangible and intangible assets respectively over time. Companies
use D&A on an income statement to reduce taxes, as they are tax-deductible
expenses. However, although D&A is accounted for when determining a company’s operating expenses and taxes, it is a non-cash expense, which does not
represent actual cash being paid out. Therefore, D&A must be added back when
calculating the company’s unlevered free cash flow.
For existing assets, fairly accurate estimates for D&A can be made using the
amount of fixed assets on the balance sheet, recent amounts of D&A, and notes
that the company provides on the remaining life of its equipment.
In addition to existing fixed assets, depending on the company and industry, it
is typically assumed that a company must at least replace its depreciating assets
with new capital expenditures to continue operating; otherwise, the ability to
produce its current product lines will disappear. Although, this is not always the
case, as improving technology in an industry might allow a company to replace
its equipment at a lower cost without sacrificing any production capacity.
Furthermore, if a company plans on increasing sales significantly in the future,
the business will likely require new production capacity, which will also impact
the amount of capital expenditures.
Once capex has been estimated, the forecasted D&A of new assets can be calculated and used in the FCF projection in addition to the projected D&A on the
company’s existing assets.
5.3.3 Changes in Net Working Capital Projections
A company’s projected unlevered free cash flow also accounts for projected
changes in net working capital. Net working capital (NWC) is a measure of
how much cash a company needs to fund its ongoing operations. Unlike the
accounting definition of working capital, which is current assets minus current
liabilities, NWC excludes cash from the equation, as changes in cash is what is
being reconciled through the calculation. The primary current assets and current
liabilities that are netted together to find a company’s net working capital are
detailed in the table below:
138
Current Assets
Current Liabilities
Accounts Receivable
Accounts Payable
Inventories
Accrued Liabilities
Prepayments and Other Current Assets
Other Current Liabilities
Therefore, the equation for net working capital is:
NWC = Accounts Receivable + Inventories + Prepayments and Other Current Assets −
Accounts Payable − Accrued Liabilities − Other Current Liabilities
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The annual change in net working capital is important, as it reflects whether
a company is using up cash or has a source of cash. As a company’s current
assets increase, this reflects a use of cash. For example, if inventory increases,
the company has spent cash to build up its product. Alternatively, as current
liabilities increase that represents a source of cash for a company. For example,
if the company’s accounts payable increase, the company is holding on to cash
for longer rather than paying its vendors. Therefore, an increase in net working
capital reflects a use of cash, whereas a decrease in net working capital represents
a source of cash. Below is a summary of sources and uses of cash:
Use of Cash
Source of Cash
Current Assets Increase
Current Assets Decrease
Current Liabilities Decrease
Current Liabilities Increase
Net Working Capital Increase
Net Working Capital Decrease
Once a company’s year-over-year change in net working capital is determined,
this information can be used to calculate its unlevered free cash flow.
Knopman Note:
Q: If two firms have substantial differences in net working capital,
what would be an appropriate valuation methodology?
A: If two firms have substantial differences in their net working
capital, a discounted cash flow analysis would be an
appropriate way to determine their relative valuation. A DCF
will capture these changes.
A company’s projected annual change to net working capital can be forecasted
in a manner similar to the other components of FCF that have been discussed.
5.3.3.1 Working Capital Ratios
In addition to net working capital, the working capital ratios discussed below
help measure how efficient a company is with its cash.
Accounts Receivable Turnover
The accounts receivable turnover measures how efficiently a company converts its sales into cash. It describes on average how many times the company is
collecting its receivables per year. It is calculated as:
Accounts Receivable Turnover
=
Sales
Average Accounts Receivable
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A higher turnover typically indicates that the company is collecting its receivables more quickly.
Alternatively, this information can be used to calculate days sales outstanding
(DSO), which is shown below:
Days Sales Outstanding (DSO)
=
Average Accounts Receivable
Sales
× 365
Days sales outstanding indicates how many days it takes for a company to collect
its receivables. Companies want this number to be lower, as they want to collect
receivables as quickly as possible to improve their cash flow.
Inventory Turnover
Inventory turnover measures how many times a company rolls over its inventory in a given year. It is calculated as:
Inventory Turnover
=
Cost of Goods Sold
Average Inventory
Generally, a higher turnover indicates that a company may have inadequate
inventory, while a lower ratio can indicate overstocking of inventory.
Alternatively, this information can be used to calculate days inventory held
(DIH), shown below:
Days Inventory Held (DIH)
Average Inventory
=
Cost of Goods Sold
× 365
This calculation describes the number of days it would take for a company to
liquidate its current inventory.
Knopman Note: Issuing debt or equity would not impact a company’s
inventory turns. It would impact other ratios, including liquidity,
leverage, and interest coverage.
Accounts Payable Turnover
The accounts payable turnover, also referred to as credit turnover, measures
how quickly a company pays its bills. It describes how many times per year a
company pays its payables. It is calculated as:
Accounts Payable Turnover
140
=
Cost of Goods Sold
Average Accounts Payable
Alternatively, this information can be used to calculate days payable outstanding (DPO), which is shown below:
Days Payable Outstanding (DPO)
=
Average Accounts Payable
Cost of Goods Sold
× 365
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Fixed-Income
Valuation
Days payable outstanding indicates how many days it takes for a company to pay
its bills. Companies want this number to be higher, within reason. A business
wants to hold on to its cash as long as possible without upsetting its vendors or
having a negative impact on its credit quality.
Knopman Note: A company’s equity turnover ratio is calculated as
sales divided by average shareholders’ equity. It helps a company
understand how efficiently it is using its equity to generate revenue.
5.3.4 Calculating Present Value of Free Cash Flows
Once EBIAT, D&A, capex, and net working capital have been forecasted for each
year of the projection period, this information can be used to calculate unlevered
free cash flow in each respective year of the projection period.
Example
Last year a company generated $60MM in EBIT, had D&A of $120MM, capital
expenditures of $90MM, and an increase in net working capital of $36MM.
Assuming a tax rate of 35%, and a forecasted 5% growth in unlevered free cash
flow over the next five years, calculate the company’s projected unlevered free
cash flow in each year of the five-year projection period.
EBIAT = $60MM EBIT × (1 − 35% Tax Rate) = $39MM
LTM Unlevered FCF = $39MM EBIAT + $120MM D&A − $90MM Capex − $36MM Increase in NWC = $33MM
Year 1 Unlevered FCF = $33MM × 1.05 = $34.65MM
Year 2 Unlevered FCF = $34.65MM × 1.05 = $36.38MM
Year 3 Unlevered FCF = $36.38MM × 1.05 = $38.20MM
Year 4 Unlevered FCF = $38.12MM × 1.05 = $40.11MM
Year 5 Unlevered FCF = $40.03MM × 1.05 = $42.12MM
Recall that an increase in NWC reflects a use of cash.
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All the unlevered free cash flows in the example above reflect the future value
of those cash flows. To determine the value of those cash flows to the company
today, the unlevered free cash flows from the projection period must be discounted back to present value. The formula to calculate present value is:
Present Value = Future Value/(1 + Discount Rate)n
Where:
n = year in the projection period
Alternatively, the present value formula can be represented as:
Present Value = Future Value × Discount Factor
Where:
Discount Factor = 1/(1 + Discount Rate)n
The discount factor is a number less than one that indicates how much to discount a future payment by in order to calculate present value.
Once the present value of each individual unlevered free cash flow is calculated,
these can be summed together to find the total present value of free cash flows
during the projection period.
Knopman Note: These present value and discounting calculations
are not tested on the exam, as you are only provided a four-function
calculator. However, they are shown above and illustrated in the
example below to further the understanding of the concept and the
process of a discounted cash flow analysis.
Example
Using the five years of projected unlevered free cash flows from the prior
example and assuming a WACC of 9.53%, calculate the present value of free
cash flows from the five-year projection period.
Present Value of Year 1 Unlevered FCF = $34.65MM/1.09531 = $31.64MM
Present Value of Year 2 Unlevered FCF = $36.38MM/1.09532 = $30.32MM
Present Value of Year 3 Unlevered FCF = $38.20MM/1.09533 = $29.07MM
Present Value of Year 4 Unlevered FCF = $40.11MM/1.09534 = $27.87MM
Present Value of Year 5 Unlevered FCF = $42.12MM/1.09535 = $26.72MM
Present Value of Projection Period = $31.64MM + $30.32MM + $29.07MM + $27.87MM + $26.72MM
Present Value of Projection Period = $145.62MM
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Knopman Note:
Q: What happens to a DCF valuation if the target’s discount rate,
or WACC, increases?
A: As a company’s discount rate, or WACC, increases, the
company’s valuation under a discounted cash flow will fall.
In this context, WACC can be thought of as the “riskiness” of a
company. Therefore, as WACC goes up, the company becomes a
riskier proposition and thus less valuable.
Chapter 5
Fundamental and
Fixed-Income
Valuation
5.4 Terminal Value
What happens at the end of the projection period? Most of the time, valuations
will involve a company that is expected to be in business indefinitely, so the valuation needs to incorporate that assumption. This is what the terminal value
accomplishes. The terminal value uses the information about the company at
the end of the projection period to estimate its long-term value. There are two
main methods for calculating terminal value: perpetuity growth method and
exit multiple method.
Knopman Note:
Q: What are the two ways to determine the terminal value?
A: Terminal value can be calculated using either the multiple
method or the growth method.
5.4.1 Perpetuity Growth Method
The perpetuity growth method assumes that the company has reached
a mature, steady state at the end of the projection period. It begins with the
amount of unlevered free cash flow from the final year of the projection period
and assumes that it grows into the future by a sustainable, long-term growth rate
each year. It is calculated as:
Terminal Value = [FCFn × (1 + g)]/(r − g)
Where:
FCFn = unlevered free cash flow in the terminal year of
the projection
g = long-term growth rate
r = WACC
Keep in mind that the final-year free cash flow from the projection period has
already been accounted for, and therefore it is necessary to grow that figure in the
numerator by the long-term growth rate to find the following year’s projected free
cash flow. If on the exam, the following year’s projected free cash flow is already
provided, terminal value could instead be calculated as:
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Terminal Value = Free Cash Flow/(Discount Rate − Growth Rate)
Knopman Note: If given last year’s cash flow, grow the numerator
by multiplying by (1 + Growth Rate). If you are provided next year’s
expected cash flow, there is no need to grow the numerator.
Keep in mind that terminal value reflects all future value of the company after the
initial projection period. Therefore, to determine the value that amount reflects
today, it must be discounted back to present value using the final year of the
projection period’s discount factor.
Present Value of Terminal Value = Terminal Value/(1 + r)n
Where:
r = WACC
n = year in the projection period
Example
Calculate terminal value using the perpetuity growth method with the information below:
◆ WACC = 9.53%
◆ Long-Term Growth Rate = 4%
◆ Unlevered Free Cash Flow in Year Five = $26.66MM
Terminal Value = [FCF × (1 + g)]/(r − g)
Terminal Value = [$26.66MM × (1 + 4%)]/(9.53% − 4%)
Terminal Value = $501.38
Once terminal value is calculated, it must then be discounted back to present value per below. Recall that the discounting calculation is not testable
on the exam. Note: the exponent “n” below is a 6 because FCF in year 5 was
projected forward a year (1+g). Always be mindful of what year your terminal
value reflects.
Present Value of Terminal Value = Terminal Value/(1 + r)n
Present Value of Terminal Value = $501.38MM/1.09536
Present Value of Terminal Value = $290.38MM
144
5.4.2 Exit Multiple Method
The exit multiple method calculates terminal value by applying a valuation
multiple to the most relevant earnings metric at the end of the projection period.
Typically, this earnings metric is EBITDA. Conceptually, it presumes that the
company will “exit” or sell itself at the end of the projection period and the buyer
will value the company at a multiple applied to the last year of EBITDA. The exit
multiple is chosen by looking at valuations of similar companies.
Chapter 5
Fundamental and
Fixed-Income
Valuation
Terminal Value = EBITDAn × Exit Multiple
Where:
EBITDAn = EBITDA in final year of projection
Like the perpetuity growth method, once the terminal value is calculated using
the exit multiple method, it needs to be discounted in order to arrive at the present value.
Example
Calculate terminal value using the exit multiple method with the information
below:
◆ WACC = 9.53%
◆ EBITDA in Year Five = $180MM
◆ Exit Multiple = 4× (this multiple is provided in the question)
Terminal Value = EBITDAn × Exit Multiple
Terminal Value = $180MM × 4
Terminal Value = $720MM
Once terminal value is calculated, it must then be discounted back to present
value per below. Recall, the discounting calculation is not testable on the
exam.
Present Value of Terminal Value = Terminal Value/(1 + r)n
Present Value of Terminal Value = $720MM/1.09535
Present Value of Terminal Value = $456.74MM
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5.4.3 Calculating Enterprise Value and Equity Value Using a DCF
Once the present value of terminal value has been calculated, it can be combined
with the present value of free cash flows during the projection period to yield a
company’s implied enterprise value.
Implied Enterprise Value = Present Value of FCF from Projection Period + Present Value of Terminal Value
Additionally, if net debt, preferred stock, noncontrolling interest, and shares outstanding are known, this information can be used to deduce an implied equity
value as well as an implied share price for the company. Note that, in a DCF,
because two different terminal values have been calculated, this will lead to two
different enterprise values and therefore two different equity values and share
prices.
Example
Calculate a company’s implied enterprise value, implied equity value, and
implied share price under both the perpetuity growth method and exit multiple method respectively using the data provided below:
◆ Present Value of Projection Period = $145.63MM
◆ Present Value of Terminal Value Perpetuity Growth Method =
$318.06MM
◆ Present Value of Terminal Value Exit Multiple Method = $456.74MM
◆ Net Debt = $150MM
◆ Outstanding Shares = 20MM
1. Using Perpetuity Growth Method
Implied Enterprise Value = $145.63MM + $318.06MM = $463.69MM
Implied Equity Value = $463.69MM Enterprise Value − $150MM Net Debt = $313.69MM
Implied Share Price = $313.69MM Equity Value/20MM Outstanding Shares = $15.68
2. Using Exit Multiple Method
Implied Enterprise Value = $145.63MM + $456.74MM = $602.37MM
Implied Equity Value = $602.37MM Enterprise Value − $150MM Net Debt = $452.37MM
Implied Share Price = $452.37MM Equity Value/20MM Outstanding Shares = $22.62
146
5.4.4 Pros and Cons of a Discounted Cash Flow
Like relative valuation methodologies, a DCF has a number of pros and cons.
The biggest advantage of a DCF is that valuation relies on thoughtful projections of the company’s performance based on the forecasting of the business’s
unlevered free cash flow. This contrasts with a trading and transaction comparable where valuation is derived from the performance of similar companies rather
than of the target company itself.
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Fundamental and
Fixed-Income
Valuation
Additionally, because the target company’s projection performance is being used
to determine valuation, there is no need to determine the universe of comparable
companies or precedent transactions, which can be challenging for companies
in a niche market.
Finally, because valuation does not rely on comparables, it is better insulated
from market aberrations that could impact valuation.
On the other hand, as discussed throughout this section, a DCF incorporates
very specific assumptions about the future performance of the company. This
dependence on projections can be a pitfall, because, if the forecasted information
is not precise, it can create inaccuracies in the company’s valuation. For example,
even small changes in a company’s WACC or growth rates can have a massive
impact on the valuation of the company calculated in a DCF.
Furthermore, terminal value accounts for a huge percentage of a company’s
enterprise value, and the two methods of calculating terminal value can lead to
very different valuations.
Finally, WACC is an important part of a DCF, as it is used as a proxy for the discount rate. However, while WACC is based on the company’s capital structure
at the time a DCF analysis is performed, it does not account for the fact that the
business’s capital structure might change in the future.
5.5 Other Uses of Discount Rate
In addition to being used in a discounted cash flow, the discount rate can also be
used in several other contexts, including perpetuity, dividend discount model,
economic value added, and pension obligations, all of which will be discussed
in this section.
5.5.1 Perpetuity Valuation
If a company is growing or changing, its most recent performance is not an accurate guide of its future performance. A DCF accounts for this by incorporating
detailed assumptions into a projection of a company’s future cash flows.
However, for companies that are mature and stable, it may be safe to assume that
current performance is indicative of the future. The same perpetuity with growth
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Valuation
method that is applied to arrive at a company’s terminal value in a DCF can be
used to find the entire value of a mature, stable company, using the company’s
current free cash flow figure. In this scenario, enterprise value can be calculated as:
Enterprise Value
Free Cash Flow
=
(WACC − Growth Rate)
or
Enterprise Value
Annual Cash Flow
=
(WACC − Growth Rate)
or
Enterprise Value
Cash Flow to Invested Capital
=
(WACC − Growth Rate)
In the formulas above, the terms free cash flow, annual cash flow, and cash flow
to invested capital are all used synonymously as an expression of a company’s
next-year unlevered free cash flow. Note that, if you are provided last year’s numbers, the numerator must be multiplied by (1 + Growth Rate) to find next year’s
expected figure.
Knopman Note: It is important to understand the many ways to
determine a firm’s equity and enterprise value. Using a firm’s
cash flows to invested capital to value is just one way—though an
important one.
For companies that are expected to generate the same cash flow each year in
perpetuity, with no growth, the calculation can be simplified to:
Enterprise Value
148
=
Free Cash Flow
Discount Rate
Knopman Note: It is important to understand both 1) the perpetuity
formula and 2) the impact of the discount rate on the value of a
perpetuity.
Perpetuity Formula
Chapter 5
Fundamental and
Fixed-Income
Valuation
Imagine an investment that generated $1 million in cash every year for
the rest of time and whose relevant discount rate was 10%.
Value of Perpetuity = $1,000,000/0.10 = $10,000,000
With a different discount rate, the present value of the perpetuity
changes. If the discount rate is only 5%, a perpetual cash flow of $1
million is worth $20,000,000 (calculated as $1,000,000/0.05). If the
discount rate is 12%, the present value is only $8,333,333 (calculated as
$1,000,000/0.12) because each future payment is less valuable.
Impact of the Discount Rate on the Value of a Perpetuity
Notice that the higher the discount rate, the smaller the present value
(as the denominator is larger).
5.5.2 Dividend Discount Model
The dividend discount model, sometimes referred to as the Gordon growth
model, implies a company’s stock price based on the present value of its future
dividend payments. The dividend discount model is an extension of the perpetuity growth method. Because dividends represent cash flows to equity holders,
these payments must be discounted at the cost of equity instead of WACC, though
this is generally not a distinction that appears on the exam. It is calculated as:
Implied Stock Price
=
(Prior Period Dividend) × (1 + Growth Rate)
(Cost of Equity – Growth Rate)
Cost of equity here will be calculated via CAPM. Note that on the exam, if next
year’s expected dividends are already provided, there is no need to grow the
numerator. In these cases, the implied stock price can be calculated as:
Implied Stock Price
=
Next Year’s Expected Dividend
(Cost of Equity − Growth Rate)
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Example
A company paid dividends of $1.45 last year. It has a cost of equity of 9% and
an expected growth rate of 2%. The company’s implied stock price can be
calculated as:
Implied Stock Price
=
(Prior Period Dividend) × (1 + Growth Rate)
Implied Stock Price
(Cost of Equity − Growth Rate)
=
($1.45) × (1.02)
(9% − 2%)
Implied Stock Price = $21.13
Knopman Note:
Q: How might one model or value a firm that plans to increase its
dividend growth rate?
A: Use caution when modeling a firm that plans to increase its
dividends by a specified dividend growth rate. Sometimes the
rate will apply to the total dividends. Other times it will apply
to the per share dividend. This is an important distinction if the
firm executes a stock buyback or otherwise changes its share
count.
Consider the example below:
Company Y pays $2MM in dividends on 20MM shares in 2019. In
2020, it expects to repurchase 1MM shares while also increasing
its dividend per share by 10%. What are the total dividends paid
in 2020?
The total dividends are determined using the following steps:
1. 2019 Dividend per Share = $2MM/20MM = $0.10
2. 2020 Dividend per Share = $0.10 × (1 + 0.10) = $0.11
3. 2020 Share Count = 20MM − 1MM = 19MM Shares
4. 2020 Total Dividends = 19MM × $0.11 = $2.09MM
Note: If, rather than the 2020 dividend per share increasing by
10%, total 2020 dividends increased by 10% (to $2.2MM), the
2020 total dividends calculated above would be incorrect.
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5.5.3 Economic Value Added (EVA)
Economic value added (EVA) aims to measure the amount of value a business
generates from its invested capital. A positive EVA indicates that the company is
generating positive returns from the capital it has invested, while a negative EVA
would indicate that the company is not generating enough value from capital
invested.
Chapter 5
Fundamental and
Fixed-Income
Valuation
Knopman Note: It is acceptable—and best practice for the exam—to
use book value to estimate the capital invested and to use market
value to estimate WACC in the EVA formula.
The EVA formula, therefore, is:
Economic Value Added = [EBIT × (1 − Tax Rate)] –
[Capital Invested × WACC]
or
Economic Value Added = EBIAT − (Capital Invested × WACC)
Example: A firm has sales of $10 million, gross profits of $7 million,
operating income of $5 million, and net income of $2 million. Its tax
rate is 40%. The firm’s market cap is $45 million, and it has five million
shares outstanding. It has existing assets in which it has capital
invested of $25 million and a cost of capital of 10%.
The firm’s current EVA from existing assets (in millions) is:
Economic Value Added = EBIT × (1 − Tax Rate) − Capital Invested × WACC
Economic Value Added = $5MM × (60%) − $25MM × 10%
Economic Value Added = $3MM − $2.5MM
Economic Value Added = $0.5MM
5.5.4 Pension Plan Obligations
A pension plan is a type of defined benefit retirement plan offered by some
corporations that promises to make payments to employees in retirement. The
amount paid to each employee in retirement is predetermined by a formula
based on each individual’s age as well as position and tenure with the firm. In a
pension plan, there is a burden on the employer to set aside enough cash today to
ensure it will have enough at the employee’s future retirement. To help estimate
how much cash to set aside to fund each employee’s retirement, companies use
the discount rate, which helps to discount those future retirement payments to
today’s present value.
Although candidates will not be asked to perform these calculations, it is important to recognize whether a higher or lower discount rate is considered more
aggressive. If a company uses a higher discount rate, the company is setting aside
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less cash today, assuming a higher rate of return on their investments. A higher
discount rate is more aggressive, since, if the expected investment returns are
not achieved, it could lead to underfunding of the plan.
Conversely, a lower discount rate would be considered more conservative: the
company would set aside more cash today, assuming a lower rate of return on
its investments.
As an example, consider two pension plans with similar future obligations: one
that uses an aggressive discount rate and another that uses a more conservative
one:
Future Obligations
Discount Rate
Discount Factor
Present Value of
Future Pension
Obligations
Plan A
Plan B
$250 million in 20 years
$250 million in 20 years
12% (Aggressive)
4% (Conservative)
The plan estimates it can earn 12% on
its investments.
The plan estimates it can earn 4% on its
investments.
= 1/(1 + 0.12)20
= 1/(1 + 0.04)20
= 1/1.1220
= 1/1.0420
= 0.104
= 0.456
($250MM)(0.104) = $25.92MM
($250MM)(0.456) = $145.09MM
Applying Plan A’s discount factor to
its future obligations, Plan A must
contribute approximately $26 million
today to have $250 million in 20
years. The bulk of the funding ($224
million) is obtained through future
investment returns.
Plan B, with its more conservative
discount rate, must contribute nearly
$114 million today to have $250 million
in 20 years. Plan B’s initial contribution
requirement is much higher because its
estimated rate of return (discount rate)
is much lower.
Knopman Note: Think of the discount rate as a growth rate for pension
obligation questions. Companies that use a higher discount rate
are being more aggressive in their assumptions, as they expect their
investments to grow at a greater rate of return.
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Progress Check
1. An increase in accounts receivable would
result in which of the following?
A.
B.
C.
D.
A source of cash
A use of cash
A decrease in a current liability
No effect on cash
2. A company has sales of $1 billion and accounts
receivable of $150 million in a given year. What
would its DSO be?
A.
B.
C.
D.
54.00
54.75
15.00
41.10
3. Which of the following financial metrics is the
best proxy for unlevered free cash flow?
A.
B.
C.
D.
EBITDA
EBITDA minus capex
Net income plus D&A
Gross profit minus D&A
4. Currently, the risk-free rate is 3.5%, and the
expected return of the S&P 500 is 11%. For a
company whose stock has a beta of 1.7, what
would be its cost of equity capital, calculated
in accordance with CAPM?
A.
B.
C.
D.
12.75%
16.25%
22.20%
39.00%
5. Company D has a cost of equity capital of 14%
and recently issued 8% debt, which currently
trades at 104. Assuming the company has 40%
equity in its capital structure and has a 40%
marginal tax rate, what is its weighted average
cost of capital (WACC)?
A.
B.
C.
D.
8.4%
10.2%
10.4%
11.0%
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Progress Check—Solutions
1.
(B)
An increase in accounts receivable represents a use of cash. Hence, companies strive to
minimize their receivables so as to speed up their collection of cash.
2. (B)
Days sales outstanding (DSO) provides a gauge of how well a company is managing
the collection of its accounts receivable by measuring the number of days it takes to
collect payment after the sale of a product or service. It is calculated as accounts
receivable divided by sales multiplied by 365. Hence, a company with $150 million in
accounts receivable and $1 billion in sales would have a DSO of 54.75 ($150 million/$1
billion × 365).
3. (B)
EBITDA minus capex takes into account cash expenditures for capital additions,
replacements, and improvements while also adding back D&A, which is a non-cash
charge.
4. (B)
Cost of Equity = Risk-Free Rate + (Beta × Market Risk Premium)
Market Risk Premium = S&P 500 Expected Return − Risk-Free Rate = 11.0% − 3.5% = 7.5%.
Therefore: Cost of Equity = 3.5% + (1.7 × 7.5%) = 16.25%.
5. (A)
WACC = (Cost of Equity × % of Equity) + (After-Tax Cost of Debt × % of Debt)
After-Tax Cost of Debt = Current Yield × (1 − Marginal Tax Rate) = 8%/104% of Par × (1 −
40%) = 4.6%
Percentage of Debt = 100% − % of Equity = 60%
Therefore: WACC = (14% Cost of Equity × 40% Equity in Capital Structure) + (4.6% AfterTax Cost of Debt × 60% Debt in Capital Structure) = 8.4%
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5.6 Fixed-Income Valuation and Characteristics
While this chapter has focused on the valuation of companies, it is also important
for candidates to understand the valuation as well as the basic characteristics of
fixed-income securities.
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Bonds and fixed-income securities represent a loan to a borrower. When buying bonds, investors are promised a return of their money (the principal), along
with interest (coupon).
Bonds are issued by corporations, governments, and municipalities. Regardless
of the issuer, all bonds share several common characteristics.
Knopman Note: Certain bonds, such as corporate bonds, are required
to be issued with a trust indenture, which is designed to protect
the interests of the bondholders. Note that a trust indenture is not
required for government or municipal bonds.
5.6.1 Par Value
Par value, which is also known as face value or principal, is the amount of
money a bondholder will receive at maturity. Corporate bonds normally have
a par value of $1,000. Note that, at maturity, investors receive the principal plus
their final semiannual interest payment.
Knopman Note: When a bond matures, investors receive the principal
(usually $1,000) plus their final semiannual coupon payment.
For example, if Roger buys a 5% discount bond for 86 (i.e., 86% of par,
equal to $860) and holds it until maturity, he will receive his final
semiannual interest payment ($25) plus the par value ($1,000) for a
final payment of $1,025.
Par value is not the price of the bond; its price fluctuates in response to a number
of factors, primarily changing interest rates. When a bond trades at a price above
par value, it is said to be trading at a premium. When a bond trades below par
value, it is said to be trading at a discount.
Knopman Note: As a bond reaches maturity, its price will move toward
par. For example, a 10-year bond trading at a discount (e.g., $930) will
increase toward par ($1,000) as it approaches maturity. A premium
bond purchased for $1,090 will decline toward par as it approaches
maturity.
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5.6.2 Coupon
The coupon, also referred to as nominal yield (NY), is the payment that bondholders receive as interest. Most bonds pay interest every six months. The coupon
is expressed as a percentage of par value. If a bond pays a coupon of 10%, and its
par value is $1,000, it will pay $100 of interest per year, or $50 semiannually.
Knopman Note: If interest rates are increasing and an investor
reinvests in new bonds when his debt matures, that would provide
greater interest income, as the new, higher coupon bonds would offer
higher coupon payments.
If the bond is issued with a coupon rate that remains the same until maturity, it
is called a fixed-rate bond.
Knopman Note: Treasury securities are the most common benchmark
used to determine the interest rate for bonds. For example, a banker
might look to the 10-year Treasury and add 150 basis points (i.e., UST +
150 bps) to price a 10-year corporate bond issue. An issuer that wants
to raise more money or have a more successful offering could increase
the rate on a bond—for example, from UST + 150 to UST + 175. In this
situation, the issuer’s interest expense will also increase.
An adjustable interest payment, or floating-rate bond, has a variable interest
rate that is tied to a specific benchmark rate, such as Treasuries.
Knopman Note: Interest rate risk is the risk that as interest rates
increase, bond prices will fall. Repricing risk is a subcategory of
interest rate risk; it can be reduced by issuing bonds with a floating
interest rate based on a benchmark rather than a fixed interest rate.
Because the coupon will fluctuate as interest rates fluctuate, the price
of these bonds tends to be stable.
5.6.3 Bond Pricing
Interest rates are one major driver of bond prices. The relationship between rates
and prices is inverse: as rates rise, outstanding bond prices fall. As rates fall, outstanding bond prices rise.
For example, if an investor holds a bond that was issued with a coupon of 5%,
and interest rates in the market have gone up such that similar bonds are coming
to market at 6%, the existing 5% bond’s price will fall because the newly issued
bonds will pay a higher coupon.
Why is this the case? Consider an investor with $1,000 to invest. This investor
could buy an existing bond that pays 5% ($50 per year) or a new bond that pays
6% ($60 per year). The investor will prefer the new, 6% bond. To make the 5% bond
marketable or competitive, the seller will have to lower the price of the 5% bond
to enable it to compete with the new, 6% bond.
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However, if interest rates fall so that similar bonds are coming to market at 3.5%,
the 5% coupon bond becomes more valuable. So, as interest rates fall, the price
of the 5% bond will rise as investors pay a premium to earn that higher coupon.
Knopman Note: The scenarios below will also impact bond prices.
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Fundamental and
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1. A decline in credit conditions usually leads to higher
interest rates and lower bond prices. In such environments,
shorter duration bonds (those that have shorter maturities
and higher coupons) are a better investment than longer
duration bonds (those that have longer maturities and lower
coupons) because they are less sensitive to a spike in rates.
Investors in such environments may also sell equities.
2. In an inflationary environment (i.e., CPI is rising), interest
rates will often also trend upward. When interest rates trend
upward, so will yields of outstanding bonds (because bond
prices will fall).
Knopman Note: If fixed income investors believe the Fed will act to
slow down a rapidly expanding economy, fed funds futures would
likely decrease to reflect their expectations of Fed actions. (Note that
this is because fed fund futures are priced at 100 minus interest rates,
and thus as rates rise to slow down the economy, the price will fall).
5.6.4 Basis Points
A basis point (bps) is a unit of measure that equals one one-hundredth of a
percentage point (0.01%). There are 100 bps (pronounced “bips”) in one percentage point (100 bps = 1.00%). Securities professionals use basis points to discuss
changes in interest rates and yields.
Knopman Note: One important application of basis points is the
calculation of underwriting fees. Underwriting fees for a bond
issuance can be assessed in basis points off the face value of the
issue. For example, if an issuer sold $125 million in bonds, and the
underwriting fees were 75 basis points, the fees to the bank would
be calculated as 0.0075 × $125,000,000 = $937,500. Note that 75 basis
points is entered on a calculator as 0.0075.
5.6.5 Callable Bonds
A bond is callable if the issuer has the right to redeem it prior to its maturity
date. When the bond is issued, the issuer must clearly state the inclusion of a call
feature and disclose when it can be redeemed and at what price. In most cases,
the price paid to the investor when the bond is called will be slightly above par
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value and will increase the earlier the bond is called. This is referred to as a call
premium.
A company is likely to call a bond if it is paying a higher coupon than current
market interest rates. The company can then issue new bonds at a lower interest
rate, saving money on the coupon payments. The process of calling bonds when
interest rates have fallen is called refunding, and it is similar to a homeowner
refinancing a home mortgage to make lower monthly payments.
Knopman Note:
Q: How much does an issuer save by refunding its debt?
A: The semiannual savings for a bond refund can be calculated
as the higher, older coupon minus the lower, newer coupon
multiplied by the amount of outstanding bonds divided by two
(taking the annual savings to semiannual savings).
Example: Acme has $200 million in 9% bonds outstanding and
refunds the debt to 5%. What is the semiannual savings?
9% − 5% = 4% Interest Rate Reduction
4% × $200 million = $8 million in Annual Savings
$8 million/2 Payments per Year = $4 million in
Semiannual Savings
Callable bonds are riskier than non-callable bonds because an investor whose
bond has been called can typically only reinvest at a lower, less attractive rate.
This risk is known as reinvestment risk. As a result, callable bonds often have a
higher coupon to compensate for the risk that the bonds might be called early.
Knopman Note: If an issuer chooses to call away the bond because of
declining interest rates, bondholders will receive par value, their final
coupon payment, and if applicable, a call premium.
Example: Dave owns a $1,000 par value, 6% bond, callable at 102. If
the bond is called, the issuer will pay Dave $1,050, i.e., $1,000 Par + $30
Final Semiannual Coupon Payment + $20 Call Premium. Note that the
call price of 102 is quoted as a percentage of par and thus is 102% of
$1,000, or $1,020.
5.6.6 Bond Yields and Yield Calculations
The general definition of yield is the return that an investor will receive if a bond
is held to maturity. There are several yield calculations.
5.6.6.1 Nominal Yield
A bond’s nominal yield (NY) is always equal to its coupon. To say a bond pays a
5% coupon is the same as saying the bond has a nominal yield of 5%.
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5.6.6.2 Current Yield
As discussed earlier for the cost of debt calculation, current yield (CY) is calculated as the annual interest payment divided by the current price. This represents
a bond’s return based on its current market price, rather than its par value. This
contrasts with nominal yield, which is always based on the bond’s par value. The
formula for current yield is below:
Current Yield
=
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Fundamental and
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Valuation
Annual Interest
Market Price
5.6.6.3 Yield to Maturity
To estimate what an investor receives if a bond is held to maturity, the bond’s
yield to maturity (YTM) can be calculated. The calculation of YTM considers
the current market price, par value, coupon, and time to maturity. It assumes that
all coupons are reinvested at the same rate.
For a discount bond, YTM reflects the additional profit the investor recognizes
at maturity: for example, the discounted purchase price (e.g., $900) compared
to the par value ($1,000) received at maturity. For a premium bond, YTM reflects
the loss the investor will recognize at maturity: for example, the premium price
paid for the bond (e.g., $1,100) compared to the par value ($1,000) received at
maturity. Because YTM reflects the additional gain (for a discount bond) or loss
(for a premium bond), YTM is higher than CY for a discount bond and YTM is
lower than CY for a premium bond.
Because calculating a bond’s YTM is complex and involves trial and error, it is
usually done by computer or with a programmable business calculator. The YTM
of a bond is equal to its internal rate of return (IRR).
Knopman Note: When calculating internal rate of return for a bond,
the timing of cash flows (when the investor will receive the interest
payments) is significant.
When considering a bond versus another investment, the fact that the
bond has greater total cash flow does not necessarily mean it will have
a greater IRR. Other factors, such as initial purchase price and the
timing of the returns, must also be considered.
For this exam, if asked to calculate yield to maturity, estimate it using the guidance in the Knopman Note below.
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Knopman Note: The difference between the NY (nominal yield) and CY
(current yield) is usually about the same as the difference between the
CY and YTM.
For example, a bond has a NY of 7% and a CY of 7.50%. This 50-basis
point spread is approximately the same as the difference between the
CY and the YTM. Thus, the bond’s YTM could reasonably be estimated
to be 8%.
NY
7.00%
CY
7.50%
YTM
8.00%
} Spread of 0.50%
} Spread of 0.50%
For a premium bond, the estimation works the same way but moves
downward:
NY
6.50%
CY
5.25%
YTM
4.00%
} Spread of 1.25%
} Spread of 1.25%
5.6.6.4 Yield to Call
Yield to call (YTC) is like YTM but instead reflects the yield earned on a bond
that is called by the issuer on the first call date rather than held until maturity.
For a bond trading at a discount, YTC is greater than YTM because it reflects
the fact that the additional gain earned by the investor is received more quickly
(e.g., a $100 gain is received when the bond is called in year five rather than the
investor having to wait until it matures in year 10).
For a bond trading at a premium, YTC is lower than YTM because it reflects the
fact that the loss is recognized more quickly by the investor (e.g., the $100 loss
is recognized when the bond is called in year five, rather than being spread out
over the full 10 years until maturity).
Knopman Note: A bond’s yield to call assumes that the bond will be
called on the first date on which the issuer could call the bond.
5.6.6.5 Yield to Worst
Yield to worst (YTW) is defined as the lowest yield (other than default) that
an investor can expect when investing in a callable bond. Technically, it is the
lower of yield to call or yield to maturity, and because it conveys the worst return
that an investor might receive, YTW must be printed on the customer’s trade
confirmation.
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Knopman Note: YTW must always be printed on a customer’s trade
confirmation. For a discount bond, YTW is the YTM (because YTM is
less than YTC). For a premium bond, YTW is the YTC (because YTC is
less than YTM).
Chapter 5
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5.6.6.6 Teeter-Totter Diagram
The teeter-totter diagram below illustrates the inverse relationship between bond
prices and yields:
YTC
YTM
CY
Premium
Par
NY
Discount
In summary:
◆ If a bond is trading at a premium, CY is greater than YTM and YTM is
greater than YTC.
◆ If a bond is trading at a discount, CY is less than YTM and YTM is less
than YTC.
5.6.7 Yield Curve
A yield curve is a graph that plots the relationship between interest rates and
the time to maturity. The shape of the yield curve is closely scrutinized because
it gives an idea of future interest rate expectations and economic activity.
There are three main types of yield curve shapes: normal, inverted, and flat (or
humped). The most common is a normal yield curve, pictured below. In this diagram, longer maturity bonds have a higher yield compared to shorter-term bonds
due to the risks associated with holding a bond for a longer period of time.
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Normal Yield Curve
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Fundamental and
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Valuation
Yield
Time to Maturity
An inverted yield curve reflects shorter-term yields that are higher than longer-term yields, which can be a sign of an upcoming recession. A flat yield curve,
also known as a humped yield curve, is one in which shorter- and longer-term
yields are very close to each other, which is a predictor of an economic transition.
Inverted and humped yield curves can be seen below:
Inverted Yield Curve
Yield
Time to Maturity
Flat (Humped) Yield Curve
Yield
Time to Maturity
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Knopman Note: There are three types of yield curves: 1) normal, 2)
inverted, and 3) humped. A barbell investment strategy, which is a
bond investment strategy, is not a type of yield curve.
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5.7 US Government and Agency Securities
The US government has historically been the largest issuer of debt in the world.
Securities that are issued by the US government are considered the safest that
can be purchased, because default risk is nearly absent. They are highly liquid
and actively traded on the over-the-counter market after their initial sale to large
investors through auctions conducted by the Treasury. This section will discuss
Treasury securities as well as US government agency securities that candidates
must be familiar with.
Knopman Note: US Treasury and US government agency securities
are not issued as bearer bonds or bonds in physical certificate form.
Ownership of these securities is recorded electronically via a bookentry system.
Knopman Note: High-yield bonds, which are bonds that pay a higher
interest rate because they have lower credit, would have wider spreads
then Treasury securities.
5.7.1 Treasury Bills
Treasury bills, or T-bills, mature in one year or less. Like zero-coupon bonds,
they do not pay interest prior to maturity; instead, they are sold at a discount
to par. Many regard Treasury bills as the least risky investment available to US
investors.
Treasury bills are quoted for purchase and sale in the secondary market on an
annualized discount percentage, or basis.
Knopman Note: Treasury bills are the most liquid US Treasury security
and have maturities of one year or less. They would be an appropriate
investment for money market funds.
Q: What is a money market fund?
A: A money market mutual fund is an investment company
that pools investors’ capital in short-term investments, such
as Treasury bills, certificates of deposit, and highly rated
commercial paper (short-term bonds). These funds offer a
relatively lower-risk alternative for investors who seek stability
and liquidity.
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Knopman Note: The bond equivalent yield (BEY) allows investors to
compare bonds with different quotations and payment schedules on
an equivalent basis.
Note that the discounted yield is always lower than the bond
equivalent yield. The specific calculation is not tested.
5.7.2 Treasury Notes
Treasury notes, or T-notes, pay interest every six months and are issued with
maturities of two, three, five, seven, or 10 years.
T-notes are quoted on the secondary market as a percentage of par in 32nds of a
point (1/32). For example, a quote of 95:07 or 95–07 on a T-note indicates that it
is trading at a discount: $952.19 (or 95 7/32%) for a $1,000 bond.
5.7.3 Treasury Bonds
Treasury bonds (T-bonds) have the longest maturity of government securities.
They pay interest every six months, like T-notes, and are currently issued with a
maturity of 30 years. The secondary market for Treasury bonds is highly liquid.
Like Treasury notes, they are quoted in 32nds of a point.
Knopman Note: Remember the different quote conventions on
Treasury securities:
• T-bills are quoted on a discounted yield basis
• T-notes and T-bonds are quoted as a percentage of par as a fraction of 32
• If a Treasury quote has a +, this indicates that 1/64 has been added
to the price
• For example, a bond quoted at 102–17+ would be trading at 102
35/64 (calculated as 102 17/32 + 1/64)
5.7.4 Federal Agency Issues
Federal government agencies and various government sponsored organizations
are authorized to raise money through issuing debt securities. The securities of
these entities are collectively called agency securities. Agency securities are not
issued by the US Treasury and are not fully guaranteed by the US government,
with the exception of GNMA (Ginnie Mae).
Still, agency securities are considered safe from default, as the US government
is likely to use its creditworthiness to guarantee investors’ interest and principal payments. But since they do not carry explicit Treasury backing, agency
securities, except GNMAs, provide yields that are higher than those of Treasury
securities.
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Knopman Note:
Q: How does the Federal Reserve define “agency bonds”?
A: The Fed defines agency bonds as mortgage-backed securities
(MBS) issued or guaranteed by federal agencies and by
government sponsored enterprises (GSEs).
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Under this definition, agency bonds include both GNMAs and
GSE-issued debt, so the overall creditworthiness of “agencies”
is second to Treasuries (as GSE bonds only have an implied
guarantee).
5.7.4.1 Mortgage-Backed Securities
Ginnie Mae, Fannie Mae, and Freddie Mac issue mortgage-backed securities
(MBS). These securities represent investments in pools of mortgages and are
backed by mortgage loans. Mortgage-backed securities are relatively safe and pay
slightly higher interest than Treasury issues and many investment-grade corporate bonds. The biggest drawback to mortgage-backed securities is prepayment
risk. When mortgage holders refinance to a lower rate, MBS holders receive their
share of the payoff, and face reinvestment risk.
Fannie Mae and Freddie Mac are government sponsored enterprises (GSEs) and
carry the implied backing of the government.
Mortgage-backed securities generate interest revenue through pools of home
loan or commercial mortgages. MBS investors own an interest in a pool of mortgages that serve as the underlying asset for the MBS. When homeowners or commercial property owners make their monthly payment of interest and a small
share of the principal, that money is passed through as income to the MBS investors or certificate holders.
Homeowner
Bank
Mortgages
“Pass-Throughs”
Investors
Broker-Dealers
Ginnie Mae
Fannie Mae
Freddie Mac
Mortgage-Backed
Security (MBS)
While Fannie Mae and Freddie Mac encountered financial distress in 2008, the
MBS they issue remain safe investments. It is their common stock and corporate
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debentures that have lost significant value. That is an important distinction,
especially as it relates to the credit risk of their products.
Knopman Note: A few additional important characteristics of agency
and GSE issues:
• Their liquidity varies greatly by issuance
• GNMA (Ginnie Mae) securities are backed by the full faith and
credit of the US government
• GSE issues (Freddie and Fannie) carry an implied backing by the
US government
5.7.4.2 Asset-Backed Securities
An asset-backed security (ABS) is based on a pool of underlying financial assets
that are aggregated into financial instruments and sold to investors. This process,
which is called securitization, has become popular because it allows financial
institutions to transform small and illiquid assets that are unable to be sold individually into a diversified pool of assets that have market appeal.
Asset-backed securities can be categorized into mortgage and non-mortgage
securities. The mortgage pools are known as pass-through securities, and investors receive their share of interest and principal payments as borrowers pay off
the underlying loans.
Non-mortgage asset-backed securities comprise assets that range from credit
cards and auto loans to more complex cash-flow arrangements, such as aircraft
leases, royalty payments, and movie revenues. Most types of financial assets can
be structured into an ABS.
Asset-backed securities are attractive to investors because of the variety of maturities, risks, and coupons available. They are secured by the underlying, pooled
assets, so their credit quality is directly related to the quality of the underlying
loans and borrowers.
Knopman Note: Asset-backed securities permit the securitization of
financial assets, not of hard corporate assets. For example:
• A pool of student loans (interest and principal), auto loans (interest and principal), and equipment leases (interest and principal)
can all be securitized into an ABS
• A piece of equipment itself (a truck, ship, or airplane) cannot be
securitized
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Unit Exam
1. Ginnie Mae, Freddie Mac, and Fannie Mae
share all of the following characteristics
except:
A. They issue mortgage-backed securities
B. Investors in their products are subject to
prepayment risk
C. Their securities are explicitly backed by
the US government
D. Investors often purchase their products
because of high credit ratings
2. Net working capital refers to which of the
following?
A. Funds that a company uses to purchase,
improve, expand, or replace physical
assets
B. An expense that approximates the
reduction of the book value of a company’s
long-term fixed assets
C. An expense that reduces the value of a
company’s definite life intangible assets
D. A measure of how much cash a company
needs to fund its operations on an
ongoing basis
3. Given the information below, calculate free
cash flow.
($ in millions)
EBITDA
$250
D&A
$50
Tax Rate
40%
Capex
$45
Increase in Net Working Capital $10
A.
B.
C.
D.
$250 million
$165 million
$115 million
$355 million
4. Which of the following measures the number
of days it takes for a company to remit funds
on its outstanding monies owed for goods and
services?
A.
B.
C.
D.
Days sales outstanding
Days inventory held
Days payable outstanding
Inventory turns
5. An investor owns a 7% bond, purchased at
95, that is callable at 102. If the bond is called
away by the issuer, how much money does the
investor receive?
A.
B.
C.
D.
$102
$1,020
$1,055
$1,090
6. DEF Corporation currently has outstanding
bonds paying 7% interest and currently trading
at 101. Assuming the company’s marginal tax
rate is 35%, calculate DEF’s after-tax cost of
debt.
A.
B.
C.
D.
4.5%
5.4%
6.93%
7%
7. Last year a company paid a $2 dividend, which
is expected to grow by 6% per year. Assuming
a discount rate of 10%, what is the company’s
implied stock price, calculated in accordance
with the dividend discount model?
A.
B.
C.
D.
$21.20
$35.33
$50
$53
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Chapter 5: Fundamental and Fixed-Income Valuation
Unit Exam (Continued)
8. Company DEF acquires Company XYZ for
$100MM. Company B expects EBIT to be
$20MM next year and pays tax at a 21% rate.
Assuming a discount rate of 12%, what is the
economic value added for Company DEF?
A.
B.
C.
D.
($3.8MM)
$2.1MM
$3.8MM
$8MM
9. A company had sales of $500 million, operating
expenses of $50 million, and EBITDA of $25
million during the past year. At the same time,
accounts receivable increased by $50 million.
How much actual cash did the company
receive during the year from its sales?
A.
B.
C.
D.
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$0
($25 million)
$450 million
$500 million
10. An issuer refinances $400 million in debt from
8.5% to 5.5%. What is the semiannual interest
savings?
A.
B.
C.
D.
$3MM
$6MM
$12MM
$18MM
Chapter 5: Fundamental and Fixed-Income Valuation
Unit Exam—Solutions
(C)
Ginnie Mae, Freddie Mac, and Fannie Mae are all agencies that issue mortgage-backed
securities; however, Ginnie Mae securities are backed in full by the US government,
while Freddie Mac and Fannie Mae securities are not. Regardless, Fannie Mae and
Freddie Mac securities have high credit ratings because of the close relationship to the
US government. As with all mortgage-backed securities, investors are subject to
prepayment risk because homeowners might refinance their mortgages when interest
rates fall.
2. (D)
Net working capital is typically defined as current assets minus current liabilities. It
serves as a measure of how much cash a company needs to fund its operations on an
ongoing basis. Depreciation is a non-cash expense that approximates the reduction
of the book value of a company’s long-term fixed assets or property, plant, and
equipment (PP&E) over an estimated useful life and reduces reported earnings.
Amortization, like depreciation, is a non-cash expense that reduces the value of
a company’s definite life intangible assets and also reduces reported earnings. Capital
expenditures are the funds that a company uses to purchase, improve, expand, or
replace physical assets, such as buildings, equipment, facilities, machinery, and other
assets.
3. (C)
Free cash flow can be calculated from the information provided as shown below:
1.
($ in millions)
EBITDA$250
− D&A($50)
= EBIT$200
− Taxes ($200 × 40%)
($80)
= EBIAT$120
+ D&A$50
− Capex($45)
− Increases in Net Working Capital ($10)
= Free Cash Flow
$115
4. (C)
Days payable outstanding (DPO) measures the number of days it takes for a company to
make payment on its outstanding purchases of goods and services. For example, a
DPO of 30 implies that the company takes 30 days on average to pay its suppliers. The
higher a company’s DPO, the more time it has available to use its cash on hand for
various business purposes before paying outstanding bills. Days sales outstanding
(DSO) provides a gauge of how well a company is managing the collection of its A/R
by measuring the number of days it takes to collect payment after the sale of a product
or service. Days inventory held (DIH) measures the number of days it takes a company
to sell its inventory. An alternate approach for measuring a company’s efficiency at
selling its inventory is the inventory turns ratio.
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Chapter 5: Fundamental and Fixed-Income Valuation
Unit Exam—Solutions (Continued)
5. (C)
When a bond is called away by the issuer, the investor receives the par value of $1,000
plus the call premium of $20, plus the final semiannual coupon payment of $35, for a
total of $1,055. Remember that bonds are quoted as a percentage of par value, so a quote
of 102, really means 102% of par, or $1,020.
6. (A)
After-Tax Cost of Debt = Current Yield × (1 − Tax Rate)
Current Yield = $70 Annual Interest/$1,010 Market Price = 6.93%
After-Tax Cost of Debt = 6.93% Current Yield × (1 − 35% Tax Rate) = 4.5%
7.
(D)
Implied Stock Price = Last Year’s Dividend × (1 + Growth Rate)/(Discount Rate −
Growth Rate)
Implied Stock Price = $2 × (1 + 6%)/(10% − 6%) = $53
8. (C)
Economic Value Added = EBIT × (1 − Tax Rate) − (Capital Invested × Discount Rate)
Economic Value Added = $20MM × (1 − 21%) − ($100MM × 12%) = $3.8MM
9. (C)
The company had sales of $500 million during the year but accounts receivable
increased by $50 million. Therefore, the company actually received $450 million in cash
from its sales ($500 million − $50 million); the remaining $50 million are sales on credit.
The $50 million of operating expenses do reduce cash flow but do not affect the cash
received by the company from its customers.
10. (B)
Annual Savings = $400MM × 3% = $12MM
Semiannual Savings = $12MM/2 = $6MM
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6. Mergers and Acquisitions
The terms merger and acquisition are used interchangeably to describe events
that combine two companies into one. Technically, an acquisition involves one
company’s purchase of another, with the acquired company ceasing to exist as
an independent entity, and a merger is a combination of two entities into one
new or changed entity. But in the modern merger and acquisition (M&A) world,
a clear distinction is not always made between these two terms.
In both transactions, cash and/or stock (i.e., the consideration) may be used as
payment for the shares of the acquired company. The consideration paid in a
merger, as well as the status of the legal entities that survive the merger, will
influence the tax consequences of the companies and shareholders.
On the exam, M&A will most often appear as a process in which the target company (i.e., a seller) hires an adviser and tries to sell itself to a potential acquirer.
The focal point is not, for example, hostile takeovers.
This chapter will review the different stages of the M&A process, including:
◆ The role of the various participants
◆ The different M&A deal types
◆ The first-round versus second-round M&A documents and process, and
◆ The steps to close a merger
6.1 Participants in an M&A Transaction
Prior to discussing the M&A process, it is important to know the various parties
to the transaction. This includes the target company, potential buyers, and the
investment bankers advising on the deal.
6.1.1 Target Company
As mentioned, the exam will focus on an M&A process in which a target company hires an adviser and seeks to sell itself to a potential acquirer. From the
target’s side, there are two main participants during this process: the target management and the target board of directors.
The target management, including the CEO, the CFO, and other key executives
at the firm, helps the sell-side adviser understand the ins and outs of their business. This includes providing the sell-side adviser with all material documents,
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articulating the investment merits of the business, and providing insight into any
unusual financial data. The adviser can then use this information to help craft
the company’s pitch, prepare marketing materials, and shape communications
to potential buyers.
The target board of directors stays informed and oversees management during
the process. The board is ultimately required to approve of any transaction. It’s
important to note that the board has a fiduciary duty to the company’s shareholders. This means it must act in the best interest of the company and its shareholders. For example, the board should attempt to maximize shareholder value
in any potential deal by seeking to obtain the best possible terms and price. A
fairness opinion and go-shop, which are vehicles to help the board confirm that
the price is fair, will be discussed later in this chapter.
6.1.2 Potential Buyers
Potential acquirers typically fall into two broad categories: strategic buyers and
financial sponsors.
Financial sponsors are buyers that are interested in the return they can achieve
by purchasing, improving, and eventually selling the target company. Examples
include private equity firms, hedge funds, and merchant banks, which is a broker-dealer’s internal private equity group. While there are exceptions, generally,
financial buyers are less interested in the long-term combination of the businesses and instead care more about the amount of cash flow the target can generate as well as making operational improvements to cut expenses and earn
additional cash. Ultimately, financial buyers hope to recognize a profit through
a future exit, whether it be a company sale or an initial public offering.
Knopman Note: Financial sponsors may value a company with steady
positive cash flow more than a company with negative cash flow but
greater long-term profit growth.
To maximize their returns, financial sponsors may engage in leveraged buyouts
(LBOs), which will be discussed in more detail later in this chapter.
Examples of mergers involving a financial sponsor are Bain Capital’s 2006 acquisition of Dunkin’ Donuts and Blackstone Group’s 2009 purchase of SeaWorld. In
2012, Bain cashed out of its Dunkin’ investment, earning close to a $2 billion-dollar
profit via Dunkin’s initial public offering and other stock sales. In 2017, Blackstone
nearly tripled its money after exiting its seven-year investment by selling its stake
in SeaWorld to a Chinese company.
Strategic buyers are competitors of the target or companies in a related business
line. The goal of strategic buyers is to maximize long-term shareholder value
through the combination of the two businesses. Specifically, the purchaser hopes
to benefit from synergies, which are cost savings and additional revenue generated through the merger of the two businesses. Examples of synergies include
economies of scale, new or shared technologies, client acquisition, enhanced
distribution networks, and geographic expansion.
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Knopman Note: Potential synergies and post-merger savings will
usually be identified by investment bankers and be modeled as
adjustments to the target’s income statement. Three examples of pro
forma EBITDA adjustments are: 1) “Non-essential employee wages”
that can be eliminated or reduced, 2) large executive bonuses that
were paid out in previous years but will not be necessary in the future,
and 3) expenses the firm incurred to operate a private jet but which
will not be incurred under the stringent expense management regime
of the acquirer.
Chapter 6
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Acquisitions
During the M&A process, strategic buyers will perform accretion/dilution analysis, which helps the potential purchaser understand the impact the acquisition will have on the company’s earnings per share and thus shareholder value.
Accretion/dilution will be discussed later in this chapter.
Because of the synergies that will be recognized, strategic buyers are typically
willing to pay a higher price for the target than financial buyers.
Examples of mergers involving a strategic buyer are Amazon’s acquisition of
Whole Foods and Microsoft’s acquisition of LinkedIn. By acquiring Whole Foods,
Amazon was able to achieve an immediate massive physical presence around
the country through Whole Foods’ more than 400 store locations. This helps to
further Amazon’s goal of faster shipping and provides customers a way to pick
up their online purchases immediately. Additionally, Amazon also benefits from
Whole Foods’ grocery market knowledge as well as its access to suppliers as it
continues to grow its own grocery business. By acquiring LinkedIn, Microsoft
is aiming to combine LinkedIn’s networking, job search tools, and professional
development content with its own productivity tools (e.g., Microsoft Office) to
create a complete workplace solution under a single umbrella. Additionally,
Microsoft will be able to use the data acquired from LinkedIn users to continue
to improve its business offerings.
6.1.3 Advisers
Other relevant parties are the investment banks hired by both the target company and potential buyers to advise them throughout the M&A process. This
section will introduce the roles of both the sell-side adviser and buy-side adviser.
6.1.3.1 Sell-Side Adviser
Once a target company decides to initiate the sale process, the first step it takes
is hiring an investment bank to advise it on the transaction. The advisory relationship between the target company and sell-side adviser is formalized by an
engagement letter, which is signed by both parties.
Knopman Note: When the company hires an adviser, the two sides
sign the engagement letter. This document discloses the fees that the
advisory firm is receiving for its work.
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The sell-side adviser’s role is to shepherd the target through the sale process. To
do so, the sell-side adviser must first conduct significant due diligence on the
client. For example, the adviser will visit the target’s key facilities and meet with
the seller’s management team to understand the goals and priorities of the target
as well as the intricacies of its business. The sell-side adviser will also perform
the valuation exercise, such as a precedent transactions analysis or a discounted
cash flow analysis, to better understand the value of the client and what price
the client can expect to receive in a sale. The actual acquisition price will also be
impacted by market conditions and the number of buyers participating in the
process.
Knopman Note:
Q: How does the sell-side adviser assess the value of the target?
A: The sell-side adviser performs a comprehensive valuation
analysis using a variety of methods, such as a precedent
transactions analysis and discounted cash flow analysis.
Q: What ratio would a sell-side adviser not generally consider
when valuing a client?
A: A sell-side adviser would not generally be concerned with
a company’s dividend payout ratio when determining an
appropriate valuation.
Once the adviser has this fundamental understanding of the target, it will look to
identify and market the target company to potential acquirers. As specific acquirers begin to come into focus, the sell-side adviser will conduct due diligence on
those buyers to help determine who might be the best fit for the target.
Knopman Note:
Q: Who would the sell-side adviser not typically interview as part
of the sale process?
A: A sell-side banker executing due diligence on a potential buyer
would not generally interview the company’s customers.
Instead, the banker would meet with consultants and company
management.
Additionally, the sell-side adviser might provide stapled financing, which is
pre-arranged financing offered to potential buyers. The purpose of stapled financing is to reduce execution risk, which is the possibility that the only reason a
deal does not materialize is that a potential buyer cannot secure financing elsewhere. The other benefit is that the stapled financing terms offered by the sellside adviser help to establish a valuation range of the target for potential bidders.
For example, the sell-side adviser might tell a buyer that it will provide a loan
at 8% interest to cover 70% of the purchase price at a multiple of 5× the target’s
EBITDA. This implies the buyer would be required to bring equity of at least 30%
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to buy the company and also implies a purchase price of no less than 7.1× EBITDA
(calculated as 5×/70%).
Buyers will likely end up using their own financing sources, but merely seeing the
terms of the staple (e.g., 8% loan, 5× EBITDA) will help model assumptions and
keep the transaction moving along.
Chapter 6
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Stapled financing does not need to be offered to all bidders. In fact, it is more typically offered to financial sponsors as opposed to strategic buyers. This is because
strategic buyers are more likely to finance an acquisition through the capital
markets, for example by issuing stock or public debt, or by using cash on hand.
Example
In 2005, Toys “R” Us was acquired by an investment group that included KKR,
Bain Capital, and Vornado Realty Trust for $6.6 billion. The transaction was
structured as a leveraged buyout (reviewed shortly) that included $5 billion of
debt. Credit Suisse, which acted as the exclusive financial adviser to Toys “R”
Us in the deal, also earned $10 million in fees helping to arrange the financing
for the acquirers.
Unable to support the massive annual interest payments on the debt, Toys
“R” Us filed for Chapter 11 bankruptcy in 2017.
Knopman Note:
Q: Who is stapled financing generally offered to?
A: Stapled financing is generally offered to financial sponsors, not
strategic buyers. Stapled financing need not be offered to all
bidders.
Q: Who offers stapled financing?
A: Stapled financing is offered by the sell-side adviser.
Q: What risk is reduced by offering stapled financing?
A: By providing buyers (often financial sponsors) stapled
financing, a seller can reduce execution risk.
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Knopman Note: A couple of additional points to know about sell-side
due diligence:
• A sell-side adviser hired by a company whose chairman and CEO is
the sole stockholder of the business will conduct extra due diligence on the CEO to ensure that company assets are being used
appropriately and not for personal reasons. Note that the sell-side
adviser would conduct the extra due diligence and not solely rely
on a signed affidavit from the CEO to this end.
• A sell-side adviser representing a target company that has union
workers should provide the collective bargaining agreement to the
buy-side adviser for due diligence purposes.
6.1.3.2 Buy-Side Adviser
As discussed above, the target company will hire an adviser to kick off the sale
process. A potential buyer, on the other hand, can wait to hire an adviser until it
concludes it has a high level of interest in the target and that hiring an investment
bank will add value to the process. Depending on the level of interest, this may
occur once a buyer receives the confidential information memorandum (CIM)
during the first round of the process, which will be addressed later in this chapter.
Once a buy-side adviser is engaged, it plays a critical role in conducting due diligence on the target, helping to analyze all aspects of its business. Ultimately, the
adviser is trying to assess the target’s worth by performing the valuation exercise
and, more specifically, assessing the target’s worth to that specific acquirer. For
example, the adviser will consider potential synergies and other nuances of the
target.
Additionally, as a potential acquirer moves further along in the process, the buyside adviser will help to advise on an optimal financing structure. That same
investment bank might even underwrite or syndicate debt or other securities to
help finance the purchase. Buy-side advisers that can both advise and provide
capital markets lending to the client will earn higher fees. However, if a buy-side
adviser backs a bidder that does not ultimately win the deal, it runs the risk of
earning zero fees. This contrasts with the sell-side advisory role, which offers the
certainty of fees, though less opportunity to earn underwriting fees in the same
deal.
Knopman Note: If a buy-side adviser receives financial statements
from the target company, it would expect to also receive updated
financials later, depending on how long the process takes. If the
target has a clause disclosing that it does not plan to provide updated
financials, the adviser could still accept the financials but would likely
reject such a clause. The adviser would be less likely to outright reject
receiving the financial statements.
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6.2 M&A Deal Types
Most M&A transactions are organized as either equity purchases or asset purchases. This section will review the various M&A deal structures as well as different types of transactions that candidates should be familiar with.
Chapter 6
Mergers and
Acquisitions
6.2.1 Equity Purchase
In an equity purchase (i.e., stock purchase), the acquirer buys the stock of the
target company. Examples include Amazon purchasing the stock of Whole Foods
and Microsoft purchasing the stock of LinkedIn.
The advantage of an equity purchase is that the transaction tends to be the simplest and least complex for the acquirer. However, unlike an asset purchase, the
buyer is not insulated from any unknown liabilities. Additionally, it does not offer
any significant tax benefits, such as a stepped-up basis, to the purchaser.
From the seller’s perspective, the tax consequences depend on the purchase
consideration, which is the form of payment by the acquirer—cash versus stock.
Cash payment offers certainty to the target company’s shareholders but has
immediate tax consequences. Alternatively, stock payment provides potential
upside in the combined entity, though no certainty, while generally avoiding any
immediate tax consequences for the target company’s shareholders.
Example
Shareholders of Whole Foods received $42 of cash per share in the company’s sale to Amazon. This amount was immediately taxable and had capital gains implications for shareholders under federal, state, and local laws.
Additionally, because Whole Foods’ shareholders received a cash payment
and no Amazon stock in the transaction, Whole Foods shareholders had no
stake in the combined entity.
Example
In April 2018, T-Mobile and Sprint agreed to a merger, which if successfully
closed, would create the country’s third-largest wireless carrier. As part
of the agreement, each shareholder of Sprint will receive 0.10256 shares
of T-Mobile for each Sprint share owned. Because Sprint shareholders are
receiving T-Mobile stock in the transaction and no cash consideration, there
are no immediate tax implications for Sprint shareholders. There will only
be tax consequences for Sprint shareholders when they eventually sell their
T-Mobile shares. Additionally, because Sprint shareholders will receive stock
in T-Mobile, they get to share in the potential long-term growth of the combined business. Of course, they will also share in the downside risk of the
combined entity.
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6.2.2 Asset Purchase
In an asset purchase, the acquirer will purchase the target company’s assets
rather than its equity. The acquisition could be for all the assets of the target, or
for specific assets.
There are a couple of important benefits for the purchaser in an asset sale. First,
the buyer is insulated from any unknown liabilities. Put differently, the purchaser
knows exactly which assets it is buying and what liabilities, if any, it is going to
assume in the transaction.
Second, there is a major tax benefit for buyers in an asset purchase. Specifically,
the acquirer benefits from a stepped-up basis, which means that the assets are
valued at the purchase price on the acquirer’s balance sheet. The higher cost
basis of the asset benefits the acquirer by creating higher depreciation expenses.
Example
XYZ Co. has assets valued at $80MM. ABC Co. purchases the assets of XYZ Co.
for $100MM. Instead of the $20MM difference being treated as goodwill, ABC
Co. can write up the value of the assets to $100MM and thus depreciate the full
$100MM purchase price. Note, if this were a stock transaction, the share price
premium paid would be considered goodwill, which cannot be depreciated.
Knopman Note: In an asset sale, the buyer benefits from a stepped-up
basis.
Asset sales do tend to be more complex transactions than stock sales and thus
can be costlier and timelier to complete. Additionally, certain tax disadvantages
exist for the seller, which are beyond the scope of the exam.
Example
Prior to the financial crisis in late 2007/2008, General Motors (GM) conducted
an asset sale in which they sold Allison Transmission to the private equity
firm, The Carlyle Group. Allison was a specific asset owned by GM, which
included several manufacturing facilities and distribution centers. In return
for spinning off this asset, GM received cash that was needed to strengthen
its liquidity and support some of its core offerings.
6.2.3 Section 338(h)(10) Election
A Section 338(h)(10) election is an equity purchase that the buyer elects to treat
as an asset sale for tax purposes. Similar to a normal asset purchase, the buyer
benefits from a stepped-up basis, which increases its depreciation, as the asset’s
value is written up. Transactions under this election are only available for subchapter S corporations, not C corporations. Therefore, these only apply to private
178
companies. Additional requirements to execute under the 338(h)(10) election are
beyond the scope of the exam.
Knopman Note:
Chapter 6
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Acquisitions
Q: What is a 338(h)(10) transaction? What does the acquirer buy?
A: In a 338(h)(10) transaction, the acquirer purchases the target’s
equity but can treat the transaction as an asset sale for tax
purposes. Put differently, this is an equity sale for GAAP
purposes and an asset sale for tax purposes.
Q: Why do a 338(h)(10) deal?
A: The benefit of this is that the buyer can increase the book value
of the purchased assets to their purchase price, rather than
take an increase in goodwill. The higher cost basis benefits the
acquirer by creating higher depreciation expenses.
6.2.4 Leveraged Buyouts (LBOs)
In a leveraged buyout (LBO), a company is purchased using borrowed money.
The acquirer takes on a significant amount of debt to buy the target and then
seeks to leverage the tax deductibility of the interest payments to reduce the
cost of financing and enhance returns. The cash flow generated by the acquired
company is then used to service the interest payments and pay down the outstanding principal.
An LBO is identical from a structural perspective to buying a house with a mortgage. The buyer deposits approximately 10%–20% of the purchase price and borrows the rest. The example below illustrates the impact that leverage has on
returns.
Example
ABC Capital purchased a $1MM asset, financing the acquisition with 80% debt
and 20% equity. If the asset were later sold for $1.3MM, the equity from the
sale would be worth $500,000 after paying down the $800,000 loan. In this
case, the asset increased in value by 30%, calculated as $1.3MM/$1.0MM, yet
equity investors realized a return on investment of 150%, calculated as $300K
Profit/$200K Investment.
Note that, if ABC financed the acquisition with 100% equity, its return on
investment would have only been 30% ($300,000 Profit/$1,000,000 Equity
Investment).
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re
l Inc
Tota 30%
Equity
$200,000
Debt
$800,000
as e
*
as e
ncre
it y I %
u
q
E
150
Equity
$500,000
*
Debt
$800,000
An LBO model assumes that, to generate a return, the buyer will subsequently
sell the target. This assumed exit allows the model to examine the deal’s internal rate of return (IRR), which will be discussed shortly. In some cases, LBOs
aim to rehabilitate faltering companies and then re-launch them into the public
market through IPOs. LBOs can also profit by liquidating or spinning off valuable
properties, business units, or hard assets of public companies taken private as
well as through a dividend recap, which will be addressed later in this chapter.
Knopman Note: When modeling an LBO, if there are recently issued
stock options, a banker would want to know if these options are
in-the-money, as it could impact the total amount paid for the
company.
Typically, LBOs are used by financial sponsors, such as private equity firms, as
these types of buyers are more likely to fund their purchase with significant debt
compared to strategic buyers. Additionally, unlike financial sponsors, strategic
buyers are not making acquisitions with a subsequent sale in mind. Rather, they
are more interested in the long-term synergies that the combination of the two
businesses will provide.
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Knopman Note:
Q: What types of acquirers perform LBO analyses?
A: Financial sponsors, including private equity firms and
merchant banks, often perform leveraged buyout (LBO)
analyses to value target companies.
Chapter 6
Mergers and
Acquisitions
Q: What is the best valuation model to examine a deal’s internal
rate of return?
A: The best type of model to examine the internal rate of return
(IRR) on an investment is an LBO model. In this type of
valuation model, the timing of cash flows being received will
impact the IRR.
Q: What type of valuations are useful in an LBO analysis? What
financial ratio is not useful?
A: When running an LBO model, the following valuation
methodologies are useful:
1. Comparable companies’ analysis
2. Precedent transactions
3. Discounted cash flow
A banker, however, would not look at the company’s current
debt/capitalization ratios when considering an LBO. This is
because the company will have an entirely new capital structure
after the deal is complete. For example, consider a house
purchase—the buyer doesn’t care one bit if the seller had a
mortgage on the house. The buyer is only concerned with the
purchase price and how they plan to finance it.
Struggling companies that generate significant cash flows and have room for
operational improvements to squeeze out additional cash are often prime acquisition targets in an LBO. Additionally, LBOs are often arranged by the executive
management teams of public companies so that the management team can avoid
the constraints of public company reporting requirements and quarterly earnings pressures.
Knopman Note: It is possible that, in a traditional company sale,
both financial sponsors and strategic buyers will be interested in
purchasing the company. In this scenario, an adviser to a strategic
buyer would inform the client that the competing financial sponsors
are likely contemplating an LBO and using this type of analysis to
value the target company.
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Knopman Note: A company interested in raising capital for expansion
and subsequently selling to a strategic buyer might begin the process
by approaching a bank to arrange for a loan. It would be less likely
to approach a private equity fund or hedge fund to achieve these
objectives. On the other hand, if a company wants cash to fund growth
and also wants to partially liquidate, it will likely approach a private
equity firm for an investment or LBO.
6.2.4.1 Exit Strategy
To recognize a return in an LBO, the financial sponsor must have an exit strategy.
Corporate actions that would achieve this goal include: 1) An IPO (if the company
was private), 2) a private sale to a strategic buyer or financial sponsors, or 3) a
dividend recapitalization.
Knopman Note: A firm seeking to do a leveraged buyout and exit
after 10 years would most likely target a company with a high annual
EBITDA growth rate and low interest expense.
In a dividend recap, the company borrows additional money and then pays out
that cash to equity investors, typically in the form of a special dividend. This is
an alternative to an outright sale when there are no buyers available, the seller
wants to unlock additional value before a sale, or when the cost of borrowing is
relatively cheap. It is possible that a financial sponsor might engage in multiple
dividend recaps before the ultimate exit. This can increase investors’ returns even
more, as they are paid out profits periodically with the goal of the financial sponsor achieving another windfall once the company is eventually sold.
Example
In 2013, the private equity firms Apollo and Metropoulos purchased Hostess
Brands, the maker of Twinkies, out of bankruptcy for $410 million. This purchase consisted of approximately a $200 million equity investment and a $210
million debt financing. Two years later, Hostess issued close to a billion dollars in additional debt, which was used to fund a dividend recap payable to
Apollo and Metropoulos. In 2016, Apollo and Metropoulos sold their majority
stake in Hostess to another private equity firm, Gores Group, for $725 million.
Between the dividend payments and sale proceeds, Apollo and Metropoulos
earned a return of close to 10 times their initial investment.
Knopman Note: A dividend recap offers liquidity without dilution.
It provides liquidity, as investors receive cash, and simultaneously
preserves their equity stake for future growth and/or sale.
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Many of the same strategies described above also apply to a large shareholder of
a company wishing to exit or liquidate its holding to retire or diversify.
Knopman Note: If a principal of a firm is interested in establishing
a trust for her kids and possibly buying a house, she might pursue
a dividend recap or a sale of the company to free up some cash (i.e.,
create liquidity). A bolt-on acquisition (e.g., an acquisition of a smaller
company in the same line of business) would not accomplish these
objectives.
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6.2.4.2 Internal Rate of Return
Internal rate of return (IRR) is defined as the interest rate, or discount rate, that
results in a series of cash flows with a net present value of zero. This important
financial metric is used in many different contexts:
◆ To determine the rate of return on an LBO
◆ To calculate the return on a bond—in this context, it is referred to as
yield to maturity
◆ By private equity firms to gauge the potential return of an acquisition
◆ By corporations to make decisions about capital projects
◆ By investors, to compare various investments
For example, if a private equity company is considering the purchase of a retail
store, it will estimate the purchase price for the business, intermediate cash flows
from profits, and the possible sale price five to eight years in the future. In this
case, the IRR will result in the present value of the cash flows (intermediate and
final sale) being equal to the upfront investment amount (i.e., acquisition price).
Many private equity firms will only consider an acquisition if there is a possibility
for IRR of at least 15%–20%.
Because calculating IRR is complex, it is typically done using a spreadsheet or
financial calculator, though a trial-and-error approach may also be used. The
exam may ask an IRR question that requires the use of this tactic.
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Example
An investor purchases an asset for $20 million and exits after five years for $60
million. Assuming no intermediate cash flows, what is the investment’s IRR?
a) 3.0%
b) 24.6%
c) 31.3%
d) 300%
Testing the 24.6% IRR reveals that $20 million earning 24.6% per year for five
years results in an ending value of $60 million.
Year
Beginning Value
Growth (at IRR)
Ending Value
1
$20.00
× 1.246
= $24.90
2
$24.90
× 1.246
= $31.00
3
$31.00
× 1.246
= $38.60
4
$38.60
× 1.246
= $48.10
5
$48.10
× 1.246
= $60.00
Applying any of the other answer choices will not result in the required $60
million ending value. For example, $20 million earning an IRR of 31.3% for five
years has an ending value of $78 million, which is too high.
Knopman Note: Be sure to carefully read the question to determine
the number of years of returns. For example, a question that states
“A company is acquired and then sold at the beginning of Year 5” is
referencing a company with four years of returns, not five.
6.3 First Round
Once the target hires an adviser, it will begin preparing the first-round marketing materials that will be distributed to potential buyers. Additionally, prior to
formal launch, the sell-side adviser will help identify the objectives of the target
and which type of auction process—a broad auction or a targeted auction—will
be used.
A broad auction seeks to maximize the universe of potential buyers and thus
the value received by the target company. The sell-side adviser will reach out to
dozens of prospective buyers, a combination of both strategic buyers and financial sponsors. Because all potentially interested suitors are being contacted, the
hope is that a broad auction will engender the most competitive sale process,
resulting in the highest possible sale price.
A broad auction has a few disadvantages. First, because there are more potential
buyers to organize, it can increase the time the process takes. Additionally, the
sheer number of participants makes it more likely that information will be leaked
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to the public, including the target’s employees, customers, and competitors, disrupting the target’s operations.
Example
Chapter 6
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Acquisitions
In early 2016, Yahoo launched a broad auction in order to sell its core business.
Because Yahoo owned a wide-ranging and significant number of patents and
intellectual property, the company believed that by maximizing the number
of potential buyers across various industries, it would attain the maximum
possible value in a sale. The process ultimately culminated in a sale to Verizon
six months later for $4.8 billion.
Alternatively, in a targeted auction, the sell-side adviser approaches a smaller,
select universe of potential buyers. The potential buyers in this small group,
which can include both financial sponsors and strategic buyers, are viewed by the
sell-side adviser as being a strong fit for the target. The sell-side adviser can even
approach just one counterparty. A one-on-one process is commonly referred to
as a negotiated sale.
A targeted auction is typically a faster process, as there are fewer parties to coordinate. In addition, because the circle of participants is smaller, there is greater
likelihood of the information being kept confidential and thus a lower possibility
of adverse business impact for the target.
However, because not all potential buyers are being contacted, the process may
be less competitive and there is a greater risk that the target might not receive
the highest possible sale price. Therefore, it will be more challenging for the target
board of directors to satisfy their fiduciary obligation and ensure they attained
the best price for shareholders.
Example
Before agreeing to its sale to Microsoft, LinkedIn engaged in a targeted auction to which it invited Microsoft, Salesforce, Google, and Facebook to participate. A targeted auction made sense for LinkedIn, as the company valued
confidentiality and believed the buyer pool for their business would be relatively limited.
Example
In November 2016, daily fantasy sports companies DraftKings and FanDuel
agreed to merge following a period of one-on-one negotiations. The companies began engaging in talks as a way to combine forces and thus reduce the
significant lobbying and legal costs both companies had been paying independently. Because the combined entity would control over 90% of the daily
fantasy sports market, the Federal Trade Commission announced intentions
to sue to block the merger over anti-trust concerns. Because neither company
wanted a long, drawn-out legal battle, they announced in July 2017 that they
were calling off the planned merger.
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For targeted auctions and negotiated sales, a fairness opinion and go-shop provision will take on heightened importance as ways for the board to defend the
price.
Once the appropriate sale process has been chosen, the first-round M&A process
will begin.
6.3.1 First-Round Marketing Materials
It is crucial to be familiar with the marketing materials presented in this section.
6.3.1.1 Teaser
The first document delivered to potential buyers is the teaser, which is a brief
one- or two-page company profile prepared by the sell-side adviser. It includes
general data about the target, such as very high-level financial information, with
the goal of trying to generate initial interest from potential buyers. Often, the
teaser will not even include the name of the target company; rather, it will include
its sector or line of business. This is because at this point in the process, none of
the prospective buyers have signed the confidentiality agreement yet. The teaser
will include the contact information of the sell-side adviser so that potential
buyers know who to reach out to with any questions.
Knopman Note: It is not uncommon for the teaser to omit the name
of the target company, as potential buyers have not yet signed the
confidentiality agreement. For this reason, the teaser will include the
contact information of the sell-side adviser.
The confidentiality agreement (see below) is delivered with the teaser.
6.3.1.2 Confidentiality Agreement (CA)
Any prospective buyers that are “teased” and want additional information about
the target must sign and return the confidentiality agreement (CA), sometimes
referred to as the non-disclosure agreement (NDA), to the sell-side adviser. A
typical confidentiality agreement includes:
◆ The length of time the CA lasts
◆ The requirement to return or destroy the information if the potential
acquirer decides not to move forward
◆ The scope of the information that must be kept confidential (such as
internal projections by the target)
◆ Prohibition against discussion of the buyer’s or seller’s involvement in a
potential merger (the mere fact that the target company is trying to sell
itself is privileged information)
◆ A restriction on clubbing, which is a joint bid by multiple buyers. This
might be prohibited in order to avoid collusion, though sometimes it is
allowed for larger deals or possibly in the second round
◆ A non-solicitation clause, which prohibits a potential acquirer from
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hiring away the target’s key personnel (defined in the CA) for an agreedupon time period, and
◆ A standstill agreement, which requires potential bidders to refrain from
certain corporate actions relating to public targets, such as purchasing
the target’s shares in the open market or trying to influence the target’s
board or management team. For example, a standstill agreement may
prohibit the bidder from nominating any individuals to the target’s board
of directors for a defined time period
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Acquisitions
Knopman Note: A confidentiality agreement would not typically
include limitations or restrictions on bidder information contained
in research reports. This is information that is already in the public
domain.
Knopman Note: Once an adviser signs an NDA with a new client, the
compliance department would likely monitor employees trading in
that stock to ensure there is no insider trading.
6.3.1.3 Confidential Information Memorandum (CIM)
Once an interested prospective buyer returns and signs the confidentiality agreement, it will receive the confidential information memorandum (CIM), also
referred to as the information memorandum, detailed memorandum, or
descriptive memorandum. The CIM, which is prepared by the sell-side adviser
in conjunction with target management, provides a detailed description of the
target. Essentially a 50- to 60-page pitch book, it is the primary first-round due
diligence document used by prospective buyers. It must provide the company
enough information to make a first-round bid if it decides to move forward.
The CIM includes:
◆ An executive summary, which describes the target and typically includes
a brief synopsis of its key products and services, management team, and
financial profile
◆ Investment considerations, which aim to explain why the target
company would be a great fit for a potential buyer
◆ An industry overview, including information about the sector, such as
market size and competitors
◆ A company overview, including information about suppliers, distribution
channels, customers, and end markets
◆ Financial information, which includes historical results (typically
normalized for any one-time or non-recurring items) as well as future
projections. Also in this section is management discussion and
analysis (MD&A), which provides context and explanation for past and
projected performance. The financial section is crucial for prospective
buyers in helping them to determine the valuation of the target
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It is also possible for the CIM to be customized depending on the recipient, as
the target company might not want to reveal as much information to a strategic
buyer at this point in the process. For example, if one of the buyers is a competitor, sensitive client data would not be disclosed at this point in the process.
Described differently, there might be a redacted version.
Knopman Note: The CIM would likely disclose any current litigation
involving the target company. A buy-side adviser would likely want to
execute due diligence to understand the lawsuit’s consequences. If the
adviser learns that the consequences are worse than reported, the rep
should notify his or her supervisor as well as the buyer.
Once a potential buyer receives the CIM, it may look to hire an adviser based on
its level of interest in the target company.
6.3.1.4 Initial Bid Procedures Letter
Typically distributed with the CIM is the initial bid procedures letter, which is
a series of instructions for submitting a first-round bid. It details the information
that prospective buyers must include in their initial bid as well as the due date.
If, after reviewing the CIM, a potential buyer is still interested, it will submit a
first-round bid, also referred to as an indication of interest (IOI), statement
of interest (SOI), or letter of intent (LOI). The buy-side adviser typically plays
a significant role in guiding its client’s initial bid to ensure that it is competitive
without being too high.
It’s important to note that this first-round bid is non-binding and subject to the
significant due diligence that occurs during the second round of the process. Still,
it will typically include preliminary information such as:
◆ Purchase price (sometimes submitted as a range) and form of
consideration (e.g., cash versus stock payment or a combination of the
two)
◆ Retention of management and employees, including who will run the
combined entity and any plans for layoffs, and
◆ Information on financing—the prospective buyer does not need to
actually have financing in place; this is simply insight into how the
prospective buyer might look to finance the transaction (e.g., using cash
on hand, taking out a loan, or issuing stock)
Knopman Note: The first-round bid in an M&A process can be
described as an indication of interest (IOI). This same term describes
a buyer’s interest in participating in an IPO or follow-on. In both cases
it is non-binding.
Upon receipt of the indications of interest, the sell-side adviser will play a crucial
role in analyzing the first-round bids. Based on its sector expertise and past experience, the sell-side adviser will assess which prospective buyers are legitimate
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and should move forward into the second round versus those that are only interested in learning additional details about the target’s business to gain a competitive advantage and are unlikely to actually move forward with a purchase.
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Acquisitions
Knopman Note: It is crucial to know the order of the items described
below:
1. Seller signs engagement letter with adviser.
2. Teaser is delivered with the confidentiality agreement.
3. Confidentiality agreement is signed and returned.
4. Confidential information memorandum is delivered along
with the initial bid procedures letter.
5. Indications of interest are submitted.
6.3.2 Accretion/(Dilution) Analysis
To help formulate first-round bids, advisers to public strategic buyers typically
conduct accretion/(dilution) analysis. This is used to determine the impact of
the transaction on the acquirer’s earnings per share. The deal is accretive if the
acquirer’s EPS will increase after the merger and dilutive if the acquirer’s EPS
will fall after the deal.
This analysis helps a potential buyer weigh the financial consequences of a merger
and whether the deal will create immediate value for its shareholders. Although
accretion/(dilution) only answers the question of short-term EPS impact and is
therefore shortsighted, perceptions about falling EPS can significantly affect the
company’s stock price. Therefore, it must be taken into account, even if the company is confident that the deal will return significant value over the long term.
Accretion/(dilution) is only used by public acquirers, as private companies are
not required to report earnings per share.
Knopman Note: One difference between a strategic buyer and a
financial sponsor in an M&A transaction is that a strategic buyer will
typically perform an accretion/(dilution) analysis while a financial
sponsor generally will not.
As soon as the first-round bids are received, the sell-side adviser will also conduct
this analysis to discern whether there is any wiggle room in the bids. For example,
if a deal will be extremely accretive to a potential acquirer, that might indicate to
the sell-side adviser that the buyer can afford to pay a higher price.
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6.3.2.1 Accretion/(Dilution) Steps
The steps to conduct an accretion/(dilution) analysis are summarized below:
1. Calculate the acquirer’s diluted shares outstanding prior to the merger.
2. Calculate the acquirer’s earnings per share prior to the merger.
3. Calculate the pro-forma (combined) net income, i.e., the new net
income, once the acquirer purchases the target and assumes its business
and profits. Combined net income is calculated as:
a) Add: Acquirer’s net income
b) Add: Target’s after-tax EBIT (i.e., acquirer assumes target’s EBIT, but
must pay taxes on it)
c) Add: After-tax synergies—Note that because net income is being
calculated, after-tax synergies must be calculated. Assume synergies are
given pre-tax unless specified otherwise on the exam
d) Subtract: Tax-effected interest expense—If the acquirer is refinancing
the target’s debt, or issuing debt to finance the purchase, the interest
expense will reduce its profits. Since the interest is tax-deductible, it
must be tax-effected (multiply interest expense by 100% minus the tax
rate) to take into account the tax savings the expense provides
4. Calculate new shares issued in the transaction. New shares will only be
issued if the acquirer is paying stock for the target company’s shares. If it is
an all-cash deal, no additional shares will be issued.
5. Calculate pro forma (combined) shares outstanding. This is calculated
by adding the acquirer’s diluted shares outstanding (Step 1) with the new
shares issued in the transaction (Step 4).
6. Calculate pro forma (combined) EPS.
7. Compare acquirer’s standalone EPS (from before the merger) to pro
forma EPS (from after the merger). If pro forma EPS is greater than standalone EPS, the deal is accretive, and if it is less than standalone EPS, the deal
is dilutive.
Example
AcquirerCo purchases TargetCo by issuing $60,000,000 in debt at an 8% rate.
TargetCo has $6,200,000 in EBIT. AcquirerCo can recognize $3,500,000 in
synergies and has a 40% marginal tax rate. An analyst covering AcquirerCo
estimates its standalone earnings per share at $3.25 per share on 25,000,000
shares. What are AcquirerCo’s pro forma earnings per share after the
transaction?
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Step 1: AcquirerCo outstanding shares is given as 25,000,000. No calculation
necessary.
Step 2: AcquirerCo standalone EPS is given as $3.25. No calculation necessary.
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Acquisitions
Step 3: Pro forma Net Income = AcquirerCo Net Income + TargetCo After-Tax
EBIT + After-Tax Synergies − After-Tax Interest Expense
Step 3a: AcquirerCo Net Income = $3.25 EPS Estimate × 25,000,000
Outstanding Shares = $81,250,000
Step 3b: TargetCo After-Tax EBIT = $6,200,000 × (1 − 40% Tax Rate) =
$3,720,000
Step 3c: After-Tax Synergies = $3,500,000 × (1 − 40% Tax Rate) = $2,100,000
Step 3d: After-Tax Interest Expense (to finance deal) = $60,000,000 × 8% Cost
of Debt × (1 − 40% Tax Rate) = $2,880,000
Therefore: Pro Forma Net Income = $81,250,000 + $3,720,000 + $2,100,000 −
$2,880,000 = $84,190,000
Step 4: Because the transaction is being financed through a debt issuance,
no additional shares are issued in the transaction. Therefore, no calculation
is necessary.
Step 5: Because no new shares were issued in the transaction, the pro forma
shares outstanding is equal to the acquirer’s standalone number of shares of
25,000,000.
Step 6: Pro Forma EPS = Pro Forma Net Income/AcquirerCo Shares
Outstanding
Pro Forma EPS = $84,190,000 Net Income/25,000,000 Shares = $3.37
Step 7: Because the question asks for the calculation of pro forma EPS, it is
not necessary to calculate whether the deal is accretive or dilutive. However,
in this case, because the pro forma EPS of $3.37 is greater than the acquirer’s
standalone EPS of $3.25, the deal is accretive by $0.12 or 3.7% ($0.12/$3.25).
Knopman Note: Raising capital by issuing bonds would be the LEAST
dilutive to a company’s earnings per share as compared to a public
or private offering of common or convertible preferred stock as the
number of shares outstanding remains unchanged.
Knopman Note: Accretion/(dilution) questions are the longest, hardest
math questions on the Series 79. Candidates typically only see one or
zero accretion/(dilution) questions on the exam, so make sure not to
spend too much time on this topic.
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Chapter 6: Mergers and Acquisitions
Progress Check
1. Which of the following is not a marketing
document in an M&A process?
A.
B.
C.
D.
Teaser
Confidential information memorandum
Management presentation
Confidentiality agreement
2. For the sale of a sizeable business, who
typically runs the sell-side process?
A.
B.
C.
D.
Company CEO
Company CFO
Investment bank
Anchor shareholders
3. Investment banks help client companies assess
all of the following strategic alternatives when
evaluating a potential sale except:
A.
B.
C.
D.
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Dividend recapitalization
IPO
Massive re-branding effort
Status quo
4. In which case would a buyer perform
accretion/(dilution) analysis as part of its
process for formulating a first-round bid?
A.
B.
C.
D.
Buyer is a financial sponsor
Buyer is public
Competing buyers are financial sponsors
Competing buyers are both financial
sponsors and strategic buyers
5. All of the following are typically included in the
M&A teaser for a private company except:
A.
B.
C.
D.
Brief description of the business
Summary historical financial data
Map of plant and sales locations
Investment highlights
Chapter 6: Mergers and Acquisitions
Progress Check—Solutions
(D)
A confidentiality agreement (CA) is a legally binding contract between the target and
prospective buyer that governs the sharing of confidential company information. All
of the other documents are key materials for the target to present its business model
and highlights to potential buyers.
2. (C)
A company typically hires an investment bank to sell itself or to sell a material part of
the business. This intense, high-stakes process usually spans several months, and the
seller typically hires an investment bank and its sell-side advisers to ensure that key
objectives are met for a favorable result.
3. (C)
A company typically hires a marketing or consulting firm to advise on branding and
related marketing issues.
4. (B)
Public strategic buyers use accretion/(dilution) analysis to measure the pro forma
effects of the transaction on earnings, assuming a given purchase price and financing
structure. The acquirer’s EPS pro forma for the transaction is compared to its EPS on
a standalone basis. If the pro forma EPS is higher than the standalone EPS, the
transaction is accretive; conversely, if the pro forma EPS is lower, the transaction is
dilutive. Because public companies are generally reluctant to pursue dilutive
transactions, due to the potential detriment to their share price, a public buyer’s
perception of valuation and corresponding bid price is often guided by EPS accretion/
(dilution) analysis.
5. (C)
The typical teaser is 1–2 pages long, providing just enough information for potential
buyers to determine whether they are sufficiently interested to move forward in
the process. A map of plant and sales locations is typically more detailed and sensitive
information than would customarily be included in a teaser. This information, however,
would be included in the CIM.
1.
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6.4 Second Round
During the second round of the process, prospective buyers conduct comprehensive due diligence on the target company. This helps ensure that potential
acquirers have a detailed understanding of all aspects of the target and allows
them to formulate their final bids, if they decide to move forward, which come
at the end of the second round. Due diligence includes in-depth analysis of the
target’s:
◆ Business issues, e.g., products, earnings, key facilities, and personnel
◆ Legal issues, e.g., contracts with vendors and clients
◆ Finance/accounting issues, e.g., quality of internal financial controls and
any tax concerns, and
◆ Regulatory issues, e.g., anti-trust concerns
Knopman Note: An adviser to a strategic buyer would perform due
diligence on a target company’s capital base (i.e., capital structure),
which includes outstanding debt and equity. For reasons discussed
earlier, financial sponsors would be less concerned with the target
company’s existing capital structure.
The due diligence in the second round is a two-way street, as the sell-side adviser
will also conduct a thorough review of each potential buyer. In a stock deal or
cash and stock deal, the target company’s shareholders will have a stake in the
combined entity after the deal is completed. Therefore, the sell-side adviser
must analyze the future prospects of the buyer. Alternatively, in an all-cash deal,
although target shareholders will have no upside in the merged entity, the sellside adviser must conduct due diligence to ensure that the buyer can obtain
financing and pay for the target. Also, to the extent senior management and
employees will become employees of the acquirer, aspects of the acquirer’s culture and compensation packages may need to be explored and negotiated.
Knopman Note: For a sell-side adviser to an all-cash transaction, the
biggest diligence concern is ability to pay. Unlike in a stock deal or
cash and stock deal, in an all-cash transaction, the seller would have
little concern with the strength of the buyer’s management team
because the seller has no stake in the company going forward.
Because second-round due diligence is an exhaustive and lengthy process that
can take weeks or even months to complete, the sell-side adviser will begin to prepare for it in the first round. For example, the sell-side adviser will begin crafting
the management presentations and populating the data room in the first round
so as to not waste any time and hit the ground running once the first-round bids
are received.
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6.4.1 Second-Round Due Diligence Activities
This section will discuss the various ways the sell-side adviser helps facilitate
second-round due diligence, including management presentations, site visits,
and the data room.
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6.4.1.1 Management Presentations
Management presentations typically kick off the second-round due diligence
process. They are delivered by target management, including the CEO, CFO, and
other key division heads, to each prospective buyer. Target management’s objective is to present a compelling business narrative and to have the presentation
serve as a forum to contextualize the information and data presented elsewhere
as well as the future trajectory of the business. The goal is to provide insight and
credibility into why the target is the right fit for that prospective acquirer. It is
meant to be an interactive presentation with potential buyers given the ability
to ask questions.
To ensure management presentations go smoothly and convey the target in the
best possible light, they are prepared and rehearsed with the sell-side adviser.
The sell-side adviser lends its expertise and experience to the process and helps
to craft the appropriate messaging and, of course, build slides.
Prospective buyers will typically bring their advisers along with their financing
sources to the management presentation so that they can provide insight and
assist with the due diligence. The buyer’s legal counsel and accountants do not
generally attend.
Knopman Note: Management presentations are generally limited to
acquirers who have submitted first-round bids.
Knopman Note:
Q: What is the best course of action if an investment banker
comes into possession of insider information about a different
company during due diligence?
A: If this happens, it would be prudent for the banker to notify
compliance. Compliance will likely put the company that is
the subject of the insider information on the broker-dealer’s
restricted list. This will prohibit other employees of the firm
from trading in the stock.
6.4.1.2 Site Visits
Often accompanying management presentations are site visits. As the name
implies, during a site visit potential acquirers and their advisers tour key facilities
of the target. This might include the target’s main factories, retail locations, or
sales offices, providing a firsthand look into the target’s operations and another
forum to ask detailed questions.
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Generally, the tour is led by the manager of that facility, as he or she will be the
individual most familiar with the innerworkings of that particular site. It is also
attended by members of the target’s management team as well as the sell-side
adviser. Generally, the true reason for the site visit is not relayed to employees in
order to avoid business disruption, as the typical employee will not be familiar
with the ongoing sales process.
Knopman Note: When confirming overseas real estate holdings of a
potential acquisition target, it would be reasonable to get legal title as
proof of ownership if a physical site inspection is not possible.
6.4.1.3 Data Room
In connection with the other second-round due diligence activities, prospective buyers will be given access to the data room, a secure location where they
can review valuable and sensitive information about the target. This includes
contracts with vendors and clients, legal issues, financial statements, tax information, environmental liabilities, and other relevant documents. The acquirer
will typically enlist a team of professionals—adviser, attorneys, accountants, and
other consultants—to help review all the content presented in the data room in
order to be as comprehensive as possible in their due diligence.
Knopman Note: If a seller gives exclusive negotiating rights to a bidder
after the party has signed a letter of intent, any updated financial
statements of the target would be provided exclusively to that buyer.
The information would not be added to the data room for other
potential buyers to access.
Historically, the data room was a physical location, though now it is located on
a secure website hosted by third-party vendors. To protect the confidentiality
of the target’s data, the vendor can employ different security features, such as
preventing the download or emailing of documents. The vendor will also give
the sell-side adviser the ability to control accessibility, maintain a visitor’s log to
follow buyer interest, and tailor the site to different buyers as they access it. It is
the responsibility of the sell-side adviser to obtain the source data from target
management and upload it to the data room. Note that prospective buyers do
not post documents or information in the data room.
Knopman Note: To facilitate due diligence, the target company
provides data-room access to each acquirer and its advisers. The sellside adviser generally recommends a data-room vendor to manage
the security of, and access to, the data room. The target provides the
source data for the data room to the sell-side adviser, which then
populates the data room with that source data. The buy-side adviser
does not set up the data room.
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Knopman Note: A data room will generally allow for printing of
materials as long as they include a watermark, date, and name of the
user.
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6.4.2 Final Bid Procedures Letter and Final Bids
As the second-round progresses, the sell-side adviser will distribute the final bid
procedures letter to the remaining prospective acquirers. Similar to the initial
bid procedures letter disseminated in the first round, it provides instructions for
submitting a final bid, including the exact due date and information to include
in the final proposal.
A draft of the definitive agreement is often distributed to potential buyers along
with the final bid procedures letter. The definitive agreement, discussed shortly,
is the binding contract between the target and purchaser. Although prospective
buyers have not yet submitted their final offers, they are each given the opportunity to review the draft definitive agreement and provide comments in order to
reduce negotiating time later in the process.
If, after completing second-round due diligence, a potential buyer still wants to
move forward, it will submit a final bid. The final bid will include:
◆ Purchase price and form of consideration, i.e., exact price and form of
payment
◆ Financing details, i.e., how will the purchase be financed and who will
provide the financing? Note that a buyer does not need financing in place
but does need to present evidence that financing can be obtained (e.g., a
commitment letter from a bank)
◆ Due diligence representation, which states that the final bid is subject to
only minimal additional due diligence (as opposed to the first-round bid,
which was subject to significant due diligence)
◆ Regulatory issues, which regulators may need to approve of the
transactions
◆ Board approval, i.e., the acquirer’s board or senior management will sign
off on the bid to ensure its legitimacy, and
◆ Draft definitive agreement, i.e., a marked-up copy with comments made
by the buyer
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Knopman Note: Here are a couple of items an adviser would consider
when evaluating final bids:
• An M&A sell-side adviser would eliminate bids that contained an
exclusivity agreement if the client wanted to pursue additional
offers.
• A buyer that wants to increase the likelihood of winning a bid, but
does not want to overpay, could offer a shorter time to close. For
example, a buyer with cash on hand would be able to close in a
timelier fashion than a buyer who needs to access capital markets
financing.
6.4.3 Fairness Opinion
After receiving the final bids, the sell-side adviser and target will review each
offer to determine which to accept. When assessing each proposal, the target and
adviser are trying to discern which prospective buyer is offering the best overall
terms, is offering the highest price, and is most likely to actually close. Once a
winning bidder is selected, but before the target board officially accepts the deal,
the target board must ensure that the bidder’s price is in fact fair in comparison
to similar transactions. This is where a fairness opinion comes into play.
A fairness opinion is a valuation analysis that is prepared for a company’s board
of directors to confirm the financial fairness of the transaction. The investment
bank hired to write the opinion will perform various valuation methods, such as
a discounted cash flow analysis, comparable transactions analysis, and comparable companies analysis, to evaluate the proposed transaction and the financial
fairness relative to similar deals that have been consummated.
For example, an airline merger would compare the valuation on the deal to that
of other transactions in the airline space during the past few years.
Knopman Note: The fairness opinion does not advise whether or not to
accept the deal. Instead, it opines on whether the price is fair.
The target board of directors is not legally required to commission a fairness opinion. However, in virtually every transaction in which the target’s shareholders
will be voting on the proposed merger, the target board will obtain one to ensure
the company is receiving a fair price and therefore that the board is meeting its
fiduciary duty.
In a proposed merger where the acquirer’s shareholders will also need to vote
to accept the deal, the buyer’s board of directors will typically commission one
as well. Put differently, in a transaction in which both the target and acquirer
shareholders will vote, both boards will separately obtain fairness opinions. The
scenarios of when each company’s shareholders do and do not vote will be discussed later in this chapter.
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Knopman Note: Fairness opinions are heavily tested on the exam.
Chapter 14 will discuss them in greater detail, including the
information they contain, required disclosures, and the rules relating
to the fairness committee of the investment bank that authors the
opinion.
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6.4.4 Definitive Agreement
As discussed above, the target board commissions a fairness opinion to review
the financial fairness of the winning bid. If the opinion concludes that the price is
in fact fair, the target board will vote on whether to accept the deal. Assuming the
target board approves of the transaction, the definitive agreement is then signed
by the buyer and seller. It is at this time that the transaction will be announced
to the public. The definitive agreement is the legally binding contract that details
the terms of the transaction.
Knopman Note: When a company signs a definitive agreement, it could
choose to announce this information to the public via a press release.
That press release would be defined as a prospectus and would need to
be filed with the SEC no later than the date of first use.
Major elements of the definitive agreement include:
◆ Transaction terms—The purchase price, form of consideration, who
will run the combined entity and where it will be headquartered, and
whether the deal includes a working capital peg (discussed shortly).
◆ Representations (reps) and warranties—Assertions by both the buyer
and seller that they have provided one another truthful information
and all relevant documents. For example, all material contracts have
been disclosed and all financial statements are accurate. The material
adverse change (MAC) clause, sometimes referred to as the material
adverse effect (MAE) clause, allows either party to back out of the deal
for a breach of reps and warranties. It also allows the buyer to avoid
closing the transaction in the event that a substantial adverse situation
(as defined in the contract) is discovered after signing the definitive
agreement or if a detrimental post-signing event occurs that affects the
target. In the negotiation of the contract, sellers typically seek to have
high hurdles for buyers to establish that a material adverse change has
occurred, while buyers, on the other hand, typically seek to keep these
hurdles as low as possible. For example, an acquirer may look to execute
the MAC if there is a dramatic and unexpected decline in the target’s
financial performance between signing and closing (e.g., the earnings
of the target fall off a cliff post-signing). Note that, generally, changes to
the business resulting from economic, industry, or market conditions;
changes in laws or in accounting rules and standards; natural disasters;
or acts of terrorism are often explicitly excluded as reasons to back out of
the deal under the MAC clause.
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◆ Pre-closing commitments—Details the obligations of each party
between signing the definitive agreement and closing the transaction
to ensure that nothing out of the ordinary occurs during this period.
For example, the target company cannot pay out any special dividends
or make any out-of-budget expenditures. Additionally, each party will
commit to use their best efforts to make sure the deal successfully closes.
◆ Indemnification—The seller may agree to reimburse the acquirer for
any unexpected liabilities or losses that may arise after the transaction is
completed, such as unknown future product liabilities or environmental
expenses.
◆ Financing—Although the purchaser does not need to have financing
in place until closing of the deal, it will need to explain how it plans
to finance the transaction and provide evidence that it can obtain the
necessary funds.
◆ Termination provisions—A list of reasons the deal can be terminated
and whether any break-up fee is required. Examples include failure
to obtain regulatory approval, shareholder approval, or financing, or
the seller accepts a better offer (whether an unsolicited offer or via a
go-shop). If the deal is structured as a no-shop, the target is prohibited
from seeking a better offer. This is typical in a broad auction, as the
seller has already sought bids from all interested parties. In these
circumstances, although the target is not permitted to shop around for
a higher offer, it often is permitted to accept an unsolicited offer, which
is an offer initiated by a third party. On the other hand, a go-shop allows
the target to seek a better offer. This is most common in a targeted
auction or in a one-on-one sale, as it enables the seller to reach out to
other parties that may be interested and thus help the target board meet
their fiduciary responsibility to shareholders.
Knopman Note: A go-shop is most common in a one-on-one sale to give
the seller one last look and ensure it is getting a fair price.
Knopman Note: If the target company has signed a letter of intent
but would like to have the option to accept an unsolicited offer
from another buyer, it would likely need to pay a break-up fee to the
acquirer, subject to the terms of the purchase agreement. A thirdparty buyer would likely see a break-up fee as the largest obstacle in
launching a bid after the buyer and seller have signed the definitive
agreement.
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Example
The 2017 Amazon and Whole Foods definitive agreement included a no-shop,
which meant that Whole Foods was not permitted to seek a better offer once
the deal was signed. However, under the terms of the purchase agreement,
Whole Foods could have accepted a superior offer if presented by a third
party. If Whole Foods had accepted an unsolicited offer, it would have been
required to pay a $400 million break-up fee to Amazon.
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Example
In 2013, Michael Dell along with Silver Lake Partners agreed to acquire Dell,
which was a public company at the time, and then take the business private.
Because it was a one-on-one negotiation and there were no other active suitors, as part of the definitive agreement both parties agreed to a 45-day go-shop
period. During this period, the company Dell could actively solicit other bidders to attempt to get a better offer. Ultimately, no other bids emerged, and
Michael Dell and Silver Lake closed the deal.
Example
In March 2011, AT&T announced an agreement to purchase T-Mobile for $39
billion, which if successfully closed would have given AT&T a more than 40%
market share of mobile phones in the United States. Due to anti-trust concerns, the Department of Justice filed, and eventually won, a lawsuit to block
the merger. As agreed to as part of the definitive agreement, because the deal
was unable to be successfully completed, AT&T was required to pay T-Mobile
a $4 billion break-up fee.
The specific scenarios above are only examples; in practice, every single deal
has its own nuances, as the terms of the definitive agreement are highly negotiated between the two parties. For example, what triggers a break-up fee and the
amount varies widely deal to deal.
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Knopman Note:
Q: In an M&A deal, a seller may indemnify or offer indemnification
to a buyer; what would this relate to?
A: A seller might offer indemnification for specific losses or
expenses arising after a deal. Indemnification means that the
party cannot be held legally liable. For example, a seller may
indemnify a buyer for unknown future products liabilities or
environmental expenses.
Q: What if the seller has significantly less cash or significantly
more payables outstanding at closing?
A: An M&A transaction price may include a working capital peg.
If actual working capital is higher than the peg, the purchase
price will be adjusted upward—vice versa if it is lower. For
example, a deal is struck assuming 100MM in working capital.
At close, working capital is 110MM; buyer pays seller an
additional 10MM.
A working capital peg prevents either party from being
adversely affected by timing, seasonality, or irregular activity
by the seller (e.g., extending payables or aggressively pulling in
receivables and distributing cash pre-closing).
6.4.5 Second-Round Timeline
The table below provides a nice summary of the events occurring in the second
round.
Start of Second Round
Due Diligence
• Management presentations
• Site visits
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Management presentations: Seller management and professionals (bankers)
present the merits of the opportunity
Site visits: Bidders visit the target’s facilities, offices, or factories
• Data room access
Data room access: Bidders review detailed information
about all aspects of the target
Distribute Final Bid Procedures
Letter and Draft Definitive
Agreement
Seller and its professionals distribute the procedures to submit final bids
Receive Final Bids
Bidders submit final bids
Fairness Opinions
The seller’s board of directors will commission a fairness opinion to ensure
the selected winning bid is fair to shareholders and provide comfort that
the board has met its fiduciary duties.
Sign DA
Sign the definitive agreement memorializing the sale; proceed toward closing
6.5 Closing a Merger
Once the buyer and seller sign the definitive agreement, it does not mean the two
businesses immediately merge. Prior to closing, the companies must receive both
regulatory and shareholder approval. This section will discuss the steps that take
place from signing to closing.
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6.5.1 Regulatory Approval
The Hart–Scott–Rodino Antitrust Improvements Act of 1976, commonly
referred to as the HSR Act, aims to ensure compliance with anti-trust guidelines.
The law requires the details of merger transactions to be filed by both parties with
the Department of Justice (DOJ) and Federal Trade Commission (FTC). The filings
are made directly after the definitive agreement is signed, with the purpose of
alerting regulators to the merger, so the DOJ and FTC can review it and ensure
that it is not anti-competitive to the industry.
Knopman Note: Under the HSR Act, a merger between two companies
in the same sector would receive the greatest scrutiny.
Once the transaction is filed, there is typically a 30-day-minimum waiting period
while the DOJ and FTC review the transaction. For all-cash tender offers, the
waiting period is reduced to 15 days. The regulators can end the waiting period
early if they do find any anti-trust concerns, or if they do see a potential issue,
they can extend the timeframe and ultimately seek an injunction from a court
to prevent the merger.
During the waiting period, gun-jumping by the buyer and seller is also prohibited. This means that the parties cannot assume they will receive regulatory
approval and begin the process of combining during the waiting period. For
example, the two businesses cannot merge their headquarters, begin joint advertising, or combine their operations during the waiting period.
HSR approval is not required for all deals; it is based on the size of the transaction. When the law was initially passed, the minimum threshold was $50 million,
which is adjusted annually for inflation. In 2019, the minimum threshold is $90
million.
Knopman Note: The minimum deal threshold for HSR submission was
originally $50MM. This figure is inflation adjusted; for example, it was
$62MM in 2010 and is even higher today.
6.5.2 Shareholder Approval
Also prior to closing, the target board must obtain shareholder approval. This
can be done through either a one-step or two-step merger.
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Knopman Note:
Q: What SEC filings would you expect to see when a company
engages in a merger or an acquisition?
A: To communicate these material events, any public company
party to a merger or an acquisition would file an 8-K within four
business days of:
1. Signing the DA
2. Terminating the merger (if terminated), and
3. Closing the merger
Each of these filings would also be considered a prospectus
under SEC rules.
Note: A public company acquiring a private company is not
required to disclose the private (target) company’s financials in
an 8-K announcement.
6.5.2.1 One-Step Merger
In a one-step merger, the issuer files a proxy statement and the target company’s shareholders vote on the transaction at a shareholder meeting. Assuming
both the buyer and seller are public companies, they jointly prepare and file the
merger proxy with the SEC. If the acquirer is a private company, then only the
target is required to file with the SEC.
Knopman Note: The buy-side adviser may conduct interviews with the
target’s suppliers and customers to learn more about the company
and analyze the target’s shareholder base. This aids in developing an
effective proxy strategy if a shareholder vote will be required to close
the deal. The adviser is less likely to interview large shareholders of
the target, especially because it is possible that a large shareholder is
a competing bidder.
A merger proxy, also referred to as an M14A, provides shareholders with all the
disclosures and information needed to make an informed vote regarding the
deal. For example, it includes a description of the merger, a recommendation
from the target’s board, a summary of all the various transaction terms from the
definitive agreement, the fairness opinion, and pro forma financials (applicable
to stock transactions only).
Knopman Note: An investment banker can review a merger proxy
to find details on a previous M&A transaction, such as the form of
consideration (cash versus stock payment). Additionally, a change
in an executive’s or director’s compensation in a change of control
situation (i.e., a merger) would be disclosed in the merger proxy.
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The definitive merger proxy (DEFM14A), which is the final version of the document, must be sent to the target’s shareholders at least 20 days prior to the
shareholder meeting. Additionally, a preliminary merger proxy (PREM14A)
must be filed with the SEC at least 10 days prior to the definitive being sent to
shareholders. This allows the SEC to review the information before it is sent to
shareholders to ensure that shareholders’ rights are being upheld. Target shareholders can also review the preliminary merger proxy in advance of receiving
the final version. Typically, for a merger to be approved, a majority of the target’s
shareholders must vote in favor of the transaction, though some targets require
a supermajority (e.g., a two-thirds majority) per their corporate charter.
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The snapshot below is from the Amazon and Whole Foods proxy statement.
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Knopman Note: When a company files a merger proxy (i.e., M14A), it is
also defined as a prospectus by the SEC.
If the acquirer is issuing public securities (e.g., public stock or debt) to finance
the transaction, a Form S-4 registration statement must be filed with the SEC to
register the newly issued securities. The S-4 will include the proxy statement, a
prospectus, and the terms of the transaction. As with the merger proxy, if both
companies are public, they jointly file the S-4 with the SEC. However, if only the
acquirer is public, then only it must file.
Example
The acquisition of Whole Foods by Amazon was closed via a one-step merger.
Amazon and Whole Foods (which were both public companies at the time)
jointly filed a proxy statement, and Whole Foods’ shareholders voted on the
transaction. Because Amazon financed the purchase by issuing private debt,
an S-4 was not required. If instead public debt (or equity) had been issued,
Amazon and Whole Foods would have jointly filed an S-4 registration.
Both the proxy statement and S-4 are subject to review and commentary by the
SEC. Therefore, depending on the size and complexity of the transaction as well as
the nature of the SEC’s comments, a one-step merger process can take anywhere
from several weeks to several months from start to finish.
Below is the cover page of CVS Health’s S-4 from its purchase of Aetna. The terms
of this merger are reviewed later in this chapter.
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Knopman Note:
Q: What filings are associated with a one-step merger?
A: The issuer (acquirer) files a merger proxy with the SEC
consisting of both a preliminary proxy (PREM14A) and a
definitive proxy (DEFM14A). A preliminary proxy is always
required in the case of a merger because it is an extraordinary
corporate event.
Q: Who prepares the proxy statements?
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A: The proxy statements will usually be jointly prepared and filed
with the SEC by the target and acquirer. Deals in which one
of the parties is a private company are an exception. In this
scenario, only the public company would prepare and submit
the proxy with the SEC.
Q: When will the proxy include pro forma financials?
A: If the deal involves stock consideration, the proxy will include
pro forma (i.e., combined) financials. If the deal is all cash, pro
forma financials are not required.
Q: What triggers the filing of an S-4 registration statement?
A: If a deal involves stock (or issuance of public debt), the two
companies file a joint prospectus on an SEC Form S-4 to register
the securities. This registration statement details the terms
of the transaction. If a public company is acquiring a private
company by issuing stock, the public company files an S-4 to
register the shares.
Q: Who signs the S-4?
A: An S-4 registration statement must be signed by the acquirer’s
CEO, CFO, controller, and majority of the board. If it is a foreign
corporation, the signature of its authorized US representative is
also required.
Q: What regulation covers the documentation and filings
governing mergers and acquisitions?
A: Regulation M-A simplifies and integrates the various disclosure
requirements for tender offers, going-private transactions,
exchange offers, and other extraordinary corporate
transactions, including what is disclosed in an S-4.
Q: What happens after the DEFM14A is sent to shareholders?
A: Target shareholders vote to accept or reject the deal. Generally,
only target company shareholders vote on whether to accept or
reject a deal, not acquirer company shareholders.
Q: What rights do dissenting shareholders have?
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A: Shareholders who vote against a merger can request appraisal
rights through a court to ensure the company is being sold for
a fair value. This would be done after the shareholder vote and
would be requested by shareholders who voted against the deal.
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Q: Between signing a DA and closing the deal, what’s required of a
firm that issues communications relating to the deal?
A: During the period between signing the DA and closing the
deal, any communications relating to the deal are deemed
“prospectuses” and must be filed with the SEC no later than the
date of first use. Note that only public companies are required
to make these filings.
6.5.2.2 Two-Step Merger
As mentioned above, closing via a one-step merger can potentially take several
months, making it an extended process. An alternative is a two-step merger, also
referred to as a two-step tender offer. If successful, it is generally less time-consuming because it avoids proxy filings and a shareholder vote.
Knopman Note: A two-step merger would allow an acquirer to close a
deal the fastest because, if successful, it avoids a shareholder vote.
Step one is a tender offer, which means the acquirer will look to purchase the
stock directly from the target company’s shareholders per the terms established
in the definitive agreement. The goal of the tender is to entice at least 90% of the
target’s shareholders to sell their shares. Once the acquirer hits the 90% threshold, it can initiate step two, which is a squeeze out (i.e., short-form merger). In
the squeeze out, the acquirer can force any remaining shareholders to sell their
shares at the same price as those who previously tendered.
Typically, in a two-step merger, the acquirer qualifies the tender with a minimum number of acceptable shares (e.g., 50.1% or 90%) to avoid winding up with
a non-majority stake in the target. This means that if the threshold is not met,
any tendered shares will be returned to the selling shareholders.
Knopman Note: To ensure the buyer will acquire a majority or
supermajority ownership stake, tender offers are often qualified (i.e.,
contingent) on sufficient acceptances. This ensures that the buyer will
not end up with a noncontrolling stake in the business.
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Additionally, if less than 90% of the target’s shares are acquired, the purchaser
will not be able to initiate a squeeze out. In this situation, in order to close the
merger, the acquirer would need to transition to a one-step merger, which would
extend the process even further.
Generally, two-step mergers are executed by acquirers who have cash on hand to
finance the purchase as opposed to those who need to issue public securities to
do so. Cash buyers are best able to take advantage of the quicker tender process
without having to worry about the potential for a lengthy SEC review of an S-4
registration. A successful two-step merger can be completed in as little as five
weeks. The details of tender offers will be discussed in greater detail in Chapter 13.
Knopman Note:
Q: Who votes on a deal closing in a two-step merger?
A: Trick question! In a two-step merger, shareholders of the target
company do not actually vote on the deal. Rather, the acquirer
offers to purchase the target company shares directly from
target company shareholders via a tender offer.
Q: Who files a proxy statement in a two-step merger?
A: Another trick! In the two-step there is no vote, so there is also no
proxy statement. In a two-step, the acquirer will file a Schedule
TO. Described differently, a tender offer and proxy statement
are mutually exclusive.
Q: What are the two steps in a two-step merger?
A: The two steps are:
1. The tender offer is the first step of the two-step merger.
2. The second step is to squeeze out any remaining
shareholders (those who did not tender) with a short-form
merger agreement.
Q: When can an acquiring firm execute a short-form merger (i.e., a
squeeze-out)?
A: A short-form merger can be accomplished once a specific
number of shares, usually 90%, is acquired. The result of the
squeeze-out is that all remaining shareholders are forced to sell
their shares.
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Q: What is a risk of the two-step merger?
A: One disadvantage of a two-step merger is that the acquirer
might not receive the desired number of shares—such as 90%
to execute a short-form merger, or 50% to maintain a majority
of the shares. To avoid this, the acquirer might specify a
minimum number of shares (e.g., 50% of the company) that
must be tendered by shareholders for the tender to close. This
ensures that the purchaser does not inadvertently purchase a
noncontrolling stake.
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Q: What are the rules surrounding executives participating
(selling) in the tender and also receiving employment at the
merged companies?
A: All shareholders of the target are required to receive the exact
same terms (e.g., price) for their tendered shares. However,
compensatory arrangements, such as employment contracts
or severance packages, are exempted from the best-price rule
calculation. Therefore, the target’s executives (e.g., CEO) can
personally tender shares and also receive an employment
contract from the new company. To further ensure that they are
not violating the best-price rules, companies can rely on an SEC
safe harbor, which allows for either the acquirer’s or target’s
compensation committee to approve of the compensatory
arrangement.
6.5.2.3 Acquirer Shareholder Approval
In some scenarios, the acquirer’s shareholders will need to vote to approve of the
merger. If the consideration is cash, whether cash on hand or financed through
debt, the acquirer’s shareholders do not get to vote. This is because a cash transaction is considered an operational decision by the purchaser. However, in a stock
transaction, the acquirer’s shareholders will get to vote if the number of outstanding shares increases by at least 20% due to the dilutive nature of the transaction.
Example
In 2017, CVS agreed to purchase the health-care company Aetna for a mix
of cash and stock consideration. The companies decided to do a one-step
merger, which means that CVS and Aetna jointly filed a proxy statement and
Aetna’s shareholders voted on the deal. Additionally, because CVS was issuing
public stock to finance the acquisition, CVS and Aetna jointly filed an S-4 to
register the shares.
To finance the merger, CVS issued approximately 280 million new shares to
Aetna shareholders. Given that CVS had approximately 1.01 billion shares outstanding prior to the merger, the transaction was 20% dilutive to the shareholders of CVS, which meant that they also had to vote to approve the merger.
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Knopman Note:
Q: When do the shareholders of the acquiring firm get to vote on a
merger?
A: Acquirer company shareholders will vote on a stock deal only if
the number of new shares issued by the acquirer will increase
the number of outstanding shares by 20% or more.
This means that, if post-deal the new share count is 1.2× or more
than the old shares outstanding, the acquirer’s shareholders
will vote. Put differently, if it is an all-cash deal, or if the deal
increases the outstanding shares by less than 20%, it is deemed
an operational decision on which the acquirer’s shareholders
will not get to vote.
6.5.3 Bring-Down Due Diligence and Closing
Once the definitive agreement is signed, in addition to obtaining regulatory and
shareholder approvals, the acquirer will begin to shore up its financing for the
purchase, if necessary. Although the definitive agreement typically provides evidence that the acquirer can obtain financing, the purchaser does not actually
need it finalized and in place until the closing date of the transaction.
Knopman Note: If the acquirer wants to ensure it has sufficient cash on
hand for acquisitions, an adviser would suggest an underwritten loan.
A best efforts deal (an underwriting agreement in which underwriters
attempt to sell all securities but have no obligation to buy unsold
shares) would not ensure that the company could have the cash it
wants.
Once regulatory approval, shareholder approval, and financing is obtained, the
two companies will meet to close the merger. One final step prior to closing is
bring-down due diligence. The purpose of this is a final review to ensure that
no material changes have occurred since the signing of the definitive agreement
and that nothing has caused the target to fall out of good standing. Best-case
scenario is that in fact nothing has changed and bring-down due diligence is just
a formality, while worst-case scenario is that drastic changes have occurred and
the transaction falls apart at the very end.
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Knopman Note:
Q: What is one of the final steps before closing?
A: The pre-closing review of the reps and warranties is referred
to as bring-down due diligence. This final review is important
because there is typically a delay between the signing of the
definitive agreement and closing—to, for example, obtain
regulatory HSR approval. Bring-down due diligence is executed
to confirm that there have not been any recent changes to the
features and characteristics of the deal. If the bring-down
due diligence reveals reps or warranties are no longer true or
accurate, the deal can be terminated without breaching the
definitive agreement. In the best-case scenario, bring-down
due diligence is a formality and the transaction can proceed to
closing.
Chapter 6
Mergers and
Acquisitions
At closing, legal title transfers from the seller to the acquirer and the purchaser
takes official ownership of the target company.
Knopman Note: If a US company is acquired and payment is made in
a foreign currency, e.g., euros, the US company would want a strong
euro so that it could exchange each euro for more US dollars.
Knopman Note: Post-closing, an adviser will generally memorialize
a deal by maintaining most documents in a deal file. The deal file
generally includes the definitive agreement and a comfort letter from
an auditor. It does not generally include any draft prospectuses.
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Chapter 6
Mergers and
Acquisitions
6.6 M&A Overview
It is important to understand the order and purpose of the documents used in
the M&A process. The M&A timeline is set forth below:
M&A Timeline
Preparation and First Round
Engagement Letter
Teaser
(produced by sell-side adviser)
Confidentiality Agreement
Discloses fees that the advisory firm is receiving for its work
One- to two-page document providing investment highlights
and basic information about the target
Legal agreement describing how information disclosed in the sale
process can be used
Confidential Information
Memorandum (CIM)
AKA: information memorandum,
detailed memorandum, or
descriptive memorandum
50- to 60-page document providing significant information
about the target, its industry, and investment opportunity
(produced by sell-side adviser)
Initial Procedures Letter
First-Round Bids
AKA: indication of interest (IOI),
statement of interest (SOI), or letter
of intent (LOI)
Instructions for submitting first-round bids
The first-round bid is a non-binding bid, subject to significant
additional due diligence
Evaluation of first-round bids by seller and professional advisers
Start of Second Round
Due Diligence
• Management presentations
• Site visits
• Data room access
Management presentations: Seller management and professionals
(bankers) present the merits of the opportunity
Site visits: Bidders visit the target’s facilities, offices, or factories
Data room access: Bidders review detailed information about all
aspects of the target
Distribute Final Bid Procedures Letter Seller and its professionals distribute the procedures to submit
and Draft Definitive Agreement
final bids
Receive Final Bids
Bidders submit final bids
Fairness Opinions
The seller’s board of directors will commission a fairness opinion
to ensure the selected winning bid is fair to shareholders and
provide comfort that the board has met its fiduciary duties
Sign DA
Regulatory Approval (if required)
Bring-Down Due Diligence
Close
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Sign the definitive agreement memorializing the sale; proceed
toward closing
HSR approval, state approval, etc.
Final diligence to confirm that nothing material has changed
between signing and closing
One-step merger; two-step merger; tender, etc.
Chapter 6: Mergers and Acquisitions
Unit Exam
1. All of the following are typically provided
access to the data room except:
A.
B.
C.
D.
I. Site visits
II. Distribution and mark-up of the
definitive agreement
III. Management presentation
IV. Data room analysis and review
Buyer functional specialists
Buy-side advisers
Acquisition financing underwriters
Buyer’s largest institutional shareholders
2. At what stage in the M&A process do buyers
start to line up financing sources?
A. In conjunction with formulating firstround bids
B. After being selected to enter the second
round
C. In conjunction with marking up the
definitive agreement
D. After the signing of the definitive
agreement
3. Which of the following do buyers typically plan
on bringing with them to the management
presentation for a given target?
I. Outside legal counsel
II. Operating partners
III. Investment bankers
IV. Auditors
A.
B.
C.
D.
4. Which of the following are key components of
the second round of a traditional auction?
I and III
I and IV
II and III
II and IV
A.
B.
C.
D.
I and III only
I, II, and III only
I, II, and IV only
I, II, III, and IV
5. Which of the following are often heavily
negotiated in a confidentiality agreement
between two corporations?
I. Initial bid date
II. Length of term
III. Indicative purchase price
IV. Non-solicitation
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
6. Why do sellers hire an investment bank?
I. Design and execute key process points
II. Alleviate burden from company
management
III. Legal comfort for the board
IV. Maximize value received
A.
B.
C.
D.
I and IV
II and IV
I, III, and IV
I, II, III, and IV
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Chapter 6: Mergers and Acquisitions
Unit Exam (Continued)
7. Under what circumstances can a buyer
withdraw from a sale process after it has
submitted a first-round bid?
A. At any time with no approvals necessary
B. With written approval from the seller
C. When proof of change in financing
conditions or other buyer circumstances
is provided
D. With approval from the SEC or other
appropriate local finance authority
8. The typical CIM contains all of the following
except:
A. Target financial projections and MD&A
B. Information on target’s industry and
competitive dynamics
C. Investment highlights
D. Preliminary valuation analysis of the
target
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9. Within the context of M&A processes, what
does a negotiated sale refer to?
A. A long-term, highly negotiated sale from a
key vendor
B. A large volume sale to an important
customer prior to deal closing
C. A sale process in which the seller
negotiates a definitive agreement with
multiple bona fide parties
D. A sale process centered on a direct
dialogue with a single prospective buyer
10. Which of the following is a legally binding
contract between the target and each
prospective buyer that governs the sharing of
nonpublic company information?
A.
B.
C.
D.
Confidentiality agreement
Engagement letter
Private placement memorandum
Private member offering
Chapter 6: Mergers and Acquisitions
Unit Exam—Solutions
1.
(D)
In conjunction with the management presentation and site visits, prospective buyers
are provided access to the data room, which contains detailed information about
all aspects of the target. Serious bidders dedicate significant resources to ensure their
due diligence is as thorough as possible, often enlisting a full team of advisers,
accountants, attorneys, consultants, and other functional specialists to help review
the data. Prospective providers of acquisition financing also need data-room access
in order to perform due diligence and gain sufficient comfort to provide a financing
commitment. The acquirer’s institutional shareholders, however, do not participate in
due diligence and therefore are not provided data-room access. Institutional
shareholders’ interests are represented by the board of directors or directly at the
shareholders’ meeting.
2. (A)
Potential buyers look to line up financing sources and get a read on financing terms as
early as possible in the process. This is important as buyers frame their first-round
bids. For financial sponsors, the basic terms of the staple are typically communicated
verbally to buyers in advance of the first-round bid date so they can use that
information to help frame their bids. Staple term sheets and/or actual financing
commitments, however, are not provided until later in the auction’s second round, prior
to submission of final bids.
3. (C)
Buyers typically bring their financial advisers (both M&A and financing providers) from
an investment bank (or banks) as well as operating partners to the management
presentation. It is important for these constituents to participate so as to gain as
deep an understanding of the target as possible from a business and financial due
diligence perspective. For financing providers, this is an essential component of due
diligence. Outside legal counsel and auditors typically do not need to participate in
the management presentation. However, they will become deeply involved in the
process if the prospective buyer decides to perform confirmatory due diligence, mark
up a definitive agreement, and submit a final bid.
4. (D)
The auction’s second round centers on facilitating the prospective buyers’ ability to
conduct detailed due diligence and analysis so potential buyers can submit strong,
binding bids. The second-round diligence process starts with the management
presentation, followed by site visits and deep analysis of the data-room contents (not
necessarily in that order). Toward the end, the buyer(s) submits a mark-up of the
definitive agreement.
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Chapter 6: Mergers and Acquisitions
Unit Exam—Solutions (Continued)
5. (D)
A confidentiality agreement (CA) is a legal contract between the target and each
prospective buyer that governs the sharing of confidential company information.
Length of term, which designates the period during which the confidentiality
restrictions remain in effect, is often heavily negotiated. Sellers typically want the
confidentiality term to be as long as possible while buyers seek to minimize it. The
non-solicitation (or no-hire) provision prevents prospective buyers from soliciting to
hire (or hiring) target employees for a designated time period. This is often a highly
sensitive topic, as sellers seek to prevent buyers from hiring away their employees after
the sharing of confidential information and during a sensitive time for the company
(i.e., during a sale process). Indicative purchase price and initial bid date are not
addressed in the CA.
6. (D)
The seller typically hires an investment bank and its team of trained professionals to
ensure that key objectives are met and a favorable result is achieved.
(A)
A buyer can withdraw from a sale process at any time under any circumstances and
without providing a cause. The only risk is reputational. Similarly, the seller can cancel
the sale process at any time.
8. (D)
The CIM is a detailed written description of the target (often 50+ pages) that serves
as the primary marketing document for the target in an auction. The information
provided is designed to be sufficiently comprehensive for potential buyers to craft
first-round bids. A preliminary valuation analysis of the target is not typically included
in the CIM—this is work to be performed by the prospective buyer and its advisers, not
the target.
9. (D)
In contrast to an auction, a negotiated sale centers on a direct dialogue with a single
prospective buyer.
10. (A)
The CA is typically distributed to prospective investors along with the teaser, with the
understanding that the receipt of more detailed information is conditioned on
execution of the CA.
7.
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Section 2
Capital Markets Activities
When a client decides to raise capital, it is the responsibility of investment
bankers to understand the different types of mechanisms through which
this can be done. By accessing the clients of a broker-dealer, an investment
banker can execute an effective capital-raising process for a business. This
section will review the process of selling a company’s securities through an
SEC-registered offering, or through a number of exempt transactions.
Chapter 7: Preparing the Prospectus
Chapter 8: Reporting Requirements Under the Securities
Exchange Act of 1934
Chapter 9: Syndication of Securities Offerings
Chapter 10: Syndicate Settlement and Regulations
Chapter 11: Private Placements
Chapter 12: Exempt Transactions
Chapter 13: Tender Offers
7. Preparing the Prospectus
The Securities Act of 1933 (the ’33 Act) is the cornerstone of federal laws for offering securities to the public. The ’33 Act protects investors by requiring the registration of securities offerings with the SEC. Anytime a company is raising capital,
it is participating in the primary market. This unit will review the following concepts related to the registration and sale of securities:
◆ Prospectus preparation and submission
◆ Free writing prospectuses
◆ Liability for misleading information
7.1 Requirements of the Securities Act of 1933
Under Section 5 of the ’33 Act, it is a felony to use any means of transportation or
communication in interstate commerce to offer or sell unregistered securities,
unless an exemption applies. Offers can be made through many media, including
mail, phone, email, or advertising.
The SEC has held that even general or preliminary solicitations can violate the
’33 Act. For example, suppose a broker sends a letter to several investors asking whether they are interested in a proposed stock offering of ABC Company,
described in general terms, before an offering is registered. This is a violation.
Knopman Note: A promissory note is a short- to medium-term loan.
Depending on the method of sale, it may be considered a security and
therefore require SEC registration for lawful public sale. Note that if
a promissory note has more than 270 days to maturity and is being
sold in a manner similar to how bonds are sold, such as to securities
investors or in a block trade, then it would likely be considered a
security. If, on the other hand, it has less than 270 days to maturity and
is not purchased in a security-like transaction, then it would likely not
be considered a security.
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Chapter 7
Preparing the
Prospectus
7.1.1 Submitting the Registration Statement
Section 7 of the ’33 Act defines the information that must be included in a registration statement, including:
◆ The identity, address, and jurisdiction (state or country) of the issuer and
a description of the issuer’s business
◆ The names and addresses of the issuer’s chief executive, financial and
accounting officers, and directors
◆ The names and addresses of the underwriters and legal counsel involved
◆ The names and addresses of owners of more than 10% of any class of
stock of the issuer, and financial stakes held by directors and officers
(“affiliates”) of the issuer
◆ A capitalization table of the issuer, including the amount of capital stock
of each class included in the offering
◆ Securities covered by options that are outstanding, or created in
connection with the offering, and owners of more than 10% of such
options
◆ A description of the funded debt of the issuer
◆ The estimated net proceeds and the use of the proceeds, for funds raised
in the securities offering
◆ Recent certified financial statements of the issuer
◆ Copies of the underwriting agreement and legal opinion of counsel in
regard to the offering
Knopman Note:
Q: What must be included in the registration statement?
A: The filing of a registration statement must include a list of
underwriters.
Q: What information can be omitted in a registration statement
and subsequently filed via amendment?
A: Timely details of the offering, such as the price, total deal size,
and gross spread, may be omitted in the initial registration
statement and be filed in subsequent amendments.
When professional advisers prepare or certify valuations, opinions, or statements
included in the registration, their written consent must also be included in the
registration.
In addition to the explicit content requirements, issuers are required to disclose
“material information” that could influence an investor’s evaluation of the issuer
or security. This includes business risk, market risk, and insurance needs.
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Knopman Note: A company could choose to proceed with a new issue
even if there were a negative material event just prior to the deal (e.g.,
customer death due to products), but the material event should be
disclosed in the registration statement and prospectus.
Chapter 7
Preparing the
Prospectus
Special attention should be given to the type of insurance a company purchases
in the event of adverse market conditions or a natural disaster. For example, a
company residing in the Gulf of Mexico region might purchase hurricane insurance to rebuild any damaged or destroyed facilities. However, to insure against
any lost revenue during the rebuilding period, the company would also need to
have purchased business interruption insurance.
Knopman Note: A capitalization table details the investments in a
company. It would show investments in common equity, straight and
convertible preferred stock, unsecured bonds, and secured bonds.
Q: What is not found in a cap table?
A: Typically, a capitalization table does not include commercial
paper.
7.1.2 Deficiencies in the Registration Filing
After a review of the registration filing, the SEC may issue a deficiency letter
addressing any omitted or incomplete information. The registration will not be
in effect until deficiencies are corrected. If the registration contains material
misstatements or omissions, the issuer can be held liable for civil claims.
Underwriters can also be held civilly liable if their due diligence process is
incomplete or faulty since the purpose of underwriter due diligence is to verify
that all material information included in the filing is accurate and complete.
Corporate officers and underwriters are required to sign off on the final registration statement.
If a banker determines that information in a registration is potentially misleading or inaccurate, the typical course of action is to identify it as such (often to
legal counsel) so that it can be corrected. A banker would not typically suggest
the issuer take action so that the statement becomes true. To continue with
the example of the issuer with hurricane insurance, if a registration statement
indicated the issuer’s hurricane insurance provided coverage in ways that it did
not, the registration statement should be modified to make the filing accurate, as
opposed to the banker suggesting the issuer purchase the business interruption
insurance policy.
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Chapter 7
Preparing the
Prospectus
7.1.3 Non-Financial Statement Content of Registration
Regulation S-K contains instructions for filing forms under the ’33 Act and
also under the Securities Exchange Act of 1934 (the ’34 Act). The regulation provides guidance on the use of projections and ratings included in registration
statements.
An issuer may make a good faith assessment projection of the company’s
future performance, even if the company lacks extensive history or experience.
An independent review may be included to establish a reasonable basis for the
projections.
The issuer can include multiple projections or a range of projected results, as long
as they are not misleading.
Ratings may be included for offerings of debt, convertible debt, and preferred stock.
The name and classification system of the rating agency should be explained, and
the issuer must include any rating made by a Nationally Recognized Statistical
Rating Organization (NRSRO) that is materially different.
7.1.4 Financial Statements Included with Registration
Regulation S-X addresses the form and content of financial statements included
in the registration statement.
Regulation S-X rules require that financial statements be prepared and attested
to by auditors who are qualified and independent. Statements not prepared
according to generally accepted accounting principles (GAAP) are presumed to
be misleading or inaccurate. A registration statement must include:
◆ Audited balance sheets for the two most recent fiscal years, unless the
company lacks two years of operating history
◆ Audited statements of income and cash flows for the three most
recent fiscal years, unless the company lacks such history
◆ Pro forma financial information if a “significant business
combination” or disposition has occurred during a period for which a
balance sheet is required
Information in a public prospectus must be clear, concise, and descriptive. It
must be drafted using short sentences and concrete “everyday words,” avoiding
legal jargon, highly technical terms, and multiple negatives. When highly technical terms are integral to an issuer’s business—as may be the case for some tech
companies—it is advisable to include a glossary defining such terms.
The SEC requires that any prospectus older than nine months not have any financial information older than 16 months. That is, an amended prospectus must
be filed after 1) the prospectus is nine months old and 2) the financials in that
prospectus are more than 16 months old. Typographical errors would not require
an amended prospectus to be filed.
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A prospectus supplement filed to update financials would not supersede the
original prospectus. The original prospectus would remain in effect and would
still need to be delivered to investors along with the supplement.
Chapter 7
Preparing the
Prospectus
7.1.5 Forms of Registration Statements
The SEC has adopted standard forms for filing registration statements. All of the
following forms can be electronically submitted through the SEC’s Electronic
Data-Gathering, Analysis, and Retrieval (EDGAR) system.
◆ Form S-1 is the general form that may be used for all newly issued
securities under the ’33 Act. IPOs are always registered on a
Form S-1.
◆ Form S-3 is a streamlined “short form” registration statement that
may be used as an alternative to Form S-1. It is often used for follow-on
offerings.
To qualify for an S-3 filing, an issuer must:
• Have a class of common stock listed on a national securities
exchange
• Be a seasoned issuer (defined shortly)
• Have made all required SEC filings for at least 12 months, and
• Not have sold more than one-third of its public float over the
previous 12 calendar months
Public float refers to common shares held by the public, and not by
insiders, such as officers, directors, or shareholders with 10% voting
interest. To calculate an issuer’s public float, it is necessary to know
1) the total number of shares outstanding and 2) the total number of
shares owned by insiders. The public float is the outstanding shares
minus the shares owned by insiders.
(Public float is distinct from market capitalization, which
encompasses all outstanding shares.)
Form F-3 is a comparable form used by foreign issuers.
◆ Form S-4 is a registration statement used in a merger, an acquisition, or
an exchange offer.
◆ Form S-8 is a registration statement filed in an offering of securities to
company employees through an employee benefit plan.
◆ Form S-11 is a registration statement filed in an offering of real estate
investment companies, including REITs.
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Chapter 7
Preparing the
Prospectus
Knopman Note: Be sure to review the various terms that describe an
issuer’s shares.
Q: What is required to calculate a company’s public float?
A: To calculate a company’s public float percentage, it is necessary
to know 1) the total number of shares outstanding and 2) the
total number of shares owned by insiders.
Public Float = Outstanding Shares − Shares Owned by Insiders
Q: Can a company issue public stock and still have unregistered
shares held by the founder, the CEO, or other early investors?
A: Yes. Insiders may continue to hold unregistered shares following
a public offering. These shares are considered outstanding
shares, but are not part of the public float. The term public float
refers to the number of shares available to trade.
Q: What happens to a company’s public float when convertible
bonds are converted into common stock by investors?
A: The company’s public float will increase upon conversion.
7.2 Categories of Issuers
In 2005, the SEC adopted major securities offering reform legislation to streamline the registration process for larger issuers. As part of this legislation, it defined
a number of different classes of issuers.
7.2.1 Well-Known Seasoned Issuers
A well-known seasoned issuer (WKSI) is defined as an issuer that is eligible
to use Form S-3 (F-3 for foreign issuers) and also meets one of the following
requirements:
◆ Has a worldwide stock market capitalization held by non-affiliates (i.e.,
public float) of $700 million or more, or
◆ Has issued, over the past three years, at least $1 billion of non-convertible
securities (other than common equity) in primary offerings for cash
A company must also have been subject to the filing requirements of the ’34 Act
(e.g., 10-Ks, 10-Qs) for at least one year to be a WKSI.
Asset-backed securities issuers, registered investment companies, and business
development companies are excluded from the definition of WKSIs.
Eligibility for WKSI status is determined at the time of an issuer’s most recent
annual report (10-K). For shelf registration filers (discussed later), the determination is made at the time of the most recent filing or amendment.
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Knopman Note: WKSI status requires meeting the $700 million
market cap within 60 days of the company’s most recent registration
statement or 10K filing.
Chapter 7
Preparing the
Prospectus
To meet the $700 million market cap threshold, a company combines the total
of all outstanding classes of voting and non-voting common equity worldwide
and then subtracts the value of voting and non-voting common equity held by
its affiliates.
Example
ABC Company has $1.2 billion of worldwide common equity, of which $400
million is held by affiliates. Its public float is therefore $800 million ($1.2 billion minus $400 million), which qualifies ABC as a WKSI because it meets the
$700 million public equity test.
Knopman Note:
Q: Who can never qualify as a WKSI?
A: These entities cannot qualify as WKSIs:
1. Investment companies (e.g., mutual funds)
2. Business development companies
For example, mutual fund companies, unit investment trusts, and
closed-end fund companies are never WKSIs.
Q: Can convertible bonds be included when determining whether
a company is a WKSI?
A: No, convertible bonds do not count for either the $700MM
equity test or the $1bn debt test.
7.2.2 Seasoned Issuers
A seasoned issuer is an issuer that is eligible to use Form S-3 and meets the
transaction requirements for an S-3 filing for primary offerings (F-3 for foreign
issuers). A seasoned issuer must have a worldwide non-affiliate market capitalization of at least $75 million. As with WKSIs, a seasoned issuer must also have
been an SEC filer for at least the previous year.
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Chapter 7
Preparing the
Prospectus
7.2.3 Unseasoned Issuers
Unseasoned issuers are those that are subject to SEC reporting requirements,
but are not eligible to use Form S-3 (or F-3) for primary offerings. For example,
an SEC filer with less than $75 million in worldwide non-affiliate market capitalization would be an unseasoned issuer.
7.2.4 Ineligible Issuers
Ineligible issuers are issuers that are not current in filing SEC-required reports,
or may have filed for bankruptcy or insolvency during the previous three years.
They also include “blank check companies,” shell companies, and penny stock
issuers.
Knopman Note: A company that filed for bankruptcy within the past
three years is an ineligible issuer and therefore is not a WKSI. Note
that once three years have elapsed, the company could qualify as a
WKSI (e.g., a company in bankruptcy four years ago can be a WKSI).
A blank check company is a development-stage company with no specific business plan or purpose, or one that has indicated its business plan is to acquire
another company in the future. Special purpose acquisition companies (SPACs)
and business development companies (BDCs) are examples of blank check
companies.
Knopman Note: A special purpose acquisition company (SPAC) is a
type of blank check company that raised money in a public offering to
eventually acquire another company. SPACs typically must complete
an acquisition within 18-24 months and invest at least 80% of its net
assets for any such acquisition. If it fails to do so, then it must dissolve
and return capital to investors.
7.2.5 Non-Reporting Issuers
Non-reporting issuers are not required to file reports under the Securities
Exchange Act of 1934. An example of a non-reporting issuer is a private company
in the process of registering an IPO.
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Knopman Note:
Q: What can cause a WKSI to lose its status and become an
ineligible issuer?
Chapter 7
Preparing the
Prospectus
A: A WKSI loses its WKSI status and becomes ineligible if it:
• Is not current and timely in filing Exchange Act reports (10Ks, 10-Qs, etc.)
• Has filed for bankruptcy in the past three years
• Violated any federal securities law (Act of ’33 or ’34) antifraud provisions within the past three years, or
• Is a shell company (i.e., blank check company)
Q: What does not result in the loss of WKSI status?
A: The fact that a company has securities that trade on a foreign
exchange does not disqualify a company from WKSI status.
7.3 Effectiveness of Registration
The ’33 Act and related rules generally require a registration to be effective before
communications may begin with the investing public.
On April 15, 2011, the Jumpstart Our Business Startups Act, or JOBS Act, was
signed into law. The purpose of the JOBS Act is to ease a number of federal securities regulations for small issuers, permitting them to raise capital in a more
timely and cost-efficient manner. Of key importance as it relates to the Series 79
is the creation of an Emerging Growth Company (EGC). An Emerging Growth
Company is a company that had annual gross revenues of less than $1 billion
during its most recent fiscal year. A company will retain EGC status until the
earliest of:
◆ The first fiscal year after its revenues reach, or exceed, $1 billion
◆ The first fiscal year following the fifth anniversary of its IPO
◆ The date on which the company has, during the previous three years,
issued more than $1 billion in non-convertible debt, or
◆ The date on which the company becomes a “large accelerated filer”
(discussed in Chapter 8)
EGCs are afforded a number of exceptions from certain registration and equity
research requirements. These exceptions will be discussed in the appropriate
sections throughout a number of upcoming chapters.
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Chapter 7
Preparing the
Prospectus
7.3.1 Pre-Filing Period
The time during which an offer is being evaluated by issuers and underwriters,
prior to the filing of the registration, is called the pre-filing period. No offer to
sell securities is permitted during the pre-filing period. An offer to sell, for this
purpose, includes “conditioning the public or arousing public interest,” otherwise
known as gun-jumping. Issuers may continue to release normal communications during this period, provided they do not discuss the offer. A pre-filing press
release in prescribed format is permitted.
Issuers should exercise great care over any speeches or presentations made by
management during the pre-filing period. Such communications should not
mention an offering and should avoid any projections that might be considered
gun-jumping.
Knopman Note:
Q: When would an issuer begin to carefully monitor
communications to avoid any gun-jumping allegations?
A: Within 30 days prior to filing a registration statement, issuers
must use care to avoid disclosing any information that could be
seen as gun-jumping. For example, an issuer should not publish
a press release disclosing financial information within this
30-day period.
An exception from prohibitions on pre-filing communications is available for
Emerging Growth Companies. EGCs are permitted to “test the waters,” or gauge
investor interest, by communicating with qualified institutional buyers (QIBs,
discussed in Chapter 12) or other institutional investors. This exception permits
smaller companies to gain a sense of investor interest for their potential IPOs.
EGCs may also confidentially file a draft registration statement with the SEC. The
SEC will then undertake a confidential, nonpublic review and provide the issuer
with comments and requests for additional information. The public registration
statement must subsequently be filed with the SEC at least 21 days prior to commencement of a road show.
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7.3.2 Cooling-Off Period
The time from the filing of the registration statement until the SEC declares the
registration effective is considered a waiting period or cooling-off period.
During this period, two events are simultaneously taking place: the SEC is reviewing the filings for adequate disclosures as required under securities law, and separately, the bankers are determining market interest and a potential price for the
new shares. The bankers, the issuer, and related parties, however, are limited in
promoting the sale of the securities to the public with written materials. Written
communications with investors are limited to:
Chapter 7
Preparing the
Prospectus
◆ A preliminary prospectus (“red herring”)
◆ A tombstone ad or limited press release in prescribed format
◆ Road show presentations
Knopman Note: When an investment banker is conducting due
diligence on a potential issuer, they would care more that the
company is well received by investors as compared to the media.
During this period, the syndicate is not permitted to provide any written materials to investors unless they contain all required prospectus disclosures. In recent
years, the SEC has loosened these rules by allowing the distribution of a free
writing prospectus (discussed shortly).
Knopman Note: A preliminary prospectus (red herring) will not
contain the offering price, though it may contain a range of potential
prices.
Once the bankers have gauged investors’ interest in the new shares and determined the best price, the underwriter will request acceleration of the effective
date from the SEC. Requesting acceleration is common given the efficiencies of
distributing information now as compared to in 1933 when the act was adopted.
If the SEC is satisfied that adequate and necessary disclosures have been made,
the registration statement will be declared effective, and the shares can be lawfully sold to the public.
Knopman Note:
Q: What does the SEC do when an issuer requests acceleration?
A: When an issuer requests to accelerate a registration, the
SEC will review the document to ensure there is sufficient
information and all necessary disclosures have been made to
the public.
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7.3.3 Post-Effective Period
Immediately following the effective date is the post-effective period, during
which securities may be offered and sales completed. Communications with
investors generally are restricted to information contained in the prospectus. Any
material developments affecting the issuer during this period must be disclosed
in a post-effective date amendment to the prospectus, or sticker.
In a new issue, the final prospectus, with pricing and the number of shares, must
be filed with the SEC within 15 business days of the effective date.
Example
An underwriter prepares a preliminary prospectus with the expected offering price of $16–$20 per share. Based on investor response and a gauge of
market sentiment, the final offering price ends up at $15 per share—outside
the published range. The underwriter would submit a post-effective amendment on behalf of the issuer and affix a sticker to the prospectus noting the
actual offering price. The issuer is not required to submit a new registration
statement.
Knopman Note: Immediately following a company’s initial public
offering, its market capitalization can be calculated by multiplying the
shares outstanding by its IPO price.
7.3.4 Initial Public Offering (IPO) Timeline
Once a company has decided to go public, a typical IPO timeline might be: Bakeoff, mandate, file registration statement, book-building and marketing, SEC effectiveness, allocation, and distribution to investors.
Knopman Note: It is important to know the sequence of events in an
IPO.
Time Period
Events
Bake-off—Banks pitch investment banking services.
Pre-Registration
Period
Mandate—Issuer awards mandate to winning investment bank by signing an
engagement letter.
Registration statement (S-1), prospectus, and offering materials are prepared.
Due diligence of S-1 is conducted to ensure accurate, complete, and truthful
information.
Filing Date
File the registration statement (S-1) with the SEC
SEC reviews the registration statement for adequate disclosures.
Cooling-Off Period
(20 days)
Bankers conduct a road show and market the deal.
Investors give non-binding indications of interest (IOIs).
Issuer may request acceleration from the SEC.
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Effective Date
Post-Effective Date
The SEC declares the registration effective (The securities can now be lawfully sold)
Bankers confirm IOIs and allocate shares to investors.
Securities begin trading in the secondary market (NYSE or Nasdaq).
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Knopman Note:
Q: What would a prudent broker-dealer do prior to signing an
engagement letter to underwrite a new client’s IPO?
A: Before signing an engagement letter for an IPO, a broker-dealer
should confirm with the issuer’s accountant that the company’s
financials are accurate.
Q: Are all new issues subject to due diligence?
A: Absolutely. All new issues, even for WKSIs, are subject to due
diligence by an underwriter.
7.4 Shelf Registrations
A shelf registration allows an issuer to make an offer of securities on a delayed or
continuous basis, at various times and prices. This enables the issuer to pre-register securities and sell them once the market is favorable. The issuer files a registration statement, and when it believes the market will be receptive to the sale,
it takes the securities “off the shelf ” and offers them to the public.
Knopman Note: A shelf registration generally includes a plan of
distribution (e.g., how the securities will be offered for sale) as well
as the maximum aggregate dollar amount of securities that will be
offered.
Knopman Note: In a shelf registration, the offer price for the securities
will generally be found in a prospectus supplement that is delivered
at the time of sale. The price does not need to be in the “base”
prospectus, since that might be filed years before the shares are
“taken off the shelf.”
A company offering bonds using a shelf registration would include the
interest rate in the prospectus supplement.
In 2005, the SEC adopted rules to allow WKSIs to file a shelf registration that
becomes automatically effective without prior review by the SEC. This is referred
to as an automatic shelf registration (ASR). The purpose of an automatic shelf
registration is to streamline the offering process for the largest issuers that regularly submit SEC filings and are already widely owned by public investors.
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Knopman Note: One benefit of a WKSI is an automatic shelf
registration.
7.4.1 Refreshing Requirements
Refreshing requirements refer to how often an issuer is required to submit an
updated registration statement.
The refreshing requirements for shelf registrations are different for the various
classes of issuers.
7.4.1.1 Automatic Shelf Registration
Automatic shelf registrations (ASRs) may be offered only if no more than three
years have elapsed since the initial effective date of the registration. At any time
during this three-year period, the issuer may “refresh” the registration by re-filing
it in full, along with all required prospectus disclosures. This process starts a new
three-year period for automatic shelf registrations.
7.4.1.2 Non-Automatic Shelf Registration
Traditional shelf registrations may continue to be offered until a new registration
becomes effective, but not later than 180 days after the third anniversary of the
prior effective date.
When an issuer files a new registration statement, the calendar resets with
respect to the next deadline to file an updated registration statement.
Example
An issuer not eligible for an automatic shelf registration files an S-3 on January
1, 2012. This registration will remain valid until 180 days following the third
anniversary of the filing (approximately June 30, 2015). If the issuer chooses
to file a new registration statement before that date, the clock starts over.
7.5 Audit Requirements
The Securities Exchange Act of 1934 (Section 10A) imposes on public accounting
firms’ audit requirements designed to detect and report illegal acts, identify related-party transactions material to financial statements, and evaluate “substantial
doubt” about the issuer’s ability to continue as a going concern.
If the auditor determines that an illegal act is likely to have occurred, the first step
is for the accounting firm to report this to the issuer’s audit committee or board
of directors. The auditor must then follow up to determine whether remedial
actions have been taken. If not, the auditor must issue a report of conclusions to
the issuer’s board of directors.
The board must notify the SEC in writing within one business day of receipt of
this report, with a copy of the written notification sent to the auditing firm. If this
requirement is not met, the auditor must resign from the engagement and furnish
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the SEC with a copy of the report. Auditors who follow these requirements are
shielded from liability for civil actions taken by the issuer or its shareholders. The
SEC may impose civil penalties on auditors who fail to meet these requirements.
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Knopman Note: When financials are audited, the auditor may render
an unqualified opinion (good) or a qualified opinion (bad). An
unqualified opinion states the financials fairly reflect the client’s
financial results and position. The qualified opinion indicates the
audit may have been limited or certain information could not be
verified.
7.6 Free Writing Prospectus
The same 2005 rules that allowed automatic shelf registrations also created more
liberal prospectus requirements for WKSIs and other issuers by permitting the
distribution of a free writing prospectus. Under Rule 405 of the ’33 Act, a free
writing prospectus (FWP) is defined as any written communication that constitutes an offer to sell or an offer to buy securities relating to a registered offering.
In plain English, an FWP lets an issuer distribute written communications to
prospective investors in addition to the red herring. Examples include a sales
sheet or a press interview with the issuer’s CEO.
Knopman Note: Marketing emails sent to prospective investors are
FWPs.
Generally, free writing prospectuses are permitted only after a registration is filed.
An exception is made for WKSIs, which can publish a free writing prospectus at
any time.
A free writing prospectus may include information beyond the registration statement’s content, provided it does not conflict with that information. However, the
rules vary for different types of issuers.
Knopman Note: The information in an FWP cannot contradict the
content in a registration statement or red herring.
Though the rules from previous sections regarding pre-effective communications
with investors still apply, it may be helpful to think of an FWP as another exception to these rules.
Example
While marketing a new issue to investors, a CEO is interviewed for an article
in a local newspaper. This would be considered an FWP, thereby requiring the
issuer to file with the SEC.
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Knopman Note: FWPs must be filed with the SEC by issuers no later
than the date of first use.
7.6.1 FWPs for WKSIs
For well-known seasoned issuers (WKSIs), the free writing prospectus may be
used in shelf offerings registered on Form S-3. WKSIs can distribute an FWP
either before or after a registration statement has been filed (i.e., at any time).
Example
A WKSI files an ASR on April 1, 2010. On May 3, 2011, the issuer decides it
wants to raise capital with a follow-on offering of common stock. The issuer
is within the three-year window of the ASR and does not need to file a new
registration statement. The WKSI could publish an FWP to offer potential
investors updated financial statements since the financial statements in the
ASR filed on April 1, 2010, will be outdated.
Knopman Note: A WKSI might use an FWP to communicate
information about a follow-on offering prior to filing a registration
statement.
7.6.2 FWPs for Seasoned, Unseasoned, and Non-Reporting Issuers
Seasoned, unseasoned, and non-reporting issuers are permitted to distribute an
FWP only after a registration statement has been filed.
7.6.3 FWPs for Ineligible Issuers
Ineligible issuers are not permitted to prepare or distribute a free writing prospectus at any time.
7.6.4 Disclosures Required in an FWP
The free writing prospectus must contain a legend such as the following:
“The issuer has filed a registration statement (including a prospectus) with the
SEC for the offering to which this communication relates. Before you invest, you
should read the prospectus in that registration statement and other documents
the issuer has filed with the SEC for more complete information about the issuer
and this offering.”
The legend may contain instructions on downloading the prospectus and registration filing on EDGAR at www.SEC.gov or obtaining these documents from an
underwriter or a broker-dealer, with a contact phone number and/or an email
address.
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Knopman Note: It is important to be familiar with when different
issuers can use FWPs.
Pre-Registration
WKSIs
Cooling-Off
Post-Effective
WKSIs
WKSIs
Seasoned issuers
Seasoned issuers
Unseasoned issuers
Unseasoned issuers
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Note: Ineligible issuers can never use FWPs.
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Chapter 7: Preparing the Prospectus
Progress Check
1. Under Section 7 of the Securities Act of
1933, which TWO of the following types of
information must be included in a registration
statement?
I. Identity, address, and jurisdiction of
the issuer
II. The specific price of the offering
III. Capitalization of the issuer
IV. Certified financial statements of the
issuer’s CEO
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
2. If an accounting firm certifies a valuation of
corporate assets, the registration statement
must also contain:
A.
B.
C.
D.
The firm’s full and detailed methodology
The firm’s written consent
A copy of the firm’s credentials or licenses
Identities of the firm’s officers and
directors
3. ABC Corporation files a registration to go
public in an initial public offering. The SEC
then issues a deficiency letter to address
incomplete information. The effective date of
the offering will:
A. Not be affected by the deficiency letter
B. Be delayed a mandatory 21 days
C. Be delayed until the deficiencies are
addressed
D. Be specified in the deficiency letter
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4. An underwriter is preparing a registration
statement for an issuer’s IPO. The company
lacks extensive operating history or
performance, and the underwriter includes
its own “good faith assessment” regarding
projections of future performance. The
following are necessary for an independent
review of these projections to be included,
except:
A. The reviewer’s qualifications are disclosed
B. The reviewer’s relationship to the issuer is
disclosed
C. The reviewer’s consent is obtained
D. The reviewer is certified by the SEC
5. Under Regulation S-X, financial statements
included in registrations must be prepared and
“attested” by auditors who:
A. Are qualified and independent of their
clients’ interests
B. Are certified by the SEC
C. Meet minimum experience standards
D. Agree in writing to follow the standards of
Sarbanes–Oxley
Chapter 7: Preparing the Prospectus
Progress Check—Solutions
1.
(A)
Important material information about the issuer must be included in a registration
statement. The specific price of the offering is not required, and generally it is not
determined until after the registration statement has been filed. Certified financial
statements are required for the issuer, not senior management.
2. (B)
Written consent is required of professional advisers to confirm their recognition that
any valuations, opinions, or statements that they prepare or certify are being included
in the registration statement. These professionals may have responsibility or liability for
such comments when they are made as part of a registration statement.
3. (C)
The SEC will not allow an effective date to be set until any deficiencies in the
registration statement are addressed. The SEC must review the revised registration
statement, including any information added, to address the deficiency.
4. (D)
To evaluate a reviewer’s “independence,” a reader of a registration statement needs to
know the reviewer’s qualifications and how the reviewer is related to the issuer. Because
the reviewer may have obligations or liability for the accuracy of the review, the
reviewer’s consent must be obtained. There is no requirement that the reviewer be
certified by the SEC.
5. (A)
Auditors must meet professional qualification standards, and they must work
independently of the client’s interests. They may not have conflicts of interest, such as
consulting assignments with attested clients.
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7.7 Graphic Communication
The SEC has clarified its views of modern electronic media under a definition of
graphic communication. Any communication that falls under this definition is
treated as “written communication” for securities offering purposes.
Graphic communication includes audiotapes, videotapes, faxes, CD-ROMs,
emails, websites, computer networks, computer data files, and mass or “blast”
voicemail messages. However, it does not include real-time, oral communication
or live presentations.
Depending on how it is presented, the same information may or may not constitute graphic communication. For example, suppose an underwriter delivers a
live presentation to a group of prospective investors. The presentation itself is not
graphic communication. If the presentation is recorded and shown to another
group later (not live), it is graphic communication.
When investor demand is high, live road show presentations may need to be
simulcast to “overflow rooms” where the speaker is not physically present. Such
simulcasts qualify as “live presentations” under these rules.
7.7.1 Electronic Road Shows
A road show is an offering (other than a prospectus) delivered in the form of a
presentation made by members of the issuer’s management and the underwriters. The primary purposes of a road show are to solicit feedback from prospective
investors, evaluate demand for the shares, and pin down the offering price.
Live road shows are not normally considered written communications. SEC Rule
433 defines a bona fide electronic road show as one that uses written communication transmitted by any graphic means, such as by PowerPoint or internet-assisted presentation.
A road show that uses written communication (including a bona fide electronic
road show) is considered a free writing prospectus by the SEC. However, the SEC
does not require a bona fide road show to be filed if the issuer and underwriters cover the same general topics in each version of the presentation and make
available at least one graphic version of the road show to any potential investor,
without restriction. Any communication provided simultaneously with the road
show is considered to be part of the road show.
This rule is designed to give investors the advantages of electronic media in
accessing road show presentations remotely, without subjecting the content
of these shows to more burdensome filing requirements. It allows issuers and
underwriters to deliver different versions of a live road show to different audiences. However, the electronic road show that is available to any potential investor must be made available no later than any other versions of the same show.
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7.8 Prospectus Content and Filing Requirements
Normally, it is the job of the underwriter to prepare various versions of the prospectus, including the preliminary prospectus (red herring), the final prospectus,
and any stickers to the final prospectus. SEC rules specify the content and filing
requirements for prospectuses.
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7.8.1 Filing Copies of the Prospectus (Rule 424)
Five copies of each form of the preliminary prospectus must be filed with the
SEC no later than the date the red herring is first delivered to investors. Copies of
a new or different form of the red herring are required only if the form contains
“substantive changes.”
Ten copies of the final prospectus must be filed prior to the date of first use
with the public. Each copy must identify the specific provision of Rule 424 under
which the filing is being made and also the registration statement number.
Any prospectus delivered by radio or television must include a full transcript, and
five copies must be filed with the SEC.
In a prospectus used more than nine months after the effective date, any outdated information must be replaced with more recent information, such as the
issuer’s certified financial statements. The latest available information must be
used.
Knopman Note: A prospectus can be delivered electronically to
investors. Any hyperlinks (and all the content on those linked
webpages) are deemed to be part of the prospectus.
7.8.2 Prospectus for Use Prior to Effective Date (Rule 430)
Prior to the effective date, a preliminary prospectus (red herring) may be used,
provided it meets the conditions of Rule 430. This prospectus must contain substantially all required information except for details of the offering not yet established, such as the public offering price, members of the underwriting syndicate,
and amount of proceeds.
7.8.3 Registration Statement Inclusion after the Effective Date (Rule 430B)
Under Rule 430B, issuers must provide information only when it is known or
reasonably available to them. Under a shelf registration, an issuer may omit information in a prospectus filed as part of a registration statement if it is not known
or reasonably available. Additional omissions are allowed in ASRs, including the
nature of the offering, the distribution plan, a detailed description of the registered securities, and the identity of other issuers. It is likely that issuers will not
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know these details of the offering at the time the ASR is filed. This permits the
shelf to be a universal shelf, covering any securities the issuer might consider
selling in the future.
7.9 Exemptions and Safe Harbors
Over time, the SEC has defined a set of permitted practices for purposes of filing
registrations and meeting prospectus requirements.
7.9.1 Tombstone Advertisements
Under Rule 134, the SEC provides a safe harbor for certain public announcements
made after a registration has been filed. Specific terms of the offering may not
be mentioned within “safe harbor” public notices. This advertisement is typically
referred to as a tombstone ad because of the sparse nature of information it
contains as well as its traditional formatting.
A tombstone ad typically includes:
◆ Factual information about the issuer, including name, address, phone
number, email address, investor contact information, country/state of
organization, and geographic areas in which it conducts business
◆ Title and amounts of the securities being offered, including whether
securities are convertible, exercisable, or exchangeable
◆ A brief description of the issuer’s general business
◆ The price of the securities; for fixed-income securities, the maturity,
interest rate, and yield
◆ The intended use of proceeds from the offering
◆ The type of underwriting, the names of underwriters, and the anticipated
schedule of the offering
If the registration has not yet become effective, a prospectus must be offered and
an SEC-prescribed legend must be included to indicate that securities may not
be bought or sold until the registration becomes effective.
7.9.2 Pre-Registration Communications
SEC Rule 163A provides an exemption for specific communications made by (or
on behalf of) issuers more than 30 days before a registration statement is filed.
Such communications are permitted, provided that:
◆ The communication does not reference a security offering that will be
registered, and
◆ The issuer takes reasonable steps to prevent such communication during
the 30 days prior to filing the registration
This exemption is not available to investment companies or business development companies, and it is limited to specified types of transactions.
An issuer that relies on this exemption for communications made more than
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30 days before filing should take special care to prevent such communications
during the 30 days prior to filing. For example, website copy may need to be
altered or withdrawn. If there is any doubt about when the 30-day period will
begin, the issuer should allot extra time as a precaution.
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7.9.3 Factual and Forward-Looking Information
SEC Rule 168 provides an exemption for specific communication made by (or
on behalf of) issuers. Such communication will not be considered an offering
provided that:
◆ The issuer has met all SEC reporting requirements, and
◆ The information meets the definitions of either factual or forwardlooking information
Factual information includes general information about the issuer and its business, advertisements about the issuer’s products or services, and dividend notices.
Forward-looking information is defined as projections of the issuer’s revenues,
income, earnings per share, and other financial terms; statements about the issuer’s management plans and objectives, and statements about the issuer’s future
economic performance.
Knopman Note: Market or systematic risk reflects the fact that the
performance of an individual security will be impacted by the
performance of the overall market. A change in legislation (i.e.,
unfavorable tax laws for businesses) could lead to market risk. Items
related to the prospects of a specific company (e.g., a product launch)
refer to business risk.
The timing, manner, and form of the information must be consistent with that
of similar past releases.
Knopman Note: A special purpose acquisition company (SPAC) will
typically include forward-looking projections of the target company
it plans to merge with.
Information about a registered offering, released as part of offering activities,
does not qualify for this exemption. This exemption is not available to investment
companies or business development companies.
Furthermore, the same factual or forward-looking information that does not constitute an offering at one time (such as more than 30 days prior to a registration)
can constitute an offering at another time (such as during a cooling-off period).
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Knopman Note:
Q: Can an issuer include forward-looking statements in its SEC
filings?
A: Forward-looking statements, including financial projections,
are permitted in SEC filings. They must include meaningful,
cautionary language identifying factors that could cause actual
results to differ from those discussed in the forward-looking
statements. Forward-looking statements are not fraudulent
unless they lack a reasonable basis or were not made in good
faith.
7.10 Research Reports
Under SEC Rule 139, a research report is defined as “written communication that
includes information, opinions, or recommendations with respect to securities
of an issuer or an analysis of a security or an issuer, whether or not they provide
information reasonably sufficient upon which to base an investment decision.”
This is a very broad definition. It can include casual research opinions, such as an
observation that the issuer’s stock is selling at an attractive price/earnings ratio.
Knopman Note: An equity research report is defined as any analysis of
equities with a recommendation that is sent to at least 15 recipients.
SEC Rule 137 covers the publication and distribution of research reports by broker-dealers that are not underwriters and are not participating in a distribution
of securities. Specifically, such research providers are not considered to be offering securities, or participating in an offering, provided they are not acting under
arrangements or understandings with issuers, selling security holders, underwriters, or other interested persons.
Knopman Note: A research report is required to disclose any
investment banking business with the subject company of the report
in the past 12 months. This includes a PIPE transaction.
A broker-dealer may commission such research or buy a subscription for it.
However, this exclusion only applies if the broker-dealer publishes or distributes
the research in the regular course of its business.
To qualify for this exclusion, any research published or purchased should be
objective and factual in nature, and not overly promotional.
SEC Rule 138 creates a “firewall” between research reports that are used as part of
securities offerings and those that are not, even if they pertain to the same issuer.
For example, suppose a broker-dealer pays for research that it will use in promoting a registered securities offering. At the same time, the broker-dealer publishes
other research pertaining to different securities about the same issuer. Rule 138
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defines criteria under which the other research will not be subject to offering
requirements. Below is a summary of the requirements.
If the Offering Is for…
Research May Be Published on . . .
The issuer’s non-convertible debt or nonconvertible, non-participating preferred stock
The issuer’s common stock, debt securities, or
preferred convertible stock
The issuer’s common stock, debt securities, or
preferred stock
The issuer’s non-convertible debt or non-convertible,
non-participating preferred stock
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SEC Rule 139 excludes a broker-dealer’s publication or distribution of issuer-specific research as an offer of securities in connection with a registration if certain
conditions are met. The exclusion applies if the issuer has either:
◆ Filed all periodic reports required during the preceding 12 months, or
◆ Meets the requirements for filing Form S-3 or F-3
The broker-dealer must publish or distribute research in the regular course of
business, and this research may not represent the member’s initial research coverage on the issuer or its securities. This exclusion is not available for securities
of blank check or shell companies, or for penny stocks.
This rule is designed to prevent broker-dealers from “cherry-picking” research
that is favorable to an issuer or an offering, and presenting it as independent,
when they have not been providing continuous research on the same issuer or
securities.
Knopman Note: If a broker-dealer publishes an industry research
report covering multiple companies in a sector and it also happens
to be in the process of underwriting an offering for one of those
companies, that client company cannot be given greater space or
prominence in the report than the other companies.
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7.11 Liabilities in Communicating Securities Offerings
Sections 11 and 12 of the ’33 Act specify the civil liabilities for legal or regulatory
errors and omissions in registration statements, prospectuses, and oral communications. Below is a summary of these liabilities.
Untrue or Omitted Information in Registration Statements
1. Registration signers
2. Directors and partners of the issuer
Who is liable?
3. Professionals preparing or certifying reports
4. Every underwriter
5. The issuer
Who may sue?
Any person acquiring the security
1. Due diligence defense
Defenses available
Damages
2. Withdraw from transactions and notify SEC
(i.e., noisy exit)
Investor made whole
7.11.1 Errors or Omissions in Registration Statements—Burden of Proof
Anyone (except the issuer) can avoid liability under Section 11 for errors or omissions in registration statements by proving any of the following:
◆ That he/she resigned from a position of responsibility, or provided a
written disclaimer of responsibility to the SEC
◆ That he/she notified the SEC in a timely manner and provided
“reasonable public notice” of “known errors or omissions,” or
◆ That he/she had grounds to believe, on the effective date, that statements
made were true and complete, based on a “prudent man” standard. This
is sometimes referred to as the due diligence defense
Example
An auditor fails to issue a “going concern” notice for a public company that
is raising capital in a registered offering. The company then fails shortly after
the offering is completed.
If the auditor had reasonable grounds for believing the company’s financial
condition was sound on the effective date of the registration, based on a prudent man standard, the auditor may be protected under the liability shield
of Section 11.
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The auditor could argue:
◆ That he/she made prudent and diligent efforts to obtain information
and was denied access to facts and truth, or
◆ That the company’s financial situation deteriorated after the effective
date
If either argument is successful, the auditor can avoid liability.
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7.11.1.1 Damages Under Errors or Omissions in Registration Statements
The maximum amount of damages that may be claimed under Section 11 is the
price at which the security was offered to the public. The persons sued (except
outside directors of the issuer, in some cases) may be held jointly and severally
liable.
In most cases, damages are limited by statute to the difference between the
amount paid, not exceeding the offering price, and the value when the suit was
brought or the securities were sold.
Example
The original price paid was $15 per share. The price had declined to $4 per
share when the suit was brought, at which time the plaintiff had not sold any
shares. In this case, damages would be limited to $11 per share.
7.11.1.2 Information Available to Purchaser at Time of Sale
Rule 159 specifies that untrue or omitted material information in a prospectus or
oral communication applies to information shared by the time of sale. If information is communicated after the sale, it is not considered for civil liability purposes.
Additionally, Rule 412 specifies that any previous information contained in a registration statement or prospectus is deemed to be superseded by a replacement
or an amended registration or prospectus.
Example
An underwriter omits material information in a prospectus. Three days
later, the error is discovered, and the prospectus is corrected with a sticker.
The omission in the original prospectus is deemed to be superseded by the
amended version. Investors relying on this information to make purchases
after the re-filing must rely on the amended version, not the original version.
247
Chapter 7
Preparing the
Prospectus
Knopman Note: Key Q&A regarding the preparation and filing of a
registration statement:
Q: What law imposes civil liability for misleading or untrue
statements in a registration statement?
A: Section 11 of the Securities Act of 1933 imposes civil liability
on issuers and their employees, underwriters, attorneys,
and consenting accountants when a securities registration
statement filed with the SEC contains a false statement or
material omission.
Q: Who signs the registration statement?
A: The registration statement must be signed by the issuer’s CEO,
CFO, controller (i.e., chief accounting officer), and a majority of
the board.
Q: How can a person avoid liability under Section 11 of the ’33 Act?
A: Liability can be avoided via the due diligence defense. The due
diligence defense allows a party to avoid liability by establishing
that, after a reasonable, prudent investigation, any untrue
statements in the registration statement were believed to be
true at the time the registration statement became effective.
Adequate due diligence does not require an attorney’s comfort
letter; a reasonable investigation merely requires that which
a prudent man in the management of his own property would
conduct. This is referred to as the prudent man standard.
Q: Who can access the due diligence defense?
A: This is available to all parties involved in the preparation and
filing of the registration statement, with two exceptions.
Q: Who cannot access the due diligence defense?
A: The issuer and non-consenting accountants cannot access the
due diligence defense.
Q: Is a WKSI’s automatic shelf registration subject to due
diligence?
A: Every registration is subject to due diligence, including those of
WKSIs.
248
Q: What should a banker do if she finds misleading or inaccurate
information in a registration statement?
A: The best course of action is to identify it as misleading (often to
legal counsel) so that it can be corrected. A banker would not
typically suggest the issuer take action so that the statement
becomes true.
Chapter 7
Preparing the
Prospectus
For example, if a registration statement described flood
insurance as replacing lost revenues following a flood, a banker
would want to notify counsel to seek clarification, as this would
be inaccurate. Flood insurance provides coverage from losses
arising from a flood, but does not replace lost revenue. Business
interruption insurance is a type of policy that will replace lost
revenue after a business interruption.
Q: Does the SEC review a registration statement for accuracy or
truthfulness?
A: No. The SEC’s review of a registration does not confirm the
integrity or quality of the deal; instead, it reviews the filing for
completeness. To indicate otherwise is fraud.
Q: What is included in a registration statement?
A: A typical registration statement contains detailed information
regarding the issuer, including disclosures on corporate
insiders, underwriters, and any legal proceedings. Also required
are audited financial statements and a capitalization table
detailing the issuer’s current debt (excluding commercial
paper) and equity capital.
That said, the registration statement is not required to include
forward-looking financial projections.
Q: What is the best course of action if information in a registration
statement becomes untrue, for example, if financial statements
have materially changed?
A: If, at any point, there is a material change in financial
statements included in a prospectus—or those statements
become outdated—they must be re-filed with the SEC.
Financials are considered outdated after 130 days for WKSIs
and seasoned issuers, and after 135 days for all other issuers.
A change in interest rates would not require an issuer to amend
a registration statement.
249
Chapter 7: Preparing the Prospectus
Unit Exam
1. An issuer of corporate bonds includes Moody’s
current rating for the bonds in its registration
statement. The bonds are also rated by S&P.
Must the S&P rating be included?
A. No, because the issuer has discretion over
what information to include
B. Only if both ratings are the same
C. Only if the S&P rating is materially
different
D. Yes, in all cases
2. Ratings may be included in a registration
statement for all of the following types of
securities except:
A.
B.
C.
D.
Common stock
Preferred stock
Debt
Convertible debt
3. An underwriter prepares the financial
statements for inclusion in the registration of
an issuer with an operating history of just two
fiscal years. Financial statements have been
audited for both years. At the minimum, which
audited statements of income and cash flows
must be included?
A.
B.
C.
D.
None
One year
Two years
The company must ask for an exemption
from the SEC
4. The registration statement that may be used
for all newly issued securities under the
Securities Act of 1933 is:
A.
B.
C.
D.
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Form S-1
Form S-3
Form F-1
Form 10-K
5. ABC Corporation has 1,000,000 shares of
common stock, of which the public float is
900,000 shares. To qualify for an S-3 filing,
what is the maximum amount of common
shares that the company may have sold under
an S-3 in the previous 12 calendar months?
A.
B.
C.
D.
300,000
333,333
450,000
500,000
6. During the course of auditing a company’s
financial statements, a CPA discovers that
the chief financial officer has absconded
with a large amount of money. As a result,
the company probably will have to go out of
business. Under the ’34 Act, how is the auditor
required to report this?
A. It must be reported as a statement of
“substantial doubt” about the issuer’s
ability to continue as a going concern
B. It must be reported immediately by the
auditor to law enforcement
C. It must be reported within 14 days by the
auditor to the SEC
D. It must be reported immediately in an
amended registration filing
7. An underwriter presents a series of bona fide
electronic road shows to potential investors
of an underwriting. Each presentation covers
the same general areas. The underwriter is not
required to file each road show presentation if
it makes available at least one graphic version
of the road show to:
A.
B.
C.
D.
Any investor upon request
Any potential investor, without restriction
All other underwriters
The SEC, upon written request
Chapter 7: Preparing the Prospectus
Unit Exam (Continued)
8. Demand for a live road show presentation
is so great that an underwriter decides to
simulcast the presentation via a live video feed
into an overflow room. Which presentation
will be considered “graphic communication”
for securities offering and prospectus delivery
requirements?
A.
B.
C.
D.
The live presentation only
The simulcast into the overflow room only
Both the live presentation and simulcast
Neither the live presentation nor the
simulcast
10. An investor claims a prospectus contained an
untrue statement. For purposes of bringing a
civil suit for liability under Section 12 of the ’33
Act, and claiming damages, the information
must have been untrue at what time?
A.
B.
C.
D.
On the effective date
On the date of the initial filing
On the date of the red herring
At the time of sale
9. XYZ Corp, an issuer, wishes to take advantage
of a Rule 163A exemption for communications
made by, or on behalf of, an issuer more than
30 days before a registration statement is filed.
The issuer takes reasonable steps to prevent
communications during the 30 days just prior
to filing. What additional requirement must be
met?
A. The issuer must avoid graphic
communication
B. The issuer must include an SEC-approved
legend
C. The issuer must avoid referencing the
upcoming offering
D. The company must be a well-known
seasoned issuer (WKSI)
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Chapter 7: Preparing the Prospectus
Unit Exam—Solutions
1.
(C)
For offerings of debt, convertible debt, and preferred stock, ratings may be included in
the registration. If one rating is included, and another rating from a Nationally
Recognized Statistical Rating Organization (NRSRO) is materially different, then that
rating also must be included. Moody’s and S&P are both NRSROs.
2. (A)
Ratings measure a company’s ability to meet recurring payment obligations, such as
interest on debt and preferred stock dividends. Common stockholders stand last in line
in claims on corporate assets. Therefore, ratings are not relevant in evaluating straight
equity offerings.
3. (C)
Normally, audited statements of income and cash flows are required for the three
most recent fiscal years. However, if the company lacks such history, it must include in
the registration the audited statements for those fiscal years it has been in operation.
4. (A)
Form S-1 may be used for any newly issued securities. It does not impose the limiting
qualifications of other registration forms, such as the short-form Form S-3.
5. (A)
The limit for an S-3 filing is one-third or 33.3% of the public float within the previous 12
calendar months. The public float is defined as shares held by the public, and excludes
officers, directors, and 10% shareholders.
6. (A)
The auditor is required to evaluate the company’s ability to continue as a going concern
and report as part of an audit any “substantial doubt” about its ability to continue.
(B)
Any potential investor, without restriction, must be given a graphic version of the road
show. If this condition is satisfied and the same general areas are covered in each
version of the presentation, the SEC does not require each road show presentation to be
filed.
8. (D)
A simulcast into an overflow room will be considered the same as a live presentation,
even if it uses electronic media, provided that it is delivered in real time. However,
a taped version of the live presentation, not delivered in real time, is considered graphic
communication.
9. (C)
The Rule 163A exemption applies to communications by or on behalf of an issuer, and it
has two main requirements. Reasonable steps must be taken to avoid communications
during the 30 days prior to filing the registration. Also, no reference should be made to
the pending securities offering.
10. (D)
Under Rule 159, the determination as to whether information in a prospectus or oral
communication is untrue or has been omitted applies to information shared by the
time of sale or contract of sale. If information became untrue after the time of sale, it is
not relevant for civil liability purposes.
7.
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8. Reporting Requirements
Under the Securities Exchange
Act of 1934
Analysts and investors depend on continuous reports filed with the SEC in order
to evaluate the ongoing operational and financial health of issuers.
The Securities Exchange Act of 1934 (the ’34 Act) created a coherent framework
for reporting information to “secondary market” investors who own (or wish to
evaluate) publicly traded stocks and bonds. Public companies must file reports
with the SEC. In addition, other entities, including senior officers of a firm and
large investors, are also required to report certain transactions with the SEC.
Investors may access these filings for free through the EDGAR system on the
SEC’s website.
8.1 Reporting Requirements for Issuers
The general registration requirements of the ’34 Act (Section 12) cover securities transactions on national securities exchanges. The issuer first files an application with an exchange, including detailed information about its business, its
securities, and the securities’ terms. All issuers with 2,000 or more shareholders
and more than $10 million in assets are required to register. Once the exchange
has approved the company’s listing, the securities are considered to be SECregistered. Companies who register securities under the Securities Act of 1933
are already registered on an exchange, so this point is generally moot.
The SEC has the authority to protect investors by denying, suspending, or revoking a registration if it finds that the issuer has failed to comply with the ’34 Act
and its rules. Broker-dealers are not allowed to transact in any security whose
registration has been suspended or revoked.
8.1.1 Annual Report—Form 10-K
A Schedule 10-K, the annual report for each fiscal year, must be filed by an issuer
following the end of the company’s fiscal fourth quarter. A Schedule 10-K has a
cover page and four parts:
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Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
8.1.1.1 Cover Page
◆ Name of the issuer
◆ Market value of voting and non-voting shares held by non-affiliates of the
company
◆ Number of shares of the issuer’s common stock outstanding
8.1.1.2 Part I—General Business Information
◆ Description of the issuer’s business
◆ Risk factors of the company (e.g., lack of profit, financial position, illiquid
securities, etc.)
◆ Current legal proceedings
8.1.1.3 Part II—Financial Information
◆ Selected Financial Data—This section highlights significant trends in
the company’s financial condition and operating results. It may include
revenue, net income, total assets, earnings per share, and dividends.
◆ Management’s Discussion and Analysis of Financial Condition—This
section comments on the company’s operating performance, capital
resources, liquidity, and any other factors that the company considers
significant. It is usually the lengthiest part of a 10-K.
◆ Disclosures about Market Risk—This section comments on the
exposure the company has to fluctuations in currencies, commodities,
and interest rates.
◆ Audited Financial Statements
• Balance sheets as of the end of each of the two most recent fiscal
years
• Income statements for each of the three preceding fiscal years
• Cash flow statements for each of the three preceding fiscal years
Knopman Note: A banker performing due diligence on a client’s
audited financial statements would most likely reach out to the
client’s accounting department with any additional questions. The
auditing firm would typically NOT discuss these with the banker.
8.1.1.4 Part III—Directors, Officers, and Beneficial Shareholders
◆ Identification of board members, executive officers, and other key
employees
◆ Compensation awarded to executive officers, including cash and noncash elements
◆ Amount of securities owned by officers, directors, and any other investor
known to be the beneficial owner of more than 5% of the company’s
voting securities
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8.1.1.5 Part IV—Exhibits, Supplements, and Signatures
◆ Exhibits, financial statement schedules
◆ Signatures of the principal executive officer(s), principal financial
officer(s), controller(s), and a majority of the board of directors
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
Knopman Note: Key features of the 10-K include:
• It is an annual report which provides a comprehensive overview of
the company’s business and financial condition, such as:
1. Audited financial statements
2. A list of officers, directors, and greater than 5% shareholders
3. A market risk disclosure, which provides information about
the company’s exposure to market risk (such as interest rate
risk, foreign currency exchange risk, commodity price risk,
or equity price risk)
4. Information about its ability to borrow money and pay
interest (e.g., to finance an acquisition), and
5. Executive compensation, or a reference to executive
compensation in the proxy, including awarding of stock
options. Awarding of options will be in the main body of the
document, whereas valuation methods and assumptions
may be located in the footnotes
Q: Who signs the 10-K?
A: The registrant itself and, on behalf of the registrant, its:
• Principal executive officer (CEO)
• Principal financial officer (CFO)
• Controller (chief accounting officer), and
• A majority of its board of directors
Note, the chairman of the board of directors may sign, but is not
required to.
8.1.2 Quarterly Report—Form 10-Q
A Schedule 10-Q, the quarterly report, must be filed after the conclusion of each
of a company’s first three fiscal quarters. Unlike the financial statements included
in the 10-K, those included in the 10-Q are not required to be audited.
255
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
Companies generally file three 10-Qs per year and one 10-K. The 10-K takes the
place of the fourth quarterly filing.
Though the items disclosed in a 10-Q are similar to those in a 10-K, substantially
fewer disclosures are required in a 10-Q. Namely, the company is not required to
include any information about officers, directors, or 5% beneficial shareholders.
A Schedule 10-Q has a cover page and two parts.
8.1.2.1 Cover Page
◆ Name of the issuer
◆ Market value of voting and non-voting shares held by non-affiliates of the
company
◆ Number of shares of the issuer’s common stock outstanding
8.1.2.2 Part I—Financial Information
◆ Financial statements
• Interim balance sheets, as of the end of the most recent fiscal
quarter and as of the end of the preceding fiscal year
• Interim income statements for the most recent fiscal quarter, the
fiscal year-to-date, and for the same periods during the previous
fiscal year
• Interim cash flow statements for the fiscal year-to-date and for the
corresponding period of the prior fiscal year (i.e., prior year-to-date)
◆ Management’s discussion & analysis (MD&A)
◆ Disclosures regarding changes to market risk factors that were previously
reported on a 10-K
8.1.2.3 Part II—Other Information
◆ Current legal proceedings
◆ Unregistered sales of equity securities
◆ Defaults on senior securities
◆ Exhibits
◆ Signature of the principal financial officer or another duly authorized
officer of the registrant
256
Knopman Note: Important points to review about the 10-Q include:
• There are three 10-Q filings each year; in the fourth quarter, the
firm files a 10-K.
• The most significant difference between the 10-K and 10-Q is that
the financial statements in a 10-Q are unaudited.
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
• A 10-Q will also disclose any changes to market risk factors that
were previously discussed in a 10-K.
• The 10-Q will be signed by one member of the firm’s senior management (e.g., CEO, CFO, or COO).
Q: What is not included in a 10-Q?
A: The 10-Q does not include a list of major shareholders. So, an
investor seeking to learn who a company’s major shareholders
are should review the company’s 10-K, not the 10-Q.
8.1.3 Current Report—Form 8-K
Form 8-K is the “current report” companies must file with the SEC to inform
shareholders of any major events regarding the company. Over time, the SEC has
expanded the types of events that must be reported on an 8-K. In most cases, the
filing must be made within four business days after the triggering event.
Common events that trigger an 8-K filing include:
◆ Earnings announcements
◆ Bankruptcy filing
◆ Defaulting on a loan
◆ Announcement of a merger
◆ Closing of a merger
◆ Change in company name or address
◆ Change in senior management
◆ Criminal legal actions against the company
Knopman Note: Private sales of securities (including convertible
bonds) that would increase the number of outstanding shares by at
least 1% must be reported on an 8-K.
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Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
Knopman Note:
Q: When companies announce quarterly earnings, do they file an
8-K or 10-Q?
A: An earnings announcement is typically accompanied by an 8-K.
The 8-K will include selected financial data for that period.
The 10-Q, filed shortly after the earnings announcement, will
include full financial statements for the recently completed
period.
Q: Do all company events trigger an 8-K?
A: No; for example, a civil or class-action lawsuit filed against a
company would not likely trigger an 8-K.
Q: At what point in an M&A process is an 8-K filed?
A: During a merger, an 8-K is filed at least twice: first when the
definitive agreement is signed, and second when the deal closes.
In addition, information about potential change of control
payments due to executives can be found on a company’s Form
8-K.
8.1.4 Filing Categories and Deadlines
Under Rule 12b-2, the filing deadlines for annual (10-K) and quarterly (10-Q)
reports may be accelerated for certain types of issuers.
8.1.4.1 Large Accelerated Filer
Large accelerated filers include issuers with an aggregate, worldwide market
capitalization (voting and non-voting stock) of $700 million, as measured on
the last day of the second fiscal quarter. This measurement then determines the
company’s category and filing deadlines for the next full fiscal year. The issuer
must also have been subject to continuous reporting requirements for at least 12
calendar months and must have filed at least one 10-K.
8.1.4.2 Accelerated Filer
The requirements for accelerated filers are the same as for large accelerated
filers except that the company’s worldwide market value (voting and non-voting
stock) must be between $75 million and $700 million, calculated on the last day
of the second fiscal quarter.
8.1.4.3 Smaller Reporting Companies
Companies that qualify as smaller reporting companies must use the standard
Forms 10-K and 10-Q to file, but they are subject to “scaled” reporting requirements. To qualify as a smaller reporting company, a company must have common
equity public float of less than $75 million. Alternatively, if a company is not able
258
to calculate its public float, it can qualify by having less than $50 million in revenue in the last fiscal year.
Both domestic and foreign companies qualify for this designation. Investment
companies, business development companies, and asset-backed issuers are not
eligible.
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
The 10-K and 10-Q filing deadlines for smaller reporting companies are the same
as for non-accelerated filers.
8.1.4.4 Filing Schedule
Below is a summary of the filing schedule for issuers under the ’34 Act.
Large Accelerated Filers
Accelerated Filers
Non-Accelerated Filers
and Smaller Reporting
Companies
Form 10-K
(annual report)
Within 60 days of fiscal
year end
Within 75 days of fiscal
year end
Within 90 days of fiscal
year end
Form 10-Q
(quarterly report)
Within 40 days of fiscal
quarter end
Within 40 days of fiscal
quarter end
Within 45 days of fiscal
quarter end
Within 4 business days of
event
Within 4 business days
of event
Within 4 business days
of event
Form 8-K
(current report)
8.1.5 Proxy Statements
A definitive proxy filing, SEC Form DEF14A, is an SEC disclosure document sent
to shareholders of a public company to inform them of matters that shareholders
will vote upon at an annual meeting. It also informs shareholders of the compensation of directors and officers of the company.
If the company requires a shareholder vote on a proposed merger or acquisition,
the proxy filing is made on Form DEFM14A (the “M” indicating the vote relates
to a merger).
The DEF14A or DEFM14A must be mailed to shareholders at least 20 days before
the shareholder meeting is held. If the proxy is made available online as well, it
must be posted in an easily accessible online location at least 40 days before the
meeting. Also, the definitive proxy statement must be filed with the SEC prior
to, or concurrent with, distribution to shareholders. These documents are public
and often provide more current details about corporate events and financial
conditions than annual (10-K) or quarterly (10-Q) filings.
In merger and acquisition transactions, preliminary proxy statements must be
filed for the SEC’s review and approval at least 10 calendar days prior to the date
a definitive proxy is first sent or given to shareholders. The preliminary proxy is
filed on Form PRE14A or Form PREM14A (the “M” indicates it is a merger proxy).
It is made publicly available by the SEC, unless the filer requests and qualifies for
confidential treatment.
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Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
General information required in a proxy statement includes:
◆ The date, time, and place of the shareholder meeting
◆ Shareholder proposals, along with the issuer’s response and
recommendation as to acceptance or rejection of the proposal
◆ A list of directors, officers, and 5% beneficial shareholders, and the
amount of shares owned by each
Knopman Note: If the proxy is issued in connection with a merger or
an acquisition, it discloses whether the management team will be
receiving some additional compensation as a result of the change in
control.
In addition, a proxy statement will include substantial information about the
existing board of directors and nominees for the board of directors. This includes:
◆ Compensation of existing directors and executive officers
◆ The names and ages of all persons nominated to be directors
◆ The composition of the existing board of directors, including of any
committee membership (e.g., audit committee, nominating committee,
or compensation committee)
◆ The status as to each director’s independence from the company. An
independent director is one who is not an employee or auditor of the
firm and is not related to an employee or auditor of the firm
◆ The total number of board meetings during the preceding year, and the
identity of any director who attended fewer than 75% of those meetings
260
Knopman Note: Understanding the requirements and characteristics
of proxies is crucial—candidates should be well-versed in their use
and requirements, as indicated above. A few highlights are:
• The preliminary proxy (PRE14A) must be filed with the SEC at least
10 days before the definitive proxy is mailed to shareholders.
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
• The definitive proxy (DEF14A) must be filed with the SEC and
distributed to shareholders at least 20 days before the annual
meeting.
• Both the preliminary and definitive proxy will contain identical
information, including:
• Director attendance, specifically listing any director who
attended less than 75% of the previous year’s meetings
• The officers, directors, and greater than 5% shareholders
• Disclosures if the management team is receiving additional
compensation as a result of the change in control
• The company’s largest shareholders (note, they would not be
found within audited financial statements)
• Change of control provisions, including additional payments
or severance packages in the company’s Schedule 14A proxy
statements
Q: What is not included in a proxy?
A: Two items that are not in a proxy are:
• Minutes from previous board meetings
• The voting record of each director or the voting results
from board meetings
8.2 Sarbanes–Oxley Act Requirements
The Sarbanes–Oxley Act of 2002 (Sarbox or SOX) was enacted by Congress
in response to accounting scandals involving a number of major public US corporations, including Enron, WorldCom, and Tyco. It required enhanced standards for US public companies and their directors, executive officers, and public
accounting firms.
One way that directors and officers adhere to better corporate governance standards is through the detailed recordkeeping of board minutes, referred to as the
minutes. Maintaining a thorough paper trail to prove that directors are acting
in the best interests of shareholders is prudent risk-and-liability management
for a company. To appropriately designate accountability for the minutes, one
board member is usually designated as secretary and is responsible for signing
the board minutes.
261
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
Knopman Note: If the designated board member isn’t available to
sign the board of directors’ minute book (a written record of the
discussions of the board), the corporate secretary or the chairman
may sign the minutes after the meeting.
8.2.1 Enhanced Conflict of Interest Disclosures
Sarbox amended Section 13 of the ’34 Act to prohibit personal loans made by any
issuer of securities, directly or indirectly, to any director or executive officer of
the issuer. This prohibition includes any extension or maintenance of credit or
arrangement for the extension of credit but does not apply to loans made in the
normal course of business by a company in the business of lending money, on
terms generally available to the public. For example, the CEO of a commercial
bank could obtain a mortgage from that bank on market terms.
8.2.2 Disclosures of Transactions Involving Management and Principal
Stockholders
Certain disclosures are required by any director or officer of the issuer, and also
any stockholder who is a beneficial owner (directly or indirectly) of 10% or more of
any class of any equity security. The disclosure statement must state the amount of
all equity securities of the issuer for which the filing person is the beneficial owner.
It must indicate the ownership as of the filing date and any changes in ownership,
purchases, or sales of security-based swap agreements since the most recent filing.
The statement must be filed electronically with the SEC at the time of the initial
’34 Act registration of the company with a national securities exchange or by the
effective date of any ’33 Act registration statement. New directors or officers must
file within 10 days after becoming a beneficial owner. For changes of ownership
involving swap agreements, the statement must be filed within two business days.
This requirement is satisfied by corporate insiders filing SEC Forms 3, 4, and 5.
8.2.3 Management Assessment of Internal Controls
Under Section 404, the SEC is authorized to create rules requiring public companies’ annual reports to state how management establishes and maintains
adequate internal controls and procedures for financial reporting. The annual
report must contain an assessment by senior management (including the CEO
and CFO), as of the end of the fiscal year, of the effectiveness of these controls.
Knopman Note: A company’s 10-K will disclose its internal financial
controls and processes.
In addition, Sarbox requires each registered public accounting firm to describe in
each audit report the scope of its testing of the company’s internal controls and
procedures. It also must present in the audit report its findings from such testing.
262
Knopman Note: Key highlights of SOX include:
• Certification of a 10-K and 10-Q by the CEO and CFO. The certification means that the person has read the filing and that it is accurate to the best of his knowledge.
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
• No personal loans to company executives, unless the firm is in the
business of lending money (i.e., a bank) and if the loans are on
market terms. SOX does not prohibit an executive from borrowing
from her 401(k) or cash advances going toward client travel and
entertainment expenses as long as the executive nets $0 from the
loan.
• A majority of all public companies’ board members must be
independent.
Audit committee requirements:
• The board’s audit committee must be made up entirely of independent directors.
• Companies must disclose whether a member of the audit committee is a financial expert (i.e., someone with experience auditing
financials). SOX does not require that a financial expert serve on
the audit committee (it merely requires disclosure of whether
there is one).
• NYSE and NASDAQ rules require listed firms to have at least one
financial expert on the audit committee.
8.3 Regulation FD
In August of 2000, the SEC adopted Regulation FD (Fair Disclosure) to prevent the
“selective disclosure” of material information about a publicly traded company
to outsiders prior to the time that the same information is generally available to
all investors.
Regulation FD was designed to promote the disclosure of material information to
individual investors simultaneously with securities market professionals, such as
stock analysts, research analysts, credit agencies, or large institutional investors.
To this end, the rules prohibit public companies from meeting with research
analysts and sophisticated investors to “guide” or “warn” about potential results
prior to making broad public disclosure.
An issuer may selectively disclose or confirm material information to an analyst,
provided it has an explicit confidentiality agreement with the analyst. An issuer
also may selectively comment on an analyst’s forecast or model, provided that
no new material information is disclosed.
The SEC rule distinguishes between intentional selective disclosures, which
must be broadly disclosed simultaneously, and non-intentional disclosures,
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Exchange Act of 1934
which must be broadly disclosed promptly. Promptly is defined as the later of
24 hours or the open of trading on the next business day.
Knopman Note: If a CEO is being interviewed and accidentally reveals
inside information, public disclosure must be made promptly;
meaning within 24 hours or by the open of trading the next business
day—whichever is later.
Companies typically make simultaneous or prompt public disclosures of material
information on an 8-K filing. The SEC has stated that other types of filings (e.g.,
10-Qs) are sufficient for disclosure purposes provided the material information
is disclosed promptly, is not buried in the filing, and is not presented piecemeal.
Companies can meet FD requirements by disclosing material information in conference calls, provided the calls are announced ahead of time and are broadly
available to the public (e.g., through transcripts or replays). The SEC has provided guidance on the distribution of such information via a company website
or social media: For purposes of Reg FD, any online delivery must occur on a
recognized channel of distribution, and the information must be broadly available and widely disseminated.
Companies cannot meet FD requirements by disclosing material information in
speeches to shareholders or to the public. The disclosure must provide “broad,
non-exclusionary distribution of information to the public.”
Regulation FD applies to communications with outsiders, not company employees. Regulation FD also does not apply to individuals who have a duty of trust to
keep information confidential, such as lawyers and accountants. Of course, no
one is permitted to commit insider trading.
Material disclosures made during a road show held in connection with a registered public offering are not subject to Regulation FD.
Knopman Note: Remember, the purpose of Reg FD is to ensure equal
access to information to all investors—Main St. and Wall St.—at the
same time.
To this end, companies may announce key information online or via
social media, like Facebook and Twitter, so long as investors have
been alerted about which social media will be used to disseminate
such information.
Q: How can an issuer meet its Reg FD disclosure requirements?
A: Regulation FD disclosures can be satisfied with an 8-K, a
press release, or a website announcement. A company cannot
generally satisfy them by inserting the information into the next
10-K.
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8.4 Reporting and Trading Requirements for Corporate Insiders
Corporate insiders, as defined under the ’34 Act, include officers of an issuer
(e.g., CEO, CFO, etc.), directors of the issuer, and any investor owning more than
10% of the voting shares of an issuer.
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
As stewards of the company, corporate insiders have unique access to sensitive
information and a unique view of the company’s prospects. To ensure that they
do not abuse this information, and to give the investing public comfort that these
individuals are acting honestly, corporate insiders are required to file documents
with the SEC disclosing changes in ownership.
Knopman Note: When corporate insiders buy stock, it will typically
have a positive impact on the company’s stock price.
8.4.1 Form 3—Initial Statement of Beneficial Ownership
Form 3 is an initial filing made when an investor becomes a corporate insider.
Examples of actions that require this filing include an acquisition of stock such
that ownership exceeds 10%, or a promotion to CEO. The form contains information on the reporting person’s relationship to the company and his or her other
purchases and sales of the company’s equity securities. The document must be
filed within 10 days of the person becoming a corporate insider.
When a private company first files a registration statement with the SEC, a Form
3 will be filed concurrently with this document for each corporate insider at the
time of registration.
8.4.2 Form 4—Statement of Changes in Beneficial Ownership
Form 4 reports changes in ownership by corporate insiders as a result of purchases and sales of the issuer’s stock in the open market. It must be filed with the
SEC within two business days of the transaction.
8.4.3 Form 5—Annual Statement of Changes in Beneficial Ownership
Form 5 is an annual statement of beneficial ownership for transactions exempt
from the filing requirements of a Form 4. Examples of transactions that are not
required on Form 4 but which may be reported on Form 5 include purchases in a
discretionary (i.e., managed) account, shares received from the issuer, derivative
securities received, or shares transferred via a gift or trust.
A Form 5 is filed by a corporate insider within 45 days of the end of a company’s
fiscal year.
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Knopman Note: It is important to understand the required filings for
corporate insiders.
• Form 3—Required within 10 days of the person becoming an officer,
director, or beneficial owner of more than 10%
• Form 4—Used to report changes in ownership within two business
days
• Form 5—Used to report changes in ownership that were not
reported on Form 4 (e.g., gifts, small purchases, transactions with
the issuer). Form 5 is due 45 days after fiscal year end
Consider the following events and filings:
Event
Filing
Note
John incorporates a new
start-up technology firm.
None required
N/A
John takes his company
public and lists his stock on
the NYSE.
Form 3
(within 10 days)
John must file a Form 3 because
he is now an insider of a public
company.
John buys shares of his
company in the public
markets (e.g., on the NYSE).
Form 4
(within 2 days of sale)
John must file a Form 4 because
he changed his ownership
position.
John sells shares of his
company in the public
markets.
John gifts personal stock in
the company to a favored
charity.
Form 4
(within 2 days of sale)
Form 144
(discussed below)
Form 5
(within 45 days of the
company’s fiscal year end)
John must file a Form 4 because
he changed his ownership
position.
Gifts, and other small
transactions (less than $10,000),
are exempt from Form 4
reporting, but are reported on
Form 5.
8.4.4 Restrictions on Short-Swing Profits by Insiders
Corporate insiders who file Forms, 3, 4, and 5 are subject to Section 16(b) of the
’34 Act, which requires disgorgement of any profits realized on insider purchases
or sales of equity securities reported within any six-month period. The amount of
the profit is repaid to the issuer. If insiders refuse to voluntarily disgorge profits,
issuers (and other shareholders) have the right to sue for recovery. Issuers are not
permitted to waive their rights to recover short-swing profits.
The only exception to short-swing profit restrictions is when the equity securities
are acquired in good faith through a previously contracted arrangement, including 401(k) plan contributions. Securities exchanged through reorganization or
reclassification events are not subject to the restrictions, provided the original
securities were purchased more than six months prior to sale.
Trades made for reasons of personal illiquidity or hardship are not exempt.
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8.5 Large Shareholder Filings
The SEC requires investors to disclose their holdings through a number of different filings. A filing requirement may be triggered by a specific acquisition, or
based on the investor’s total assets.
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
8.5.1 Beneficial Ownership Reports
Investors are required to file with the SEC once they own 5% or more of a company’s common stock. The SEC allows investors to decide for themselves whether
they are activist investors or passive investors.
8.5.1.1 Schedule 13D
A Schedule 13D filing is made by a beneficial holder of more than 5% of a public company’s common stock when the intent of the holder is to influence or
control the decisions, direction, or policies of the company. The filing must be
made within 10 calendar days once the 5% threshold is crossed, and it must be
promptly amended each time holdings change (acquire or disposition) by 1% or
more from the investor’s previous filing. The investor must also disclose his/her
intention as it relates to any plan to replace senior management, increase his/
her investment, or seek to acquire the company outright. Multiple investors who
come to an agreement, whether implicit or explicit, to vote their shares in concert
would also be required to file Schedule 13D (as a joint filing or individually) if their
combined holdings exceed 5%. This is called “acting in concert.”
Analysts watch 13D filings to learn the identities of activist holders and evaluate
their intent to influence or control the company. The filings are also of interest to
hedge funds that specialize in mergers and acquisitions and other “event-driven”
strategies.
Knopman Note: Candidates should be familiar with both the specific
and general filing requirements of the 13D. Be sure to review the above
information on this filing. The highlights are here:
Filing Threshold
• Specific rule—Investors must file Schedule 13D at 5.1% ownership,
not at 5%. This is because all percentages are to be rounded to the
nearest tenth (one place after decimal point).
• General characterization—It would be appropriate to indicate 13D
filings occur at 5% ownership and not 7%, 9%, or 13%, even though
technically the filing would be at 5.1%.
Timing
An activist investor will file a Form 13D within 10 calendar days of the
transaction.
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8.5.1.2 Schedule 13G
A Schedule 13G filing is made by a beneficial holder of more than 5% of a public
company’s stock when the holder has no intent to influence or control the company. It must be made within 45 days after the end of a calendar year in which
the 5% level is reached. For passive holders of 10% or more, the filing deadline is
10 days from the end of the first month in which the 10% level is reached. Form
13G is considered a “short form” of 13D, because the SEC requires less disclosure
from passive investors than from activists.
Knopman Note: An investor who owns more than 5% of a company
and would like to engage with the company to change majority voting
standards, amend corporate governance rules, or advocate for the
removal of a staggered board (i.e., where board members are not
all up for re-election each year), would still be considered a passive
investor and could file a 13G instead of a 13D.
The SEC permits investors to decide whether they fall under the jurisdiction of a
Schedule 13D filing or a Schedule 13G filing. If an investor initially files a 13G and
later decides on taking a more active role in the issuer’s business, that investor
must file a 13D within 10 days.
Knopman Note:
Q: What kind of investor files a 13G?
A: Investors who become more than 5% shareholders with a
passive intent. For example, mutual funds and employee stock
ownership plans (ESOPs) are often passive investors and
therefore file a 13G rather than a 13D.
8.5.2 Schedule 13F—Institutional Investment Managers
A Schedule 13F filing is made by institutional investment managers to declare
holdings in public stocks at the end of each calendar quarter. The filing deadline
is 45 days from the end of each quarter. This form is used by financial media and
analysts to evaluate what portion of a company’s public float is held by money
managers, and also to see which managers are increasing or decreasing their
positions.
An institutional investment manager is defined as any entity managing discretionary assets of $100 million or more. Examples of institutional investment
managers include broker-dealers, hedge funds, investment advisers, university
endowments, foundations, and any company that manages its own portfolio (e.g.,
Berkshire Hathaway). An individual investor managing his/her own portfolio is
never defined as an institutional investment manager, even if the portfolio is
worth $100 million or more.
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Schedule 13F requires disclosure of long equity positions. It does not require disclosure of short positions, positions in debt securities, or positions in derivative
securities.
Institutional investment managers who hold 5% or more of a public company’s
stock must file both Forms 13G and 13F. Advisers are considered beneficial owners
of the stocks they manage if they exercise either voting power or the power to
dispose of the security (i.e., investment discretion). If the adviser intends to be
an activist shareholder, Form 13D is filed instead of Form 13G.
Chapter 8
Reporting Requirements
Under the Securities
Exchange Act of 1934
Knopman Note: The large shareholder filings (13D, 13G, and 13F) are all
important concepts—the rules surrounding these filings must be wellunderstood and memorized.
Filing Threshold
Filing Deadline
Who Files
(examples)
Notes
13D
>5%, with active intent
Within 10
calendar days of
acquisition
Activist
investors
Filed with SEC, primary
exchange, and issuer
13G
>5%, with passive intent
Within 45 days of
calendar year end
Mutual funds
Must file 13D if intent
changes from passive to
active
13F
>$100 million assets
under management in a
discretionary securities
portfolio
Within 45 days of
calendar quarter
end
Investment
managers
Discloses long equity
positions only
Q: How can a company use the above filings to learn who its major
shareholders are and what other stocks those investors own?
A: The company can first review all 13D (or 13G) filings and then
review those investors’ Form 13Fs. An investor could also review
the company’s 10-K and 14A (proxy) to view a list of major
shareholders.
Q: Based on these filings, how might a company classify its
investor base?
A: A company can use these filings to analyze its shareholder
base and classify them by institutional ownership and insider
ownership.
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Chapter 8: Reporting Requirements Under the Securities Exchange Act of 1934
Unit Exam
1. The Securities Exchange Act of 1934 requires
an issuer to register with a national securities
exchange once it has reached which TWO of
the following thresholds?
I.
II.
III.
IV.
A.
B.
C.
D.
At least 100 shareholders
At least 2,000 shareholders
At least $10 million in assets
At least $50 million in assets
I and III
I and IV
II and III
II and IV
2. All of the following types of organizations
are exempt from the ongoing reporting
requirements of the ’34 Act except:
A. Educational institutions
B. Fraternal or charitable organizations
C. Companies with less than 5,000
shareholders
D. Separately regulated insurance companies
3. The annual report that public companies
must file to meet the ongoing reporting
requirements of the ’34 Act is the:
A.
B.
C.
D.
8-K
8-Q
10-K
10-Q
4. What information is contained in Part III of a
company’s annual 10-K report?
A. Exhibits and financial schedules
B. The business and its operations
C. Audited statements and management’s
discussion
D. Information on directors, officers, and
stock ownership
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5. Which of the following best describes the
difference between a Schedule 13D and a
Schedule 13G?
A. A Schedule 13D is for 5% shareholders,
whereas a Schedule 13G is for 10%
shareholders
B. A Schedule 13D is for affiliates, whereas a
Schedule 13G is for non-affiliates
C. A Schedule 13D is only for individual
investors, whereas a Schedule 13G is only
for institutional investors
D. A Schedule 13D is for activist investors,
whereas a Schedule 13G is for passive
investors
6. Which of the following categories of filers must
file their Form 10-Q within 40 calendar days?
I.
II.
III.
IV.
A.
B.
C.
D.
Large accelerated filer
Accelerated filer
Non-accelerated filer
Small accelerated filer
I and II only
I and III only
II and III only
I, II, III, and IV
Chapter 8: Reporting Requirements Under the Securities Exchange Act of 1934
Unit Exam (Continued)
7. What is the primary use of Form 8-K?
A. To offer official notification to various
classes of shareholders of matters to
be brought to a vote at a shareholders’
meeting
B. For registrants to report quarterly
financials, management discussion and
analysis, and any changes in accounting
principles
C. To report equity holdings by institutional
investment managers having equity assets
under management of $100 million or
more
D. For registrants to report any unscheduled,
and previously unreported, material
events or corporate changes which could
be deemed important to investors or
security holders
9. The final proxy statement filed with the SEC
for an ordinary annual shareholder meeting is
also known as:
A.
B.
C.
D.
10. Which TWO of the following are TRUE of the
timing of required public disclosure under
Regulation FD?
I. It must be simultaneous if the selective
disclosure was intentional
II. It must be made promptly if the
selective disclosure was intentional
III. It must be simultaneous if the selective
disclosure was unintentional
IV. It must be made promptly if the
selective disclosure was unintentional
8. Annual reports must be filed on Form:
A.
B.
C.
D.
8-K
10-Q
10-K
N-Q
DEFM14A
PREM14A
DEF14A
PRE14A
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
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Chapter 8: Reporting Requirements Under the Securities Exchange Act of 1934
Unit Exam—Solutions
1.
(C)
The SEC requires registration of any issuer with at least 2,000 shareholders and
at least $10 million in assets.
2. (C)
The exemption for registration and ongoing reporting requirements covers issuers that
operate exclusively for religious, educational, benevolent, fraternal, or charitable
purposes and separately regulated insurance companies. Also exempt are corporations
with fewer than 2,000 shareholders and no more than $10 million in assets.
3. (C)
Two periodic reports that public companies must file are the 10-K for annual reports
and the 10-Q for quarterly reports.
4. (D)
Part I of the 10-K provides an overview of the business; Part II contains numbers and
analysis; Part III lists the officers, directors, and 5% shareholders; and Part IV includes
exhibits and schedules.
5. (D)
Schedules 13D and 13G are both triggered by an investor’s beneficial ownership of at
least 5% of the voting shares of a company. The difference between the two forms is
that a 13D is for investors with an active role in company management, whereas a 13G is
for investors with a passive role in company management.
6. (A)
According to the deadlines for filing periodic reports, large accelerated filers ($700
million or greater public float) and accelerated filers ($75 million or greater public float)
have 40 calendar days to file a Form 10-Q.
7.
(D)
Form 8-K details information that needs to be disclosed on a timely basis to the
registrant’s stakeholders. It is meant to be more current than the 10-Q or 10-K.
8. (C)
Form 10-K is filed on an annual basis after the fourth quarter of a registrant’s fiscal year.
9. (C)
DEF14A is the proper SEC form for a definitive proxy statement as denoted by the prefix
“DEF.” A preliminary proxy statement is denoted by the prefix “PRE.” A proxy statement
filed in conjunction with an M&A transaction has “M” after “DEF” and “PRE.”
10. (B)
The objective of Regulation FD is to prohibit selective disclosure of inside information.
The timing of the required public disclosure depends on whether the selective
disclosure was intentional or unintentional; for an intentional selective disclosure, the
issuer must make public disclosure simultaneously; for an unintentional disclosure, the
issuer must make public disclosure promptly.
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9. Syndication of Securities
Offerings
When corporations or governments need additional capital, they can sell equity
or debt securities to both institutional and retail investors. A broker-dealer’s
investment banking department is often engaged to assist the issuer in determining how best to structure the offering and distribute the securities. A group
of firms working together in this process is called a syndicate, and the firms that
share financial risk in the offering are underwriters.
Due to competitive pressures and regulatory requirements, most securities offerings are brought to market and sold to investors in a defined (often brief) window. Before this window opens, the underwriters, the selling group members,
and their sales channels and distributors must be prepared to call or meet with
investors.
This chapter will cover the role of broker-dealers throughout this process,
including:
◆ Identifying current trends and competitive offerings in the same time
window
◆ Forming a syndicate
◆ Underwriter compensation
◆ Selling shares to the public
◆ Completing the offering
9.1 Types of Offerings
An issuer’s sale of securities can either be classified as a new issue or an additional issue. An initial public offering (IPO) is an issuer’s first public sale of
securities. An additional issue (i.e., a follow-on or an add-on) occurs when an
issuer that already has publicly traded securities sells additional stock to the
public.
Further classifications of offerings are:
◆ Primary offering—A new issue in which all proceeds belong to the
issuer.
◆ Secondary offering—An offering in which a shareholder sells shares
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Securities Offerings
held in the issuing corporation, and proceeds of the offering belong to
that shareholder. An example of this type of transaction is a founder of
the company, an angel investor, or a venture capital firm liquidating a
sizable position in the company. If a transaction is a secondary offering,
the company’s net worth will be unchanged, as all proceeds are received
by existing shareholders.
◆ Split offering—A combination of primary and secondary offerings.
This is very common, as large shareholders may choose to sell shares
alongside the company in a registered offering.
An investor can examine the cover of a prospectus to learn about the issuer’s
offering. Typically, the cover’s first paragraph will disclose if the issue is an IPO
or a follow-on and if the shares are being offered by the company (i.e., primary),
selling shareholders (i.e., secondary), or a combination of the two (i.e., split).
Knopman Note: It is crucial to understand the terminology pertaining
to the different types of offerings discussed above, as well as where an
investor can learn about the nature of a particular deal.
Q: A company registers to sell the shares of a director (an
existing shareholder) and a private equity shop (an existing
shareholder), but does not register any primary (new) shares—
what type of deal is this?
A: The prospectus would identify this deal as a secondary offering,
because only existing shareholders are selling.
9.2 Identifying Current Trends and Competitive Offerings
Successful securities offerings are brought to market when conditions are favorable, as indicated by strong investor demand for comparable offerings and receptive distribution channels. The most favorable conditions also include a stable
stock market and a lack of crowding from competing issues coming to market at
the same time. Several sources of data can help to evaluate recent and upcoming
offerings.
9.2.1 Initial Public Offerings
The first public indication of a new offering is an SEC filing, which may include
an offering amount in shares or dollars. The filing usually does not indicate an
expected offering date or a specific price. Instead, the lead underwriter generally
announces an expected offering date several weeks in advance, along with an
expected price range. Data services such as Hoover’s compile these announcements into IPO calendars. These same services then publish results of recent
IPOs with the offering price and the first-day trading range.
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9.2.2 Follow-On Offerings
Commercial services offer search engines for tracking follow-on offerings filed
with the SEC and for locating news reports of follow-on offerings, including shelf
offerings.
Chapter 9
Syndication of
Securities Offerings
9.3 Types of Underwriting Commitments
The most common type of underwriting is a firm commitment, in which the
managing underwriter agrees to purchase all shares that are to be offered. If
part of the new issue goes unsold, any unsold shares are distributed among the
members of the syndicate.
A standby commitment is a type of firm commitment underwriting that applies
when additional shares are issued and current shareholders have pre-emptive
rights. In this arrangement, the securities are offered exclusively to existing shareholders for a two- to four-week standby period. This process is referred to as a
rights offering. The underwriter will purchase for resale any of the shares that
are not subscribed to during this period. This arrangement ensures that all of the
shares will be sold either to existing shareholders or the underwriter(s).
Knopman Note: A standby underwriting is a type of firm commitment
that is used in connection with a right offering.
A best efforts is an underwriting agreement in which the underwriters attempt
to sell all the securities but have no obligation to buy any unsold shares. These
agreements are usually used for higher-risk securities.
An all-or-none is a type of best efforts underwriting. If the underwriter is not
able to sell all the shares within a certain period, the entire deal will be cancelled.
A minimum-maximum (mini-max) is a type of best efforts that will be cancelled unless a minimum amount is raised. Once the minimum threshold has
been reached, it becomes a traditional best efforts underwriting. A mini-max is
also called a part-or-none.
Both all-or-none and mini-max best efforts underwritings are referred to as contingency underwritings. This is because a sales threshold (100% for an all-ornone, some lower threshold for a mini-max) must be met for the transaction to
be confirmed.
Knopman Note:
Q: What is the most typical type of underwriting commitment?
A: Most registered offerings are sold via a firm commitment. The
underwriter will purchase all the shares from the issuer then
resell them to the public. The underwriter is liable for any
unsold shares.
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9.3.1 Rules Regarding a Best Efforts Underwriting
Private placements and other offerings of risky securities are usually structured
as best efforts or contingency offerings.
SEC Rule 10b-9 states that issuers and broker-dealers must be truthful with
the public about the type of underwriting commitment. It is a manipulative and
deceptive practice to indicate or represent that a security is being offered or sold
on an all-or-none or a contingency basis unless it actually is, or that all or part
of the consideration paid for a security may be refunded to the purchaser if the
offering is unsuccessful, unless that is actually the case. For example, in an allor-none, the issuer could not decide to purchase any unsold shares to satisfy the
contingency—that would make it a firm commitment.
SEC Rule 15c2-4 requires that broker-dealers participating in all-or-none or
mini-max offerings deposit investor funds in a separate escrow account at an
independent bank, or any other qualified financial institution (QFI), for the benefit of the investors. Once the contingency is satisfied, the funds are transmitted
to the issuer promptly.
Many best efforts underwritings, however, fail to meet the minimum order
threshold and are unable to close. A failure to close means that all investor funds
must be returned. If the sale is cancelled, then the money must be returned to
the investors and no more orders will be taken.
A written agreement must be in place to ensure the bank handles the funds properly in the event that the contingency is reached or the offering is cancelled.
Knopman Note: There are a few key characteristics of a best efforts
underwriting that candidates must know.
Q: Once a deal reaches the required threshold, when will an issuer
client receive the proceeds from the sale of its securities?
A: The underwriters must release the proceeds from escrow
“promptly,” which is defined as by noon the next business day.
Q: Where can an underwriter hold the escrow proceeds prior to
meeting the contingency?
A: Funds must be held in escrow at a qualified financial
institution (QFI); they may not be held in an attorney’s escrow
account.
Q: An issuer seeking to offer securities while incurring lower fees
would seek what type of underwriting?
A: A company seeking to sell shares and incur low underwriting
expenses would pursue a best efforts underwriting rather
than a firm commitment. A best efforts will have the lowest
underwriting fees.
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9.4 Participants in an Underwriting
Once it decides to sell securities, the issuer will select its underwriter through
either a negotiated underwriting or competitive bid process. In a negotiated
underwriting, the terms of the offering are determined between the issuer and
a single underwriter. Typically, the issuer will meet with a number of prospective
underwriters and decide which it is most comfortable working with based on a
variety of factors. This process is referred to as a bake-off.
Chapter 9
Syndication of
Securities Offerings
Knopman Note: An investment bank pitching a prospective client
could include a tombstone of recently completed deals.
Knopman Note: An investment bank that has gained market share
through an impressive list of public company clients and wants to
include this information in its marketing materials would most likely
incorporate this data by listing the names of the customers by sales
rank and include the customers’ familiar logos.
In a competitive bid process, underwriters submit sealed bids to the issuer to
sell the securities. The issuer awards the contract to the underwriter with the
best price and contract terms.
Most corporate underwritings are structured through a negotiated process.
Select municipal bond deals are awarded via a competitive bid.
In either arrangement, underwriters purchase the securities from the issuer and
resell them to the public at the offering price. The terms and conditions of the
public offering and the agreement between the issuer and the underwriter are
formalized in a contract known as the underwriting agreement.
9.4.1 Formation of the Syndicate
The next step in the underwriting process is forming a syndicate. Syndication
occurs because most new issues are too large for one underwriter to effectively
manage. In forming a syndicate, the lead underwriter, or managing underwriter,
invites other investment banks to participate in a joint distribution of the offering. Members of the syndicate usually commit to distribute a certain percentage
of the entire offering and are held financially responsible for any unsold portions.
The syndicate is a temporary group and is dissolved after completion of the sale.
Within a broker-dealer, the syndicate desk (sometimes called the capital markets desk) is tasked with marketing, selling, and possibly stabilizing the new
issue. The syndicate desk generally is not responsible for preparing the offering
documents.
The composition of a syndicate is determined by several factors, including the
size and complexity of the deal, the financial reputation and seasoning of the
issuer, investor demand for the deal, and current market demand for similar
issues.
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The terms established between syndicate members are found in the agreement
among underwriters (AAU). The AAU:
◆ Appoints the originating investment bank as the managing (lead)
underwriter
◆ Assigns each of the syndicate members a proportionate liability, and
◆ Authorizes the manager to allocate a portion of the issue to a selling
group
Both the underwriting agreement and the agreement among underwriters are
discussed in greater detail in Chapter 10.
Knopman Note:
Q: What are some of the key roles the syndicate desk performs
during an underwriting?
A: The lead manager’s syndicate desk will:
• Visit potential investors to market the securities on a road
show
• Distribute red herrings and FWPs
• Collect indications of interest (IOIs) to determine deal size
and price
Q: What would the syndicate desk not do?
A: Syndicate members do not typically participate in the
preparation of the underwriting documents (e.g., the
registration statement, FWPs, etc.). The issuer, attorneys, or
accountants prepare and file the FWP with the SEC.
9.4.1.1 The Selling Group
A selling group is comprised of broker-dealers that sell an allotment of the newly
issued securities on behalf of an underwriter or syndicate members. The syndicate sells the securities to the selling group members at a mark-up from its price
but still at a discount from the public offering price.
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Knopman Note:
Q: Why would a lead underwriter engage a selling group?
A: A lead underwriter might engage a selling group to increase
sales channels and demand.
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Doing so would allow more investors to express interest in the
deal because a selling group can collect indications of interest
(IOIs) from its clients in a new issue.
Note: Selling group members cannot sell shares to the public at
a discount and they do not take on any financial liability for the
securities.
Unlike the syndicate members, the selling group members are not financially
responsible for any unsold shares. Any shares the selling group cannot distribute
are returned to the underwriting syndicate.
The selected dealer agreement stipulates the terms for the selling group.
Included in the selected dealer agreement is:
◆ Affirmation that the firm is in good standing with its regulators
◆ Agreement by the selected dealer to follow all applicable SEC regulations
in the distribution
◆ Methods of communicating supplemental information about the offering
(i.e., a “deal wire”)
◆ Payment terms for the selected dealer’s participation, and
◆ Circumstances under which the agreement will terminate
Knopman Note:
Q: How does the selling group differ from the syndicate members
in an underwriting?
A: The selling group members sell shares as agent only and do
not purchase the shares. Any unsold shares from the selling
group are returned to the underwriting syndicate or syndicate
member or manager. The selling group’s only role is to collect
indications of interest.
9.5 Underwriting Compensation
The compensation to the syndicate in an underwriting is the underwriting
spread. The spread is calculated as the difference between what the underwriters
pay an issuing company per share and the public offering price (POP), which
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is the price the public must pay to purchase the securities. The size of the spread
depends on the negotiations between underwriters and the company. The spread
increases with the amount of risk the underwriters take on.
When underwriters determine a security’s public offering price, they evaluate a
number of factors, including:
◆ Issuer financial status and profitability
◆ Investor demand
◆ Industry trends and growth rates
◆ Investor confidence
The syndicate must always sell to the public at the public offering price. Discounts
from the public offering price are only available to members of the syndicate or
selling group—never to the public.
The syndicate members purchase the securities from the managing underwriter
at the takedown price.
9.5.1 Components of the Spread
The price paid to the issuer to purchase the shares is known as the underwriting
proceeds. The spread between the POP and the underwriting proceeds is divided
into the following components:
◆ Manager’s fee—Compensates the managing underwriter for negotiating
and managing the offering
◆ Underwriting fee—Compensates syndicate members for assuming the
risk of not being able to sell the shares
◆ Selling concession—Compensates the managing underwriter, the
syndicate member, or the selling group member for actually selling the
shares. For example, a retail broker that is not part of the syndicate
might sell shares and therefore earn the concession.
Below is the typical amount of the spread allocated to each of these components.
Manager’s Fee
(10%–20% of spread)
Underwriting Fee
(20%–30% of spread)
Spread
Selling Concession
(50%–60% of spread)
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Full/Total
Takedown
Knopman Note:
Q: What is not considered part of the spread?
A: FINRA defines the gross spread as having exactly three
components: the management fee, underwriting fee, and selling
concession. The following are not included in the gross spread.
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• The book-runner fee
• Reimbursed issuer expenses
• Blue sky fees
Q: Who is permitted to purchase shares at a discount to the offer
price and earn the spread?
A: Only members of the syndicate, including selling group
members, can purchase shares at a discount. All other
investors, including institutional investors and broker-dealers
not in the syndicate, must pay the offer price.
Only the manager can potentially receive the full spread as compensation. The
syndicate members can potentially receive the underwriting fee and selling concession, which together are known as the full takedown, total takedown, or
underwriting concession. The selling group members receive only the selling
concession.
Knopman Note: Even when a selling group member sells a share,
a syndicate member might keep a small percentage of the selling
concession, known as the reallowance. The reallowance goes to
syndicate members, not the selling group.
Typical Gross Spreads
Gross spreads can vary greatly based on the size and complexity of the offering,
the amount of competition among investment bankers for the offering, and the
type of security offered. For IPOs of small companies, gross spreads of up to 10%–
15% are not uncommon. For investment-grade corporate bond offerings, spreads
can be as low as 2%–3%. Spreads on equity IPOs tend to cluster around 7%.
Example
The example below shows a typical hierarchy of a syndicate. Let’s assume that
the public offering price is $20 per share and the total spread is $1.50 per share,
or 7.5%. The gross proceeds to the issuer will be $18.50 per share. The issuer registers 150,000 shares in the offering. The syndicate manager receives an allocation of 100,000 shares, and the syndicate members are liable for the remaining
50,000 shares. Remember, the selling group acts only as an agent and therefore
does not receive an allocation. The breakdown of the capital raised by the
issuer and the compensation paid to the syndicate is shown below.
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Public Offering Price
$20.00 per share
Spread
$1.50 per share
Spread
$1.50 per share
Manager’s Fee
$0.30 per share
Proceeds to Issuer
$18.50 per share
Underwriting Fee
$0.45 per share
Total Takedown
$1.20 per share
Selling
Concession
$0.75 per share
Subsequently, the syndicate manager sells 95,000 shares, the syndicate members sell 40,000 shares, and the selling group sells the remaining 15,000 shares.
The syndicate manager will receive the syndicate manager’s fee for all 150,000
shares, the underwriting fee for its allocation of 100,000 shares, and the selling
concession for the 95,000 shares it sells. The syndicate members will receive
the underwriting fee for their allocation of 50,000 shares and the selling concession for the 40,000 shares they sell. The selling group will receive only the
selling concession for the 15,000 shares it sells. The breakdown of the compensation to each participant is set forth below.
Shares Sold
Public Offering Price
Gross Spread - 7.5%
Proceeds to Issuer
150,000 shares
Per Share
Total
$20.00
$1.50
$18.50
$3,000,000
$225,000
$2,775,000
20% of spread
$0.30
Role
Lead Manager
Syndicate Member
Selling Group
Total
Allocation
100,000
50,000
0
150,000
Shares
Sold
95,000
40,000
15,000
150,000
30% of spread
$0.45
Management
Fee
$
$
$
$
45,000
45,000
50% of spread
$0.75
Underwriting
Fee
$
$
$
$
45,000
22,500
67,500
Selling
Concession
$
$
$
$
71,250
30,000
11,250
112,500
Total
$
$
$
$
161,250
52,500
11,250
225,000
Knopman Note: When an allocation is granted to an underwriter, this
can also be referred to as being fractioned. For example, a co-manager
fractioned 30% of a $600MM deal would be responsible for selling
$180MM worth of shares.
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Progress Check
1. The document used by the issuer and lead
manager to outline the terms under which the
broker-dealer will take on the shares is called
the:
A.
B.
C.
D.
Preliminary study
Due diligence review
Underwriting agreement
Tender offer
2. All of the following statements are TRUE
regarding a selected dealer agreement
except:
A. It is permissible to communicate terms of
the selected dealer agreement by wire
B. It is permissible to amend terms of the
selected dealer agreement by wire
C. It identifies the terms of payment between
the selected dealers and the managing
underwriter
D. It specifies that all selected dealers must
be FINRA members
4. Underwriters have a firm commitment
responsibility in which of the following?
A.
B.
C.
D.
All-or-none
Mini-max
Best efforts
Standby
5. All of the following statements describe a firm
commitment underwriting except:
A. The underwriters purchase all securities
directly from the issuer
B. The securities are purchased from the
issuer at a price below the public offering
price
C. The securities are offered to the public at
the price specified in the prospectus
D. The underwriters return to the issuer any
securities that cannot be sold
3. A non-underwriter that participates in an
underwriting only to take down securities for
re-sale to investors is a:
A.
B.
C.
D.
Syndicate manager
Syndicate member
Selected dealer
Distribution member
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Progress Check—Solutions
1.
(C)
The underwriting agreement outlines the type of underwriting commitment along with
the offer price and spread to the underwriter.
2. (D)
The selected dealer agreement specifies the terms of the offering between members of
the selling group and the syndicate manager. In distributions involving exempt
securities, a syndicate can include banks or other non-FINRA-member firms.
3. (C)
A selected dealer is a non-underwriter distributor of a new issue, earning only the
selling concession portion of the gross spread, and only on the securities it actually
sells. Selected dealers have no financial risk for unsold securities.
4. (D)
In a standby commitment, the underwriter will purchase for resale any remaining
securities that have not been subscribed to by existing shareholders. This is a firm
commitment because the underwriter acts as a dealer by taking on the risk of the
offering. In an all-or-none, if the whole offering cannot be subscribed, it is cancelled.
A mini-max is similar, except it will be cancelled if a certain minimum amount has
not been sold. In a best efforts, the underwriter pledges to sell as much as possible but
is not responsible for the unsold portion.
5. (D)
A firm commitment is an underwriter’s agreement to assume all inventory risk
and purchase all of the securities directly from the issuer for sale to the public at the
price specified. Unsold shares cannot be returned to the issuer.
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9.6 Building the Book
Before an initial public offering becomes effective and orders are taken, an
important process takes place to pre-market the offering to qualified investors.
This process is called building the book. It begins with the lead manager in a
syndicate determining the allocation of shares among underwriters. Each underwriter then attempts to build a book by marketing to investors (mainly large
institutions), who make indications of interest (IOIs). Unless IOIs are cancelled,
they become orders on the effective date.
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Underwriters and selling group members can obtain IOIs through phone calls,
in-person meetings with investors, or road show presentations.
The book-building process serves several purposes:
◆ It verifies that a market exists for the shares and apportions shares
among interested investors. In most cases, underwriters have flexibility
in how their allocations are divided among interested investors.
◆ It stirs up interest among the large institutions that are critical to the
success of any offering, especially IPOs.
◆ Based on investor demand, it determines the public offering price for the
IPO.
Knopman Note:
Q: What documents may be used to market a deal prior to its going
effective?
A: A red herring and tombstone can be used to market a deal
before it is effective.
During the book-building process, the price of the offering is usually expressed as
a range—e.g., $22.50 to $25.00 per share. This range is not binding, and the lead
manager can change it based on market demand.
If demand for shares is strong, the range can be adjusted upward, and the public offering price can even be set above the top of the range. Conversely, weak
demand can cause the price range to drop, and the offering price to be set below
the low end of the range. In extreme cases of weak demand, the offering can be
delayed or cancelled.
The underwriter could also increase the number of shares sold prior to the effective date (upsize the deal) based on strong investor demand.
While building customer orders, the underwriter might be tempted to allocate
shares of the IPO to executives of other companies with the intention of further developing a relationship and doing investment banking business with that
firm in the future. This type of quid pro quo arrangement—the allocation of new
shares in exchange for future investment banking business—is prohibited and
is referred to as spinning. Specifically, underwriters are prohibited from selling
an IPO to a client who is an executive of a public company if the broker-dealer
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has received compensation from that client in the past 12 months for investment
banking services or expects to receive compensation in the next three months.
An exemption is available if the issuer directs sales to any of those individuals,
in writing, without influence from the underwriter.
Once shares are allocated, they are circled and committed to those investors.
Prior to the effective date, investors may renege on their circled shares by cancelling all or part of the allotment. However, this practice is discouraged because
it exposes the underwriter to risk.
Knopman Note: Member firms must follow certain rules when
allocating new shares (e.g., IPO shares) to investors and avoid any
abusive or prohibited allocation arrangements. These prohibited
allocation arrangements include:
• Quid pro quo allocations—An allocation of a new issue is awarded
to a customer that agrees to pay excessive compensation for other
services the underwriter offers. A customer cannot pay for an allocation through the purchase of the underwriter’s other services.
• Tie-in arrangements—Allocations that require investors who
receive IPO shares to purchase additional shares in the secondary
market. This is considered a form of market manipulation.
• Spinning allocations—Spinning is the allocation of new shares to
officers, directors, or other senior management of current, future,
or prospective investment banking clients, defined as entities from
which the broker-dealer has received compensation for investment banking services in the past 12 months or expects to in the
next three months.
Aside from spinning, it is also prohibited to withhold new-issue shares
as consideration or inducement for the receipt of compensation that
is excessive in relation to the services provided by the member.
An exemption is available if the issuer directs sales to any of those
individuals, in writing, without influence from the underwriter. These
are referred to as issuer-directed allocations. More casually, these are
referred to as friends and family shares.
Note that when allocating shares in an IPO, a banker may look for
long-term investors. One indication would be if the investor held
comparable companies in its portfolio (e.g., a fund that holds lots of
technology companies would likely hold other tech companies).
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9.6.1 Returned Shares and Short-Selling
Returned shares are shares that are allocated (circled) but not purchased by
customers. In a firm commitment underwriting, they become a liability for the
underwriter to which they were allocated. Returned shares can also result from
operational mistakes by the underwriter, customer inability to pay for shares, or
an unexplained failure by the customer to settle the trade.
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In most cases, each underwriter is responsible for any losses or liabilities related
to returned shares. This is one reason underwriters should take care in confirming orders and the buyers’ ability to pay for shares on settlement.
Overselling the offering (also called over-allotting) helps underwriters manage this risk. It’s a practice similar to overbooking an airplane when airlines
know that a few reserved seats will not be filled by the final boarding call. The
book-building process can help underwriters evaluate how firm indications of
interest are and whether to oversell the offering (as well as by how much). In
deals that offer underwriters an over-allotment option (also known as a greenshoe option; discussed shortly), the book-building process can help underwriters
decide whether to exercise this option.
9.7 Identifying Shareholders of the Issuer and Comparable
Companies
The largest current shareholders of the issuer (and comparable companies) are
typically a target market for new issues. Lists of such shareholders can be created
using a combination of sources, including SEC filings, filings with Secretary of
State offices, and information that issuers themselves make available.
Forms 3, 4, and 5 are the SEC filings for transactions by corporate insiders. Also,
each state’s Office of the Secretary of State collects public records with names
and addresses of the company’s directors and principal officers.
9.8 Allotments and Directed Orders
Based on the agreement among underwriters, the lead manager may receive a
retention of shares above the allocation granted to other underwriters. Part or all
of this retention may be used as a “pot” for sale directly to large institutions. This
makes the selling process more efficient by ensuring that multiple underwriters
don’t solicit the same large institutional clients.
9.8.1 Fixed Pot Arrangement
In a fixed pot arrangement, the allocation of sales credits on “pot sales” is predetermined among the underwriters and does not depend on who originates institutional sales. Underwriter compensation on these sales is defined by agreement.
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9.8.2 Jump Ball Pot Arrangements
Under a jump ball pot arrangement, the credits may go on a first-come-firstserved basis to any underwriter that places institutional orders through the pot.
Underwriters compete to receive designations of sales credits from institutional
investors.
Regardless of how the sales credits are allocated, directed orders are usually
placed and settled directly between institutions and the lead manager.
Under a jump ball pot arrangement, underwriters that are entitled to sales credits
on directed orders must document these transactions.
In the US, most equity offerings are done via a fixed pot arrangement, with a small
percentage of some deals sold as a jump ball.
9.9 Pricing and Scheduling the Offering
Pricing and scheduling decisions are usually the responsibility of the lead manager or book-runner. This firm is in the best position to communicate with the
issuer and evaluate market conditions for the offering as well as the success of the
book-building effort. On a day-to-day basis, the book-runner will evaluate how
“hot” or “cold” demand for shares is running relative to supply. The book-runner
may also evaluate overall new-issue market conditions and investor demand,
and discuss these factors with other underwriters, before making final pricing
and scheduling decisions.
Knopman Note: If a deal is substantially oversubscribed (e.g., the
underwriter accepts indications of interest for 100 million shares for
a 10 million share offering), the underwriter may upsize the deal by
increasing the number of shares in the deal, increasing the offering
price, or both.
Among large institutional investors, it may be helpful to evaluate whether indications of interest in any given offering are consistent with past practices. An
institution’s indication to buy fewer shares may indicate a lack of interest in the
offering, or an intent to flip the shares after a short time. Flipping means immediately selling IPO shares allocated through the syndicate, usually on the first
day of market trading.
The book-runner can also evaluate the percentage of all indications of interest
placed by large institutions. It is not uncommon for up to 75% of IPO shares to
be sold to institutions, which are more likely to flip shares than individual investors. The hottest IPOs tend to have the highest after-market trading volumes and
flipping activity.
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Knopman Note: In hot IPOs (for example, Facebook or Twitter) retail
investors often want to participate and buy the newly offered shares.
It is important to understand the rules governing the timing and types
of acceptable retail orders surrounding a new issue.
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Assume that an NYSE issuer has priced the deal at $30 per share
and requested acceleration and the SEC plans to clear the issue on
Tuesday, after the market close.
9:30
AM
Tuesday
Wednesday
Market Open
Market Open
New shares are not yet trading on the
NYSE.
New shares are priced, and the
first trade occurs on the NYSE (the
primary exchange).
After the first trade:
11:00
AM
• Shares can trade on all other
exchanges (e.g., Nasdaq, ECNs, etc.).
• Customers can place both limit
(priced) and market (unpriced)
orders.
4:00
PM
Market Close
Market Close
SEC registers the shares, after which:
4:05
PM
• Syndicate confirms IOIs with clients
and sells the newly registered shares
($30 per share).
• Broker-dealers may accept customer
limit orders (priced orders).
• Broker-dealers may not accept
customer market orders (unpriced
orders).
The number of syndicate members can also have an impact on successful pricing
and scheduling. Syndicate members tend to have a vested interest in the success
of the issuer and securities, both during the offering and afterward. In many
cases, syndicate members continue to make a market in the securities, and their
analysts continue to follow the issuer and the securities in the secondary market.
Having at least one underwriter headquartered in the same geographical region
as the issuer may contribute to effective pricing and scheduling decisions, and it
can also stimulate local market demand.
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Knopman Note:
Q: Once a deal is priced, who can purchase shares at a discount?
A: Underwriters may not sell new securities at a discount to any
member of the public—this means retail and institutional
investors, including mutual funds, who all must purchase at the
public offering price (POP).
Q: What is a large risk for an underwriter executing a follow-on
underwriting?
A: An underwriter executing a follow-on offering for a company
with a substantial number of shares owned by a few large
investors would likely view a block trade by an investor as the
largest execution risk. The large trade might “capture” potential
purchasers from the new issue and accordingly reduce overall
demand for the new shares.
9.10 Managing an Over-Allotment Option (Greenshoe)
An over-allotment option (also called a greenshoe) gives underwriters the
right to offer more shares than the amount specified in the underwriting agreement. The name is taken from the first over-allotment arrangement, which was
made in 1963 for the Green Shoe Manufacturing Company.
A greenshoe allows up to 15% more shares to be issued, at the underwriters’ discretion and at the public offering price. This can help underwriters meet strong
market demand for the shares.
A greenshoe can also protect underwriters when they oversell a hot issue—i.e.,
allocate to investors more shares than are initially authorized. For example, suppose an underwriter underestimates public demand for shares and therefore
circles 110% of the firm’s allocation. When the offering becomes effective, if all
circles become orders, the underwriter then will have a 10% short position in the
shares—i.e., owe investors 10% more shares than it has available. The greenshoe
gives the underwriter protection that it won’t have to go into the market to buy
those shares at a price above the public offering price and then deliver those
shares to investors at a loss.
If, on the other hand, the shares are trading below the offer price post-IPO, the underwriter would likely go into the market to purchase shares to cover any over-allotment. This process of the underwriter purchasing the shares in the market to cover
any over-allotment is referred to as a syndicate covering transaction, and will have
the impact of helping to drive the price back up. In this scenario, the underwriter
would profit on the difference between the IPO price and the lower market price at
which it was able to purchase the shares.
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Knopman Note: Unlike stabilization (discussed later), there are no
specific pricing requirements or restrictions for syndicate covering
transactions.
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Also note that while stabilization requires daily notification to the
SEC, syndicate covering transactions do not. However, an underwriter
must notify FINRA in writing prior to conducting its first syndicate
covering transaction and within one business day of completion of a
syndicate transaction.
In most cases, underwriters can exercise a greenshoe option in full or in part at
any time within the first 30 days of trading. Normal underwriting discounts and
spreads apply to greenshoe shares.
Deciding whether or not to exercise a greenshoe option can begin by evaluating
public demand for shares during the book-building process. The decision may also
be affected by the amount of flipping activity in the shares, the presence of any
penalty bids to discourage flipping, and the net short position of underwriters.
Knopman Note: Q&A regarding greenshoes:
Q: What is the maximum size of a greenshoe?
A: Typically 15% of the deal size. Anything greater than 15% is
unreasonable and prohibited under FINRA rules.
Q: What are the mechanics of exercising a greenshoe?
A: A greenshoe will be exercised when the stock is trading above
the IPO price. When it is exercised, the underwriter purchases
shares from the issuer at the IPO price less the spread—i.e.,
with the same economics as the rest of the deal.
Q: Does the greenshoe need to be exercised in whole?
A: No, the greenshoe can be exercised in whole or in part within
30 days.
Knopman Note: When deciding whether to exercise the greenshoe
clause, the least relevant factor for the underwriter would be the
underwriting discount. More important would be whether the shares
are trading at a premium or discount in the market as well as whether
the underwriter has a net short position in the shares.
9.11 Lock-Up Agreements
To protect against significant price fluctuations in newly issued stock, underwriters
generally require the issuer’s management and other significant shareholders to
enter into lock-up agreements. An IPO lock-up agreement is a contract between
these shareholders and the underwriter that prohibits the sale of shares for a
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defined period after completion of the IPO. These agreements help ensure that the
market isn’t flooded with the new stock; a single shareholder selling a large position
in the first week of trading could cause a significant decline in the price. Also, the
lock-up period helps avoid any negative perception that could be created from a
senior executive selling shares immediately following a public offering.
The typical length of the lock-up period is 180 days after the completion of the
IPO, but it can frequently be much longer. Corporate insiders in particular will
generally have continued restrictions on the sale of shares, especially if they have
access to inside information.
Although lock-ups are not required by law, nearly all IPOs feature them because
of the likelihood that a large portion of the newly issued shares is owned by corporate insiders.
Knopman Note:
Q: What are some of the key features of lock-ups?
A: Their purpose is to help maintain a stable share price and avoid
negative perception of the company, or an indication of bad
faith, that can come from executives selling immediately after
the deal.
An underwriter must notify an issuer at least two business days
before a lock-up period on that issuer’s shares expires.
9.12 Books and Records Requirements
After an offering has been completed, underwriters are responsible for accurately documenting communications, transactions, and compliance measures.
The complete deal file includes:
◆ Communications with the issuer
◆ Copies of correspondence with the underwriting group and selling group
◆ Archives of road show materials and other marketing materials and
correspondence
◆ Book-building records
◆ Copies of all filed communications and responses from the SEC, FINRA,
and state securities commissions
Knopman Note: A broker-dealer storing records electronically must
preserve the records in a non-rewritable, non-erasable form.
9.13 Direct Listings
In recent years, rather than going through the traditional IPO process, some private companies have instead opted to go public by engaging in a direct listing.
Unlike a traditional IPO, in a direct listing, no underwriters are hired, no new
capital is raised, and no new shares are sold. Instead, existing shareholders of
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the company are granted the opportunity to directly list and immediately trade
their previously private shares of stock on an exchange, such as the New York
Stock Exchange or Nasdaq. Put differently, all shares sold in a direct listing are
secondary shares.
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Direct listings can be attractive to certain companies because they serve to provide liquidity to existing shareholders by allowing them to freely sell their shares
on the exchange, all while the company avoids the large fees paid to underwriters
in a traditional IPO process.
On the flip side, companies are not able to raise any capital through a direct
listing, and because there is no underwriter syndicating the deal, there is an
additional risk of price volatility when the shares begin trading on the exchange,
without the support of any underwriter to help prevent a decline in price.
Knopman Note: Unlike traditional IPOs, because direct listings have no
underwriter, there is no stabilization agent to support the price of the
newly public shares.
Slack and Spotify are examples of notable companies that have gone public via
a direct listing.
Knopman Note: A company engaging in a direct listing of securities
can register the new securities for trading on the exchange via SEC
Form 10. Securities registered on Form 10 require SEC, FINRA, and
Exchange approval prior to trading.
9.14 Recommendations to Customers
Solicitations of indications of interest (by phone, at road shows, etc.) usually
accompany recommendations to purchase the securities being offered. FINRA
Rule 2111, which applies to institutional customers, requires that recommendations be suitable for the client based on its needs, objectives, time horizon, risk
tolerance, tax bracket, and more.
SEC Regulation Best Interest (BI), which applies to retail investors goes a step
further than FINRA’s suitability standard, requiring that broker-dealers only make
recommendations to retail clients that are in their customers’ best interests.
9.14.1 Regulation Best Interest (BI)
In 2019, the SEC passed Regulation Best Interest (Reg BI) to enhance standards
of retail investor protection. It establishes a heightened standard of conduct for
broker-dealers and registered representatives when making recommendations of
securities transactions, investment strategies, or types of accounts to retail customers. In meeting this standard, the interests of the customers must be placed
ahead of the interests of the firm and its representatives.
Reg BI raises the bar from FINRA’s suitability standard, which previously applied
to all customer recommendations. It requires that broker-dealers do the right
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thing, not just make recommendations that are within the zone of what is appropriate for the customer.
Reg BI requires broker-dealers to disclose all material facts relating to conflicts of
interest when making a recommendation, including conflicts of interest associated with proprietary products, payments from third parties, and compensation
programs.
9.14.2 Suitability for Institutional Accounts
FINRA clarifies that an institutional account is an account for:
◆ A bank, a savings and loan association, an insurance company, or a
registered investment company
◆ An investment adviser, or
◆ Any other entity (including natural persons) with total assets of at least
$50 million
Requirements for institutions are different than those for individuals. For institutions, recommendations simply need to be suitable (appropriate) for the client,
not in their best interest as required for retail investors. Additionally, institutional
investors can be exempt from certain suitability requirements if:
◆ The rep believes the client is capable of evaluating investment risk
independently, and
◆ The client indicates it is exercising independent judgment in evaluating
recommendations
Some considerations for evaluating capabilities include:
◆ The client’s use of consultants, investment advisers, or bank trust
departments
◆ The customer’s general experience in financial markets, and with the
type of instruments being recommended
◆ The customer’s ability to understand economic features, market
developments, and complexities of the securities being recommended
◆ The nature of the relationship between the firm and the customer
Institutional investors can affirmatively indicate that they are exercising independent judgment on a trade-by-trade basis, on an asset-class-by-asset-class
basis, or for all transactions.
Knopman Note: Sophisticated institutional investors can be exempt
from certain suitability requirements as they can effectively gauge risk
on their own.
If a customer is not capable of evaluating risks, then suitability requirements
apply.
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9.14.3 Suitability Requirements for New Issues
In the course of building the book for an offering and obtaining indications of interest, an underwriter may meet with many prospective investors. For example, road
show invitations may fall into the hands of dozens of institutions and individual
investors affiliated with different syndicate members and selling group firms. The
key points that underwriters and selling group members should keep in mind are:
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◆ Made at the point of sale and completed at the point of purchase, an
offering constitutes a recommendation to buy a new issue.
◆ Reasonable basis due diligence should be done on the issuer and offering
by each underwriter.
◆ For purposes of meeting suitability obligations, it is important to
determine whether prospective investors in the offering qualify as
“institutions.”
◆ Know-your-customer requirements apply when newly issued securities
are kept in the firm’s own account and subsequently sold.
Also, each member of the syndicate and selling group should have access to the
due diligence information obtained by the lead manager.
Knopman Note: When allocating IPO shares, the investment banker
will want to consider the long-term investment views of the buyer and
whether this new stock meets those goals.
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Knopman Note: Suitability refers to the “appropriateness” of a
recommendation to an investor.
Examples of suitable recommendations:
• Distressed funds or special situations funds might receive recommendations to invest in companies that have experienced performance challenges, such as those with recent operating losses or
that have recently pulled their earnings guidance.
• A quantitative trader should receive recommendations based on
trading statistics, such as the advance/decline line (number of
stocks up versus down), trading patterns, and a stock’s 10-, 50-, or
100-day moving average.
• An investor seeking to purchase securities that are likely to experience growth, but who does not want to overpay, would receive
recommendations consistent with a growth at a reasonable price
(GARP) strategy.
• An aggressive growth investor would seek funds or securities with
high capital gain potential, with the expectation of exceeding the
growth in the overall stock market. Should these investments distribute any dividends, it would be suitable to recommend these be
reinvested into the fund or security.
• An investor who invests in a company with high revenue growth,
but a very low net income margin, is likely also pursuing an
aggressive growth strategy.
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Unit Exam
1. Which of the following agreements specifies
rules for the group of financial institutions
that assists an underwriter in the sale of a new
issue but is not responsible for any unsold
securities?
A.
B.
C.
D.
Letter of intent
Selected dealer agreement
Syndicate letter
Selling agreement
2. Which two of the following statements are true
of underwriters in an initial public offering?
I. They receive lower fees than the selling
group
II. They receive higher fees than the
selling group
III. They are listed first on the tombstone
IV. They are listed last on the tombstone
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
3. The largest portion of the underwriting spread
is the:
A.
B.
C.
D.
Selling concession
Manager’s fee
Underwriting fee
Issuer’s fee
4. Which of the following could receive the full
spread when securities are sold to the public?
A.
B.
C.
D.
Syndicate manager
Syndicate members
Selling group members
Issuer
5. When an investor purchases shares in an
offering and then sells them right after the
effective date, often on the first day of trading,
this is called:
A.
B.
C.
D.
Front-running
Burning
Flipping
Cut-and-run trading
6. Syndicates with several committed
underwriters are said to have:
A.
B.
C.
D.
Deep pockets
Breadth
Structural integrity
Flow
7. What process stirs up interest in an IPO among
investors and helps determine the public
offering price?
A.
B.
C.
D.
Syndication
Book-building
Gun-jumping
Stabilization
8. How does the manager normally price an IPO
during the book-building process?
A. As a flexible range, which may be changed
B. As a fixed range, which may not be
changed
C. As a fixed share price
D. No pricing quotes or estimates are allowed
during this period
9. A customer provides an indication of interest
in an offering, and the underwriter allocates
these shares to the customer. The shares are
said to be:
A.
B.
C.
D.
Blocked
Outlined
Circled
Subscribed
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Unit Exam (Continued)
10. A stipulation whereby a specified shareholder
is prohibited from selling his/her shares to
another party is known as a:
A.
B.
C.
D.
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Breakup provision
Lock-up agreement
Shareholder rights agreement
Standstill agreement
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Unit Exam—Solutions
1.
(B)
A selected dealer agreement is used between the underwriter/syndicate and the selling
group. The selling group has no financial responsibility for unsold shares.
2. (C)
In an initial public offering, the selling group is made up of institutions that help the
issuer place a new issue without taking on risk. They are not responsible for unsold
securities and, therefore, receive lower fees than the syndicate. The underwriters receive
higher fees and are listed first on the tombstone.
3. (A)
The selling concession, which is the largest component of the spread, is paid to the
broker-dealer that places the securities with the investor.
4. (A)
Only the manager can receive the full spread as compensation. The syndicate members
receive the underwriting fee and the selling concession, which is also known as the
full takedown. The selling group members receive only the selling concession, or a
partial takedown.
5. (C)
Flipping means participating in an offering for a quick gain, and it can disrupt
underwriters’ efforts to maintain a stable share price. Institutions are more likely to flip
than individual shareholders.
6. (B)
The number of committed underwriters is a measure of a syndicate’s breadth because
underwriters have a vested interest in the success of the issuer and securities.
(B)
The book-building process generates interest and enthusiasm in an offering, ahead of
its effective date, especially among large institutional investors. It can also help in
determining the optimal public offering price for shares.
7.
8. (A)
During the book-building process, the share price is usually quoted as a range that can
change based on market conditions, demand, and other factors.
9. (C)
As underwriters take indications of interest and allocate them to customers, the shares
are said to be circled.
10. (B)
Often preceding a takeover, a lock-up provision prevents a significant shareholder from
selling shares to a defined buyer or group of buyers. Lock-up provisions help the
company avoid the negative perception that can result when large shareholders unload
a big position in the market.
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10. Syndicate Settlement and
Regulations
During the book-building and syndication process, underwriters must comply
with a number of rules to ensure that a new issue is sold in a fair and equitable
manner. This chapter will address a number of these regulations, including:
◆ Prospectus delivery requirements
◆ Marketing restrictions
◆ Eligible investors
◆ Conflicts of interest
10.1 Delivering the Red Herring
When the SEC is asked to respond to a request to accelerate a registration’s effective date, it will consider whether the underwriting syndicate has taken “reasonable steps” to inform the public of the offering terms through a preliminary
prospectus, or red herring.
The SEC will also review the registration statement to ensure that all the required
information has been submitted.
In Rule 460, the SEC defines “reasonable steps” as delivery of sufficient copies of
the red herring to each underwriter and broker-dealer expected to participate
in the distribution. The SEC expects underwriters to make the red herring “conveniently available” to all investors.
10.1.1 Prospectus Delivery Requirements in Corporate Transactions
SEC Rule 153a clarifies prospectus delivery requirements for securities transactions involving corporate mergers, acquisitions, reclassifications, or asset
transfers. The rule states that securities may not be sold or delivered in connection with these transactions unless accompanied or preceded by a prospectus.
“Preceded by a prospectus” means “prior to the vote of security holders.”
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Example
ABC Corp issues securities in connection with a corporate merger that is
subject to a shareholder vote. A prospectus must be delivered to each shareholder prior to his or her vote.
A press release issued by ABC Corp to discuss the transaction would also be
filed with the SEC as a prospectus. The filing deadline is no later than the
date of first use.
10.2 Setting Deal Terms
Two contracts are important in setting the terms of an underwriting.
10.2.1 The Underwriting Agreement
The underwriting agreement (UA), also known as the purchase agreement,
is a written contract between the issuer and the investment banking firms in the
syndicate. It may be preceded by a letter of intent between the issuer and the
lead manager. The UA specifies:
◆ The amount of the spread and the net proceeds of the transaction that
will go to the issuer
◆ Any over-allotment options that will be granted to the underwriters
under a greenshoe
◆ Any warrants the underwriters will receive from the company upon
successful completion of the offering
◆ Any right of first refusal given to the underwriters to conduct future
public offerings for the same issuer
◆ Which costs will be the responsibility of each party
◆ Material adverse change, also referred to as market-out clause, which
allows the underwriter to cancel the agreement if some exceptional
event occurs (e.g., the company’s CEO is arrested or extroadinary market
conditions)
Knopman Note: A “market-out clause” is a provision in an
underwriting agreement that permits the underwriter to terminate
the engagement or deal in the event of a material adverse change or
material adverse event.
Knopman Note: An underwriter working in an industry where there
have been a significant number of mergers and other consolidations
(i.e., substantial saturation) might closely examine change of control
provisions in an underwriting agreement. The banker would do this
to be prepared in case one of the clients became the target of an
acquisition.
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Knopman Note: A prospectus for a new issue will include the
names of the underwriters and gross spread, but will not include
the breakdown of the spread or a copy of the full underwriting
agreement.
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10.2.2 The Agreement Among Underwriters
The agreement among underwriters (AAU) is also called a syndicate contract,
master underwriting agreement, or purchase group agreement. The AAU:
◆ Identifies the lead manager, and the co-manager (if any)
◆ Establishes authority for forming a selling group
◆ Describes expected terms of the offering, including the participation,
i.e., the amount to be underwritten
◆ Describes each underwriter’s responsibilities and liabilities
◆ Allocates shares among underwriters and describes the concessions that
will be offered to underwriters, selling group members, and securities
dealers; the total takedown is the aggregate of all concessions paid to
underwriters.
◆ Describes any retentions (securities available for allocation to syndicate
members, without regard to allocations)
Knopman Note: The agreement among underwriters (AAU) in an IPO
must require that shares trading at a premium that are returned by a
purchaser to a syndicate member after trading begins be:
1. Used to offset any syndicate short positions
2. Offered at the public offering price to unfilled customer
orders using a random allocation methodology, or
3. Sold on the secondary market with the profits anonymously
donated to charity (to avoid any reputational benefit to the
member)
The shares may not be placed into the firm’s investment account—
this would violate FINRA’s rules on new-issue allocations and
distributions.
The AAU also may require a good faith deposit from each syndicate member.
Knopman Note: An underwriting with fixed economics provides an
underwriting firm a pre-set amount of deal revenue based on their
allocation, regardless of the number of securities actually sold by that
underwriter.
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10.3 Rules on Underwriting Terms and Arrangements
FINRA’s Corporate Financing Rule regulates the underwriting terms of most
public offerings, including shelf offerings, conducted by member firms.
The rule requires filing specific documents with FINRA’s Corporate Financing
Department (CFD), including a registration statement. Before the offering can
become effective, broker-dealers must receive the department’s opinion of no
objection. The managing underwriter must file documents with FINRA within
three business days of filing with the SEC.
The required documents include:
◆ Three copies of each of the following: the proposed underwriting
agreement (UA), the agreement among underwriters (AAU), and any
related attachments or agreements, such as an agency agreement, a
purchase agreement, a letter of intent, a warrant, or escrow agreements
◆ The final registration statement
◆ A list of the underwriting syndicate members, and one copy of the final
underwriting documents
◆ A statement of any association or affiliation by a member with any officer
or director of the issuer, and disclosure by any member of any beneficial
ownership of 10% or more of any class of the issuer’s securities
◆ An explanation of any arrangements entered into by the member firm
and the issuer during the 180-day period immediately preceding the
required filing date of the public offering
Knopman Note: The underwriter must receive a no-objection letter
from FINRA to sell the securities. If FINRA has issued a no-objection
letter, a new underwriter can enter into the transaction and sell the
securities without being required to get a new letter from FINRA.
Described differently, the no-objection letter applies to the deal, not
to each underwriter.
10.3.1 Underwriting Compensation
After the filing of the offering documents, FINRA will review the total compensation paid to the syndicate. FINRA prohibits the sale of securities by an underwriter when the underwriting terms are deemed unfair or unreasonable. When
examining compensation terms, FINRA considers a variety of factors, including
the total proceeds, amount of risk, and type of securities.
Knopman Note: Investment banks must charge fair and reasonable
fees for underwriting services. As a percentage, the highest fair and
reasonable underwriting fee is 7% of the gross offer price. For large
deals, however, a fair and reasonable fee may be lower.
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10.3.1.1 Items of Value
To determine the fairness of compensation to the syndicate, FINRA will examine
all items of value being received by the underwriter in connection with a transaction. FINRA considers the following to be compensation paid to the underwriter:
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◆ The underwriting spread
◆ Reimbursement for underwriting expenses (e.g., underwriter’s counsel).
Fees for the underwriter’s counsel and other syndicate expenses are
typically deducted from the underwriting fee (not the manager’s fee or
selling concession)
◆ Finder’s fees
◆ Securities credited to the underwriter’s investment account
◆ Right of first refusal (ROFR) or exclusivity agreement for future
underwriting transactions
FINRA defines these items of value to be part of the underwriting compensation
for a particular transaction if they were received or agreed to anytime within 180
days prior to the filing of a registration statement.
FINRA does not consider as compensation the reimbursement of expenses
defined as issuer expenses. Examples of issuer expenses include printing fees,
blue sky (i.e., state registration) fees, and accounting fees. For example, if the
underwriter pays the invoice to its printer for running off copies of the red herring and is subsequently reimbursed by the issuer, this would not be factored into
the compensation being received.
Knopman Note:
Q: Does FINRA consider a right of first refusal or an exclusivity
agreement compensation to an underwriter?
A: Yes, a right of first refusal (ROFR) and an exclusivity agreement
are items of value that will be counted as compensation when
FINRA evaluates the fairness of fees in an underwriting.
Q: If a broker-dealer is engaged to underwrite a new deal, and will
receive reimbursements, which records must be retained?
A: Broker-dealers must maintain records of all non-cash
compensation (such as reimbursed travel expenses, e.g., hotel,
airfare, etc.) received in connection with an underwriting.
Q: Can the issuer prepay fees to an underwriter?
A: Yes, but FINRA still considers these fees to be compensation.
FINRA will look back 180 days prior to filing a registration to
identify any compensation.
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10.3.1.2 Prohibited Arrangements
FINRA prohibits certain types of compensation, regardless of their value.
Examples of terms and arrangements that are always considered unfair and
unreasonable include:
◆ Any reimbursement by the issuer to the underwriter for general
overhead, salaries, supplies, and normal course of business expenses
◆ Any right of first refusal extending for more than three years for future
underwriting business
◆ Any warrants, options, or convertible securities that are exercisable for
more than five years from the effective date or have a strike price below
the offering price of the securities being sold
◆ Any tail-fee arrangement with a duration of more than two years. In a
tail-fee arrangement an underwriter receives underwriting fees if the
issuer cancels the offering and subsequently does a similar transaction
with another firm
Also, any stock received by an underwriter as compensation must have a minimum holding period of 180 days, unless the shares granted represent no more
than 1% of the value of the securities being sold.
Knopman Note: Key aspects regarding syndicate compensation
include:
• Underwriting fees must always be fair and reasonable. The maximum spread FINRA will generally be comfortable with is 7% of the
gross offer price.
• FINRA’s Corporate Financing Department (CFD) will examine all
compensation paid by the issuer to the underwriter beginning six
months prior to the filing date of the registration statement.
• Certain reimbursements from client to underwriter are counted
as compensation. Examples include 1) underwriter’s counsel and
2) marketing expenses. These will be added to the spread when
FINRA evaluates overall fairness.
• Tail-fee provisions are permissible (and included as part of the
underwriter compensation), but they must expire after two years.
• CFD must be notified within three business days after an issue is
declared effective. If the deal is not expected to close on the settlement date, the lead manager must notify FINRA no later than the
expected closing date.
10.4 Preparing and Delivering the Road Show
The road show presentation that issuers and underwriters make to prospective
investors, usually just before the effective date of the registration, has become
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a highly regulated event. Careful planning is required to create road show presentations that deliver factual, accurate information, meet all regulations and
compliance guidelines, and address the specific requirements of different presentation media and environments. Diligent road show planning will address
many issues, including:
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◆ PowerPoint files and any other presentation materials should be
reviewed in advance by both the issuer’s and underwriters’ legal counsel.
◆ A copy of the most recent version of the red herring should be prepared
for each road show attendee. A signature log (or equivalent) should
be prepared to verify that each attendee receives the preliminary
prospectus.
◆ Care must be taken to avoid handing out any materials other than the
red herring. Such materials (including company profiles, press releases,
and recent financial results) can become free writing prospectuses,
subject to filing requirements. All the information presented during the
road show should be consistent with the red herring, and should avoid
details that go beyond it.
◆ Underwriters should avoid letting any internal documents or memos
(e.g., communications between the issuer and underwriters) be
distributed or shown to attendees.
◆ Care should be taken to prevent media representatives from attending
road show presentations. Any account of a road show published or
distributed by the media can constitute a free writing prospectus.
◆ Research analysts should not be invited to attend the presentation or
participate in it.
Knopman Note: Research analysts are prohibited from attending a
road show for any investment banking services transaction, including
common stock, preferred stock, or debt.
◆ PowerPoint (or similar) presentations used to support road shows
should stick to facts, be easy to read and understand, and avoid complex
explanations or unnecessary jargon. If the presentation contains
forward-looking statements, they should be labeled as such and
supporting data or calculations should be included.
10.5 Coordinating Communications with the Issuer
Most issuers rely on a constant flow of communication with the public at all
times. The SEC generally allows issuers to continue their normal and customary
public communications during an offering, provided a few guidelines are followed. During the public offering period, corporate communications should be
coordinated so that they:
◆ Follow customary formats and include usual content
◆ Avoid forecasts, predictions, projections, or valuations
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◆ Do not mention the proposed public offering or its specific terms, except
through approved offering materials and road show presentations
◆ Do not speculate on whether or when a registration will become effective
It is common practice for the underwriter to monitor the issuer’s communications to ensure that these guidelines are followed. Underwriters often advise issuers to refrain from publishing press releases containing material information
immediately after the registration has become effective, to avoid the additional
work and cost of having to sticker the final prospectus.
Example
In the weeks just prior to an offering, the CEO of a company gives a speech to
announce the opening of a new regional distribution facility. The text of the
speech should be reviewed in advance by underwriters to ensure that it does
not contain forecasts, predictions, projections, or valuations.
Prior to the effective date, the issuer is not allowed to issue communications suggesting that an offering or selling effort is “coming soon” or “in the works.” Even
casual conversation by company officers about the offering should be avoided.
Any such statements may cause the SEC to delay review of the registration and
impose an additional “cooling-off ” period.
The exception to this rule is for Emerging Growth Companies, which are permitted to “test the waters.”
The key to successful offerings is regular and frequent communications between
underwriters and issuers. Underwriters should keep the issuer informed of key
filing dates and deadlines, the progress of the offering, and the nature of market
conditions and investor demand. Issuers, in turn, should provide underwriters
access to communications, including press releases, published articles written
by company officers or managers, and public speeches.
10.6 Regulations Concerning the Marketing of Securities
Offerings
10.6.1 Offerings “At the Market”
An “at the market offering” allows a company to quickly raise capital by selling
newly issued shares directly into the existing market based on the current trading price. One advantage over traditional follow-on offerings is that it allows
a company to raise small amounts of capital on a regular basis as opposed to
conducting one larger fixed offering.
SEC Rule 15c1-8 prohibits broker-dealers involved in securities offerings from
stating that securities are offered at the market, unless such a market exists and
has not been made solely by the broker-dealer or the syndicate. The SEC deems
this “manipulative, deceptive or fraudulent,” so if this statement is made, a clear
public market must exist.
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Knopman Note: For an issuer that will need capital on a regular basis,
an at-the-market offering could present the best opportunity as
opposed to traditional follow-on or rights offerings (as these are onetime capital raises).
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10.6.2 Exemptions from State Registration
Section 18 of the ’33 Act exempts securities listed on national securities exchanges,
including the New York Stock Exchange and Nasdaq, from state registration. No
state law may require state registration or qualification of such covered securities by states.
The anti-fraud provisions of state law do apply to covered securities, however.
State securities commissioners may bring enforcement actions for fraud, deceit,
or unlawful conduct in connection with all securities transactions, even for covered securities.
If securities are not defined as federal covered, they need to be appropriately
registered in each state where they are sold.
Also, in all cases, the underwriter needs to be appropriately registered under blue
sky laws in each state.
10.7 Fixed-Price Offerings
In a fixed-price offering, the lead manager sets the public offering price prior to
publication of the prospectus.
FINRA Rule 5141 prohibits any broker-dealer firm engaged in a fixed-price offering
from selling securities to a related person at a discounted price. A related person
is a firm or person under common control with the broker-dealer. This rule does
not prohibit securities from being sold to the syndicate or selling group at the
appropriate discount concession.
Also, new issues of Treasury securities, municipal bonds, and registered investment companies (e.g., mutual funds) are not subject to this rule. These securities
could be sold at a discount without violating FINRA 5141.
Knopman Note: In a fixed-price offering, all shares must be sold at the
public offer price. They cannot be sold at a discount to any investor.
Only the syndicate members and selling group can receive shares at a
discount (i.e., less the underwriting fee/selling concession).
This rule does not apply to Treasuries, municipal bonds, or registered
investment companies (e.g., mutual funds).
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10.8 Marketing Timeline (Fully, One-Day, Overnight)
Different types of deals require different marketing efforts. Depending on the
time spent marketing the new securities, a deal may be described as fully marketed, one-day marketed, or overnight marketed. Each will be discussed in turn.
A fully marketed offering consists of a one- to two-week road show run by
senior management of the issuer and the lead underwriter. A fully marketed
offering carries the greatest risk that the issuer and underwriter will not be able
to generate enough interest in the shares since these are generally used for IPOs
where there is a greater possibility of potential investor uncertainty as to the
performance of the stock and lack of familiarity with the company.
In a one-day marketed offering, an issuer files a registration statement 24 hours
before the anticipated effective date and subsequently prices the deal after the
close of trading the next day. For example, an issuer might file a registration
statement at 4:00 pm on Wednesday, collect indications of interest overnight
and throughout the next trading day, and subsequently request effectiveness at
4:00 pm on Thursday. In this particular transaction, the stock is likely to decline
on Thursday due to ownership dilution. A one-day marketed deal carries less
risk than a fully marketed deal since they are typically used in connection with
follow-on equity sales.
For certain deals, the marketing period might be even shorter, structured as an
overnight-marketed offering. For example, the issuer might file a registration
on Wednesday at 4:00 pm and request effectiveness on Thursday before the market opens. Overnight-marketed deals are more typical in investment-grade debt
offerings and less typical for equity deals. These offerings carry the least risk for
the issuer and underwriters due to the brief marketing period.
10.9 Conflicts of Interest
In certain transactions, it is possible that a broker-dealer will have a conflict of
interest. For example, if a broker-dealer is an underwriter in a transaction, but is
also the issuer of the shares (e.g., the firm’s own IPO), it will have a conflict when
determining the offering price. In its capacity as an issuer, it will want the highest
price, but in its capacity as an underwriter, the firm will want to price the deal so
all the securities can be successfully sold.
Specifically, a conflict of interest occurs if:
◆ The issuer is a broker-dealer
◆ The issuer is owned at least 10% by a broker-dealer
◆ The issuer is owned at least 10% by associated persons (i.e., employees) of
a broker-dealer
◆ The issuer will use at least 5% of the proceeds to pay a broker-dealer the
balance on a loan or for any other purpose, or
◆ The issuer intends to become a broker-dealer
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Under FINRA Rule 5121, a member firm with a conflict of interest may not participate in a public offering unless:
◆ The nature of the conflict is prominently disclosed
◆ The member complies with certain net capital, discretionary account,
and filing requirements, and
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◆ A qualified independent underwriter (QIU) participates in the offering
While the first two requirements must be met, the broker-dealer is not required
to engage a QIU if the firm is not the syndicate manager, or if the securities are
already publicly traded. A QIU is defined as a member firm that:
◆ Does not have a conflict of interest in the offering
◆ Is not an affiliate of any member with a conflict
◆ Does not beneficially own more than 5% of the class of securities involved
in the conflict of interest
◆ Has agreed to undertake the responsibilities and liabilities of an
underwriter
◆ Has previously served as underwriter in at least three public offerings of
similar size during the preceding three-year period, and
◆ Has no associated person in a supervisory capacity responsible for
conducting due diligence on the offering
Though the QIU isn’t required to actually distribute the securities, it must participate in the preparation of the registration statement and prospectus.
Furthermore, the prospectus must clearly disclose the nature of the conflict, the
name of the firm acting as the QIU, and a discussion of the QIU’s roles and responsibilities. Investors must receive this written disclosure prior to purchasing the
new issue.
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Knopman Note: Consider the following underwriting scenarios as they
apply to conflicts and QIUs.
Scenario 1: Acme has a $200 million term loan outstanding from BD A.
Acme engages BD A to take Acme public and raise $1 billion in equity.
As part of the deal, Acme will use 20% of the $1 billion raised ($200
million) to pay back the loan.
This is a conflict, and BD A will need a QIU to underwrite the deal.
Note that a broker-dealer simply owning a significant portion of the
issuer’s debt is not a conflict, but if at least 5% or more of the proceeds
from the issuance are used by the issuer to reduce the debt, then a conflict exists.
Scenario 2: BD B has a merchant banking division that makes equity
investments in start-ups. Through these dealings, BD B owns 25% of
LittleTech, and has engaged BD B to underwrite LittleTech’s IPO.
Because BD B owns more than 10% of LittleTech, this is a conflict and
will require a QIU.
Note: If 10% or more of LittleTech was owned by employees of BD B
(e.g., a group of managing directors) as opposed to BD B itself, the
conflict would remain.
Scenario 3: Bravo, Inc., regularly uses BD C to help it raise capital
via debt and equity offerings. Bravo owns 30% of Delta, Inc., and
recommends that Delta use BD C to help Delta raise capital. Later,
Delta does in fact engage BD C to do an IPO.
There is no conflict. BD C will not need to retain a QIU to do the deal.
Scenario 4: BD D, a full-service financial institution with a large
wealth-management division, underwrites a follow-on offering for
Echo Co. with a conflict and retains a QIU on the deal. The bankers
on the deal discuss the deal with their colleagues in the wealthmanagement division, who think the investment opportunity would
be attractive to a number of their clients. What is required for BD D’s
wealth management to sell these shares to BD D’s retail clients?
If a conflict of interest exists, any sale of the new issue to the conflict
firm’s clients requires verbal disclosure of the conflict prior to the sale
and written disclosure of the conflict no later than upon completion (i.e.,
settlement) of the transaction.
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10.10 Restrictions on IPO Offerings
FINRA Rule 5130 is designed to protect the integrity of equity IPOs by requiring
underwriters to make bona fide public offerings. Thus, the rule prohibits the sale
of new issues to “restricted persons.”
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Knopman Note: FINRA Rule 5130 regarding bona fide public offerings
is an important rule. Be sure to understand its nuances and
characteristics.
10.10.1 Restricted Persons
The term restricted person is fairly expansive. It covers:
d. FINRA member firms and their employees
e. Finders and fiduciaries (e.g., attorneys and accountants) of the
management underwriter
f. Anyone owning 25% or more of a broker-dealer
g. Portfolio managers in their personal investment accounts, and
h. Immediate family members of restricted persons
It also includes anyone with the ability to control the allocation of a new issue.
Under this rule, family members are defined as a spouse, parents, in-laws, siblings, children, and anyone else to whom a restricted person provides material
(i.e., financial) support.
The definition of family member does not include aunts and uncles, grandparents, nieces and nephews, cousins, or ex-spouses; so, these people can invest in
an IPO, absent any other restriction.
10.10.2 Permitted Purchases
Some restricted persons are allowed to purchase common stock IPOs from the
underwriter. These permitted purchasers would normally be restricted but may
participate in the IPO under certain limited circumstances. Exceptions to the
rule are available for:
a. Employees of the issuer and their family members
b. Non-household family members of a broker-dealer employee who is
not underwriting a particular deal (note, the employee still cannot
invest)
c. An account that has no more than 10% beneficial ownership by
restricted persons (e.g., an investment club that is 8% owned by
restricted persons is a permitted purchaser). Note that this 10%
test is based on fund ownership, not the number of investors in
the fund
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d. Issuer-directed sales not designed to circumvent the rule. For
example, the issuer might offer important clients the opportunity
to invest in the IPO
e. A broker-dealer, provided the underwriter certifies that it was
unable to find any other purchasers for the securities. This is
commonly referred to as a standby purchaser
f.
A broker-dealer or registered representative was already an
investor in the company prior to its IPO and wants to avoid
dilution
Knopman Note: An employee benefit plan (i.e., employee retirement
plan) that is not sponsored solely by a broker-dealer and has at least
10,000 participants and beneficiaries and at least $10 billion in assets
is permitted to invest in an IPO under the rule.
10.10.3 Authorization to Purchase an IPO
Prior to the sale of an IPO, a member must have obtained within the 12 months
prior to the sale a representation from beneficial owners (or their representatives)
that the account is eligible to purchase new issues—i.e., that it does not belong to
a restricted person and it is not materially owned by a restricted person.
Knopman Note: Broker-dealers underwriting IPO shares will require
potential investors to certify they are not restricted prior to allocating
an investor any new shares. An underwriter can satisfy this obligation
by sending the customer a letter annually to confirm that they are not
restricted.
No later than three business days after the offering date, the book-running managing underwriter of the issue must file with FINRA:
◆ An initial list of distribution participants and their underwriting
commitments, and
◆ The final list of distribution participants and their commitments
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Knopman Note:
Q: How does 5130 define an immediate family member?
A: In its definition of family member, 5130 includes parents,
in-laws, siblings, children, and spouses. Outside this definition
are grandparents, nieces/nephews, aunts/uncles, cousins, and
ex-wives/ex-husbands—these persons can purchase IPOs.
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Q: When are immediate family members restricted?
A: Immediate family members are restricted in three scenarios:
1. The immediate family lives in the same house as the
employee, or receives material support from the employee.
2. The employee works at the firm selling the new issue to the
family member.
3. The employee has the ability to control the allocation of the
new issue.
Q: When can normally restricted persons buy an IPO?
A: In a few situations restricted persons can purchase IPO shares.
These include:
• The restricted person is an employee of the issuer.
• The restricted person owns 10% or less of the account (e.g.,
an investment club or a hedge fund).
Q: When can a broker-dealer employee buy an IPO?
A: Employees of broker-dealers (whether on the deal or not)
cannot purchase common stock IPOs. There is one exception: if
their employing broker-dealer is doing an IPO, they can rely on
the “employee of the issuer” exemption.
10.11 Interests in Distribution
SEC rules prohibit broker-dealers from using manipulation or deception to
induce any sales of securities. The SEC explicitly requires broker-dealers to disclose to customers any control relationship they may have with the issuer of
the security offered or sold. Failure to issue a written disclosure of control relationships before completion of the transaction is a violation.
A broker-dealer may make a verbal disclosure of a control relationship at the
point of the offer. A written disclosure is required at or before completion of
the transaction.
Broker-dealers are required to provide written disclosure of any financial interest
they may have in the securities they are offering or selling, including a participation in their primary or secondary distribution. Failure to provide such disclosure
is considered manipulative and deceptive.
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For example, though it is not prohibited for a registered representative to solicit
an investor to purchase the stock of his or her own employer, the rep would be
required to disclose the conflict of interest.
FINRA Rule 2262 requires broker-dealers that are controlled by the issuer of a
security to disclose to customers the extent of control before entering into a
contract with customers for the purchase or sale of the issuer’s securities.
FINRA Rule 2269 also requires broker-dealers to provide written disclosure to
customers of any interest they have in the primary or secondary distribution of
securities being offered, sold, or advised for a fee.
Example
A broker-dealer (which manages a client’s portfolio for a fee) recommends
that the client hold in this portfolio a common stock. The broker-dealer previously has participated in the primary or secondary distribution of the stock.
Under Rule 2269, this participation must be disclosed in writing.
10.12 Equity Research
Investment banking and research analysts must be separate.
Knopman Note: The rules governing equity research and investment
banking are heavily tested. Candidates should understand and know
the rules below.
◆ Equity research analysts cannot participate in efforts to solicit
investment banking business (e.g., attend an investment banking pitch or
“bake-off ”). There is an exception for Emerging Growth Companies.
◆ Equity research analysts cannot participate in joint due diligence with
an investment banker prior to the bake-off. Due diligence is the process
of researching the issuer to prepare for the pitch. Note that there is an
exception for EGCs—the research analyst can participate if the issuer is
an EGC.
◆ Investment bankers cannot attend equity research “teach-ins” where
company management meets with equity researchers.
◆ Equity research reports must reflect the personally held views of the
research analyst.
◆ Physical (e.g., different floors, locked doors) and electronic separation
(information firewalls or Chinese Walls) of the departments are required.
◆ Investment bankers cannot preview research reports for any reason.
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Knopman Note: Although equity research reports cannot be previewed
by an investment banker, the report may be reviewed by the subject
company or non-investment banking personnel solely for the
verification of facts. The sections submitted to the target company
may NOT include the research summary, the research rating, or the
price target. A complete draft of the report must be provided to legal/
compliance before submitting the research report to the subject
company for any factual verification.
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◆ Communications between investment banking and research, whether
written or oral, must be chaperoned by legal and compliance. An
exception is that investment bankers and research analysts can speak to
one another at a social function without a chaperone.
Knopman Note: A research analyst and investment banker would be
permitted to discuss recent transactions in a space they both happen
to cover as long as there is a chaperone.
These restrictions are designed to reduce the pressure on analysts to slant or
color their presentations or recommendations in favor of the firm’s investment
banking clients.
Knopman Note: If the issuer is an Emerging Growth Company, three
exceptions are afforded to research analysts:
1. A research analyst can attend the pitch or “bake-off.”
2. A research analyst can conduct joint due diligence with an
investment banker.
3. A research analyst can publish research on the issuer
immediately after the effective date, with no holding
period.
Note that even for EGCs, a research analyst cannot attend the road
show.
10.12.1 Inducements and Retaliation for Research
NYSE and FINRA rules prohibit member firms from offering a favorable research
rating or specific price target as an inducement for business or compensation.
Also, members may not threaten, retaliate against, or bully research analysts for
issuing adverse, negative, or unfavorable research reports or public appearances.
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Knopman Note: Gordon is an investment banker who regularly helps
Antico, Inc., raise capital in the debt and equity markets and serves
as a trusted adviser on most of Antico’s M&A transactions. As a result,
Antico is one of the firm’s best investment banking clients.
Bob, an equity research analyst, believes Antico is overvalued and
lacks business prospects. Bob publishes a report on Antico indicating
a “sell” rating. Gordon is furious that the equity research department
would publish such a report on one of the firm’s best clients. However,
the firm may not retaliate, punish, or bully Bob in any way as a result
of this report.
Knopman Note: Investment bankers can give feedback to the research
department to publish a report or cover a certain company based on
client feedback, but they cannot order the research department to
publish research on a company. In no event can an investment banker
influence the content of the report.
10.12.2 Research Quiet Periods
NYSE and FINRA rules create quiet periods, sometimes referred to as blackout
periods, surrounding securities offerings, during which analysts employed by
managers or co-managers of offerings may not issue research reports or engage
in public appearances for the issuer’s securities.
Analysts must be made aware of investment banking activities being conducted
by their firms so that they can avoid inadvertently publishing research or engaging in public appearances connected to the issuer during a quiet period.
Knopman Note: During the quiet period, a research analyst can still
engage in a password protected conference call with existing clients of
the firm as long as no media members are on the call.
Below is a summary of the quiet periods for syndicate participants during IPOs
and follow-on offerings.
Initial Public Offering (IPO)
Follow-On Offering
Syndicate Manager
10 calendar days after
the effective date
Three calendar days after
the effective date
Underwriter/Syndicate Member
10 calendar days after
the effective date
No quiet period
Selling Group
No quiet period
No quiet period
Quiet periods apply only to Non-Emerging Growth Companies. Research on
EGCs can be published at any time following a transaction’s effective date.
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Knopman Note: A research analyst whose firm is not involved in the
IPO can engage in a public appearance with investors and the media
immediately after the IPO.
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Knopman Note: When making a public appearance, research analysts
must disclose any material conflicts of interests, including if their
firm has received compensation from the subject company in the past
12 months. Note that the analyst is NOT required to disclose whether
the firm intends to provide investment banking services in the next
three months.
10.12.3 Equity Versus Debt Research Analysts
The FINRA rules governing equity research and debt research analysts are similar,
though some key differences are highlighted below:
◆ Equity research must promptly notify customers if it intends to
terminate a subject company’s coverage. This is NOT required for debt
research.
◆ All equity research must include specific disclosures and potential
conflicts of interest; debt research provided to institutions does not have
these requirements as these recipients are sufficiently sophisticated.
◆ Equity research is not required to have an information barrier between
it and trading desk personnel. Debt research must have information
barriers. Note that all research must have information barriers between
research and investment banking.
Knopman Note: Any communication by a debt-research analyst to
internal personnel must be fair, balanced, and not misleading. For
example, it would not be appropriate if a debt research analyst
communicates to internal employees of the firm that a distressed
company is a “good buy” without discussing any of the risks of the
transaction, as a balance opinion was not presented.
10.13 Fiduciary Use of Information
During the course of securities offerings, several entities that act as fiduciaries
may gain access to information about the ownership of securities. They include
paying agents, transfer agents, and trustees. Under FINRA Rule 2060, fiduciaries may under no circumstances use this information for soliciting purchases,
sales, or exchanges, except per the issuer’s request.
Knopman Note: The following chart lays out some key points about the
SEC registration process.
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Pre-Registration
Period
Cooling-Off Period
Registration
Statement
Preliminary Prospectus
(i.e., Red Herring)
• Gun-jumping
describes the
prohibited
practice of
marketing
securities prior
to filing the
registration
statement.
• A red herring must be
re-distributed whenever its
contents (e.g., underwriters,
offering price, or financials)
change.
• Five copies of each version of
the preliminary prospectus
must be filed with the SEC
no later than by its first
distribution to potential
investors.
• The preliminary prospectus
must be delivered to all
investors upon request, but it is
not considered an offer for the
securities.
• The issuer will request
effectiveness from the SEC
when it has engaged in
sufficient marketing efforts and
has determined an appropriate
offer price.
• During the SEC registration
process, the issuer must also
register its securities under
state securities laws, called blue
sky laws.
• The securities, the underwriting
firm, and the individual
bankers must be appropriately
registered in all states where
the securities are sold.
Post-Effective Period
Final Prospectus (includes # of shares and price)
• Once the final prospectus is effective, the
issuer will file 10 copies of it, including the final
offering price, with the SEC.
• The underwriter can now confirm IOIs and sell
the securities.
• Issuers may file the final prospectus (including
pricing and the number of shares) with the
SEC up to 15 business days after the effective
date, but delaying this filing rarely occurs. If
pricing is delayed by more than 15 days, the
issuer must submit an updated registration
statement to the SEC.
• The sale of any new security must include a
prospectus, and any prospectus more than
nine months old must not have any financial
information that is more than 16 months old.
That is, an amended prospectus must be filed
after 1) the prospectus is nine months old and
2) the financials in that prospectus are more
than 16 months old.
• A prospectus supplement filed to update
financials would not supersede the original
prospectus. The original prospectus would
remain in effect and would still need to be
delivered to investors.
• Typographical errors do not require the filing
of an amended prospectus.
• Following the effective date, underwriters
are prohibited from publishing research for a
certain number of days.
• For IPOs: 10 days for syndicate
managers and members
• For follow-on offerings: Three days
for syndicate manager (no quiet
period for syndicate members)
• This rule does not apply to
Emerging Growth Companies
• Although the broker-dealer is responsible for
distributing the prospectus, it is not required
to maintain a permanent record of these files,
because they are considered issuer materials.
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Progress Check
1. In preparing a road show presentation, an
investment banking group makes sure to have
on hand a red herring to give each attendee.
What step should be taken to make sure each
attendee receives a red herring?
A. Prepare a signature log and make each
attendee sign for receipt of the red herring
B. Mail a copy of the red herring to all
prospective attendees
C. Sticker the red herring, to indicate that it
is the most current version available
D. Make sure the red herring is written in
both English and Spanish
2. Under what circumstance may state securities
commissioners bring enforcement actions for
transactions in federal covered securities?
A. Only if the securities are registered under
state law
B. Only if the securities fail to meet
registration requirements under state law
C. For fraud, deceit, or unlawful conduct,
under anti-fraud provisions of state law
D. For failure to meet state continuous
reporting requirements
4. A research analyst who participates in a nondeal road show is not allowed to communicate
with customers:
A. About equity securities
B. About the issuer’s merits
C. In the presence of investment bankers or
representatives of the issuer
D. Using electronic or graphic media for
support
5. For an IPO of a Non-Emerging Growth
Company, how long is the research quiet
period for syndicate managers?
A.
B.
C.
D.
Three days after the offering
10 days after the offering
25 days after the offering
The duration of the road show schedule
3. Under SEC Rule 15c1-8, a broker-dealer is not
allowed to claim that securities are offered
“at the market” unless which TWO of the
following conditions exist?
I. A clear public market exists
II. The security is traded on a national
exchange
III. The market is not made solely by the
broker-dealer
IV. The security is traded OTC
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
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Progress Check—Solutions
(A)
In planning the road show, an investment banking group should ensure each attendee
will be asked to sign a log, verifying attendance and receipt of the red herring.
2. (C)
State anti-fraud provisions apply to all securities transactions, including transactions
in covered securities listed on national securities exchanges. States may bring
enforcement actions for fraud, deceit, or unlawful conduct in offering or selling
securities.
3. (A)
An at-the-market order implies that an active public market exists that is not controlled
by the broker-dealer. Unless this condition is true, an “at the market” offer is considered
manipulative, deceptive, or fraudulent. The securities are not required to be traded on
an exchange or over-the-counter.
4. (C)
FINRA rules are designed to reduce pressure on analysts to slant or color their
presentations or recommendations. If they speak to customers or prospective
investors at non-deal road shows, it must be outside the presence of investment bankers
or representatives of the issuer. Research analysts may never attend road shows related
to investment banking transactions.
5. (B)
The quiet period’s length depends on the type of offering and the employer of the
analyst. For an IPO, it is 10 days for a deal in which an analyst is employed by any
underwriter. For follow-on offerings, a three-day quiet period applies only to
analysts of the syndicate manager. Quiet periods do not apply for a new issue by an
Emerging Growth Company, defined as a company with less than $1 billion in revenue.
1.
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10.14 Regulation M
A fundamental goal of federal securities law is the prevention of manipulation,
which undermines fairness and independence in the markets. Regulation M was
enacted to prevent manipulative conduct by persons with an interest in the outcome of an offering, including underwriters, issuers, and selling security holders.
Its overall objective is to prohibit activities and conduct that could artificially
influence the market for a new issue.
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Regulation M includes a definitional introduction, Rule 100. The key takeaway of
Rule 100 is that Regulation M applies to both the security being sold—the subject
security—and the security into which the subject security can be converted—the
reference security.
Knopman Note: For example, if an issuer is selling convertible bonds,
both the convertible bonds and the issuer’s common stock would be
covered by the provisions of Regulation M.
Regulation M has five subsequent conduct rules:
◆ Rule 101: Activities by underwriters or other persons who are
participating in a distribution
◆ Rule 102: Activities by the issuer or selling shareholders
◆ Rule 103: Nasdaq passive market-making
◆ Rule 104: Stabilization
◆ Rule 105: Short-selling in connection with a public offering
It is more important to know the content of the rules rather than the actual rule
numbers.
10.14.1 Rule 101—Activities by Distribution Participants
In general terms, Rule 101 prohibits a distribution participant from attempting
to bid for or purchase, or attempting to induce any other person to bid for or
purchase, a covered security during the applicable restricted period.
Distribution participants include underwriters, prospective underwriters, broker-dealers, or other persons who have agreed to participate or who are participating in a distribution.
The period during which the restrictions apply is defined by a two-pronged test
based on the average daily trading volume (ADTV) of the securities and the public float value of an issuer’s outstanding common stock. There are three categories
of securities and applicable restricted periods:
◆ Actively traded securities are subject to no restricted period. These are
securities with an ADTV of at least $1 million and a public float value of
at least $150 million.
◆ For any security with an ADTV of at least $100,000 and a public float
value of $25 million or more, the restricted period begins one business
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day prior to the determination of the offering price and ends when that
person’s participation in the distribution is complete.
◆ For all other securities, the restricted period begins five business days
prior to the determination of the offering price and ends when that
person’s participation in the distribution is complete.
Knopman Note: Be sure to know the three categories and time
restrictions under Reg M and how they relate to the restricted security.
• The restricted period under Regulation M can be five days, one day,
or zero days.
If securities are being distributed in connection with a merger, an
acquisition, or an exchange offer, the restricted period begins on the
first day proxies or offering materials are sent to security holders, and
ends upon the completion of the distribution.
Rule 101 permits certain activities by distribution participants during the
restricted period, including:
◆ The publication of research or recommendations
◆ Odd-lot transactions
◆ Exercises of options, warrants, and rights and conversions into the
security
◆ Unsolicited transactions, where the customer calls the representative to
place the order
◆ Basket transactions which include a basket of 20 or more securities in
which the covered security is not more than 5% of the basket value
◆ Certain de minimis transactions
◆ Rule 144A transactions with qualified institutional buyers and non-US
buyers
Certain securities are not subject to the provisions of Rule 101:
◆ Investment-grade non-convertible securities and asset-backed securities,
and
◆ Face-amount certificates or securities issued by an open-end
management investment company or a unit trust
10.14.2 Rule 102—Activities by Issuers and Selling Security Holders
During a Distribution
Rule 102 is similar in format to Rule 101, but it addresses activities of issuers and
selling security holders, and their affiliated purchasers, during a distribution of
securities. In general, these persons must refrain from bidding for, purchasing,
or attempting to induce any person to bid for or purchase, a covered security
during the applicable restricted period, unless an exception permits the activity.
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10.14.2.1 Notification Requirements
The manager of the syndicate is responsible for providing written notice to
FINRA of information regarding compliance with Regulation M Rules 101 and
102. Below is a summary of the events that require FINRA notification regarding
Regulation M.
Notification Event
Date Required
Length of restricted period and date it will begin
No later than the business day before the first
trading session of the applicable restricted
period
Pricing of the distribution, the security and
symbol, number of shares offered, and offering
price
No later than the close of business the next
business day following the pricing of the
distribution
Cancellation or postponement of any
distribution for which prior notification had
been made
Immediately
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Knopman Note: How will FINRA learn about the restricted period? The
lead underwriter must notify FINRA of the restricted period and its
length:
• For stocks with a five-day restricted period or a one-day restricted
period, notification is required one day prior to the restricted
period.
• For “actively traded” securities (i.e., no restricted period), FINRA
must be notified of the transaction by the day after pricing.
10.14.3 Rule 103—Nasdaq Passive Market-Making
SEC Regulation M, Rule 103, allows broker-dealers to engage in passive market-making transactions in Nasdaq securities that are the subject of a securities
offering.
This can occur during the restricted period and allows a firm that is both an
underwriter and a market maker in a security to continue to make a market.
In general, a passive market maker may not purchase the securities at a price
exceeding the highest independent bid at the time of the transaction. If all independent bids are reduced to a price below the passive market maker’s bid, the
market maker must bid promptly at a price not higher than the highest independent bid.
Example
The highest independent bid in a security is $24 per share. A passive market
maker can bid as high as $24 per share, but may not bid higher than $24 per
share.
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During the restricted period, a passive market maker’s net purchases on each day
cannot exceed the greater of 30% of the market maker’s daily trading volume
(DTV) limit or 200 shares. The DTV is the market maker’s average daily trading
volume in the security during the two full calendar months immediately preceding the filing of the registration statement.
Example
A market maker’s average daily trading volume in a stock is 100,000 shares.
Therefore, the market maker’s net purchases may not exceed 30,000 shares.
Note that the market maker may buy more than 30,000 shares on any day but
the net total, or purchases minus sales, may not exceed 30,000.
In summation, passive market makers may not offer a higher bid price than the
highest independent bid, and they are limited on bid size. Their bids must be
clearly identified, and they must notify FINRA in advance of their intention to
engage in passive market-making.
10.14.4 Rule 104—Stabilization and Penalty Bids
Stabilization is one of the most important functions that a syndicate performs
during an offering, but it is also an area that must be managed carefully to stay
within regulatory guidelines.
Stabilization allows the underwriter to bid on a new issue in the secondary market to prevent a decline in price. The firm that stabilizes on behalf of the syndicate
is referred to as the stabilization agent. This is usually the syndicate manager.
The stabilization bid can last indefinitely, as no rule limits the duration of a stabilizing bid.
Stabilization activity may not be designed to manipulate a higher price, however.
Stabilization bids are heavily regulated and must comply with all of the following:
◆ The stabilization agent must give priority to an independent bid at the
same price, regardless of its size
◆ Only one stabilization bid can be entered at any one time
◆ The stabilization agent cannot bid on the stock in addition to its
stabilization bid
◆ The entity engaged in stabilizing must give prior regulatory notice
Stabilizing activities must always be anticipated, planned, and announced in
advance. They cannot be done as a knee-jerk response to a falling IPO price.
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Knopman Note:
Q: What are the rules surrounding a Rule 104 stabilization if the
principal market is closed?
Chapter 10
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and Regulations
A: Stabilizing bids may be initiated and maintained after the
principal market for the security is closed (i.e., in after-market
trading).
Q: Who is responsible for stabilizing?
A: One underwriter, usually the syndicate manager, will stabilize.
An issuer would not stabilize its own transaction.
10.14.4.1 The Principal Market
When an underwriter stabilizes a new issue, there are restrictions on the price
of the stabilizing bid. First, a stabilization bid must always be below the public
offering price. For example, if the public offering price is $30, a stabilizing bid
may never be higher than $30.
Second, the stabilizing bid must be entered at a specific price depending on the
current bid, ask, and last independent transaction. That is:
◆ If the current best asked price is greater than or equal to the last
independent transaction price (i.e., last sale), stabilization can occur at
that last independent transaction price
◆ If the current best asked price is less than the last independent
transaction price (i.e., last sale), stabilization can occur at the highest
current independent bid
This chart will help explain how and where stabilization can occur.
Scenario 1
Scenario 2
Current best ask ≥ last independent
transaction price (i.e., last sale)
Current best ask < last independent transaction
price (i.e., last sale)
Stabilize at last independent transaction price (i.e.,
Stabilize at highest current independent bid.
last sale).
Examples
POP: $30.00
POP: $30.00
Last independent transaction: $27.50
Last independent transaction: $27.50
Current Bid–Ask: $27.10–$27.90
Current Bid–Ask: $27.10–$27.30
Stabilize at $27.50 (last independent
transaction)—because the current ask is greater
than or equal to the last independent transaction.
Stabilize at $27.10 (highest current independent
bid)—because the current ask is less than the last
independent transaction.
The principal market is defined under Rule 100 as the securities market with
the largest reported trading volume for that security during the prior 12 calendar
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months. If such trading data is not available, the stabilization bid will be entered in
the market where the issuer elected to have its primary listing (e.g., NYSE or Nasdaq).
10.14.4.2 Disclosure of Penalty Bids
A penalty bid is imposed (usually by the lead manager) against a syndicate member when offered securities allotted to the member are “flipped.” Any concessions
granted to the member are normally forfeited, and the broker-dealer involved in
the trade is not paid. Penalty bids are designed to discourage the allocation of
shares in the offering to “fast-buck speculators.” They also reduce selling pressure
during the first days of after-market trading.
SEC Regulation M Rule 104 requires any person making a penalty bid to provide
prior notice to regulators of the principal market in which the penalty bid is
imposed.
FINRA Rule 5190(e) requires broker-dealers to notify FINRA of the intention
to impose penalty bids on OTC equity securities, prior to imposing the bids or
engaging in the first syndicate covering transaction. The broker-dealer must
identify the security, its symbol, and the dates any penalty bids may be imposed.
Penalty bids must be anticipated and announced to syndicate members, prior to
the effective date. They can’t be imposed retroactively.
Knopman Note: If the syndicate manager imposes a penalty bid, every
underwriter is subject to returning the selling concession for flipped
shares. A penalty bid cannot apply to some underwriters and not
apply to others. Furthermore, a penalty bid must be announced in
advance of implementation.
10.14.4.3 Recordkeeping Requirements for Stabilization and Penalty Bids
SEC Rule 17a-2 defines the recordkeeping requirements for syndicate group members who engage in stabilizing activities or penalty bids. The following records
must be maintained for at least three years in total, and for at least two years in
an easily accessible place:
◆ The name and class of security stabilized or subject to a penalty bid
◆ The price, date, and time at which each stabilizing purchase was entered,
and whether any penalties were assessed
◆ The names and addresses of members of the syndicate or selling group
◆ The commitments of each member in the group
◆ The dates when any penalty bid was in effect
It is the responsibility of each member of the syndicate or selling group to
promptly furnish the date and time at which the first stabilizing purchase was
made and the date and time at which stabilization was terminated.
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The rule requires that all members of the syndicate be informed of the start and
end points of stabilization efforts. Any member’s stabilizing activities must be
transparent to others.
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and Regulations
Knopman Note:
Q: Who stabilizes a deal after the effective date?
A: After the effective date and once the security begins trading, the
syndicate manager is responsible for stabilizing a deal.
Q: What can an underwriter do in lieu of Rule 104 stabilization to
support the price of a new issue?
A: Underwriters oversell the offering and then close their short
position by buying shares in the market, which supports
the share price. As discussed earlier, this is referred to as a
syndicate covering transaction.
For example, in a 20-million-share deal, the underwriter might
sell 23 million shares, representing a 15% oversold deal.
• If the stock falls below the offer price, the underwriter will
purchase three million shares in the open market to cover
the short position, creating demand and supporting the
price.
• If the stock trades above the offer price, the underwriter
can exercise a greenshoe clause and purchase the excess
shares from the issuer, instead of buying them in the open
market. The greenshoe is available to the underwriter for
30 days after the effective date.
Q: What disclosures are required to engage in a stabilization?
A: In order to stabilize, the underwriter must disclose its intent to
potentially do so in the prospectus and notify the SEC each day
stabilization is in effect.
Q: How long can a stabilization bid last?
A: A stabilization bid can last indefinitely; there is no time limit.
10.14.5 Rule 105—Short-Selling During the Restricted Period
Under SEC Regulation M, Rule 105 prohibits anyone from purchasing securities in
a public offering and simultaneously selling short the same securities. This rule’s
purpose is to prevent an investor from shorting a significant amount of stock just
prior to the pricing of a follow-on offering and subsequently closing that short
position by repurchasing the stock at a now depressed offer price.
Regulation M Rule 105 restrictions on short sales and purchases during the
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330
restricted period apply to all investors. This rule does not apply to short sales
executed more than five days before the pricing of the new issue.
Knopman Note: There is an exception Rule 105. Specifically, bona fide
investors who cover their short position prior to the effective date of
the offering are allowed to invest in the new issue.
Chapter 10: Syndicate Settlement and Regulations
Progress Check
1. According to Regulation M Rules 101 and 102,
FINRA must receive notification from offering
participants for which two of the following?
I.
II.
III.
IV.
A.
B.
C.
D.
For listed securities only
For listed and unlisted securities
Only if a restricted period applies
Whether or not a restricted period
applies
I and III
I and IV
II and III
II and IV
2. Who is responsible for notifying FINRA of
the restricted period in the distribution of
securities?
A.
B.
C.
D.
The issuer
Any syndicate member
The managing underwriter
The issuer’s purchasing representative
3. All of the following statements regarding
notification requirements under Rules 101 and
102 of Regulation M are true except:
A. Required notices must be in writing
B. Offering documents must accompany the
notice
C. If no restricted period applies for an
actively traded security, notice must be
made within one business day of pricing
the distribution
D. Notice of an applicable restricted period
and the basis for the determination is
required no later than the business day
prior to the first complete trading session
of the restricted period
4. Restricted periods under Rules 101 and 102 of
Regulation M apply to purchases by which two
of the following?
I.
II.
III.
IV.
A.
B.
C.
D.
Issuers
Accredited investors
Distribution participants
Institutional buyers
I and III
I and IV
II and III
II and IV
5. According to Regulation M, FINRA notice is
required in all of the following circumstances
except:
A. Determination of the applicable restricted
period for a new offering of securities
B. Determination of the price of a security for
which a restricted period applies
C. Intention of an OTC market maker that
is participating in the distribution to
withdraw its quotes
D. Intention of the underwriters to conduct
penalty bids or syndicate covering
transactions
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Chapter 10: Syndicate Settlement and Regulations
Progress Check—Solutions
1.
(D)
Rules 101 and 102 of Regulation M address notification requirements for offering
participants. The rules specify that offering participants must notify FINRA of
distributions of both listed and unlisted securities and that such notice is required
whether or not a restricted period applies. The notice must include the basis for the
determination of the restricted period’s length.
2. (C)
The managing underwriter must fulfill the notification requirements under Regulation
M and Rule 5190.
3. (B)
While the FINRA notices required under Rules 101 and 102 must be in writing, they
need not include offering documents. If no restricted period applies for an actively
traded security, notice must generally be made at least one business day after pricing. If
a restricted period applies, notice of the applicable restricted period and the basis
for the determination are required no later than the business day prior to the first
complete trading session of the restricted period.
4. (A)
Regulation M was enacted to protect against market manipulation during stock
offerings. Provisions apply to both distribution participants (i.e., underwriters) and the
issuer and its purchasing representatives.
5. (C)
Regulation M requires that FINRA be notified of restricted periods for distribution
participants and also of the price of the security for which a restricted period applies.
Further, if a syndicate intends to stabilize the offering by conducting penalty bids or
covering transactions, additional FINRA notice is required. The withdrawal of quotes by
market makers in a subject OTC equity security does not require FINRA notification.
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10.15 Settlement of Syndicate Accounts
FINRA Rule 11880 requires final settlement of syndicate accounts by the syndicate manager within 90 days following the syndicate settlement date. No later
than this date, the syndicate manager must provide each syndicate member
with an itemized statement that includes expenses by category, including legal,
advertising, travel and entertainment, closing, losses allocated to the syndicate,
telephone, postage, communications, co-manager expenses, computer and data
processing, interest, and miscellaneous expenses.
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Syndicate Settlement
and Regulations
Knopman Note: The final syndicate settlement must occur within 90
days following the syndicate settlement date.
10.15.1 Key Terms for Syndicate Settlement
A syndicate account is formed by members of the selling syndicate for the purpose of purchasing and distributing the public offering.
The syndicate settlement date is the date on which corporate securities of a
public offering are delivered by the issuer to the syndicate members.
In a firm commitment underwriting, the manager of a public offering must notify
FINRA of any anticipated delays in the closing of the offering. This notification
must be made no later than the initially scheduled closing date.
Knopman Note: The syndicate manager must notify FINRA’s
Operations Department of any anticipated delay in the closing of an
underwriting.
10.16 Direct Participation Programs (DPPs) and Unlisted REITs
The underwriting terms for offerings of direct participation programs (DPPs)
and unlisted real estate investment trusts (REITs) are covered under FINRA Rule
2310.
Most DPPs are limited partnerships structured with a general partner, who
makes day-to-day management decisions, and several limited partner investors,
who are passive investors in the business. DPPs are organized to pass revenues
and tax deductions directly through to limited partners, without taxation at the
partnership level. They are commonly offered to raise capital for real estate and
energy drilling/transmission ventures.
Though many DPPs are structured as private placements for a select group of
sophisticated investors, Rule 2310 covers underwritings of DPPs and unlisted
REITs offered to the public. Underwriters are required to file specific information
about the offering with FINRA and receive a “no objections” opinion regarding
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and Regulations
the offering terms prior to participating in the offering. FINRA pays special attention to three types of organization and offering (O&O) expenses:
◆ Bona fide issuer expenses
◆ Underwriting compensation
◆ Due diligence expenses connected to the offering
Rule 2310 limits the total O&O expenses for DPPs and unlisted REITs to 15% of
gross offering proceeds.
Example
A master oil and gas DPP partnership offering raises $40 million in gross proceeds. The maximum that may be spent on total O&O expenses is $6 million
(15%).
Bona Fide Issuer Expenses
An issuer expense is bona fide—rightfully charged to the issuer, but paid from
offering proceeds—if it is for:
◆ Costs of assembling and mailing advertising documents and generating
general advertising materials
◆ Legal and accounting services provided to the sponsor or issuer
◆ Salaries and compensation paid to employees or agents of the issuer
◆ Fees paid to transfer agents, escrow agents, engineers, or other experts
◆ Taxes and fees paid to register or qualify securities
Each such expense must be specifically identified in the FINRA report if it is paid
from offering proceeds.
Any expense that is considered a bona fide issuer expense will not be included
in underwriting compensation.
FINRA does not allow bona fide issuer expenses to be classified as “miscellaneous.” An expense must fall into one of the categories listed above, or else it will
be considered an underwriting expense.
10.16.1 Underwriting Compensation
Underwriting compensation is defined as all types of compensation, from any
source, paid to underwriters, broker-dealers, or their affiliates. It specifically
includes:
◆ Payments to wholesaling, retailing, or marketing firms engaged in the
distribution of DPP securities
◆ Payments for training or educational meetings or conferences sponsored
by broker-dealers or attended by registered representatives
◆ Payments related to the legal services of distributors participating in the
offering
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◆ Costs of offering-related sales materials prepared by broker-dealers
There is one exception to the “all types of compensation” definition, and that is for
non-transaction-based compensation paid to registered persons who perform
only clerical or ministerial functions for the offering—not sales activities (or only
incidental sales activities).
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Syndicate Settlement
and Regulations
For any offering, Rule 2310 limits underwriting compensation from whatever
source to 10% of gross offering proceeds. This 10% is included in the 15% limit
for total O&O.
Example
A $40 million master oil and gas partnership offering would be limited to $6
million in O&O (15%), of which only $4 million (10%) could be for underwriting
compensation.
Even if a registered person is employed by the issuer, or performed services for
the issuer for compensation, all payments to that person will be considered
underwriting compensation—not bona fide issuer expenses.
10.16.2 Due Diligence Expenses
Rule 2310 includes “bona fide due diligence expenditures” in the 15% overall cap
on O&O expenses, but not in the 10% cap on underwriting compensation.
A bona fide due diligence expense must be detailed on an itemized invoice that
an underwriter or a distributor prepares and submits to the investment program,
with the invoice amount paid in full.
Any other due diligence expenditure may be included in underwriting compensation as a non-accountable expense—without details or itemization. However,
the total of all non-accountable underwriting expenses is limited to 3% of the
offering proceeds.
10.16.3 Liquidity Disclosures
Rule 2310 also requires underwriters and distributors of DPPs to make liquidity
disclosures to prospective investors about prior programs offered by the same
sponsor.
These disclosures are required if the sponsor has previously offered a program
in which a goal was to liquidate the program within a given period, or by a given
date. The prospectus or offering materials must disclose whether the prior programs met the stated goal of liquidating by the target date(s). They also may
explain relevant facts about the sponsor’s liquidity track record, provided that a
complete picture is offered.
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Chapter 10: Syndicate Settlement and Regulations
Unit Exam
1. A willful attempt by a broker-dealer to support
the price of a security by interfering with fair
market operations is referred to as:
A.
B.
C.
D.
A de minimis transaction
Post-offering price support
Fair game
Market manipulation
2. In the event the lead book-runner of a
follow-on offering seeks to exercise an
over-allotment option, at what point is the
distribution deemed complete?
A. When all of the syndicate members receive
their underwriting fees
B. After the securities have been distributed
and trading restrictions are terminated
C. Once the securities have been distributed,
though restrictions can still apply
D. At the end of the fiscal year
3. Conducting a road show in connection with an
initial public offering is considered a:
A.
B.
C.
D.
Special selling effort
Distribution
Covered security
Reference security
4. Which TWO of the following factors influence
the research quiet period’s length?
I. Whether the analyst’s opinion is
favorable or unfavorable
II. Whether the participant is a manager
III. Whether the issue is an IPO or a
follow-on
IV. Whether the securities are traded on
an exchange or OTC
A.
B.
C.
D.
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I and III
I and IV
II and III
II and IV
5. Under FINRA Rule 2060, under what
circumstance(s) may fiduciaries use
information about the ownership of securities
to solicit purchases, sales, or exchanges?
A.
B.
C.
D.
In any case
In no case
Only per the request of the issuer
Only in routine communications with
regular customers
6. Which TWO of the following are “fiduciaries”
covered under FINRA Rule 2060’s restrictions
on using information about the ownership of
an issuer’s securities to solicit transactions?
I.
II.
III.
IV.
A.
B.
C.
D.
Broker-dealers
Transfer agents
Investors
Trustees
I and III
I and IV
II and III
II and IV
7. An underwriter plans to offer a direct
participation program (DPP) to a select
group of sophisticated investors. Prior to
participating in the offering, the underwriter
must file specified information with FINRA
and:
A.
B.
C.
D.
Pay a licensing fee
Obtain an independent legal opinion
Hire a certified appraiser
Receive a “no objections” opinion from
FINRA
Chapter 10: Syndicate Settlement and Regulations
Unit Exam (Continued)
8. In an offering for a direct participation
program, fees paid to transfer agents and fees
paid for legal and accounting services are
examples of:
A.
B.
C.
D.
Due diligence expenses of the offering
Underwriting compensation
Separately billed underwriting expenses
Bona fide issuer expenses
9. In a direct participation program, all of the
following types of compensation paid to
broker-dealers are included in underwriter
compensation except:
10. Under FINRA Rule 5141, broker-dealers that
participate in fixed-price syndicates are not
allowed to offer another broker-dealer:
A. An over-allocation of shares, without prior
disclosure
B. Selective communication of material
information
C. A price reduced below the public offering
price
D. A fixed share price during the waiting
period
A. Sales commissions
B. Non-transaction compensation for clerical
or ministerial functions
C. Referral fees paid
D. Continuing fees and trail commissions
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Chapter 10: Syndicate Settlement and Regulations
Unit Exam—Solutions
(D)
Broker-dealers that attempt to support the price of a particular security can be deemed
market manipulators, which violates federal securities laws.
2. (B)
Only when all of the securities have been distributed, and after any stabilization and
trading prohibitions have been terminated, can the distribution be deemed complete. If
an over-allotment option is exercised at a later date, the distribution is still deemed
complete, unless the over-allotment is exercised for an amount greater than any short
position by the syndicate at exercise.
3. (A)
Drafting and distributing a prospectus, making sales calls, and conducting a road show
are all considered special selling efforts and selling methods by the SEC.
4. (C)
The quiet period does not depend on what type of research or opinion the analyst
is offering or where the securities are traded. For an IPO, the quiet period is 10 days
for a deal in which an analyst is employed by a syndicate manager or syndicate member.
For follow-on offerings, it is three days for the syndicate manager, and there is no
quiet period for syndicate members. In all cases, the quiet period begins on the
effective date. These quiet periods do not apply to issuers of Emerging Growth
Companies.
5. (C)
Rule 2060 prohibits fiduciaries, such as paying agents, transfer agents, and trustees,
from using information about the ownership of securities for soliciting purchases, sales,
or exchanges. The one exception is when this is done at the issuer’s request.
6. (D)
Specified types of fiduciaries are covered under FINRA Rule 2060, including transfer
agents, paying agents, trustees, and others who have privileged access to information
about ownership of the issuer’s securities.
1.
7.
(D)
Under Rule 2310, DPPs must file information with FINRA and receive a review and clean
bill of health prior to the offering. FINRA focuses on several issues, including expenses
of the offering and underwriter compensation.
8. (D)
Bona fide issuer expenses are charged to the issuer and paid from offering proceeds.
9. (B)
Underwriting compensation includes all types of compensation, from any source,
paid to underwriters, broker-dealers, registered representatives, and their affiliates. The
one exception is for non-transaction-based compensation paid to registered persons
who perform only clerical or administrative functions.
10. (C)
FINRA Rule 5141 requires transactions between broker-dealers in a fixed-price syndicate
to be made only at the public offering price, until the offer is terminated. Only other
underwriters can receive shares at a discount.
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11. Private Placements
Investment banking responsibilities are not limited to public offerings and syndicate activities. Issuers also offer securities through private placements for a
variety of reasons. In a private placement, an issuer offers securities to a select
universe of potential buyers, often operating on a much smaller scale for cost
savings and faster access to capital. Because these offerings are not available
to the public at large, they are frequently outside the scope of SEC registration
and are considered exempt transactions. As such, these securities are typically
not required to file a registration statement under the ’33 Act. Specific rules and
definitions of exempt transactions will be reviewed in Chapter 12. This chapter
will discuss private offerings in general and the roles that investment bankers
are called upon to fill.
Even though private placement securities are offered privately instead of publicly,
they are still subject to federal securities anti-fraud regulation. The issuer remains
responsible for false or misleading information distributed to potential investors.
Furthermore, although the securities sold may not be subject to federal securities
registration, they may still be subject to state securities laws in the states where
the issuer does business.
11.1 Offeree and Purchaser Restrictions
Private placements involve the nonpublic sale of securities to a relatively small
number of investors. While there is no specific limitation on the number of offerees, the greater the number of offerees, the higher the likelihood that the offering
will not qualify for the private placement exemption.
Qualification for the private placement exemption requires that the issuer ensure
that the offerees and purchasers of the securities:
◆ Are sufficiently knowledgeable and experienced in finance and
business matters to evaluate the risks and merits of the investment.
These investors are known as sophisticated investors and are often
institutions, although individuals may qualify as well
◆ Are able to bear the investment’s capital risk
◆ Have access to the type of information normally provided in a
prospectus, and
◆ Agree not to resell or distribute the securities to the public. The securities
are to be purchased for investment purposes. The holding period is one
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Private Placements
of the factors used to evaluate whether investment intent existed at the
time of purchase. A two-year holding period is a common requirement
used by issuers to validate intent.
Knopman Note: A disadvantage of private placement securities is that
they are restricted and thus more and difficult to sell (illiquid).
11.2 The Private Placement Process
As in any offering process, a series of steps must be completed before capital can
be raised.
11.2.1 Capitalization Strategy
One of the first steps for the issuing company is preparing a business plan that
defines its long-term capitalization strategy. The company and its advisers must
plan its capital structure, which includes the determination of matters such as:
◆ Amount of money to be raised
◆ Evaluation and selection of preferred financing options
◆ Valuation of the securities
◆ Types of securities to be offered
If the business is organized as a corporation, shares can be sold directly to investors, who often favor preferred shares over common because of their priority in
dividend payment.
If the business is organized as a limited liability company (LLC) or limited partnership (LP), shares can be sold in the form of membership units in the company.
Membership units can be either preferred or general units.
The optimal financial structure is one that minimizes loss of control and dilution.
If the business has collateral assets, debt financing that is backed by the collateral
may be viable for a portion of the capital needs, which would limit the potential
for dilution.
Convertible debt is another option that can be attractive to both the issuer and
the investor. Like debt, it reduces risk to the investor because it offers a fixed
interest payment. Like equity, it offers greater long-term potential if converted
into shares. This is an attractive option for start-ups that prefer to postpone valuation of the company until a later date. The hope is that, in the future, the track
record of sales and profits will support a higher company valuation, resulting in
less dilution than would have been necessary in an earlier capital raise.
11.2.2 The Private Placement Memorandum
The company’s business plan is typically the source document for the private
placement memorandum (PPM), which is the disclosure document prepared
for circulation to potential investors. The business plan and the private placement memorandum describe the company’s current situation and include a
340
summary of its plans for the future. The purpose of the PPM is to provide the
same type of disclosure information as a prospectus.
The PPM typically includes information about:
Chapter 11
Private Placements
◆ Company management
◆ Company products or services
◆ How investment proceeds will be used
◆ Risks investors may face
◆ Recent significant transactions
◆ The company’s overall condition
An abbreviated version of the PPM, the offering circular, is often used to provide
a summary of preliminary information to potential investors.
The issuer and any parties acting for the issuer in preparing the PPM must do
a final due diligence review to ensure that all information and summaries are
accurate and complete.
The PPM will also include cautionary language, typically in all caps on the front
cover, confirming that 1) the securities are not registered under the Securities Act
of 1933, 2) the PPM has not been reviewed by the SEC, and 3) the securities may
lose value. One of the primary concerns when considering investing in a private
placement is the lack of liquidity in the stock because it is unregistered.
All information passed on in the course of the private placement, either verbally
or by memorandum, is subject to the anti-fraud provisions of federal and state
securities laws. The fact that the offering memorandum is not reviewed by the
SEC does not lower the standards for accuracy.
Finally, prior to actually beginning to raise funds, the PPM and supporting documentation must be filed in each state in which investors may be solicited.
11.3 Offering Commencement
The commencement date of a private offering is typically determined by the availability of the offering documents for distribution. In preparing to sell to investors,
the issuer frequently enlists the services of a broker-dealer with experience in
private placement distributions. A number of documents are used to formalize
the arrangement.
11.3.1 Placement Agent Agreement
A placement agent agreement is an agreement between a company that issues
stock and a party that agrees to use “best efforts” to secure investors in the offering. This party is known as the placement agent. Generally, a placement agent
agreement is the first step in the process of finding investors. This agreement
identifies the parties, purpose, and terms of the arrangement. Compensation
to the placement agent is typically a percentage of the total capital raised in the
offering.
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While the agreement clearly expresses the terms agreed upon by the issuer and
the placement agent, it does not obligate the placement agent to:
◆ Purchase the securities
◆ Ensure the successful placement of the securities, or
◆ Procure any other means of financing
Placement agents help issuers in all aspects of fundraising, including positioning
themselves for the market and identifying lists of potential investors. They facilitate introductions and arrange meetings so that presentations can be made to
prospective buyers. They also assist in the preparation of marketing materials,
such as teasers. Teasers are executive summaries, or one-page documents, that
describe the financial opportunity, and are used to attract the interest of potential buyers.
A confidentiality agreement (CA) is usually signed by both the issuer and any
outside contractors. Typically structured as a mutual non-disclosure agreement,
it protects against the exposure of proprietary information, such as trade secrets,
financial results, and intellectual property.
Knopman Note: An investment bank engaged as a private placement
agent must always conduct its own due diligence on the private
placement memorandum (PPM). If the client produced the PPM itself
to reduce the placement fee, special attention must be given to the
PPM’s adequacy and completeness.
11.3.2 The Subscription Process
Purchasers in a private placement must acquire the securities for investment and
not for the purpose of further distribution. The issuer is responsible for assessing
the suitability of the investment for the buyer. As a result, the placement agent
will generally target accredited investors—such as institutional investors (e.g.,
hedge funds, pension funds) and the current officers and directors of the issuer.
11.3.2.1 The Subscription Agreement
The issuer’s offering memorandum includes a subscription agreement, which
is the sales contract between the investor and the company. This subscription
agreement contains an Investor Suitability Questionnaire that helps the company determine the appropriateness of the investment for the potential buyer.
By signing the subscription agreement, the subscriber acknowledges the unregistered nature of the securities and his/her intent to hold the securities for investment purposes.
In all private placement offerings, the subscribers must be formally accepted by
the issuer, based on information provided by the investor in the questionnaire.
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11.3.3 Termination of the Offering
The termination date for a private offering depends on the type of offer. In an allor-none, a termination date is predetermined. In a best efforts, sales efforts may
continue until a required minimum amount of capital has been raised.
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Private Placements
11.4 Special Rules for Private Placements by Member Firms
In addition to the general rules and guidelines that apply to private placement
transactions, FINRA has established Rule 5122, which pertains to private placements by broker-dealers, or by an entity that is controlled by a broker-dealer. A
control relationship exists if the outside entity has a beneficial interest of more
than 50% of the outstanding voting securities of the broker-dealer or, for non-voting entities, the right to more than 50% of the distributable profits or losses.
11.4.1 Requirements of FINRA Rule 5122
The offerings to which FINRA Rule 5122 applies are frequently referred to as member private offerings (MPOs). The purpose of this rule is to prevent potential
conflicts of interest and require sufficient disclosure to investors.
To help ensure that proceeds from these types of offerings are not misused,
FINRA requires that broker-dealers engaged in these offerings:
◆ Provide investor disclosure through a private placement memorandum,
a term sheet, or another offering document that discloses the intended
use of the offering proceeds and the offering expenses
◆ File offering documents, and any amendments or exhibits, with FINRA’s
Corporate Financing Department at or prior to the time they are
provided to any investor, and
◆ Commit that at least 85% of the offering proceeds will be used for
business purposes, which do not include offering costs, discounts,
commissions, and any other cash or non-cash sales incentives
In an MPO, there is no requirement to wait for a no-objection letter from FINRA
before proceeding with the offering.
Rule 5122 includes a number of exemptions based on the types of offerings and
investors. Exemptions apply if MPO securities are sold to institutions and other
qualified purchasers, which are generally defined as investors with a portfolio
of at least $5 million or investment managers with at least $25 million under
management. An exemption also applies when securities are sold via an exempt
transaction.
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Chapter 11: Private Placements
Unit Exam
1. All of the following are key sources of capital
in the equity funding life cycle of a company,
except:
A.
B.
C.
D.
Venture capital
Private equity
Initial public offering
Bond issue
2. An engagement letter in a private placement
contains all of the following information
except:
A. The engagement of the investment bank as
an underwriter
B. The duration of the engagement
C. The material covenants of the offering
D. The fees or percentage of capital raised to
be paid to the investment bank
3. The outline of the material provisions and
conditions of an offering is known as:
A.
B.
C.
D.
An engagement letter
A master agreement among underwriters
A term sheet
A binding agreement
4. Which of the following is an offering document
prepared by a financial adviser as part of
a private placement, and subsequently
distributed to potential investors?
A.
B.
C.
D.
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Confidentiality agreement
Engagement letter
Private placement memorandum
Private member offering
5. Which of the following is a valid reason for a
company to pursue a private placement rather
than a registered offering?
A. Sales are not subject to anti-fraud
provisions
B. It is likely to be subject to less regulatory
scrutiny, and will permit the issuer to offer
the securities in a more timely fashion
C. It can be marketed to more investors
D. Investors expect a lower return
6. The subscription agreement in a private
placement can be best characterized as:
A. An agreement between a company that
issues stock and a placement agent to use
their best effort in finding secure investors
B. A document between an issuer and an
investor that subscribes each party to the
confidentiality of proprietary information
C. A contract between the investor
and company that contains a
suitability questionnaire outlining the
appropriateness of the investment for the
potential buyer
D. A disclosure for the investor on behalf of
the company outlining the company’s
business plan and risks
7. All of the following are roles of a placement
agent in a private placement except:
A. Facilitate the transfer of restricted shares
one the deal has closed
B. Assist in the preparation of marketing
materials, such as teaser
C. Help identify potential investors
D. Arrange meetings between the issuer and
investors
Chapter 11: Private Placements
Unit Exam (Continued)
8. The document that protects against the
exposure of proprietary information is the:
A.
B.
C.
D.
Confidentiality Agreement
Subscription Agreement
Private Placement Memorandum
Offering Circular
10. Qualified purchasers are investors with a
securities portfolio of at least:
A.
B.
C.
D.
$1 million
$5 million
$10 million
$20 million
9. Broker-dealers engaged in a member private
offering are required to do all of the following
except:
A. Provide disclosure to investors through
a private placement memorandum that
discloses the intended use of proceeds
B. Commit that at least 85% of the offering
proceeds will be used for business
purposes
C. File any amendments with the Corporate
Financing Department at or prior to the
time they are provided to any investor
D. Wait for a no-objection letter from FINRA
before proceeding with the offering
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Chapter 11: Private Placements
Unit Exam—Solutions
1.
(D)
All of the equity capital types listed are part of the equity funding life cycle. Venture
capital is for the start-up stage, private equity is for product development, an initial
public offering is for revenue growth, and a follow-on offering is for net income growth
as well as market share growth. A bond issue is a form of debt financing, not equity
financing.
2. (C)
The material covenants of the offering are outlined in a term sheet. The engagement
letter officially hires the investment bank to serve as the underwriter or placement
agent for the deal.
3. (C)
A term sheet outlines the basic details of the offering, whether it is private debt,
preferred stock, or equity. It includes information regarding coupon, maturity,
ownership, covenants, and other material provisions.
4. (C)
The private placement memorandum, or confidential information memorandum, is the
key marketing document in a private placement. It is typically a 25- to 50-page
document that describes the issuer, its business operations, and the offering in detail.
5. (B)
Private placements are not required to go through the full registration process. As
a result, though there is still a notice filing with the SEC, getting to market is much
faster. The deal is still subject to anti-fraud provisions. Also, it can only be marketed
to accredited investors, not the general public. Investors expect a higher return since
the securities are less liquid than registered shares.
6. (C)
The subscription agreement is a sales contract between the investor and the company.
Its purpose is to determine the appropriateness of the investment for the potential
buyer.
(A)
Placement agents have a variety of rules in a private placement with the exception of
a few roles – the purchase of securities, ensuring the successful placement of securities
or procuring any other means of financing.
7.
8. (A)
The confidentiality agreement is usually signed by both the issuer and any outside
contractors. It protects against the exposure of proprietary information, such as trade
secrets, financial results, and intellectual property.
9. (D)
In an MPO, there is no requirement for broker-dealers to wait for a no-objection letter
from FINRA before proceeding with the offering.
10. (B)
Qualified purchasers are generally defined as investors with a securities portfolio of at
least $5 million.
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12. Exempt Transactions
Previous chapters have reviewed the process of registering securities with the
SEC through public offerings. Because these transactions are subject to the SEC
filing and registration process as defined under the Securities Act of 1933, they are
known as non-exempt transactions. This chapter will focus on exempt transactions, which are legal ways to offer and sell securities without registering with
the SEC.
All securities transactions, even exempt transactions, are subject to anti-fraud
provisions of federal and state securities laws. Issuers remain responsible for false
or misleading statements, whether oral or written. In addition, offerings that
are exempt from federal securities laws may still be subject to the notice filing
obligations of various state laws.
This chapter covers the following exempt transactions:
• Regulations A and A+
• Rule 147 (and 147A)
• Regulation D
• Rule 144A
• Regulation S
• Rule 144
• Crowdfunding
12.1 Exempt Securities
Prior to a discussion of exempt transactions, it is important to note that certain
securities are exempt from registration no matter how they are sold. These securities are not required to file a registration statement with the SEC and distribute
a prospectus to all potential investors. Exempt securities include:
◆ US government securities and US government agency securities
◆ Securities issued by nonprofit organizations
◆ Municipal bonds
◆ Commercial paper and other short-term debt with a maximum maturity
of no more than 270 days
◆ Securities of banks supervised by a federal or state authority
Regarding securities sold by banks, this exemption applies specifically to commercial banks. Securities of investment banks and securities of bank holding
companies are not exempt from registration.
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Eurodollar bonds and Eurodollars are also not subject to SEC registration.
Eurodollar bonds are USD bonds traded outside the United States. Eurodollars
refers to any foreign deposits of US dollars.
Knopman Note: Candidates should know all the exempt securities
under the ’33 Act. It may help to remember that most types of common
stock, including ADRs, mutual fund shares, and exchange traded
funds (ETFs) are non-exempt.
12.2 Regulations A and A+
As part of the JOBS Act, the SEC updated and expanded the ability of smaller
issuers to raise capital under Regulation A. The provisions under Regulation
A remain, but issuers can now raise more capital under new provisions called
Regulation A+.
12.2.1 Regulation A
The Securities Act of 1933 authorizes the SEC to exempt small securities offerings
from registration if they comply with Regulation A. This regulation specifies
that a public offering is exempt from SEC registration if the amount of securities
offered does not exceed $5 million in any 12-month period. Regulation A also
permits shareholders to sell up to $1.5 million of securities. Any sale by existing
shareholders counts against the $5 million total.
Companies that choose to claim this exemption must file an offering statement
on Form 1-A with the SEC for review. This statement consists of a notification,
offering circular, and exhibits. The offering circular must be furnished to all investors at least 48 hours prior to the mailing of a confirmation of sale.
Knopman Note: To initiate a Reg A offering the issuer uses Form 1A.
Issuers are permitted to publish and deliver to potential purchasers a written
document, or make scripted radio or television broadcasts, to determine whether
there is interest in a contemplated securities offering. A copy of the written document or script must be submitted to the SEC on or before the first day of use. The
filing must include the name and telephone number of a person able to answer
questions.
Issuers may not solicit or accept money until the SEC completes its review of the
filed offering statement and offering materials are delivered to investors. Also, the
issuer is required to aggregate and report to the SEC every six months the total
amount of securities sold pursuant to Regulation A during that period.
Regulation A offerings share many characteristics with registered offerings. For
example, an issuer must provide purchasers with an offering circular that is similar in content to a prospectus. Like registered offerings, the securities can be
offered publicly and are not restricted, meaning they can be freely traded in the
secondary market.
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Advantages of Regulation A offerings include:
◆ Financial statements are simpler and do not need to be audited
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Exempt Transactions
◆ There are no Exchange Act reporting obligations after the offering, unless
the company has more than $10 million in total assets and more than
2,000 shareholders
◆ Filing with the SEC is less expensive than with the normal process
12.2.2 Regulation A+
Regulation A+ permits private companies to raise more capital than with traditional Regulation A offerings. Regulation A+ (which was enacted in 2015) allows
issuers to choose from two tiers of registration-exempt offerings.
In a Tier 1 offering, eligible issuers may offer and sell up to $20 million of securities in a 12-month period, of which no more than $6 million may constitute
secondary sales by security holders that are affiliates of the issuer.
In a Tier 2 offering, issuers may offer and sell up to $75 million of securities in a
12-month period, of which no more than $22.5 million may constitute secondary
sales by affiliates.
A Regulation A+ offering requires an offering statement to be filed with the SEC
just like with Regulation A. This statement must include specified disclosures
regarding the issuer and the offering, including a description of the securities,
material risks associated with the offering, how the proceeds will be used, a
description of the issuer’s business, and information regarding the compensation of executive officers and directors.
Both Tier 1 and Tier 2 offerings must be accompanied by financial statements for
the issuer’s two most recently completed fiscal years. The financial statements of
a Tier 2 issuer must be audited, whereas the financial statements of a Tier 1 will
not generally be required to be.
With respect to ongoing reporting and disclosure requirements post-offering, Tier
1 offerings will not generally require follow-up reporting by the issuer, whereas
Tier 2 offerings will require the issuer to file annual reports, which must include
audited financial statements, as well as semiannual reports.
One of the major hurdles issuers faced with Regulation A offerings was that the
offering had to be reviewed by state securities regulators, under the blue sky laws.
This imposed a significant regulatory burden on the issuer, in light of the modest
amount of capital being raised. In the new Regulation A+ regime, Tier 1 offerings
will remain subject to state securities law oversight, while Tier 2 offerings will not
be subject to compliance with state securities law, though traditional anti-fraud
regulations still apply.
In summary, Regulation A+ offers an alternative for nonpublic companies to raise
more significant amounts of capital from investors without becoming fully registered public companies.
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Knopman Note: Be sure to review the table below, which characterizes
the key elements of Regulations A and A+ offerings.
Max Annual
Allowable
Amount
Ongoing SEC Reporting
Requirements
(financial statements)
State Securities
Registration
(blue sky)
Regulation A
$5 million
None
Required
Regulation A+
Tier 1
$20 million
None
Required
Regulation A+
Tier 2
$75 million
Semiannual and
annual reports
Not Required
Note: Under all three tiers, a Regulation A or A+ issuer must make semiannual
disclosures to the SEC indicating the amount of capital raised under these provisions in the prior six months. This is distinct from the ongoing reporting requirements that relate to disclosures to the investors.
12.3 Rule 147—Intrastate Offering Exemption
The Securities Act of 1933 includes an exemption that facilitates the financing of
local business operations. Known as the intrastate offering exemption, Rule
147 applies to companies that:
◆ Are incorporated or have had their principal place of business (for a
partnership) in the state where the securities are to be offered
◆ Carry out a significant amount of their business in that state, and
◆ Offer and sell their securities only to residents of that state
For purposes of the intrastate exemption, an issuer is deemed to be doing “a significant amount of its business” within a state if the issuer satisfies at least one
of these requirements:
◆ Has a majority of its employees based in the state
◆ Derived at least 80% of its gross revenues in the past six months from
that state
◆ Has 80% of its assets located in that state, and
◆ Uses at least 80% of the net proceeds from the offering to operate a
business, purchase property, or render services within that state
There is no limit on the size of the offering or the number of purchasers.
It is the issuing company’s responsibility to determine the residence of each purchaser. If any of the securities are mistakenly offered or sold to just one out-ofstate resident, the exemption may be lost, and the offering could be in violation
of the Securities Act of 1933.
For the first six months after the date of sale by the issuer, the shares may only
be resold to state residents. After six months, the shares can be sold out of state.
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Rule 147 does not prohibit general advertising or general solicitation as long as
it complies with applicable state law and does not result in an offer or sale to
non-residents of the state.
Chapter 12
Exempt Transactions
Knopman Note: Under a Rule 147 offering, the issuer must be a resident
of the state where the securities will be sold.
Q: How is residency under Rule 147 defined?
A: For businesses, residency is defined by the state of
incorporation. If the business is not incorporated under any
state law (e.g., a partnership), then residency is based on the
principal office’s location.
Q: Could an issuer sell securities in one state and then
immediately relocate to another state?
A: If an issuer plans to move its business to another state shortly
after an offering, an investment banker would likely advise
against a Rule 147 transaction.
Q: What is the difference between Rule 147 and Rule 147A?
A: Few differences exist between Rules 147 and 147A. Under Rule
147A, issuers are not required to be incorporated in the state.
Also, offers can be made to anyone, provided sales are only to
state residents.
12.4 Regulation D—Private Placements
Further exemption from the registration requirements of the Securities Act of
1933 is available under sections 4(a)(2) and 4(a)(5). Section 4(a)(2) exempts transactions not involving any public offering, and 4(a)(5) exempts transactions solely
with accredited investors. The SEC has provided objective standards that issuers
can rely upon to gain comfort that their issuance, often described as a private
placement, is private and within the requirements of sections 4(a)(2) and 4(a)(5).
Regulation D establishes three exemptions from registration for private placements of equity or debt securities under sections 4(a)(2) and 4(a)(5). As with the
Regulation A and Rule 147 exemptions, it enables an entity to obtain funding
faster and avoid certain costs associated with a public offering.
In order to qualify for any one of the exemptions available through Regulation D,
some basic rules must be followed:
◆ Sufficient information and disclosure must be provided to the SEC and to
potential purchasers
◆ There must be no general solicitation (subject to certain exceptions,
discussed shortly)
◆ There are restrictions on the resale of the securities, meaning they cannot
be sold without registration or an applicable exemption
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Chapter 12
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◆ All sales within 30 days that are part of the same Regulation D offering
must be integrated, or treated as one offering
Regulation D requires the issuing company to file a notice with the SEC. This
notice, Form D, must be filed within 15 days after the first sale of securities. It also
prohibits any general solicitation or general advertising, including:
◆ Any advertisement, article, notice, or other communication published in
any newspaper, magazine, or similar media or broadcast over television
or radio
◆ Any seminar or meeting whose attendees have been invited by any
general solicitation or general advertising
Regulation D transactions can be broken down further as follows:
◆ Rule 504 is for offerings of up to $10 million
◆ Rule 506 can be used for offerings of any size
Knopman Note:
Q: How many non-accredited investors can participate in a Rule
504 private placement?
A: Under Regulation D Rule 504 (less than $10MM), a private
placement can have an unlimited number of non-accredited
investors.
Q: What is not permissible under Reg D Rule 504?
A: Raising more than $10MM in capital.
12.4.1 Accredited Investors
The Regulation D exemptions available under Rule 506 allow sales to an unlimited number of accredited investors and, depending on the specific subsection
of the rule (discussed shortly), up to 35 non-accredited investors.
An accredited investor is defined as any of the following:
◆ A natural person with a net worth of at least $1 million, exclusive of the
value of his/her primary residence
◆ A natural person with income exceeding $200,000 in each of the two
most recent years, or joint income with a spouse exceeding $300,000 for
those years, and a reasonable expectation of the same income level in the
current year
◆ A bank, an insurance company, a registered investment company,
a business development company, or a small business investment
company
◆ An employee benefit plan
◆ A charitable organization, family offices providing investment advice,
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trusts, Municipal and ERISA employee benefit plans, corporation, or
partnership with assets exceeding $5 million
◆ A director, an executive officer, or a general partner of the issuer
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Exempt Transactions
◆ A business in which all the equity owners are accredited investors
◆ A trust with assets of at least $5 million, formed for purposes other
than to acquire the securities, and whose purchases are directed by a
sophisticated person
◆ Investors that hold a Series 7, Series 65, or Series 82 qualification. Other
professional designations will be added to this list
◆ “Knowledgeable employees” associated with private funds such as
qualifying hedge funds, venture capital funds, or private equity funds.
These “knowledgeable employees” include officers and directors of the
fund as well as certain employees who have been engaged in investing
activities at the fund for at least a year. These individuals are considered
accredited investors for investments in their fund only
Knopman Note: Be sure to be able to identify which investors are and
are not accredited.
Accredited investors include:
• Officers and directors of the issuer
• Institutions (including unit trusts) with assets of at least $5MM and
which have legitimate business purposes
• Individuals with $200,000 of net income ($300,000 if married) in
each of the last two years or with $1 million of net worth, excluding
their primary residence
Two tricky examples:
• While banks, insurance companies, and others are accredited
investors, certain institutions, such as trusts, must have at least
$5MM in assets to be accredited. Furthermore, they must have a
legitimate business purpose (i.e., cannot be organized solely to
invest in a private placement).
• Employees of the issuer and existing shareholders are not
accredited just by virtue of their employment or shareholder
status. Therefore, they would generally not be solicited in a private
placement.
Purchasers of securities offered through Regulation D must buy for investment
only, and not for resale. The issued securities are restricted. Consequently, investors may not freely sell the securities.
Under Rule 506, all non-accredited investors must be sophisticated. Sophisticated
investors are persons who possess sufficient knowledge and experience in
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Exempt Transactions
financial and business matters to evaluate the merits and risks of the prospective investment.
To better evaluate the merits and risks of the Regulation D securities, investors
may choose to use the services of a purchaser representative, often an attorney
or a financial adviser. A purchaser representative must not be associated with
the issuer as an affiliate, a director, an officer or another employee, or a beneficial
owner of 10% or more of any class of the equity securities. The purchaser representative is also subject to certain conflict of interest disclosure requirements in
acting on behalf of the investor, and there must be written documentation of the
relationship between the investor and a purchaser representative. Investors who
are not otherwise sophisticated are required to work with a purchaser representative in a private placement.
Knopman Note: To verify an accredited investor’s status, an investment
banker can evaluate income by reviewing income tax forms, such as
Form W-2, Form 1099, Schedule K-1 of Form 1065, or a Form 1040. Net
worth can be verified by reviewing specific types of documentation
dated within the prior three months, such as bank statements,
brokerage statements, certificates of deposit, tax assessments, or a
credit report.
12.4.2 More on Rule 506
The JOBS Act required the SEC to reduce barriers to capital formation by offering
additional ways for issuers to sell securities without SEC registration under the
Securities Act of 1933. These changes, set forth in Rule 506(c), relax the prohibition
against general solicitation and advertisements used in connection with private
placements. Issuers can now raise capital in two ways under Rule 506.
The traditional method, Rule 506(b), prohibits the general solicitation (e.g., advertisements) of private placement securities. Also, as before, the securities may
be sold to an unlimited number of accredited investors and no more than 35
non-accredited investors.
Knopman Note: The percentage of a Reg D Rule 506(b) deal being sold
to non-accredited investors does not matter. All that matters is that
there are no more than 35 non-accredited investors.
The new method, set forth in Rule 506(c), permits general solicitation for securities being offered in a private placement. This allows the issuer to cast a wider net
using advertising and mass communications, including ads on public websites,
television, radio, or newspapers, to target potential investors. However, under Rule
506(c) non-accredited investors cannot participate in the transaction. To ensure
compliance, the issuer is required to take “reasonable steps” to verify that all purchasers in the deal are accredited investors. To determine an investor’s accredited
status, the rule’s non-exclusive list of methods cites examination of tax returns and
bank statements or a certification letter provided by the purchaser’s broker-dealer.
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Below is a summary of Rules 504, 506(b), and 506(c).
Reg D Safe Harbor
504
506(b)
506(c)
Maximum Capital
$10 million
Unlimited
Unlimited
General Solicitation (Advertising)
Permitted
Prohibited
Permitted
Accredited Investors
• Officers, directors, or >10% shareholders
• Institutional investors
• High-net-worth individuals (as defined)
Unlimited
Unlimited
Unlimited
Non-Accredited Investors
Unlimited
35
None Permitted
Filing Requirement
Form D
Form D
Form D
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Exempt Transactions
12.4.3 Bad Actor Provisions
The JOBS Act also required the SEC to incorporate bad actor provisions into
Regulation D, specifically into Rule 506, as well as Reg A/A+. Issuers are prohibited from relying on the private placement exemption if the issuer, or an individual associated with the issuer:
◆ Has been convicted of any felony or securities-related misdemeanor in
the previous 10 years
◆ Has been subject to a securities-related court injunction in the previous
five years
◆ Is subject to an order from a state securities commissioner barring
securities-related activities
◆ Has had its registration revoked by the SEC or any SRO (e.g., FINRA)
It may help to think of the bad actor items as roughly equivalent to statutory
disqualification events.
Again, this rule applies to the issuer and anyone associated with the issuer,
including any:
◆ Predecessor of the issuer
◆ Officer, director, or general partner of the issuer
◆ Beneficial owner of more than 20% of the issuer’s equity securities
◆ Investment manager of the issuer (if the issuer is an investment fund)
◆ Person that will be paid for solicitation of purchasers for the deal (e.g.,
underwriters), including directors and officers of the solicitor
The SEC retains the authority to waive these disqualifications upon a showing of
good cause that the disqualification is not necessary under the circumstances.
Bad actor provisions do not apply to Rule 504 (i.e., private placements under $10
million).
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Knopman Note:
Q: What disclosure documents are used in a public offering? Reg A
offering? Reg D offering?
A: Public offering: Prospectus (424(b))
Reg A (small business): Offering circular
Reg D (private offering): Private placement memorandum (PPM)
Q: Under Reg D, who must receive a copy of the PPM?
A: In a private placement, a PPM is not required to be prepared
for accredited investors. If, however, non-accredited investors
participate in the deal, a PPM must be produced and made
available to all investors. The exception is that a PPM is not
required if the private placement is for less than $10mm (Rule
504).
Q: What determines whether two private placements by a company
are subject to Regulation D rules separately or together?
A: To avoid multiple private placements being treated as one
transaction, at least 30 days must elapse without any offerings
to investors. For example, if an issuer did a private placement
on August 1st and then another transaction of August 15th, the
transactions would be considered part of the same capital raise
and must comply with the private placement rule in aggregate
(e.g., no more than 35 non-accredited investors combined).
On the other hand, if a company did a private placement on
February 1st followed by another one on November 1st, these
would be treated as two separate transactions since more than
30 days have elapsed.
12.5 Rule 144A
Rule 144A of the Securities Act of 1933 makes it easier for companies, both domestic and international, to raise money in US capital markets. It permits companies
to buy and sell unregistered securities through a broker-dealer or among themselves, as long as they are classified as qualified institutional buyers (QIBs). To
be a QIB, the institution must control a securities portfolio of at least $100 million
on a discretionary basis. Broker-dealers with a securities portfolio of at least $10
million are also considered QIBs. Unlike with Rule 144, securities sold under Rule
144A are not subject to a holding period.
Since its adoption in 1990, Rule 144A has greatly increased the liquidity of unregistered securities by enabling a more liquid and efficient institutional resale market. It has also made US capital markets accessible to foreign companies.
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The most common uses of Rule 144A include the issuance of high-yield debt and
the issuance of pre-IPO shares. In many scenarios, investors in Rule 144A securities are given the opportunity at some point in the future to sell their securities
to the public. This is referred to as piggyback registration rights.
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Exempt Transactions
Knopman Note:
Q: In a Rule 144A deal, who must be a QIB?
A: Under Rule 144A, the purchaser must either be a qualified
institutional buyer (QIB) or purchasing on behalf of one.
Q: Who qualifies as a QIB?
A: A qualified institutional buyer (QIB) is an institutional investor
managing at least $100MM of discretionary securities or a
broker-dealer managing at least $10MM of securities on behalf
of others. Discretionary means the investor is actually making
the investment choices.
Q: Is a broker-dealer required to be a QIB to facilitate a Rule 144A
trade between two clients?
A: No. A broker-dealer may act as agent in a 144A trade without
itself having to be a qualified institutional buyer.
Q: Do QIBs require an offering memorandum when investing in
Rule 144A securities?
A: No, an offering memorandum is not required under Rule 144A.
Q: What is an example of piggyback registration rights?
A: A young company might raise capital by selling pre-IPO
shares in a Rule 144A offering or Reg D private placement.
As a condition of the deal, the investor requires the issuer to
include the investor’s securities in the prospectus, at the issuer’s
expense. This is called piggyback registration rights. Should the
company eventually go public, the early investor can have its
shares registered, or “piggybacked,” on the issuer’s registration
statement.
These registration rights can extend to securities with
conversion rights, such as warrants. In this case, the issuer
would likely notify the warrant holders of an upcoming IPO,
so they could exercise and have their stock registered and
potentially sold to the public.
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Exempt Transactions
12.6 Regulation S
The SEC has historically taken the position that securities offerings outside the
United States are not subject to the registration requirements of the Securities
Act of 1933. Regulation S codifies this position, confirming that offshore offerings
are not subject to SEC registration. It also offers a means for US public companies
to tap offshore capital markets without an SEC registration statement.
Regulation S contains three main rules. The first, Rule 101, establishes the general
principal that offerings occurring outside the United States are not subject to registration. The other two, Rules 903 and 904, are safe harbors that apply to offers
or sales made in an offshore transaction. Securities sold in offshore transactions
are exempt as long as:
◆ No offer is made to any person physically located in the United States.
Each purchaser of securities must be outside the United States at the
time of the decision to purchase the security, and
◆ No directed selling efforts are made in the United States. There can be no
solicitation of investors or written communications to investors while
they are in the US
Knopman Note: A registered investment adviser located in the United
States, which has discretionary authority on behalf of its clients, can
invest in a Regulation S offering on behalf of its clients as long as the
clients are not U.S. residents.
Regulation S does not limit the number of persons to whom securities may be
offered or sold, nor does it contain requirements as to the wealth or financial
sophistication of potential purchasers.
Rule 903 of Regulation S prescribes other requirements for the sale of securities:
◆ Issuers must obtain the written agreement of each distributor in the
offering, if any, to concede to certain resale limitations
◆ Certain statements and legends must be placed within materials and
documents circulated in connection with the offering
◆ Securities cannot be sold to a US person (as defined in Regulation S)
during the distribution compliance period
◆ Each purchaser of the securities must certify that he or she is not a US
person and is not purchasing the securities for the benefit of any US person
Example
An investment banking rep is facilitating a Regulation S transaction on behalf
of an issuer. Just prior to sale, the rep learns that one of the potential investors
has moved to the US.
The consequences of selling to even a single US investor in a Regulation S deal
are severe—it violates the rule and would not result in an exempt transaction.
Therefore, the rep should notify a supervisor immediately.
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12.6.1 Resale of Regulation S Securities
Rule 905 of Regulation S states that securities issued through this exemption are
restricted securities, and are not freely tradable.
Chapter 12
Exempt Transactions
◆ Debt securities issued under Regulation S may only be resold in the
United States after a 40-day holding period.
◆ Equity securities may be resold in the US subject to Rule 144:
• Current SEC filers: Six months
• Non-current SEC filers: 12 months
Alternatively, securities listed on an SEC-designated, offshore securities exchange
(e.g., the London Stock Exchange) can be resold immediately on that exchange.
Knopman Note: Reg S shares can be immediately resold on an offshore
securities exchange. For example, if Reg S shares are sold in the UK,
they can immediately be resold on the Hong Kong exchange.
Knopman Note:
Q: Who can participate in a foreign issuer’s Regulation S follow-on
offering?
A: Anyone who resides outside the US, including US citizens living
abroad. Note that Regulation S investors are NOT required to be
accredited.
Q: Who cannot participate in Reg S offerings?
A: No one who resides in the US (regardless of citizenship) can
participate in a Reg S deal.
12.7 Rule 144
Rule 144 defines the conditions under which securities acquired through an
exempt transaction, or restricted from resale for other reasons, can be sold. It
defines both restricted and control securities, and provides direction on how
to have a restrictive legend removed so that securities can be resold.
Knopman Note: Be sure to review the two prongs of Rule 144 closely,
understanding the definitions of restricted stock (unregistered) and
control stock (owned by an insider), as well as the rules surrounding
their sale.
12.7.1 Restricted Securities
Investors typically receive restricted stock through private placements, Regulation
D offerings, Regulation S offerings, employee stock benefit plans, as compensation for professional services, or in exchange for providing seed money or start-up
capital to the company. In fact, any stock that has not been SEC-registered is
restricted stock.
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Chapter 12
Exempt Transactions
When a purchaser acquires restricted stock, the stock is nearly always accompanied by a certificate stamped with a legend. The legend indicates that the securities may not be resold in the marketplace unless they are registered with the
SEC or are exempt from registration.
Restricted stock must be held for a certain period of time before being sold. The
holding period is a minimum of six months for securities issued by companies
subject to reporting requirements of the Securities Exchange Act of 1934, and
at least one year for those from issuers that are not subject to these reporting
requirements or that are not filers in good standing with the SEC.
There must also be adequate current information about the issuer before the
sale can be made. For example, securities of a private company that does not file
financials would not be eligible for sale under Rule 144.
Knopman Note: Consider two Rule 144 restricted stock scenarios:
• A private placement, after being held for only three months, can
only be sold to the public if the shares are registered, since they
have not met the six-month holding period.
• An investor that acquires restricted shares on January 1 can buy
put options to limit downside in those shares and still sell the
securities under Rule 144 on July 1, six months later. The Rule 144
holding period is not affected by hedges the investor may put in
place to limit risk.
12.7.2 Control Securities
Control securities are those held by an affiliate of the issuing company. An affiliate, also referred to as a corporate insider, is commonly defined as being either:
◆ An officer of the company (e.g., CEO or CFO)
◆ A member of the board of directors, or
◆ An individual owning at least 10% of the voting shares
Control stock is not stamped with a restrictive legend if the shares were purchased in the open market.
A limit is imposed on the number of shares that an affiliate may sell during any
three-month period. The shares sold cannot exceed the greater of:
◆ 1% of the outstanding shares of the same class being sold, or
◆ The average reported weekly trading volume during the four weeks
preceding the sale
Trading volume is only measured for securities traded on NYSE or Nasdaq.
Securities traded on the OTC Bulletin Board or through OTC Pink are subject to
the 1% of outstanding shares limit only.
If the securities being sold by the affiliate are also restricted, the holding period
of six months or one year also applies.
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Knopman Note:
Q: Kathy is CEO of Ace, Inc. She owns Ace stock and wants to
liquidate some shares to diversify. As CEO, how many shares can
she sell?
Chapter 12
Exempt Transactions
A: Kathy needs to compare 1% of the outstanding shares of the
same class being sold with the average reported weekly trading
volume during the four weeks preceding the sale. Whichever
figure is greater she will include on her Form 144 filing, which
will then open a 90-day window during which she can sell that
number of shares. After selling in the open market, Kathy would
file a Form 4.
12.7.2.1 Filing a Notice of Proposed Sale with the SEC
Affiliates must file a notice with the SEC on Form 144 if the sale involves more
than 5,000 shares or the aggregate dollar amount is greater than $50,000 in any
three-month period. The sale must take place within three months of filing the
form. If the securities have not been sold by the end of the three-month period,
an amended notice must be filed.
Form 144 can be filed up to the first day on which shares are sold. Another way of
thinking about it: the 90-day period to sell shares begins the day Form 144 is filed.
12.7.3 Removal of the Legend
Even if other conditions of Rule 144 have been met, restricted stock cannot be
sold to the public until the legend has been removed from the certificate. Only
a transfer agent can remove a restrictive legend. The transfer agent will remove
the legend only if the issuer has given consent. This is usually in the form of an
opinion letter from the issuer’s counsel.
Below is a summary of the resale requirements under Rule 144.
Sale of Restricted
Securities by Affiliates
Sale of Restricted
Securities by Non-Affiliates
Sale of Registered
Securities by Affiliates
Holding period of six
months or one year
Holding period of six months
or one year
No holding period
Legend must be removed
Legend must be removed
No legend
Volume limits apply to
sale
Volume limits do not apply
to sale
Volume limits apply to sale
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Chapter 12
Exempt Transactions
12.8 Crowdfunding
Historically, unregistered, US-based securities investments were only available
as private placements to accredited investors. With the proliferation of online
investing, the JOBS Act of 2012 provides all individual investors the means to make
private investments. This type of investment is known as equity crowdfunding.
Crowdfunding is generally defined as businesses (usually small) raising small
amounts of equity capital online from potentially thousands of investors. For
example, a tech start-up might raise $900,000 to build its first app by collecting
$1,000 from each of hundreds of investors. These investors end up owning stock
in this new company.
Unlike private placements, which are only available to sophisticated investors,
crowdfunding is available to all investors, including less experienced individuals.
Therefore, FINRA and the SEC have enacted a number of rules to prevent abusive
sales practices. The primary SEC rule is Regulation Crowdfunding.
As of March 2021, through Regulation Crowdfunding, an issuer can raise up
to $5,000,000 in a 12-month period. This limit only applies to crowdfunding.
For example, an issuer could raise $3,000,000 via crowdfunding and another
$3,000,000 via a Regulation D private placement.
In traditional crowdfunding, on sites such as Kickstarter and GoFundMe, products or services are offered in return for a donation. Since those investors receive
products, the rules are not subject to US securities law. However, equity crowdfunding is an investment arrangement and therefore subject to US securities law.
AngelList and EquityNet are examples of equity crowdfunding sites.
12.8.1 Intermediaries
Issuers seeking to raise equity via crowdfunding can offer securities to investors
via an intermediary, defined as either:
1. A registered broker-dealer (similar to any other securities offering), or
2. A FINRA-registered funding portal
A funding portal is essentially a website where issuers can solicit funds from
investors. An issuer’s page includes key company data (similar to what might be
seen in a prospectus), such as:
◆ Business plan/model
◆ Planned use of funds
◆ Current valuation
◆ Risks of investing
◆ Management profiles
◆ Money raised to date
To be clear, issuers are not permitted to directly collect crowdfunding investments
from individuals—they are only permitted to sell shares through an intermediary.
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12.8.2 SEC Filing Requirements
Issuers raising money via crowdfunding are required to file Form C with the SEC.
Form C is similar in purpose to a larger SEC registration. Given that crowdfunding issuers are smaller and have less financial means, the disclosures are far fewer
than in a formal registration. Form C disclosures include:
Chapter 12
Exempt Transactions
◆ Description of issuer’s business
◆ Information about officers, directors, and anyone owning 20% or more of
the issuer
◆ Amount paid to intermediary (similar to the spread)
◆ Name of intermediary (i.e., broker-dealer or funding portal)
◆ Type of security offered
◆ Target capital to be raised (and willingness to accept oversubscription)
◆ Number of employees
◆ Selected financial data for current and prior year (including assets, cash,
debt, sales, taxes, and net income)
Certain issuers are required to update this information annually with the SEC.
Furthermore, the issuer must update Form C (on a Form C-U) within five business
days of reaching 50% of its target raise and then within five days of reaching 100%.
Companies that cannot raise equity crowdfunding include:
◆ Foreign companies
◆ Existing public companies
◆ Investment companies
◆ Companies that have previously broken crowdfunding rules
◆ Companies with no specific business plan (e.g., SPACs)
◆ Companies where senior management or other qualified persons are
disqualified under bad actor provisions (e.g., a director has been subject
to an SEC cease-and-desist order)
Issuers cannot advertise crowdfunding offers; instead they give a notice that
directs investors to the intermediary. The notice only discloses the amount being
raised, the price, basic information about the issuer (i.e., contact info, address),
and the description of its business.
Knopman Note: If a company’s owners were subject to SEC disciplinary
action (e.g., cease-and-desist orders) within the past five years, the
company could NOT raise capital via crowdfunding or Regulation A/
A+.
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Chapter 12
Exempt Transactions
12.8.2.1 Demo Day Activities
Demo day events are used by start-up companies to make presentations to prospective investors. These events typically focus on the company’s business plan,
but frequently conclude with the company’s capital-raising plans. Crowdfunding
rules permit companies to discuss their securities offerings, provided these discussions are limited to:
◆ Notification that the issuer is in the process of offering or planning to
offer securities
◆ Description of the type and amount of securities being offered
◆ Description of the intended use of the proceeds from the offering
Demo day communications, including this information about potential offerings,
are not deemed general solicitation or general advertising.
12.8.3 Investment Limitations
The SEC, for purposes of crowdfunding, does not place an investment limit
for accredited investors. However, SEC crowdfunding rules limit the amount a
non-accredited investor can invest on an annual basis in all crowdfunding issuers. The investment limit is based on an individual’s annual income or net worth,
as detailed in the chart below.
Investor Group
Maximum Investment Amount
Investor’s annual income or net worth is
less than $107,000
Greater of: $2,200 or 5% of annual income
or net worth
Investor’s annual income and net worth
(must be both) are $107,000 or more
10% of the greater of annual income or net
worth, not to exceed $107,000
The intermediary is responsible for ensuring an investor does not exceed this
limit across all crowdfunding investments. The issuer is not responsible for
ensuring investors abide by the rule, unless the issuer specifically has reason to
know that an individual has exceeded the limit.
The income/net worth threshold is adjusted periodically for inflation. Understanding
the concept is more important than being able to calculate contribution limits.
12.8.4 Risks of Equity Crowdfunding
Investors considering an equity crowdfunding investment should be mindful that
this type of security is far different from traditional registered common stock,
such as Apple or Google stock. As such, it has unique risks.
An investor who is unwilling to risk losing her entire investment should not invest
in a crowdfunding venture. If an investor is willing to assume such capital risk, the
investor should also be aware that there are fraudulent schemes out there. As with
registered offerings, the SEC and FINRA are not approving an issuer’s business
model or honesty. Investors should carefully research a potential crowdfunding
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investment, rely on professionals when necessary, and never invest other than
through a FINRA-registered intermediary.
Equity crowdfunding investments are highly illiquid. Investors can sell them only:
Chapter 12
Exempt Transactions
◆ To the issuer
◆ To accredited investors
◆ In a registered SEC offering (e.g., IPO)
◆ Upon death, to a family member, trust, or estate
Finally, investors should always consider whether a crowdfunding investment is
consistent with their personal financial goals. For example, a retired couple living
on a pension and seeking to preserve income should stay away.
12.9 Exempt Transactions Review
Knopman Note: Exempt transactions are a key topic on the
examination.
◆ Regs A/A+: The issuer must notify the SEC of the aggregate securities
sold under Regulation A every six months. The sum of these two filings
cannot exceed the annual limits under Reg A ($5MM, $20MM, or
$75MM).
◆ Reg D (private placement): Sections 4(a)(2) and 4(a)(5) of the ’33 Act
allow unregistered securities to be lawfully sold in private transactions.
Therefore, a company raising equity through a private placement would
not file a registration statement. Be sure to review the various deal sizes
and permitted investors under Reg D Rules 504 and 506(b)/506(c).
• Issuers may not use 506(b) and 506(c) if the issuer or any of its
principals are bad actors, meaning they have a relevant criminal
conviction or are subject to another disqualifying event.
• In a private placement, investors will receive substantially similar
information as in a registered offering; however, the disclosure
document is called a private placement memorandum (PPM)
instead of a registration statement or prospectus. The PPM will be
shorter and is not reviewed by the SEC, so the deal will often be
cheaper and faster than a registered offering. Investors, however, may
be concerned about the liquidity of unregistered (private) securities.
◆ Reg S: Reg S securities can be resold in the US only after a seasoning
period, but they can be resold immediately on an offshore exchange.
◆ Reg D v. Reg S: A foreign issuer seeking to raise US capital by targeting
accredited investors would typically engage in a Reg D private placement.
The key points are: 1) an accredited investor is a term specifically
associated with private placements, and 2) Reg S does not permit the
raising of US capital.
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Chapter 12
Exempt Transactions
◆ Rule 144: Permits the sale of restricted and control stock. This important
rule must be understood well.
• A company seeking to raise equity would not use Rule 144. Rule 144 is
for investors to sell stock into the open market.
◆ Rule 144A: Qualified institutional buyers (QIBs) can freely—and
immediately—trade unregistered securities between each other. QIBs
are defined as institutional investors with at least $100 million in assets.
◆ Rule 147 (local deals): Under Rule 147, securities can be sold to nonresidents six months after the last sale of the new issue. These securities
must be stamped with a legend indicating that they can only be resold
under the Rule 147 provisions.
◆ Crowdfunding: Regulation Crowdfunding allows small businesses to
raise money online from individual investors.
Knopman Note: Crowdfunding, though testable, is less important on
the exam than the other exemptions.
Knopman Note: Be sure to review the different ways for investors and
issuers to sell unregistered securities.
Type of Stock
Unregistered
Stock
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Sold Via
Permitted
Purchasers
Additional Restrictions
Rule 144A
QIBs
None
Rule 144
Any investor
• Six-month holding period
for seller
• Issuer must be an SEC filer
(i.e., public company)
Public offering via a
registration statement
(S-1)
Unlimited number
and all types of
investors
Cannot sell until securities are
registered by SEC
Chapter 12: Exempt Transactions
Unit Exam
1. Which SEC rule provides an exemption from
the registration requirements of the Securities
Act of 1933 for intrastate offerings?
A.
B.
C.
D.
5. An “affiliate” refers to which two of the
following?
I. Member of senior management who
does not own company stock
II. Employee of the issuer
III. Person, such as a director or large
shareholder, in a relationship of
control with the issuer
IV. A mutual fund that owns 3% of the
outstanding shares
Rule 147
Rule 144
Rule 144A
Rule 504
2. Regulation A authorizes the SEC to exempt
registration for:
A. Public offerings not exceeding $10 million
in any 12-month period
B. Private offerings not exceeding $10 million
in any 12-month period
C. Public offerings not exceeding $75 million
in any 12-month period
D. Private offerings not exceeding $75 million
in any 12-month period
A.
B.
C.
D.
6. Investors typically receive restricted securities
through which two of the following?
I.
II.
III.
IV.
3. All of the statements about Rule 147 are
accurate except:
A. The issuer must be incorporated in the
state
B. State residents cannot resell the securities
for six months
C. There is no limit to how much capital that
can be raised
D. At least 80% of the investors must be state
residents
I and III
I and IV
II and III
II and IV
A.
B.
C.
D.
Open market transactions
Regulation D offerings
Primary offerings
Compensation for professional
services
I and III
I and IV
II and III
II and IV
4. Rule 144 provides which of the following?
A. Guidelines for the communication
between public companies and PIPE
investors
B. Guidelines permitting the resale of
restricted or control shares to the public
C. An exemption from reporting
requirements for issuers with foreign
subsidiaries
D. Federal guidelines for lending standards to
private companies
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Chapter 12: Exempt Transactions
Unit Exam (Continued)
7. According to Rule 506 of Regulation D, which
TWO of the following statements are TRUE of
a sophisticated investor?
I. The investor must be accredited
II. The investor can be accredited or nonaccredited
III. The investor must be credentialed as
a professional in the financial or legal
industry
IV. The investor must be capable of
evaluating the merits and risks of the
prospective investment
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
8. Which of the following investors would an
underwriter most likely solicit in a private
placement?
A. An individual with a net worth of $3
million, excluding their primary residence
B. A current shareholder of the company
C. A current employee of the company
D. A trust with $10mm in assets which was
specifically organized to invest in the
transaction
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9. An issuer must take which TWO of the
following actions to sell securities under
Regulation A?
I. File a limited registration with the SEC
II. File accredited financial statements
with the SEC
III. Provide a prospectus to investors
IV. Provide an offering circular to
investors
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
10. A corporate insider intending to sell shares
under Rule 144 must file Form 144:
A.
B.
C.
D.
At least 48 hours before the date of sale
At least 24 hours before the date of sale
No later than the date of sale
No later than the date of the final sale
Chapter 12: Exempt Transactions
Unit Exam—Solutions
1.
(A)
Rule 147 details an intrastate offering exemption from Section 3(a)(11) of the Securities
Act of 1933.
2. (C)
Regulation A exempts registration for public securities offerings of no more than $75
million in any 12-month period. Issuers that rely on this exemption must still file an
offering statement with the SEC.
3. (D)
Under Rule 147, 100% of the securities must be sold to state residents, who cannot resell
the securities outside of the state for six months.
4. (B)
SEC Rule 144 provides a safe harbor for the sale of restricted and affiliate securities
without requiring registration.
5. (A)
Affiliates are individuals who own at least 10% of the issuer’s voting shares or who are
officers or directors of the issuer.
6. (D)
Restricted shares are received through many avenues, but they would never, by
definition, be acquired in a registered offering or through a secondary-market
transaction.
7.
(D)
Rule 506 requires that investors have sufficient knowledge and experience in financial
and business matters to be capable of evaluating the merits and risks of the prospective
investment. They are not required to be accredited.
8. (A)
An issuer looking to raise capital via a private placement would most likely target
accredited investors. Of these choices, the only investor that is accredited is the
individual with a net worth of $3 million (remember the threshold is $1 million,
excluding primary residence). Institutions are accredited if they have at least $5mm
assets and a legitimate business purpose. Because the trust was specifically organized
to invest in this transaction, it does not have a legitimate business purpose and
therefore is not accredited.
9. (B)
An issuer that sells securities under Regulation A must file an abbreviated registration
statement with the SEC (called a Form 1-A). The information in this form must be
provided to investors in the form of a preliminary or final offering circular.
10. (C)
Corporate insiders selling shares under Rule 144 are required to file Form 144 by no later
than the date of sale. The filing date begins the 90-day period during which the insider
can sell shares.
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13. Tender Offers
A tender offer is a broad solicitation made by one party (the bidder or acquirer)
to purchase all or a substantial part of the ownership of a public company. Tender
offers are usually made contingent on the acquirer’s ability to convince a specified
percentage of shareholders to sell shares at the fixed price. Since the offer usually
is made at or above the market price for shares, shareholders have some incentive
to accept. However, the market price of securities often rises when tender offers
are announced, or even rumored.
Most tender offers aim to acquire a controlling or fairly large ownership stake in
a company, and these offers must meet filing and disclosure requirements. They
are also subject to the anti-fraud provisions of securities law.
Tender offers to acquire less than 5% of the outstanding shares of the target company are called mini-tenders and are subject to minimum filing and disclosure
requirements.
The most common types of filings required in tender offers include:
◆ Schedule TO, required under the ’34 Act, must be filed by entities that
expect to own more than 5% of a class of the target company’s securities.
◆ Schedule 13D is required for anyone who acquires more than 5% of
a voting class of a public company’s common stock with intent to
influence the company. In addition to acquirers, it may be required of
traders and arbitrageurs who participate in tenders for profit.
◆ Schedule 14D-9 must be filed by the target company to announce its
response to the tender offer.
13.1 Tender Offers by Issuer
SEC Rule 13e-4 defines an issuer tender offer as an offer, a request, or an invitation for tenders of any class of equity security made by the issuer or an affiliate of
the issuer. Technically, an issuer must have at least one class of equity securities
publicly registered to make an issuer tender offer. However, there is no requirement that the class of equities involved in the issuer tender offer be publicly
registered.
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Chapter 13
Tender Offers
13.1.1 Filing Requirements
The issuer must file all written communications relating to the tender offer
with the SEC, including any communications that have preceded the tender
or filings (“pre-commencement communications”). This includes any public
announcements of the tender made in writing by the issuer, at any time. A public announcement is defined as any communication by the issuer (or affiliate)
that informs the public or security holders about the tender offer.
Example
A financial journalist hears about an issuer tender offer and reports this as a
rumor. The issuer responds in a press release to clarify the rumor. The journalist’s account is not a public announcement, since it was not made by the
issuer. However, the issuer’s response is a public announcement.
The issuer must also file a tender offer statement (Schedule TO) with the SEC,
sending five copies of the schedule along with all exhibits. Any material changes
to Schedule TO must be disclosed through an amended filing, and the final
amended filing has to promptly report the offer’s results.
Any pre-commencement written communications must include a “prominent
legend in clear, plain language” that advises the target’s security holders to read
the Schedule TO.
13.1.2 Disclosure Requirements
Most disclosures are provided in the contents of Schedule TO, including a summary term sheet written in plain English and describing, in bullet points, the material terms of the proposed transaction. The issuer also must disclose the purpose
of the transaction, the intended use of the securities to be acquired, and any plans,
proposals, or negotiations that would result in future business combinations.
13.1.3 Dissemination of the Offer
It is the issuer’s responsibility to make sure the tender offer is adequately disseminated to shareholders. For cash-only offers, dissemination requirements may be
met by publishing an announcement in a newspaper on the date the tender offer
begins. For other issuer tenders (e.g., to close a merger), dissemination must be
through a personal mailing to shareholders. If the mailing is made to broker-dealers holding securities in street name, the issuer must reimburse those firms for
the cost of forwarding the announcement to beneficial owners.
13.1.4 Other Required Terms of Issuer Offerings
A tender offer made under the terms of Rule 13e-4 must remain open for at least
20 business days from commencement and at least 10 business days from the
date of any notice increasing or decreasing the tender’s size. The tender offer
must be open to all shareholders of the same class, and all holders must receive
the same consideration. This is commonly referred to as all holders, best price.
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Tendered shares may be withdrawn at any time the tender remains open, and
for up to 40 days after expiration, as long as the shares have not already been
accepted for payment.
Chapter 13
Tender Offers
If a tender offer is terminated or withdrawn, the issuer must promptly either
return the tendered shares or pay for them.
During the tender period, and for at least 10 days after termination, the purchaser
cannot acquire stock outside the tender.
13.1.5 Dutch Auction Issuer Share Repurchase Programs
In a conventional issuer tender to repurchase its own shares, a company states
a price at which it will purchase any shares tendered. In an alternative tendering method called a modified Dutch auction, the issuer states a share price
range within which tenders will be accepted. The issuer also states an amount
(or range) of shares it is willing to acquire, or in some cases, a maximum dollar
amount. Then, each shareholder who wishes to tender shares states an acceptable price within the defined range. The lowest bid that will allow the company
to purchase the stated amount of shares is called the clearing bid or purchase
price. All accepted tenders are paid this share price. If more tenders are made
below the purchase price than the company can accept, shares are accepted pro
rata. This means that the purchaser will accept the same percentage of tendered
shares from each shareholder who has chosen to sell.
Knopman Note: In a Dutch auction tender offer, all accepted shares
receive the clearing price.
Example
A company tenders to buy up to 500,000 shares within a price range of $15 to
$17 per share. The shares offered by shareholders into the tender are shown
below.
Price
Shares
Tendered
Total Shares at That
Price or Below
15.25
85,000
85,000
15.50
95,000
180,000
15.80
80,000
260,000
16.10
150,000
410,000
16.35
90,000
500,000
16.50
90,000
Not Accepted
16.60
110,000
Not Accepted
16.65
85,000
Not Accepted
5 Clearing Price
All tendered shares below
this price are accepted and
are paid the clearing price.
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Chapter 13
Tender Offers
Based on the shares tendered, the clearing bid is $16.35, because this is the
lowest price at which the issuer can repurchase the full 500,000 shares it is
seeking. Those who tendered their shares at $16.35 or below will sell into the
tender at $16.35, regardless of their actual tender price. Any shares offered at
a price higher than $16.35 are rejected.
13.2 “Going Private” Transactions
SEC Rule 13e-3 covers purchases, solicitations, and tender offers in which the
effect is to cause equity securities to become eligible for termination of registration and/or delisting on a national securities exchange. Typically, these transactions are made by private companies or leveraged buyout groups to “take private”
a public company. As a result, a majority of shares will rest in private hands, and
the board of directors may then decide not to remain a public company subject
to the continuous reporting requirements of the ’34 Act.
A going private transaction may be structured as an acquisition by a privately
held company or group, or it may be completed through a tender offer made by
the company itself.
Knopman Note: When researching a public company that has since
gone private, it would be best to look at the proxy statement and
prospectus from the going-private deal.
A deal in which a controlling shareholder bids for the remaining minority interest
in a firm is called a minority freeze-out. In going-private transactions, securities
laws provide protection for minority public shareholders that may feel they are
not offered a fair price in these types of deals.
Going-private transactions must be filed on Schedule 13E-3, which informs dissenting shareholders whether they are entitled to any appraisal rights under state
securities laws.
Knopman Note: Shareholders who vote against a merger can request
appraisal rights through a court to ensure the company is being sold
for a fair value. This would be done after the shareholder vote and
would be requested by shareholders who voted against the deal.
In going-private transactions, often the goal of bidders is to acquire 90% of the
outstanding common stock. At this threshold, state corporate law allows for
a short-form merger that is not required to meet an entire fairness test on
behalf of remaining minority shareholders, and this has become the norm for
most states. This test was developed by a 1994 Delaware Supreme Court decision, which stipulates that the remaining shareholders can be forced to sell their
shares.
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Knopman Note: It is important to review these tender offer basics.
Q: What is a tender offer?
Chapter 13
Tender Offers
A: In a tender offer, a purchaser (acquirer or third party) offers to
buy a specific percentage of a company at a specific price in the
open market.
Q: What notice and filing is required in connection with a tender?
A: Tender offers must be registered with the SEC via a Schedule TO.
Q: How long must the tender offer remain available to
shareholders?
A: The tender offer must remain outstanding to shareholders for
at least 20 business days. For example, an issuer would be in
violation if it launched a tender on July 5 and terminated it on
July 25—since this would not be at least 20 business days later.
Q: Can the terms of a tender offer change? And what are the rules
surrounding the new terms?
A: Yes. If the tender’s terms change at any point (for example, the
price increases), the new terms must be available for at least 10
business days. Also, the updated terms will apply retroactively
to all tendered shares. This is referred to as all holders, best
price.
Q: What is required of the target company’s board of directors?
A: Within 10 business days of the tender launch, the target
company’s board of directors must respond with a
recommendation to shareholders on Schedule 14D-9. It can
either:
a. Recommend acceptance or rejection of the tender
b. Express no opinion and remain neutral toward the tender
offer, or
c. Express that the company is unable to take a position with
respect to the tender offer
These are the only three permitted responses, and in each case,
the board must provide the reasons for its response. Note that
the board may not suggest shareholders purchase additional
shares in the open market.
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Chapter 13
Tender Offers
Q: What is required of a shareholder that wishes to tender?
A: Investors can sell into tenders only to the extent that they are
net long the stock.
Q: If there is a partial tender (i.e., a tender for less than 100%
of the outstanding shares), how will the acquirer handle an
oversubscribed deal?
A: If shareholders tender more shares than the purchaser wants to
buy, shares are accepted on a pro rata basis from shareholders
who tendered their shares. That is, each shareholder will tender
the same percentage of shares, not the same number of shares.
Q: If an acquirer launches a tender offer, where else can it
purchase shares?
A: The purchaser in a tender cannot accumulate shares in the open
market during the tender period.
But, during a tender offer for common stock, the purchaser can
continue purchasing that issuer’s non-convertible bonds in the
secondary market. Note, only non-convertible bonds may be
purchased.
Q: What can an investment bank’s sales and trading department
do when advising an acquirer to launch a tender offer for a
target?
A: An investment bank advising a company on launching a tender
offer for a target company cannot buy stock or call options in
the target but can do underwriting work for the target.
Q: Following a tender offer, what generally happens to the stock
price?
A: After a tender offer, the stock price generally rises.
Q: What happens to an investor’s ownership if the investor does
not tender?
A: The ownership percentage of investors who do not tender
will increase since the tender/buyback will reduce the total
outstanding shares.
Q: What happens to a company’s market cap after it repurchases
shares via a tender offer?
A: The company’s market cap will fall as the company will have
fewer shares outstanding following the tender.
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13.3 Other Tender Rules
13.3.1 Pre-Commencement Communications
Chapter 13
Tender Offers
Any communication made by certain entities about a tender offer will not be
considered a “recommendation or solicitation” if made before the start of the
tender offer. However, the communication must be covered under a solicitation/
recommendation statement (Schedule 14D-9) filed no later than the date of communication. The statement must be clearly identified on the filing as “pre-commencement communication” and include a prominent legend in clear language,
pointing to the 14D-9.
Entities that may make such pre-commencement communications include:
◆ The subject company and its directors, officers, employees, affiliates, or
subsidiaries
◆ Record holders or beneficial owners of securities issued by the subject
company, the bidder, or any affiliate of either
◆ Anyone who makes a solicitation or recommendation on behalf of the
subject or bidding company
These entities do not include any bidder that has filed a Schedule TO to commence a tender offer.
13.3.2 Equal Treatment of Securities Holders
Under Rule 14d-10, tender offers must be open equally to all shareholders. The
consideration paid to any one holder must be the same as to others. All holders
must also be given equal rights to cast any votes (all holders, best price).
Knopman Note: One conflict that might arise out of this rule is when
a company executive is tendering shares in an effort to close a deal
via a two-step merger and will be receiving an employment contract
from the acquiring company. This is permitted, but the acquirer’s
compensation committee must approve the arrangement.
13.3.3 Unlawful Tender Offer Practices
Rule 14e-1 specifies a number of practices that are not allowed in tender offers.
13.3.3.1 Short Offer Periods
All offers must be kept open a minimum of 20 business days from the date the
tender offer is first published.
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Chapter 13
Tender Offers
13.3.3.2 Short Revised Offer Periods
After any increase in the percentage of securities included in the tender or an
increase in the soliciting fee paid, the offer must remain open for at least 10 business days from the date of the change. However, an exception is made for an
increase of not more than 2% in the size of the tender.
13.3.3.3 Reneges
The bidder must pay the amount stated in the offer or else promptly return the
securities tendered.
13.3.3.4 Unannounced Extensions
Tender offers may not be extended without a public announcement or press
release issued no later than 9:00 am (EST) on the first business day after the
scheduled expiration.
13.3.3.5 Position of the Subject Company
The subject company must release a statement no later than 10 business days
after the tender offer, stating whether it recommends acceptance or rejection
of the bid, expresses no opinion (i.e., remains neutral), or is unable to take a
position.
As previously discussed, the recommendation, which helps shareholders decide
whether or not to tender their shares, is filed on a Schedule 14D-9 and is prepared by the board. The recommendation is not binding; it is merely the board’s
opinion.
13.3.3.6 Material Nonpublic Information
During a tender offer, Rule 14e-3 prohibits trading in the shares by anyone possessing material nonpublic information obtained directly or indirectly from the
offeror, issuer, or any officer, director, partner, or employee acting for the offeror
or issuer. This rule does not apply to securities purchased by a broker-dealer or
an agent on behalf of the offeror, or to sales by issuers to the offeror.
13.3.3.7 Prohibited Transactions
Under Rule 14e-4, shareholders may not tender shares during a tender offer unless
they have a net long position equal to or greater than the amount they wish to
sell, including any “equivalent securities.” Any equivalent securities must be convertible into the tendered securities and delivered upon acceptance of the tender.
Example
An investor tenders 5,000 shares. At the time, the investor has 3,000 shares
long and another 2,000 shares that can be obtained through a convertible
bond. The bond can be converted into the tendered securities and delivered
upon acceptance of the tender, so the requirement is satisfied.
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13.3.4 Purchases by Covered Persons Outside a Tender
Under Rule 14e-5, covered persons are defined as:
Chapter 13
Tender Offers
◆ The purchaser and its affiliates
◆ The purchaser’s broker-dealer and its affiliates
◆ Any adviser to a covered person whose compensation is dependent on
offer completion, or
◆ Any person acting in concert with a covered person to purchase affected
securities
Unless an exception applies, covered persons are prohibited from purchasing
the securities except as part of the tender offer—that is, covered persons cannot
accumulate any shares in the open market during the tender period. This prohibition applies from the time the tender is publicly announced until the offer
expires.
Exceptions include:
◆ Exercise of related securities deliverable for the affected securities,
assuming the related securities were purchased before the offer was
announced
◆ Purchases obtained in “odd-lot offers” (generally less than 100 shares)
◆ Basket transactions in which the affected securities are purchased as
part of a basket of securities made in the ordinary course of business and
containing at least 20 securities
◆ Purchases to cover a pre-existing obligation or to fulfill a contractual
obligation
◆ Specified purchases made by an affiliate of the dealer manager
◆ Specified purchases by exempt market makers or exempt principal
traders connected to the offering
13.4 Issuer Buybacks
Though issuers can choose to repurchase their shares pursuant to a tender offer,
an alternative for issuers is to repurchase their own shares through an open
market transaction in the secondary market. Issuers may choose to repurchase
shares as a means of returning excess cash to shareholders or to increase earnings per share. If an issuer repurchases shares using its cash, a potential result is
that its interest income will fall. The firm will earn less interest because its cash
balances (e.g., savings account balance) will be reduced.
Public companies announce their intentions to engage in open market share
repurchases, pursuant to board authorization, by filing a Form 8-K that states the
maximum amount of shares to be purchased and the time frame of the purchases.
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Chapter 13
Tender Offers
13.4.1 SEC Rule 10b-18
In 1982, the SEC adopted Rule 10b-18 to create a “safe harbor” covering an issuer’s
purchases (buybacks) of its own common stock in the open market. The rule
applies to common stock and may not be relied upon during certain corporate
events, such as mergers and tender offers. By following the template of this rule,
the issuer will be deemed not to have violated Rule 10b-18 or the manipulative
and deceptive practices provisions of the ’34 Act.
13.4.1.1 Safe Harbor Provisions of Rule 10b-18
The safe harbor covers issuer common stock purchases per trading day, and it
sets four types of conditions for these purchases.
Manner of Purchases
For purchases that are solicited by the issuer, the issuer must use a single broker-dealer per day to buy back its common stock. This single entity, in turn, is
allowed to engage in appropriate and customary arrangements with other broker-dealers to execute orders. The facts and circumstances of each case determine whether or not an order is considered solicited.
Timing of Purchases
Buybacks must be made at times other than the opening of trading or the last
half hour of trading. For stocks with an average daily trading volume of at least
$1 million and a public float of at least $150 million, the end-of-day restriction
applies to the last 10 minutes of trading.
Price of Purchases
The issuer may not purchase at a price greater than 1) the highest independent
published bid or 2) the last independent transaction price, whichever is higher.
The SEC believes this price ceiling indicates a value set by independent market forces. For OTC stocks not reported in a consolidated system, prices are
determined by the highest independent bid obtained from three independent
broker-dealers.
Volume of Purchases
An issuer may repurchase up to 25% of the average daily trading volume (ADTV)
of its shares, with the ADTV determined over a four-week period. One block
purchase per week is permitted outside the 25% limit, provided that the issuer
makes no other repurchases on the same day.
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Knopman Note:
Q: What are the key aspects of the 10b-18 safe harbor?
Chapter 13
Tender Offers
A: The key provisions of the 10b-18 safe harbor include:
1. Dealer—The issuer must purchase all shares from one
market maker per day during normal market hours (9:30
am–4:00 pm).
2. Size—The issuer cannot purchase more than 25% of the
stock’s average daily trading volume per day.
3. Price—The issuer can bid on its own securities only at
the greater of the highest independent bid or the last sale
price.
4. Time—The issuer cannot repurchase shares at the first
trade of the day or within the last 30 minutes of trading.
a. For actively traded securities ($1MM ADTV and
$150MM float), the end-of-day restriction applies only
to the last 10 minutes of trading.
If these criteria are met, the issuer will obtain a safe harbor
from liability for market manipulation for the repurchased
shares.
Q: What is one exception to 10b-18’s size limitation?
A: An issuer can do one block trade per week, purchasing as many
shares as it wants, provided it does no other buybacks on that
particular day.
Q: Can an issuer execute a share buyback under rule 10b-18
immediately following an IPO?
A: Rule 10b-18 permits an issuer to execute a share buyback no
sooner than four weeks post-IPO.
Q: What is the impact to the company’s income statement when it
does a share buyback?
A: When a company does a buyback, it is spending cash. That cash
will no longer earn interest. Therefore, the company’s interest
income will fall.
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Chapter 13
Tender Offers
13.4.1.2 Transactions Outside the Safe Harbor
If an issuer decides to buy back its stock, compliance with Rule 10b-18 is voluntary, and the safe harbor is not available unless all four conditions are met. If any
single condition is not met, the effect is the same as if none of the four conditions
are met.
However, share buybacks are not presumed to be manipulative or deceptive
merely because the safe harbor is not obtained. The facts and circumstances
of each buyback transaction are considered. SEC disclosures are required in all
share buybacks, whether or not the safe harbor is obtained.
13.4.2 Accelerated Share Repurchase Program
An accelerated share repurchase program (ASR) is an agreement between
an issuer and an investment bank, under which the issuer agrees to repurchase
a quantity of shares from the bank over a stated period of time. The investment
bank may borrow (“go short”) the shares that it sells back to the issuer and then
cover its short position through open market purchases. ASR transactions are
normally made at a preset share price, such as the closing price on a given day.
This allows the issuer to purchase a larger number of shares and get the immediate impact to its earnings per share.
Knopman Note:
Q: How does a share buyback impact a firm’s balance sheet as it
relates to cash, share count, and interest income?
A: When a company uses cash to repurchase stock in the open
market, outstanding shares and interest income will decrease.
Interest income will fall because the company no longer earns
interest on the cash spent in the buyback.
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Chapter 13: Tender Offers
Unit Exam
1. What document must be filed by a person
acquiring beneficial ownership of 5% of the
registrant’s equity securities?
A.
B.
C.
D.
Schedule 1-A
Form 8-K
Form 14A
Schedule 13D
2. Which SEC document is filed in response to
Schedule TO?
A.
B.
C.
D.
424(b)
S-4
14D-9
DEFM14A
3. When must a 14D-9 be filed?
A. Within 30 business days of Schedule TO
filing
B. Within 10 business days of Schedule TO
filing
C. Six months prior to DEFM14A filing
D. One business day following a transaction
announcement
4. Schedule 13D is commonly referred to as a:
A.
B.
C.
D.
Majority owner statement
Beneficial ownership report
Rule 144 disclosure document
Voting class certificate
6. Which of the following is not a permitted
recommendation by a company’s board of
directors in a 14D-9?
A. Shareholders should accept the tender
B. Shareholders should buy more stock on
the open market
C. Shareholders should reject the tender
D. The board remains neutral or is unable to
comment
7. Tender offers must remain open for at least:
A.
B.
C.
D.
10 days
10 business days
20 days
20 business days
8. Which of the following statements relating to
tender offers is not accurate?
A. The acquirer who launched the tender
cannot simultaneously purchase the
company’s stock in the open market but
is allowed to buy convertible bonds of the
issuer
B. A shareholder can only tender the stock to
the extent they are net long
C. If a tender if oversubscribed, the shares
are accepted proportionately from
shareholders who tendered
D. Any changes to the terms of a tender
offer must remain available for at least 10
business days
5. A mini-tender offer is subject to minimum
filing and disclosure requirements, provided
that it seeks to acquire:
A.
B.
C.
D.
A noncontrolling interest
Family-held shares
Less than 5% of the outstanding shares
Less than 15% of the outstanding shares
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Chapter 13: Tender Offers
Unit Exam (Continued)
9. ABC Corporation has an average daily trading
volume of $10 million and a public float of $300
million. When during the trading day is ABC
corporation restricted from executing a share
buyback under Rule 10b-18?
A. At the opening of trading and the last half
hour of trading
B. At the opening of trading and the last hour
of trading
C. At the opening of trading and the last 10
minutes of trading
D. The first half hour and last half hour of
trading
384
10. Under Rule 10b-18, when can issuer execute a
share buyback following its IPO?
A.
B.
C.
D.
Immediately
After four weeks
After six months
After one year
Chapter 13: Tender Offers
Unit Exam—Solutions
1.
(D)
Schedule 13D must be filed within 10 calendar days after the acquisition of more than
5% of a publicly traded company’s voting stock.
2. (C)
In a tender offer, the acquirer offers to buy shares directly from the target’s shareholders.
As part of this process, the acquirer mails an offer to purchase to the target’s
shareholders and files a Schedule TO. In response to the tender offer, the target files a
Schedule 14D-9 within 10 business days of commencement of the tender offer. A
solicitation of shareholder votes in a business combination is initially filed under SEC
Form PREM14A (preliminary merger proxy statement) and then DEFM14A (definitive
merger proxy statement). When a public acquirer issues shares as part of the purchase
consideration for a public target, the acquirer is typically required to file a registration
statement/prospectus as an S-4/424(b) in order for those shares to be freely tradable
by the target’s shareholders. Similarly, if the acquirer is issuing public debt securities (or
debt securities intended to be registered) to fund the purchase, it must also file a
registration statement/prospectus.
3. (B)
The target files a Schedule 14D-9 within 10 business days of the Schedule TO filing.
4. (B)
Beneficial owner is a defined SEC term that includes any individual who directly or
indirectly has the power to vote on corporate decisions. A Schedule 13D must be filed
when an investor’s beneficial ownership is equal to or exceeds 5%.
5. (C)
A mini-tender offer can avoid some filing and disclosure requirements, but it must not
seek to acquire more than 5% of the outstanding shares of the target company.
6. (B)
A 14D-9 is a response of a company’s board of directors to a tender offer. In the filing,
the board can recommend that shareholders accept the tender, reject the tender, or
the board can remain neutral. The board of directors is not permitted to recommend
that shareholders buy shares of the company in the open market.
7.
(D)
Shareholders in a tender offer must be given at least 20 business days to decide whether
or not to accept the offer.
8. (A)
The purchaser who launches a tender offer cannot simultaneously buy the company’s
shares in the open market. Additionally, they could not buy convertible bonds of the
issuer. Note, non-convertible bonds would be allowed to be purchased.
9. (C)
For actively traded securities, which are companies that have an average daily trading
volume (ADTV) of at least $1 million and a public float of at least $150 million, buybacks
are restricted at the opening of trading and the last 10 minutes of trading. For
companies that do not meet these ADTV and public float thresholds, the restriction is
for the open of trading and the last half hour of trading.
10. (B)
Rule 10b-18 permits an issuer to execute a share buyback no sooner than four weeks
after conducting its IPO.
385
Section 3
Rules & Regulations
As is the case in any industry, participants must act in a manner that is
consistent with the regulatory framework established by the appropriate
authorities. As it relates to the investment banking industry, a registered
representative must be familiar with the rules established by the SEC, by
FINRA, and under the US Bankruptcy Code.
Chapter 14: Corporate Finance Rules
Chapter 15: Liquidation and Restructuring
14. Corporate Finance Rules
This chapter focuses on what investment bankers need to know to provide guidance to clients on mergers and acquisitions. It includes:
◆ Standards for issuing fairness opinions
◆ Rules relating to mergers and acquisitions under the Securities Act of
1933 and under the Securities Act of 1934
14.1 Fairness Opinions
A fairness opinion is an objective and independent analysis performed for a
fee by a third party (usually an investment bank) for the benefit of the board of
directors of a company that is involved on either the buy side or sell side of a
transaction. The transaction may be a merger, an acquisition, a sale, a spin-off,
or a business combination. The fairness opinion may also be useful in evaluating proposed purchases for which no definitive market value exists, such as the
acquisition of a privately held company.
Fairness opinions are not required by law, and they do not allow corporate boards
of directors to delegate to third parties their fiduciary responsibilities to shareholders. However, they can provide the board an objective basis for believing that
a proposed transaction is fair to shareholders from a financial perspective. They
also provide directors with essential information that they may use in evaluating
proposed transactions, including a valuation methodology and an independent
appraisal of deal value or terms.
Fairness opinions became more common after a landmark Delaware Supreme
Court decision in 1985 determined that the directors of Trans Union Corporation
had violated their fiduciary responsibilities in a leveraged buyout of the company
by Jay Pritzker’s Marmon Group. In this case (Smith v. Van Gorkom), the court
found that the Trans Union CEO and other directors had grossly undervalued
their company’s worth and were grossly negligent in agreeing to the buyout.
The board may choose to make the fairness opinion available to shareholders in
order to support its recommendation to shareholders to accept a deal. When the
opinion is expected to be distributed to shareholders, the author of the fairness
opinion must include a number of disclosures and have written procedures for
approval of the opinion.
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Chapter 14
Corporate Finance Rules
Knopman Note: A fairness opinion may be distributed to shareholders
to support the board’s recommendation to accept the deal. Note that
the opinion would be written for shareholders, not the company’s
employees.
14.1.1 Necessity of Fairness Opinions
Fairness opinions are useful in transactions that are large, complex, and not
clearly based on competitive bidding or established valuations. For example, if
AcquirerCo is bidding to acquire TargetCo, a fairness opinion may be advisable if:
◆ TargetCo is a privately held company of undetermined value
◆ TargetCo is a public company, and AcquirerCo is bidding far in excess of its
current market value. In this case, the fairness opinion would explain why
the board of AcquirerCo feels the company is worth a substantial premium
◆ AcquirerCo is bidding for specific divisions or properties of TargetCo. In
this case, the fairness opinion would value the parts to be acquired
◆ TargetCo is involved in controversy or litigation, or it has large potential
liabilities (e.g., lawsuits) or is experiencing rapid declines in its revenues
and profits
In addition, fairness opinions are often necessary when a transaction involves:
◆ Potential or perceived conflicts of interests
◆ Expectations of intangible or hard-to-measure benefits, such as synergies
between two companies
◆ Complex or unorthodox transaction terms, such as assumption of hardto-value or undefined liabilities
◆ Large payments for executive terminations (“golden parachutes”) or
mass employee layoffs
◆ Dissenting shareholders and minority shareholders who are entitled to
appraisal rights under state laws
One scenario in which TargetCo would not commission a fairness opinion is in a
hostile takeover. In a hostile takeover, the board is attempting to reject the deal,
not confirm its financial fairness.
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Knopman Note:
Q: What is a golden parachute?
Chapter 14
Corporate Finance Rules
A: A golden parachute is a provision of an employment agreement
that provides an employee will receive certain significant benefits
if the employee is terminated; often the benefits are triggered as a
result of a termination resulting from a merger or an acquisition.
Q: Are there any tax consequences associated with large golden
parachutes?
A: Internal Revenue Code Section 280G states that if an acquirer
pays a golden parachute to an executive of a target company in
excess of three times the executive’s average compensation for
the last five years, the amount of the excess payment (i.e., the
amount over three times) is not tax deductible to the acquirer.
The employee will also be required to pay a 20% excise tax.
14.1.2 Factors to Consider in Preparing Fairness Opinions
Under civil case law and FINRA regulation, it is essential for investment bankers
to establish clear procedures for rendering fairness opinions. Procedures should
begin by defining the specific scope of the assignment.
14.1.2.1 The Entities or Securities to Be Valued
A board of directors may wish to commission separate opinions and/or analyses
of different assets or risks. The fairness opinion can thus be designed to include
(or exclude) specific assets or risk factors, such as the value of synergies expected
to result from an acquisition.
14.1.2.2 The Time Period Covered by the Opinion
In most cases, investment bankers base fairness opinions on facts that are known
at the time the opinion is rendered. They are not normally responsible for changes
or risks that occur after the opinion is issued.
14.1.2.3 Reliance on Information Provided by Management
The opinion may specify that it is based on information provided by the management of either the bidder or the target company, and that the information was
not independently verified.
Knopman Note: An investment bank that prepares an M&A fairness
opinion can avoid being sued by shareholders if it discloses that
it is relying on information provided by the company and is not
independently verifying that information. Shareholders unsatisfied
with an M&A sale price could still sue the board.
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Chapter 14
Corporate Finance Rules
14.1.2.4 Valuation Methodologies
Although the adviser may use a variety of valuation methods (or a combination
of multiple methods) in a fairness opinion, each method must be consistently
applied and meet professional standards.
14.1.2.5 Public Disclosures
The assignment should address the question of whether the opinion will be disclosed to directors only or whether it will be included in proxy materials sent to
investors and made public.
14.1.2.6 Fairness Committees
Most fairness opinions must be reviewed and approved by a fairness committee
of the investment banking firm before they are forwarded to client companies.
The procedures for selecting members of the committee should be consistent
and documented. They should ensure that all members are capable of acting
independently, without conflicts of interest.
The most common methods used to value assets, for fairness opinion purposes,
include:
◆ Discounted cash flow (DCF) analysis
◆ Comparable transactions analysis
◆ Comparable companies analysis
◆ Unique industry metrics
14.1.3 Preparing the Fairness Opinion Letter
The fairness opinion letter typically contains:
◆ Background of the proposed transaction—This section reviews
the fairness opinion assignment and the proposed transaction under
review. It may summarize the proposed terms of the transaction and
the scope of the assignment covered in the opinion letter. It also may
include a summary conclusion as to whether the proposed terms are fair
for the client company and its shareholders. It will not, however, advise
shareholders on whether to vote to accept the transaction.
◆ Basis of the opinion—This section defines the facts and methodology
upon which the opinion is based, including the financial data and
valuation methods relied upon.
◆ Disclosures and limitations—This section provides required disclosures
and includes any limitations on the adviser’s work in preparing the
fairness opinion, such as reliance on financial statements provided by
the company and inability to assess any future changes in the company’s
condition. It also discloses any potential conflicts of interest.
◆ Responsibility—The investment bank and its managing director(s)
392
accept responsibility for making the opinion within the parameters of
the assignment disclosed, by signing and dating the letter.
◆ Details of the transaction—This section, which may be part of
attachments or appendices, includes details on the proposed transaction
and companies or business units involved. It also may include a narrative of
operations, management strategy, products, and business growth drivers.
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If the assignment specifies that the fairness opinion will be included in proxy
materials distributed to investors, the investment banker will also assist the client in preparing proxy statement language and prospectus disclosures.
14.1.4 FINRA Rule 5150
FINRA Rule 5150 outlines specific disclosures that must be made when fairness
opinions are provided to a company’s public shareholders.
It also requires written procedures for developing any fairness opinion, whether
it is made on a confidential basis or made public.
Knopman Note: Fairness opinion disclosures and broker-dealer
procedures for a fairness committee are heavily tested topics.
Candidates should be intimately familiar with the details of this rule.
14.1.4.1 Required Disclosures
A broker-dealer that issues a fairness opinion must meet disclosure requirements
if it knows, or has reason to know, at the time the opinion is made, that the opinion will be provided or described to public shareholders.
Knopman Note: Be sure to review all the disclosures required in
fairness opinions that will be sent to public shareholders.
The required disclosures are as follows, if they apply:
◆ Contingent fees—Disclosure must be made of any fees or “other
significant payments” the adviser will receive contingent on the
transaction’s successful completion. This means that any significant fee,
or portion of a fee, that will only be paid if and when the deal closes must
be fully disclosed. The receipt of de minimis fees need not be disclosed.
Knopman Note: Although existence of a success fee must be disclosed,
the actual amount of the fee need not be.
◆ Material relationship for compensation—Broker-dealers must disclose
any material relationship that they have had with any party to the transaction
during the past two years that involved payment or compensation. This
disclosure applies not only to relationships with the client company or its
board of directors, but also with any other party to the transaction.
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Example
A broker-dealer is hired to provide a fairness opinion for TargetCo, the target
in a proposed acquisition. A year ago, the broker-dealer was paid a fee for an
underwriting assignment for AcquirerCo, the company bidding for TargetCo.
Even though the broker-dealer does not now work for AcquirerCo, this relationship must be disclosed.
◆ Independent verification—If a broker-dealer bases a fairness opinion on
any information supplied by the client company, the broker-dealer must
disclose whether it independently verified this information through other
sources or methods. A description of the information or categories of
information that were verified must be included. This requirement applies
for information that provides a “substantial basis” for the opinion.
Example
A client company’s financial statements clearly provide a substantial basis for
a fairness opinion, but they are not verifiable through any source apart from
the company itself. This must be disclosed. On the other hand, independent
verification of a statement provided by the client company about details of
its products need not be disclosed (even if it is not independently verifiable),
if it does not provide a substantial basis for the opinion.
◆ Fairness committee—Disclosure must be made as to whether or not
the fairness opinion was approved or issued by a fairness committee or
another group performing a similar function.
◆ Insider compensation—Disclosure must be made as to whether the
fairness opinion evaluates the fairness of compensation to any insider
of the client company relative to compensation to public shareholders.
For this purpose, “insider” includes a company’s officers, directors,
or employees. This requirement is designed to alert investors to the
potential conflict of interest arising when the fairness opinion states
that certain insider compensation is fair or in the best interest of
shareholders, since public shareholders can pay directly or indirectly for
excessive insider compensation.
14.1.4.2 Additional Fairness Opinion Requirements
FINRA Rule 5150 requires any broker-dealer that issues a fairness opinion to
have written procedures in place. These procedures need not be made public or
shared with the client firm. However, they are normally included in the fairness
opinion letter. The required procedures are as follows:
◆ The types of transactions and circumstances under which a fairness
committee issues or approves a fairness opinion must be in writing. The
procedures may state that the committee is used in every engagement or
in specific types of engagements.
◆ In transactions using a fairness committee, the procedures must state 1)
the process for selecting committee members, 2) necessary qualifications
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of committee members, and 3) how a balanced review is obtained among
committee members.
◆ Procedures must describe the process that determines whether
valuation methods or analyses used in the opinion are appropriate. This
requirement is not simply a review of the methods or analyses used.
Rather, it describes how the committee has verified that it is using
relevant, accurate methods.
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14.1.4.3 Balanced Review
FINRA requires that the procedures promote a “balanced review” that includes
persons who are not part of the transaction deal team.
Knopman Note: The fairness committee writing a fairness opinion
does NOT need to be 100% or a majority of non-deal team members.
It must, however, include some persons who did not serve on the deal
team to the transaction.
Note that the regulation specifies that these “independent people” must both
review and approve the process in order to promote a balanced review by the
fairness committee. The rule does not specify identities or titles for these “independent people” by position, background, or qualifications—it only requires that
they not be part of the deal team.
Knopman Note: It is important to understand the purpose and rules
surrounding fairness opinions. Consider the Q&A below:
Q: What is a fairness opinion?
A: A fairness opinion is a valuation analysis to confirm that the
price being paid for a company is fair and reasonable.
Q: Who can prepare a fairness opinion? Can an adviser on a deal
prepare a fairness opinion for that deal?
A: The fairness opinion can be prepared either by an independent
bank or by a bank that is also an adviser on the deal. However,
an adviser on a deal would not be tasked by a client with finding
another bank to write the opinion. The company would need to
do that.
Q: Does a fairness opinion provide a recommendation to the
board?
A: No. It does not recommend that the board accept or reject the
deal; it opines on whether the deal is fair.
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Q: Is a fairness opinion required?
A: No. A fairness opinion is not required. For example, if the board
evaluates all offers and decides against selling the company, it
would not need a fairness opinion.
Even if the board goes forward with a sale, obtaining a fairness
opinion is not legally required. If the board does approve a deal,
the fairness opinion would typically be used to support the
board’s recommendation to shareholders to accept the deal.
Q: Do the acquirer and buy-side adviser get to preview the fairness
opinion?
A: No. The acquirer and buy-side adviser do not have an
opportunity to preview the fairness opinion. However, they will
often see it in the closing documents.
Q: What is required if the board distributes the fairness opinion to
shareholders?
A: In the case that the fairness opinion is distributed to
shareholders, the broker-dealer writing the opinion must
disclose certain information, such as:
1. Whether its compensation for preparing the opinion is
contingent on the successful completion of the transaction.
Note, this type of arrangement is permissible; it just
requires disclosure.
2. Any material relationships between the preparing firm and
other participants in the deal (including any relationships
over the past two years).
3. Whether the data provided to prepare the opinion was
verified by an independent third party.
4. Whether a fairness committee was used and whether
insider compensation fairness was commented on.
Take note, the rules do not prohibit material relationships or
require data verification; instead, they mandate disclosure.
14.2 Registration of Business Combinations
SEC Rule 145 clarifies that business combinations are considered “offers to sell”
securities, subject to registration requirements of the ’33 Act, whether or not a
security holder takes action to buy, sell, or exchange securities. The rule defines
specific business combinations for this purpose, as follows:
◆ Reclassification—A change that involves the substitution of one
security for another, except for a stock split, reverse stock split, or change
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in par value. For example, an offer to swap one class of debt security for
another may be a reclassification.
◆ Merger, acquisition, or consolidation—A transaction in which
securities of one entity will be exchanged or converted into securities of
another, unless the only purpose is to change an issuer’s domicile within
the US.
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◆ Transfer—An exchange of assets involving 1) the issuance of securities
under a dissolution, 2) pro rata distribution of securities, 3) the adoption
of a board resolution within one year of a board vote, or 4) a pre-existing
plan for distribution of securities.
Securities involved in such combinations must be registered if shareholders are
asked to vote or give consent for a plan or agreement involving any of these
transactions. Registration is required whether or not securities holders consent,
and whether or not they receive new or different securities. In most cases, the registration is made through Form S-4 for domestic companies and through Form
F-4 for foreign companies. For example, if a public company acquires a private
company by issuing stock, the public company would file an S-4.
An exception is made for securities exchanged by the issuer solely among its
existing securities holders, when no commission or other remuneration is paid
to broker-dealers, directly or indirectly.
Knopman Note: New shares issued to existing shareholders via a stock
split or stock dividend are exempt from SEC registration.
If a business combination does not involve a change of securities, but only a cash
payment, there is no requirement to register the securities or meet prospectus
requirements. However, if the cash payment is contingent on a vote of shareholders, a proxy statement must be filed.
The offer to sell securities in a business combination is not always made by the
issuer of the securities held by voting shareholders. In a tender offer to exchange
one security for another, for example, the offer is made by the bidder or acquirer,
and the acquirer is subject to registration and prospectus delivery requirements.
However, in a merger or consolidation that involves the proposed exchange of
securities, both the acquirer and target company prepare a combined S-4 registration and prospectus, as well as the proxy disclosures.
14.2.1 Form S-4 Requirements
Form S-4 is used to register offerings involving business combinations and
exchange offerings. It may not be used by registrants that are investment companies or business development companies.
The form may be used for registering:
◆ Business combinations covered under Rule 145
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◆ Mergers that require the consent of shareholders of the acquiring
company
◆ Exchange offers for securities of the issuer or another entity
◆ Public re-offerings of securities acquired through a business combination
The S-4 filing contains information on the registrant and the company being
acquired. In shareholder votes or consent authorizations solicited via proxies,
the filing must contain specified information from Schedule 14A, the proxy statement. If such votes or consents are not solicited, or if it’s for an exchange offer,
the S-4 must contain such information as:
◆ The date, time, and place of the meeting of security holders, unless such
information is otherwise disclosed in a prospectus
◆ The dissenters’ rights of appraisal
◆ A description of any material interests by affiliates of the registrant and
of the company being acquired, such as a severance package that would
be awarded
◆ A brief summary of the terms of the acquisition
◆ The reasons the issuer and the target are engaging in the transaction
◆ A description of any new securities being issued
◆ Any material differences between the rights of target shareholders (predeal) versus their rights in any new securities being offered (post-deal)
◆ A statement regarding the accounting and tax treatment of the transaction
14.2.2 Exemption for Business Combination Offers
SEC Rule 165 provides exemptions for certain communications made in regard to
business combinations. It does not apply when the intended effect of an offer is to
condition the market for another transaction, such as a capital-raising or resale.
The exemption covers communications made before a registration statement is
filed. Securities may be offered for sale provided that any written communications, other than nonpublic communications among offering participants, meet
specified conditions.
◆ The offering communications are prospectuses filed with the SEC as of
the date of first use.
◆ Communication is limited to a basic announcement of the offering. This
information may include a legend stating that the announcement is not
an offer, the name of the issuer, the title, amount and basic terms of the
offering, the anticipated time frame of the offering, and use of proceeds.
It must be filed with the SEC prior to first use.
These communications must identify the filer, the target or subject of the offering,
and the file number of the Form S-4 (or F-4). Five copies of these communications
are filed with the SEC.
The exemption also covers certain communications after a registration is filed.
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If a prospectus has been previously filed, written communication made after
registration may be distributed, provided that it is included in a prospectus
supplement.
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Corporate Finance Rules
To fall under the exemption for written communication made either before or
after registration, the prospectus must contain a legend urging investors to read
SEC documents and filings, stating that documents may be obtained for free at
the SEC’s website, and specifying which documents they are and why they are
used. Also, any exchange offer made under tender rules or transactions involving
a vote of security holders must be made under proxy rules.
It’s important to note that the exemption applies not only to the offeror of securities but also to any other participant that communicates about the transaction.
This applies to any communications with the public surrounding the transaction.
Example
The target company of an acquisition offer communicates with its shareholders through a press release. Furthermore, the target company posts detailed
information about the post-merger scope and operations of the company on
a special website. Both of these interactions are considered a prospectus and
must be filed with the SEC. This includes a transcript of the press release and
screen shots from the company’s website.
14.2.3 Proxy Information
SEC Rule 14A specifies that the following information must be included in a proxy
statement:
◆ The identity of the registrant and the person filing the proxy statement
◆ The aggregate number of securities to which the transaction applies
◆ The price or value of the transaction to shareholders, and the proposed
maximum aggregate transaction value
◆ The date, time, and place of the meeting of shareholders; or, if action is
taken by written consent, the date by which consents must be submitted
◆ Rights and limits on shareholders’ ability to revoke proxies after they are
given
◆ Information about the entities making the solicitation, the cost of the
solicitation, and how costs of the solicitation are being paid
◆ A description of the voting securities and their holders
◆ Information on any directors or executive officers who are to be elected
by vote of shareholders and their current compensation
◆ Information on the registrant’s relationship with its independent public
accountant, and whether the public accountant will be present, will
speak, or will respond to shareholder questions at the meeting
◆ Information on any non-cash compensation plans that may be voted on
◆ Information about the acquiring and target companies from Registration
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Form S-4 (or F-4), including financial statements for the latest two fiscal
years
◆ A description of any property to be acquired or sold, or accounts to be
restated, resulting from the transaction
◆ The type of proxy being filed: a preliminary proxy, confidential proxy (for
SEC use only), definitive proxy, definitive proxy with additional materials,
or soliciting material proxy filed under Rule 14a-12
14.2.3.1 Preliminary Proxy
A preliminary proxy, Form PREM14A, is the first copy filed with the SEC, at least
10 calendar days before the date definitive copies are first sent to shareholders.
Revised material will not restart this 10-day period unless the revised proxy contains material revisions or new proposals that constitute fundamental changes.
Five copies of the preliminary proxy must be filed.
14.2.3.2 Confidential Proxy
A confidential proxy is a preliminary proxy that will remain confidential until
the definitive proxy is filed. To qualify for confidential treatment, the preliminary proxy must be marked “confidential” and parties to the transaction (or their
authorized representatives) must not have made any public communications
relating to the transaction, except for a basic announcement of offering terms.
Confidential treatment is not allowed for certain going-private and roll-up transactions. If a registrant requests confidential treatment for a preliminary proxy
but then engages in public communications, the proxy statement must be refiled
without the confidential request.
14.2.3.3 Definitive Proxy
The definitive proxy, Form DEF14A, must be filed no later than the date proxies
are first sent to security holders. Eight copies must be filed with the SEC, and
three copies must be filed with each national securities exchange on which the
registrant has a class of securities listed or registered. One copy of the definitive
proxy statement filed with the SEC must include a signed copy of the accountant’s report.
Soliciting material consists of any written communication distributed to shareholders before providing those holders with a valid proxy statement. This material must be filed with the SEC no later than the date of first publication. Three
copies must be filed with each national securities exchange on which any class
of the registrant’s securities are registered or listed.
14.2.3.4 Proxy Information Required in Business Combinations
For business combinations transactions, Rule 14A specifies additional proxy filing
information required of each party to the transaction, including:
◆ Summary term sheet written in plain English, which must briefly
describe in bullet-point format material terms of the transaction and
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cross-reference a more detailed discussion provided to shareholders. It
must contain enough information to help them understand essential
features of the transaction.
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◆ Contact information for principal executive officers.
◆ Brief description of the business conducted by the party.
◆ Detailed discussion of transaction terms.
◆ Statement of any federal or state regulatory requirements that must
be obtained for the transaction, and a status report on compliance
approvals.
◆ Any reports, opinions, or appraisals obtained from outside parties and
referred to in the proxy statement. All outside parties must be identified
and their qualifications and material relationships with the party must
be described. If the outside party rendered a fairness opinion on the
consideration to be received, the entity that approved this consideration
must be disclosed.
◆ Past contacts, transactions, or negotiations between parties to the
proposed transactions, during the periods for which financial statements
are presented.
◆ Selected financial data for each of the last five fiscal years, presented in
tabular fashion and including net sales or operating revenues, income
(or losses) from continuing operations (total and per share), total assets,
long-term obligations, and cash dividends paid on common stock.
◆ Pro forma selected financial data for the acquiring company, showing the
pro forma effect of the transaction; pro forma data must be presented in
a table that facilitates comparisons of historical and pro forma financials
of the acquiring company and target company for book value per share,
cash dividends declared, and income (loss) per share from continuing
operations.
Knopman Note: The summary term sheet must begin on page one or
two of the disclosure document.
There are a few exceptions to these “Item 14” requirements:
◆ If the transaction consists solely of securities offered to existing
shareholders, it is sufficient to file the applicable registration Form (S-4
or F-4).
◆ If the transaction consists solely of cash offers to shareholders,
information is not required on the target (acquired) company, unless the
information is material to an informed voting decision.
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Chapter 14: Corporate Finance Rules
Unit Exam
1. In which SEC filing would a fairness opinion be
found?
A.
B.
C.
D.
DEFM14A
10-K
10-Q
S-1
2. At which point in an M&A sale process is a
fairness opinion typically rendered?
A. Upon deal closing
B. Just prior to board approval and execution
of the definitive agreement
C. Upon launch of the finance marketing
period
D. Immediately after receipt of first-round
bids
3. From whom must investment bankers receive
approval for the fairness opinion before it can
be presented to the client company?
A.
B.
C.
D.
Internal fairness opinion committee
Outside auditors
Client company CFO
Key shareholders
4. For a given company, a fairness opinion for
a company in the same sector serves as a
valuable source of information by providing
data about which TWO of the following?
I.
II.
III.
IV.
A.
B.
C.
D.
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Precedent transactions
Market share information
Customer information
Comparable companies
I and III
I and IV
II and III
II and IV
5. If a public company were to purchase a private
company by issuing public shares, which
SEC filing would contain the terms of the
transaction?
A. An S-4 filed by the public company
B. An S-4 filed by the private company
C. A proxy statement filed by the public
company
D. A proxy statement filed by the private
company
6. Which of the following is not a required
disclosure in a fairness opinion provided to
shareholders?
A. Whether the opinion was approved by a
fairness committee
B. Whether the firm writing the opinion is a
market maker in the securities involved in
the deal
C. Whether the firm writing the opinion will
receive compensation contingent on a
successful closing of the deal
D. Whether the firm writing the opinion
independently verified the data used to
prepare the opinion
7. When preparing a fairness opinion, the firm
authoring the opinion must disclose any
material relationships with the buyer or seller
in the transaction within the past:
A.
B.
C.
D.
Six months
One year
Two years
Three years
Chapter 14: Corporate Finance Rules
Unit Exam (Continued)
8. Which of the following statements about the
process surrounding fairness opinions is not
accurate?
A. A fairness opinion reviews the financial
fairness of the transaction, but not the
legal fairness
B. The acquirer’s board of directors would
not be permitted to preview a fairness
opinion commissioned by the target
company
C. An adviser on a deal is permitted to
prepare the opinion
D. A fairness opinion will recommend
whether the board of directors should
accept the deal
10. A summary term sheet in a merger proxy must
begin:
A.
B.
C.
D.
On page one of the proxy statement
On the cover page of the proxy statement
On page one or two of the proxy statement
Within the first 10 pages of the proxy
statement
9. In order to ensure a balanced review, a fairness
committee:
A. Must be 100% composed of non-deal team
members
B. Must include a majority of non-deal team
members
C. Must include at least some non-deal team
members
D. Can include all deal team members, as
long as this is disclosed to shareholders
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Chapter 14: Corporate Finance Rules
Unit Exam—Solutions
1.
(A)
DEFM14A is the definitive proxy statement filed by a target company in order to obtain
approval from its shareholders for a given deal through a vote at a shareholder meeting.
It contains a summary of the background and terms of the transaction, a description of
the financial analysis underlying the fairness opinion, a copy of the definitive purchase/
sale agreement (definitive agreement), and summary and pro forma financial data
(depending on the form of consideration).
2. (B)
In response to a proposed offer for a public company, the target’s board of directors
typically requires a fairness opinion to be rendered, as one item, to aid them in making
a recommendation on whether to accept the offer. This deliberation is typically done
at the board meeting where a final decision is made on whether to execute the
definitive agreement.
3. (A)
Prior to the delivery of the fairness opinion to the client company’s board of directors,
the sell-side advisory team must receive approval from its internal fairness opinion
committee. While the actual constituents of the committees and procedures differ from
bank to bank, this is a highly serious, thoughtful, and comprehensive process. In a
public deal, the fairness opinion and supporting analysis is publicly disclosed and
described in detail in the relevant SEC filings.
4. (B)
A fairness opinion opines on the financial “fairness” of the consideration offered in a
transaction. The opinion letter is supported by detailed analysis and documentation
providing an overview of the sale process, as well as an objective valuation of the target.
The valuation analysis typically includes comparable companies, precedent
transactions, DCF analysis, and LBO analysis (if applicable), as well as other relevant
industry and share price performance benchmarking analyses. The analysis, however,
does not contain company market share, customer, or supplier information.
5. (A)
When a public company issues shares to complete a transaction, it will file an S-4 with
the SEC. The filing will include the terms of the transaction. A proxy might also be filed,
but only if the number of shares would be dilutive by 20% or more. The private company
would not be required to submit SEC filings.
6. (B)
The firm writing a fairness opinion is not required to disclose whether they are a market
maker in the securities involved in the merger. All the other items require disclosure.
Note that the firm writing the opinion must disclose whether they are receiving a
success fee, but they are not required to disclose the amount of the fee.
7.
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(C)
The firm writing a fairness opinion must disclose any material relationships with the
participants in the deal over the past two years.
Chapter 14: Corporate Finance Rules
Unit Exam—Solutions (Continued)
8. (D)
A fairness opinion does not opine on whether the company should accept the deal.
Instead, it is a valuation analysis to confirm whether the price is fair relative to similar
transactions.
9. (C)
The fairness committee writing a fairness opinion does not need to be 100% or a
majority of non-deal team members. It must, however, include at least some individuals
who did not serve on the deal team to the transaction.
10. (C)
A merger proxy must include a summary term sheet, which explains the material terms
of the transaction in bullet point form. The summary term sheet must begin on page
one or two of the proxy statement.
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15. Liquidation and Restructuring
Companies become insolvent when they are not able to pay debts and liabilities.
Insolvency may occur because a company’s liabilities exceed its assets or because
the company lacks sufficient liquid assets and cash flow to make timely payments
to bondholders and creditors.
Article I, Section 8, of the US Constitution gave Congress the power to create “uniform laws on the subject of bankruptcies throughout the United States.” Under
federal bankruptcy law, insolvent companies may have several choices for either
restructuring their debts or winding down their business. Bankruptcy cases are
handled through the bankruptcy courts established by each of the federal judicial
districts, under provisions of Title 11 of the US Code (“the Bankruptcy Code”).
15.1 Types of Bankruptcy Filings
Most bankruptcies filed by businesses fall under one of two sections of the
Bankruptcy Code Chapter 7 or Chapter 11.
Knopman Note: If an issuer stops making its SEC filings, and its stock
stops trading (i.e., it is halted), that is a strong indication that the
company should file for bankruptcy protection.
15.1.1 Chapter 7 Bankruptcy Filing
Bankruptcies filed under Chapter 7 result in the liquidation of the insolvent firm,
with its assets distributed to creditors. In addition to filing a bankruptcy petition with the court, companies must file schedules of assets, liabilities, current
income, and expenses. Debts must be detailed as to creditors and the amount
of their claims. Creditors are also required to file a proof of claim with the bankruptcy court in a timely fashion. A proof of claim confirms that the creditor is
owed funds by the debtor.
Chapter 7 allows individual debtors to obtain a “fresh start” by discharging debts,
but corporate and partnership filers are not always allowed to discharge debts
through this process. For that reason, Chapter 7 filings are not common among
insolvent businesses. When corporations choose to file Chapter 7, equity holders
are usually wiped out and the business terminates.
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Chapter 15
Liquidation and
Restructuring
Knopman Note: Some key points regarding a Chapter 7 bankruptcy:
• A trustee will be appointed to liquidate the assets and distribute
funds to creditors.
• A proof of claim is required.
15.1.2 Chapter 11 Bankruptcy Filing
A Chapter 11 filing allows a company to continue operating while restructuring
its financial obligations. Because filings under Chapter 11 provide a plan for reorganizing or rehabilitating the business and maintaining continuity, they are the
most common choice of insolvent partnerships and corporations. In addition to
the schedules required under Chapter 7, Chapter 11 filings require 1) a plan of reorganization and 2) a disclosure document that contains enough details to enable
creditors to make informed judgments when voting to accept or reject the plan.
Chapter 11 also provides an automatic “stay” of creditor claims when the bankruptcy petition is filed. This requires creditors to cease their collection efforts
(e.g., lawsuits, foreclosures, seizures, etc.) outside of the bankruptcy court.
Knopman Note:
Q: What is an immediate benefit of filing a petition for bankruptcy
protection (i.e., filing for bankruptcy)?
A: All debtors (bankrupt companies) benefit from an immediate
automatic stay on claims. This begins upon the filing of the
bankruptcy and requires creditors to cease their collections
efforts outside of the bankruptcy court.
Creditors have significant rights in Chapter 11, including the ability to form a
committee of the largest unsecured creditors and provide input on the plan of
reorganization. If no creditor committee is formed, the US Trustee may intervene
to protect the interests of creditors. Chapter 11 requires debtors to be timely when
providing filings to the court of records, reports, and fees. The filings and legal
documents are then sent to parties of interest.
Knopman Note: The company’s legal counsel would generally be
responsible for filing any motions in court in a bankruptcy. This would
not be the role of a financial adviser, who instead might be tasked with
performing a valuation of the company’s assets and helping identify
potential buyers or funding for the company.
Unlike with a Chapter 7 filing, a creditor is not required to file a proof of claim if it
agrees with the amount listed on the debtor’s bankruptcy petition. If it does not
agree with the amount, it must file a proof of claim in a timely fashion.
The final plan may provide that some creditor claims be paid in full, while others may be impaired—paid less than full value. After court review, the plan is
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submitted to a vote of the creditors, and the outcome of this vote determines
whether the court will confirm or deny the plan.
In order for the bankruptcy plan to be approved, creditors representing at least
two-thirds of the dollar amount of the claims and one-half of the number of
claims must vote to confirm the plan.
Chapter 15
Liquidation and
Restructuring
If the plan of reorganization does not receive the required votes, it can still be
approved through a cramdown. In a cramdown, the highest class of impaired
creditors, referred to as the fulcrum class, gets to vote. As long as this impaired
creditor class has an affirmative vote of at least two-thirds of the dollar amount
of the claims and at least one-half of the number of claims, excluding any votes
cast by the insiders of the debtor, the plan can be approved by the bankruptcy
court over objections by the other creditors.
Knopman Note:
Q: What legal requirement must be met so the court will submit a
plan of reorganization to a creditor vote?
A: The court will evaluate a variety of legal requirements, but for
exam purposes, one factor of note is that the plan must provide
for the repayment of administrative claims (e.g., lawyers’ fees,
trustee expenses), as well as wages (up to $10,000) in cash on the
plan’s effective date.
Q: What is required for a plan to be approved by creditors?
A: For a plan to be confirmed, the creditor vote must include:
1. Two-thirds vote of the dollar amount of the claims, and
2. One-half the number of claims
Q: If a plan of reorganization does not receive the required votes,
what happens?
A: If the plan does not receive the required votes, it can still be
approved through a cramdown.
In a cramdown, the plan can be approved if at least one
impaired creditor class votes in to accept the plan.
Q: Whose votes are excluded when evaluating the cramdown vote?
A: It’s important to note that the impaired creditor class vote
excludes the votes of any company insiders in that class.
Equity holders are not always wiped out in Chapter 11 bankruptcies. By filing a
proof of interest with the court, an equity holder can be treated as a creditor and
vote on the restructuring plan. Normally, however, equity holders stand behind all
secured and unsecured debt holders to claim corporate assets in bankruptcy. The
value of their shares may be greatly reduced or wiped out in the reorganization.
409
Chapter 15
Liquidation and
Restructuring
Knopman Note:
Q: When might a company file for bankruptcy rather than
negotiate with its creditors?
A: A company that is expecting to pay a large legal settlement or
has operational challenges might benefit from a bankruptcy
restructuring rather than a negotiation with creditors since
filing for bankruptcy would allow the company to renegotiate
its capital structure and contracts.
15.1.2.1 Chapter 11 Debtor in Possession (DIP)
Chapter 11 allows the debtor filing the bankruptcy petition to retain possession
of property against which creditors have claims or liens. The debtor acts in a
fiduciary capacity called debtor in possession (DIP) and has trustee powers
granted by the Bankruptcy Code. The DIP is obligated to pay all debts incurred
after the filing of the petition but cannot pay debts incurred before the filing,
unless approved by the courts. The DIP may not sell or transfer assets except
with court approval and must file all required tax returns. Normally, the DIP must
close all bank and financial accounts open at the time the petition is filed, and
open at least one new DIP bank account. Any financial institution that holds DIP
funds must comply with the specific requirements of the US Trustee.
Chapter 11 allows DIP financing, which typically consists of new loans advanced
after the bankruptcy filing to help the company maintain operations and rebuild
working capital. The court may permit DIP financing sources to “move to the
head of the line” for purposes of debt repayment, or to file the most senior claims
to specific corporate assets.
Knopman Note:
Q: After filing for Chapter 11 bankruptcy who runs the debtor’s
day-to-day operations?
A: Following a Chapter 11 bankruptcy filing, the debtor in
possession (typically the existing board and management)
remains responsible for managing the day-to-day operations of
the company.
Q: What is the debtor in possession not required to do?
A: A debtor in possession (DIP) is not required to perform the
investigative functions of a Chapter 11 trustee (i.e., investigate
the debtor’s acts, conduct, assets, liabilities, and financial
condition).
410
15.1.2.2 Conferences and Creditors’ Committees
In a Chapter 11 filing, the debtor must attend an initial debtor conference with
the US Trustee within seven working days after the petition is filed. At this conference, the US Trustee will verify that pre-filing bank accounts have been closed,
tax returns and financial statements are available, and adequate insurance exists
to protect creditor claims.
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The Bankruptcy Code requires at least one meeting of creditors, which the debtor
is required to attend with legal counsel. At this meeting, called a Section 341
meeting, creditors have the right to examine records of the debtor’s compliance
with DIP requirements. The US Trustee presides over the Section 341 meeting,
and the DIP’s statements are sworn under oath.
Following the 341 meeting, the US Trustee will appoint members to the unsecured creditors’ committee (UCC). Typically, the committee consists of the
seven largest unsecured creditors that are willing to serve, but a creditor isn’t
required to serve in order to recover on its claim.
Once appointed, the creditors’ committee plays a central role in the bankruptcy
case, serving as a cost-effective means for all unsecured creditors to have a voice
and advocate for themselves. Because the committee owes a fiduciary duty to all
unsecured creditors, it must represent the interests of all unsecured creditors,
not just the interests of the committee members. This fiduciary duty allows the
debtor to negotiate with a single body acting on behalf of all unsecured creditors.
The responsibilities of the committee vary from case to case, but in general, the
committee will consult with the debtor in possession on case administration;
review motions and appear in court to support or object to requested relief;
negotiate and advise on the terms of any DIP financing; investigate the debtor’s
conduct and the continued operation of the business; participate in formulating
a plan; and advise all creditors whether the committee endorses a plan. This
ultimate recommendation of whether to vote for or against a proposed plan of
reorganization typically carries great weight with the body of unsecured creditors and, as a result, gives the committee significant influence during the plan
negotiations and formation.
With court approval, the creditors’ committee may hire an attorney or other professionals, such as bankers, accountants, or appraisers, to assist in the performance of the committee’s duties. These professional expenses will be paid out
of the debtor’s estate as an administrative expense. The committee members
themselves, however, are not paid for their services, but may be reimbursed for
reasonable expenses, such as travel to court or committee meetings.
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Restructuring
Knopman Note:
Q: What is an unsecured creditors’ committee (UCC)?
A: An unsecured creditors’ committee consists of the seven largest
unsecured creditors and is appointed by a US Trustee (a division
of the Department of Justice) to represent the interests of
unsecured creditors in a bankruptcy proceeding. The UCC is not
appointed by the issuer, the debtor, or secured creditors.
Q: What can the UCC do?
A: The UCC can review motions filed with the court and participate
in the creation of the debtor’s reorganization plan.
Q: What is not the responsibility of the UCC?
A: The creditors’ committee does not perfect liens for secured
creditors.
15.1.2.3 Section 363 Acquisitions
A Section 363 merger or acquisition can be a relatively efficient way for a financially distressed company to emerge from bankruptcy under new ownership.
Section 363 of the Bankruptcy Code is so effective because it allows assets of the
debtor to be transferred (i.e., sold) to a purchaser “free and clear” of any liens.
Thus, a purchaser can buy assets (including an entire business or business division) stripped of any liens, conditions, or prior covenants entered into by the
debtor. The buyer can then deploy the assets quickly without having to wait for
a plan of reorganization to go effective.
A Section 363 sale usually begins with a prospective acquirer targeting the distressed company by buying its debt instruments. The distressed company then
files a Chapter 11 bankruptcy petition. However, rather than develop a full reorganization plan subject to creditors’ committee input and creditor voting, the
debtor (acting as DIP) signs an asset purchase agreement (APA) with the prospective acquirer. Normally, the acquirer (as a major creditor) would provide
significant input and vote on the reorganization plan. However, the APA negotiated with the DIP allows the acquirer to make a pre-emptive bid on favorable
terms. The agreement may include a “stalking horse” provision to clarify terms
the acquirer will receive in reorganization, including:
◆ A breakup fee if the court or other creditors do not approve the
acquisition
◆ Accelerated deadlines for submitting bids
◆ Reimbursement of due diligence expenses incurred in making the
stalking horse bid
◆ Additional restrictions or requirements on outside bidders, such as overbid protection
412
When an investment bank provides DIP financing, it may then become the
Section 363 stalking horse, or a Section 363 stalking horse may emerge to cash
out the DIP financing source with its APA and bid.
Although Section 363 bids avoid many cumbersome steps in the Chapter 11
process and accelerate the restructuring, stalking horses do not always win
the majority share of a company or its assets after restructuring. DIP financing
claims may have priority in some cases, and a judge may reject the terms of the
APA agreement or deny the sale of the company to the stalking horse acquirer.
Even so, the stalking horse still may emerge with a profitable transaction because
it may hold sizeable amounts of the company’s debt, and its involvement may
have served to attract competitive bidding, increasing the funds recovered for
creditors.
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413
Chapter 15
Liquidation and
Restructuring
Knopman Note:
Q: How can a debtor liquidate its assets in bankruptcy?
A: Section 363 of the Bankruptcy Code allows a debtor to sell its
assets during a bankruptcy case. A Section 363 sale is used to
sell assets, not arrange DIP financing.
Q: What is a significant benefit of selling assets via Section 363?
A: It allows assets to be transferred (i.e., sold) to a purchaser
“free and clear” of any liens. These assets can include property,
plants, equipment, business lines, or even the entire business.
Q: How are investment bankers involved in the 363 sale process?
A: Because the asset being sold can be an entire business or part
of a business, investment bankers are often retained to run the
363 sale process. The bankers may be involved in the marketing,
negotiating, and sale and auction process.
Q: How does the 363 sale process often begin?
A: A 363 process often begins with the recruitment of an initial
bidder, or a stalking horse bidder, that will sign an asset purchase
agreement (APA) to purchase the debtor’s assets, thereby setting a
floor, or minimum bid. Of note is that a 363 sale process can begin
immediately after a bankruptcy filing by either a DIP or trustee.
Q: How might bankers entice a stalking horse to diligence the
assets and enter a binding, initial APA?
A: To attract a stalking horse, the debtor will often reimburse the
stalking horse’s professional fees, such as lawyers and bankers,
as well as offer a breakup fee if the stalking horse does not win
the auction.
If no one else bids on the debtor’s assets, the stalking horse
bidder is obligated to complete the transaction. But if a bidder
other than the stalking horse wins the auction, the debtor will
sell the assets to the highest bidder and increase the assets
available to satisfy creditor claims. Put another way, the
stalking horse bid is not an exclusive bid.
Q: Can a stalking horse attempt to purchase a company just prior
to filing for bankruptcy?
A: The term stalking horse describes a potential buyer for a
company in bankruptcy. An acquirer attempting to purchase a
distressed company prior to that company filing for bankruptcy
is referred to as a white knight.
414
Q: Once a 363 deal is agreed upon, what legal documents will
memorialize the transaction? What is not found in the APA?
A: The winning bidder in a 363 sale typically signs an asset
purchase agreement (APA) detailing the terms of the purchase.
This APA, however, would not include any debt covenants, as
debt covenants are typically found in a trust indenture or other
financing documentation.
Chapter 15
Liquidation and
Restructuring
15.1.2.4 Fiduciary Responsibilities
A Chapter 11 bankruptcy imposes significant fiduciary responsibilities on debtor
companies and their directors and executive officers. The board of directors will
remain in place and must meet all requirements of DIP fiduciaries while maintaining company operations and following applicable bankruptcy laws. For example,
a common reason for companies to enter Chapter 11 bankruptcy is to obtain relief
from burdensome contracts for employee pension and retiree healthcare benefits. These contracts, often made with unions, may either be rejected or revised
by the debtor under bankruptcy court supervision or they may be assigned to a
Section 363 acquirer. To be assigned, they must first be “cured” of any defaults or
missed payments, or modified in a way acceptable to counterparties.
Corporate fiduciaries must have arm’s-length negotiations with any stalking
horse candidates, and only agree to APA terms that are fair to other creditors
and contract holders, and in the best interests of stakeholders.
Knopman Note:
Q: Why might a company file for Chapter 11 versus Chapter 7?
A: A Chapter 11 filing permits either a liquidation or
reorganization of the debtor. Chapter 7 is only for liquidation.
Under Chapter 11, a creditor does not need to file a proof of
claim if the creditor agrees with the amounts scheduled on the
debtor’s bankruptcy petition. In a Chapter 7, a proof of claim is
always required.
In a Chapter 11 filing, the debtor’s existing board of directors
and management will often continue to operate the business
and prepare a reorganization plan (i.e., debtor in possession).
In a Chapter 7 filing, a trustee is always appointed.
15.2 Priority of Claims in a Bankruptcy
In a bankruptcy proceeding, creditors are repaid according to a priority schedule
set forth in the Bankruptcy Code. Each creditor class will be paid in full before
the next class receives a distribution. This waterfall continues until there are no
assets left to distribute. The distribution is set forth below:
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Chapter 15
Liquidation and
Restructuring
1. Secured claims—Secured creditors or secured lenders place first liens
on specific corporate assets, such as equipment, vehicles, or plants. The
liens may be “perfected” by filing under the Uniform Commercial Code
(“UCC filing”).
In general, creditors with secured claims are paid back in a bankruptcy
to the extent that the collateral, or lien, supporting their claims has
value. Any amounts owed in excess of the value of the collateral become
unsecured claims.
Example
In 2012, ABC Corporation borrowed $100,000 from a bank in a secured loan,
and posted business equipment as collateral. In 2013, ABC filed for bankruptcy and the equipment sold for $60,000, which was paid to the secured
creditor. The remainder of the loan ($40,000) became an unsecured claim
for the bank. The amount of a secured claim may not exceed the value of the
collateral or lien.
2. Priority claims­—Priority claims are paid after secured claims. A partial
list of the priority claimants is provided below.
a. Administrative expenses incurred in bankruptcy, including trustee
expenses, investment banker fees, and attorney costs
b. Up to $11,725 per employee for wages or commissions earned
within 180 days before filing of the bankruptcy petition or
cessation of the business (whichever is earlier)
c. Unmet claims for contributions to an employee benefit plan
within the 180-day period prior to the filing. (Note: Most ERISA
benefit plan assets are held separately in trust and are not
included in a bankruptcy filing. Only contributions are considered
unsecured priority claims)
d. Government claims, such as taxes or penalties
The dollar amounts in the priority of claims are adjusted for inflation
periodically.
3. Unsecured claims—Unsecured claims—including general creditors
(such as trade vendors, suppliers, and service providers), bondholders,
bank lenders, and credit card issuers—are paid after secured and priority
claims. Within the capital structure lenders may arrange their unsecured
claims vis-à-vis one another. A typical arrangement might be:
a. Senior debt—Senior corporate debt that is not secured by specific
assets, but only by the issuer’s promise to repay, has the highest
priority claim after secured debt and priority claims. It is also
called a debenture. Trade vendors and general creditors are also
on par with senior debt holders.
416
b. Junior debt—These are debentures that rank behind senior debts
in claims against corporate assets.
4. Mezzanine debt—Mezzanine debt is lower in priority than all other debt
issues, yet higher than equity claims. It may be structured as straight
debt or as a class of preferred stock. It is often issued at a high rate of
interest through a private placement when more traditional forms of
financing are not available. If the company is not able to meet interest
payments, mezzanine debt may include a provision for pay-in-kind (PIK)
interest, which increases the principal due at maturity, or add “equity
kickers,” such as warrants to purchase common stock. Mezzanine debt
may be structured into multiple tiers of senior and subordinated (junior)
mezzanine debt.
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Liquidation and
Restructuring
5. Preferred stock—Holders of preferred stock have a priority claim over
common stock holders. However, preferred stock dividends are not
guaranteed, and the claims of preferred stock holders fall below all debt
holders of the issuer.
11. Common stock and warrants—Common stock, and warrants
exercisable into common stock, fall last in the priority of claims. In most
corporate bankruptcies, common stockholders are wiped out.
15.2.1 Summary of Priority of Claims in a Bankruptcy
Knopman Note: Be sure to know the priority of the creditors in a
bankruptcy.
The order of claimants in a bankruptcy is set forth below:
1. Secured claims
2. Priority claims
3. Unsecured claims
4. Mezzanine claims
5. Preferred stock
6. Common stock, rights, and warrants
Knopman Note: Debtor-in-possession (DIP) financing is treated as
an administrative expense, and if needed to secure DIP financing, a
court may grant the DIP loan super-priority status or a “priming” lien
such that it will be paid before any other creditor, including secured
lenders.
417
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Liquidation and
Restructuring
15.3 Terms of Loan Documents
The rights of lenders in a bankruptcy are determined by the terms of the credit
agreement, inter-creditor agreements, and any bond indenture documents executed at the time of financing (stock certificates would not be considered). In
addition to setting the maturity date and interest payments due under a bond
or loan, these documents may include the following terms:
◆ Prepayment and early refinancing—The terms under which the
borrower may prepay principal and/or interest or refinance the debt.
Debt holders are vulnerable to prepayments and early refinancing if
interest rates decline. The indenture may specify restrictions or penalties
on prepayments or early refinancing.
◆ Default events—Events that constitute a default by the borrower, such
as non-payment of timely interest, failure to maintain adequate reserves,
transfers of corporate assets, or failure to maintain specified financial
ratios. An indenture might also include a cross default clause, under
which a default is triggered if the issuer defaults on other debt in its
capital structure. It is designed to protect investors holding any tranche
of the issuer’s debt, not only the tranche subject to the default.
◆ Restrictive covenants—Also called negative covenants, these terms
limit or restrict the borrower’s ability to use corporate capital or assets
for purposes that may be harmful to creditors.
◆ Ability to assume or guarantee additional indebtedness—The more
additional debt a borrower assumes, the more vulnerable all creditors
may be to defaults or bankruptcies. The indenture may limit a company’s
total borrowing, its ability to incur new debt senior to the creditors’
claims, or to encumber property with liens or mortgages.
◆ Right to redeem junior debt—Using corporate assets to redeem debt
claims junior to a borrower’s claims can reduce the borrower’s financial
strength and ability to meet loan or bond indenture terms, so doing so is
limited by the indenture.
◆ Corporate transactions—Indentures may set limits on a borrower’s
ability to sell or dispose of company assets or enter into transactions
such as mergers, consolidations, or transactions with affiliates.
Knopman Note: Inter-creditor agreements set forth the rights and
obligations of creditors to receive distributions from a borrower,
including during a bankruptcy distribution.
418
Knopman Note:
Q: What documents would be useful, to determine the order in
which creditors might be repaid in a bankruptcy? What would
not be a useful document?
Chapter 15
Liquidation and
Restructuring
A: Helpful documents include:
1. Inter-creditor agreement
2. Bond indenture, and
3. Credit agreement
Unhelpful documents include:
1. Stock certificates
15.3.1 Financial Covenants and Key Ratios
Financial covenants require the issuer to maintain a certain credit profile. They are
often included in loan agreements and indentures through the following ratios.
Some of these ratios, including the coverage ratio, debt-to-EBITDA, and tangible
book value were discussed in prior chapters, though a few additional ones to be
familiar with are detailed below.
15.3.1.1 Current Ratio
This ratio, drawn from the balance sheet, measures short-term liquidity by comparing current assets to current liabilities. The covenant may specify a minimum
current ratio, such as current assets equal to or greater than 75% of current liabilities. Since liquidity can deteriorate quickly in troubled companies, the covenant
may specify that the ratio be measured quarterly.
Knopman Note: When calculating a company’s liquidity, the amount
of a revolver (i.e., cash available to be borrowed from a bank) that can
be included in the figure should be no more than the limit without
violating any covenants. Current cash would also be included in a
liquidity calculation but expected cash needs for the next period
would be subtracted.
419
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Liquidation and
Restructuring
15.3.1.2 Quick Ratio (i.e., Acid Test Ratio)
The quick ratio, like the current ratio, is calculated from the balance sheet but is
a more stringent test of liquidity because it excludes certain current assets that
are not readily convertible into cash, such as inventory.
Quick Ratio
=
(Current Assets – Inventory)
Current Liabilities
A second way to calculate the quick ratio is:
Quick Ratio
=
(Cash + Marketable Securities + Accounts Receivable)
Current Liabilities
Knopman Note: Be sure to review the formula for the quick ratio. And
note, all types of inventory (e.g., work-in-progress, finished inventory,
raw materials) would be subtracted in the numerator.
420
Chapter 15: Liquidation and Restructuring
Unit Exam
1. For a bankruptcy reorganization plan to be
approved, it must be approved by creditors
representing:
A. Two-thirds of the dollar amount of the
claims and one-half of the number of
claims
B. One-half of the dollar amount of the
claims and one-half of the number of
claims
C. One-half of the dollar amount of the
claims and two-thirds of the number of
claims
D. 90% of both the dollar amount of the
claims and the number of claims
2. A creditor is required to file a proof of claim in:
A. A Chapter 7 bankruptcy
B. A Chapter 11 bankruptcy
C. Both a Chapter 7 and Chapter 11
bankruptcy
D. Only a situation where an outside trustee
is appointed by the court
3. In the event a material default is not waived by
a borrower’s creditors, the borrower typically
seeks:
A. Protection under Chapter 7 of the
Bankruptcy Code
B. Protection under Chapter 11 of the
Bankruptcy Code
C. A covenant amendment
D. A trial by jury
5. Which of the following would not be the
responsibility of a financial adviser in a
bankruptcy?
A. Performing a valuation of the company’s
assets
B. Helping to find a potential buyer for the
company
C. Filing motions with the court
D. Helping to find funding for the company
6. A buyer that saves a distressed company from
filing for bankruptcy is called a:
A.
B.
C.
D.
Angel investor
Stalking horse
Debtor-in-possession
White knight
7. The initial bidder in a Section 363 sale is often
referred to as a:
A.
B.
C.
D.
White knight
Debtor-in-possession
Stalking horse
Trustee
8. Which of the below has the lowest priority
claim in a bankruptcy?
A.
B.
C.
D.
Preferred stock
Warrants
Government claims
General creditors
4. Negative covenants require the borrower to:
A. Perform specified actions
B. Maintain its credit profile by repaying debt
and/or growing cash flow
C. Limit the undertaking of specified actions
D. Prevent cash from being distributed by the
borrower to equity holders
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Chapter 15: Liquidation and Restructuring
Unit Exam (Continued)
9. A company reports the following data on its
balance sheet:
• Current assets: $200 million
• Current liabilities: $65 million
• Inventory: $50 million
• Cash: $15 million
What is its quick ratio?
A.
B.
C.
D.
422
0.43x
2.31x
3.08x
3.31x
10. All of the following are potential roles of
the unsecured creditors’ committee in a
bankruptcy filing except:
A. Liaise between the debtor and the various
creditors
B. Review motions filed with the court
C. Negotiate with stalking horse bidders
D. Perfect secured liens
Chapter 15: Liquidation and Restructuring
Unit Exam—Solutions
1.
(A)
For a bankruptcy reorganization plan to be approved, it must be approved by creditors
representing two-thirds of the dollar amount of the claims and one-half of the number
of claims.
2. (A)
Under Chapter 11, a creditor does not need to file a proof of claim if the creditor agrees
with the amounts scheduled on the debtor’s bankruptcy petition. In a Chapter 7, a proof
of claim is always required.
3. (B)
A borrower/issuer seeks protection under Chapter 11 of the Bankruptcy Code to
continue operating as a “going concern” while attempting to restructure its financial
obligations. During bankruptcy, while secured creditors are generally stayed from
enforcing their remedies, they are entitled to certain protections and rights not
provided to unsecured creditors.
4. (C)
Restrictive covenants, also called negative covenants, limit or restrict the borrower’s
ability to perform certain actions that may be harmful to creditors, such issuing
additional debt.
5. (C)
The company’s legal counsel would generally be responsible for filing any motions in
court in a bankruptcy. This would not be the role of a financial adviser, who instead
might be tasked with performing a valuation of the company’s assets and helping
identify potential buyers or funding for the company.
6. (D)
A buyer that saves a distressed company from filing for bankruptcy is called a white
knight.
7.
(C)
A 363 sale is an asset sale by a company in bankruptcy, where the debtor is able to sell
the asset free and clear of any interests and claims. Generally, the debtor will try to
entice an initial bidder, referred to as a stalking horse.
8. (B)
Common stock, and warrants exercisable into common stock, fall last in the priority of
claims.
9. (B)
The quick ratio, also called the “acid test,” is a stringent measure of short-term liquidity.
It is similar to the current ratio (current assets/current liabilities) except it subtracts
from current assets non-liquid assets such as inventory. Subtracting $50 million of
inventory from $200 million of current assets = $150 million; dividing this by $65 million
in current liabilities gives a quick ratio of 2.31x.
10. (D)
Perfecting a lien is not part of the bankruptcy process, nor is it the responsibility of the
unsecured creditors’ committee. A lien is perfected at the time a secured loan is
originated. It requires that the loan be placed on file with a department within the state
of origination. Effectively, it makes the lien legally enforceable.
423
Index
A
C
accelerated filers 258
accelerated share repurchase program
(ASR) 51, 382
accounts payable turnover 140
accounts receivable turnover 139
accredited investors 13, 352
accretion/(dilution) analysis 173, 189
accretive 189
acid test ratio 420
actively traded securities 323, 381
additional issue 273
additional paid-in capital (APIC) 50
agreement among underwriters (AAU) 278,
303
all holders, best price 372
all-or-none 275
amortization 40
angel investors 19
asset-backed security (ABS) 166
asset purchase 178
asset purchase agreement (APA) 412, 415
at the market 308
automatic shelf registration (ASR) 233
automatic stay 408
callable 157
call feature 157
call premium 158
capital asset pricing model (CAPM) 133
capital efficiency 86
capital expenditures (capex) 138
capitalization strategy 340
capital structure 60
cash flow statement 52
clearing bid 373
clubbing 186
comparable companies analysis 78, 113
comparable transactions analysis 118
competitive bid 277
confidential information memorandum
(CIM) 187
confidentiality agreement (CA) 186, 342
confidential proxy 400
contingency underwritings 275
control securities 360
cooling-off period 231
Corporate Financing Department 304, 306,
343
Corporate Financing Rule 304
corporate insiders 26, 265
cost of debt 133
cost of equity 133
cost of goods sold (COGS) 36
coupon 156
coverage ratio 92
covered securities 309
credit rating 94
crowdfunding 362
current assets 47
current discount rate on debt 133
current liabilities 48
current yield (CY) 159
B
bad actor 355, 363
bake-off 232, 277
balance sheet equation 45
basic shares outstanding 64
basis point (bps) 157
best efforts 275
beta 134
blank check company 228
block trade 290, 381
bona fide electronic road show 240
bonds 155
book-runner 288
book value (equity) 46, 49
book value of common equity 49
book value (PP&E) 47
break-up fee 200
bring-down due diligence 212
broad auction 184
Business Development Companies (BDCs)
228
buy-side adviser 176
D
data room 196
days inventory held (DIH) 140
days payable outstanding (DPO) 141
days sales outstanding (DSO) 140
DCF 129
deal file 292
debt covenants 415
debtor in possession (DIP) 410
425
Index
debt-to-EBITDA 92
debt-to-equity 90
debt-to-equity ratio 136
debt-to-total capitalization 90
deferred tax liabilities 48
deficiency letter 223
definitive agreement 197, 199
definitive merger proxy (DEFM14A) 205
depreciation 39
depreciation and amortization (D&A) 138
descriptive memorandum 187
detailed memorandum 187
diluted shares outstanding 66
dilutive 189
direct participation programs (DPPs) 333
discounted cash flow (DCF) analysis 129
dividend discount model 149
dividend payout ratio 95
dividend recap 182
dividend recapitalization 182
dividend yield 94
due diligence 341
due diligence defense 246
Dutch auction 373
E
earnings-based multiples 103
earnings before interest, taxes, depreciation,
amortization, and rent expense 92
earnings growth 81
EBIT 40
EBITDA 40
EBITDAR 92
Economic value added (EVA) 151
effective multiple 112
Emerging Growth Companies (EGCs)
229, 308
engagement letter 173
enterprise value 62, 68
enterprise value multiples 107
enterprise value-to-EBIT 108
enterprise value-to-EBITDA 108
enterprise value-to-sales 107
equity crowdfunding 362
equity purchase 177
equity REITs 14
equity research 316
equity value 63
equity value multiples 103
escrow 276
EV/EBIT 108
426
EV/EBITDA 108
EV/Sales 107
exempt transactions 339
exit multiple method 143, 145
F
fairness committee 392, 394
fairness opinion 198, 390
final bid 197
final bid procedures letter 197
final prospectus 232
financial covenants 419
financial sponsors 119, 172
FINRA Rules
FINRA Rule 5121 311
FINRA Rule 5122 343
FINRA Rule 5130 313
FINRA Rule 5141 309
FINRA Rule 5150 393
firm commitment 275
fixed charge coverage ratio 93
fixed-income securities 155
fixed pot arrangement 287
fixed-price offering 309
fixed-rate bond 156
flipping 288
floating-rate bond 156
follow-on offering 21, 275
Forms
Form 3 265
Form 4 265
Form 5 265
Form 8-K 257
Form 10-K 253
Form 10-Q 255
Form C 363
Form D 352
Form DEF14A 400
Form DEFM14A 259
Form PREM14A 400
Form S-1 225
Form S-3 225
Form S-4 206, 225, 397
Form S-8 225
Form S-11 225
forward-looking information 243
free and clear 414
free writing prospectus 235
fully marketed offering 310
fundamental valuation methodologies 129
funding portal 362
G
L
going private 374
golden parachute 390, 391
goodwill 47
Gordon growth model 149
go-shop 200
graphic communication 240
greenshoe clause 329
gross profit 37
growth at a reasonable price
(GARP) 296
gun-jumping 203, 230
large accelerated filers 258
letter of intent (LOI) 188
leverage 89
leveraged buyout (LBO) 172, 179
levered beta 135
limited liability company (LLC) 11, 340
limited partnership 12, 340
lock-up agreements 291
long-term liabilities 48
H
Hart–Scott–Rodino Antitrust Improvements Act of 1976 203
hedge funds 15
HSR Act 203
humped yield curve 162
hybrid REITs 14
I
implied dividend yield 94
income statement 36
income tax 43
indemnification 200
indication of interest (IOI) 188, 279
ineligible issuers 228
information memorandum 187
initial bid procedures letter 188
initial public offering (IPO) 20, 273
inter-creditor agreement 418
interest coverage ratio 92
interest expense 42
intermediary 362
internal controls 262
internal rate of return (IRR) 180, 183
intrastate offering exemption 350
inventory turnover 140
inverted yield curve 162
issuer expenses 305
J
JOBS Act 229
joint due diligence 316
jump ball pot arrangement 288
junior debt 417
Index
M
M14A 204
management discussion and analysis
(MD&A) 187
management presentations 195
manager’s fee 280
margin ratios 85
market cap 63
market capital 63
market capitalization 63
market risk 133
market risk premium (MRP) 134
market value of equity 63
master limited partnerships 13
material adverse change (MAC) 199
material adverse effect (MAE) 199
M&A timeline 214
member private offerings 343
membership units 340
merger proxy 204
mezzanine debt 417
minimum-maximum (mini-max) 275
minority freeze-out 374
minority interest 70
minute book 262
mortgage-backed securities (MBS) 165
mortgage REITs 14
N
negative net debt 70
negotiated sale 185
net debt 69
net income 44
net working capital (NWC) 138
net worth 46
noisy exit 246
nominal yield (NY) 156, 158
427
Index
noncontrolling interest 70
non-current assets 47
non-disclosure agreement (NDA) 186
non-reporting issuers 228
non-solicitation clause 186
normalize 96
normal yield curve 161
no-shop 200
Q
O
R
offering circular 341
offering statement 349
one-day marketed offering 310
one-step merger 204
operating leverage 41
real estate investment trusts (REITs) 13
reallowance 281
reclassification 396
recordkeeping 328
red herring 231, 301
refreshing requirements 234
refunding 158
registration statement 222
Regulations
Regulation A 348
Regulation A+ 348
Regulation Crowdfunding 362
Regulation D 351
Regulation FD 263
Regulation M 323
Regulation S 358
Regulation S-K 224
Regulation S-X 224
relevered 135
representations (reps) and warranties 199
request acceleration 231
restricted person 313
restricted stock 359
restrictive legend 359
retained earnings 51
returned shares 287
return on assets 88
return on equity 88
return on invested capital 86
return on the investment 86
return ratios 85
revenue 36
revenue growth rate 81
rights offering 275
risk-free rate 134
ROA 88
road show 240, 306
ROE 88
ROI 86
ROIC 86
Rules
Rule 14e-3 378
Rule 101 323
Rule 102 324
P
part-or-none 275
par value 155
passive market-making 325
pass-through securities 166
PEG ratio 85
pension plan 151
P/E ratio 82
perpetuity growth method 143
piggyback registration rights 357
PIK interest 42
placement agent agreement 341
post-effective period 232
precedent transactions analysis 78, 118
pre-closing commitments 200
pre-commencement communication 377
pre-filing period 230
preliminary merger proxy (PREM14A) 205
preliminary prospectus 231, 241, 301
preliminary proxy 400
prepayment risk 165
price-to-book value 105
price-to-earnings growth ratio 85
price-to-earnings ratio 82
price-to-tangible book value 106
primary offering 273
priority claims 416
private equity funds 14
private placement memorandum (PPM) 24
private placements 24
projections and ratings 224
proof of claim 407, 408
property, plant, and equipment (PP&E) 47
prospectus supplement 225
proxy statement 204, 260, 399
public float 21
purchase consideration 177
purchaser representative 354
428
qualified financial institution (QFI) 276
qualified independent underwriter (QIU)
311
qualified institutional buyers (QIBs) 27, 356
qualified purchasers 343
quick ratio 420
Rule 103 325
Rule 104 326
Rule 105 329
Rule 144 359
Rule 144A 356
Rule 147 350
Rule 504 352
Rule 506(b) and (c) 352
SEC Rule 10b-9 276
SEC Rule 13e-3 374
SEC Rule 14A 399
SEC Rule 15c2-4 276
SEC Rule 145 396
S
Sarbanes–Oxley Act of 2002 (Sarbox or
SOX) 261
Schedules
Schedule 13D 267, 371
Schedule 13E-3 374
Schedule 13F 268
Schedule 13G 268
Schedule 14D-9 377
Schedule K-1 12
Schedule TO 372
scrub 96
seasoned issuer 227
secondary offering 273
Section 4(a)(2) 351
Section 338(h)(10) election 178
Section 363 merger 412
Securities Act of 1933 221
securitization 166
selected dealer agreement 279
selling concession 280
selling, general, and administrative
(SG&A) expenses 39
selling group 278
sell-side adviser 173
senior debt 416
shareholder distribution 94
shareholders’ equity 49, 51
shelf registration 233
short-form merger 209
site visits 195
Small Business Investment Companies
(SBICs) 19
smaller reporting company 258
Special Purpose Acquisition Companies
(SPACs) 228
spinning 285
spin-off 21
split offering 274
squeeze-out 209
stabilization 326
stabilization agent 326
stalking horse 412, 414
standby commitment 275
standby purchaser 314
standstill agreement 187
statement of interest (SOI) 188
stepped-up basis 178
stock purchase 177
strategic buyer 119, 172
subchapter C corporation 9
subchapter S corporation 10
subscription agreement 342
syndicate account 333
syndicate expenses 305
syndicate settlement date 333
synergies 172
synergies-adjusted multiple 112
systemic risk 133
Index
T
tail-fee arrangement 306
takedown price 280
target board of directors 172
target company 171
targeted auction 185
target management 171
T-bills 163
teaser 186, 342
tender offer 209, 371
terminal value 143
termination provisions 200
Tier 1 offering (Reg A+) 349
Tier 2 offering (Reg A+) 349
time value of money 129
tombstone ad 242
trading comps 113
transaction comps 118
transaction comps output page 120
Treasury bills 163
Treasury bonds (T-bonds) 164
Treasury notes (T-notes) 164
treasury stock 50
treasury stock method 66
trust indenture 415
two-step merger 209
two-step tender offer 209
U
underwriters 273
underwriting agreement (UA) 277, 302
underwriting fees 280, 306
429
underwriting proceeds 280
underwriting spread 279
universe of comps 113
unlevered betas 135
unlevered free cash flow 136
unlevering beta 135
unregistered securities 221
unseasoned issuers 228
unsecured claims 416
unsecured creditors’ committee 411
W
V
yield 158
yield curve 161
yield to call (YTC) 160
yield-to-maturity (YTM) 159, 183
yield to worst (YTW) 160
valuation 57
valuation multiples 102
venture capital 20
430
weighted average cost of capital (WACC)
129, 132
well-known seasoned issuer (WKSI) 226
white knight 414
working capital 138
working capital peg 199
working capital ratios 139
Y