Investments:
Theory and Applications
Mark Hirschey
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Chapter 4
(Part 2)
Buying and Selling
Equities
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Initial Public Offerings
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Initial Public Offerings
Key Terms
 Primary Market
 Road Show
 Secondary Market
 Firm-Commitment Offering
 Initial Public Offerings (Ipos)
 Best Efforts Underwriting
 Seasoned Issue
 All-or-none Offerings
 Secondary Offerings
 Syndicate
 Private Placements
 Underwriter’s Allotment
 Offering Circulars
 Dealers Agreement
 Investment Banks
 Tombstone Ad
 Underwriter
 Hot IPO
 Flipping Shares
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IPO Process
 A corporation issues debt or equity securities
when it needs new capital to:

Expand production facilities

Build inventories, etc
 Newly issued securities are sold in the -
Primary Market: the market for new
securities
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IPO Process
 All subsequent trading of those securities is
done in the Secondary Market: the market for
seasoned securities.
 Secondary Markets involve:

The organized trading of outstanding securities on
exchanges and over-the-counter markets

The NYSE, Nasdaq, the bond markets, etc. are
secondary markets.
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IPO Process
 An Initial Public Offering (IPO):

A first sale of stock or bonds to the public

Newly issued securities sold in the “Primary
Market” – which is the market for new securities

Initiated by companies seeking:

Outside equity capital

A public market for their stock
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IPO Process
 Seasoned issue: Issuance of securities for
which a public market already exists

i.e. IBM sells additional stock or bonds to the
general public
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IPO Process
 Secondary Offerings: Public sale of
previously issued securities held by large
investors, corporations, or institutional
investors.

For Example: Corporate insiders selling large
blocks of stock obtained through incentive
compensation plans.
 Typically handled informally by securities firms
and offered at a fixed price related to the current
market price of the stock.
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IPO Process
 The Difference:

In a Primary Offering: the issuing corporation
receives the proceeds.

In a Secondary Offering: the issuing corporation
does not receive any sale proceeds.
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IPO Process
 Private placement: Sale to “a small
group of investors”, generally under
exemption of SEC and state securities
registration requirements.

Small Group of Investors: assumed to be
“sophisticated” or knowledgeable investors
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IPO Process
 Some smaller companies may be exempt from:

SEC registration under Regulation A


companies raising less than $5 million in a 12-month
period
Filing reports on EDGAR
 Instead, these companies must file an Offering
circular: special SEC filing that describes a
private placement

contains financial statements and other information4-12
IPO Process
 In most cases companies seeking additional
investment capital hire an Investment bank:
Investment backer who endorses and sponsors a
company’s new securities.

Also called an underwriter

One who guarantees the purchase of stocks or bonds
 Different levels: firm commitment, best-efforts, allor-none

Act in the role of advisor and distributor
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IPO Process
 Investment Bank Services include:

Underwriting of debt and equity securities
 Advising on mergers
 Acquisitions





Privatization
Restructuring
Participating in real estate
Project finance
Leasing activities
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IPO Process
 Road Show: Series of presentations to promote
company securities

Issuing companies and their investment bankers
promote new issues to institutional investors
(pension plans, insurance companies, mutual
funds) and the general public.
 Discuss the investment merits of the corporation’s
securities
 Drum up interest in the offering
 Determine investor appetite for the firm’s
securities under different pricing scenarios.
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IPO Process
 Through this process, the issuing corporation
and the investment banker come to agreement
on:

Amount of capital needed by the corporation

Type of security to be issued

Price of the security to be issued

The amount of compensation (or commission) paid
by the firm to the investment banker
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IPO Process
 Two broad categories of agreements between
investment bankers and issuing corporations:

Firm-Commitment Underwriting

Best-Efforts Underwriting
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IPO Process
 Firm-commitment underwriting: Security
offering in which the underwriter purchases the
entire issue from the corporation and re-offers it
to the general public

The investment banker guarantees to provide a
certain sum of money to the corporation


Commit both reputation and investment capital
Any risk associated with failing to resell securities
falls entirely on the investment bank

Typically used with large and highly respected
corporations such as IBM
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IPO Process
 Best-efforts underwriting: Security offering in
which the investment banker simply agrees to
make “its best effort” at selling the agreed-on
amount of securities.
 If the investment banker fails:
 The corporation receives only the amount sold, less
necessary commissions
 The investment banker loses out on potential
commission income but suffers no capital loss
 Used with Risky startups
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IPO Process
 A “Best-Efforts” underwriting is called an all-
or-none offering when:

The underwriter agrees to do its best to sell an
entire issue by a certain date

But: if all securities are not sold by that time, all
money is returned to purchasers and the issue is
canceled.

All-or-none offerings: Requirement for a
complete sale.
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THE SYNDICATE
 Group of underwriters

Share the risk
 Syndicate manager
 Underwriter’s allotment
 Dealers agreement
 Tombstone ads
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THE SYNDICATE
 Many times, investment banks don’t want to
take on “all” the risk of an offering so they form
a Underwriting Syndicate – is group of
underwriters who agree to participate in selling
an issue.

Share the risk
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THE SYNDICATE
 The lead investment bank is the Syndicate Manager
 Determine the offering price
 Set the timing of the issue
 Respond to any deficiency letters by the SEC
 Modify selling commissions
 Control advertising
 Control the amount of each underwriter’s allotment: the
investment banker’s allocation
 Responsible for the dealers agreement: contractual
obligation of syndicate members.

specifies how securities dealers who are not part of the syndicate
may contract to purchase some of the securities from the issue
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THE SYNDICATE
 Tombstone Ad – An advertisement announcing
a security offering (Figure 4.4 Page 139)

Name of the new issue

Number of shares offered

The offering price

List of lead investment bankers and syndicate
members
4-24
Regulatory
Requirements
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SEC Regulatory Requirements
Key Terms
 Securities Act of 1933
 Registration Statement
 Filing Date
 Cooling-Off Period
 Preliminary Prospectus
 Red Herring
 Effective Date
 Deficiency Letter
 Final Prospectus
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Regulatory
Requirements
 Following the SEC Act of 1933, when a company
makes a public offering it must file a Registration
Statement: SEC document that describes an offering.



Description of the company’s main line of business
Biographical material on officers and directors
The amount of shares held by: officers, directors, and other
large shareholders owning more than 10% of the company



(so-called insiders)
Complete Financial Statements
Info regarding how proceeds of the offering will be used
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Regulatory
Requirements
 The date that the investment bank submits a
registration statement with the SEC is known as
the filing date.
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Regulatory
Requirements
 After the registration statement has been filed, the SEC
requires a cooling-off period: marketing period

period during which the issuing company and the
investment banker try to drum up interest in the issue.
 They do this though a Preliminary Prospectus:
preliminary statement of offering characteristics.



Also called a red herring – because it has red printing across the
top and in the margins
Contains much of the information from the registration
statement.
Does not contain the public offering price or the effective date of
the IPO
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Regulatory
Requirements
 During the cooling-off period:



The issuing company and its investment banker may not
provide any other information to the investment bank’s
clients beyond that which is contained in the preliminary
prospectus
No firm orders can be taken
Indications of interests: Expressions of intent to buy


Are recorded as an indication of potential demand for the issue
Are a critical guide to the investment bank in its final pricing of the
issue
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Regulatory
Requirements
 The public offering price is determined on the effective
date after investor interest in the issues has been
determined.
 Effective date: Date that securities are offered to
institutional investors and the general public.
 If the SEC does not approve a given issue, a
Deficiency Letter is issued and the effective date is
postponed.:

Deficiency Letter: Disapproval notice issued by the SEC.
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Regulatory
Requirements
 Due Diligence: Required analysis

A meeting just prior to the effective date between
the corporation and its investment banker to ensure
that material changes have taken place between the
filing date and the effective date.
 Final Prospectus: Final statement of offering

Issued once the effective date arrives

The securities are sold and money is collected
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Regulatory
Requirements
 The public offering price stated on the face of
the prospectus is what the general public pays.

The issuing corporation: receives a lower price
determined by the agreed upon spread.
 Any dealer or broker participating in the
underwriting: is compensated out of the spread
(the difference between what the general public
pays and what the issuing corporation receives) as
specified in the underwriting agreement

And other allocations
4-33
Regulatory
Requirements
 More money was raised in 1999 than during the
1970s and 1980’s combined:

It’s reasonable to expect a slowdown in the pace of
IPOs

IPO activity tends to follow dramatic growth in the
overall market averages (i.e. technology boom)

Difficult market periods tend to follow active IPO
markets, such as that experienced during 1998-99.
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Post-issue Performance
of IPOs
 Hot IPO – An IPO with limited shares and high
demand

Previous Internet IPO’s qualified as “Hot IPOs”

Generally investment bankers allocate shares of
hot IPOs to their top-performing stockbrokers and
most loyal clients (i.e. commission)
4-35
Individual
Retirement Accounts
IRAs
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Individual Retirement
Accounts (IRAs)
 Individual Retirement Accounts (IRAs):
provide a powerful way to save money for
retirement.
 Now: $3000 contribution per person per year


Earnings inside the IRA “grow” tax free
Table: 4.10 Page 149
– Tax Deferral Benefits of IRAs are Substantial
4-37
Tax Deferral
Benefits of IRAs
IRAs

Tax-deductible (within certain AGI limits)
 Tax-deferred growth—tax collected on distributions only
“New” Roth IRAs

After-tax contributions
 No taxes due on distributions
Education IRAs

Nondeductible contributions
 Tax-free withdrawals for education purposes
4-38
Taxes
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Tax Code Provisions
 Pages 150 through 152:
 Capital Gain rates
 Qualified five-year Gains
 Gift and Estate Tax Provisions
 Exclusion for Gain on the Sale
of Principal Residence
4-40
Answers to Selected
End of Chapter Questions
and Suggested Homework
 Study the following end-of








chapter questions:
1. (c)
2. (a)
4. (d) page 120
5. (d) page 122
6. (a)
7. (a)
10. (b)
11. (a)
12. (c)
 13. (b)
 14. (c)
 15. (d)
 16. (b)
 18. (b)
 19. (c)
 20. (c)
 Read the Chapter
 Read the Chapter
Summary
 Review the Power Point
Presentations
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