Securities: Publicly Traded Companies

Publicly Traded Companies: The Game of Stocks

Getting Started

Imagine you're at a party, and someone offers you a chance to join a game. This game involves a private firm raising capital from a wide range of investors. If the firm wants to play big, it decides to go public. It's like the firm opens its doors to the party and sells its securities to the general public, allowing them to trade shares in established securities markets. The first issue of shares to the general public is known as the firm's initial public offering or IPO. Later, the company may come back to the public and issue additional shares, which is like throwing an encore performance. For instance, think of Apple releasing new shares of stock to the party people, calling it a seasoned new issue.

Who's the life of this party, you ask? Well, it's the investment bankers! They're like the hosts of the game night, marketing these public offerings of stocks and bonds. Picture them as the underwriters, managing the game. They gather a squad of other investment bankers to share the responsibility for the stock issue. It's like building a dream team to make sure the game goes smoothly.

These investment bankers give advice to the firm, guiding them on how to sell the securities. It's like having a wise friend at the party who tells you the best strategy to win. They file a preliminary registration statement with the Securities and Exchange Commission (SEC), describing the issue and the prospects of the company. When the statement is finally accepted by the SEC, it's like the host announces the game rules to the players. They call it the prospectus. And that's when everyone knows the price at which the securities will be offered to the public.

In this game, the investment bankers purchase the securities from the issuing company and then resell them to the public. It's like buying a bunch of game tickets and selling them to eager players. The issuing firm sells the securities to the underwriting squad for the public offering price, but there's a little compensation called the spread that serves as a thank-you to the underwriters. It's like giving the hosts a little something extra for their hard work. This whole process is called a firm commitment. Oh, and sometimes the investment banker may even receive shares of common stock or other securities of the firm as an extra bonus. It's like getting a party favor to enjoy later.

The Game Changer: Shelf Registration

Now, imagine a new rule introduced in 1982 that revolutionized the game. It's like someone introducing a new game board or rule that changes everything. This rule, called shelf registration, allows firms to register securities and gradually sell them to the public for up to 2 years following the initial registration. It's like having securities "on the shelf," ready to be played. No extra paperwork, no hassle. And the best part? They can be sold in small amounts without incurring substantial flotation costs. It's like having the ability to play the game in bite-sized pieces.

The Excitement of Initial Public Offerings

Let's get to the most thrilling part of this game: initial public offerings or IPOs! This is where the investment bankers take charge and manage the issuance of new securities to the public. It's like hosting a blockbuster event. Once the SEC has commented on the registration statement and a preliminary prospectus has been distributed, it's time for the investment bankers to kick things into high gear.

They organize road shows, which are like promotional tours, where they travel around the country to publicize the imminent offering. It's like hyping up the crowd for the big game. These road shows serve two purposes. First, they generate interest among potential investors and provide information about the offering. It's like creating buzz and building anticipation. Second, they provide valuable information to the issuing firm and its underwriters about the price at which they can market the securities. It's like getting insider knowledge about the strategies of other players in the game.

During this hype-building process, large investors communicate their interest in purchasing shares of the IPO to the underwriters. This is called the book. It's like RSVPing to the party and indicating your level of excitement. The investment bankers go around polling potential investors, a.k.a. bookbuilding. It's like conducting a popularity poll to see who's most interested. And guess what? The book provides valuable information to the issuing firm. It's like getting insights into the demand for the security and understanding the competition. Based on this feedback, the investment bankers frequently revise their initial estimates of the offering price and the number of shares offered. It's like adjusting the game rules and rewards based on what the players want.

But here's an interesting twist in this game: Why do investors truthfully reveal their interest to the investment banker? After all, they might think it's better to express little interest in the hope of driving down the offering price. But truth is the better policy in this case. Shares of IPOs are allocated based on the strength of each investor's expressed interest. If a firm wants a large allocation when it's optimistic about the security, it needs to reveal its optimism. And in turn, the underwriter needs to offer the security at a bargain price to these investors to entice them to participate in bookbuilding and share their information. It's like playing a card game where you need to show your excitement to get the best cards. That's why IPOs commonly end up being underpriced compared to their actual market value. It's like finding a great deal or a hidden gem in the game. These underpricings often lead to price jumps when the shares are first traded in public security markets. It's like experiencing a sudden surge in value. Remember the November 2011 IPO of Groupon? The stock price closed that day at a bit more than 30% above the offering price. It's like hitting the jackpot!

But hold on, while IPOs may seem like the ultimate winning move, there's a catch. The explicit costs of an IPO tend to be around 7% of the funds raised. So, you may think that's the only cost. But underpricing should be seen as another cost of the game. Let's take the example of Groupon. If they had sold their shares for the price investors were willing to pay, they could have raised 30% more money than they actually did. That's a lot of money "left on the table" just because of underpricing. But here's the thing, underpricing is like an unwritten rule of this game. It's a universal phenomenon. IPOs are marketed to investors at attractive prices, giving them an edge in the game.

But remember, not every game has a happy ending. Some IPOs don't perform well after the initial excitement. Take Facebook's 2012 IPO, for example. Within a week, its share price was already below the offer price, and five months later, it was selling at about half the offer price. It's like scoring a goal, but then losing the game in the end. Sometimes, the game doesn't go as planned.

Interestingly, despite their typically attractive first-day returns, IPOs have been poor long-term investments. They often underperform the broad stock market and comparable portfolios of other firms. It's like getting all hyped up for a game, but it doesn't live up to expectations in the long run. But hey, every game has its winners and losers. That's what makes it exciting, right?

And just like in any game, there are risks involved. Some IPOs cannot even be fully sold to the market, leaving the underwriters with unmarketable securities. They end up selling them at a loss on the secondary market. It's like having leftover game pieces that nobody wants. In this case, the investment banker bears the price risk for an underwritten issue. It's like taking one for the team.

This article takes inspiration from a lesson found in FIN 4504 at the University of Florida.