BBK34133 | Investment Analysis Prepared by Khairul Anuar L2 - Initial Public Offering & Rights Issue 1 Content Content 1. Sources of Funds for Private Companies 2. Initial Public Offering 3. Advantages and Disadvantages of Going Public 4. Appointment of Advisers 5. The IPO Process 6. Pricing of the IPO Shares 7. IPO Puzzles 8. Raising Additional Capital: The Seasoned Equity Offering 9. Rights Issue 10. Dilution of Percentage Ownership 2 Security Markets Are designed to allow corporations and governments to raise new funds and to allow investors to execute their buying and selling orders. Primary and Secondary Security Markets Primary Market Secondary Market Where corporate and Where previously government entities can issued securities are raise capital traded among investors. In short: All securities are first traded in the primary market, and the secondary market provides liquidity for these securities. 1. Sources of Funding for Private Companies -1 A private company can seek funding from several potential sources: • Angel Investors • Venture Capital Firms • Institutional Investors • Corporate Investors • Corporations 5 1. Sources of Funds for Private Companies -2 Angel Investors • Individual investors who buy equity in small private firms. • For many start-ups, the first round of outside private equity financing is often obtained from „angels‟. Institutional Investors • Include superannuation funds, insurance companies, investment companies and charities. • May invest directly in private firms, or may invest indirectly by becoming investors in venture capital firms. 6 1. Sources of Funding for Private Companies -3 Venture Capital Firms • A venture capital firm specialises in raising money to invest in the private equity of young firms. • Typically, institutional investors, such as superannuation funds, are investors in a venture capital firm. • They provide substantial capital for young companies, but in return, venture capitalists often demand a great deal of control of the company. Corporate Investors • Many established corporations purchase equity in younger, private companies. • Corporations might invest for corporate strategic objectives in addition to the desire for investment returns. 7 8 1. Sources of Funding for Private Companies -4 Venture capital funds raised in Australia, 1999-2008 9 2. Initial Public Offering • The process of selling stock to the public for the first time is called an initial public offering (IPO). It is also referred to as “going public” or “unseasoned new issue”. • The shares sold at an IPO may either be new shares that raise new capital, known as a primary offering, or existing shares that are sold by current shareholders, known as a secondary offering. 10 3. Advantages and Disadvantages of Going Public Advantages: 1. To raise additional capital. 2. The Increases liquidity and allows founders to harvest their wealth. 3. Permits founders to diversify. 4. Facilitates raising new corporate cash. 5. Establishes a value for the firm. 6. Facilitates merger negotiations. 7. Increases potential markets. 8. Use stock options as part of their compensation plans 9. Free advertising and publicity, 10. Status as listed companies may enhance their prestige 11 3. Advantages and Disadvantages of Going Public Disadvantages: 1. Equity holders become more widely dispersed resulting in loss of control 2. Cost of reporting. - SEC and/or various state agencies. burden, especially for small firms 3. Disclosure of information to public 4. Self-dealings and consumption of perks 5. Inactive market and/or low price 6. Investor relations. 7. Target of take-overs 12 4. Appointment of Advisers • A number of professional firms are involved in IPO exercises: Investment Bank as Principal Adviser Legal Firm (provide advice on all legal matters in relation to your application) Accountants (prepare the Accountants‟ Report as well as undertake the due diligence on the application documents) Property Valuer (if company‟s listing exercise involves any property, plant, machinery an equipment that have been or to be revalued) Issuing House (will oversee the balloting, issuance and allotment process of your company‟s shares) 13 5. The IPO Process • The approval IPO process differs from to country to country. In Malaysia, the applications are submitted to the Securities Commission and Bursa Malaysia (the Malaysian stock exchange). • Subsequent to the above approvals, a Prospectus must be issued by the company to investors. • A prospectus is a document setting out the terms of its equity issue. • It provides information on the company, and financial performance of the company so that investors are able to make informed decisions about whether to invest. • The must be lodged with authorities (with the Securities Commission in Malaysia). 14 5. The IPO Process Step 1: Appointing Professionals Step 2: Implementing Organisational Changes Step 3: Appointing Independent Directors Step 4: Method of Listing and Valuation Step 5: Preparing Documents for Submission Step 6: Submission and Review Step 7: Approvals Step 8: Registration of the Prospectus Step 9: Investor Briefings Step 10: Balloting Process Step 11: Listing 15 6. Pricing of the IPO Shares • The investment bank and underwriters will work with the company to come up with a price that they believe is a reasonable valuation for the firm and the price at which the company‟s shares will be offered to investors. • Two ways used to value a company: . Estimate the future cash flows and calculate the present value; or . Examine comparable companies. Also take into account the net assets of the company, PE ratio, future prospects etc 16 7. IPO Puzzles -1 Four characteristics of IPOs which puzzle financial economists: 1. On average, IPOs appear to be underpriced: The price at the end of trading on the first day is often substantially higher than the IPO price. 2. The number of IPOs is highly cyclical: When times are good, the market is flooded with IPOs; when times are bad, the number of IPOs dries up. 3. The costs of the IPO are very high: It is unclear why firms willingly incur such high costs. 4. The long-run performance of a newly public company (three to five years from the date of issue) is poor: That is, on average, a three- to five-year buy and hold strategy appears to be a bad investment. 17 7. IPO Puzzles -2 1. Underpriced IPOs • Generally, underwriters set the issue price so that the average first- day return is positive. • Studies have examined the underpricing of IPOs and found that, on average, they are underpriced by 10-15%. • Note that, although underpricing is a persistent and global phenomenon, it is generally smaller in more developed capital markets. • Who wins and who loses because of underpricing? 18 7. IPO Puzzles -3 Average first-day returns 19 7. IPO Puzzles -4 2. “Hot” and “Cold” IPO Markets • As with all market activity, trends related to the number of IPO issues are cyclical with large magnitude of swings. • It appears that the number of IPOs is not solely driven by the demand for capital. • Sometimes firms and investors seem to favour IPOs; at other times firms appear to rely on alternative sources of capital. 20 7. IPO Puzzles -5 Number of IPOs in Australia, 2003-07 21 7. IPO Puzzles -6 3. High cost of issuing an IPO • In the US, the discount below the issue price at which the underwriter purchases the shares from the issuing firm is 7% of the issue price. • The typical spread in Australia is abut 4%. • This fee covers the cost to the underwriter of managing the syndicate of managers and helping the company prepare for the IPO. • Still, this fee is large, especially considering the additional cost to the firm associated with underpricing. 22 7. IPO Puzzles -7 Relative Costs of Issuing Securities 23 7. IPO Puzzles -8 4. Poor post-IPO long-run share performance • Newly listed firms appear to perform relatively poorly over the following three to five years after their IPOs – so why do investors pay as much as they do for the hares when they begin trading? • Possibly that underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place. 24 8. Raising Additional Capital: The Seasoned Equity Offering • A firm‟s need for outside capital rarely ends at the IPO as profitable growth opportunities occur throughout the life of the firm. • Seasoned Equity Offering (SEO): When firms return to the equity markets and offer new shares for sale: 1. General cash offer: The firm offers new shares to investors at large. 2. Rights offer: The firm offers the new shares only to existing shareholders. Each shareholder is issued rights to buy a specified number of new shares from the firm at a specified price within a specified time, after which the rights are said to expire. 25 9. Rights Issue • A rights issue is an issue of rights to buy additional securities in a company made to the company's existing security holders. • It is a way to raise capital. • With the issued rights, existing security-holders have the privilege to buy a specified number of new securities from the company at a specified price within a specified time. • Rights Issue basis –rights shares are offered in a proportion to the existing shares held by a shareholder. Eg. Rights issue on the basis of 1 shares for every 2 shares held (1:2) For a shareholder who holds 10,000 shares in the company, under the RI he will receive 5,000 rights issue shares. 26 9. Rights Issue • Calculating theoretical ex-rights price • TER price is market price that a stock will theoretically have following a new rights issue. • Eg. ABC Berhad undertakes a rights issue on the basis of 2 rights shares for every 5 shares held, an an issue price of RM1.30. The market price of the company‟s shares is RM1.60.