Question

a) Discuss two advantages and two disadvantages of going public for firms.

b) A company makes an initial public offering of shares to raise $220 million, at an offer price of $5.30 per share. The issue is underwritten at $5.00. The costs of preparing the prospectus, legal fees, ASIC registration and other administrative costs add up to $800,000. If the firms’ share price closes at $6.40 on its first day of trade. What is the total cost of the IPO?

c) Explain two important roles of investment bankers in the process of IPO.

Answer 1

b) 1) Underwriting Spread :-

Underwriter's spread = ($5.30 - $5.00) = $0.30 per share

No. of shares outstanding = $220,000,000 / $5.30 = 41509433

Total due to underwriter = ($0.30 * 41509433 shares) = $12452830

2) Out of pocket expenses

Out of pocket expenses = $8,00,000

3) Underpricing

Share price at the end of the first day = $6.40

First day underpricing = ($6.40 - $5.30) = $1.10

Total Underpricing = ($1.10 * 41509433 shares) = $45660376

Total cost to the company selling the IPO = $12452830 + $8,00,000 + $45660376) = $58,913,206

a) An entrepreneur initially starts a company with a few closely known members as the shareholders. The profit or loss of the Company is borne by these people. As the company continues to mature, and is seen to have growth potential, any Company head would think of making his/her business even bigger. To make it even bigger & to achieve greater heights, the entrepreneur will need a huge capital investment. And he/she cannot rely on the bank loans every time for this purpose. This is when the entrepreneur actually starts contemplating on going public or making an Initial Public Offer.

An initial public offering (IPO) is the first sale of stock by a company. Small companies looking to further the growth of their company often use an IPO as a way to generate the capital needed to expand. Although further expansion is a benefit to the company, there are both advantages and disadvantages that arise when a company goes public. However, there are many private companies that are also thriving, such as Dell, Cargill, and Koch Industries.

Advantages of going public

• Fundraising - The most often cited advantage of an initial public offering is money i.e. the financial benefit in the form of raising capital. For example, in 2012, Facebook. the social media giant, made its initial public offering (IPO) - its debut as a publicly traded company - on the New York Stock Exchange. In just one day of trading, Facebook sold 421.2 million shares of itself to investors for $38 per share, raising a huge $16 billion in new capital just about instantly. Facebook's IPO became the largest tech offering - and third largest overall - in U.S. history.
  These IPO funds can benefit a growing company in countless ways. Companies may use an initial public offering to finance research and development, hire new employees, build buildings, reduce debt, fund capital expenditure, acquire new technology or other companies, or to bankroll any number of other possibilities. The money provided by an IPO is significant, and can transform the growth trajectory of a company.

• Publicity And Credibility - If a company hopes to continue to grow, it will need increased exposure to potential customers who know about and trust its products; an IPO can provide this exposure as it takes a company into the public spotlight. Analysts around the world report on every initial public offering in order to help their clients know whether to invest, and many news agencies bring attention to different companies that are going public. Not only do companies receive a great deal of attention when they decide to go public, but they also receive credibility. To complete an offering, a company must go through intense scrutiny to ensure what they are reporting about themselves is correct. This scrutiny, combined with many investo'rs tendencies to trust public companies more, can lead to increased credibility for a company and its products.

Disadvantages of going Public

• Additional Regulatory Requirements And Disclosures & resulting high reporting costs
  Unlike private companies, public companies are required to file their financial statements with the Securities and Exchange Commission (SEC) every year, which is also called the annual report. These financial statements must be prepared in accordance with United States Generally Accepted Accounting Principles and audited by a certified public accounting firm. These SEC regulations are both burdensome and costly. Reporting a company’s financial position publicly every year requires that company to establish more stringent financial controls, hire a financial reporting team staff and audit committee, implement quarterly and yearly financial close processes, hire an audit firm, and complete many other allied tasks. These responsibilities cost public companies millions of dollars every year and require thousands of labor hours. More importantly, especially for smaller companies, is that the cost of complying with regulatory requirements can be very high.

• Market Pressures - Market pressures can be very difficult for the company leadership to hande who were earlier used to doing what they feel is best for the company. Founders tend to have a long-term view, with a vision of what their company will look like years from the present and how it will impact the world. The stock market, on the other hand, has a very short-term, profit-driven view. Once a company is public, its every move is scrutinized by investors and financial analysts around the world, who are generally interested in only one question i.e. whether the co. will meets its quarterly earning targets. If a company meets its target, its stock price will normally increase; if not, its stock price will normally decrease. Even if leadership is doing what is best for the company in the long-run, failing to meet the public’s short-term goals may cause the company to lose value and the leadership might get replaced as a result. Entrepreneurs who do not like the idea of being constrained by short-term public goals should think before going public.

c) Investment banking is the division of a bank or financial institution that serves governments, corporations, and institutions by providing underwriting (capital raising) and mergers and acquisitions (M&A) advisory services. Investment banks act as intermediaries between investors (who have the money to invest) and corporations (who require capital to grow and run their businesses).
Full-service investment banks offer a wide range of services that include underwriting, M&A services, sales and trading, equity research, asset management for large investment funds and personal wealth management for high-net-worth individuals, commercial banking, and retail banking. The investment banking division of a bank however provides only the underwriting and M&A advisory services. Some of the major investment banks include Goldman Sachs, JPMorgan Chase, Morgan Stanley and Credit Suisse.

One of the primary roles of an investment bank is to serve as a sort of intermediary between corporations and investors through initial public offerings (IPOs). Before issuance of IPO company hire an investment bank. This bank is chosen based on different criteria like market reputation, industrial experience, quality of research and distribution channels, etc. The investment banker provide 3 basic services while bringing an IPO to the market. They are as follows :-

1) Origination - During this phase, the investment banker helps the management of the client co.determine whether the firm is ready for the IPO. This requires determining whether the management team, thhe firm's historical financial performance, & the firm's expected future performance are solid enough to attract serious considerations from the sophisticated market investors. If the firm is weak on any of these criteria then the investment banker might help the firm in finding some private capital. Otherwise, if the firm is good to go public, then other issues that must be decided are how much money the firm needs to raise & how many shares must be sold.
Since the securities that are to be sold to the public are needed to be registered with the SEC, the first step in this process is to file a registration statement with the SEC. A portion of this statement is called the preliminary prospectus, containing all the details about the proposed IPO.

2) Underwriting - Once the origination is complete the security issues can be sold to the investors. The company needs to set a price for its stock; they want to set it high enough to raise as much money as possible but low enough that they will be able to sell their stock. Thus, there is a risk to the company in the offering of securities. For all types of securities, whether offered by companies or the government, there is a risk that the issuer may not be able to have a successful securities offering. That is where the job of the security underwriter/ investment banker comes in. The securities can be underwritten in 3 ways:-

• Firm Commitment – The underwriter agrees to buy the entire issue and assume full financial responsibility for any unsold shares. The investment banker guarantees the issuer a fixed amount of money for the stock sale. The investment banker actually buys the stock from the firm at a fixed price and then resells it to the public. The underwriter bears the risk that the resale price might be lesser than the price the underwriter pays to the co. - this is called the price risk. The investment banker's compensation is called the underwriter's spread. the spraed is the difference between the investment banker's purchase price & the offer price. In the vast majority of IPOs in the United states the underwriter's spread is 7%.
• Best Efforts – Underwriter commits to selling as much of the issue as possible at the agreed-upon offering price but can return any unsold shares to the issuer without financial responsibility. Hence the investment bank makes no gaurantee to sell the securities at a fixed price. It promises to make its best efforts to sell as mush issue as possible at a certain price.
• All-or-None – If the entire issue cannot be sold at the offering price, the deal is called off and the issuing company receives nothing.

3) Distribution - An underwriting group manages the distribution of a new securities issue, such as a single company stock or a bond. The group purchases the issue from the issuing corporation at a specified price and then resells the issue to investors in order to make a profit. The profit is the difference between the purchase price and the resale price.