Organisations and the financial system
Organisations and the financial system

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Organisations and the financial system

Initial public offerings

The usual method for a Ltd to go public is to offer its shares via an initial public offering (IPO). The process of an IPO can be summarised in three steps. Watch the following animation for an outline of the process.

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Skip transcript: Video 2 The process of an IPO

Transcript: Video 2 The process of an IPO

The initial step for the company would normally be to appoint a lead bank or possibly a small number of co-leads in case the issuance is particularly large, to advise it through the listing process, and to manage the sale of shares to investors. The lead bank, or the co-leads, would usually be expected to underwrite the transaction, in effect, committing to buy those shares not subscribed by investors on the launch date.
Simultaneously, the company would appoint legal advisors to take charge of the documentation requirements. At this stage, other banks can be invited into the transactions to work under the lead or co-leads.
Next, the company must decide which stock exchanges to list the shares on. Among the key determinants of this choice will be the relative costs, where the company is domiciled, and, particularly in the case of a multinational company, where it conducts the largest volume of its business.
The second stage of the process involves the compilation of an issuing prospectus that must be reviewed by the relevant regulator. In the UK, this would be the Financial Conduct Authority, or FCA. And in the USA, this would be the Securities and Exchange Commission, or SEC. The information contained in the prospectus would include details of the company financial performance in the recent past, usually up to five years, and projections for future business performance.
Part of the process of producing the prospectus involves what's known as due diligence - where the company financial performance, current financial standing, and future plans are subject to review by the lead bank or co-leads underwriting the transaction. Particular focus is placed on the viability of the company business plan since the success of this will critically influence both the company's share price and the dividends in the years after the IPO.
Ahead of the launch, the company and the lead bank or co-leading banks would be likely to roadshow the issue, making presentations to groups of institutional investors such as pension funds and hedge funds. After assessing market sentiment, the lead bank and other members of the syndicate of banks can advise on the appropriate price to offer the shares. This is often a range rather than a specific price.
The underwriting bank can see how much interest there is from investors and where within the price range they're prepared to buy. The book of bids for the shares at prices within the range can then be built up. In doing this, the company will know where it should price to sell it shares. The exact price can then be set, and the issue launched.
This process of book building to determine the share price is a practise that's spread to other major financial markets from the US. This is perhaps not surprising, given that US investment banks dominate the international markets.
End transcript: Video 2 The process of an IPO
Video 2 The process of an IPO
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Activity 7  Equity finance in practice

Timing: Allow around 50 minutes for this activity

Part A Should DrinkIT stay private or go public?

DrinkIT is a private limited company established in the food and beverage sector. The managers at DrinkIT are currently exploring possibilities to expand the business even further, for which a large injection of funds will be needed. In particular, they are in the process of building a complex business plan to sustain the production of innovative non-alcoholic drinks called Mocktails. As the financial manager of DrinkIT, you must evaluate the case for raising the required funds through equity finance.

Question 1

What do you think the main advantages and disadvantages of DrinkIT’s two options? List your ideas below.

Table 6 Advantages and disadvantages

Advantages of staying private Disadvantages of staying private
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Advantages of going public Disadvantages of going public
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Table 6 Advantages and disadvantages (completed)
Staying private Going public
Advantages Disadvantages Advantages Disadvantages
  • Higher degree of control of the business
  • Preserving the organisation’s culture
  • Limit to cash resources
  • Less attractive to new talent
  • Access to large amounts of funding
  • Increased growth potential
  • Improved reputation
  • Scrutiny from the relevant exchange commission
  • Accountability to shareholders
  • Partial loss of control
  • Expensive and time-consuming

Question 2

Which is the option you would recommend for DrinkIT? Why?

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Given both the information provided and the main advantages and disadvantages for the two options, in the case of DrinkIT it would be preferable to go public. However, management should be aware of the effort it will have to put into the processes required for DrinkIT to go public, and the challenges this may pose for the business plan.

Part B Facebook’s ‘botched’ IPO: what went wrong and why?

Much interest has been shown by financial analysts in the so-called ‘underpricing’ of shares offered through IPOs. Underpricing is evidenced by the price of shares rising (often sharply) in the immediate aftermath of the launch. Many traders try to take advantage of this common phenomenon.

If a fixed-price method is used for an IPO, then the lead bank (or co-leads) leading the offering will set the offer price at a level at which they are confident that all the shares will be sold to investors. This will mean that the banks underwriting the issue will not have to purchase a large proportion of the offer. Investors, knowing that the lead banks want to see a successful launch, may indicate a low price to force the issue price down as far as possible. Therefore, this often results in an unmet demand at the final offer price, with a surge in the traded share price on and after the launch date.

On 18 May 2012, Facebook held its IPO. By raising over $16 billion it became one of the largest IPOs in history. Quite surprisingly, there was no underpricing. On the first day of trading, the stock closed flat at its offer price. Many commentators described Facebook’s IPO as a ‘failure’ for the market.

Figure 6 NASDAQ welcomes Facebook’s listing

Just four days after it went public on the stock market, Facebook became the centre of intense attention both on Wall Street and in Washington DC as shares hit $32, well below the initial offering price. Watch this video entitled ‘Facebook’s “botched” IPO: what went wrong and why?’ from 1.31 to the end.

Skip transcript: Video 3 Facebook’s ‘botched’ IPO: what went wrong and why?

Transcript: Video 3 Facebook’s ‘botched’ IPO: what went wrong and why?

And we tackle some of the questions and investigations surrounding all this with Anant Sundaram, he teaches business administration at Dartmouth's Tuck School of Business, and Rob Cox, US editor of Reuters Breakingviews, a financial news website. Well, Rob Cox, so when we start to look at what went wrong, start with Morgan Stanley and the other underwriters. What's their role, and what questions are there now for them?
Well, in any IPO, what you try to do is balance the demand for the stock from institutional investors like big pension funds and hedge funds, and some retail investors. You try to get the right balance so that you price it appropriately so that in the first day of trading, it doesn't go way up in the sky and pop like it used to back in the big internet IPO days of the late '90s, but also sort of doesn't decline like we've seen with Facebook. And it's a really delicate balance, it's a very difficult job. But generally you try to get it right so that everybody's happy at the end of the day. You don't have four days later, everybody talking about a botched IPO, a problematic IPO. You don't have Mary Schapiro and the SEC and all sorts of regulators jumping in on it. And that clearly didn't happen in this case.
Anant Sundaram, what would you add - these questions about what the underwriter has to tell potential investors, when, what kind of information is important? What would investigators be looking at in a case like this?
It is at this moment alleged that there might have been some information asymmetry that might have been exploited by some with favoured access to that information. I have only seen allegations so far. But let me first say that yes, there is a lot of criticism about this IPO and Morgan Stanley. But from an issuer standpoint, we have to recognise that this was a huge success. And Morgan Stanley's job, we should recognise, is to maximise the proceeds to the issuer. So to some extent, I find that part of the commentary a bit baffling.
But back to the information asymmetry issue, what is being suggested is that perhaps in the last minute, there was some information that might have been given to analysts at Morgan Stanley and a couple of other underwriter firms, that might have enabled them to revise their forecasts in their valuation models, thereby making institutional investors pull back on their demand for the IPO.
Now I find it extremely surprising that something like that would happen. But we don't know what the facts are. But I will say this. Facebook filed many amendments to its prospectus right up until the final date of the IPO, which I think was May 18. And they explicitly stated that their revenue has been declining from 155% all the way down to 45%, and that they continued to see declines.
Now it is not clear to me what an investor looking at that would have guessed, other than to say, well, they expect it to decline further. So it's a bit of a fine line, but we don't have all the facts.
Well, Rob Cox, help us out here. What is the problem, then? Where do you look at with what Facebook did say or didn't say, or Morgan Stanley did or did not say?
Look, I take your point, Anant, about the idea that the issuer in this case, Facebook and the venture capitalists and the people behind Facebook with earlier supporters, had sold woohoo, 38 bucks a share, $16 billion of stock. But on day two, Mark Zuckerberg, the CEO and founder, who only sold stock in so far as he was dealing with tax issues, and all the 3,000 some odd people who are at Facebook, they've got to live with this company going forward. So what might have been a quick win for the backers of venture capitalists here, I think it's a real loss for Facebook.
We're sitting here talking about how Facebook is sort of up there with Morgan Stanley and the Wall Street money grubbers, as it were, rather than how Facebook is connecting 900 million people around the world, our ex-girlfriends, our old bosses, our parents, all those kinds of things. The very thing that Mark Zuckerberg tried to avoid by really taking himself out of the frame with the IPO. And remember, he said all along, I'm only doing this for my investors and my employees who want liquidity with the stock.
In a sense now, he's got more distractions than he bargained for. He's got lawsuits, he's got litigation. He's got Mary Schapiro, he's got the SEC, he's got us talking about it on television. And we're not talking about what a great creation it is, but what a botched IPO it is. So I just sort of would balance yes, it was a great deal financially for a few people. But on the broader term, this is not a great thing for Facebook going forward.
Well, Anant Sundaram, what does history tell us about these kinds of IPOs, if there is any good analogy? Is it too early to tell about its success or failure?
Yes, it is too soon to tell us about its success or failure. But we do have considerable evidence on long run performance of IPOs in the academic finance literature. In general, on average, IPOs underperform over a three to five year horizon, it actually turns out. But actually, if the evidence again, on average, is to be believed, that the empirical evidence is pretty strong, that it's the stocks that are large IPOs such as Facebook that actually tend to outperform, and also stocks that are taken public by higher quality within courts, in which bankers, such as Morgan Stanley or Goldman Sachs, are supposed to sort of second tier. And with some bankers, the evidence shows that the extent of the underperformance is less.
My personal view is, six months from now, one year from now, which is really what an investor should care about from the point of view of his or her holding and wealth creation, and what the intrinsic value of this business is, six or seven months or ten months or one year from now, I think we will have forgotten the first few days. And the focus really will be on whether they're executing their strategies as they need to, and the fundamentals of where they are implied by this valuation.
Well, Rob Cox, briefly, what do you think? We use the word investors. Let me put it in sort of small investors that we're talking about. What do you think small investors should learn from all this?
Well, there is a two tiered market in this country. And $100 billion of value was created before this thing went public. It was created for about 1,000 people or institutions. And retail investors were really not one of them. The retail investors are getting a bit of the drag of the market, because you can keep funding these companies through their best growth cycle, and they're not getting a great deal. I would say for IPOs it's a bad game to play if you're a retail investor generally. Wait it out as an onset. In a year, we'll see whether Mark Zuckerberg is able to execute on his strategy to make money from this fabulous creation of his.
All right. Rob Cox, Anant Sundaram, thank you both very much.
End transcript: Video 3 Facebook’s ‘botched’ IPO: what went wrong and why?
Video 3 Facebook’s ‘botched’ IPO: what went wrong and why?
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What factors discussed in the video do you think are the most likely to have caused Facebook’s ‘botched’ IPO?

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One interpretation of Facebook’s botched’ IPO could be that going public was the right choice in order to grow the business. However, investors overvalued the company with respect to its fundamentals (e.g. data about earnings and sales growth, market share, etc.). Facebook’s valuation reached over 100 times its revenues. After the initial ‘euphoria’, investors acknowledged the discrepancy between the earnings (coming entirely from selling adverts) and its astonishingly high valuation. The share price started to lose value, reaching a new, disappointing, level.

In this section you have learned about the key steps in the process of stock issuance. The next section describes the other tool available to Plcs (as well as governments) to acquire financial resources, namely bond issuance.


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