value on the business. After this first-stage financing, your companyâ€™s balance sheet
looks like this:
FIRST-STAGE MARKET-VALUE BALANCE SHEET
(figures in millions)
Assets Liabilities and Shareholdersâ€™ Equity
Cash from new equity $ .5 New equity from venture capital $ .5
Other assets .5 Your original equity .5
Value $1.0 Value $1.0
Why might the venture capital company prefer to put up only part of the funds up-
front? Would this affect the amount of effort put in by you, the entrepreneur? Is your
520 SECTION FIVE
willingness to accept only part of the venture capital that will eventually be needed a
good signal of the likely success of the venture?
Suppose that 2 years later your business has grown to the point at which it needs a
further injection of equity. This second-stage financing might involve the issue of a fur-
ther 1 million shares at $1 each. Some of these shares might be bought by the original
backers and some by other venture capital firms. The balance sheet after the new fi-
nancing would then be as follows:
SECOND-STAGE MARKET-VALUE BALANCE SHEET
(figures in millions)
Assets Liabilities and Shareholdersâ€™ Equity
Cash from new equity $1.0 New equity from second-stage financing $1.0
Other assets 2.0 Equity from first stage 1.0
Your original equity 1.0
Value $3.0 Value $3.0
Notice that the value of the initial 1 million shares owned by you and your friends
has now been marked up to $1 million. Does this begin to sound like a money machine?
It was so only because you have made a success of the business and new investors are
prepared to pay $1 to buy a share in the business. When you started out, it wasnâ€™t clear
that sushi and sauerkraut would catch on. If it hadnâ€™t caught on, the venture capital firm
could have refused to put up more funds.
You are not yet in a position to cash in on your investment, but your gain is real. The
second-stage investors have paid $1 million for a one-third share in the company. (There
are now 3 million shares outstanding, and the second-stage investors hold 1 million
shares.) Therefore, at least these impartial observersâ€”who are willing to back up their
opinions with a large investmentâ€”must have decided that the company was worth at
least $3 million. Your one-third share is therefore also worth $1 million.
For every 10 first-stage venture capital investments, only two or three may survive
as successful, self-sufficient businesses, and only one may pay off big. From these sta-
tistics come two rules of success in venture capital investment. First, donâ€™t shy away
from uncertainty; accept a low probability of success. But donâ€™t buy into a business un-
less you can see the chance of a big, public company in a profitable market. Thereâ€™s no
sense taking a big risk unless the reward is big if you win. Second, cut your losses; iden-
tify losers early, and, if you canâ€™t fix the problemâ€”by replacing management, for ex-
ampleâ€”donâ€™t throw good money after bad.
The same advice holds for any backer of a risky startup businessâ€”after all, only a
fraction of new businesses are funded by card-carrying venture capitalists. Some start-
ups are funded directly by managers or by their friends and families. Some grow using
bank loans and reinvested earnings. But if your startup combines high risk, sophisti-
cated technology, and substantial investment, you will probably try to find venture-
The Initial Public Offering
Very few new businesses make it big, but those that do can be very profitable. For ex-
ample, an investor who provided $1,000 of first-stage financing for Intel would by mid-
2000 have reaped $43 million. So venture capitalists keep sane by reminding them-
How Corporations Issue Securities 521
selves of the success stories1â€”those who got in on the ground floor of firms like Intel
and Federal Express and Lotus Development Corporation.2 If a startup is successful, the
firm may need to raise a considerable amount of capital to gear up its production ca-
pacity. At this point, it needs more capital than can comfortably be provided by a small
number of individuals or venture capitalists. The firm decides to sell shares to the pub-
lic to raise the necessary funds.
A firm is said to go public when it sells its first issue of shares in a general
offering to investors. This first sale of stock is called an initial public offering,
offering of stock to the
An IPO is called a primary offering when new shares are sold to raise additional cash
for the company. It is a secondary offering when the companyâ€™s founders and the ven-
ture capitalist cash in on some of their gains by selling shares. A secondary offer there-
fore is no more than a sale of shares from the early investors in the firm to new in-
vestors, and the cash raised in a secondary offer does not flow to the company. Of
course, IPOs can be and commonly are both primary and secondary: the firm raises new
cash at the same time that some of the already-existing shares in the firm are sold to the
public. Some of the biggest secondary offerings have involved governments selling off
stock in nationalized enterprises. For example, the Japanese government raised $12.6
billion by selling its stock in Nippon Telegraph and Telephone and the British govern-
ment took in $9 billion from its sale of British Gas. The worldâ€™s largest IPO took place
in 1999 when the Italian government raised $19.3 billion from the sale of shares in the
state-owned electricity company, Enel.
ARRANGING A PUBLIC ISSUE
Once a firm decides to go public, the first task is to select the underwriters.
Underwriters are investment banking firms that act as financial midwives to a
that buys an issue of
new issue. Usually they play a triple roleâ€”first providing the company with
securities from a company
procedural and financial advice, then buying the stock, and finally reselling it
and resells it to the public.
to the public.
A small IPO may have only one underwriter, but larger issues usually require a syn-
dicate of underwriters who buy the issue and resell it. For example, the initial public of-
fering by Microsoft involved a total of 114 underwriters.
In the typical underwriting arrangement, called a firm commitment, the underwriters
buy the securities from the firm and then resell them to the public. The underwriters re-
SPREAD ceive payment in the form of a spreadâ€”that is, they are allowed to sell the shares at a
between public offer price
slightly higher price than they paid for them. But the underwriters also accept the risk
and price paid by
that they wonâ€™t be able to sell the stock at the agreed offering price. If that happens, they
will be stuck with unsold shares and must get the best price they can for them. In the
more risky cases, the underwriter may not be willing to enter into a firm commitment
and handles the issue on a best efforts basis. In this case the underwriter agrees to sell
as much of the issue as possible but does not guarantee the sale of the entire issue.
522 SECTION FIVE
Before any stock can be sold to the public, the company must register the stock with
the Securities and Exchange Commission (SEC). This involves preparation of a detailed
and sometimes cumbersome registration statement, which contains information about
the proposed financing and the firmâ€™s history, existing business, and plans for the fu-
ture. The SEC does not evaluate the wisdom of an investment in the firm but it does
check the registration statement for accuracy and completeness. The firm must also
comply with the â€śblue-skyâ€ť laws of each state, so named because they seek to protect
the public against firms that fraudulently promise the blue sky to investors.3
The first part of the registration statement is distributed to the public in the form of
a preliminary prospectus. One function of the prospectus is to warn investors about the
risks involved in any investment in the firm. Some investors have joked that if they read
summary that provides
prospectuses carefully, they would never dare buy any new issue. The appendix to this
information on an issue of
material is a possible prospectus for your fast-food business.
The company and its underwriters also need to set the issue price. To gauge how
much the stock is worth, they may undertake discounted cash-flow calculations like
those described earlier. They also look at the price-earnings ratios of the shares of the
firmâ€™s principal competitors.
Before settling on the issue price, the underwriters may arrange a â€śroadshow,â€ť which
gives the underwriters and the companyâ€™s management an opportunity to talk to poten-
tial investors. These investors may then offer their reaction to the issue, suggest what
they think is a fair price, and indicate how much stock they would be prepared to buy.
This allows the underwriters to build up a book of likely orders. Although investors are
not bound by their indications, they know that if they want to remain in the underwrit-
ersâ€™ good books, they must be careful not to renege on their expressions of interest.
The managers of the firm are eager to secure the highest possible price for their
stock, but the underwriters are likely to be cautious because they will be left with any
unsold stock if they overestimate investor demand. As a result, underwriters typically
try to underprice the initial public offering. Underpricing, they argue, is needed to
tempt investors to buy stock and to reduce the cost of marketing the issue to customers.
Issuing securities at an
offering price set below the
Underpricing represents a cost to the existing owners since the new investors
true value of the security.
are allowed to buy shares in the firm at a favorable price. The cost of
underpricing may be very large.
It is common to see the stock price increase substantially from the issue price in the
days following an issue. Such immediate price jumps indicate the amount by which the
shares were underpriced compared to what investors were willing to pay for them. A
study by Ibbotson, Sindelar, and Ritter of approximately 9,000 new issues from 1960 to
1987 found average underpricing of 16 percent.4 Sometimes new issues are dramati-
cally underpriced. In November 1998, for example, 3.1 million shares in theglobe.com
3 Sometimes states go beyond blue-sky laws in their efforts to protect their residents. In 1980 when Apple
Computer Inc. made its first public issue, the Massachusetts state government decided the offering was too
risky for its residents and therefore banned the sale of the shares to investors in the state. The state relented
later, after the issue was out and the price had risen. Massachusetts investors obviously did not appreciate this
4 R. G. Ibbotson, J. L. Sindelar, and J. R. Ritter, â€śInitial Public Offerings,â€ť Journal of Applied Corporate Fi-
nance 1 (Summer 1988), pp. 37â€“45. Note, however, that initial underpricing does not mean that IPOs are su-
perior long-run investments. In fact, IPO returns over the first 3 years of trading have been less than a con-
trol sample of matching firms. See J. R. Ritter, â€śThe Long-Run Performance of Initial Public Offerings,â€ť
Journal of Finance 46 (March 1991), pp. 3â€“27.
Project Analysis 523
were sold in an IPO at a price of $9 a share. In the first day of trading 15.6 million
shares changed hands and the price at one point touched $97. Unfortunately, the bo-
nanza did not last. Within a year the stock price had fallen by over two-thirds from its
first-day peak. The nearby box reports on the phenomenal performance of Internet IPOs
in the late 1990s.
Underpricing of IPOs
Suppose an IPO is a secondary issue, and the firmâ€™s founders sell part of their holding
to investors. Clearly, if the shares are sold for less than their true worth, the founders
will suffer an opportunity loss.
But what if the IPO is a primary issue that raises new cash for the company? Do the
founders care whether the shares are sold for less than their market value? The follow-
ing example illustrates that they do care.
Suppose Cosmos.com has 2 million shares outstanding and now offers a further 1
million shares to investors at $50. On the first day of trading the share price jumps to
$80, so that the shares that the company sold for $50 million are now worth $80 mil-
lion. The total market capitalization of the company is 3 million Ă— $80 = $240 million.
The value of the foundersâ€™ shares is equal to the total value of the company less the
value of the shares that have been sold to the publicâ€”in other words, $240 â€“ $80 = $160
million. The founders might justifiably rejoice at their good fortune. However, if the
company had issued shares at a higher price, it would have needed to sell fewer shares
to raise the $50 million that it needs, and the founders would have retained a larger
share of the company. For example, suppose that the outside investors, who put up $50
million, received shares that were worth only $50 million. In that case the value of the
foundersâ€™ shares would be $240 â€“$50 = $190 million.
The effect of selling shares below their true value is to transfer $30 million of value
from the founders to the investors who buy the new shares.
Unfortunately, underpricing does not mean that anyone can become wealthy by buy-
ing stock in IPOs. If an issue is underpriced, everybody will want to buy it and the un-
derwriters will not have enough stock to go around. You are therefore likely to get only
a small share of these hot issues. If it is overpriced, other investors are unlikely to want
it and the underwriter will be only too delighted to sell it to you. This phenomenon is
known as the winnerâ€™s curse.5 It implies that, unless you can spot which issues are un-
derpriced, you are likely to receive a small proportion of the cheap issues and a large
proportion of the expensive ones. Since the dice are loaded against uninformed in-
vestors, they will play the game only if there is substantial underpricing on average.
Underpricing of IPOs and Investor Returns
Suppose that an investor will earn an immediate 10 percent return on underpriced IPOs
and lose 5 percent on overpriced IPOs. But because of high demand, you may get only
5The highest bidder in an auction is the participant who places the highest value on the auctioned object.
Therefore, it is likely that the winning bidder has an overly optimistic assessment of true value. Winning the
auction suggests that you have overpaid for the objectâ€”this is the winnerâ€™s curse. In the case of IPOs, your
ability to â€świnâ€ť an allotment of shares may signal that the stock is overpriced.
FINANCE IN ACTION
Internet Shares: Loopy.com?
The value being placed on Broadcast.com is not ob-
The tiny images are like demented postage stamps
viously loopier than a number of other gravity-defying
coming jerkily to life; the sound is prone to break up and
Internet stocks, particularly the currently fashionable
at times could be coming from a bathroom plughole.
â€ś portalsâ€ť â€” gateways to the Webâ€” such as Yahoo! and
Welcome to the Internet live broadcasting experience.
America Online. Yahoo!, the Internetâ€™s leading content
However, despite offering audio-visual quality that
aggregator, has nearly doubled in value since June. On
would have been unacceptable in the pioneering days
the back of revenue estimates of around $165m, it has
of television, a small, loss-making company called
a market value of $8.7 billion.
Broadcast.com broke all previous records when it made
Mark Hardie, an analyst with the high-tech con-
its Wall Street debut on July 17th.
sultancy Forrester Research, does not believe, in any
Shares in the Dallas-based company were offered at