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Sale of securities open to all lows the same procedure used when it first went public. This means that it must first
investors by an already- register the issue with the SEC and draw up a prospectus.8 Before settling on the issue
public company. price, the underwriters will usually contact potential investors and build up a book of

8 The procedure is similar when a company makes an international issue of bonds or equity, but as long as
these issues are not sold publicly in the United States, they do not need to be registered with the SEC.
How Corporations Issue Securities 529

likely orders. The company will then sell the issue to the underwriters, and they in turn
will offer the securities to the public.
Companies do not need to prepare a separate registration statement every time they
issue new securities. Instead, they are allowed to file a single registration statement cov-
ering financing plans for up to 2 years into the future. The actual issues can then be sold
to the public with scant additional paperwork, whenever the firm needs cash or thinks
it can issue securities at an attractive price. This is called shelf registration”the regis-
tration is put “on the shelf,” to be taken down, dusted off, and used as needed.
A procedure that allows firms
Think of how you might use shelf registration when you are a financial manager.
to file one registration
Suppose that your company is likely to need up to $200 million of new long-term debt
statement for several issues
over the next year or so. It can file a registration statement for that amount. It now has
of the same security.
approval to issue up to $200 million of debt, but it isn™t obliged to issue any. Nor is it
required to work through any particular underwriters”the registration statement may
name the underwriters the firm thinks it may work with, but others can be substituted
Now you can sit back and issue debt as needed, in bits and pieces if you like. Sup-
pose Merrill Lynch comes across an insurance company with $10 million ready to in-
vest in corporate bonds, priced to yield, say, 7.3 percent. If you think that™s a good deal,
you say “OK” and the deal is done, subject to only a little additional paperwork. Mer-
rill Lynch then resells the bonds to the insurance company, hoping for a higher price
than it paid for them.
Here is another possible deal. Suppose you think you see a window of opportunity
in which interest rates are “temporarily low.” You invite bids for $100 million of bonds.
Some bids may come from large investment bankers acting alone, others from ad hoc
syndicates. But that™s not your problem; if the price is right, you just take the best deal
Thus shelf registration gives firms several different things that they did not have pre-
1. Securities can be issued in dribs and drabs without incurring excessive costs.
2. Securities can be issued on short notice.
3. Security issues can be timed to take advantage of “market conditions” (although any
financial manager who can reliably identify favorable market conditions could make
a lot more money by quitting and becoming a bond or stock trader instead).
4. The issuing firm can make sure that underwriters compete for its business.
Not all companies eligible for shelf registration actually use it for all their public is-
sues. Sometimes they believe they can get a better deal by making one large issue
through traditional channels, especially when the security to be issued has some unusual
feature or when the firm believes it needs the investment banker™s counsel or stamp of
approval on the issue. Thus shelf registration is less often used for issues of common
stock than for garden-variety corporate bonds.

Whenever a firm makes a cash offer, it incurs substantial administrative costs. Also, the
firm needs to compensate the underwriters by selling them securities below the price
that they expect to receive from investors. Figure 5.7 shows the average underwriting
spread and administrative costs for several types of security issues in the United States.9
9These figures do not capture all administrative costs. For example, they do not include management time
spent on the issue.

Total direct costs as a percentage of gross proceeds. The total direct costs for initial
public offerings (IPOs), seasoned equity offerings (SEOs), convertible bonds, and
straight bonds are composed of underwriter spreads and other direct expenses.


IPOs Convertibles
SEOs Bonds
Total direct costs (%)



2“ 9.99 10“ 19.99 20“ 39.99 40“ 59.99 60“ 79.99 80“ 99.99 100“ 199.99 200“ 499.99 500“ up
Proceeds ($ millions)

Source: Immoo Lee, Scott Lochhead, Jay Ritter, and Quanshui Zhao, “The Costs of Raising Capital,” Journal of Financial Research 19 (Spring
1996), pp. 59“74. Copyright © 1996. Reprinted by permission.

The figure clearly shows the economies of scale in issuing securities. Costs may ab-
sorb 15 percent of a $1 million seasoned equity issue but less than 4 percent of a $500
million issue. This occurs because a large part of the issue cost is fixed.
Figure 5.7 shows that issue costs are higher for equity than for debt securities”the
costs for both types of securities, however, show the same economies of scale. Issue
costs are higher for equity than for debt because administrative costs are somewhat
higher, and also because underwriting stock is riskier than underwriting bonds. The un-
derwriters demand additional compensation for the greater risk they take in buying and
reselling equity.

Use Figure 5.7 to compare the costs of 10 issues of $15 million of stock in a seasoned
Self-Test 4
offering versus one issue of $150 million.

Because stock issues usually throw a sizable number of new shares onto the market, it
is widely believed that they must temporarily depress the stock price. If the proposed
issue is very large, this price pressure may, it is thought, be so severe as to make it al-
most impossible to raise money.
This belief in price pressure implies that a new issue depresses the stock price tem-
porarily below its true value. However, that view doesn™t appear to fit very well with the
notion of market efficiency. If the stock price falls solely because of increased supply,
How Corporations Issue Securities 531

then that stock would offer a higher return than comparable stocks and investors would
be attracted to it as ants to a picnic.
Economists who have studied new issues of common stock have generally found that
the announcement of the issue does result in a decline in the stock price. For industrial
issues in the United States this decline amounts to about 3 percent.10 While this may not
sound overwhelming, such a price drop can be a large fraction of the money raised. Sup-
pose that a company with a market value of equity of $5 billion announces its intention
to issue $500 million of additional equity and thereby causes the stock price to drop by
3 percent. The loss in value is .03 — $5 billion, or $150 million. That™s 30 percent of the
amount of money raised (.30 — $500 million = $150 million).
What™s going on here? Is the price of the stock simply depressed by the prospect of
the additional supply? Possibly, but here is an alternative explanation.
Suppose managers (who have better information about the firm than outside in-
vestors) know that their stock is undervalued. If the company sells new stock at this low
price, it will give the new shareholders a good deal at the expense of the old share-
holders. In these circumstances managers might be prepared to forgo the new invest-
ment rather than sell shares at too low a price.
If managers know that the stock is overvalued, the position is reversed. If the com-
pany sells new shares at the high price, it will help its existing shareholders at the ex-
pense of the new ones. Managers might be prepared to issue stock even if the new cash
were just put in the bank.
Of course investors are not stupid. They can predict that managers are more likely to
issue stock when they think it is overvalued and therefore they mark the price of the
stock down accordingly.

The tendency for stock prices to decline at the time of an issue may have
nothing to do with increased supply. Instead, the stock issue may simply be a
signal that well-informed managers believe the market has overpriced the

The Private Placement
Whenever a company makes a public offering, it must register the issue with the
SEC. It could avoid this costly process by selling the issue privately. There are no hard-
and-fast definitions of a private placement, but the SEC has insisted that the security
should be sold to no more than a dozen or so knowledgeable investors.
Sale of securities to a limited
number of investors without
a public offering. 10 See, for example, P. Asquith and D. W. Mullins, “Equity Issues and Offering Dilution,” Journal of Finan-
cial Economics 15 (January“February 1986), pp. 61“90; R. W. Masulis and A. N. Korwar, “Seasoned Equity
Offerings: An Empirical Investigation,” Journal of Financial Economics 15 (January“February 1986), pp.
91“118; W. H. Mikkelson and M. M. Partch, “Valuation Effects of Security Offerings and the Issuance
Process,” Journal of Financial Economics 15 (January“February 1986), pp. 31“60. There appears to be a
smaller price decline for utility issues. Also Marsh observed a smaller decline for rights issues in the United
Kingdom; see P. R. Marsh, “Equity Rights Issues and the Efficiency of the UK Stock Market,” Journal of Fi-
nance 34 (September 1979), pp. 839“862.
11 This explanation was developed in S. C. Myers and N. S. Majluf, “Corporate Financing and Investment De-

cisions When Firms Have Information that Investors Do Not Have,” Journal of Financial Economics 13
(1984), pp. 187“222.

One disadvantage of a private placement is that the investor cannot easily resell the
security. This is less important to institutions such as life insurance companies, which
invest huge sums of money in corporate debt for the long haul. However, in 1990 the
SEC relaxed its restrictions on who could buy unregistered issues. Under the new rule,
Rule 144a, large financial institutions can trade unregistered securities among them-
As you would expect, it costs less to arrange a private placement than to make a pub-
lic issue. That might not be so important for the very large issues where costs are less
significant, but it is a particular advantage for companies making smaller issues.
Another advantage of the private placement is that the debt contract can be custom-
tailored for firms with special problems or opportunities. Also, if the firm wishes later
to change the terms of the debt, it is much simpler to do this with a private placement
where only a few investors are involved.
Therefore, it is not surprising that private placements occupy a particular niche in the
corporate debt market, namely, loans to small and medium-sized firms. These are the
firms that face the highest costs in public issues, that require the most detailed investi-
gation, and that may require specialized, flexible loan arrangements.
We do not mean that large, safe, and conventional firms should rule out private
placements. Enormous amounts of capital are sometimes raised by this method. For ex-
ample, AT&T once borrowed $500 million in a single private placement. Nevertheless,
the advantages of private placement”avoiding registration costs and establishing a di-
rect relationship with the lender”are generally more important to smaller firms.
Of course these advantages are not free. Lenders in private placements have to be
compensated for the risks they face and for the costs of research and negotiation. They
also have to be compensated for holding an asset that is not easily resold. All these fac-
tors are rolled into the interest rate paid by the firm. It is difficult to generalize about
the differences in interest rates between private placements and public issues, but a typ-
ical yield differential is on the order of half a percentage point.

How do venture capital firms design successful deals?
Infant companies raise venture capital to carry them through to the point at which they can
make their first public issue of stock. More established publicly traded companies can issue
additional securities in a general cash offer.
Financing choices should be designed to avoid conflicts of interest. This is especially
important in the case of a young company that is raising venture capital. If both managers
and investors have an important equity stake in the company, they are likely to pull in the
same direction. The willingness to take that stake also signals management™s confidence in
the new company™s future. Therefore, most deals require that the entrepreneur maintain large
stakes in the firm. In addition, most venture financing is done in stages that keep the firm
on a short leash, and force it to prove at several crucial points that it is worthy of additional

How do firms make initial public offerings and what are the costs of such offerings?
The initial public offering is the first sale of shares in a general offering to investors. The
sale of the securities is usually managed by an underwriting firm which buys the shares
from the company and resells them to the public. The underwriter helps to prepare a
prospectus, which describes the company and its prospects. The costs of an IPO include
How Corporations Issue Securities 533

direct costs such as legal and administrative fees, as well as the underwriting spread”the
difference between the price the underwriter pays to acquire the shares from the firm and
the price the public pays the underwriter for those shares. Another major implicit cost is the
underpricing of the issue”that is, shares are typically sold to the public somewhat below
the true value of the security. This discount is reflected in abnormally high average returns
to new issues on the first day of trading.

What are some of the significant issues that arise when established firms make a
general cash offer or a private placement of securities?
There are always economies of scale in issuing securities. It is cheaper to go to the market
once for $100 million than to make two trips for $50 million each. Consequently, firms
“bunch” security issues. This may mean relying on short-term financing until a large issue
is justified. Or it may mean issuing more than is needed at the moment to avoid another
issue later.
A seasoned offering may depress the stock price. The extent of this price decline varies,
but for issues of common stocks by industrial firms the fall in the value of the existing stock
may amount to a significant proportion of the money raised. The likely explanation for this
pressure is the information the market reads into the company™s decision to issue stock.
Shelf registration often makes sense for debt issues by blue-chip firms. Shelf
registration reduces the time taken to arrange a new issue, it increases flexibility, and it may
cut underwriting costs. It seems best suited for debt issues by large firms that are happy to
switch between investment banks. It seems least suited for issues of unusually risky
securities or for issues by small companies that most need a close relationship with an
investment bank.
Private placements are well-suited for small, risky, or unusual firms. The special
advantages of private placement stem from avoiding registration expenses and a more direct
relationship with the lender. These are not worth as much to blue-chip borrowers.

What is the role of the underwriter in an issue of securities?
The underwriter manages the sale of the securities for the issuing company. The
underwriting firms have expertise in such sales because they are in the business all the time,
whereas the company raises capital only occasionally. Moreover, the underwriters may give


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