An Example of a Followon Offering

"New" and "Old" Shares

There are two types of shares that are sold in secondary offerings. When a company requires additional growth capital, it sells "new" shares to the public. When an existing shareholder wishes to sell a huge block of stock, "old" shares are sold to the public. Follow-on offerings often include both types of shares.

Let's look at an example. Suppose Acme Company wished to raise $100 million to fund certain growth prospects. Suppose that at the same time, its biggest shareholder, a venture capital firm, was looking to "cash out," or sell its stock.

Assume the firm already had 100 million shares of stock trading in the market. Let's also say that Acme's stock price traded most recently at $10 per share. The current market value of the firm's equity is:

$10 x 100,000,000 shares = $1,000,000,000 ($1 billion)

Say XYZ Venture Capitalists owned 10 million shares (comprising 10 percent of the firm's equity). They want to sell all of their equity in the firm, or the entire 10 million shares. And to raise $100 million of new capital, Acme would have to sell 10 million additional (or new) shares of stock to the public. These shares would be newly created during the offering process. In fact, the prospectus for the follow-on, usually called an S-2 or S-3 (as opposed to the S-1 for the IPO), legally "registers" the stock with the SEC, authorizing the sale of stock to investors.

The total size of the deal would thus need to be 20 million shares, 10 million of which are "new" and 10 million of which are coming from the selling shareholders, the VC firm. Interestingly, because of the additional shares and what is called "dilution of earnings" or "dilution of EPS," stock prices typically trade down upon a follow-on offering announcement. (Of course, this only happens if the stock to be issued in the deal is "new" stock.)

After this secondary offering is completed, Acme would have 110 million shares outstanding, and its market value would be $1.1 billion if the stock remains at $10 per share. And, the shares sold by XYZ Venture Capitalists will now be in the hands of new investors in the form of freely tradable securities.

Market reaction. What happens when a company announces a secondary offering indicates the market's tolerance for additional equity. Because more shares of stock "dilute" the old shareholders, and "dumps" shares of stock for sale on the market, the stock price usually drops on the announcement of a follow-on offering. Dilution occurs because earnings per share (EPS) in the future will decline, simply based on the fact that more shares will exist post-deal. And since EPS drives stock prices, the share price generally drops.

The process. The follow-on offering process differs little from that of an IPO, and actually is far less complicated. Since underwriters have already represented the company in an IPO, a company often chooses the same managers, thus making the hiring the manager or beauty contest phase much simpler. Also, no real valuation work is required (the market now values the firm's stock), a prospectus has already been written, and a roadshow presentation already prepared. Modifications to the prospectus and the roadshow demand the most time in a follow-on offering, but still can usually be completed with a fraction of the effort required for an initial offering.

Bond Offerings

When a company requires capital, it sometimes chooses to issue public debt instead of equity. Almost always, however, a firm undergoing a public bond deal will already have stock trading in the market. (It is relatively rare for a private company to issue bonds before its IPO.)

The reasons for issuing bonds rather than stock are various. Perhaps the stock price of the issuer is down, and thus a bond issue is a better alternative. Or perhaps the firm does not wish to dilute its existing shareholders by issuing more equity. Or perhaps a company is quite profitable and wants the tax deduction from paying bond interest, while issuing stock offers no tax deduction. These are all valid reasons for issuing bonds rather than equity. Sometimes in down markets, investor appetite for public offerings dwindles to the point where an equity deal just could not get done (investors would not buy the issue).

The bond offering process resembles the IPO process. The primary difference lies in: (1) the focus of the prospectus (a prospectus for a bond offering will emphasize the company's stability and steady cash flow, whereas a stock prospectus will usually play up the company's growth and expansion opportunities), and (2) the importance of the bond's credit rating

Stock and Bond Offerings

(the company will want to obtain a favorable credit rating from a debt rating agency like S&P or Moody's, with the help of the "credit department" of the investment bank issuing the bond; the bank's credit department will negotiate with the rating agencies to obtain the best possible rating). As covered in Chapter 5, the better the credit rating - and therefore, the safer the bonds - the lower the interest rate the company must pay on the bonds to entice investors to buy the issue. Clearly, a firm issuing debt will want to have the highest possible bond rating, and hence pay a lower interest rate (or yield).

As with stock offerings, investment banks earn underwriting fees on bond offerings in the form of an underwriting discount on the proceeds of the offering. The percentage fee for bond underwriting tends to be lower than for stock underwriting. For more detail on your role as an investment banker in stock and bond offerings, see Chapter 8.

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