Brian Ghilliotti

Naugatuk Valley Community College

Money and Banking

Chapter 10 Summary

4/1/2018

Firms do not seek public equity until they are ready to sell at least $50 million worth of
stock. Public offerings of stock are feasible only if the firm has large enough 
shareholder base to support it in an active secondary market.

There are also many fixed cost associated with seeking public equity, which would be
cost prohibitive for a firm to raise only a small amount of funds.

Even if a firm is capable of selling $50 million worth of stock, it may not have a long
enough history of stable business performance that it can refer to while raising money
from a large number of investors. Private firms needing large equity investment that are
not yet in a position to go public sometimes seek funding from venture capital funds.

These funds to receive money from wealthy investors and pension funds who are
willing to maintain an investment for a long period of time. These investors are not
allowed to withdraw their money before specific deadline.

The venture capital market brings together private businesses needing equity funding
and the venture capital funds that could provide this funding. 

When VCs see proposals that they believe have much potential, it may arrange a
meeting with the business owners and request more detailed information. Many
proposals are rejected sense VC funds recognize that the majority of new businesses
ultimately fail. 

If one of these funds decides to invest in a business, it will negotiate the terms of its
investment, to include amount of funds it is going to invest. It will also set up their
requirements that the firm must meet and set up detailed progress reports. When VC
funds invest in a firm, the fund managers have an incentive to ensure that the business
performs well. In some cases VC fund manager acts as a business advisors.

VC funds typically plan to exit from its original investment within 4 to 7 years. The
common exit strategy is to sell shares to the public after the business engages in a
public stock offering. Many VC funds sell their shares of the business in which they
invest during the first 6 to 24 months after the business goes public.

The performance of the VC funds tends to vary over time. When stock prices are low,
VC funds can invest their money more wisely under conditions where companies have
a better chance of earning decent returns. When stock prices are high, VC funds may
pay too much with investing in companies.

Private equity funds pool equity funding provided by institutional investors and invest in
businesses. They also rely heavily on borrowing to finance their investments. Unlike VC
funds, private equity funds commonly take over businesses and manage them.

Some critics suggest that private equity firm‘s destroy firms by laying off employees.
Yet private equity firm‘s may counter that the firms they target are overstaffed need
restructuring to help them survive.

Performance of private equity firm‘s turned varies over time. Like VC funds, private
equity funds invest more wisely when stocks are low. However, if they invest in
companies while stock prices are high, private equity funds may be subject to large
losses, even if they can improve the firms operations.

When a firm goes public, it issues stock in the primary market in exchange for cash.
This changes the firm’s ownership structure by increasing the number of owners. It
changes the firms, capital structure by increasing the equity investment in the firm,
allowing the firm to pay off some of its debt. It also enables corporations to finance
growth.

A stock is a certificate representing partial ownership and the firm. A purchaser of

stock becomes a part owner of the firm, not a creditor.

Stock markets are like other financial markets by linking surplus units with deficit units.

There is also a secondary market for stocks that allows investors to sell stock they
previously purchased to other investors who want to buy it.

Ownership of common stock and entitles shareholders to a number of rights. Owners

of common stock are permitted to vote on certain key matters concerning the firm,
such as the election of the Board of Directors, authorization to issue new shares of
common stock, add amendments of the corporate charter, etc. Investors make their
votes to management by use of a proxy.

Preferred stock is the type of equity interest in a firm that usually does not allow for
significant voting rights. Preferred shareholders share the ownership of the firm with
common shareholders and are therefore compensated only when earnings have been
generated. Thus if firm doesn’t have sufficient earnings to pay for the preferred stock
dividends, it may omit the dividend without fear of being forced into bankruptcy.  A
provision on most preferred stock for is to pay dividends to preferred stock owners first
before common stock holders.

Because the dividends of preferred stock can be omitted, firms assume less risk when
issuing it in comparison to issuing bonds. However, a firm that omits preferred stock
dividends may be unable to raise new capital until the omitted dividends have been
paid. Because the firm is not legally required to pay preferred stock dividends, they
must entice the investor to assume the risk involved by offering higher dividends.

Investors can be classified as individual or institutional.

Investors make decisions to buy a stock when its market prices are below their
valuation, which means they believe the stock is undervalued. They may sell their
holdings of a stock when the market price is above their valuation, which means they
believe the stock is overvalued. Stock valuation drives  investment decisions.

When investors revise their expectations of a firm’s performance upwards, they revise
their valuations upward. Conversely, if the investors lowered the firm’s future
performance, they are more likely to sell their stock shares. In this case shares for sale
exceed the demand, placing downward pressure on the market price.

In general, favorable news about a firm’s performance will make investors believe that
the firm’s stock is undervalued out of the prevailing price. Unfavorable news about a
firm’s performance make investors believe that the firm stock is overvalued at its
current price.

Each stock has its own demand and supply conditions, and therefore has a unique
market price. However, new information about macroeconomic conditions commonly
causes expectations for many firms to be revised in a similar direction, and therefore
causes stock prices to move in the same direction.

Investors continue to respond to new information in real time to purchase stock at

prices they consider as under valued or sell their stock  shares when they believe they
are overvalued.

When corporations first issues stocks to the public in order to raise funds, this is a
process called an initial public offering. In IPO not only obtain new funding, but also
offer some founders and VC funds a way to cash out of their investments. A typical IPO
is at least $50 million.

If a firm plans on going public, it normally hires a securities firm that serves as the lead
underwriter for the initial public offering. The lead underwriter is involved in the
development of the prospectus and pricing and placement of the shares.

A few months before the IPO, the issuing firm develops a prospectus and files it with
the security exchange commission. The prospectus contains detailed information
about the firm and includes Financial Statements in the discussion of the risks
involved.  It’s intention is to provide potential investors with information they need to
decide whether to invest in the firm.

Once the SEC approves the prospectus, it is sent to institutional investors who may
want to invest in the IPO. In addition, the firms management and the underwriters of
the IPO can meet with institutional investors in meetings called road shows.  These are
face-to-face meetings set up at different places in the country and are designed to
promote the initial public offering.

Before a firm goes public, it tries to gauge the price that will be paid for at shares. They
usually rely on the lead underwriter to determine the so-called offer price. The valuation
of the firm should equal to the present value of the firm’s future cash flow’s. Although
future cash flows are uncertain,  the lead underwriter may forecast future cash flow‘s
based on the firms recent earnings.

The offer price may also be influenced by prevailing market and industry conditions.

The lead underwriter may rely on a group of other securities firms to participate in the
underwriting process, which is called a syndicate. Each underwriter in the syndicate
contacts Institutional investors and informs of them of the initial public offering. The
transaction costs of the  firm issuing the initial public offering is usually 7% of the funds
raised.

The lead underwriter’s performance can be partially measured by the movement of the
initial public offering’s share price following its initial issue. If investors quickly sell the
stock that they purchased during the initial public offering in the secondary market,
there will be downward pressure on the stocks price. Underwriters may attempt to
stabilize the stock’s price by purchasing shares that are for sale in the secondary
market  shortly after the initial public offer. 

The lead underwriter, to ensure stability in the Stocks price after the offering, may
require lock up provisions, which prevents the original owners of the firm and the VC
firms from selling their shares for a specified period. The purpose of the lock up
provision is to prevent downward pressures on prices that could occur if the original
owners or the VC firms immediately sell their initial public offering shares in the
secondary market.

Initial public offerings occur more frequently during bull stock markets. Potential
investors are more interested in purchasing new stocks.  Prices of stocks tend to be
higher in these periods, and issuing firms attempt to capitalize on such introductory
prices.

Some investors who are aware of the unusually high returns of initial public offerings
may attempt to purchase the stock at its initial price and sell the stock shortly
afterward. This is referred to as flipping. Investors engaging flipping have no intention
of investing in the firm for the long run, and are simply interested in capitalizing on the
initial return that occurs for many initial public offerings.

Spinning occurs when the underwriter allocates shares from an IPO to corporate
executives you may be considering an IPO or to another business requiring the help of
a security firm. The underwriter hopes that the executives will remember the favor and
hire the securities firm in the future.

Some brokers may charge excess commissions when demand is high for an initial
public offering.  Investors are willing to pay the price because they could normally
recover the cost from the return on the first day.

Prior to an initial public offering, you must disclose financial statement summarizes,
revenues, expenses, financial conditions. Many investors use this information to derive
the valuation of the firm,  which can be used to determine a value per share based on
the firm’s number of shares. Some financial statements are distorted, and so may be
the valuations.

There is strong evidence that on average initial public offering perform poorly over a
year or longer. From a long-term perspective. many IPOs are overpriced at the time of
the Issue.

A secondary stock offering is a new stock offering after a stock is already publicly
traded. Some firms are engaged in several secondary offerings to support expansion.

When corporate managers believe that a firm’s stock is undervalued, it could purchase
a portion of its shares in the market at relatively low prices based on their valuation the
stock. Firms tend to repurchase some of their shares when share prices are at low
levels.

Floor brokers are either commission brokers or independent brokers. Commission

brokers are employed by brokerage firm‘s and execute orders for clients on the floor of
the New York Stock Exchange. Independent brokers trade for on their own account
and are not employed by any particular brokerage firm. However they sometimes
handle the overflow for brokerage firm‘s or orders for brokerage firms that do not have
full-time brokers. Specialists can match orders of buyers and sellers. In addition they
can buy or sell stock on their own account, creating more liquidity for the stock.

Some exchanges offer extended training sessions beyond normal trading hours.

Stocks not listed on the organized exchanges are traded in the over-the-counter
market. Unlike the organized exchanges, the over-the-counter market does not have a
trading floor. Buy and sell orders are completed through the Internet.

Standard quotations include the stocks price to earnings ratio, which represents a
prevailing stock price per share, divided by the firms earnings per share, generated
over the last year.

Dow Jones industrial average is evaluates average stock prices of 30 large US

companies.

Standard & Poor’s 500 index evaluates stock prices of 500 large US firms.

Wilshire 5000 total market index was created in 1974 to reflect the values 5000 US
stocks. It has since expanded.

The New York Stock Exchange provides quotations on indexes that it has created. The
composite index is the average of all stocks traded on the New York Stock Exchange.
It is an excellent indicator of the general performance of stocks traded on the New York
Stock Exchange

The NASDAQ provides quotations on indexes of stocks traded electronically . It is a

useful indicator of mall stock performance because many small stocks trade on that 
exchange.

The separation of ownership by shareholders and control by managers can result in

agency problems, leading to conflicting interests. Managers may be tempted to serve
their own interest rather than those of the investors who own the firm’s stock. Many
institutional investors with millions of shares of a single firm do have an incentive to
pressure managers to serve the shareholders interests.

All the stock analyst can provide useful information for investors, they have been
historically very generous when analyzing stocks.

US stock exchanges impose new rules to prevent conflicts of interest faced by

analysts. First, analysts cannot be  supervises by the division providing advisory
services. Secondly, security firms must disclose some past analyst ratings for all the
firms rated by the analyst so that investors can determine whether the ratings are too
optimistic.

Sarbanes-Oxley act was enacted in 2002 to ensure more accurate disclosures of

financial information to investors, therefore allowing investors to affectively monitor the
financial conditions of firms.

Satisfying the Sarbanes Oxley act can be very costly.  As a result many small publicly
traded firms decided to revert back to private ownership as a result of the act.

Shareholders can communicate concerns to managers to place more pressure on the

firm’s managers. Institutional investors commonly communicate with high-level
corporate managers and have opportunity to offer their concerns about the firm’s
operations

Shareholders may also engage in proxy contest and attempt to change the
composition of the board.

Investors may sue  the board if they believe that the directors are not meeting
responsibilities to the shareholders.

With managers showing increase the governance, there is some evidence that the
governance Is not very affective. There are numerous examples of executives receiving
high compensation even when  performance of the firm is weak.

When corporate managers notice another firm in the same industry with low stock
prices as a result of poor management, they may attempt to acquire the firm. They
hope to purchase the business at the low price and improve its management so they
can increase the value of the business. In addition, the combination of the two firms
may reduce redundancy and allow for synergistic benefits.

Leverage buyouts or acquisitions require substantial amounts and borrowed funds.

When these occur,  the goal is to make the firm that was bought more productive and
profitable with the intent of selling it and a higher price later on.

Some firms have added anti takeover amendments to their corporate charter.

Poison pills are special rights awarded to shareholders are specific managers on the
occurrence of specified events such as leveraged buy outs. Make LBO’s more
expensive.

Golden parachute specify compensation for managers in the event that they lose their
job or there is a change in the control of the firm. Make LBO’s more expensive.

The legal protection of shareholders differ substantially among different countries. The
government enforcement of security laws also varies among countries.  The degree of
financial information that must be provided by public companies also varies in different
countries. In general, more investors prefers stock markets in countries provide voting
rights and legal protection for shareholders, strictly enforce laws, do not tolerate
corruption, and impose tough accounting requirements.

Methods used to invest in foreign stock markets include direct purchases, International
Mutual Fund, International Exchange Traded Funds, and American Depository Receipts
(ADRs). Many non-US companies establish ADRs in order to develop name recognition
in the United States. In addition some companies wish to raise funds in the US.