Chapter 10
Stock Offerings and Investor Monitoring
Outline
Private Equity
Financing by Venture Capital Funds
Financing by Private Equity Funds
Financing by Crowdfunding
Public Equity
Initial Public Offerings
Process of Going Public
Long-Term Performance Following IPOs
Stock Offerings and Repurchases
Secondary Stock Offerings
Stock Repurchases
Stock Exchanges
Organized Exchanges
Monitoring Publicly Traded Companies
Role of Analysts
Market for Corporate Control
Use of LBOs to Achieve Corporate Control
Barriers to the Market for Corporate Control
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Globalization of Stock Markets
Key Concepts
1. Explain the role of venture capital funds and private equity funds provide equity financing to firms.
2. Describe the process of an engaging in an initial public offering.
POINT/COUNTER-POINT:
Should a Stock Exchange Enforce Some Governance Standards on the Firms
Listed on the Exchange?
COUNTER-POINT: Yes. By enforcing governance standards such as requiring a listed firm to have a
majority of outside members on its board of directors, a stock exchange can enhance its own credibility.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: An exchange and the listed firms can be viewed as more credible if there are governance
Questions
1. Shareholder Rights. Explain the rights of common stockholders that are not available to other
individuals.
ANSWER: Common stockholders are permitted to vote on key matters concerning the firm such as
amendments to the corporate charter, and adoption of by-laws.
2. Stock Offerings. What is the danger of issuing too much stock? What is the role of the securities firm
that serves as the underwriter, and how can it ensure that the firm does not issue too much stock?
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ANSWER: The issuance of too much stock can cause dilution of ownership and can depress stock
3. IPOs. Why do firms engage in IPOs? What is the amount of fees that the lead underwriter and its
syndicate charge a firm that is going public? Why are there many IPOs in some periods and few IPOs
in other periods?
ANSWER: Firms engage in IPOs when they have feasible expansion plans but are already near their
debt capacity.
4. Venture Capital. Explain the difference between obtaining funds from a venture capital firm and
engaging in an IPO. Explain how the IPO may serve as a means by which the venture capital firm can
cash out.
ANSWER: Before a firm engages in an IPO, it may obtain equity funding from a venture capital firm
5. Prospectus and Road Show. Explain the use of a prospectus developed before an IPO. Why does a
firm do a road show before its IPO? What factors influence the offer price of stock at the time of the
IPO?
ANSWER: A prospectus specifies how the proceeds of the offering are to be used, the past
6. Bookbuilding. Describe the process of bookbuilding. Why is bookbuilding sometimes criticized as a
means of setting the offer price?
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ANSWER: The lead underwriter engages in bookbuilding by soliciting indications of interest in the
7. Lockups. Describe a lockup provision and explain why it is required by the lead underwriter.
ANSWER: Describe the pressure of the share price at the lockup expiration date. The lockup
8. Initial Return. What is the meaning of an initial return for an IPO?
9. Flipping. What does it mean to “flip” shares? Why would investors want to flip shares?
ANSWER: Flipping shares refers to selling shares shortly after (such as a day or two) obtaining them
10. Performance of IPOs. How do IPOs perform over the long run?
11. Asymmetric Information. Discuss the concept of asymmetric information. Explain why it may
motivate firms to repurchase some of their stock.
12. Stock Repurchases. Explain why the stock price of a firm may rise when the firm announces that it
is repurchasing its shares.
13. Corporate Control. Describe how the interaction between buyers and sellers affects the market value
of a firm and explain how that value can subject a firm to the market for corporate control.
ANSWER: If a firm’s business performance is weak, investor demand for shares will typically be
14. ADRs. Explain how ADRs enable U.S. investors to become part owners of foreign companies.
15. NYSE. Explain why stocks traded on the NYSE generally exhibit less risk than stocks that are traded
on other exchanges.
ANSWER: Stocks traded on the NYSE tend to represent larger firms. These stocks also have a large
16. Role of Organized Exchanges. Are organized stock exchanges used to place newly issued stock?
Explain.
ANSWER: Organized exchanges are used to facilitate secondary market transactions. They are not
Advanced Questions
17. Role of IMFs. How have international mutual funds (IMFs) increased the international integration of
capital markets among countries?
ANSWER: International mutual funds (IMFs) have allowed investors easy access to foreign
18. Spinning and Laddering. Describe spinning and laddering in the IPO market. How do you think
these actions influence the price of a newly issued stock? Who is adversely affected as a result of
these actions?
ANSWER: Spinning is the process in which an investment bank allocates shares from an IPO to
corporate executives who may be considering an IPO or other business that would require the help of
19. Impact of Accounting Irregularities. How do you think accounting irregularities affect the pricing
of corporate stock in general? From an investor’s viewpoint, how do you think the information used
to price stocks changes in response to accounting irregularities?
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ANSWER: Generally speaking, accounting irregularities introduce additional uncertainty and risk.
20. Impact of Sarbanes-Oxley Act. Briefly describe the provisions of the Sarbanes-Oxley Act. Discuss
how this act affects the monitoring performed by shareholders.
ANSWER: The Sarbanes-Oxley Act:
1) Prevents a public accounting firm from auditing a client firm whose employees were employed by
the client firm within one year prior to the audit.
monitor firms.
21. IPO Dilemma. Denton Co. plans to engage in an IPO and will issue 4 million shares of stock. It is
hoping to sell the shares for an offer price of $14. It hires a securities firm, which suggests that the
offer price for the stock be $12 per share to ensure that all the shares can be easily sold. Explain the
dilemma here for Denton Co. What is the advantage of following the securities firm’s advice? What is
the disadvantage? Is the securities firm’s incentive to place the shares aligned with that of Denton
Co.?
ANSWER: The advantage is that Denton Co. wants to have a successful offering in which it can sell
22. Variation in Investor Protection among Countries. Explain how shareholder protection varies
among countries. Explain how enforcement of securities laws varies among countries. Why do these
characteristics affect the valuations of stocks?
ANSWER: Shareholders in some countries have more voting power and can have a stronger
23. International ETFs. Describe international ETFs and explain how ETFs are exposed to exchange
rate risk. How do you think an investor decides whether to purchase an ETF representing Japan,
Spain, or some other country?
ANSWER: Exchange-traded funds are passive funds that track a specific index. By investing in an
international exchange-traded fund, investors can invest in a specific index representing a foreign
24. VC Fund Participation and Exit Strategy. Explain how venture capital (VC) funds finance
private businesses, as well as how they exit from their participation in a firm.
ANSWER: VC funds review proposals by private businesses that need funding. If they provide the
business with an equity investment, they may attempt to exit about 4 or 7 years later by selling its
25. Dilemma of Stock Analysts. Explain the dilemma of stock analysts who work for securities firms
and assign ratings to large corporations. Why might they prefer not to assign low ratings to weak but
large corporations?
ANSWER: Although analysts can provide useful information for investors, they have historically
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26. Limitations of an IPO. Businesses valued at less than $50 million or so rarely go public. Explain
the limitations to such businesses if they did go public.
ANSWER: A public offering of stock may be feasible only if the firm will have a large enough
27. Private Equity Funds. Explain the incentive for private equity funds to invest in a firm and improve
its operations.
28. VCs and Lockup Expiration Following IPOs. Venture capital firms commonly attempt to cash out
as soon as possible following IPOs. Describe the likely effect that would have on the stock price at
the time of lockup expiration. Would the effect be different for a firm that relied more heavily on VC
firms than on other investors for its funds?
ANSWER: If many VC firms are selling their shares at lockup expiration, there is downward pressure
29. Impact of SOX on Going Private. Explain why some public firms decided to go private in response
to the passage of the Sarbanes-Oxley (SOX) Act.
ANSWER: For many firms, the cost of adhering to the guidelines of the act exceeds $1 million per
30. Pricing Facebook’s IPO Stock Price. Describe the dilemma of securities firms that served as
underwriters for Facebook’s IPOs, when attempting to satisfy Facebook and the institutional investors
that invested in Facebook’s stock. Do you think that the securities firms satisfied Facebook or its
investors in the IPO? Explain.
ANSWER: Based on the stock price movements over the first few months after the IPO, one may
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31. Private Stock Market. What are some possible disadvantages to investors who invest in stocks
listed on a private stock market?
ANSWER: Investors need to register with the private stock exchange and prove that they have
32. Use of Financial Leverage by Private Equity Funds Explain why private equity funds use a very
high degree of financial leverage, and how this affects their risk and potential return on investment.
ANSWER:
Private equity funds tend to rely heavily on borrowing to finance their investments. This enables them
to purchase larger companies or to buy more businesses with a given level of equity. Their use of
financial leverage also magnifies the return that they earn on their equity investment. However, if
33. Overallotment Option in IPOs. Explain how underwriters use the overallotment option in IPOs.
ANSWER:
The overallotment option gives the lead underwriter the right to purchase those extra shares from the
34. Designated Market Maker on NYSE. Describe the role of the designated market maker on the New
York Stock Exchange.
ANSWER:
Chapter 10: Stock Offerings and Investor Monitoring ❖ 10
In 2008, the specialist was replaced with the designated market maker (DMM). The DMMs can match
CRITICAL THINKING QUESTION
Valuations of IPOs. Write a short essay explaining why there is so much uncertainty surrounding the
valuation of a firm that is engaged in an IPO. Why do you think some investors overvalue firms at the
time of their IPO?
ANSWER
Firms that pursue IPOs tend to be young firms that have grown substantially in recent years and need
additional funding to support their growth. The valuation of a company is highly dependent on how much
it grows over time. Yet, the growth rate is subject to much uncertainty.
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers:
a. “The recent wave of IPOs is an attempt by many small firms to capitalize on the recent run-up in
stock prices.”
Firms prefer to go public when stock market conditions are favorable so that they can benefit
b. “IPOs transfer wealth from unsophisticated investors to large institutional investors who get in at
the offer price and get out quickly.”
Some institutional investors invest in IPOs at the offer price, and then quickly sell (flip) their
Chapter 10: Stock Offerings and Investor Monitoring ❖ 11
c. “Firms must be more accountable to the market when making decisions because they are subject
to indirect control by institutional investors.”
If a firm performs poorly, the institutional investors with a large stake in that firm may engage in
Managing in Financial Markets
As a portfolio manager of a financial institution, you are invited to numerous road shows at which firms
that are going public promote themselves, and the lead underwriter invites you to invest in the IPO.
Beyond any specific information about the firm, what other information would you need to decide
whether to invest in the upcoming IPO?
Problem
1. Dividend Yield. Over the last year, Calzone Corporation paid a quarterly dividend of $0.10 in each of
the four quarters. The current stock price of Calzone Corporation is $39.78. What is the dividend
yield for Calzone stock?
ANSWER:
Flow of Funds Exercise
Contemplating an Initial Public Offering (IPO)
Recall that if the economy continues to be strong, Carson Company may need to increase its production
capacity by about 50 percent over the next few years to satisfy demand. It would need financing to
expand and accommodate this increase in production. Recall that the yield curve is currently upward
sloping. Also recall that Carson is concerned about a possible slowing of the economy because of
potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the
next year.
a. If Carson issued stock now, it would have the flexibility to obtain more debt and would also be
able to reduce its cost of financing with debt. Why?
If Carson supports some of its growth with stock, it changes its capital structure to include more
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b. Why would an IPO result in heightened concerns in financial markets about Carson Company’s
potential agency problems?
When the firm is publicly owned, management is at least partially separated from ownership.
c. Explain why institutional investors such as mutual funds and pension funds that invest in stock
for long-term periods (at least a year or two) may prefer to invest in IPOs rather than to purchase
other stocks that have been publicly traded for several years?
Institutional investors may believe that the market does not properly price newly issued stock,
d. Given that institutional investors such as insurance companies, pension funds, and mutual funds
are the major investors in IPOs, explain the flow of funds that results from an IPO. That is, what
is the original source of the money that is channeled through the institutional investors and
provided to the firm going public?
The money invested by insurance companies comes from insurance premiums paid by