I want to write about what I think are the implications of the new legislation circulating in Congress to permit greater use of crowdfunding by start-up companies raising money. But to do this I think I should outline the way corporate equity capital is typically raised today.
going public through a traditional IPO
This is still the best way to raise LARGE amounts of money for expansion. That’s not the only reason for going public, however.
One of the many clichés on Wall Street is that small companies should raise equity capital when they can (in other words, when investors would kill to acquire shares in a hot new concept), not when they absolutely need to. Better to have cash you don’t have a present use for than to find the equity market closed to IPOs in a recession.
A public listing will probably be seen by potential business partners as a sign of company maturity and stability.
A public listing allows a company to pay employees in stock and stock options rather than cash. For techy start-ups, it’s the possibility of making a fortune on stock options by being in on the ground floor of the next Google or LinkedIn that lets the fledgling firms attract top-notch talent.
the IPO process
Anyway, let’s say a firm decides to go public through a traditional IPO. What happens next? The firm contacts an investment bank. It may be that the company’s CFO already has connections on Wall Street. It may be that brokerage house securities analysts (who in many ways are marketing agents for the bank) have already been calling on the firm for a while and the company selects the firm the most influential of them works for. Investment bankers may have made marketing pitches as well.
The investment bank performs several functions:
1. it helps the firm gather the materials it needs to file a registration statement with the SEC
2. it performs its own investigation that allows it to vouch for the company with its clients
3. it forms an underwriting group and a selling syndicate to market the issue. The salespeople will already have the necessary national and state licenses to sell equities; the firms will already have established that the securities are suitable investments for the clients they sell them to.
4. it prepares a preliminary prospectus (called a red herring in the US because the fact it isn’t final is highlighted in red print) to circulate within its client network and obtains informal indications of interest
5. it arranges a sales campaign that may include meetings between management and potential buyers
6. it recommends the final issue size and price.
Until the past few years–when the big brokerage houses laid off most of their experienced analysts–the investment bank would also commit itself to have continuing analyst coverage of the firm.
there are lots more ins and outs, but that’s the basic process.
The traditional IPO route gives a firm access to the investment bank’s distribution network.
It also gets the company a lot of publicity.
In normal equity offerings, the underwriters buy all the stock from the issuer and take the (usually negligible) risk of selling the issue to investors. At the very least, the issuing company gets a specified price on a given date.
The traditional IPO is expensive. The investment bank may charge as much as 10% of the issue for its services.
In pricing the issue, the investment bank’s loyalty is divided. The issuer wants a high offering price, so it gets the most money. The bank’s biggest customers, on the other hand, want a low offering price so the stock will go up a lot on opening day.
Many small companies are below the minimum size that will interest an investment bank.
That’s it for today. More tomorrow.