types of offering are typically made on a best efforts basis. The correct offering price is difficult to determine and depends on the investment bank's assessment of the company's value. The bank's best estimate of the market price is its estimate of the company's value divided by the number of shares currently outstanding. However, the bank will typically set the offering price below its best estimate of the market price. This is because it does not want to take the chance that the issue will not sell. (It typically earns the same fee per share sold regardless of the offering price.)
Often there is a substantial increase in the share price immediately after shares are sold in an IPO (sometimes as much as 40 %), indicating that the company could have raised more money if the issue price had been higher. As a result, IPOs are considered attractive buys by many investors. Banks frequently offer IPOs to the fund managers that are their best customers and to senior executives of large companies in the hope that they will provide them with business. (The latter is known as “spinning” and is frowned upon by regulators.)
Dutch Auction Approach
A few companies have used a Dutch auction approach for their IPOs. As for a regular IPO, a prospectus is issued and usually there is a road show. Individuals and companies bid by indicating the number of shares they want and the price they are prepared to pay. Shares are first issued to the highest bidder, then to the next highest bidder, and so on, until all the shares have been sold. The price paid by all successful bidders is the lowest bid that leads to a share allocation. This is illustrated in Example 2.2.
EXAMPLE 2.2
A company wants to sell one million shares in an IPO. It decides to use the Dutch auction approach. The bidders are shown in the table following. In this case, shares are allocated first to C, then to F, then to E, then to H, then to A. At this point, 800,000 shares have been allocated. The next highest bidder is D who has bid for 300,000 shares. Because only 200,000 remain unallocated, D's order is only two-thirds filled. The price paid by all the investors to whom shares are allocated (A, C, D, E, F, and H) is the price bid by D, or $29.00.
Dutch auctions potentially overcome two of the problems with a traditional IPO that we have mentioned. First, the price that clears the market ($29.00 in Example 2.2) should be the market price if all potential investors have participated in the bidding process. Second, the situations where investment banks offer IPOs only to their favored clients are avoided. However, the company does not take advantage of the relationships that investment bankers have developed with large investors that usually enable the investment bankers to sell an IPO very quickly. One high profile IPO that used a Dutch auction was the Google IPO in 2004. This is discussed in Business Snapshot 2.1.
Advisory Services
In addition to assisting companies with new issues of securities, investment banks offer advice to companies on mergers and acquisitions, divestments, major corporate restructurings, and so on. They will assist in finding merger partners and takeover targets or help companies find buyers for divisions or subsidiaries of which they want to divest themselves. They will also advise the management of companies which are themselves merger or takeover targets. Sometimes they suggest steps they should take to avoid a merger or takeover. These are known as poison pills. Examples of poison pills are:
1. A potential target adds to its charter a provision where, if another company acquires one third of the shares, other shareholders have the right to sell their shares to that company for twice the recent average share price.
2. A potential target grants to its key employees stock options that vest (i.e., can be exercised) in the event of a takeover. This is liable to create an exodus of key employees immediately after a takeover, leaving an empty shell for the new owner.
3. A potential target adds to its charter provisions making it impossible for a new owner to get rid of existing directors for one or two years after an acquisition.
4. A potential target issues preferred shares that automatically get converted to regular shares when there is a change in control.
5. A potential target adds a provision where existing shareholders have the right to purchase shares at a discounted price during or after a takeover.
6. A potential target changes the voting structure so that shares owned by management have more votes than those owned by others.
Poison pills, which are illegal in many countries outside the United States, have to be approved by a majority of shareholders. Often shareholders oppose poison pills because they see them as benefiting only management. An unusual poison pill, tried by PeopleSoft to fight a takeover by Oracle, is explained in Business Snapshot 2.2.
BUSINESS SNAPSHOT 2.1
Google's IPO
Google, developer of the well-known Internet search engine, decided to go public in 2004. It chose the Dutch auction approach. It was assisted by two investment banks, Morgan Stanley and Credit Suisse First Boston. The SEC gave approval for it to raise funds up to a maximum of $2,718,281,828. (Why the odd number? The mathematical constant e is 2.7182818 …) The IPO method was not a pure Dutch auction because Google reserved the right to change the number of shares that would be issued and the percentage allocated to each bidder when it saw the bids.
Some investors expected the price of the shares to be as high as $120. But when Google saw the bids, it decided that the number of shares offered would be 19,605,052 at a price of $85. This meant that the total value of the offering was 19, 605, 052 × 85 or $1.67 billion. Investors who had bid $85 or above obtained 74.2 % of the shares they had bid for. The date of the IPO was August 19, 2004. Most companies would have given investors who bid $85 or more 100 % of the amount they bid for and raised $2.25 billion, instead of $1.67 billion. Perhaps Google (stock symbol: GOOG) correctly anticipated it would have no difficulty in selling further shares at a higher price later.
The initial market capitalization was $23.1 billion with over 90 % of the shares being held by employees. These employees included the founders, Sergei Brin and Larry Page, and the CEO, Eric Schmidt. On the first day of trading, the shares closed at $100.34, 18 % above the offer price and there was a further 7 % increase on the second day. Google's issue therefore proved to be underpriced – but not as underpriced as some other IPOs of technology stocks where traditional IPO methods were used.
The cost of Google's IPO (fees paid to investment banks, etc.) was 2.8 % of the amount raised. This compares with an average of about 4 % for a regular IPO.
There were some mistakes made and Google was lucky that these did not prevent the IPO from going ahead as planned. Sergei Brin and Larry Page gave an interview to Playboy magazine in April 2004. The interview appeared in the September issue. This violated SEC requirements that there be a “quiet period” with no promoting of the company's stock in the period leading up to an IPO. To avoid SEC sanctions, Google had to include the Playboy interview (together with some factual corrections) in its SEC filings. Google also forgot to register 23.2 million shares and 5.6 million stock options.
Google's stock price rose rapidly in the period after the IPO. Approximately one year later (in September 2005) it was able to raise a further $4.18 billion by issuing an additional 14,159,265 shares at $295. (Why the odd number? The mathematical constant π is 3.14159265 …)
Valuation, strategy, and tactics are key aspects of the advisory services offered by an investment bank. For example, in advising Company A on a potential takeover of Company B, it is necessary for the investment bank to value Company B and help Company A assess possible synergies between the operations of the two companies. It must also consider whether it is better to offer Company B's shareholders cash or
