Equity Financing Definitions 1. Initial public offering (IPO) -a corporation s first offering of stock to the public -almost invariably an opportunity for the existing investors and participating venture capitalists to make big profits, since for the first time their shares will be given a market value that reflects expectations for the company s future growth 2. Lockup -the 180-day period after an IPO during which insiders are not legally allowed to sell their shares 3. Phantom shock -shares issued to employees which, unlike options, function like a bonus pool, which has to be charged out of earnings 4. Preemptive rights -a right giving existing stockholders the opportunity to purchase shares of a new issue before it is offered to others -its purpose is to protect shareholders from dilution of value and control when new shares are issued -states can pay shareholders to waive their preemptive rights; it can also be placed in the statutes that the preemptive right is only valid if set forth in the corporate charter -since the new shares would be typically priced below the market, a financial incentive exists to exercise the preemptive right; if the right is not exercised, it can be sold 5. Primary distribution -sale of a new issue of stocks or bonds, as distinguished from a secondary distribution, which involves previously issued stock -all issuance bonds are primary distributions (primary offering, but not IPO) 6. Private placement -sale of stocks, bonds, or other investments directly to an institutional investor like an insurance company -a private limited partnership is also considered a private placement -a private placement does not have to be registered with the SEC as a public offering does, if the securities are purchased for investment as opposed to resale 7. Secondary distribution -also known as a second offering; a public sale of previously issued securities held by large investors, usually corporations, institutions, or other affiliated persons -differs from a primary offering where the seller is the issuing corporation -no commissions are paid by buyers since all costs are borne by the selling investor -a similar form of secondary distribution, called a special offering, is limited to members of the New York Stock Exchange 8. Securities and exchange commission rule 144: public sale of unregistered securities -a holder of unregistered securities may make a public sale without filing a formal registration statement -no letter security purchased through a private placement may be sold for at least two years after the date of purchase -thereafter, during any three month period, the following amounts may be sold: if listed securities, the greater of one percent of the amount outstanding or the average trading volume within the four preceding weeks; or if unlisted, one percent of outstandings 9. Securities and exchange commission rule 144a -proposal which would exempt US and foreign corporations from registration requirements in the sale of stock and bond offerings to some large institution -would allow <a href="/keyword/institutional-investors/" >institutional investors</a> to freely trade most privately placed securities among themselves, which would make private placements as liquid as many public debt offerings without the hassle and expense of SEC registration 10. Securities and exchange commission rule 415: shelf registration -permits corporations to file a registration for securities they intend to issue in the future when market conditions are favorable -shelf registration allows a corporation to comply with registration requirements up to two years prior to a public offering of securities -with the registration on the shelf, by maintaining updated reports, the corporation can go to market as conditions become favorable with a minimum administrative preparation -substantial savings of time and expenses for corporate issuers 11. Tracking stock -usually issued by a parent company to create a financial vehicle to track the performance of a particular division or subsidiary -when a tracking stock is issued by a parent company all revenues and expenses of the division are separated from the parent company s financial statements and attributed to the tracking stock -this is often doe to separate a high growth division with large losses from the financial statements of the parent company -owners of such stocks purchase it with the sole anticipation of growth -future acquisition or reabsorption into the parent company is usually the sole anticipation of reward for tracking stocks (tracking stocks usually don t pay dividends) 12. Venture capital -important source of financing for start-up companies or others embarking on new or turnaround ventures that entail some investment risk by offer the potential for above average future profits, also called risk capital Common methods of financing 1. Debt -bank loans -loans from individuals -loans from suppliers (accounts payable) -commercial paper -bonds -convertible bonds 2. Leases 3. Equity -common stock -retained earnings -rights -warrants -preferred stock -preference stock -convertible preferred The cost of common stock equity -the return required or expected by holders of a firm s common stock -the rate used to discount future dividends in order to determine the current fair price of a share of the stock -assume that the firm pays an annual dividend and that the next dividend, equal to D1, will be paid one year from now -assume that annual dividends will grow at rate g -the annual cost of common stock equity is represented by ke ke = (D1/P0) + g, if ke &gt; g ke, annual = (D1, annual/P0) + gannual -a firm may only pay dividends quarterly; in this case: ke, quarterly = (D1, quarterly/P0) + gquarterly -you can then calculate the annualized cost of common stock using: 1 + ke, annual = (1 + ke, quarterly)^4 -the phrase cost of equity is almost always the cost of common stock equity (as an annual cost) The cost of preferred stock equity -the return required or expected by the holders of a firm s preferred stock -the rate used to discount future preferred stock dividends in order to determine the current fair price of a share of the preferred stock -assume that the dividends are promised forever, are expected to be paid in full on schedule, and the annual payment will not change -therefore, the preferred stock discussed is a perpetuity; with a participating preferred stock the dividend may increase if the firm does well, but that is excluded in this scenario Pp,0 = Dp annual/ Kp annual Kp annual = Dp annual/ Pp,0 -a firm may pay its preferred dividend on a quarterly basis, in this case: Kp quarterly = Dp quarterly/ Pp,0 -you can then calculate the annual cost of preferred stock using: 1 + kp, annual = (1 + kp, quarterly)^4 Rights offerings -a right is like a very short term warrant (a warrant gives its owner the option to purchase a share of stock at a set price on or before the set date; the issuer of the warrant is the firm, so exercising of this option increases the number of outstanding shares) -if, for instance, a share is equal to three rights, one right gives its owner the option to purchase one third of a share; for each new share the exercise price is the subscription -the subscription price is set enough below the current market price so that it would be unlikely for the stock price to fall below the subscription price before the rights expire -as long as the stock price is above the subscription price at the rights expiration, the rights would be exercised and the firm would indeed raise the desired equity capital -given: - Pon = the rights-on stock price - Pex = the ex-rights stock price - Ps= the subscription (or exercise) price -N = the number of shares outstanding before the rights offering -n = the number of rights needed (in addition to the subscription price) to purchase a new share Pex = [(N)(Pon) + (N/n)( Ps)]/[N + (N/n)] -the numerator represents the total value of the stockholders equity after exercise of the rights while the denominator represents the total number of shares outstanding after exercise; assume all rights are exercised Pex = [(n)(Pon) + ( Ps)]/[n + 1] -this is a simplified expression; you can purchase n shares rights-on and pay the subscription price Ps in order to end up with n + 1 shares *note: -additions of equity capital occur when the firm makes a secondary offering, when convertible debentures and convertible preferred s are converted to common stock, or when warrants and executive stock options are exercised -subtractions of equity capital occur when the firm repurchases common stock Dutch auctions -a type of auction which can be used to sell or repurchase shares of stock or other assets -if shares are being sold, as in an IPO, the auction price is set so that the number of shares bid for at that price or higher equals the number of shares being sold; all shares are sold at the single auction price -if the shares are being purchased, as in a share repurchase, the auction price is set so that the number of shares offered at that price or lower equals the number of shares being repurchased; all shares are sold at the single auction price Tax rates -for individuals the 2004 maximum marginal tax rates are given: Source of Income Dividends Interest Short-term capital gains Long-term capital gains Maximum Marginal Rate 15% 35% 15% 15% -for corporate investors the 2004 maximum marginal tax rates are given: Source of Income Dividends Interest Short-term capital gains Long-term capital gains Maximum Marginal Rate 39% 39% 35% 35% -short-term capital gains are gains realized when the asset is held less than one year -long-term capital gains are gains realized when the asset is held for one year or more Interest uses of equity securities -to finance voyages to the new world -(Don) bell golf inc. (march 2001) -death spiral preferred -pokershare.com