Public versus Private Financing
Our discussion to this point has assumed the firm was distributing stocks or bonds in the public markets (as explained in Chapter 14). However, many companies, by choice or circumstance, prefer to remain private—restricting their financial activities to direct negotiations with bankers, insurance companies, and so forth. Let us evaluate the advantages and the disadvantages of public placement versus private financing and then explore the avenues open to a privately financed firm.
Advantages of Being Public
First of all, the corporation may tap the security markets for a greater amount of funds by selling securities to the public. With over 90 million individual stockholders in the country, combined with thousands of institutional investors, the greatest pool of funds is channeled toward publicly traded securities. Furthermore, the attendant prestige of a public security may be helpful in bank negotiations, executive recruitment, and the marketing of products. Some corporations listed on the New York Stock Exchange actually allow stockholders a discount on the purchase of their products.
Stockholders of a heretofore private corporation may also sell part of their holdings if the corporation decides to go public. A million-share offering may contain 500,000 authorized but unissued corporate shares and 500,000 existing stockholder shares. The stockholder is able to achieve a higher degree of liquidity and to diversify his or her portfolio. A publicly traded stock with an established price may also be helpful for estate planning.
Finally, going public allows the firm to play the merger game, using marketable securities for the purchase of other firms. A public company can purchase another firm using its own stock as currency, whereas a private firm might be forced to buy using cash. The high visibility of a public offering may even make the acquiring firm a potential recipient of attractive offers for its own securities. (This may not be viewed as an advantage by firms that do not wish to be acquired.)
Disadvantages of Being Public
The company must make all information available to the public through SEC and state filings. Not only is this tedious, time-consuming, and expensive, but also important corporate information on profit margins and product lines must be divulged. The CEO (chief executive officer) and the CFO (chief financial officer) must adapt to being public relations representatives to all interested members of the securities industry.
Another disadvantage of being public is the tremendous pressure for short-term performance placed on the firm by security analysts and large institutional investors. Quarter-to-quarter earnings reports can become more important to top management than providing a long-run stewardship for the company. A capital budgeting decision calling for the selection of Alternative A—carrying a million dollars higher net present value than Alternative B—may be discarded in favor of the latter because Alternative B adds two cents more to next quarter’s earnings per share.
In a number of cases, the blessings of having a publicly quoted security may become quite the opposite. Although a security may have had an enthusiastic reception in a strong “new-issues” market, such as that of 1967–68, 1981–83, or 1998–99, a dramatic erosion in value may later occur, causing embarrassment and anxiety for stockholders and employees.
As was evidenced in Tables 15-4 and 15-5, there can be a high cost to going public. For small firms, the underwriting spread and the out-of-pocket costs can run in the 15–18 percent range. Moreover, after going public the firm faces higher compliance costs because of various public disclosure requirements. In response to the collapse of Enron Corporation and its accounting firm, Arthur Andersen and Co., Congress passed the Sarbanes–Oxley Act of 2002 which created several costly new requirements.
A Classic Example—Rosetta Stone Goes Public
A classic example of an IPO is that of Rosetta Stone Inc., which went public on April 16, 2009. The company offers self-study language software for over 30 languages. Prior to the offering, the company filed a registration statement with the SEC that included a prospectus that was distributed to potential investors. Every public offering must be preceded by a prospectus that offers details about the company and the offering. The front page of Rosetta Stone’s prospectus is shown in Figure 15-5.
As shown in the figure, 6.25 million shares (top of page) were offered to the public at a price of $18 per share (middle of page). Underwriting commissions were $1.26 per share, exactly 7 percent of the offer price. Also, the company received only half of the remaining proceeds. The other half went to shareholders who sold part of their interest in the company. Table 15-7 on page 488 shows the out-of-pocket costs that Rosetta Stone incurred.
Members of the underwriting syndicate are shown along the bottom of Figure 15-5. Morgan Stanley was the lead underwriter with William Blair & Company listed as a co-lead. The other members of the syndicate are listed below these underwriters. On the whole, the features shown in Figure 15-5 are all very standard for primary offerings.
The day of the offering, Rosetta Stone’s shares began trading on the NYSE at $23 and closed at $25.12, for a first-day gain of more than 39 percent ($25 – $18)/$18. This is a good example of the first-day underpricing that frequently accompanies IPOs. Over the next several months, the price of Rosetta Stone continued to climb, and the stock traded for almost $31 per share on August 10, 2009. After the stock market closed on that day, Rosetta Stone announced that it had filed another registration statement with the SEC for a secondary offering of its common stock. Most of the stock to be sold in the secondary offering would come from two shareholders who owned large stakes prior to the IPO, not from new stock issued by the company. Because very little of the stock would be newly issued, dilution would not be a problem. Nevertheless, the financial markets interpreted this news negatively. If two large insiders believed the stock should be sold at this price, then perhaps the market price was too high.
Figure 15-5 Rosetta Stone’s prospectus
Source: The Wall Street Journal, Tuesday, December 21, 1999, C7, © 1999 Dow Jones & Co. Inc. All Rights Reserved Worldwide.
Table 15-7 Out-of-pocket costs for Rosetta Stone IPO
|SEC registration fee||$ 6,819|
|FINRA filing fee||12,719|
|Initial NYSE listing fee||157,500|
|Legal fees and expenses||700,000|
|Accounting fees and expenses||2,000,000|
|Transfer agent and registrar fees and expenses||10,000|
Source: Rosetta Stone prospectus.
Over the next week, Rosetta Stone’s price fell to $20 per share, a 35 percent drop in one week. On August 17, the firm announced that the secondary offering was canceled. The stock price immediately stabilized, and the stock rose in value to over $22 per share by the end of the month. Figure 15-6 shows Rosetta Stone’s stock price performance and the S&P 500 Index return during all of 2009.
Figure 15-6 2009 stock returns for Rosetta Stone and S&P 500 Index
Source: Yahoo! Inc., http://finance.yahoo.com.
This narrative offers several general observations about IPOs and secondary offerings. IPOs are typically underpriced and have high first-day returns. Consistent with Rosetta Stone’s original plan, secondary offerings frequently occur after a stock has risen significantly in value. Often the stockholders sell because they want to diversify their portfolio, but the market generally interprets secondary offerings as a sign that company managers or insiders view the stock as overvalued, and the share price declines when the offering is announced. However, Rosetta Stone’s decline was larger than most.