>> In this video, I'd like to get into the nuts and
bolts as to how securities are sold to the public.
Let's start with learning more details about how
investment banks work as intermediaries to help sell stock to the public.
Investment banks are sometimes called underwriters because
they are taking on or underwriting the risk of the issuance.
Recall that investment banks buy all the shares
of stock from a company at an agreed upon price,
and then attempt to resell to the public via an IPO.
Investment bank makes money by selling the IPO for more than it paid to the firm.
This difference is called the underwriters spread.
A group of investment banks might work together to
spread risk if a company has a particularly large issuance.
This grouping is called the syndicate,
and yes I agree that sounds shady.
The details of the services an investment bank provide to
a firm are our three-fold; underwriting and distributing,
of course, but also advising the firm on the issuance.
Underwriting the issuance of stock is an assumption of risk.
The bank has risk if they have
poorly forecasted market demand and the price for the stock.
The investment bank distributes the newly issued shares to
the ultimate investor at the conclusion of the IPO.
Finally, they advise the issuing firm on the timing of the sale,
types of securities to be issued, etc.
Okay. So how does a firm decide on an investment bank,
and how do they agree on a price?
Well, there are five common methods used to do this.
They're all listed on that slide, let's go through them.
A negotiated price is when a firm select
some investment bank and then negotiates a price, it's pretty straightforward.
The competitive bid method occurs when a popular firm is going public for the first time.
Although Google's IPO wasn't done this way,
it could have been because many investment banks would have wanted its business.
The process is pretty straightforward too.
Several banks submit bids for their services and the price per stock.
The firm usually chooses the highest price.
Another possible method is called the commission or best efforts basis.
Usually, if there is a lot of uncertainty about market demand for a stock,
an the investment bank might not buy shares from the firm.
Rather, they will attempt to sell shares in
the primary market and earn a commission on the sale,
rather than pay one price upfront and try to sell for a higher price in the market.
A rarer transaction is a privileged subscription.
Rather than sell the issuance in the open market,
an investment bank tries to sell shares to select
groups like existing shareholders, employees, or customers.
Finally, the crazy Dutch auction method.
This is actually the way Google did their IPO.
Investors place bids indicating
how many shares they are willing to buy and at what price.
The auctioneer works backwards from the highest bid
until all the shares are bid on and accounted for.
The final bid price that ends the auction becomes the price that all successful bids pay.
If you offered a $100 for 10 shares,
and the final bid to close out the auction was $75 per share,
you would only have to pay $75 per share for your 10 shares.
Dutch auction, go figure.
Recall that some securities can be issued without the help of investment bank.
This can be done with either a direct sale or a private placement.
A direct sale can incur in an IPO.
The firm sells directly to the public.
This is very rare however.
A private debt placement raises money directly from
prominent investors like life insurance companies and pension funds.
The advantage of this method is,
it's faster to raise money,
has lower flotation costs,
which we'll learn about in a minute,
and offers financing flexibility.
Some disadvantages include; the interest costs are higher than public issues,
possible restrictive covenants to protect investors,
and possible future SEC regulations and registrations.
Finally, a word about flotation costs.
These are the transaction costs and fees incurred to issue securities.
They include the underwriters spread and other costs of issuance like printing,
legal, and accounting fees.
We'll factor in flotation costs and some calculations later in the material.