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How a Corporation can Raise Capital



When a corporation needs to raise capital, they either issue debt securities (bonds) or by equity (selling stock). Anytime a corporation issues new stock it comes from 'Authorized But Not Yet Issued Stock'. If the corporation has sold stock before, this is known as a 'Primary Offering'.

Assuming the company is using an investment bank, there are several things the parties need to discuss, negotiate, and agree on. They need to agree on the amount of capital needed by the corporation, the type of security to be issued, the price of the security, any special features of the security, and the cost to the firm to issue the securities. If they can agree on these things, the investment bank will act as the middleman between the corporation and the general public.

A firm may have many Primary Offerings. If the corporation has never sold stock before it is known as an 'Initial Public Stock Offering'. A company can only have one Initial Public Stock Offering. The first step for the corporation is to hire an investment bank. The investment bank will act as the advisor and the distributor. This firm is also known as the 'Underwriter'.



'Underwriting' is the actual process of raising capital through debt or equity. The corporation seeking to raise capital doesn't necessarily need to use an investment bank. There are no rules to say that they have to. If they wanted to, they could go door to door selling their bonds or stock!

There are two different types of agreements between the investment bank and the corporation. The first of these is the 'Firm Commitment'. With a 'Firm Commitment' the investment bank agrees to purchase the entire issue from the corporation and then re-offer them to the general public.

With this type of an agreement, the investment bank has guaranteed to provide a certain amount of money to the corporation. The risk of the issue falls entirely upon the investment bank. If it fails to re-sell the amounts of securities it purchased, the investment bank still has to pay the agreed upon sum of money to the corporation.

The second type of agreement is known as a 'Best Effort' agreement. With a Best Effort agreement, the investment bank agrees to sell the securities for the corporation but does not guarantee the amount of capital raised by the issue.

When a company makes a public offering it must comply with the Act of Full Disclosure. This is in The Securities Act. They must file a 'Registration Statement'. The investment bank will file the registration statement with the SEC.

The day the investment bank turns in the registration statement with the SEC is known as the filing date. Contained in this registration statement will be a description of the business raising the money, biographical material on the officers and directors of the company, the amount of shares each insider (officers, directors, and shareholders owning more than 10% of the securities) owns.

Also, complete financial statements including existing debt and equity securities and how they are capitalized, where the proceeds of the offering are going (use of funds), and any legal proceedings involving the company including strikes, lawsuits, antitrust actions, copyright/patent infringement suits, all for the present or if they are aware of impending or future actions.

After the registration statement is filed by the investment bank on behalf of the issuing corporation, the SEC requires a 'Cooling Off Period'. During the Cooling Off Period, the issue is considered as 'In Registration'. During the Cooling Off Period, while the issue is in registration, the SEC will investigate and make sure that 'Full Disclosure' has been made.

During the cooling off period the investment bank will try to drum up interest in the issue. They do this by distributing a 'Preliminary Prospectus'. The preliminary prospectus is also known as a 'Red Herring'. It has red printing across the top and in the margins. The investment bank pays for the printing of the red herring.

Contained in the red herring is much of the information from the registration statement including a description of the company, a description of the securities to be issued, the company's financial statements, the company's current activities, any regulatory bodies over-seeing the firm, nature of the company's competition, who the management of the company is, and planned use of funds from the issue.

Assuming the new issue is approved by the SEC, the stock will be offered to the general public. This date is the 'Effective Date'. If the SEC does not approve the issue, a 'Letter of Deficiency' is issued. The letter of deficiency will notify the company what was wrong. Thus, the effective date will be postponed.

The public offering price is determined on the effective date. That way, the issue can be prices in accordance with current market conditions.

If clients are interested in the new stock offering, the client will give his stock broker an 'Indication of Interest'. The stockbroker can't take an order for the issue from the client. All the client is allowed to do is indicate that he is interested. The higher the indication of interest is from clients, the better for the offering. In fact, it will probably aid the investment bank in making pricing decisions.

While the issue is in registration (during the cooling off period) the investment bank may not provide any other information to its clients other than what is contained in the red herring. They can't provide research reports, recommendations, sales literature, or anything from any other firm about the company. They can only provide the client with the red herring.

Just before the effective date the investment bank will sit down with their client (the issuing corporation) and have a 'Due Diligence' meeting. They will iron out any last minute things which have come up. And they will make sure that there are no material changes which have taken place between the registration date and the effective date.



Once the effective date arrives, the security can be sold and money collected. Also, the 'Final Prospectus' is issued. This will be very similar to the Red Herring. Except it will have the missing numbers for the public offering price and the effective date filled in. It also won't have any red writing on it.

Many times investment banks don't want to take on all the risk of an issuing all by themselves. Instead they form 'Syndicates'. A syndicate is a group of investment bankers (underwriters) who will participate in selling the issue. Usually, the 'Syndicate Manager or Underwriting Manager' is the head of the syndicate.

The underwriting manager will then sign a letter of intent with the issuing corporation. This formalizes the relationship. However, it is a non-binding arrangement. Once the SEC has approved the issue, all parties to the agreement sign a binding contract which binds the parties to the letter of intent. There are three primary underwriting contracts. These are the 'Agreement Among Underwriters', the 'Underwriting Agreement', and the 'Dealer Agreement'.

The 'Underwriting Agreement' is a contract which is what establishes the relationship between the corporate issuer of the securities and the underwriters comprising the syndicate. Or it might be just with one underwriter if there is no syndicate. The UA is executed by the managing underwriter based on the authority it has been given.

Finally we get to the so called 'Dealer Agreement'. The dealer agreement or selling agreement, is the agreement in which securities dealers who are not part of the syndicate, are contracted to purchase some of the securities from the issue. The underwriters may not be able to locate enough purchasers for the issues. They approach other securities dealers and see if they might want to participate.

These other securities dealers may have even been offered a chance to participate as an underwriter but chose not to. What these other securities dealers can do is help move the product (the securities) to the general public. Basically, they are another distribution channel. However, these securities dealers don't have any risk at all. The Dealer Agreement or selling agreement will allow these dealers to purchase the securities at a discount from the offering price in order to fill order they may have gotten after the effective date from their clients.

All of what we have discussed so far has been if there was a firm commitment to the corporate issuer by the syndicate. However, with a 'Best Efforts Underwriting', there will be no syndicate. The underwriters don't make a commitment to purchase the securities. They merely agree to do the best that they can in selling the issue. The underwriters form a 'Selling Group'. Each participant in the underwriting does his best to sell his allotted share of the issue.

There is one last variation. That is called an 'All Or None Underwriting'. Under this type of underwriting the underwriter agrees to do his best to sell the entire issue by a certain date. All of the proceeds go into an escrow account. If the securities are not all sold by the certain date, the money is returned to the purchasers and the issue is canceled.

The underwriters and dealers get paid out of the proceeds of the issue offering. The public offering price is what the general public pays. This is the amount on the face of the prospectus. However, the issuing corporation receives a lower price than that from the managing underwriter. The difference between these two prices is the 'Spread'.

Any firm participating in the underwriting is compensated out of the spread. The amount of the spread is determined through a negotiation between the managing underwriter and the corporate issuer. However, there are certain parameters which are known to have taken place in previous under writings and the negotiations take place around these. All members of the syndicate are paid out of the spread. The managing underwriter receives a fixed amount for each share which is sold. This is referred to as the managers fee.

Also, a portion is kept by each member of the underwriting syndicate. This is referred to as the underwriting or syndicate allowance. This compensates each member of the underwriting syndicate for their expenses and the risk they incur. The selling group which sells the securities is also allocated a portion of the spread. This is known as the selling concession. A reallowance is paid to securities firms which contacts one of the members of the syndicate to purchase part of the issue to fill its own customer orders after the effective date. Because this firm has incurred no risk and made virtually no effort in the underwriting, this is the smallest fee earned by any firm.

On the hot issues which go through an initial public stock offering, the shares are limited and the demand might be high. Generally, a firm which has shares to sell (perhaps one of the underwriting syndicate) will allocate shares to its top performing stockbrokers. It's a sort of reward. Each broker will then call his best customers (assuming they're profile is right for this particular issue) and see if they are interested in the issue. If they are, on the effective date the broker will allocate a portion of the issue to this customer. It's also a reward.

Here's the catch. Most brokerage firms don't compensate their brokers on these issues unless their client has held the security for a certain period of time. What they don't want is for the customer to sell the issue the same day or a few days later. They want them to hold the security for a while. The longer the better. If the client wishes to sell quickly, the probability is that the broker won't get paid his commission on the sale. Expect the broker to try to talk the client out of selling the security too soon. And if you do sell the security quickly, don't expect the broker to call you back with another hot IPO too soon.

'Private Placements' are the direct sale of an issue of securities to large institutional investors and large private investors. There is no public offering. Also, there is no registration statement. The registration statement's purpose is to protect the public. Regulation D covers Private Placements. Under Reg. D. an accredited investor is either an institution such as banks or insurance companies, Broker/Dealers purchasing for their own accounts, Employee benefit plans and non-individual entities with net worth of at least $5,000,000.

Also, Insiders of the issuer, Individuals with a net worth of at least $1,000,000 (spouse may be included); or individuals with $200,000 in earnings for each of the past 2 years as well as this year (if spouse is included then $300,000). Also, the maximum number of non-accredited purchases is limited to 35. No advertising is permitted. A non-sophisticated investor must be represented by a 'purchaser representative'. This person must be an attorney, accountant, or financial planner, etc. There are also restrictions on the resale of the securities.

Public traders access to initial public stock offering's are not easy. Not everyone can get the shares until they hit the secondary market. Also, many IPO's pull back in price a short time after their effective date. Sometimes patience pays off. Also, these can be risky securities that are highly volatile. One should be quite careful when evaluating the purchase of a new initial public stock offering.

For people who want to purchase shares of an IPO, it's suggested they call their stock broker. First see if they are the underwriter or they can tell you who the underwriter is. Also, find out which firms are part of the underwriting syndicate - if there is one. Contact those stock market trading firms.