 Hello and welcome to this session. This is Professor Farhad in which we would look at how firms issue securities or raise money This topic is covered on the CPA exam BEC section and the CFA exam also covered in an undergraduate or graduate of essentials of Or principles of investments as always I would like to remind you to connect with me only then if you haven't done So YouTube is where you would need to subscribe. I have 1700 plus accounting auditing tax finance and Excel tutorial if you like my lectures Please like them share them put them in playlists if they benefit you it means they might benefit other people connect with me on Instagram on my website farhadlectures.com you will find additional resources To supplement your accounting education your finance education study for the CPA and the CFA exam Let's go ahead and start by looking at the need for money Obviously each firm whether it's small large medium private public. They need money So firms need to raise capital to help pay for many investment project. You need money I mean you're gonna make a profit, but that may not be enough to expand Therefore you need money you need to raise funds by either borrowing you can either borrow money or you can sell shears Sell stocks so simply put if you remember the accounting equation and hopefully you do and the accounting equation says that assets are Equal to liabilities Plus equity what does that mean? It means liabilities borrowing that and equity is selling stocks This is basically how companies raise funds. This is how they raise money either to start or that is or to sustain themselves now We have to understand that we have we're gonna break the type of companies into two types We have private and we have public because the way the private Finance themselves will be different than the public. So we're gonna break this discussion into let's look at how private company do things What are the characteristics of private companies? Let's look at public companies. How they how do they do things and what are the characteristics of public companies? Also, we want to differentiate between the primary market and the secondary market What's the primary market market for new shares of securities for new issues when the company first issues sells the stock Let's assume Facebook sells the stock to the public This is a new issuance. It's it. This is the primary market now The public then sells it to other people in the public then the public sells it to another person in the public and this public Sells it to another person after they buy the stock. They trade it when this happens when the public I'm gonna After the first individual, this is the primary market when these public exchange the stock among themselves It's called the secondary market market for already existing securities So simply put not every time the stocks are sold or bought Facebook is affected Facebook is affected when they sell it first to this individual this individual gives them back the money And they give them stocks in return and that's that then the public trade those stocks in the it's what's called secondary market It's very important. So the issuance company is not involved simply put Facebook is not involved So we're gonna start by talking about private companies and when I think of private companies or private firms I like to think of a company called wow If you are from New York, New Jersey, Pennsylvania, I don't know Virginia Maybe North Carolina, Florida. We have this convenience store called wow. They have a great coffee. I love that place My son loves it too. So I we visit that place very often But wow is a private company is if wow was a public company. I practically will invest all my money in wow Okay, but let's talk about private companies private companies are relatively young or small They don't have to they could be large as well. Others may be well established like wow that are still largely owned by Company founders and basically wow is still owned mainly by the family or friends Friends and other investors friends and other investors So simply put wow is if I have to buy stocks and wow I have to find someone who owns the stock now I spoke to their manager look when I when I visit the store I speak to the manager or to the employees if you are not working with wowa you cannot own the stocks I did do the employees do own some stocks, but you have to work there. You have to work there So and if you live and if you leave my understanding is you have to sell it back They will buy it back from you. Okay, so no requirement to issue financial statement The first thing about public private companies. They don't have to issue financial statements Simply put they don't have to prepare financial statements if they don't want to why because the family It's you know what's going on if you don't want to issue financial statements for anyone You don't have to as a result you're going to save cost So they don't have to issue financial statements. That's in contrast That's in contrast to public companies public companies will see they have to issue financial statements And not issuing financial statement will protect you from competitors because when you issue financial statement You reveal certain information that your competitor can use so that's going to shield you from your competitors And you have more time to pursue your strategic goals. So rather than focusing on the financial statement You can have your focus somewhere else And again, as I said shares by private companies could also be held by managers as well as investors So people that work at these companies they might own some stocks Now there was recently few changes about private companies the jump start our business startup act of 1912 2019 2012 the act called the jobs it increased the number of owners from 500 to 2000 before you were limited to 500 owners and in certain companies And what they wanted to do they wanted to expend the pool of investors because if you want more investors Well, you know change the law you cannot limit the investors to 500 Also, what they did is partnership for example a partnership could have 10 investors is counted as one investor So you could have 10 people form a partnership then invest in the private in a private company And allowed to engage them in crowd fund crowd funding. They can raise money without going through the sec How do these companies these private companies raise money as I told you you could use friends families connection But usually they are allowed to do what's called the private placement private placement is basically selling Quote and quote to the public. So private companies selling to the public you can sell You could have a what's called the primary offering to which shares are sold directly to small group of Institutional investors. So you have to understand you cannot sell it to anyone You have to sell it to a group called institutional investor, which it means they know what's going on It means they can protect their interest they understand the business or Wealthy investors all the wealth wealthy investors is defined as somebody who has a certain amount of money I don't remember the exact number but simply put wealthy investors They have the time they have the money to hire lawyers accountant to Vet those companies. Therefore the public don't get involved. So the sec does allow you something called rune rule 144a of the sec allow private companies to make these placement without preparing the extensive and costly Registration required for public companies. So they can still they can still sell some some shares But it's not the the scale of to everyone like public companies only to wealthy investors and institutional investors What's what's called knowledgeable investors? Look if you made a bad investment and you're wealthy investor That's your fault if you're an institutional investor and you made lousy investment. That's your fault. That's not the sec's fault Okay, but bear in mind these shares. They don't they don't have a secondary market Although they might have something similar to the secondary market. Now. Why the secondary market is important Why the secondary market is important is because you're you lack liquidity You lack liquidity if you don't have a secondary market. What is liquidity? It means you cannot sell your shares fairly quickly on a short notice So if you have the stock of a private company and you want to sell it You're not going to find a buyer real quick if a publicly traded company I'll open my computer and today I sold some shares and I click on the sell button and it's gone So it's liquid private companies are not liquid So investors demand price concession to buy a liquid security So if I want to find someone to buy my shares Well, that's somewhat already knows I'm trying to sell What does that mean if I am if I am supplying something the person says well, you need to buy it I'm gonna lower my price. Why because you need me. There's no there's no market for your security Okay Now now more recently though some firms set up computer network to enable holders or private company Stocks to trade among themselves. For example, Facebook used to be traded on this network So basically you have private companies. They have their own network like their own trading network Okay, but unlike the stock market regulated by the SEC, you have to be careful These networks require little of financial disclosure. So they don't tell you what's going on in the company They don't issue financial statements. So you're basically taking more risk. Okay And provide correspondingly little oversight of their operations. So basically no one is overseeing what's going on simply put Okay, skeptics worry that investors in this market cannot obtain clear view of the firm Indeed when you when you when you buy when you buy these stocks Guess what you are you are flying blind and no one is going to protect your interest because they are private Private basically private stock market. Okay, the interest the interest among investors in the firm is not really known And the process by which the trade firms shares are executed You really don't know who bought your shares or the process because it's a private network So only people who knows what's going on deal with this private Private network. So this is what we're going to talk about about private companies. How do they raise money? Now we're going to move to public companies public companies are a little bit different from the word public It means they are publicly traded It means now facebook is publicly traded. So in a private firm like facebook Remember facebook was private all companies start private actually all companies started very small Then they become private then they go public. So in a firm when a firm When a firm Goes from private to public is to do what is to increase to raise capital and increase The number of investors they could invest in them open themselves to anyone and everyone This is part of being going public. It means anyone can buy your stock. You open yourself to the whole world Okay So the first issue of shares to the general public is called ipo or initial public offering So the first time facebook sold their stock It's called initial public offering if my memory serves me right may 2010 I still remember and we're going to talk about ipo's more in a moment So when the first time you sell your stock, it's called ipo Then you have something called a seasoned equity offering seasoned equity offering. It means the firm May go back to the public and issue additional shares of stocks without going through through a through a formal process Like if apple wants to sell more shares, they don't have to go back every time to the sec They are considered seasoned equity offering. It means they've been offering stocks for so long. We should trust that You know, they're not gonna Lie or defraud the public. Okay shares of publicly listed stocks are continually traded on a well-known market such as NYSC or nasdaq and this is an advantage over private Over private companies private companies. Remember we thought we talked about liquidity. They lack liquidity. Well, guess what? Public companies on the other hand, they don't lack liquidity. Why not because they are publicly traded You can find as I told you I just sold some some of my some of my Some of my Some of my apple stocks today. It was very simple process. So there's a private so any investor can choose to buy For his or her portfolio or actually sell for that matter Um sell for that matter. Okay, these companies are also called publicly traded publicly owned or just public How do how do these companies raise money? Okay, so how do they raise money? Well, we said private companies. They can ask friends families connection as well as have private placement. How about Public companies. Well, the reason they went public is to have public offering public It means they can sell stocks and bonds for anyone bonds means that they're typically marketed by investment bankers Who's the role? Who's who's who's in this role are called underwriter simply put they would hire an investment banker like jp morgan Was considered an underwriter. For example, google when google went public. They sold Durstag directly to the public. So they took out the underwriter role That's a different story, but what maybe we'll talk about it later. Okay So you could have more than one investment banker usually market the securities because not one specific Not one specific Underwriter would like to take on On selling all the shares. What if they could not sell them? There are specific rules for that So what they do is they they they they form a syndicate with other people um elite firm Elite firm of an underwriting syndicate of other investment banker to share the responsibility for issuing the stocks again You don't want to take over this by yourself. You want to have other people helping you in other words Helping you sell the stock because if you cannot sell it, you're going to be stuck with it and sometimes Most of you know, sometimes you'll be happy getting stuck with some of those stocks because they go up and value eventually Okay investment bankers advise the firm regarding the terms of which it should sell those securities So they tell you how much you should sell them for the price of the the price of the security Then what we have is we have what's called the preliminary registration statement That must be filed with the sec describing the issue and the prospect of the company What is basically put what is a preliminary registration is when the company tell the the sec about themselves You know, they'll give them financial statements audited financial statements. What's their plan? What's their plan? What's their business plan? What are they applying? What are they planning to do with the money? What's their business called so on and so forth now When the statement is final And approved by the sec in the final form. It's called the perspective. This is called the perspective This perspective is basically it will tell you everything you need to know about the company before it goes public You know, they're saying basically we're looking at their income statement balance sheet cash flow notes any additional disclosure Okay at this point the price which securities will be offered to the public is announced once you have Kind of a perspective. It's ready to go. Then the price is announced So but let's go through a typical underwriting process How does it work and typical underwriting arrangement the investment banker jp morgan purchased the securities from the issuing firm And resell them to the public Okay The the leading the leading firm sells the securities to the underwriter syndicate for the public offering price Less spread that serves as the compensation to the underwriter. So the underwriter, for example buys them for 100 sells them at 101 Well, they need to make money. That's that's the spread. That's the spread. That's der profit The process is called a firm commitment This process is called firm commitment in addition to the spread the investment banker may also receive shares of common stock or other Securities of the firm sometime what they do they'll give you a piece of the company Like they'll give you two three four five percent and you can keep Four later, which is hopefully the stock will go up. That's the whole purpose of it. Okay So this is what the picture looks like. This is the issuing firm. This is facebook This is jp morgan and they can jp morgan can hire other Investment banker, but jp morgan will be the lead and they sell it to the to the public and in terms of Google what google did google Eliminated the step and they went directly to the public what's called the dutch auction I believe also companies what hope the option to have what's called self registration It allows the firm to register securities and gradually sell them in the following two years. So what you do is Is by this Have the stock registered and sell them later in the next two years So you don't have to go back and go through the same process with the sec They're called self registration because the securities are the securities the stacks are already registered So they can be sold on a short notice with little additional paper paperwork So you don't have to go back and waste time So if you need money you can sell those shares and those they can be sold in small amount without incurring substantial What's a fee cost you don't have to pay a fee cost the reason they're called on the shelf It means they are ready to go. That's what ready, you know shelf registration They're on the shelf if you want to sell them we can sell them immediately like in a store Let's go back and talk about the IPO initial public offering Basically the investment bank banker manages the issue of the new of the new Securities to the public as we said, you know think of jp morgan Once the sec has commented on the registration statement and a preliminary prospectus Remember we talked about perspective is distributed to the interested investors the investment berkin The investment bankers organize roadshow in which they travel around the country to public to publicize now They don't have to do this anymore. They could do it online the imminent offering So once the prospectus is ready, we're gonna go and we're gonna They're gonna go and solicit interest to find out how much interest Is there in those stocks? So the roadshow serves to purpose They generate interest among potential investors and provide information about the offering And what they build the book they provide information to the issuing firm and its underwriters about the price of which they will be able to market the securities At this point, they're gonna have start to have a better idea about what the price is Okay, large investors communicate their interests and purchasing shares of the IPO. So investors. They will tell you, okay, I'll pay 30 Some will say pay 28 some 32. So you'll start to get an idea Okay, these indication of interests are called book and the process of Polling potential investors is called book building. This is what you're trying to see What is the interest in this company? How how much Interest can we generate in selling those stocks? So the book provides valuable information to the issuing firm because institutional investors Often will have useful insight about both the market demand And for the security as well as the prospect of the firm and its competitor Look They have the prospect investors will have the perspective now they understand your business at this point They're gonna make a decision if they like your business they're gonna say, okay, we'll buy The price at 32 and we want to buy 500 million shares. Some other company says well, we'll pay 25 will buy 100 million shares So you'll start to have an idea. What's the demand in the market? So it's like those are valuable signals for it for the underwriters as well as the company They will know how much interest how much interest the public have in them It's common for investment bankers to revise both their initial estimate Um the initial estimate of the offering price and the number of shares offered Based on the feedback. Remember if there's that's assumed they want on this road show Virtual or real road show and they did not find any interest They did not find any interest in the investors. So what's going to happen is as a result They're either gonna lower their price Or the older price or lower the number of shares offered because there's enough not enough interest If they find out everybody wants to buy the stock then they will do exactly the opposite They would raise the price and they will tell the company to issue more stocks Yeah So now we're going to talk about possible explanation why IPOs are underpriced. What does it mean underpriced? It means they get less money than what they should have That's what underpriced is and then we're going to look at some possible Explanation the first thing is why do investors? Truthfully revealed their interest in an offering So when when when the underwriters go on on the road show when the underwriters go goes on the road show Why do investors sell them the truth like how much do they want to buy? Well, guess what if they don't Then they don't buy the number of shares that they want if let's assume You like the company, but you don't want to tell them you want to buy 100 million shares You tell them you want to buy only 20 million shares. What's going to happen is They're going to think you're only interested in 20 and they might find someone else to buy the 100 and you're going to lose that So if you have Interest you have to show the interest so it shows in larger allocation Okay, so you have to show so you from the investment's perspective you have to show your interests Okay, so From the underwriters perspective the underwriter. They have to be very careful They need to offer the securities at a bargain price to these investors Why because they want to entice you to participate in this book building and share their information so You're gonna kind of you you're In a sense they're both working against their interests in a sense that the investors It's not in their best interest to tell the truth, but they have to And the underwriter it's not in their best interest to give you a bargain price But they have to so both of you are trying to meet someplace in the middle So as a result what happened is commonly IPOs are underpriced compared What why do we why do we mean it's underpriced? Compared to the price of which they eventually sell especially the following day So that's why we mean it's underpriced. That's could be one possible explanation Such underpricing is reflected in the price jumps that occur on the date when the shares are first traded in public In the in the public market. Okay, so in 2017 when snapshot snap ink went public snap is the Snapping the parent company of the snapshot Snapchat was was typically an example of underpricing the company issued 200 million shares At $17 that same day by the end of the day the stock was traded at $24 and 48 cent 44 percent then what they thought the price should be 17. Okay, so simply put what happened is Snapshot snapchat the parent company lost the difference So basically they lost 200 million times approximately $7 and 48 cent because they could have because the price ended up at 2448 there was interest But they did not raise the price. So that's part of it is the underwriter is careful and And and the investor is you know trying to show interest in the company. So there's kind of conflict in one way or another. Okay Well, the explicit cost of an IPO tend to be seven percent The underpricing is also considered the cost of the issue Simply put it's going to cost you around seven percent to go public. That's what we're saying here Okay, for example if if snap had sold its shares at 2448 That investors obviously were willing to pay for them. The IPO would have raised 44 more money than they actually did so they left some money on the table. That's basically what they did Okay, in this case far exceeded the explicit cost of the stock issue Nevertheless underpricing is very common and it's universal phenomenon. So it's always That always happened part of it is ego a lot of people They want to buy this new company that same day or the following day because it's it's it's like There's a lot of rumor about it. Nobody knows anything. Nobody wants them to sell And sometimes it's becoming self-fulfilling if all companies they go up the same day or the following day So it's a guarantee profit. Let's all buy it becomes a self-fulfilling if people buy the stock goes up Oh, yes, IPOs are underpriced. Not really. Maybe it's the whole psychology believe when an when an IPO comes to public It's always overpriced underpriced. Therefore that a day or two it it goes up in value And this this phenomenon is is showing in the us as well as outside the us So this is the average first day return on mostly European IPOs And this is non-european IPOs and obviously in the u.s. The same thing They always they always trade for example increase some IPOs trade at 50 percent more the following day but again at ranges at ranges but the point is IPOs usually they're underpriced historically speaking from a from a research perspective in the next session We would look at how securities are traded as always. I'm going to ask you to like this recording share it Subscribe and don't forget to visit my website for head lectures calm if you're planning to supplement or compliment your accounting and finance education Or help you pass the cpa or cfa exam. Good luck study hard and stay safe