Final answer:

Going public allows companies to raise a significant amount of capital by selling shares to the public. It
provides increased visibility, credibility, and access to additional financing options. However, there are
also disadvantages, such as increased regulatory requirements and loss of control for existing
shareholders.

Explanation:

Understanding the process of going public and related concepts

Randy’s, a family-owned restaurant chain, is considering expanding throughout the Southeast and needs
to raise $18.3 million in new capital. The family wants to sell common stock to the public while retaining
voting control. To address their concerns, let's explore the following questions:

a. What agencies regulate securities markets?

The securities markets are regulated by several agencies, including the Securities and Exchange
Commission (SEC), which is the primary regulatory body overseeing the securities industry in the United
States. The SEC ensures that companies comply with disclosure requirements and protects investors
from fraudulent activities.

b. How are start-up firms usually financed?

Start-up firms are typically financed through various sources, such as personal savings, loans from family
and friends, venture capital, or angel investors. These funding options provide the necessary capital for
start-ups to develop their products or services and grow their businesses.

c. Differentiate between a private placement and a public offering.

A private placement involves selling securities directly to a select group of investors, such as institutional
investors or accredited individuals, without making a public offering. In contrast, a public offering, also
known as an Initial Public Offering (IPO), involves selling securities to the general public for the first time.

d. Why would a company consider going public? What are some advantages and disadvantages?

A company may consider going public to raise a significant amount of capital by selling shares to the
public. This capital can be used for expansion, research and development, debt repayment, or other
business purposes. Going public also provides increased visibility, credibility, and access to additional
financing options in the future. However, there are disadvantages to going public, such as increased
regulatory requirements, loss of control for existing shareholders, and the need to disclose financial and
operational information to the public.

e. What are the steps of an initial public offering?

The steps of an initial public offering (IPO) typically include selecting an investment bank to underwrite
the offering, preparing the necessary documents and disclosures, conducting due diligence, pricing the
shares, and marketing the offering to potential investors.

f. What criteria are important in choosing an investment bank?

When choosing an investment bank for an IPO, important criteria to consider include the bank's
experience and reputation in handling IPOs, their understanding of the company's industry, their
distribution capabilities, and the fees and services they offer.

g. Would companies going public use a negotiated deal or a competitive bid?

The choice between a negotiated deal or a competitive bid depends on the company's specific
circumstances and preferences. A negotiated deal involves direct negotiations between the company
and the investment bank, while a competitive bid involves multiple banks submitting proposals to win
the underwriting mandate.

h. Would the sale be on an underwritten or best efforts basis?

The decision to sell shares on an underwritten or best efforts basis depends on the company's
confidence in the demand for its shares and its willingness to bear the risk of unsold shares. In an
underwritten offering, the investment bank guarantees the sale of the shares, while in a best efforts
offering, the bank makes its best efforts to sell the shares but does not provide a guarantee.

j. What is a roadshow? What is book-building?

The management team will make three to seven presentations each day to potential institutional
investors, who typically are existing clients of the underwriters. The institutional investors ask questions
during the presentation, but the management team may not give any information that is not in the
registration statement. Nor may the management team make any forecasts or express any opinions
about the value of their company.

After each presentation, the investment banker asks the investor for an indication of interest based on
the offering price range shown in the registration statement. Investment banker records the number of shares
each investor is willing to buy, which is called book-building.

k. Describe the typical first-day return of an IPO and the long-term returns to IPO investors.

Although IPOs on average provide large first-day returns, their long-term returns
over the following 3 years are below average. For example, if you could not get in at the
IPO price but purchased a portfolio of IPO stocks on their second day of trading, your
3-year return would have been lower than the return on a portfolio of similar but seasoned
stocks. In summary, the offering price appears to be too low, but the first-day run-up is
generally too high.

l. What are the direct and indirect costs of an IPO?

Other direct costs components are fees paid to the stock exchange, external auditing, lawyer fees,
printing, stock certificates, registration and filing, advertising and press costs and expenses incurred to
comply with disclosure and corporate governance rules. The most prominent indirect costs component
is the impact of the listing decision on the equity valuation. “Money left on the table” = no. of shares *
(First day closing price – offering price)

m. What are equity carve-outs?

An equity carve-out (also called a partial public offering or spin-out) is a special IPO in which a publicly
traded company converts a subsidiary into a separately traded public company by selling shares of stock
in the subsidiary. The parent typically retains a controlling interest

n. Describe some ways other than an IPO that companies can use to raise funds from the capital
markets.

 When a company with publicly traded stock issues additional shares, this is called a seasoned equity
offering, also known as a secondary or follow-on offering. Because the stock is already publicly traded, the
offering price will be based upon the existing market price of the stock
 However, under the SEC’s Rule 415, large, well-known public companies that issue securities frequently
may file a master registration statement with the SEC and then update it with a short-form statement just
 prior to each individual offering. Under this procedure, a company can decide at 10 a.m. to sell securities
and have the sale completed before noon
 Private placements
 The asset securitization process involves the pooling and repackaging of loans secured by relatively
homogeneous, small-dollar assets (such as an automobile) into liquid securities. Usually several different
financial institutions are involved, with each playing a different functional role
 Large corporations (or even countries) often borrow substantial amounts via syndicated loans, in which a
group of financial institutions act jointly to fund the loan. The syndicate is created by one or more banks,
investment banks, or other financial institutions acting as lead arranger.
 Project financing

o. What are some other investment banking activities? How did these increase investment banks’ risk?

 First, the investment bank helps the firm determine the preliminary offering price,
or price range, for the stock and the number of shares to be sold. The investment bank’s
reputation and experience in the company’s industry are critical in convincing potential
investors to purchase the stock at the offering price. In effect, the investment bank implicitly
certifies that the stock is not overpriced, which obviously comforts investors.
 Second, the investment bank actually sells the shares to its existing clients, which include a mix
of institutional investors and retail (that is, individual) customers.
 Third, the investment bank, through its associated brokerage house, will have an analyst “cover”
the stock after it is issued. This analyst will regularly distribute reports to investors describing
the stock’s prospects, which will help to maintain an interest in the stock. Well-respected
analysts increase the likelihood that there will be a liquid secondary market for the stock and
that its price will reflect the company’s true value.
 Some activities in finance involve as much marketing skill as finance expertise. For
example, the selection of an underwriter often is described as a bake-off in which the competing
investment banks woo the company with their best sales pitch, much like a cakebaking contest
in which bakers vie for first prize.

p. What is meant by “going private”? What are some advantages and disadvantages?

Going private means that a small group of investors, including the firm’s senior management, purchases
all the equity in the company. Such deals usually involve high levels of debt and are commonly called
leveraged buyouts (LBOs)

1. Administrative cost savings. Because going private takes the stock of a firm out of public hands, it
saves on the time and costs associated with securities registration, annual reports, SEC and exchange
reporting, responding to stockholder inquiries, and so on.

2. Increased managerial incentives. Managers’ increased ownership and equity incentive plans mean
that managers benefit more directly from their own efforts; hence, managerial efficiency tends to
increase after going private. If the firm is highly successful, then its managers can easily see their
personal net worth increase twentyfold, but if the firm fails, then its managers end up with nothing.

3. Increased managerial flexibility. Managers at private companies do not have to worry about what a
drop in the next quarter’s earnings will do to the firm’s stock price, so they can focus on long-term,
strategic actions that ultimately will have the greatest positive impact on the firm’s value. Managerial
flexibility concerning asset sales is also greater in a private firm, because such sales need not be justified
to a large number of shareholders with potentially diverse interests.

4. Increased shareholder oversight and participation. Going private typically results in replacing a
dispersed, largely passive group of public shareholders with a small group of investors who take a much
more active role in managing the firm. These new equity investors have a substantial position in the
private firm; hence, they have a greater motivation to monitor management and to provide incentives
to management than do the typical stockholders of a public corporation.

5. Increased financial leverage. Going private usually entails a drastic increase in the firm’s use of debt
financing, which has two effects. First, the firm’s taxes are reduced because of the increase in deductible
interest payments, so more of the operating income flows through to investors. Second, the increased
debt service requirements force managers to hold costs down to ensure that the firm has sufficient cash
flow to meet its obligations—a highly leveraged firm simply cannot afford any fat.

What role do private equity funds play?

A private equity fund is a limited liability partnership created to own and manage investments in the
nontraded equity of firms.

q. What is project financing?

In project financing, the payments on debt are secured by the cash flows of a particular project.