Question

Case EAST COAST YACHTS GOES PUBLIC Larissa Warren and Dan Ervin have been discussing the future of East Coast Yachts. The company has been experiencing fast growth and the future looks like clear sailing. However, ne fast growth means that the company's growth can no longer be funded by internal sources, so Larissa and Dan have decided the time is right to take the company public. to take the company public. To this end, Whey have entered into discussions with the investment bank of Crowe & Mallard. The company has a working relationship with Robin Perry, the underwriter who assisted wit previous bond offering. Crowe & Mallard have helped numerous small companies in their process, so Larissa and Dan feel confident with this choice. Robin begins by telling Larissa and Dan about the process. Although Crowe & Mallard changed an underwriter fee of 4 percent on the bond offering the underwriter fee is percent on all initial stock offerings of the size of East Coast Yachts' initial offering. Robin tells Larissa and Dan that the company can expect to pay about $2.2 million in legal fees and expenses, $15,000 in SEC registration fees, and $20,000 in other filing fees. Additionally, to be listed on the NASDAQ. the company must pay $100,000. There are also transfer agent fees of $8,500 and engraving expenses of $525,000. The company also should expect to pay $75,000 for other expenses associated with the IPO. Finally, Robin tells Larissa and Dan that to file with the SEC, the company must provide three years' worth of audited financial statements. She is unsure of the costs of the audit. Dan tells Robin that the company provides audited financial statements as part of its bond inden- ture and the company pays $325,000 per year for the outside auditor. 1. At the end of the discussion, Dan asks Robin about the Dutch auction IPO process. What are the differences in the expenses to East Coast Yachts if it uses a Dutch auction IPO versus a traditional IPO? Should the company go public with a Dutch auction or use a traditional underwritten offering? 2. During the discussion of the potential IPO and East Coast Yachts' future, Dan states that he feels the company should raise $75 million. However, Larissa points out that if the company needs more cash soon, a secondary offering close to the IPO would be poten- tially problematic. Instead, she suggests that the company should raise $100 million in the IPO. How can we calculate the optimal size of the IPO? What are the advantages and disadvantages of increasing the size of the IPO to $100 million? 3 Alter deliberation, Larissa and Dan have decided that the company should use a firm commitment offering with Crowe & Mallard as the lead underwriter. The IPO will be for 590 million. Ignoring underpricing. how much will the IPO cost the company as a per centage of the funds received? 4 Many of the employees of East Coast Yachts have shares of stock in the company because fan existing employee stock purchase plan. To sell the stock, the emplovees can tender their shares to be sold in the IPO at the offering price, or the employees can retain their tock and sell it in the secondary market after East Coast Yachts goes public (once the 18.day Jockup period expires). Larissa asks you to advise the employees about which option is best. What would you suggest to the employees?

Answer 1

1. A Dutch auction based IPO is appealing for young companies like East Coast Yachts because of the lower expenses in comparison to the Traditional IPO. In the Dutch Auction IPO, anyone can bid for the issue of the company that means more bidders make it possible to have a better valuation of the company stock. In the Dutch auction, though companies need an investment bank for underwriting the IPO but the costs, in comparison to traditional route, are lower. In a Traditional auction there are too many legal fees and additionally, underwriter will get commission for every per share making it more expensive than the fees charged in Dutch auction. In Dutch auction, investors can enter only one bid and not multiple bids at different quantities. In this kind of bid process, the allotment is made "to the bidders from the highest bids down, until all of the allotted share are assigned" (Investopedia, 2014). In the traditional method, usually the institutional and large investors are involved while the Dutch auction process facilitates small investors to participate in the bid. Advantage with the Dutch auction is that the process can fetch price of the share close to its market value at lower expense. Hence East Coast Yachts needs to go for a Dutch auction to go public.

2. The optimal size of the IPO depends upon the company's projected Cash flow; for a young company like ECY, the IPO should be able to cover the company's funding requirement for the immediate expansion projects and short term need for funds, say for atleast 2 years. Raising $100 million when the company currently needs only $75 million means ECY will have advantage of increased liquidity or cushioning to face liquidity crunch that may arise due to unforeseen circumstances in the business in future. However, in this process the company’s equity base will increase by 33% putting unnecessary pressure on the company’s earnings per share. This is disadvantageous because lower earnings per share will fetch lower market price assuming P/E ratio remains constant. After all, efficient financial management is a critical need for any company to enhance operational performance hence cushioning of 5-10% is fine while raising money in public but raising $100 million (33% higher than current requirement) is certainly detrimental to the long-term financial health of the company.

3.  Likely expenses in course of the IPO can be listed as per the following.

Legal fees and expenses --> $2,200,000

SEC Registration fees --> $15,000

Other filing fees --> $20,000

Nasdaq listing fees --> $100,000

Transfer agent fees --> $8,500

Engraving expenses --> $525,000

Other expenses --> $75,000

Total expenses --> $2,943,500

Note: Audit expenses of $325,000 per year shall not form a part of the cost of IPO as it is not an expense incurred exclusively for the IPO and shall be incurred with or without the IPO.   

Crowe & Mallard's will charge 7% as underwriting commission to the total issue of $90 million, that amounts to
$6.30 million.
Therefore, total cost of the IPO to the company is ($6.30+ $2.9435) = $9.2435 million.
Therefore, Cost of the IPO as a percentage of funds received
= $9.2435million / $90million
= 10.27%.

or, it can also be calculated as
= $9.2435 / (90 - 6.30) .... since the underwriters shall deduct the commision at source. (Both views can be taken)
= 11.04%

4. East Coast Yachts employees can sell their shares at the beginning of the IPO and safeguard themselves from any decrease in the price of shares during the lockup period of 180 days.
However, it's in the interest of the company that the employees hold on to their stock and sell it in public after the expiry of 180 days. This is because there will be too many East Coast Yachts shares in the market if employees sell their shares, which will in turn decrease the price of shares in the market decreasing the market capitalization and the value of the compan. Therefore, employees should be advised to wait until company’s shares are consumed by investors in the market.