Question

Mark Sexton and Todd Story have been discussing the future of S&S Air. The company has been experiencing fast growth, and the two see only clear skies in the company’s future. However, the fast growth can no longer be funded by internal sources, so Mark and Todd have decided the time is right to take the company public. To this end, they have entered into discussions with the investment bank of Crowe & Mallard. The company has a working relationship with Renata Harper, the underwriter who assisted with the company’s previous bond offering. Crowe & Mallard have assisted numerous small companies in the IPO process, so Mark and Todd feel confident with this choice. Renata begins by telling Mark and Todd about the process. Although Crowe & Mallard charged an underwriter fee of 4 percent on the bond offering, the underwriter fee is 7 percent on all initial stock offerings of the size of S&S Air’s offering. Renata tells Mark and Todd that the company can expect to pay about $1,800,000 in legal fees and expenses, $12,000 in SEC registration fees, and $15,000 in other filing fees. Additionally, to be listed on the NASDAQ, the company must pay $100,000. There are also transfer agent fees of $6,500 and engraving expenses of $520,000. The company should also expect to pay $110,000 for other expenses associated with the IPO. Finally, Renata tells Mark and Todd that to file with the SEC, the company must provide three years’ audited financial statements. She is unsure about the costs of the audit. Mark tells Renata that the company provides audited financial statements as part of the bond covenant, and the company pays $300,000 per year for the outside auditor.

a. At the end of the discussion, Mark asks Renata about the Dutch auction IPO process. What are the differences in the expenses to S&S Air if it uses a Dutch auction IPO versus a traditional IPO? Should the company go public through a Dutch auction or use a traditional underwritten offering?

b. During the discussion of the potential IPO and S&S Air’s future, Mark states that he feels the company should raise $75 million. However, Renata points out that if the company needs more cash in the near future, a secondary offering close to the IPO would be problematic. Instead, she suggests that the company should raise $90 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 $90 million?

c. Many employees of S&S Air have shares of stock in the company because of an existing employee stock purchase plan. To sell the stock, the employees can tender their shares to be sold in the IPO at the offering price, or the employees can retain their stock and sell it in the secondary market after S&S Air goes public. Todd asks you to advise the employees about which option is best. What would you suggest to the employees?

d. 5 years after IPO, S&S Air is planning to raise fresh equity capital by selling a large new issue of common stock. S&S Air is currently a publicly traded corporation, and it is trying to choose between an underwritten cash offer and a rights offering (not underwritten) to current shareholders. S&S Air management is interested in minimizing the selling costs and has asked you for advice on the choice of issue methods. What is your recommendation and why?

Please help to understand it ...

Answer 1

a.         The main difference in the costs is the reduced possibility of underpricing in a Dutch auction. As to which is better, we don’t actually know. In theory, the Dutch auction should be better since it should eliminate underpricing. However, as Google shows, underpricing can still exist in a Dutch auction. Whether the underpricing is a severe in a Dutch auction as it would be in a traditional underwritten offer is unknown.

b.         There is no way to calculate the optimum size of the IPO, so whether Mark is correct or Renata is correct will only be told in time. The disadvantages of raising the extra cash in the IPO include the agency costs of excess cash. The extra cash may encourage management to act carelessly. The extra cash will also earn a small return unless invested in income producing assets. At best, cash and short-term investments are a zero NPV investment. The advantages of the increased IPO size include the increased liquidity for the company, and the lower probability that the company will have to go back to the primary market in the near term future. The increased size will also reduce the costs of the IPO on a percentage of funds raised, although this may not be a large advantage.

c.        Because of legal repercussions, you should not provide specific advice on which option the employees should choose. There are advantages and disadvantages to each. If the employee tenders the stock to be sold in the IPO, the employee will lose out on any underpricing. This could be a significant cost. However, if the employee retains the stock, he/she must hold the stock for the lockup period, typically 180 days. Additionally, during the lockup period, the employee is legally prohibited from hedging the price risk of the stock with any derivatives. And heavy selling by insiders is considered a negative signal by the market. Another risk in not selling in the IPO is that after the lockup period expires, the employees may be considered insiders, subject to SEC restrictions on selling stock.