4. IPO Process & Trading in Equity Securities

Primary market

Market where firms issue new securities and receive the proceeds

Secondary market

Market where investors trade existing securities with each other

IPO (Initial Public Offering)

First time a firm sells shares to the public

SEO (Seasoned Equity Offering)

New equity issue by a firm that is already public

Privately held firm

Firm whose shares do not trade publicly and are held by a small group

Why firms issue equity

To raise capital to finance investment projects

Role of investment bankers

Advise firm, price securities, and sell shares to investors

Underwriter

Investment bank that helps issue and sell securities

Bake-off

Process where firms listen to IB presentations and choose a lead underwriter

Syndicate

Group of investment banks formed to sell an IPO

Prospectus

Final approved document describing the company and the offering

Regulators (IPO)

OSC in Canada and SEC in the U.S.

Road show

Presentations to investors to promote the IPO

Bookbuilding

Process of collecting investor demand to help set IPO price

Firm commitment (bought deal)

Underwriters buy securities and bear risk of selling them

Best efforts agreement

Underwriter helps sell but does not guarantee sale

IPO underpricing

IPO offer price is set below first-day market price

Money Left on the Table (MLT)

(First-day closing price − offer price) × shares sold

Why IPOs are underpriced

To attract investors and compensate for uncertainty

Short-run IPO performance

Usually strong first-day returns

Long-run IPO performance

Typically underperform the market over time

Issuer interests

Maximize proceeds, liquidity, research coverage, reputation

Underwriter interests

Fees, trading profits, long-term client relationships

Secondary market trading

Trading between investors after issuance

Lock-up period

Restriction preventing insiders from selling shares after IPO

Brokered market

Brokers match buyers and sellers

Dealer market

Dealers trade from their own inventory

Auction market

Buyers and sellers meet directly; centralized pricing

Bid price

Price dealers are willing to buy at

Ask (offer) price

Price dealers are willing to sell at

Bid-ask spread

Difference between ask and bid; dealer profit

Market order

Order executed immediately at best available price

Limit order

Order executed only at a specified price or better

Stop-loss order

Order triggered when price reaches a preset level

Market depth

Number of shares available at best bid and ask prices

Buying on margin

Borrowing money from broker to buy stocks

Initial margin requirement

Minimum equity investor must contribute

Maintenance margin

Minimum margin that must be maintained

Margin call

Request to add funds or sell securities when margin falls too low

Short selling

Selling borrowed shares to profit from price decline

Short interest

Total number of shares sold short

Short interest ratio

Short interest divided by average daily trading volume