Page 38 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

24 The Complete Guide to Executive Compensation

Based on this information, the underwriter sets the final IPO stock price the day before
trading is to begin. Setting the IPO price is important—too high and investors are turned off,
too low and the company is losing money. The lowest offering price acceptable to the IPO
company is typically called a collar. A prospectus, filled with financial data as well as special risks
and how the company intends on using the money, is prepared for filing with the SEC. A
draft prospectus preliminary to the actual offering is called a red herring (because of the red
ink on the top of the page). An agreement with underwriters that they can buy up to a spec-
ified percentage more of company stock during the first month of trading is referred to as a
green shoe. When shares begin trading, they often do so at a premium to the initial offering
price. Essentially, this is the result of an imbalance, namely, there are more buyers than sell-
ers on the first day. It is not uncommon to see a 50 percent gain in the stock price on the day
of the IPO. Those interested in a quick profit flip (or sell) their shares. For some companies,
the rapid rise is a short-run phenomenon as sellers begin to outnumber buyers. If this
happens during the lockup period when insiders cannot sell their stock, they see their profits
disappear. A small gain in the stock price of a failing company is sometimes called a dead
cat bounce (with apologies to animal rightists).
For their work, investment bankers will probably get about 7 percent of the IPO pro-
ceeds, with the lead underwriter getting about half of that amount. The lead underwriter not
only sells the greatest number of shares but also arranges the deal and prices the stock. The
higher the price, the more money the company and underwriter make. Secondary offerings
in later years because of the need for more capital can also generate underwriting activity.
The company founders, employees and venture capitalists could account for well over
half of the stock after the IPO. They are all subject to a lockup. This is not incarceration but
a time restriction before they can sell the stock. This could be as short as 90 days or as long
as three years. But most likely it is 180 days. It can be expected that when the lockup expires
there will be downward pressure on the stock price due to sales.
An IPO of a self-standing company typically occurs during the threshold stage, whereas
an IPO from a parent organization is typically done in the latter part of the growth stage or
in maturity. After the IPO is completed, it is important that the company increase revenues
so it can reinvest in the business. Some companies attempt this solely by internal actions,
often called organic growth. Others look externally for ways to expand the scope of their
business, namely, through mergers and acquisitions (M&As).

Mergers and Acquisitions
A merger is the joining together of two companies to form a new organization. Typically, these
companies are of comparable size and a new stock is created, whereas with an acquisition, one
company clearly buys out the other. Acquisitions are easier to finance if the acquirer’s stock has
been on the ascent and the stock of the company being acquired has been dropping. However,
the latter is likely to be quickly reversed by speculative investors. Until mid-2001, wherever
possible, pooling-of-interest accounting was attempted. This meant both income statement
and balance sheets were combined, unless the acquisition was deemed to be performing poor-
ly, in which case the asset had to be written down because of an impaired value. However, to
qualify for pooling, companies are required to use their common stock (not cash) for the
acquisition and are limited for two years in stock buybacks and selling acquired company
assets. Under purchase accounting, the acquired company’s assets are written up to reflect
current market value. The increase over book value of the acquired company is considered