Issue mechanism - Security Analysis and Investment Management

Issue Mechanism of Primary Market

New issues can be made in any of the following ways:

  1. Public issue through prospectus,
  2. Through offer for sale,
  3. Through placement of securities— private placement and stock exchange placing,
  4. Issue of bonus shares,
  5. Book-building, and
  6. Stock option.

Issue through prospectus

After getting the company incorporated, promoters will raise finances. The public is invited to purchase shares and debentures of the company through an advertisement. A document containing detailed information about the company and an invitation to the public subscribing to the share capital and debentures is issued. This document is called ‘prospectuses. Private companies cannot issue a prospectus because they are strictly prohibited from inviting the public to subscribe to their shares. Only public companies can issue a prospectus. Section 2 (36) of the Companies Act defines prospectus as, “A prospectus means any document described or issued as prospectus and includes any notice, circular, advertisement or other documents invent deposits from public or inviting offers from the public for the subscription or purchase of any shares in or debentures of a body corporate.”

The prospectus is not an offer in the contractual sense but only an invitation to offer. A document constructed to be a prospectus should be issued to the public. A prospectus should have the following essentials.

  • There must be an invitation offering to the public.
  • The invitation must be made on behalf of the company or intended company.
  • The invitation must to be subscribed or purchase.
  • The invitation must relate to shares or debentures.

A prospectus must be field with the Registrar of companies before it is issued to the public. The issue of prospectus is essential when the company wishes the public to purchase its shares or debentures.

If the promoters are confident of obtaining the required capital through private contacts, even a public company may not issue a prospectus. The promoters prepare a draft prospectus containing required information and this document is known as ‘a statement is lieu of prospectus.’ A prospectus duly dated and signed by all the directors should be field with Register of Company before it is issued to the public.

A prospectus brings to the notice of the public that a new company has been formed. The company tries to convince the public that it offers best opportunity for their investment. A prospectus outlines a detail the terms and conditions on which the shares or debentures have been offered to the public. Every prospectus contains an application from on which an intending investor can apply for the purchase of shares or debentures. A company must get minimum subscription within 120 days from the issue of prospectus. If it fails to obtain minimum subscription from the members of the public within the specified period, then the amount already received from public is returned. The company cannot get a certificate of commencement of business because the public is not interested in that company.

Advantage of public issue through prospectus

  1. Entire issue process in terms of the amount of issue, the type and mix of issue, terms of issue, etc. appears transparent to the public and the concerned authorities.
  2. The company and its issue get full publicity.
  3. A major portion of the issue is allotted among the applicants on non-discriminatory basis.
  4. Issue gets widely distributed. Wide diffusion of ownership of securities helps reducing concentration of wealth and economic power.

Drawbacks of Public Issue through Prospectus

This mode of issue of securities is quite expensive as it involves the following types of costs:

  1. Floatation costs, e.g., underwriting expenses, brokerage, etc.;
  2. Administrative costs, e.g., cost of printing prospectus and other documents, related administration costs, postage and bank charges, etc.;
  3. Publicity costs; and
  4. Legal costs, e.g., stamp duty, registration fee, listing fee, mortgage deed registration fee, expenses relating to filling of documents, etc.

Bought out deals (Offer for sale)

Under this method, the company does not directly offer its shares to the public, but through intermediaries, such as, issuing houses or a firm or firms of stock-brokers. A prospectus with prescribed minimum contents is distributed to applicants on a nondiscriminatory basis. The issue is also underwritten to avoid the possibility of the issue largely remaining with the issue houses. This method sells securities in two stages. In the first stage, the issuing company makes an en bloc sale of securities to the issue houses or stock brokers at an agreed fixed price. The second stage involves re-sale of these securities by issue houses or stock brokers to ultimate investors at a higher price. The difference between the sale and the purchase price of issue houses is called ‘turn’. The issuing houses have to meet various expenses, such as, underwriting commission, prospectus cost, advertisement expenses, etc., out of this ‘turn’; any leftover being their profit.

In this method, the issuing company is saved of the hassles involved in selling the shares to the public directly through prospectus. However, the method is expensive. Moreover, securities are sold to the investing public by issue houses at a higher price. The price difference is pocketed by these intermediaries and does not add to the resources of the issuing company.

Private placement of securities

A private placement happens when a company offers its securities directly to an individual or a small group of people who will invest, instead of offering it to the public. These offerings need not be registered to the Securities and Exchange Commission or SEC, and are also exempted from the typical reporting compliance. Private placement of investments is considered by experts to be more practical, cost-effective and time-saving manner of raising pertinent capital without the need to go public. A lot of investors are looking into going to private placements instead, because of the many advantages it offers.

These days, financial experts advise companies who want to go public, to choose private placement of securities instead, not only because it is cheaper, but also it is less time consuming. It also involves a limited number of people. This is considered best for companies who are not strong financially, yet they need to seek funds to expand. For new ventures, private placement is also advantageous, because if they do not have the reputation yet, it may be difficult to appeal to the investing public. There are many advantages in choosing private placements in contrast to IPOs. Private placements do not require the service of underwriters or brokers, which is why it is considerably cheaper and consumes less time. Aside from this, private placements could be the only source of available capital to start up firms or risky ventures. A private placement of securities could enable the proprietor to choose and hands pick the investors who may have similar goals and interests.

Since the investors could be people of higher financial status, it is possible for the company to place the securities in a more confidential transaction. If the investors are experienced businessmen, you can also take advantage of their input in regards to the management of the company. Private placements also allow you to maintain your privacy, offering your securities without divulging the information regarding your business and liquidity. As with any decision, there are also disadvantages to going private instead of public. First, it could be challenging to find investors to suit your interests and needs. And if you are lucky to find some, they could have limited funds to fully invest in your company. Private placement of securities is also commonly sold below the normal market value. You may need to relinquish more equities, too, because your investors could demand for more compensation in taking a bigger risk in assuming an illiquid status with your company.

Issue of bonus shares

Abonus shareis a freeshare of stockgiven to currentshareholdersin acompany, based upon the number of shares that the shareholder already owns. While the issue of bonus shares increases the total number of shares issued and owned, it does not change the value of the company. Although the total number ofissued sharesincreases, the ratio of number of shares held by each shareholder remains constant.

An issue of bonus shares is referred to as abonus issue. Depending upon theconstitutional documentsof the company, only certainclasses of sharesmay be entitled to bonus issues, or may be entitled to bonus issues in preference to other classes. Bonus shares are distributed in a fixed ratio to the shareholders.

Sometimes a company will change the number of shares in issue by capitalizing its reserve. In other words, it can convert the right of the shareholders because each individual will hold the same proportion of the outstanding shares as before.

A bonus share issue is not adividend. Although these shares are "distributed" from a company to its shareholders, this is almost never a "distribution" in the corporate law sense. That is because they represent no economic event – no wealth changes hands. The current shareholders simply receive new shares, for free, and in proportion to their previous share in the company. Therefore, a bonus share issue is very similar to astock split. The only practical difference is that a bonus issue creates a change in the structure of the company'sshareholders equity. Another difference between a bonus issue and a stock split is that while a stock split usually also splits the company'sauthorized share capital, the distribution of bonus shares only changes itsissued share capital.

Book-building

Book buildingrefers to the process of generating, capturing, and recording investor demand for shares during anIPO in order to support efficientprice discovery.Usually, theissuerappoints a majorinvestment bankto act as a majorsecurities underwriterorbook runner. The “book” is the off-market collation of investor demand by thebook runnerand is confidential to the book runner, issuer, andunderwriter. Where shares are acquired, or transferred via a book build, the transfer occurs off-market, and the transfer is not guaranteed by an exchange’s clearing house. Where an underwriter has been appointed, the underwriter bears the risk of non-payment by an acquirer or non-delivery by the seller.

Book building is a common practice in developed countries and has recently been making inroads into emerging marketsas well. Bids may be submitted on-line, but the book is maintained off-market by the book runner and bids are confidential to the book runner. The price at which new shares are issued is determined after the book is closed at the discretion of the book runner in consultation with the issuer. Generally, bidding is by invitation only to clients of the book runner and, if any, lead manager, or co-manager. Generally, securities laws require additional disclosure requirements to be met if the issue is to be offered to all investors. Consequently, participation in a book build may be limited to certain classes of investors. If retail clients are invited to bid, retail bidders are generally required to bid at the final price, which is unknown at the time of the bid, due to the impracticability of collecting multiple price point bids from each retail client. Although bidding is by invitation, the issuer and book runner retain discretion to give some bidders a greater allocation of their bids than other investors. Typically, large institutional bidders receive preference over smaller retail bidders, by receiving a greater allocation as a proportion of their initial bid. All book building is conducted ‘off-market’ and most stock exchanges have rules that require that on-market trading be halted during the book building process.

The key differences between acquiring shares via a book build (conducted off-market) and trading (conducted on-market) are: 1) bids into the book are confidential vs. transparent bid and ask prices on a stock exchange; 2) bidding is by invitation only (only clients of the book runner and any co-managers may bid); 3) the book runner and the issuer determine the price of the shares to be issued and the allocations of shares between bidders in their absolute discretion; 4) all shares are issued or transferred at the same price whereas on-market acquisitions provide for a multiple trading prices.

Employee’s stock option

A stock option granted to specified employees of a company. ESOs carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price.An employee stock option isslightly different from a regularexchange-traded option becauseitis notgenerally traded on an exchange, andthereis no put component.

Furthermore, employeestypically must wait a specified vesting period beforebeing allowed to exercise the option.

The idea behind stock options is to align incentives betweentheemployees and shareholders of a company. Shareholders want to see the stock appreciate,so rewarding employees when the stock goes up ensures, in theory that everyone is striving for the same goals.Critics point out, however,that there is a big difference between an option and the ownership of the underlying stock. If the stock goes down, the holder of an option would lose the opportunity for a bonus, but wouldn't feel the same pain as the owner of the stock. This is especially true with employee stock options becausethey are often granted without any cash outlay from the employee.

Another problem with employee stock options is the debate over how to value them and the extent to which they are an expense on the income statement. This is an ongoing issue in the U.S. and most countries in the developed world.

Guidelines regarding stock options in India:

Any company whose securities are listed on any stock exchange in India may offer securities to its employees through the Employees Stock Option Scheme subject
to the conditions specified below:

  1. Promoters and the part-time directors are not entitled to receive securities under the Employees Stock Option Scheme even if the promoter(s) are employees of the company. However, a director who is not a promoter but is an employee may be entitled to receive securities under the scheme.
  2. The issue of shares/convertible instruments under an Employee Stock Option Scheme has not to exceed 5 per cent of the paid up capital of the company in any one year.
  3. Issue of shares under Employees Stock Option Scheme on a preferential basis can be made at a price not less than the higher of the following: (a) The average of the weekly high and low of the closing prices of the related shares quoted on the stock exchange during the six months preceding the relevant date; or (b) The average of the weekly high and low of the closing prices of the related shares quoted on a stock exchange during the two weeks preceding the relevant date. ‘Relevant date’ for this purpose means the date thirty days prior to the date on which the meeting of General Body of shareholders is convened to consider the proposed issue.
  4. A company introducing an Employees Stock Option Scheme has to submit a certificate to the concerned stock exchange at the time of the listing of the securities issued through the Stock Option Scheme certifying that the securities have been issued as per the scheme to permanent regular employees.
  5. The companies are free to devise the Employees Stock Option Scheme for issue of shares/warrants or debt instruments/ bonds with warrants including the terms of payment.

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