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, the fast growth means that the companyâ€™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 this end, they have entered into discussions with the investment bank of Crowe & Mallard. The company has a working relationship with Robin Perry, the underwriter who assisted with the companyâ€™s previous bond offering. Crowe & Mallard have helped numerous small companies in the IPO process, so Larissa and Dan feel confident with this choice.
Robin begins by telling Larissa and Dan 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 â€˜East Coast Yachtsâ€™ initial offering. Robin tells Larissa and Dan that the company can expect to pay about $1,200,000 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 $450,000. The company should also 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 yearsâ€™ 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 indenture, and the company pays $300,000 per year for the outside auditor.
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?
Young companies, like East Coast Yachts, use Dutch Auction because of lower fees. Instead of just investment banks and their top clients, also small investors can participate in public offering process with Dutch auction. Dutch auction is advantageous for small investors because the final bidding price become the market value of a company and they can purchase the share easily. But there are not much informations about the company who is selling its share by Dutch auction. In traditional IPO, a company has to give full information to the public and investors can make decisions about purchasing the share with more information which is dependable than Dutch auction.
But in traditional auction there are too many legal fees and additionally, underwriterâ€™s top clients will purchase shares instead of many small investors. In traditional IPO, underwriter will get commission for every per share and itâ€™s expensive than the fees charged in Dutch auction. However, the investment return is likely to be substantially less than it would be for a traditional IPO. In my opinion, East Coast Yachts company should use Dutch Auction because of lower underwriting fees.
During the discussion of the potential IPO and East Coast Yachtsâ€™ future, Dan states that he feels the company should raise $50 million. However, Larissa points out that if the company needs more cash soon, a secondary offerings close to IPO would be potentially problematic. Instead she suggests that the company should raise $80 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 $80 million?
The advantages ofn raising $80 million is; company can receive required financial amount for its investments if demand for itâ€™s shares suddenly increase. The price of per share will increase (of course it depends of number of shares) and it will increase value of the company.
Disadvantages can be: underwriter does not benefit from a higher stock price on open market because it only receive the IPO subscription fees. Because of the company is unknown, do not have reputation, this price will be too high for investors and they do not prefer to buy these shares.
Optimal sizet of the IPO, depends on the companyâ€™s expenditures but most of all cashout/in flows. Because if cash outflows mismatch with cash inflows there will be a short term cash flow problems. Because of the East Coast Yachtsâ€™ is a young company, as stated in the case, it needs financial sources bu the amount of these sources depends on the expenditures and the target of the company. If they need more money with respect to opening branches or making investment, as Larissa stated, company should rise $80 million. But if they have just need money for their short term planing, they have to raise $50 million, to put money up for the company.
From a different viewpoint, owners of the company has to consider market risk. If the East Coast Yachts had a reputation like Starbucks Coffee Company, it can raise high amounts of money for the IPO. Because companies like Starbucks, Wal Mart, Microsoft or Apple give confidence to consumers and consumers know that if they purchase shares of these companiesâ€™, they will receive high return comparing with the purchasing price. But in this case East Coast Yachts is a young company, itâ€™s risky to raise high amount of money like $80 million. Consumers may not being interested with these kind of unknown companiesâ€™ shares.
As we learn in our finance courses, we try to maximize firms profit to increase the value of the firm. Yes, the East Coast Yachts is young company, but letâ€™s think about market conditions. If there are no rivals, the price of company can arrange by owners because there will be monopoly. If the company raise $50 million, whole shares can be sold and underwriter could avoid the company to make more money because of wrong market condition determinations.
Many of the employees of East Coast Yachts 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 East Coast Yachts goes public (once the 180 day lockup expires). Larissa asks you to advise the employees about which option is best. What would you suggest to the employees?
East Coast Yachts sharesâ€™ can have high demand by investors and this will increase the prices and the value of the firm. Iâ€™m thinking a company like Facebook, young and famous, which offered itâ€™s shares to public and attracted intensive attention by investors. But as we know right now, Facebook share price is $19.50 and itâ€™s fluctuating every week. If I was an employee in Facebook, in very first day of the public offering, I try to sell my Facebook shares, because there were no negative comments, criticism or speculations exist in the market and the value of a firm is still high and I can make profit from very beginning of the IPO process.
East Coast Yachts employees can sell their shares at the beginning of the IPO because prices will decrease during those 180 days and they may not get any profit from their arranged investment.
If employees sell their shares—> there will be too many East Coast Yachts shares in the market
Many East Coast Yachts shares—-> decrease the price of per share ( indirect effect)
If prices are decrease—-> value of East Coast Yachts will also decrease
A firm with low value —-> decrease demand for the firmâ€™s shares
Low level of demand—-> mismatching between cash outflows and inflows
So this is a frequent financial problem.. Employees should take their stocks and wait until companyâ€™s shares consumed by investors in the market.