PROCEDURE FOR

COMPANIES
SELLING SECURITIES
TO THE
PUBLIC
The Basic Procedure for a New Issue
The exact procedure to be followed by a company making a public floatation
of securities will depend on the precise terms of the issue. However, the
following is a summary of the principal steps that are to be borne in mind:
1. Management’s first step in any issue of securities to the public is to
obtain approval from the board of directors.
2. Next, the firm must prepare and file a registration statement with the
SECP. This statement contains a great deal of financial information,
including financial history, details of the existing business, proposed
financing, and plans for the future. It can easily run to 50 or more
pages.
3. The SECP studies the registration statement during a waiting period.
During this time, the firm may distribute copies of a preliminary
prospectus. A prospectus contains much of the information put into
registration statement, and is given to potential investors by the firm.
The company cannot sell the securities during the waiting period.
However, oral offers can be made.
4. The registration statement does not initially contain the price of the
new issue. On the effective date of the registration statement, a price is
determined and a full-fledged selling efforts gets under way. A final
prospectus must accompany the delivery of securities or confirmation
of sale, whichever comes first. Where a company allots any shares or
debentures with a view to offering those shares or debentures for sale
to the public, any document by which the offer for the sale to the
public shall be made, for all purposes, be deemed to be a prospectus.
5. Prospectus, when issued, is an invitation to the public to make offers
for the company’s securities. The prospectus embodies the terms of the
invitation for offer, the application made by intending purchasers of
securities to go in for the securities are in the application made by
 intending purchasers of securities to go in for the securities are in the
nature of offers made to the company which the company might
accept or reject.
6. The company then makes the subscription lists of those whose
application for securities are accepted.
7. Process of allotment of securities begins to those who are in the
subscription list.
8. Letters of allotment are send to whom the securities are allotted.
Auction market is a system by which securities are bought and sold at the
best possible price through competitive bidding. Prices are established by
brokers acting as agents of buyers and sellers, as well as principal dealers
acting for their own accounts. In the securities market, the best example is
the Karachi Stock Exchange, where buyers and sellers make competitive
bids for exchange listed securities by submitting order tickets to the
exchange. The commodity futures market where interest rate fixtures are
traded, is in contrast, an open outcry market, where market prices are set by
direct interaction of exchange members, standing in a pit on the trading
floor.

Alternative Issue Methods

When a company decides to issue a new security, then it can sell it as a
public issue or a private issue. If it is a public issue, the firm is required to
register with the SECP. Is the issue is sold to fewer than 35 investors, then it
can be treated as a private issue. A registration statement is not required in
this case.
There are two kinds of public issues: the general cash offer and the rights
offer. Cash offers are sold to all interest investors, and rights offers are sold
to existing shareholders. Equity is sold by both cash offer and the rights
offer, though almost all debt is sold by cash offer.
The first public equity issue that is made by a company is referred to as an
initial public offering or an unseasoned new issue. All initial public offerings
are cash offers because, if the firm’s existing shareholders wanted to buy the
shares, the firm would not need to sell them publicly. A seasoned new issue
refers to a new issue where the company’s securities have been previously
issued. A seasoned new issue of common stock may be made by using a cash
offer or a rights offer.

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Public Issue
Cash Offer
Stock is sold to all interest investors in a cash offer. If the cash offer is a
public one, investment banks are usually involved. Investment banks are
financial intermediaries who perform a wide variety of services. In addition
to aiding in the sale of securities, they may facilitate mergers and other
corporate reorganizations, act as brokers to both individual and institutional
clients and trade for their own accounts.
There are two basic methods of issuing securities for cash:
1. Firm Commitment: Under this method, the investment bank (or a
group of investment banks) buys the securities for less than the
offering price and accepts the risk of not being able to sell them.
Investment banker underwrites the securities in a firm commitment.
The difference between the underwriters’s buying price and offering
price is called the spread or discount. It is the compensation received
by the underwriter.
Firm-commitment underwriting is just a purchase-sale
agreement and the syndicate’s fee is the spread. The issuer receives
the full amount of the proceeds less the spread, and all risk is
transferred to the underwriter. If the applications for buying the
securities exceed the number of securities offered, then they are scaled
down in proportion. If the underwriter cannot sell all of the issue at
the agreed-upon offering price, it may need to lower the price on the
unsold shares. However, because the offering price usually is not set
until the underwriters have investigated how receptive market is to the
issue, this risk is usually minimal. So, any unsold shares are usually
left with the underwriters.
2. Best Efforts: The underwriter bears risk with a firm commitment
because it buys the entire issue. Conversely, the syndicate avoids this
risk under a best-efforts offering because it does not purchase the
shares. Instead, it merely acts as an agent, receiving a commission for
each share sold. The syndicate is legally bound to use its best efforts
to sell the securities at the agreed-upon offering price. If the share
cannot be sold at the offering price, it is usually withdrawn. This form
is more common for IPOs than for seasoned issues.

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For either firm-commitment or best-efforts issues, the principal underwriter
is permitted to buy shares if the market price falls below the offering price.
The purpose is to support the market and stabilize the price from temporary
downward pressure. If the issue remains unsold after a time, members may
leave the group and sell their shares at whatever price the market will allow.

Role of Investment Bankers

Investment
Issuer Banker Investor
offer price or
buying price
issue price

Investment bankers are at the heart of new security issues. They provide
advice, market the securities (after investigating the market’s receptiveness
to the issue), and underwriter the proceeds. They accept the risk that the
market price may fall between the date the offering price is set and the time
the issue is sold.
In addition, investment banks have the responsibility of pricing fairly. When
a firm goes public, particularly for the first time, the buyers know relatively
little about the firm’s operations. So, the buyers have to rely on the judgment
of the investment bank, who has presumably examined the firm in detail.
Determining the correct offering price is the most difficult the lead
investment bank must do for an initial public offering. The issuing firm faces
a potential cost if the offering price is set too high or too low. If the issue is
priced too high, it may be unsuccessful and be withdrawn. If the issue is
priced below the true market price, the issuer’s existing shareholders will
experience an opportunity loss.

The Cost of New Issues

Issuing securities to the public is not free, and the costs of different issuing
methods are important determinants of which will be used. The costs fall
into following categories:

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 1. Spread or underwriting discount: The spread is the difference
between the price the issue receives and the price offered to the
public.
2. Other direct expenses: These costs incurred by the issuer that are
not part of the compensation to underwriters. They include filing
fees, legal fees, and taxes-all reported in the prospectus.
3. Indirect expenses: These costs are not reported in the prospectus
and include management time on the new issue.
4. Abnormal returns: In a seasoned issue of stock, the price drops
by 3 percent to 4 percent upon the announcement of the issue. The
drop protects new shareholders against the firm’s selling
overpriced stock to new shareholders.
5. Underpricing: For initial public offerings, the stock typically rises
substantially after the issue date. This is a cost to the firm because
the stock is sold for less than its efficient price in the aftermarket.
6. Green Shoe Option: The Green Shoe option gives the
underwriters the right to buy additional shares at the offer price to
cover overallotments. This is a cost to the firm because the
underwriter will only buy additional shares when the offer price is
below the price in the aftermarket.

Rights
When new shares of common stock are offered to the general public, the
proportionate ownership of existing shareholders is likely to be reduced.
However, if a preemptive right is contained in the firm’s articles of
incorporation, the firm must first offer any new issue of common stock to
existing shareholders. This assures each owner his or her proportionate
owner’s share.
An issue of common stock to existing stockholders is called a rights
offering. Here, each shareholder is issued an option to buy a specified
number of new shares from the firm at a specified price within a specified
time, after which the rights expire. For example, a firm whose stock is
selling at Rs.30 may let current stockholders buy a fixed number of shares at
Rs.10 per share within two months. The terms of the option are evidenced by

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certificates known as warrants or rights. Such rights are often traded on
securities exchange or over the counter.
The process of issuing rights differs from the process of issuing shares of
stock for cash. Existing shareholders are notified that they have been given
one right for each share of stock they own. Exercise occurs when a
shareholder sends payment to the firm’s subscription agent (usually a bank)
and turns in the required number of rights. Shareholders have the choice to
exercise their rights or sell them.

In rights offering, the subscription price is the price that existing

shareholders are allowed to pay for a share of stock. A rational shareholder
will only subscribe to the rights offering if the subscription price is below
the market price of the stock on the offer’s expiration date. For example, if
the stock price is Rs.13 and the subscription price is Rs.15, no rational
shareholder will subscribe. As long as the market price does not fall by half
before expiration, the rights offering will succeed.

Undersubscription can occur if investors throw away rights or if bad news

causes the market price of the stock to fall below the subscription price. To
ensure against these possibilities, rights offerings are typically arranged by
standby underwriting. Here, the underwriter makes a firm commitment to
purchase the unsubscribed portion of the issue at the subscription price less a
take-up fee. The underwriter usually receives a standby fee as compensation
for his risk-bearing function.
In practice, the subscription price is usually set well below the current
market price, making the probability of a rights failure quite small.