Most of this blog is about reducing investment costs by lowering transaction and other costs associated with acquiring exposure to equity returns. Today's post is about opposite way transactions: lowering a company's cost of equity capital by minimizing the value a company transfers when selling its equity for cash ... or in other words maximizing the cash a company receives in exchange for a given percentage of its equity.
Today was LinkedIn's first day as a publicly-traded company. LinkedIn's share price increased substantially from the initial public offering price. The large increase makes timely a short discussion about a provision in a new rule from FINRA, the self-regulatory organization for American securities firms: Rule 5131.
FINRA Rule 5131 addresses several abuses (FINRA's word, not mine) in the new equity issues market. The rule is many years in the making. The rule has its origin in the May 2003 report and recommendations of the NYSE/NASD IPO Advisory Committee, a committee formed at the SEC’s request. The report’s introduction states why the committee was formed: “[i]n recent years … public confidence in the integrity of the IPO process has eroded significantly.” According to FINRA, "the new rule is intended to sustain public confidence in the initial public offering (IPO) process ... ." Note FINRA's use of the word "sustain" rather than the more natural "increase"; avoiding the latter word avoids connotations of present insufficiency. No comment.
Most of the new rule's provisions take effect on May 27, 2011, which probably not coincidentally is more or less when the traditional equity offerings season pauses for the summer.
The new rule addresses several areas of banker abuse. Most of the trade press and law firm memoranda about the new rule focus on paragraph (b), which effective September 26, 2011 will prohibit prophylatically what is known as "spinning." "Spinning" is an investment bank's allocation of new issue shares to current and certain former and prospective directors and executive officers of the bank's clients. As a practical matter paragraph (b) will make it difficult but not impossible for public company directors and executive officers to receive IPO allocations.
Other paragraphs of the rule deal with prohibiting kickbacks associated with IPO allocations (... really, does FINRA need a new rule for that?) and with new issue "flipping."
Because the rule's provisions are aimed at banker abuses all have as their purpose -- indirectly at least -- reducing banker fees and commissions. Paragraph (d)(1), however, is aimed at reducing investment costs more directly.
Paragraph (d)(1) requires that in handling a new equity issue the "book-running" lead underwriter regularly provide the prospective public company with regular report of indications of interest (i.e., interest in purchasing the company’s shares), including the names of interested institutional investors and the number of shares indicated by each. Paragraph (d)(1) also requires that the report to the company include aggregate demand from retail investors.
The concept behind paragraph (d)(1) is that the prospective public company needs the information in those reports -- especially the most recent report -- to learn about the demand for its shares. With that knowledge, so goes the concept, the company can reduce the huge information advantage the underwriter has over the company when, after the IPO roadshow is over, it’s time to negotiate (or "price") the offering.
Rule 5131(d)(1) is written generally, without specifics. The generality creates many loopholes benefiting investment banks. A practice pointer: a going-public company should incorporate Rule 5131(d)(1) into its engagement letter with its prospective lead underwriter(s) but with specifics that eliminate the loopholes.
Even with the company's awareness of the Rule 5131(d)(1) information the underwriter's advantage is unfair. The reason for the unfairness: a prospective public company dissatisfied with the underwriter's view of an initial public offering price has few alternatives, even fewer of which are practical, to acceding to the underwriter's view about price.
And so the underwriting agreement is then signed, memorializing the negotiated initial public offering price. And then it's off to the races: the public offering occurs and the share price increases substantially during the first trading day. The company has left substantial money on the table; the value held by its pre-offering shareholders has been diluted unnecessarily.
Back to LinkedIn: determining an initial public offering price is a commercial contract negotiation between the prospective public company and its investment bank underwriter. Notions of fiduciary duties and the underwriter as an advisor are inapplicable. Judging by results -- and despite the success to date of LinkedIn’s business and the headlines and euphoria over its IPO -- LinkedIn negotiated poorly.
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Addendum: subsequent to the post above the NYT's Joe Nocera wrote a column questioning whether LinkedIn was "scammed" by its investment bankers. Joe's NYT colleague Andrew Ross Sorkin then weighed in with a short opinion piece politely begging to differ with Joe's column. Andrew's view is that although the investment bankers could have done better he doesn't believe that in this instance the investment bankers were scamming.