Negotiated Purchase

The negotiated purchase is the distribution method most likely to be used by the private corporation. It makes sense, then, to cover in some detail the sequence of events the comprise the negotiated underwriting.

1. Preunderwriting conferences. A series of preunderwriting conferences will be held between the firm and the investment banker. Key items discussed are (1) the amount of capital to be raised, (2) whether the capital markets seem to be especially receptive at this time to one type of financing instrument over another, and (3) whether the proposed use of the new funds appears reasonable. At these conferences it will be confirmed that a flotation will, in fact, take place, and that this particular investment banker will manage the underwriting. The investment banker will then undertake a complete financial analysis of the corporation and assess its future prospects. The final outcome of the preunderwriting conferences is the tentative underwriting agreement. This will detail (1) the approximate price the investment banker will pay for the securities and (2) the upset price. The upset price is a form of escape mechanism for the benefit of the issuing firm. If the market price of the firm's securities should drop in a significant fashion just before the new securities are to be sold, the price that the investment banker is to pay the firm might drop below the upset price. in this situation the new offering would be aborted.

3. Formation of the underwriting Syndicate. An underwriting syndicate is a temporary association of investment bankers formed to purchase a security issue from a corporation for subsequent resale, hopefully at a profit to the underwriters. The syndicate is formed for very sound reasons. First, the originating investment banker probably could not finance the entire underwriting himself. Second, the use of a syndicate reduces the risk of loss to any single underwriter. Third, the use of a syndicate widens the eventual distribution effort. Each underwriter has his own network of security dealers who will purchase a portion of his participation in the offering. Most syndicates will contain ten to sixty investment banking houses. Since each house will have its own distribution network, the selling group can often consist of 100 to 600 dealers, An agreement signed by all members of the syndicate will bind them to certain performance standards. This will detail their participation (amount they can purchase) in the offering and their liability for any portion of the issue unsold by their fellow underwriters.

4. Registering the securities. Before a new public issue can be offered to prospective investors, it must be registered with the Securities and Exchange Commission (SEQ) Securities that are exempt from registration will be discussed later in this chapter when we examine the regulation of the securities markets. Most new issues must comply with the requirements of the Securities Act of 1933. This dictates that a registration statement must be submitted to the SEC aimed at disclosing all facts relevant to the new issue that will permit an investor to make an informed decision . The SEC itself does not judge the investment quality of securities. The registration statement is a lengthy document containing (1) historical, (2) financial, and (3) administrative facts about the firm. The details of the new offering are presented, as well as the proposed use of the funds that are being raised. During a 20 day waiting period the SEC examines the registration statement for any errors or omissions. While this examination process is being carried out, the investment banking syndicate cannot offer the security for sale. Part of the package presented to the SEC for scrutiny is a document called a prospectus. Once approved, it is the official advertising vehicle for the security offering. During the waiting period a preliminary prospectus, outlining the important features of the new issue, may be distributed to potential investors. The preliminary prospectus contains no selling price information or offering date. In addition, a stamped red ink statement on the first page tells the reader that the document is not an official offer to sell the securities. In the jargon of finance, this preliminary prospectus is called a red herring. Once the registration statement is approved by the SEC, the security can be offered for sale provided the prospectus is made available to all concerned parties.

5. Formation of The selling group. In order to distribute the securities to final investors, a selling group is formed. The dealers comprising the selling group will purchase portions of the new issue from the syndicate members with whom they regularly do business. They will pay for each security a price higher than that paid by the syndicate member, but less than the offering price to the investing public. The responsibilities and rewards of the selling group are contained in the selling group agreement. Formation of the selling group completes the distribution network for the new offering. The structure of such a network is diagrammed in Figure 17 3.

6. The due diligence meeting. 'This is a "last chance" gathering to get everything in order before taking the offering to the public. Usually, all members of the syndicate are present along with key officers of the issuing firm. Any omissions from the prospectus should be caught at this meeting. Most importantly, the final price to be paid by the syndicate to the firm will be settled. As we said earlier in this chapter, if the issue is additional common stock, the underwriting price may be a fixed amount below the closing price of the firm's outstanding stock on the day prior to the new offering. Capital market conditions will be discussed, and the offering price of the security to the public will be set in light of those conditions. The "go ahead" will be given to print the final prospectus, which will now contain all relevant price information. The offering will usually be made the next day.

7. Price pegging. Once the issue has been offered for sale, the managing underwriter will attempt to mitigate downward price movements in the secondary market for the security. He will do this by placing orders to buy at the agreed upon public offering price. The objective of this activity is to stabilize the market price of the issue so that it can be sold at the initial offering price. The syndicate manager's intent to perform this price maintenance operation must be disclosed in the registration statement.

8. Syndicate termination. A contractual agreement among the underwriters identifies the duration of the syndicate. Pragmatically, the syndicate is dissolved when the issue has been fully subscribed. If the demand for the issue is great, it may be sold out in a few days. if the issue lingers on the market, without much buyer interest, the remaining inventory may be sold at the existing secondary market price. The name of the game in investment banking is not margin, but turnover. Should the issue go sour, the underwriters will quickly absorb their loss and get on to the next underwriting.