As a company grows, its growth prospects will likely require additional financing. For many companies, raising new capital can be done by issuing more common stock. This may be done privately, where new shares are sold to existing owners or to investors within the personal networks of these existing owners. However, for efficiency reasons, many companies choose to issue new stock on an organized exchange. A company's first issue of common stock to the public is called an Initial Public Offering. Afterwards, a corporation may issue new equity at any time in order to finance its growth. When new common shares are offered to existing shareholders first, this is called a rights offering.
Underwriters play an important role in the issue of new securities. Underwriters help price and sell the new securities, often by buying the securities themselves and reselling them. To manage risk, underwriters often work together in groups, called syndicates. Typically, major financial institutions such as banks all offer underwriting services.
The Costs of Issuing Equity
Spread: The difference between the price that the underwriter pays the issuing company for each new security and the price that the underwriter resells the security at is known as the spread. The spread is considered to be a direct expense incurred from issuing the new equity. Direct expenses of any new issue must be reported on a prospectus given to the Securities and Exchange Commission.
Other Direct Expenses: Legal fees, filing fees and taxes for example are other direct expenses paid by the issuing firm. Direct expenses must be reported on a company’s prospectus.
Indirect Expenses: An issuing company may incur other costs such as the cost of management’s time working on the security issue. These fees are not reported on the company’s prospectus.
Abnormal Returns: The announcement of a new issue causes the price of existing stock to drop. Since the firm raises money in any new issue, the price should not drop since we would not expect a dilution affect if the new issue is correctly priced.
Underpricing: Often during an IPOs the a new issue will be underpriced. This leaves cash on the table that could have been collected if it was appropriately priced. One explanation is the winner’s curse. That is, because smart investors are able to get their hands on hot IPOs, when the average investor wins and gets shares from a new issue, it is probably because the smart investor knew better and avoided the issue. An underwriter may underprice the stock to attract more average investors.
Overallotment (Green Shoe) Option: Underwriters may buy more shares from the issuing company at the offer price when the underwriter allots more shares to investors than issued.