Memo from the Chairman
Robert A. Spira
CHAPMAN SPIRA &
Investment Banking Consultants
(November , 1998)
- Coping With Changing Environments
- Maximization of Your Results, Staying Within Your Abilities
and Not Stubbing Your Toes.
- In an innovative approach, Chapman Spira and Carson has established
an offsite evaluation and systems department for small to mid-sized
companies. The purpose of this division is to provide management
with all of the necessary tools to facilitate decision making
in our ever-evolving business scene. The day of the local cabinetmaker
who only had to concern himself with where to buy the best wood
to build his product are over. We are overwhelmed with innovation,
which allows todays business the ability of expanding
beyond anything before dreamed possible or in the alternative
falling prey to competitors that are not even visible.
- Technological innovations such as the Internet have changed
the way products are marketed. No longer is your only competition
the guy next door. Today he can be across the continent and
tomorrow he may reside half a globe away.
- Banking has also altered its face as the era of dropping by
the local office and refinancing the business over lunch has
gone the way of the dinosaur. The financial business has become
institutionalized and loans are made more by being a candidate
that the computer recognizes as a good risk than a good dinning
companion. Dealing with the banking community now requires mew
expertise totally contrary to the requirements of the past.
- American industry has learned well from the Japanese, and
we have taken their "just in time" inventory
methodology and lowered the average amount of time that the
product is kept on the shelf from a two month supply to that
of one month. This has caused suppliers to look for less expensive
and more exact ways of shipping product, more centralized manufacturing
facilities and alternative raw material suppliers.
- The minimum wage has been raised recently and payroll expenses
continue to climb. Unemployment has reached almost at historic
lows while immigration has been cut off. Green cards are no
longer issued by the Passport and Emigration Service upon request
and the union movement has regained strength. Insurance costs
have risen unmercifully and social security rates continue to
climb. It would take a Ph.D. just to follow what is happening
on a daily basis. It is not conceivable that a small business's
can do this and grow their business, the number of hours in
a day has remained at a constant twenty-four.
- The rules and perceptions regarding corporate reorganizations
have changed dramatically over the last several years and the
stigma of using the regulations covering these actions has literally
evaporated. Many of the practices that historically were considered
immoral are in todays climate considered "good
business". All business has good and bad times. There
are alternatives to cover the rough spots that were not viable
just a few short years ago.
- During the Republican years, many of the government agencies
that were charged with aiding businesses had much of their funding
diminished severely. The Clinton Administration has
taken a 180-degree turn and resurrected many of the old programs
while simultaneously aiding new ones. There are programs geared
to assist all businesses, not just minorities. It is only a
matter of knowing what they are and how to go about utilizing
them. The states have also installed economic development programs
that can be of great value to the entrepreneur if you just know
where to find them.
- Roll-ups have become the new Wall Street fad. A roll-up is
simply the combination of a large number of small businesses
within the same general business category for the purpose of
saving money through greater purchasing power, sharing general
and administrative expense, keeping up with government regulations,
analyzing current business trends and creating solid marketing
plans to cope with the ever changing marketplace, and ultimately
to go public at a combined price earning ratio far higher than
the local business would ever have received by itself. Car agencies,
doctors practices, franchised food takeout stores, hardware
stores and funeral parlors are just a few of the recent "roll
ups" that have "worked" for owners and investors
- The only way for many to survive would be the acquisition
on other competitors so that you can receive the benefits of
quantity discounts in materials and shipping. Centralized manufacturing,
low tax and available labor areas are also important consideration.
The quest for financing, location and acquisition is time consuming
and an art form that takes a lifetime of experience.
- These are some of the areas that our management experts cover.
Let our people come in and make recommendations on everything
from the ground up. We will also individualize management assistance
on an ongoing basis for as long as it may be required under
a number of unique plans because they dont know whether
it will ever be worth anything. For the most part this is a
pretty hard sell. However, there are some exceptions. You can
use what is called the "Bill Gates Anecdote" about
the guy that knew Bill from school, who went to work for him
and faithfully took his entire salary in Microsoft Stock. The
loyal employee in question now owns two major-league sports
teams and is one of the richest people in the United States.
- Raising Money in the Public Marketplace.
The Terms, The Tricks and the Essence.
- This memorandum has been an attempt by Chapman Spira and Carson
LLC to put in rational prospective the process of going public.
We have attempted to make the reading of a most difficult subject
enjoyable and have added a few stories of our own to illustrate
what we believe to be important points. We are not underwriters,
or even brokers for that matter so this is a primarily public
interest document, but if there are questions that arise when
perusing the material presented, please free to call or e-mail
us and we will do our best to get back to you with a response.
If you have a deal that should happen, let us find you a firm
on the "Street" that best suits your criteria.
- What do we do first?
- Before you raise money publicly (or any other way) you should
consult your lawyer and accountant and ask them about the advantages
of incorporation. It is generally more suitable to use a corporate
structure because personal liability is diminished and, for
practical purposes, it is the only entity that is acceptable
for public offering purposes. The risk of raising money in our
own name is that if things do not go as well as expected you
could find yourself either in bankruptcy court or paying creditors
off for a long time to come. Incorporation is a relatively painless
process and can be accomplished literally overnight in most
jurisdictions. Legally, you are allowed to incorporate wherever
you desire, and substantial competition exists among the states
in the form of incentives to induce corporations to chose their
locale. These incentives include lower tax rates and protection
of officers and directors from certain types of litigation under
specific statutes. The state in which you ultimately incorporate
has no bearing on where your business is located. Your lawyer
and accountant will give you advice concerning the best jurisdiction
and the best corporate form to fit your long-term goals.
- SECTION ONE
- Corporation- must apply for a charter "Articles of Incorporation."
Or "Certificate of Incorporation". Before incorporating
you will have to know:
- What name you want to give the corporation
- Where you want to incorporate
- How many shares you want to be able to issue
- How much money the corporation can or should borrow
- What each of the officers should be able to do
- Who the original directors of the corporation will be and
where they live
- This stuff is all pretty basic although certainly important.
Of the checklist above, the name is most important and should
be considered carefully. Changing it down the road can be both
confusing and expensive. The name should relate to the companys
business and send a message that tells people that see it what
you are about. General Motors obviously sells cars, Mary Carter
Paint Company didnt sell paint at all but would you believe
owned Resorts Casino.
- Board of Directors
- The Board of Directors is elected by the stockholders. On
day one, the original incorporator who probably owns most if
not all of the stock calls a meeting and names the board. If
you are attempting to raise money, you should add some strength
and maturity on the board with you. This means the wife and
kids may not be your best choices as Board members. As a general
rule we would also eliminate from consideration, hardened criminals,
defrocked clergy, and disbarred lawyers. Investors generally
like to feel that the people guiding the ship have been through
the treacherous waters of business before, and can react constructively
to any problems that may arise.
- When you are talking to people about raising money, you may
need to know the meaning of some key words:
- Websters defines capitalization as: "The total
capital funds of a corporation represented by stocks, bonds,
undivided profits, surplus, etc."
- Capitalization is composed of debt and equity. Stocks are
commonly referred to as equity securities. Bonds are commonly
referred to as debt securities.
- It pays to get your lawyers and accountants best
thinking on the initial capital structure. After the initial
capital structure is in place, any capitalization change must
be approved by the stockholders, who can get to be a pain. It
is best to have an unlisted telephone number at home, if you
intend to have a lot of shareholders.
- There are different kinds of shares of stock and the number
of possibilities are as great as the human mind has the ability
of thinking things up. We have simple things like voting and
non-voting common. We have participating and non-participating
shares; you may ask participating in what and I would answer,
participating in anything, dividends, votes or conversion, take
your choice. We have war-like classifications such as exploding
common and preferred and more down to earth items such as founders
shares. There are shares with warrants attached and shares that
have rights to more shares and there are shares that have shares.
Drexel Burnham during the Millikin years probably did more for
exponentially expanding our equity universe with new creations
than had been accomplished in total since man first walked upon
the earth. In spite of the above we will go into some of the
classifications that you will run across in the ordinary course
- Authorized Shares
- The authorized shares are the total number of shares issued
and in the hands of stockholders along with those that may be
issued at some later date by a vote of the Board of Directors
of the corporation. Our corporation could have 500 authorized
shares of which you own 300 and other shareholders hold 100.
Another 100 is in the treasury and can be issued on Board authorization
for any legitimate corporate use. It may be better to issue
more shares than you currently need in order to avoid having
to beg the shareholders down the road to approve more if something
good comes down the pike.
- Hypothetically, the competition could be in a situation where
it would be in the familys best interest to get their
estate planning in order and exchange their shares for those
in a publicly traded company. The head of the company is very
ill and the lawyers want to make a quick deal to avoid extensive
probate problems. The easiest deal to make quickly is usually
one in which the negotiators are familiar with each other. You,
as their primary competition, fall into that category and when
their lawyers reach out to you, it becomes quickly obvious that
this would be a terrific fit for all concerned. An agreement
is quickly reached on the number of shares to be exchanged.
However when your corporate secretary checks he finds that there
are not enough shares authorized to accomplish the transaction
within the timeframe required.
- The by-laws require that certain notice must be given to shareholders
regarding the issuance of additional shares. In spite of the
fact that it is a foregone conclusion that the transaction would
have ultimately been approved; the insiders that negotiated
the merger also control 50% of the companys shares, but
yet there is no realistic waiver to the required notice period.
The condition of the competitions president becomes grave,
his lawyers determine that although you are the best deal for
all concerned, they just cannot take the time to wait for the
shareholders to agree to the issuance of additional shares.
- The company is quickly sold for less money to someone else.
The new purchaser turns out to be in a much stronger financial
condition and dedicates his substantial resources to his newly
acquired line of business. The result becomes a disaster, you
were not fortunate enough to acquire a major competitor and
that have forfeited the benefits of increased volume and the
savings of lower unit costs. Worse, you are now confronted with
a competitor far more formidable than before only because someone
had fumbled the ball and had not taken the simple precaution
to have additional authorized shares on the shelf in case something
like this happened.
- One of the most canny guys we know jokingly asks his lawyers
whether their malpractice insurance is fully paid up when they
are setting up new corporations. Although incorporation itself
is one of the most painless tasks in business, the price for
even the smallest mistakes can cause problems that will effect
your business for a long time to come. Make sure that it is
done right the first time.
- Issued shares
- Public stock is useful for more than just corporate acquisitions.
You can exchange authorized shares for services necessary in
getting the business started such as accounting fees, office
rent, furniture and fixtures, fees for board members and executives
and employee salaries. In many cases, until the company has
gone public most people are reluctant to accept stock because
they dont know whether it will ever be worth anything.
For the most part this is a pretty hard sell. However, there
are some exceptions. You can use what is called the "Bill
Gates Anecdote" about the guy that knew Bill from school,
who went to work for him and faithfully took his entire salary
in Microsoft Stock. The loyal employee in question now owns
two major-league sports teams and is one of the richest people
in the United States.
- Treasury stock
- These are shares that were authorized but not issued, or were
issued and repurchased by the issuing company. Treasury stock
has no voting rights. As we have just explained, these shares
just sit in a "bank" waiting for someone to draw them
out. Once all the shares have been issued, the company will
have to go back to the stockholders and ask them to allow the
issuance of additional shares.
- Private Placement
- All offerings of stock to investors are covered by securities
laws and even though sales of shares to relatives and friends
seems reasonably harmless, this is not always the case. Any
exchanges of cash for stock should be discussed with legal counsel.
Money is commonly raised for non-public companies though private
placements. Generally, this is an offering of stock to investors
in which the group of investors is larger than just friends
and family. It may include wealthy individuals who have "been
around the block" and have assets over a limit set by federal
securities laws. The line between a private placement and a
public offering is clear, but the rules are many and very technical.
When you are deciding between the two,you need to have a good
securities lawyer on board.
- So, the Blodget family incorporated the company and started
up the business. They set up a small production line in the
barn behind the tavern and before you knew it, they were actually
producing an item, that at a meeting of the family was named,
"the Blodget" after themselves. These gadgets were
literally amazing, no one had any idea of how they worked and
some of the stores on Main Street started carrying them. Would
you believe it, people actually began buying them, some even
bought more than one so that the kids could use it during the
- The Blodget family went to the well and raised money from
the old gang in a private placement offering and used the money
to retire bank debt and to hire a marketing team. Business is
exploding and they now need some real money but everyone says
our capital base is too small. They think we ought to go public.
Out of the blue, one of the local brokers who had bought one
of the Blodgets and really freaked out came back and bought
them for the rest of his family. He then asked if they wanted
to go public. Before you knew it a letter of intent
is signed with the brokerage firm next to the barber shop and
they tell me that it wont be long before we will be on
small cap NASDAQ, whatever that is."
- At this stage of the process you need to be familiar with
some other terms:
- New Issue or "IPO" ("initial public offering")
- An Initial Public Offering is the first issue of securities
by a company that has previously not been public.
- Assume for a moment that you have been through the initial
public offering stage and business opportunities are continuing
to come your way. The scenario could go something like this:
- So time has really flown by, someone by the name of Clinton
is President and Russia has become our friend, Blodget has now
been public for several years. Business has remained good and
the customer baser base has been extended into the Far East
and Europe. They just couldnt get the stuff out the door
fast enough in the small plant in Blogetville so the Blodgetss
talked to their consultants and the conclusion was that manufacturing
facilities should be setup in the Pacific Rim. A partner was
identified and a joint venture arranged with a Korean Company
but it was required that Blodget put up its share of the joint
venture expenses. The companys bank lines are at the limit
creating a short term crunch and additional debt would screw
up the balance sheet. Touché recommended that we sell
more stock. What is a secondary?
- The local guy that took the company public thinks that Blodget
has outgrown his financial resources and came up with some suggestions
as to people in New York that could raise the kind of money
were talking about. So the Blodget'ss flew to New
York and visited with Goldman and Solomon and Morgan and Bear
Stearns. The family went to all the sport events and the nice
restaurants. Cousin Franklin was so overwhelmed that he muttered,
"I think they all really liked us."
- The price of poker is rising here. We think that it is time
that you become familiar with some more serious words:
- Securities and Exchange Commission ("SEC") - The
SEC enforces a group of federal laws that prevent fraud in the
sale of securities. When your company sells securities they
must be registered and must provide purchasers with a prospectus
that states that in spite of the fact that the SEC has spent
substantial time going over and over and over and over the offering
statement, it is not making any representations regarding the
adequacy or accuracy of information.
- Your accounting and legal advisors should be aware of these
acts, and you should be able to trust them I have heard
something like the following a little too often from prospective
- "I told the lawyers that in advertising we call it puffing
and its perfectly ok. I mean, where would the automobile
and cosmetic companies be if they didnt lie a little bit
about the product. I told the lawyers that they are working
for me, not the other way around, and that I call the shots.
All I asked them to do was to carry my stamp collection as an
asset on the books. It would make us look better; wed
be eligible for National NASDAQ, whatever that is, and I dont
look at the collection too much any more."
- They said that I couldnt do it because of GAAP (generally
accepted accounting practices) and if I tried it, I would be
breaking both the 33 and 34 acts. Well I dont
know much about acts, and I'm the boss, so I told them to do
it anyway. They left and said something about not wanting to
go to jail over my stamp collection. Im not sure I know
what to do next."
- If you want to sound smart when you talk to any of your advisors,
you need to know some more about the key events and terms surrounding
registration with the SEC:
- Filing date
- Blodget, Inc.s filing date is their day their registration
statement is received by the SEC.
- Blodget, Inc. will have to provide at least the following
information to the lawyer who prepares its registration statement:
- Blodget, Inc. will have to describe its business and disclose
the shareholdings of senior officers, directors and underwriters.
It must identify people who hold at least 10% of the companys
securities. The purpose of the exercise is to make sure that
the public is told just who is in control of the company. Theoretically
you could be John Dillinger and they would have to approve the
registration if it is factually correct. On the other hand,
if you were incarcerated at the time of the offering, you would
have to disclose that fact as well, which might cause investors
to have second thoughts about investing.
- Blodget will have to provide the biographies of officers and
directors. The SEC wants to make sure the public is aware of
the skills and experience of the people who run the company.
Investors want to know that the folks handling their money are
not going to put it in a bag and leave the country. It is wise
not to choose travel agents, airline personnel or people in
the passport bureau as board members, because investors tend
to think the worst.
- Blodget will have to disclose the Companys capitalization
- how funds are brought in - through stock and bond offerings.
It will also be necessary to describe how Blodget made money
and raised money, how it spent money and paid taxes. All those
things seem to wind up on the liability side of the balance
sheet and magically they are supposed to make everything come
out even. Actually, I think that the accountants are cheating
a little bit, I mean if it isnt exactly in balance, you
can take little for over here and put it over there. It doesnt
make any sense that they find every nickel and account of it.
Im sure that that is what really happens.
- Specific uses of the proceeds. Investors want to know exactly
how their money will be spent. Ive heard the following
a little too often:
- "We really need the money for this joint venture in Korea,
but my Shirleys car is starting to show some wear, so
we will make her an officer of Blodget and let her run a division
called "area evaluation" and get her a new car so
the company will pay for it. After all, the kids are already
running sales and marketing. The little woman should be on the
old gravy train as well. The accountants say that this is all
right as long as the car is used exclusively for business and
that she is really working at her job. Well, I told them that
this was the case, but Shirleys never been down here and
doesnt even know what a Blodget is, let alone how to "area
evaluate". Were going ahead and hoping for the best."
- Blodget will have to provide certified financial statements.
Unbelievably, some of the smartest entrepreneurs Ive met
have reacted this way to the duty of providing certified financials:
- "So this guy that I never saw before comes in. Someone
says that he is the outside accountant and that Blodget will
have to certify its books. The whole thing doesnt
make much sense. If he is working outside, how can he know what
happening inside? Well maybe, with the way we are running things
its all for the best and he shouldnt come in. Anyway,
our regular accountants, Touché Anderson and Ross, say we have
to give this fella access to all of the records. Im not
letting him see my proctoscopic x-rays though."
- The Securities and Exchange Commission Act of 1933 is designed
to provide purchasers of new issues of securities with information
regarding the company and to prevent fraud in their sale. In
the event the SEC sees a deficiency or misrepresentation, it
can postpone the effective date of the issue or issue a stop
order -- which prohibits the sale of securities.
- Investors can sue officers, directors, principal stockholders
and underwriters if a registration statement has material omissions,
errors, or misrepresentation of facts. They also can sue officers,
directors, principal stockholders and underwriters for anything
else they want to sue them for as well. As a matter of fact,
so many stockholders filed so many lawsuits against public companies
that two things happened. The first was that lawyers became
very rich. The second was that the price of Directors
and Officers Insurance
- (D & O) went to the moon. D & O insurance is the type
of policy that officers and directors buy so that they can screw
things up as badly as they like and not have to take the money
out of their own pockets when stockholders sue them for mismanaging
- In the last couple of decades, the price of D&O insurance
increased faster than the Dow Jones Averages, until a recent
change in the law. The important people on Wall Street became
concerned when even brokerage firms became parties to the lawsuits
filed against corporations. It seems that the public, for some
strange reason, felt that brokerage firms should check to see
that all of the things being stated by the company are true.
The SEC requires that all brokerage houses involved in the money
raising process make sure that everything is on the up and up
before weaving their wondrous stories espousing the companys
attributes to their customers. While this approach made a lot
of sense to the Securities and Exchange Commission, some brokers
and securities lawyers took offense at the notion that they
should have know their client that well before siphoning money
out of clients accounts. The general feeling among this
group was that lawsuits are bad for the country, bad for motherhood
and bad for members of the New York Stock Exchange. Congress
agreed with the important people on Wall Street and passed new
laws that were not helpful to the investing public or class
- Congresss law in essence states that you cant
file frivolous securities-oriented lawsuits; I mean, you had
better have these guys red handed or you will be looking at
rule eleven charge. Lawyers who do not understand the term frivolous
have taken the high road and have gone into other lines of practice.
Seeing this mass exodus of litigating attorneys from the Street,
insurance companies determined that they could again afford
to drop their rates on Directors and Officers Insurance (DO)
coverage. With the rates becoming more affordable and litigation
no longer hanging over the heads of management. Wall Street
has regained the more relaxed approach to funding new companies
that it normally has during periods of when the governmental
has a more laissez fare toward the securities business.
Although it will not work out to well for the investing public,
we are again seeing smiling faces on the Street, which has become
a more pleasant place to work.
- Cooling off period: a time, usually measured from the day
a proposed registration arrives at the SEC for its review and
the day the SEC indicates it has had enough and the underwriting
is a go.
- During the cooling off period, a preliminary prospectus or
"red herring" is prepared by the corporation.. The
document is dubbed a "red herring" because the prospectus
has a cover page with a red border that advises potential investors
that a registration statement has been filed, but isnt
yet effective. During the McCarthy era, the word "red"
had very negative overtones. Perhaps this is what the commission
had in mind when they created the red stripe down the side of
the offering memorandum.
- Some people that are in the know say that in King Arthurs
time, when people where being chased by the hounds, if a "red
herring" was dragged across the path of the hard charging
dogs, the dogs senses were total screwed up by the strange smell
and they lost all track of the quarry. The dictionary elucidates
on this by stating that a red herring is something used to divert
attention from the basic issue. We couldnt agree more.
- The "red herring" is a tentative document that will
resemble the ultimately approved copy. It is used primarily
by lawyers to as a draft, but occasionally brokers will share
its message with their clients. For the most part neither the
"red herring" nor its ultimate successor, the approved
registration statement, will have anything good to say about
anything or anybody. You could tell anyone within hearing distance
all of the negatives, the "risk factors", but making
any unqualified positive statement, particularly if it predicted
the success of the company in some way, has historically been
treated as a crime against nature, punishable by a long visit
to a government facility at their expense.
- Problems arise during the cooling off period (also known as
the quiet period for unknown reasons) when a product release
occurs simultaneously and the marketing people and the legal
staff become confrontational. Management steps in when this
happens, the companys marketing, public relations/advertising
agency and the securities lawyers meet for hours trying to reinterpret
the SEC regulation so that they can hype the product and still
collect the much needed funding.
- The SEC, speaking out of both sides of its mouth says in one
breath that if the incident is material, the company has an
affirmative obligation to publicize the event in order to keep
stockholders informed as to what has happened. If the SEC believes
that the event was not material, and that an announcement is
made only to "hype" the securities issue, the perpetrators
can be censured, fined or even imprisoned. The meaning of "material"
is elusive. The SEC has indicated that they are not in the dictionary
business, and added that if they told everyone what they were
going to do and when they were going to do it, then everyone
would know what was going on and would lose respect for their
mission. Additional there was some feeling among "the staff"
(anybody that works for the SEC including the janitor) that
this would probably cause people to comprehend what steps had
to be taken to avoid these penalties, thus income from fines
would drop causing some career people at the Commission to become
- One staffer was quoted saying that, "It was best for
everyone if we leave definitions to Webster and just concentrate
on our mission of putting people that break the rules in jail."
One of the solutions that Doctor Bob came up with to avoid this
problem was that companies should time product releases so that
they are not released when the company needs money. Someone
said to Doctor Bob that this would in effect stop the company
from performing its profit making function. Doctor Bob indicated
that he understood.
- Also during cooling off period, the issuer will "Blue
Sky" or register the issue in the states where the underwriter
plans to market the IPO. A state may approve or disapprove the
sale of securities within its borders based on its own regulations.
States regulations may contain provisions that are diametrically
opposed to those in the SEC code. For many years the Securities
and Exchange commission has been attempting to create a set
of regulations that could be accepted by all of the states but
this has been viewed as a ploy by many to eliminate regulatory
- The fact that there is no compromise in sight continues to
create a lot of legal business for lawyers. Surprisingly, the
American Bar Association has been strongly supportive of states
rights. A sage once said that to be "Blue Skied" in
all fifty states, the company must have sales of over $100 million,
no debt, no officers of questionable background, no advertising
and, preferably, no product. They can have no litigation against
them and the officers and directors must be regular churchgoers.
Each state has its own prejudices. Some states like California
and New York are liberal on taxation issues, yet conservative
when it comes to certain environmental issues and straddle the
road on others.
- Immediately prior to the issuance of the final prospectus,
a due diligence meeting is held. The purpose of the meeting
is to review various aspects of the planned underwriting, specifically
the issuers and underwriters exercise of "due
diligence" in meeting federal and state laws and examining
the subject company that is a candidate for an IPO. The forum
is arranged to accept questions from the audience, but usually
the bar is opened for some time before the question and answer
session is scheduled to begin. The objective is to encourage
the audience to be receptive to the companys own version
of its story. A succession of speakers then proceeds to make
a series of increasingly outlandish statements intended to stampede
the audience into buying the shares. The outlandish statements
assume substantially greater credibility as the evening wears
on. It isn't until the next day that attendees try to figure
out how many shares they had committed for the previous evening.
Many frantic calls are exchanged between the attendees and the
- To recap, the following steps are usually taken in laying
the groundwork for bringing an issue public:
- File registration statement with Securities and Exchange Commission
- Blue Sky the Issue
- Issue Preliminary Prospectus
- Due Diligence Meeting
- Issue Final Prospectus.
- Earlier we discussed in detail the steps leading up to the
issuance of the final prospectus so we felt that it would be
apropos to address the most difficult aspect of the process
independently. This can be very painful for all of the people
involved because no one is quite sure what the rules really
are. We have been told that the SEC gives all of its examiners
a secret book that details exactly what the final prospectus
should contain but we have never met anybody that has actually
seen it. Supposedly, each of the SEC representatives carries
this book about him wherever he goes.
- Some have said it is biblical in nature and the agent is to
read it at all hours that he is not on the job. This book is
a roadmap advising the agent on how to best make the issuer
totally miserable. When exciting new methods of torturing companies
new to the process are discovered, a new edition of the book
is immediately published containing this important information
so that it can be shared by the field staff. Some embittered
issuers have stated that the SEC must be rewarding examiners
who create new impediments with substantial bonuses.
- The final prospectus must be promptly distributed to prospective
buyers of the issue after the effective issues date. Once
the purchaser of the shares in the offering has had time to
peruse the final document, he has the right to rescind his purchase
literally for any reason whatsoever. In practice this occurs
only when there are substantial differences between statements
made by the broker and the facts that appear in the prospectus.
Even if every client purchasing stock in the IPO, if it were
a firm deal, were to rescind it would not effect the company
in that they received good funds from the underwriter at the
time the deal became effective.
- Many people cant tell whether they have been told the
truth or not by reading the prospectus because it is written
in a language which at best is must be considered most unusual.
Knowledgeable people have said that it is a cross between Sanskrit
and Esperanto which we are told, the SEC believes is the language
of the future. Having qualified interpreters available to determine
what was meant in these languages has not been too successful
in court. The next hurdle the is the most difficult,
- Exempt Securities
- These are securities that are not subject to the registration
requirements of the 1933 Securities Act. Exempt securities also
include securities that do not have to follow certain provisions
of the Securities Exchange Act of 1934 in terms of margin, registration
of deals, certain reporting requirements, and the identity of
- U.S. Government and U.S. Government. Agency Securities
- Municipal Securities
- Securities issued by non-profit organizations
- Bank Securities
- They may be exempt, but we are not sure what that means. It
may have something to do with registration the fact that they
can be freely offered without a regulatory authority passing
on them. In the particular case of Government securities, we
think that the term exempt means that the government is not
going to lie in an offering memorandum regarding the placement
of their securities and a buyer shouldnt worry too much.
In other words, if you cant trust Uncle Sam, who can you
- At the same time, salesmen recommending government securities
have several problems. First, there is not much profit in these
instruments for the broker. Second, it is hard to get a customer
once invested in governments to switch into a penny stock on
which the broker makes a lot of money. Therefore, when all is
said and done, the U. S. Government has taken the position that
you can call its securities whatever you want, but dont
call them late for dinner.
- For some period of time firms that dealt exclusively in the
U. S. government arena didnt even have to be registered
as a broker. Some people, such as the more prestigious brokers
and banks, abused their privileges and did bad things in the
government market, treating it more as their territory than
the Governments. The Government became upset at losing
turf and was forced to punish some of them severely. They made
the government look bad. These are institutions you do business
- The government said, even though our securities are exempt,
you cannot go around breaking securities laws whenever you want.
After all, the public is still protected by the anti-fraud provisions
in the act arent they? Well the bad guys said, awe come-on,
when you needed your merchandise moved you didnt mind
our rigging the market now and then, now that you dont
need help any more youre becoming sassy. What the bad
guys said is mostly true.
- Now municipal bonds are something else. They are almost universal
free from Federal Taxation. Because of all the rights granted
the states in the constitution, states and their subdivisions
could independently do their own financing and not have to worry
about paying assessments to the federal government. Because
of this quirk, the states, cities, municipalities and taxing
districts were able to pass along this benefit to the buyers
of their bonds. Municipal bonds of an equivalent rating with
that of the U. S. Government would sell at a price equal to
the current federal income tax rate deducted from the equivalent
government bond. In other words you have to compare apples with
apples and not with oranges. A 20-year Virginia general obligation
compared with a 20-year Treasury bond.
- In any event, the non-federal taxing authorities found a good
idea. They would raise a lot of money by telling people that
they were going to do something or other and then they wouldnt
do it. (After all the bonds were exempt, werent they?).
Instead, they would buy U. S. Government paper with the proceeds,
thus making a profit on the difference between their interest
cost on debt and the rate they received from Uncle Sam. This
caused taxpayers in states that werent smart enough to
do illegal things to ship money into states that were engaged
in these activities. Luckily, I always lived in a state that
knew how to do this. They fact that they lied as to what they
were going to do with the money seemed to be OK because they
were the government. I guess that seems all right, but Im
really not sure.
- Another thing that the non-federal tax accessing bodies can
do that seems strange is that they can sell bonds that represent
financing for private industrial concerns. These strange bonds
are called industrial revenues. States and other taxing authorities
interesting in attracting industry can give companies showing
interest in their location various benefits. These could include
tax abatements, free land, plant and machinery, a cash bounty
for each employee they hire along with a never ending list of
additional goodies if the facility will ultimately hire enough
residents, produce enough taxes and become a good enough citizen.
The package given to various Japanese auto companies by various
states to set up manufacturing literally went on for pages and
pages. I have often wondered why no American company ever qualified
for something like that but Doctor Bob said it has something
to do with the CIA and it is best not to pry.
- To most companys, the most singly beneficial part of
the offering package is the ability to get Industrial Revenue
Status. This allows the company to issue a tax-free bond and
rates under those of the competition that is only paid back
from the particular revenue of the project being financed. Often
startup or companies with poor credit can raise money through
this method that would be unavailable under any other scenario.
- Primarily, because of these strange characteristics, many
people have lost their savings in these investments. Vietnam
veterans and old people have been particular targets of inventive
financiers who create companies as fast as nefarious brokerage
houses can move the paper that they generate. To some degree
a damper has been put on this activity after everyones
money was lost so I guess I shouldnt even have brought
it up but I still feel sorry for some of those people.
- Charities that qualify for tax exempt status, are able to
raise money with reasonable latitude. Recently one organization
offered investors the opportunity of donating to a fund that
would match whatever they put up dollar for dollar. Thus, the
potential patrons were told they would receive a double deduction
from the internal revenue service. With taxes (including federal
income taxes) approaching 50% in some states, money could be
given to charity and when the tax benefits were added in, there
literally would be no cost to the donor and he would be held
in great esteem in his community. Many important people donated
to this cause because they wanted to be held in greater esteem
then they already were. When the whole thing turned out to be
a fraud, they became liable for unpaid taxes, and lost whatever
esteem they had previously garnered and probably a little more
for being such idiots to believe in being able to get something
for nothing. They guy is that ran the charity is going to be
in jail for a long time but that wont help everybody who
- Most of the money we donate to charity is never used for the
purpose the donor intended. By far the largest percentage as
a rule goes for general and administrative expenses, so that
the people running the charity can have nice homes, big cars
and send their kids to college so that they can become legitimate
when they graduate. I guess thats why charities are exempt.
If we knew that none of the money was going where we intended,
we probably wouldnt be so generous and these kids couldnt
go to college. We think that continued exemptions for charities
is probably a good idea, Uncle Louie runs a not-for-profit and
maybe someday Ill need a good job.
- Bank Securities are also exempt. This may be because most
of the crash of 1929 was blamed on the banks and when the securities
laws were written in 1933 and 1934 it was thought best to stay
totally clear of anything remotely connected with banking because
it would give the brokerage industry a bad name. Brokers have
gotten a bad name on their own and many of the exemptions in
the 1933 and 1934 acts are no longer required.
- It was also felt that banks needed more latitude in telling
their stories so that they could raise money. If banks had to
disclose everything, the SEC felt that no one would ever put
money into that kind of security. They felt it best to allow
the banks to make up whatever story they wanted for the good
of making the industry health again. The banks became very adept
at making up stories and raised substantial sums of money.
- Regulation D
- The Securities and Exchange Regulation D exempts registration
for private placements of Securities and Exchange Commission
- Issuer believes buyer is a sophisticated investor- I think
this is one of the more important definitions that we will deal
with. Notice that the discretion as to the buyers sophistication
is left to the Issuer. This seems a little like having the fox
guard the chicken coupe. I can just picture the president of
Blodget Widgets, a company that is down to its last $20 in the
bank, saying to an investor holding a check for $ 1 million,
"I dont believe that you are sophisticated enough
to invest in may company". It is possible that this has
occurred in the distant past, but it was not the action of a
company officer that caused the event; it was more likely the
corporate counsel that was afraid to lose his license to practice.
You can make book on the fact that the attorney never did any
work for Blodget again.
- Another confusing aspect of this regulation is the fact that
the going definition of an accredited person is one who earned
$200,000 during the previous two years and has a net worth of
$1 million. Im not sure that this is a good definition
of a sophisticated investor. Doctor Bob is probably worth a
whole lot more than that and he certainly earns more than $200
thousand a year, but I have never seen anybody worse with money.
- I mean this guy puts his money into every hair-brained investment
that comes down the pike. You may remember that he was the guy
that said buy comic books; comic books are going through the
roof. That was just before they collapsed. Next he started buying
something called commemorative plates that were also going to
make him a lot of money. The plate market fell apart when the
moving people were moving them into the warehouse, the guy dropped
them on the pavement. Then he invested in a company that looked
for sunken treasure, and they actual found the stuff, but the
state impounded it. Doctor Bob still visits his treasure in
the state nautical museum though and thinks of what might have
- Ultimately, things got so bad that they had to appoint a conservator
for Doctor Bob so he wouldnt keep messing up. Well, in
spite of the fact that the court wont let him sign his
own name to a check for anything but groceries, Doctor Bob can
still fill out private placement memorandums and qualify as
a sophisticated investor in the eyes of the securities laws
of the U. S. Government. Things keep going from bad to worse
for him. Yesterday the fella in the white jacket said that Doctor
Bob couldnt write with anything that had a sharp point
anymore. How is he going to write complicated prescriptions?
- Buyer must have financial information in memorandum form.
This too is extremely important. It makes a lot of sense that
they get all of this information, except for one thing, the
financials are not necessarily done by an accountant. As a matter
of fact for the most part, they are created by highly imaginative
people that could have found more successful careers writing
science fiction. They weave stories that would make the characters
in Alice in Wonderland stand up and take notice.
- Almost all private placement memoranda show a series of projections
that have no basis in fact in the real world; they predict that
the issuing company will have a profit somewhat in excess of
the combined gross national products of the European Community
by the year 2004. Many people with great intellect (among them
Doctor Bob) place a lot of faith in these projections. It was
once estimated that if you added all of the projected after-tax
income to be generated by companies doing private placements
in 1996, they would show earnings of more than the estimated
gross domestic product of China, The United States and Japan
in 2050. These kind of statistics make a person less than sanguine
when approaching financials that appear in many of the private
- Issuer is assured buyer does not intend to make a quick sale
of the securities. This one is a real corker. The private placement
memorandum contains a statement that the buyer is not going
to turn around and sell the offering immediately. We dont
understand why that is of any consequence, other than as a subliminal
message by the government saying, "your odds of ever seeing
a nickel on this investment are next to zilch. Dont get
any ideas that youre going to be able to turn this thing
around for a quick profit." We would ask the government
a more germane question. To whom would I sell this thing if
I could sell it at all? Maybe the government knows people that
are buying up all of these gems and they are subversive or something.
Doctor Bob would certainly like to meet them.
- Exit Strategies
- Things tend to get so bad in these deals that for the most
part we wont do them at all unless there is an exit strategy.
What this means is that I have no interest in becoming a permanent
minority stockholder in a company run by a bunch of people I
know nothing about. If it is successful I dont want management
filtering all of the profits out of the company in large salaries
and expenses accounts. I am not interested in helping put their
children through school by having the corporation pay interest
on classes of stock I dont own and I am not interested
in having to go through extensive litigation to get what I was
promised in the first place. What we insist upon is managements
agreement to a definitive exit program, in writing, before
we even think of making the investment.
- There are many ways that it can be done such as guaranteeing
to do a public offering in which your shares are freed up as
part of the registration process. For legal purposes, these
intentions should be spelled out, chapter and verse within the
private placement itself. This will not help a lot, because
if the deal is a bummer anyway, nothing is going to save you
from losing your money. One major American brokerage firm admittedly
sold its customers over a billion dollars worth of questionable
securities and is now after getting caught is trying to figure
out how much they have to give back. An exit strategy only protects
you from losing all of your money if the deal is a success and
even then your odds are poor.
- Securities may not be sold to more than 35 non-accredited
investors. Sometimes this statement is true and sometimes it
isnt. In the deals that you are likely to run across it
is probably true. In actuality, this is not what the SEC means
and it is somewhat strange that it has become so convoluted
over time. While it is true that most transactions cannot be
sold to more than 35 non-accredited investors, it is also the
fact that it cannot be shown to more than 35 non-accredited
investors. Doctor Bob was telling me about a Temperance League
meeting he went at which they were pushing a Monaco gold mining
- Doctor Bob was saying that this guy got up at the League meeting
and started talking about all the gold laying all over the place
and that everyone could be rich and we could spread the word
on alcoholism to the far corners of the earth with all the money
we would make. Doctor Bob got a warm and fuzzy feeling from
the excitement and indicated that he had a large tax loss carry-forward
and would be using his gains to offset his substantial losses
of past years.
- The rest of the audience was mostly elderly women who were
living on social security pensions. Usually there are over a
hundred at any given meeting and with an opportunity like this
you can bet that at least that many were present. Many of them
saw the last of their cash go down the drain on Monaco Gold
and yet, the transaction was totally illegal relative to the
Securities Act. It would also have been illegal under the "Blue
Sky" laws of the state in which the offering was made.
Once a general solicitation was made to over thirty-five people
they had closed the books on taking any money at all from unaccredited
investors. We are fairly certain that the intent of this regulation
is bent out of shape on a regular basis.
- Relevant Regulation
- Rule 147- Intrastate-offering exemption for securities sold
within borders of one state.
- Small Issue exemption -- Regulation A- a new issue of $5 million
or less during a 12 month period and is exempt under the Act
(Rule 147). Issuer must file an offering statement with the
Securities and Exchange Commission.
- Rule 144 -- exempts persons from the definition of underwriter.
Actually, Rule 144 frees up the stock that you got in that private
placement issue. As you remember, we signed essentially a lock-up
agreement when we purchased the private placement by agreeing
to hold the securities. Even if we had not agreed to that, companies
have to file registration statements governing their securities
ability to be bought and sold in the marketplace. Historically
these rules allowed sales after the securities were held for
a period of two years if the company was a filing company. If
the company was not a filing company, the securities had to
be held for three years or longer.
- In spite of the fact that you may well, own a security that
you bought in a private placement 20 years ago you can negotiate
away the shares fungability. For example, management negotiates
an IPO with an underwriter who as a precondition for the deal
has management agree to "lock up" all of the potentially
free trading securities in the company. The lock up is a contractual
agreement stating that although you have the right under securities
laws to sell your stock whenever you want to, you are waiving
that right and for the purpose of interesting us in doing your
IPO and you must agree to hold it for another 18 months.
- Often your alternative to not signing the lockup is either
sitting around for another twenty years waiting for the next
offer, which if you are lucky will be pretty much under the
same terms and conditions as what you are not agreeing to now.
That probably wont be something to worry about, without
the public offering the company will not have enough money to
survive and go out of business. This happened regularly to Doctor
- The underwriters position is that I am not going to do two
underwritings, the first of which is the sale of the shares
of your company to my clients and then after that is finished,
also find a home for all of the selling shareholders of your
company in the open market. If you dont like this approach
and your shareholders are unwilling to hold their stock just
a little longer to insure the companys success, why the
hell should I.
- There are certain people that can hold on to their stock forever
and yet without a registration statement will be restricted
to some degree as long as they own the shares and are affiliated
with the company. These are shares owned by officers, directors
and affiliated persons of the company, as well as holders of
10% or more of the corporations shares. These folks are
insiders. For the most part they may not sell more than
1% of the outstanding shares in the company every quarter.
- This may not seem like a lot, but to guys like Bill Gates,
who files to sell every quarter, you are not talking about chum
change. Gates quarterly sales amount to hundreds of millions
of dollars, the number of hundreds of millions depends on what
price the stock is selling at when his quarterly prerogative
comes due. For the foreseeable future we believe that Bill Gates
will be able to sell over $1 billion per year of Microsoft shares
per year and not materially effect the price of the stock or
his percentage ownership in the company.
- Investment Banking --
- Object of investment banking is to raise capital. Sometimes,
proceeds represent new funds, which others are refinancing their
capital structure. Investment Bankers is at term of art yet
nobody had aptly defined to our satisfaction. Because it sounds
respectable, some brokers call themselves Investment Bankers,
but that term is usually left to those people on the street
that have a little money to invest for themselves and know where
a lot more is buried. We think of it as a term of endearment
for the many years most of us toiled as executives and floor
brokers for broker dealers. Investment Bankers are for the most
part, people with some money searching potentially rewarding
transactions for themselves and their associates. This field
if it were located in England would probably be known more as
- Underwriter, i.e. a banker, assumes risk by buying the new
issue from the corporation and reselling it to the public. There
are two basic types of underwriting, one is called a "best
efforts" and other is called a "firm commitment".
Neither is a guaranteed contract that anything is going to happen
and when one friend of our attempted to borrow on his brokers
firm commitment contract his banker called the police. These
contracts have so many holes in them that they make limburger
cheese seem solid. These are agreements that are as good as
the people that are involved in them, thus, some firms on the
street, anything they give is not worth the paper it is written
on while with others nothing in writing is really critical.
- A best effort type of financing usually consists of the underwriter
taking the client out to dinner, asking for a $50,000 retainer
and having him agree that he will try really hard to get the
deal done. To some underwriters, "really hard" consists
of discussing the deals merits with their mistresses,
in others it may be just a case of waiting for a sign.
- Usually the client has to pay for a road show, accountant
and legal, all of which can amount to a substantial amount of
money if the deal never happens. This occurs more often than
the "street" would care to admit and usually the reasons
are earth shattering, the most common heard on the street is
the fact that the stars were not lined up in proper sequence
and concluding the fund raising under those circumstances would
have probably resulted an a global catastrophe. "It is
best for us all to forget that we have ever heard of this deal",
is the common pronouncement of horoscope driven underwriters.
It is best to ask if you are in sink with the underwriter before
giving him the money.
- Another all too often heard response to an underwriters
failure is the fact that the market is not acting well. It can
be going up or down to conform to this anomaly. We have learned
that if the market is going down, it may make sense to use this
as an excuse for pocketing $50,000 and not doing anything for
it but when it is going up it become a more serious situation.
An underwriter cornered by someone asking these types of questions
will answer on of the following depending upon what business
the Subject Company is in:
- Only the cyclicals are performing well
- Only the non-cyclicals are performing well
- Only the blue chips are seeing any buying interest and it
looks better than it is.
- Only the non-blue chips are seeing any buying and your company
is considered a blue chip.
- The high-Tec's are hot and the cyclicals arent going
- Your company is terrific but it just doesnt have enough
sex appeal in this market.
- Your company has a lot of sex appeal but the guys in your
industry did so many deals in the last couple of months that
the market became saturated.
- Interest rates are so high; people are buying bonds not equities.
- Interest rates are so low; people are buying proven companies
with dividends and not speculating.
- People are waiting to see if the new capital gains tax reduction
- When I took your money, I didnt tell you that it was
going to done in this decade.
- Therefore, the deal didnt get done and the money is
down the drain. However, the underwriter didnt really
promise you anything either. All he said was that he would use
his best efforts; I am sure he did. The guy you picked has been
using his best efforts for the last 20 years and it hasnt
been good enough to get a deal done yet.
- Then we have the sure thing, the "firm commitment"
underwriting that is issued by only the most blue nose, high
quality brokerage firms in the country. I mean their firm commitment
means they are on that day putting their capital at risk by
buying the entire underwriting for their own account and redistributing
to their clients and other broker dealers. You say that in retrospect
when Goldman Sachs offered to give you a firm commitment you
took the Best Effort of Ajax Concrete and Broker Dealer Services
instead? You thought that best efforts meant that they would
try harder. While Goldman probably would have completed the
deal even at a loss in a bad market, many of the "better
firms" on the street would look to their "out"
clauses instead. Cant you see in the fine prints
fine print where it says we will only do the deal if the principal
of the clients firm is caught in a tornado in a telephone
booth on the day the deal is effective or at our discretion?
Another "out" clause that is common besides the old
tornado in the telephone booth excuse is old the "subject
to market conditions" ploy. Every IPO has that clause in
the body of the agreement and as we have seen, for the guy wanting
to wiggle out of deal, it is the perfect excuse.
- "You mean to tell me that a high grade firm doing a firm
commitment deal would use the same flimsy excuse as the firm
that was only doing a best efforts deal?"
- "You bet your bonnet he would bunkie! You think the guys
on this street were born yesterday?
- "Every Rube thinks he can come to town and the street
for a ride, but tell you what were going to do. You sit
here and start calling every friend and relative and customer
you have. Get them to buy seventy-five percent of the deal and
well still do the rest of because we have a lot of confidence
in your deal. Bunkie, you can even use my desk, but dont
take long, now."
- Several takeoffs on the "best efforts" form of deal
are the "mini maxi" and the "all or none".
These apocryphal sounding visions are Wall Street works of art.
The "mini maxi" means, "I cant raise
less than this or more than that." In many cases the accounting,
legal, printing, and underwriting fees are included in the "less
than this". Thus, all of the shareholders participating
in the transactions have made many friends in the legal and
accounting professions with their charity but they have not
been left with much of a company. It would be wise not to invest
in too many "mini-maxis" or you could wind up
keeping Doctor Bob company at the funny farm.
- The "all or none" is a much kinder type of underwriting
to shareholders, but it usually acts as a depth charge hitting
a submarine amidships as far as the target company is concerned.
It has been estimated by the SEC that accounting, legal, and
other costs run over $300,000 in the average offering. Obviously
the company wouldnt trying to go public if it didnt
need the financing, so the principals begged, borrowed and stole
the necessary $50,000 non-refundable deposit for the underwriter.
The underwriter had them hire a Big Six accounting firm that
his son was apprenticing at, mind you not because his son is
there but because it would look good on the title page. The
law firm that the underwriter said was necessary to get the
deal done asked for $100,000 retainer and assigned the job to
a $400 an hour partner. "We need a firm that is reliable
and can get the work out on time,"
- Usually, about the same time that the principal at the brokerage
firm announces that he cant do the whole deal and that
you have to bring in the customers, he will have available in
his handy, dandy pocket legal reference guide the names of attorneys
that specialize in bankruptcy reorganizations, plans for victims
of failed IPOs. I really believe that some firms on the
street are paid for as many deals that they dont do as
- Selling Group
- A selling group is a group of broker dealers who help distribute
the stock they are graciously invited to participate
in this process by the managing underwriter, who in dulcet tones
says: "You take all of my deals or none of them. If you
dont like that setup get the hell out of my office."
- In the underwriting business you are only as good as your
last deal. You can have twenty straight underwritings that go
to the moon, but come up with one bad apple your firm becomes
persona non grata on Wall Street.
- Formerly, Wall Street underwriters created successful issues
by carefully placing the stock in the hands of brokers who bought
it as an investment rather than as a source of quick profits.
In the old days, the guys that would really hold onto stuff
were the institutions. Today, in an intensely competitive market,
five minutes can be long term for the new breed peripatetic
- Another strange characteristic of an underwriting is that
there must be enough shareholders when it is all over for the
company to qualify for one of the exchanges or NASDAQ. (seven
hundred is kind of minimum) Even if the institutions were willing
to hold the stock until hell froze over, it wouldnt do
the shareholders any good if it wasnt traded anywhere.
Therefore, there has to be a mix between institutional and retail
underwriters of the stock.
- Wall Street brokers also seek out broker/dealers who are regionally
orientated within close proximity of the Target Company. If
the company is located in Iowa, often finding the top regional
Iowa broker-dealer to come into the deal will add buying power
and credibility to the transaction. People that are familiar
with the company on a day to day basis make better long-term
players than traders having no ongoing interest in its affairs.
Nobody, including Wall Street underwriters, discounts the home
- The more focused Wall Street underwriters, if it isnt
a wire house (the term originated from all the branches being
connected by telephone or telegraph wire) such as Merrill or
Smith Barney is extremely specialized in their approach to the
IPO business. Their deals tend to share common characteristics,
and the group of firms that they tend to allow into their underwritings
historically remains intact over the years. These firms are
called "selling group" members. These people have
no particular axe to grind.
- They have no financial interest in bringing out the deal other
than the commissions that they receive and the good will, which
is generated if the deal goes to a premium. They receive a much-diminished
commission because they are taking on a reduced risk. Selling
groups receive none of the glory that comes with a successful
underwriting but share none of the shame if it goes bad. They
are the mules of the underwriting business. As long as they
continue to be good lads and bring more buyers than sellers
to the table, the managing underwriter continues to abide them.
When the managing underwriter is "hot" every member
of its selling group makes money. When the managing underwriter
is not "hot" the loyal group soon dissolves and looks
for a new fearless leader type.
- In firm underwritings, the underwriters capital is at
risk on of the effective date. The underwriter buys the shares
of the company that is going public at the cost of the shares
less his underwriters commission based on the terms of
the letter of intent. At this time more often than not for the
purposes of being in the securities business, he goes "out
of ratio". This means that in the complex formula used
to compete whether brokers are healthy or not, this guy has
just become critically ill. His penalty for this affliction
is either promptly raising more money or getting rid of some
of the risk.
- For this reason, underwriters form "syndicates"
which operate somewhat akin to the Mafia. Syndicate members
are placed in "brackets" which define their hierarchy
in the organization just as the Mafia places "made men"
on top, the most important members, next come the "captains"
or "capos" who are important but not in the inner
circle and bringing up the rear are the "soldiers"
who if need be a dispensable. When the Tombstone is appears
in print you have the managing underwriter or underwriters appearing
over everyone else, kind of floating above the lower ranking
members. The next group appears alphabetically for several lines
and then the alphabet start over. This is the point when we
enter the second tier underwriters, and then a third and a fourth
and even a fifth depending on the transactions size. It
you want to get a better idea of how the firm you do business
with is perceived by the Street, find a tombstone bearing their
name and see what group they are in. Remember, some guys arent
there are all, and these are the selling group members or those
not even qualified for that.
- In order for underwriting members to become more important
to the organization (syndicate) they must perform outstanding
things such as being perceived by institutions as being bigger
than life. This is an extremely had thing to do and usually
people remain in the same niche during the life of the syndicate.
- Usually, the only way to break out of this rut is to buy out
your higher-ranking competition, which catapults you ahead of
other members into the "bracket" of the firm you acquired,
subject to approval of the loftiest members, usually consummated
at a sit-down. This effectuates three things at once, you are
allowed to lose or make more money in each transaction, your
name appears ahead of your peers in the newspaper whenever the
"syndicate" transacts business making you appear magisterial
in the publics eyes and least important you have eliminated
substantive competition, increased your profitability and added
to your management base.
- The organizer of the syndicate, you know, the fellow whose
firm didnt have enough in the bank to finance the deal,
still runs the show as "syndicate manager" the "Don"
of the underwriting world, he determines who will make up his
syndicate and what each ones participation in the profits
will be. This is usually determined by how well the member performed
in his last assignment. (Performance is usually determined by
how many shares of the deal his customers purchased in the market
after the underwriting books were closed. ("After market").
You do not stay in the organization very long without showing
- For all of his organizational skills and more importantly
his convincing the target company that they should sign with
him, the managing underwriter receives an override of all of
the spoils before the profits are divvied up among the participants.
Although these groups remain together without changes for long
periods of time, from time to time certain unforeseen circumstances
arise and specialists must be brought in to help the syndicate
in nuances of the transaction. (Similar needing an expert safecracker
when committing in a bank robbery, usually these people are
brought in from out of town just for the one deal).
- At the successful culmination of the underwriting, the syndicate
proudly displays the members of the group and their respective
position in the hierarchy in the press. Substantial outlays
of money are expended to proclaim the members, their roles,
the subject of the transaction that they put together and how
much money was involved. Members that appear at the bottom of
the list usually do not feel ashamed because they, for some
reason, are proud to be in the company of such an esteemed company.
These newspaper announcements are for some reason called "tombstones",
and the only reason that we know of for that name, is that by
comparing the current "tombstone" with its predecessor
you can determine which firms have ceased business or have committed
an unnatural act since the previous deal.
- Often firms stop appearing in a "Tombstone" when
they have gone out of business or committed a violation of the
syndicates code. This information is not part of the tombstone
and the public often is unaware that a grave sin has been committed
by the former member. Often when people see this handsome advertisement
they become interested in purchasing stock in the underwriting.
When they call their broker there are informed that if they
had read the "fine print" in the ad, they would have
seen that this was not an offering of securities, it was just
a matter of record of a transaction that had been completed.
- It has been said that tombstone advertising is the most costly
form of advertising, it offers nothing and says little. It is
historic in nature, requires no comment, and contains no redeeming
characteristics other than giving members self-gratification.
We could have told the tombstone reader that the stock had been
allocated among favored clients of the various firms that participated
in the deal. The reason is that these people gave great amounts
of business to the firms and are rewarded for their loyalty
if it was known in advance that the deal was going to go to
a premium. If it were expected that the price would diminish,
you can rest assured that the caller that came in late would
have somehow been offered the ability to participate in the
- Sales of Hot Issues
- Hot Issue -- New Issue of stock that is in great demand and
- Firms are restricted in the sale to:
- A Broker Dealers proprietary acct.
- Accounts of officers, directors, partners, employers of Company
- Senior officers of a bank, insurance company, or any employee
involved in a securities department.
- General speaking the price at which an IPO will come to market
and where it will then trade are uncomplicated to figure out,
but that is only if you are on the inside. An underwriter is
in the inexplicable position of representing both the buyer
and seller as principal. This in terms of law is an extremely
tenuous position to be placed and can result in substantial
legal problems. Strangely brokers are not apprehensive of being
put into this strange legal position because it is such a profitable
place to be. On one hand, he has the legal obligation as a fiduciary
to always try to get his client the best possible price when
executing an order. On the other hand, his obligation to the
company going public is to get them the maximum amount of money
he can. Historically making a decision between the two has been
a no-brainer for the broker. His client is in the market everyday
and represent the brokers bread and butter, so that if there
is latitude in the pricing of the underwriting, and there is,
the broker will price it so that it will go to a premium immediately
upon becoming effective. Thus demonstrating to the world that
the company was shortchanged. This makes all of the brokers
friends who were on his "A" list happy campers. The
broker also is made contented because everyone will see in the
tombstone that he was the underwriter and recognize he had a
winner. It will probably make the company that went public sad
to know that the underwriter could have gotten them much more
for their property and literally sold them down the river. They
probably will never know that the how much it really was. When
asked by company officials the syndicate manager usually replies
that they have no control over public demand for an issue and
therefore do the best they can when pricing the deal. If you
believe that then we have a bridge here in New York that can
be purchased from Chapman Spira and a bargain price. how do
they know what the price will be.
- Sounds good in principal, but they know almost to the nickel
what the price is going to be. The managing underwriter keeps
the books, he knows exactly how many shares are desired by other
brokers, he knows how many shares his firm wants, he also knows
how many he is going to give them. So in the interest of simplicity,
let us say that there are requests for three times as much stock
as are going to be underwritten, a certain number of those people
will purchase the shares at a higher price in the market, a
number represents an historic percentage that varies somewhat
based on the degree of premium. (difference between the effective
price and the price the share are selling at in the marketplace).
In brokerage parlance, running the books in a syndicate is like
betting on a horse a week after the race is over.
- Some brokers make it mandatory that if you are assigned share
at the original price, more shares must be purchased at higher
prices.. (this is illegal but common) There are many people
that think this is a good idea, those are the same people that
fought so hard to get the deck shares on the Titanic. This causes
the stock to rise even higher and friends and nominees of the
broker are the only ones allowed to sell. When the smoke has
cleared, often the deal is
in shambles and the money has found its way into the underwriters
pocket. Luckily most firms do not specialize in this business,
but the unsuspecting can ferret them out without to much trouble.
Doctor Bob has dealt with almost every one and look where he
is. After a number of years, the owners of the brokerage firm
become philanthropists and are looked upon as public-spirited
citizens who promote import projects in the community. The securities
industry is not the only one in which people turn legitimate
only after they retire.
- There are more sophisticated ways that new issues can be used
to help the broker become very rich. Some money managers are
very greedy people, others have little or no conscience. These
people have many friends in the brokerage community. In exchange
for shares having been allocated to the money managers personal
account, the manager agrees to place substantial of the funds
under his management (belonging to other people) at the disposal
of the broker. Thus the broker has provided himself with source
of funding for his pet projects. Many people that have entered
into these types of transactions are now in jail, but not enough.
Many of the people that have entered into these types of transactions
are still on the Street and highly regarded in their profession.
They will probably never be caught.
- A more important way for a broker to profit from his own underwritings
is to open an offshore account domiciled in a country where
there are laws keeping depositors identities secret. This account
becomes a retirement nest egg and if set up in the right place
totally avoids all taxation. Often brokers find it convenient
to have money stowed away somewhere else when they are required
to leave the country very abruptly. These are forward thinking
people who probably did well in college.
- Fairness Opinions
- Often when an underwriting is being contemplated the brokerage
firm that has been chosen for the job has conflicts of interest
that may prevent them from being totally objective about the
deal. These conflicts can assume various forms but the most
common is the instance where the brokerage firm or its principals
are also large shareholders in the issue. The National Association
of Securities Dealers (NASD) does not find a problem with a
brokerage firm selling the stock in a firm that is controlled
by the managing underwriter, they dont even have a problem
with the fact that it is the brokerage house negotiating all
sides of the transaction, the price at which the issue will
be brought public, the percent interest the public will receive,
the amounts spent on professional fees, corporate salaries and
managements stock options.
- What the NASD says is required for the brokerage firm to get
away with murder is simply that they must hiring another broker
has been in the business for a reasonable amount of time and
has had a good record to participate in the evaluation of the
deals pricing to determine the fairness in the pricing
of the proposed transaction. They do not tell you that you cant
hire your college roommate who still owes you six big ones that
you lent him when his girlfriend got pregnant. This is the same
character that the last time this guy did an underwriting was
the historic instance of the president of the company fleeing
the country with the proceeds of the deal just ahead of his
parole officer and the tobacco and firearms people. The deals
selling group members that lost their shirt when the president
skipped were so mad that rumor has it, a hit was put on the
underwriter. In spite of all of that, his name will appear in
the prospectus along with his charitable statements regarding
the deals pricing. Even Doctor Bob said that he thought
something was wrong with this.
- Green shoe the broker has other ways of controlling
his own income and the price of the underwritten security. Most
agreements call for the use of a "green shoe" at the
underwriters discretion. A green shoe is one in which the brokerage
syndicate is allowed to expand the size of the offering by up
to 10% at the last minute solely at the underwriters discretion.
This is done for several reasons, it increases the money that
the broker makes, it increases the money going to the company
and it allows more participation in the deal. The additional
shares also have a tendency of holding the price down a bit.
- The background for the name green shoe is somewhat obscure,
but an influential Wall Street person once told me that green
is the color of money and shoes are what you can buy with the
additional profits generated from the extra stock. I think he
must have been thinking about the expression from crap games
where the shooter hollers something about his baby needing a
new pair of green shoes. Some ninny once said that there was
a company by the name of Green Shoe Company in which the term
was first applied. We dont see any reason why anyone would
want to name a company Green Shoe. This is probably just an
old wives tale.
- Free riding and withholding -- member firms may not withhold
securities that are part of a new issue if hay have unfilled
public orders. The underwriter has the deck totally stacked
in his favor because they know how many shares there are to
buy and sell coming into the market, they are usually making
the market in the securities and are able to field all the inquires
from the straight relative to the issue, they have the pent-up
demand of people obligated to buy additional shares and they
have a magic time stamp machine.
- The time stamp is an integral part of a brokerage operation.
Every order that is entered on the books of the broker-dealer
must be stamped at that time. When the trade is executed another
time stamp is made on the order so that a complete record is
made of when the order went into the system and when it came
out. This is an excellent method of determining who is right
when a customer complains that his price should have been different
than what was reported to him.
- The name of the contra-party (the other side of the trade,
all transactions of another side) is listed on the same ticket
as the time stamp, thus in the case of a dispute reference can
be made to the contra-parties time stamp as well. If that isnt
enough, the transaction was reported and this too is stamped.
Thus a pretty good case can be made at all times, what the stock
was selling for in the market when the order was executed. As
a matter of fact the system seems almost foolproof.
- When a firm commitment underwriting is completed the stock
is taken down in one piece by the brokerage firm and then reassigned
to customers. These transactions can be of record in the places
indicated above. However, Doctor Bob was telling us a funny
story about that. He was sitting in the brokers office
and there was this guy with a timestamp putting the time on
hundreds of tickets, Doctor Bob introduced himself to timestamp
Harry and asked what was going on. Harry said that there was
this big offering coming out and he was getting ready for it
by stamping the tickets. "How do you know how many to stamp?"
asked Doctor Bob, "I dont see you keeping an account."
"Well". Harry said, " they dont tell me,
because maybe they are going to need extras" You see they
wait to see how well the deal does, how much of premium it goes
to. If it goes way up they take the tickets that are stamped
and are in blank and put their own names on them. If it doesnt
do so well, they give it to customers that have discretionary
accounts with the firm. When Im done stamping I have to
have enough to two sets of tickets, its a more exact job
than you think. Time stamping is really complicated you know
and I report only to the boss because I do such a good job.
He told me that we were really working together and I shouldnt
discuss this with anyone else, but Ive seen you around
and know that youre OK."
- Bob wasnt sure what Harry meant, but since he never
heard of anyone doing nothing but time stamping things all day
he thought that it was worth repeating. Bob wondered whether
this was something that you could go to school to learn.
- Doctor Bob said that he became very nervous around timestamp
Harry when he Harry informed him that he was the one in the
company responsible for reporting to Edgar. He mentioned that
everything anyone in the firm did was Edgar's affair and that
Edgar was expecting to update shortly on the final elements
of the deal he was time stamping. This sounded really scary,
Doctor Bob thought the top guy was working right here, in the
big office down the hall. It now seemed to Doctor Bob that he
was really a figurehead and someone much bigger was running
- Bob became really concerned because he had a lot of money
sitting at the firm and he called the SEC and told them that
the brokerage firm he was dealing with was reporting everything
to Edgar. The fella Doctor bob was talking said that this was
good and hung up. Believing he had discovered a massive securities
plot where even the SEC had become involved Bob left no stone
unturned in his efforts to find out what was really going on.
- Ultimately, the U. S. Attorney asked Doctor Bob to put his
problem in writing and when they got back to Bob they explained
that it wasn't a guy named Edgar but a computer program called
EDGAR (Electronic Data Gathering Analysis and Retrieval).It
seems that this computer system was created and is operated
by the SEC to eliminate unnecessary paper work and speed the
securities processes along. Relieved, Doctor Bob and Timestamp
Harry became fast friends and would often lunch together after
Harry had finished his work.
- Stabilization -- form of price manipulation permitted by the
Securities and Exchange Commission. If the underwriter didnt
posses enough tools, the SEC itself allows him to stabilize
the deal. In other words, the SEC doesnt want this thing
trading all over the place where nobody can keep up with whats
going on. Theyre interested in a "fair and orderly"
market being maintained in the issue and appoint the underwriter
as their representative with the power manipulate the market
so that trading becomes non-chaotic.
- Dishonest brokers can use this to their advantage. Whereas
the rules state that the stabilization should take place at
the deals offering price, they do not address the price
at which the securities in question can be sold. The underwriter
then legitimately issues the shares to his clientele and the
stock goes nowhere. Becoming disenchanted with the deal the
clients sell the stock, which under the regulations can be purchased
by the dealer. When he has accumulated a large enough amount
of the float and there are no sellers left, the issue suddenly
sprouts wings and becomes a success. The underwriter did not
make many friends among his customers with this tactic but he
did make a lot of money and felt that this was good.
- Lawyer Someone who went to law school and passed the
bar exam in at least one state. This person instead of becoming
a legitimate member of his community began practicing securities
law. This is a good field for someone with a computer because
having once completed an offering, you can use the same documents
over and over again by just making minor changes in the name,
amount of money being raised and the name of the underwriter.
Although lawyers in securities work complain of long hours and
grueling work, we think it is mostly for effect. As long as
the word processor is in good order, lawyers are capable of
making a good living.
Underwriters counsel A lawyer that
represents the underwriter and passes on the legal merits of the
deal for the brokerage house.
Issuers counsel A lawyer that represents the
issuer, how in manner cases is picked by the underwriter
because he has all of this stuff on his word processor
and for other high sounding reasons. Underwriters
counsel and issuers counsel often are good friends
after hours, which makes the negotiations go much faster.
Both lawyers are paid substantial amounts of money,
much of which comes from the proceeds of the transaction. It is
in both of their interests under the that the underwriter
stays healthy, at least until the deal is completed. They try
to arrange that underwriter does not have to lose his temper and
get his blood pressure up in his dealings with the parties involved.
Because of the substantial concern that these good people maintain
for the underwriters health, most arguments are quickly
settled in his favor.
- The Process of Registration
- The process is much more complex, expensive and harrowing
then can possibly be envisioned by a few short paragraphs in
a memorandum such as this. You will be entering a battlefield
that will require all of you guile to transverse all of the
obstacles that have been placed between you and your objective.
Critically important is not to make the process even more difficult
that it already is. This requires teamwork between your accountants,
lawyers and broker. You as the field marshal must make certain
that they are constantly coordinating their efforts so that
all required documents are submitted not only on a timely basis
but that they are submitted in the form required by the Securities
and Exchange Commission.
- The process begins when a proper preliminary prospectus is
filed with the SEC. This gets you into the queue, but it isnt
the type of line that you had at the movies in high school.
In this line, each time you strike out the teacher sends you
to the back and makes you do it over again until you can get
it right. So until the first step is done correctly the queue
doesnt even accept you, it is only when you submission
is considered acceptable that you allowed to be in line.
- This is extraordinarily import because your underwriter has
created a calendar of IPOs and has scheduled them based on when
he is best able bring them to market and more important when
he has room in his stable for another issue. If an issue is
delayed by Washington for an unreasonably long period of time,
for any number of reasons, the issuer may suffer two simultaneously
adverse events. The first is that the SEC queue line has begun
without him other event that could make it a really bad hair
day is that the offerees place in line with the underwriter
now runs the risk of becoming usurped by another IPO because
of scheduling problems. There may not be are recovery from this
problem because as the longer the clock fails to tick, the more
the risk that the submissions have become "stale"
(outdated) and the SEC, like Mother Nature does not abide stale
- With the each tick of the clock, the substantial costs of
registration run like an runaway whirling dervish. Pity the
poor issuer that had deficient advise to begin with, the lawyers
and accounting fees may soon make up an unacceptably high percentage
of the deals "use of proceeds " and both the SEC and
the underwriter could determine that they are no longer interested
in a public offering, the proceeds of which are primarily dedicated
to paying off the professionals. Sage advice would have mandated
that the professionals agree in advance to a set fee in taking
the deal all the way through to completion. Many Wall Street
accountants and lawyers would agree in advance to a lessor fee,
or hopefully no charge at all, if the deal aborts because of
uncontrollable developments such as very poor market conditions
and problems in the issuers industry that did not antedate the
- One of the pet peeves of the SEC in reviewing a registration
statement is that of inferior readability. In other words, the
lawyers are really trying to strut their stuff and draft the
registration in legalese rather than readable English. The SEC
would view that as not being able to be read by the average
investor and would send it back to the issuer to start again.
- There are times when underwriting are popular and other times
when you couldnt give one away. The staff that works on
these things at the SEC remains fairly constant during both
periods so that as a generally rule delays in busy periods produce
a wait in back of a longer line than one when things are quiet.
Actually, the person assigned to walking your project through
the commission will have much more time to be of assistance
during quiet periods.
- The use of EDGAR and other electronic filing devices have
improved turnaround time, but in spite of that, more deals than
ever are being perused by the commission and very often it is
liking trying to go cross town in Mexico City during the rush
hour. On the other hand, if when making the original submission,
a well written transmittal letter is furnished the commission
with all material matters discussed in workmanlike manner the
commission would also attempt to live with a realistic underwriting
timetable if it is possible. Remember that coming out of the
SEC to early and you underwriter might not be ready for you
and the data you have in your registration statement may have
to be updated, the market could collapse in the meantime or
even worse the broker could go out of business. I mean it has
been known to happen.
- Competent lawyers are well aware of the preceding but sometimes
local attorneys attempt to practice on their client because
it doesnt so hard to do and Ive got something similar
in the word processor. Down deep in my heart, I believe that
the SEC looks a lot closer at stuff submitted by lawyers that
have not practiced before the commission previously. Kind of
an initiation to the big leagues. Man, if it were my deal, I
wouldnt want an hazing taking place at my expense. Additionally,
the pro knows how to work with the underwriter and they have
undoubtedly had other deals in the past together. The natty
young graduate who is just spreading his wings and attempting
to impress his client will antagonize the commission, not get
the cooperation of the accountants and give the underwriter
"agita. Although we know some reasonably intelligent young
lawyers, they are intelligent because they are aware that they
have much to learn about the system and are also in a queue
of sorts, a learning one. But, alas, for a little less money
you can wind up with a wet faced kid who will get you into more
trouble than you can shake a stick at.
- Contact us at your convenience.