Underwriting Stock and the Art of Legal Stock Price Manipulation [Guest Post]
Guest Post By: Irwin Stein, Esq.There is a synergy in the stockbrokerage world upon which few people focus but without which the entire system of that capital formation as we know it might suffer. When a stockbrokerage firm sells its customers shares in an IPO both the firm and the customers want the same thing; they want the shares to appreciate in price. It is up to the firm acting as the underwriter to make that happen.
Pricing the IPO
Like the price of everything else, the price of a security is determined by supply and demand. With a new issue of securities the underwriter is in a unique position to influence both sides of the equation.
The price at which shares will be issued is determined at the end of a long process of structuring the offering and pre-selling it to the underwriter’s customers. In the weeks before the offering the underwriter will march the company executives to a number of presentations in front of larger, institutional buyers so that they can ask questions and kick the tires. In the industry these are called “dog and pony” shows. They exist only to get the institutions excited about the company and to get their commitment to buy at the offering.
The underwriter will take indications of their interest to buy the shares from these institutions and from retail customers. Just prior to the offering the underwriter will know approximately how many shares it can sell. It will price the offering based upon how much money the company wants to raise and the number of shares that it thinks that it can sell.
This is also the point in time where the issuer and underwriter get a clear indication of the company’s valuation. Institutional buyers will do their own analysis of the company’s balance sheet and prospects and will tell an underwriter what they think. If they think the valuation is high the company might have to sell a larger percentage of the company to investors to raise the amount it wants.
If a company anticipates raising $150 million by selling 10 million shares @ $15 it is incumbent on the underwriter to have orders for more than the 10 million shares. In that way the underwriter can boost the share price to $16 making the issuing company happy because it got an extra $10 million and assuring itself of further business from the company down the road.
Large institutional buyers will often want the stock to “pop”; i.e. trade at a higher level in the immediately after the offering. Many large buyers are happy to get out with a quick profit.
For both of these reasons offerings are typically oversubscribed. This leads to a number of buy orders in the immediate aftermarket.
A broker might tell a retail customer, “if I can’t get you 1000 shares in the offering, I will get as many as can and buy the rest as soon as trading starts.” This leaves a large pool of buy orders as soon as the offering closes. The share price will move up and the institutions and favored customers will sell. If you thought about it, someone has to sell as soon as trading starts or there would be no trading.
While some institutions will get in for the long term and some for a quick profit, retail customers are often dissuaded from getting out quickly. If a small purchaser wants to buy at $15 and then sell in a few days to make a quick profit they may find that they will not be invited to participate in the next offering.
The underwriting firm usually employs research analysts to follow specific industries. They may use a knowledgeable analyst to evaluate the company prior to the underwriting. After the underwriting, the firm’s research analyst will issue a positive report about the company quarterly and often more frequently. If a firm takes a company public in January the analyst will still like the company’s prospects in July and often the next July as well.
During the tech bubble many firms used unique methodologies to justify sky high price multiples and never suggested that a company should be sold at any price. That part of the industry has cleaned up a little since the tech wreck. Still it is not good for a firm’s business if its own analysts are being negative about a company that it recently sold to its own customers.
A newly public company that is flush with cash is going to hire new executives, sign new contracts and execute its business plan. Each new event will be accompanied by an appropriate PR piece keeping the company in the financial press in a positive way. This also tends to raise the stock price.
If all this sounds like manipulation of the stock’s price it is but it is perfectly legal. Securities laws protect against companies that put false or misleading information into the marketplace. Nothing like that occurs here. Just good old-fashioned “cheerleading”.
A good underwriter will keep an eye on the market when the stock is new and will say ”buy” as often and loudly as it can. It wants to keep the issuer and the investors happy for as long as possible.
About Irwin Stein, Esq.
Irwin Stein is a Wall Street trained attorney with 4 decades of experience working in finance. He has represented banks and brokerage firms, venture funds and large private investors. He advises established companies and start-ups in need of funding. He blogs on Law and Economics in the Capital Markets. http://laweconomicscapital.com/
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