Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 16 Long-term finance 415

When ordinary shares are first issued, they are given nominal or par values. For

example, a company could issue million ordinary share capital in a variety of con-

figurations, such as 10 million shares at a nominal value of each, or 500,000

shares of each. The main consideration is marketability. Investors tend to view

shares with lower nominal values (e.g. 50p) as more easily marketable, particularly

when, after a few years, shares often trade well above their nominal value. The most

common unit nowadays is 25p. Issued share capital appears on the Balance Sheet at its

par value, which explains why it often seems a minor item. For example, Scottish

Powers’ issued share capital (it refers to this as ‘called-up share capital’, i.e. issued and

paid for), denominated in 50p units, accounts for only million (20 per cent) of

shareholders’ equity However, the market value of these shares (July 2004)

was considerably higher than the par value, at 390p each.

Once a company is established, its shares usually trade above the basic par value.

A company wanting to sell new shares is therefore likely to issue them not at their

nominal value, but at a premium. Share premium forms an integral part of the share

capital, million (49 per cent) in the case of Scottish Power. Most companies are

limited liability companies incorporated under the Companies Acts. This implies that

the owners (or shareholders) have obligations limited to the amount they have invest-

ed. If the company were ever wound up or liquidated, leaving outstanding debts, the

shareholders would not be liable to meet such claims. Limited liability companies in

the UK with a capitalisation over and shares held by the public are termed

public liability companies and denoted by the letters ‘plc’. Public status does not nec-

essarily mean that their shares are quoted on a stock exchange.

■ Preference shares

Preference shares also constitute part of shareholders’ funds – designated ‘non-equi-

ty shareholders’ funds’, as they are hybrids falling between pure equity and pure

debt. Holders receive an annual dividend, usually a fixed percentage of the par value.

Holders also have preferential rights over ordinary shareholders. Preferred dividends

are paid before ordinary share dividends, and preference capital precedes ordinary

share capital when assets are sold in a liquidation and the sale proceeds are distrib-

uted.

In the UK, they normally carry no voting rights except in the case of a proposed liq-

uidation or a takeover, or when the company passes the dividend. Preference share

dividends do not qualify for tax relief. This lack of a tax shield explains why prefer-

ence shares are relatively unattractive to companies compared to other forms of fixed

rate security. They may have some appeal to risk-averse investors looking for a rela-

tively reliable income stream and a limited degree of participation in company affairs.

Types of preference share

Firms can issue many varieties of preference share. For example, the accounts of

Tomkins plc for 2004 showed:

Convertible cumulative preference shares: million

The dividend rate on these shares is 5.56 per cent of its par value. The shares have

US dollar-denominated par values ($50), but are expressed on the Balance Sheet at

their equivalent sterling values.

The labels have the following meanings:

■ Convertible means that the preference shares can be converted into ordinary shares

at some future date. In this case, securities can be converted at any time at the hold-

ers’ option into fully paid ordinary shares on the basis of 9.77 ordinary shares of par

value 5p each for every convertible preference share.

£337

£50,000

£2,276

1£4,691 m2.

£930

£10

£0.50

£5

premium

The difference between the

issue price of an ordinary share

and its par (or nominal value)

CFAI_C16.QXD 10/28/05 4:57 PM Page 415

416 Part V Strategic financial decisions

redeemable

Repayable (usually at nominal

value)

■ Cumulative means that if a dividend is passed (i.e. not paid), it will be carried for-

ward for payment at some future date.

Some preference shares are redeemable, meaning that holders will eventually be

repaid their capital, usually at par. In 2003, Tomkins’ redeemed another US dollar pref-

erence stock worth £386 million.

Preference shares may also be ’participating’. In an exceptionally good year, the

directors may decide to declare an extra dividend for preference shareholders above the

regular fixed return, i.e. holders participate in the profits otherwise attributable to ordi-

nary shareholders.

Maybe one can now appreciate why these are called hybrids – they can exhibit char-

acteristics of both equity and debt, but the question often arises as to which they most

resemble, for example, when calculating gearing ratios. The answer really depends on

what type of preference share we are dealing with, and the strength of the commit-

ment made to investors:

■ If they are cumulative, so that a passed dividend will eventually be paid, they

resemble debt more than equity.

■ If convertible, and the conversion date is near, they look more like equity than debt.

■ If redeemable, they look more like debt.

■ If participating, they look more like equity.

At one extreme, non-cumulative, convertible, irredeemable, participating preference

shares look very much like equity, while the cumulative, convertible, redeemable, non-

participating variety look very much like debt. However, there is plenty of room along

the spectrum for preference shares with less clear-cut combinations of features.

■ Reserves

Reserves are also part of shareholders’ funds. It is a common mistake to assume

that reserves represent cash balances. Some reserves may once have had a cash

counterpart, but this will almost certainly already have been re-invested in wealth-

creating assets such as plant and machinery, stocks and debtors. In addition to

share premium, reserves are created to account for profits retained from the recent-

ly ended, and preceding, years. These may be called revenue reserves, retained earn-

ings or, simply, Profit and Loss Account, to indicate their origin. This reserve sets the

limit on the amount of dividend that a company can pay. A revaluation reserve is

created when a revaluation of assets reveals a surplus – without such a reserve

to represent enhanced value of the shareholders’ stake, the Balance Sheet would

not balance.

Internal finance, including retained profits, provides the main source of new capi-

tal for companies in general. This is partly because it is less costly than selling new

shares, as it avoids expensive issuing costs. It may seem that retained earnings are a

free source of finance and far more attractive to management than, say, raising interest-

bearing loans. However, retention of earnings imposes an opportunity cost – if

returned to shareholders as a dividend, the cash could be invested to yield a return.

The cost of retained earnings is therefore the return that could be achieved by share-

holders on investments of comparable risk to the company: in other words, the usual

cost of equity. However, the cost of using retained earnings can be adjusted as follows

to reflect the issue costs saved:

where f is the percentage costs of issue, or flotation, costs that are avoided.

Cost of retained earnings  k



normal cost of equity

11  f 2

participating

Preference shares that may

qualify for payment of an

additional dividend payment in

a good year

CFAI_C16.QXD 10/28/05 4:57 PM Page 416

Chapter 16 Long-term finance 417

16.5 METHODS OF RAISING EQUITY FINANCE

Self-assessment activity 16.2

Criticise the following statement made by your marketing director:

‘Well, we can always finance the new product development from our reserves.’

(Answer in Appendix A at the back of the book)

It is useful to make a distinction between companies not quoted on the Stock Exchange

and those which are listed. A listing opens up far greater access to capital of all kinds,

and to a wider pool of shareholders. This is one reason why many private and other

unquoted companies aspire to an eventual listing.

■ Unquoted companies

The supply of equity to an unquoted company depends partly on its size and partly on

its stage of development. Most new companies find it virtually impossible to raise equi-

ty finance except of a ‘personal’ nature, i.e. from supportive friends and relatives. Some

venture capitalists (see below) will provide start-up finance for highly promising activ-

ities, but most invariably look for a track record on the part of the entrepreneur(s). Until

this is established, such companies need to rely on additional supplies of personal finance

and retained earnings for further equity.

Having established some sort of record of operating success and potential, further

avenues open up. Among these are the following.

Business angels

A business angel is a private equity investor with spare funds to invest who wishes to

gamble on the future prospects of young companies, often start-ups, managed by entre-

preneurs lacking a track record but possessing a good idea plus enthusiasm. Angels are

motivated partly by the prospect of riches and partly out of a desire to nurture the spir-

it of entrepreneurship. Bank of England data suggests that 20,000 angels invest some

billion in 6,000 UK firms each year. Unlike venture capitalists, which typically seek an

exit in 3–5 years, angels tend to invest for much longer periods. However, despite

attractive tax relief (see below) angel investment is not for the faint-hearted. Mason and

Harrison (2002) estimate that angels lose money in 40 per cent of their investments and

make returns exceeding 50 per cent in less than a quarter of them.

Several networks or ‘marriage bureaux’ are designed to bring together prospec-

tive investors who seek high returns but are prepared to tolerate a high risk of total

loss, and entrepreneurs needing capital and prepared to release an equity stake.

Many are localised, and some are highly informal, operated by accountants and

solicitors; others are more organised. The umbrella organisation for introducing

capital-hungry entrepreneurs to wealthy individuals is the British Business Angels

Association (BBAA). This evolved from the National Business Angels Network

(NBAN) formed in 1999 by the major high street banks and leading firms of solici-

tors and accountants. Backed by the Department of Trade and Industry, it grew out

of the former Local Investment Networking Company (LINC), that had operated

for ten years, and absorbed the NatWest Bank’s own scheme, Network Angels, set

up in 1996.

Increasingly, it is recognised that many businesses fail to raise equity, not merely

because of ‘finance gaps’ on the supply side, but also because they are not ‘investment

ready’ (Mason and Harrison, 2004). Accordingly, enterprise support agencies are now

£1

CFAI_C16.QXD 10/28/05 4:57 PM Page 417

418 Part V Strategic financial decisions

giving increasing attention to provision of information on sources of finance and pre-

sentational skills, e.g. what to include in a business plan, and how to present it to poten-

tial investors in a convincing way.

Government-backed schemes

In 1981, the Business Start-up Scheme (later named the Business Expansion Scheme or

BES) was introduced to assist small, newly-formed and hence high-risk companies to

raise equity finance, and was extended to include existing companies in 1983. Investors

could invest up to p.a. in such companies and qualify for relief from income tax

and also capital gains tax on disposal of shares if held for five years.

The BES had only modest success in its early years, but grew rapidly in the late

1980s and early 1990s after it was extended to include investment in companies

investing in residential property on short leasehold terms. This shift was ostensibly

to increase the supply of rented accommodation to encourage greater labour mobility.

Whereas orthodox companies were restricted to raising just million p.a. under the

BES, residential property companies were allowed to raise up to million p.a. This

change spawned an upsurge in speculative property schemes, and because it became

clear that company sponsors were using the BES primarily as a tax avoidance device,

it was abolished as from December 1993.

It was superseded in January 1994 by the Enterprise Investment Scheme (EIS) with

similar objectives to the original version of the BES, but offering less attractive tax

reliefs. Investors may invest up to in any tax year in qualifying companies,

receive relief from Income Tax at 20 per cent and freedom from Capital Gains Tax if the

investment is held for three years. Unlike the old BES, losses realised under the

scheme are allowable against Income Tax. Companies cannot raise more than mil-

lion under the scheme in any one tax year.

£1

£200,000

£5

£0.5

£40,000

Venture Capital Trusts (VCTs) are a form of investment trust set up specifically to

provide equity capital to small and growing companies. To attract investors concerned

at the high risks of EIS companies, VCTs offer investors a wider spread of investments

than is possible under the EIS, thus operating in a similar way to orthodox investment

trusts. At present (2005–6), investors can obtain income tax relief at 40 per cent in the

year of investment plus freedom from capital gains tax and tax on dividends if the

funds remain invested for at least three years. The maximum investment in any tax

Business Start-up Scheme

(BES)

A now-defunct scheme set up

to provide ‘seed-corn’ finance

for new businesses.

Raising equity under the EIS

In March 2004, Carnaby International plc advertised an issue of 5 million ‘B’ shares at a price

of £1 each to finance the firm’s three proposed business activities:

■ To produce and distribute films and other viable media.

■ To act as a distribution agent for films made by other firms.

■ To exploit any other media or entertainment rights having strong commercial potential.

The company was already entitled to receive royalties from a portfolio of rights held in a library

of TV programmes including Backup, All the King’s Men and Silent Witness.

The ‘B’ shares would be subordinate to the ‘A’ shares held by the founding directors once

aggregate dividend payments of £5 million had been made. Specifically, the ‘A’ shareholders

would receive 50 per cent of any dividend or return of capital above this level as an incentive.

However, the prospectus declared the intention to pay no dividends for at least three years,

aiming for capital growth (free of tax under EIS rules).

Other firms were also invited to subscribe for shares under the Corporate Venturing Scheme.

Venture Capital Trusts

Stock-market listed financial

vehicles set up to invest in a

spread of highly risky new or

young firms

CFAI_C16.QXD 10/28/05 4:57 PM Page 418

year is The VCT can only invest up to million in any one company in any

calendar year, no more than 15 per cent of its funds in each company and each com-

pany assisted cannot have gross assets of more than million. The VCT itself must

be quoted on the Stock Exchange.

More information on VCTs can be found on the website of the British Venture

Capital Association (www.bvca.co.uk).

Corporate venturing

The Confederation of British Industry describes corporate venturing as: ‘a formal,

direct relationship usually between a larger, and an independent smaller company, in

which both contribute financial management or technical resources, sharing risks and

rewards equally for mutual growth’. The larger partner aims to foster the development

of the small firm for a variety of reasons, partly altruistic. The arrangement can take a

number of forms. The two parties could simply agree to cooperate in joint distribution

or production, they could form a joint venture and/or the major company could take a

minority equity stake in the small firm and inject cash into it. Aside from idealistic

notions of nurturing the capitalist ethic, there are sound business reasons behind devel-

oping such links. For example:

■ the large firm can tap into innovative R&D at low cost

■ it may be able to use spare managerial capacity for training purposes

■ it may develop a new source of supply

■ it may gain access to a new market.

The UK government provides fiscal incentives to encourage corporate venturing

under the Corporate Venturing Scheme, for example, Corporation Tax relief at 20 per

cent on corporate venturing investments in new ordinary shares held for at least three

years, and tax relief for capital losses on disposals of shares. In addition, the ‘investing

company’ must not hold more than 30 per cent of the ‘issuing company’s’ ordinary

share capital over the three-year qualifying period.

Venture capital (see also www.bvca.co.uk)

Venture capital (VC) is funding mainly for the development of existing companies

with sound management and high growth potential, but sometimes for especially

attractive start-ups. Funds are usually provided in large packages (typically over

) of debt and equity, split this way partly to offer a degree of security, but main-

ly to allow the VC company to participate in any major success. VC companies will be

hoping for an eventual flotation of the companies they assist, are usually prepared to

see their investments ‘locked in’ for five to ten years, but will anticipate an annualised

return of 30 per cent or more. VC companies often provide managerial assistance, and

some (e.g. the biggest VC company, 3i, itself a listed company following its own Stock

Exchange flotation in 1994) reserve the right to place their own appointee on the Board

of Directors, although this is infrequently done.

VC companies fall into two groups: independent companies and captive firms.

Independent funds are set up by private venture capitalists, raising funds from a vari-

ety of sources to invest in projects for a specified time and then to liquidate the invest-

ments. Captive funds are subsidiaries of major financial institutions, such as banks

and insurance companies, set up to channel a portion of their capital into risky enter-

prises. VC companies are often criticised for their preoccupation with the south-east of

England. An exception is the Leeds-based company Capital for Companies Ltd, a cap-

tive offshoot of Rensburg plc, the stock-broking and financial services group.

In recent years, VC organisations have devoted more of their energies and funding

to large management buy-out (MBO) investments, rather than concentrating on

smaller and riskier start-up and development capital. In an MBO, the existing man-

agement of a company undertakes to purchase the firm from the present owners. Most

£250,000

£15

£1£200,000.

Chapter 16 Long-term finance 419

Corporate Venturing

Scheme

A device to enable larger firms

to take an equity stake in

much smaller businesses with

attractive prospects

independent companies

Investment companies set up

as ‘stand-alone’ entities by

venture capitalists to invest

money in risky but potentially

attractive businesses

captive firms

Subsidiaries of banks and other

institutions established to

invest in risky but attractive

businesses

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420 Part V Strategic financial decisions

MBOs involve managers buying out an unwanted, often underperforming, subsidiary

from a larger parent, which feels that the business unit no longer fits its strategy.

Exceptionally, the buy-out may involve taking an existing quoted company off the

Stock Exchange, usually financed by large amounts of debt, but with equity provided

by the managers, who themselves borrow heavily to provide these funds. There is an

element of ‘moral hazard’ here – managers wishing to buy out a company or division

may be tempted to depress its performance so as to lower the price they need to pay

to acquire it. Moreover, there is a problem of information asymmetry – managers are

far better able to judge the value of a company or operating unit than an outside ana-

lyst or the head office of a larger company.

Nevertheless, given the structure of the funding arrangements, the managers of

MBOs are under considerable pressure to perform in order to service debts out of cash

flow and to enhance the values of their own equity stake (and that of the venture cap-

italist). Many VC firms find the risk–return prospects of these deals more appealing

than those of orthodox businesses. This is largely because the time taken before the

venture capitalist can make an exit is usually much shorter.

In a management buy-in (MBI), an outside group of managers buys a stake in an

existing company and assumes managerial responsibility for its operation. MBIs are

largely financed in the same ways as MBOs, and occur for similar motives.

Private placing (or ‘placement’)

Private placing is a means whereby well-established companies can widen their share-

holder base without going for a Stock Exchange listing. It is arranged through a stock-

broker or issuing house, which buys the shares and then ‘places’ them with (i.e. sells

them to) selected clients.

private placing

An issue of shares directly to a

selected number of financial

institutions

Piercing the jargon

Venture capitalists, suspended between the worlds of heady financiers and down-to-earth busi-

nessmen, have developed their own incomprehensible jargon. Here’s an introduction to the terms

that make their hearts beat faster:

Business plan: needed to apply for financing. A good plan should outline the business opportu-

nity, the management’s track record, the company’s past and present performance, market

demand, competition and trends, the structure of the company and the shareholders, long-term

plans and goals, and the proposed role of venture capital (how much and what for). See Due dili-

gence.

Control: one of the most hotly debated topics. Even where venture capitalists have a minority

share, they want to be able to influence and/or have veto rights over decisions on strategy, like

taking out credits, setting up subsidiaries or signing licensing agreements. This issue often creates

conflict with entrepreneurs, but venture capitalists disagree among themselves as to whether

control requires a majority share or just a good shareholders’ agreement, and where the balance

lies between supporting and stifling the entrepreneurial spirit. See Hands on.

Deal flow: the number and quality of applications for investment that come to the venture cap-

italist. Deal flow can come from referrals (banks, accountants, advisory services), walk-ins, or from

hard work pounding the streets.

Development capital: also known as expansion capital.Venture capital financing used for expan-

sion of an already established company.

Due diligence: several months of scrutiny designed to dig up all the necessary information for

evaluating the business plan and establishing whether the entrepreneur is a solid investment.

CFAI_C16.QXD 10/28/05 4:57 PM Page 420

Chapter 16 Long-term finance 421

Exit: the all-important sale of the shareholding in a company which enables the venture capital-

ist to (at least) recoup his investment and pacify his investors. Most exits in Central Europe will

be by trade sale, but some might be by management buy-out or flotation on the stock market –

or by write-off, if the investment is a disaster. The usual time-frame for exit is around five years,

meaning there has been very little so far in the region.

Hands on: what most venture capitalists in Central Europe claim to be. It means that they’re not

interested in a passive shareholding but want to support the management with expertise, usual-

ly in marketing, finding export partners, or in financial planning.

Living dead: a company that is not a failure but which is making the sort of insignificant profits

that make it almost impossible to sell, and even then would yield low returns.

Management buy-out: the purchase of a business by the existing management. The venture

capitalist pays proportionately much more for his stake to recognise the value the management

brings to the enterprise. Also used to describe a possible exit route, by which the management

buys out the venture capitalist’s share. The question is: at what price?

Second-round financing: most companies need more than the initial injection of capital,

whether to enable them to expand into new markets, develop more production capacity, or to

overcome temporary problems. There can be several rounds of financing.

Seed capital: capital used to turn a good idea into a commercially viable product or service; a

very risky form of investment, although it generally involves small sums.

Start-up capital: capital used to establish a company from scratch or within the first few

months of its existence. Also risky, but with huge returns for the few successes.

Trade sale: the sale of a company (or part of it) to a larger corporation. This is the main source

of exits envisaged for Central Europe, but it means that the entrepreneur may have to become

an employee or sell out his share.

Venture capital: equity finance in an unquoted, and usually quite young, company to enable it

to start up, expand or restructure its operations entirely. It’s cheaper than bank finance initially

because paying dividends can be deferred; it also provides a strategic partner – but it implies

handing over some control, a share of earnings and decisions over future sales.

Source: Business Central Europe, February 1995. Reprinted with permission.

■ Quoted companies

Seeking a quotation: from unquoted to quoted status

Eventually, the unquoted company may require such a large amount of new capital that

it may decide to ‘go public’ by issuing shares through a Stock Exchange. When a firm

obtains a listing on a Stock Exchange by selling shares, this is referred to as an Initial

Public Offering (IPO). Such issues are managed by sponsors, such as a merchant bank

or a member of the Stock Exchange, which advises on aspects such as the timing and

the price of the shares to be issued.

To enhance the prospects of a successful IPO, the company ought to show a record

of consistent and increasing profitability, and that it is managed by respected, experi-

enced directors. There are numerous other criteria to qualify for a ‘full listing’ on the

main London market that must also be satisfied, principally:

■ It must provide fully audited accounts covering at least three years.

■ It must be an independent business activity that has earned revenue for at least

three years.

■ The senior management and key directors should not have changed significantly

throughout the three-year period, and should possess appropriate expertise and

experience.

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422 Part V Strategic financial decisions

■ If the company has a controlling shareholder, this must not prevent it from operat-

ing and making decisions independently.

■ At least 25 per cent of the company’s ordinary shares must be in public hands after

listing.

The Stock Exchange cites a seven-point list of benefits and possible drawbacks involved

in obtaining a quotation:

■ Prestige. Being seen to comply with the rules of the Stock Exchange may enhance the

company’s standing in the business community. This may lead to better relation-

ships with suppliers, creditors and customers.

■ Growth. The initial flotation can be used to raise cash, which can be used to lower

gearing. Flotation may also lower the cost of using bank facilities. Access to the

wider markets can be exploited if the company wishes to raise more finance in the

future. Greater marketability of the shares increases the ability to conduct takeovers

by offering equity in exchange for the target company’s shares.

■ Access. As well as giving companies greater access to fresh supplies of capital, flota-

tion gives shareholders access to a wider market, enabling existing owners to con-

vert shares into cash, and new ones to buy and sell more readily, i.e. it makes the

company’s shares more liquid.

■ Visibility. The initial flotation gives the company publicity and more regular cover-

age by the media as it announces subsequent results. Greater awareness among the

securities industry may enhance the ability to raise further capital on favourable

terms.

■ Accountability. Quotation imposes new responsibilities on directors and increases

the need to consult shareholders before taking major decisions, such as a major

acquisition.

■ Responsibility. Directors must ensure that the company meets the listing rules of the

Exchange, and that price-sensitive information is released in a timely and orderly

way, so that every shareholder has equal access to it.

■ Regulation. The Stock Exchange, as the only competent authority for listing, rigor-

ously screens applications of companies seeking a listing, monitors companies’

ongoing compliance with its rules and deals with breaches of its rules.

Source: London Stock Exchange

Sistema in record $1.3 bn flotation

By Christopher Brown-Humes

Sistema, a diversified Russian

conglomerate controlled by bil-

lionaire Vladimir Yevtushenkov,

yesterday raised $1.35 bn in the

country’s largest ever initial

public offering.

The London IPO was the

biggest test of investor confi-

dence in Russia since the

attack on Yukos, once Russia’s

biggest oil company, which was

widely perceived to be politi-

cally motivated. Investor nerv-

ousness about possible further

government interference in

Russian business has hit senti-

ment towards Russian stocks,

and the RTS index remains 16

per cent below its April 2004

peak.

‘We have been saying that

the political risks are overesti-

mated in Russia, and the suc-

cess of this offering would seem

to be a sign of that,’ said

Aivaras Abromavicius, a fund

manager with Sweden’s East

Capital.

The sale of 79.6 m global

depositary receipts at $17 a

share values Sistema at $8.2

bn. It is the largest London

IPO since Yell in 2003 and the

biggest involving a non-UK

company since Orange four

years ago. The offer was 2.5

times oversubscribed. Sistema

GDRs moved to a small premi-

um yesterday, reaching $17.45

in afternoon trade.

The timing of the sale has

partly been dictated by the

upcoming privatisation of

Svyazinvest, a state-controlled

telecoms group, as Sistema is

keen to participate in this

process.

Sistema was deliberately

positioned as a play on

Russian consumer sentiment,

even though most of its assets

CFAI_C16.QXD 10/28/05 4:57 PM Page 422

Chapter 16 Long-term finance 423

■

Methods of obtaining a listing

There are three main methods of obtaining a quotation on the Stock Exchange:

(1) Offer for sale by prospectus. Shares are sold to an issuing house, generally a mer-

chant bank, and then are offered at a fixed price to the public at large, including both

institutions and private individuals. Application forms and a prospectus, setting out all

relevant details of the company’s past performance and future prospects, as stipulated

by Stock Exchange regulations laid down in ‘The Yellow Book’, must be published in the

national press. An offer for sale is obligatory for issues involving million or more.

Usually such an issue is underwritten, i.e. the issuing house guarantees to buy up

any shares not taken up by the public so as to ensure that the company receives the

monies required. To spread the risk of being called upon to buy up possibly substan-

tial blocks of shares, the lead underwriter usually makes sub-underwriting arrange-

ments with other financial institutions.

Offers for sale are usually made at a fixed price, which is determined before the offer

period based on the expertise and knowledge of the company’s financial advisers.

There is a tendency to price prospectus issues conservatively to ensure their success –

companies whose shares have to be bought up by the underwriters often find it diffi-

cult to raise further capital through the Stock Exchange on attractive terms.

A variant on this method is the issue by tender, where no prior issue price is

announced, but prospective investors are invited to bid for shares at a price of their

choosing. The eventual ‘striking price’ at which shares are sold is determined by the

weight of applications at various prices. Essentially, the final price is set by supply and

demand. A tender is often used when there is no comparable company already listed

to use as a reference point in valuing the company. However, by underlining the

uncertainty in valuation, it may deter investors. In a tender, the shares are underwrit-

ten at a certain minimum price. This is the most expensive form of issue, although it

may be argued that there is less risk of underpricing.

(2) In a placing, shares are ‘placed’, or sold to, institutional investors, such as pension

funds and insurance companies, selected by the merchant bank advising the company

and the company’s stockbroker. In this case, the general public has to wait until official

dealing in the shares begins before it, too, can buy the shares. Placings are geared to

smaller companies and involve relatively little publicity and, hence, limited expense.

Conversely, although placings should aim at securing a wide distribution of share-

holdings to promote liquidity on the secondary market, the resulting spread of hold-

ings is inevitably far narrower than with offers for sale.

£30

offer for sale by prospectus

An issue of ordinary shares

through an issuing house that

promotes the shares in a

detailed prospectus aimed at

the public in general

are in telecoms via a 51 per

cent stake in MTS, Russia’s

biggest mobile phone compa-

ny. Sistema’s other operations

include insurance, real estate

and a flagship children’s store

in Moscow. ‘Investors are get-

ting a good deal, it’s a 20 per

cent discount to net asset

value,’ said Mr Abromavicius.

Mr Yevtushenkov, a former

Moscow government official,

has seen his holding in Sistema

cut from 78 per cent to 63 per

cent after the IPO. A listing in

London gives Sistema and

Mr Yevtushenkov political pro-

tection at a time when business

tycoons in Russia increasingly

fear government interference.

Jerome Booth at Ashmore

Investment Management, one

of the world’s biggest emerging

market funds, said expecta-

tions that the rouble would

appreciate against other cur-

rencies had increased the

attractiveness of Sistema’s IPO.

The IPO was handled by

Morgan Stanley and Credit

Suisse First Boston.

Additional reporting by

Arkady Ostrovsky in Moscow

and Päivi Munter in London

Source: Financial Times, 10 February 2005.

issue by tender

A share issue where prospec-

tive investors are invited to bid

or ‘tender’ for shares at a price

of their own choosing

placing

An issue of ordinary shares

directly to selected institution-

al investors, who may re-sell

them on the stock market

when dealings officially

commence

CFAI_C16.QXD 10/28/05 4:57 PM Page 423

424 Part V Strategic financial decisions

intermediaries offer

A placing made to stock bro-

kers other than the one advis-

ing the company making the

issue

Stock Exchange introduction

Where an established firm

obtains a Stock Market listing

without selling any shares

disclosure

Release of financial and oper-

ating information about a firm

in to the public domain

An intermediaries offer is a placing with financial intermediaries that allows brokers

other than the one advising the issuing company to apply for shares. These brokers are

allocated shares that they can subsequently distribute to their clients.

(3) Stock Exchange introduction. This is applicable when the shares are already wide-

ly held, the proportion in public hands already exceeds 25 per cent, and existing share-

holders do not intend to dispose of shares at the time of flotation. No money is actually

raised from the public – the purpose of the exercise is merely to create a wider market

in the company’s shares. Because no underwriting is required, and advertising costs are

minimal, this is the cheapest form of issue.

■ Continuing obligations

Once a company is listed, its directors have to obey a strict set of rules in order to safe-

guard its continued listing. In particular, it must observe the regulations relating to dis-

closure and directors’ dealings.

1 Disclosure. A quotation places considerable demands on directors, especially in the

release of price-sensitive information about the company’s activities. The main

occasions on which announcements are required through the Stock Exchange

include:

■ major developments in a company’s activities, e.g. new products, contracts or

customers

■ decisions to pay (or not pay) a dividend

■ preliminary announcements of profits for the year or half-year

■ an acquisition or disposal of major assets

■ a change in directors, or directors’ responsibilities

■ decisions to make major capital issues.

2 Directors’ dealings. Share dealings by the directors of a listed company are subject

to the Criminal Justice Act 1993 and the Exchange’s ‘Model Code for Directors’

Dealings’, aimed to prevent insider dealing. Directors are precluded from dealing

for a minimum period (normally two months) prior to an announcement of recur-

rent information such as trading results, or dealing in advance of the announcement

of extraordinary events involving the publication of price-sensitive information.

Companies whose directors infringe these rules are likely to jeopardise the contin-

ued listing of the company and also to sour relationships with investors, especially

the financial institutions.

■ The Alternative Investment Market (AIM)

The AIM was set up by the Stock Exchange in 1995 to replace the declining Unlisted

Securities Market. Its purpose is to provide a market for the shares of companies that

are too young or too small to qualify for, or benefit from, a full listing. The Exchange

organises a service called SEATS PLUS, which displays information about orders to

buy and sell shares, to enable matching of buyers and sellers. To qualify for the AIM,

companies have to satisfy certain criteria – in the main, less demanding than those

of the full market – and to observe certain ‘ongoing obligations’ regarding the release

of key information at appropriate times and the conduct of directors. In addition,

the company must appoint and retain a nominated adviser to assist with continu-

ing compliance with the AIM’s rules and a nominated broker to organise share

transactions. By December 2004 there were 1,020 companies with an AIM listing

with total market capitalisation of billion. Like the main market, AIM admits

international companies.

£31.8

directors’ dealings

Share sales and purchases by

senior officers of the firm.

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