Chapter 14: How Corporations Issue Securities

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Welcome back to The Deep Dive.

Today we are stripping away the corporate facade.

You know, you walk down the street, you see the skyscrapers, the ticker symbols scrolling on TV, these trillion -dollar market caps.

But we almost always look at these companies as they exist now, as, you know, fully formed adults.

We rarely think about the colony before it became an empire.

Exactly.

We see the finished product.

We don't see the messy, chaotic biology that got it there.

And biology is the perfect word.

We're working with Chapter 14 of Principles of Corporate Finance, and the authors use this really great metaphor.

They treat a corporation not as a static thing, but as a living organism.

It has a life cycle.

It starts in infancy, totally dependent.

It hits this really awkward adolescence where it needs help, doesn't quite know how to get it.

And then if it's lucky, it reaches adulthood in the public markets.

It's a perfect way to frame it, because just like with people,

the decisions you make in those early stages, who you take money from, the specific terms you agree to, they completely shape your future.

It's not just about getting cash.

It's about the cost of that cash, the control you give up, the signals you're sending to everyone else when you ask for it.

So that's our mission for this deep dive.

We're going to trace that entire life cycle.

We'll get into the weeds of venture capital math, the game theory behind an IPO, and even why stock prices often drop when a big, successful company tries to sell more shares.

And we should be clear, this is absolutely central to financial decision -making.

If you're a manager, you just can't understand your company's value unless you get the friction and the psychology involved in raising capital.

To keep us grounded, we're going to follow the main character from our source text.

It's this fictional startup called Marvin Enterprises.

Ah, yes.

The makers of the revolutionary gargle blaster.

Which honestly sounds like a lawsuit waiting to happen, but we'll roll with it.

So year is 2034.

Marvin is born.

You've got, let's say, three founders in a garage.

They scrape together $100 ,000 of their own money.

They issue themselves a million shares.

And at that exact moment, they are the absolute masters of their own universe.

And that's the infancy stage.

It's pure.

The owners and the managers are the same people.

There are no agency costs, which is just a fancy way of saying there's no conflict of interest.

They're burning your own cash.

Exactly.

So they're naturally going to be careful with it.

But that honeymoon period, it ends fast.

To actually build the gargle blaster, they need a factory inventory marketing that hundred grand just evaporates.

And this is where most companies die.

Right.

The text calls this the problem of adolescence.

So the first thing you'd think to do is just, you know, walk into a bank and ask for a loan.

And the bank is almost certainly going to say no.

Why?

I mean, banks lend money to pizzerias and trucking companies all the time.

What's so different about Marvin?

Think about what a bank actually does.

They're renting out their capital and they want collateral against that loan.

If a trucking company fails, what does the bank do?

They take the trucks.

They repossess the trucks, they sell them, they get their money back.

Marvin Enterprises doesn't have any trucks.

They have an idea.

They have what we call intangible assets.

You can't repossess a brainway.

You can't.

If the gargle blaster is a total flop, the bank is left with nothing.

So traditional debt financing,

it's just off the table for these high growth startups.

So they're too risky for a bank, but they're way too small and unproven for the stock market.

They're stuck in this financing gap.

Yep.

Enter the venture capitalist.

In our story, it's a firm called First Miriam Venture Partners.

And the sharks are in the water.

Okay, we have to stop here and really break down the math because this is where first time founders can get their minds blown and sometimes get taken to the cleaners.

We have to talk about pre -money versus post -money valuation.

This is the entire scoreboard for the negotiation.

If you don't get this distinction, you just don't understand venture capital.

Okay, let's run the numbers from the text.

Marvin has 1 million shares, all owned by the founders.

First Miriam comes in and says, okay, we like this idea.

We'll give you $1 million in cash.

But in exchange, we want 1 million new shares issued to us.

Let's just pause on the arithmetic there.

First Miriam is paying $1 million for a million shares.

So that sets a price, right?

A dollar a share.

Simple enough.

Right.

Now look at the company after the deal is done, after the check clears.

You've got the original 1 million founder shares and you have the new 1 million VC shares.

So that's 2 million shares total.

If you take those 2 million shares and multiply by the price $1 a share,

the total value of the company is now $2 million.

That is the post -money valuation.

The value of the company after the cash goes in.

Correct.

Which means the value before the check arrived, the pre -money valuation, must have been $1 million.

And for the founders, this has to be a huge moment.

They put in $100 ,000 and suddenly some smart investor is saying their stake is worth a million bucks.

That's a 900 % return on paper.

They must feel rich.

They do.

But the text gives a big warning here.

Don't confuse that paper wealth with actual cash in your pocket.

And more importantly, don't confuse a check with charity.

So why did first Miriam write that check?

It wasn't just a good PowerPoint.

The text really emphasizes the idea of signals.

This is such a critical concept.

In a world of intangible assets where you can't just look at a factory, investors have to look for other things.

They look for signals of commitment.

The book mentions that the founders had fully mortgaged everything they could to get that initial 100 ,000.

That sounds incredibly reckless.

It is reckless.

But that's the whole point.

It's the signal.

It's a credible signal.

It tells the VC, we are so all in on this idea that we are literally risking homelessness.

If the founders had just put in a little bit of their savings and worked on Marvin on the weekends,

the VC would have walked.

The willingness to accept personal ruin.

That is the collateral.

That is a heavy thought.

Your pain is my collateral.

But trust only goes so far.

I was reading about the deal structure and VCs seem almost paranoid.

They don't buy the same kind of stock that the founders own.

No, almost never.

They don't buy common stock.

They buy something called convertible preferred stock.

This thing is a masterpiece of financial engineering.

It's designed to solve all their risk problems.

How does it work?

Let's break it down.

Preferred means seniority.

If Marvin Enterprises completely fails and they have to sell off the office furniture for 50 grand, the preferred shareholders, the VCs, get paid back first.

The founders get nothing until the VCs get their original investment back.

So that protects the VC on the downside.

Okay, and the convertible part.

That's for the upside.

If the company becomes the next big thing, that preferred stock has the option to convert into common stock.

So the VCs get to participate in all that massive growth.

It's a structure that basically says, heads I win, tails I don't lose as much.

There was another mechanism in the text that frankly sounds terrifying if you're a founder,

the ratchet.

The anti -dilution provision.

This is for the nightmare scenario.

The down round.

Okay, let's play that out.

So stage one financing was at a dollar a share.

Let's say Marvin messes up.

The prototype catches fire.

They need more cash, but the company is actually worth less now.

So the VCs say, fine, we'll give you more money, but the new price is 50 cents a share.

That's a down round.

Now, if the VCs have a full ratchet clause in their contract, this is what happens.

They go back to their original investment, that first million dollars, and they say, hey, since you're now selling stock at 50 cents,

our original deal retroactively changes.

We now get twice as many shares for the money we already gave you.

Wait, wait, they get more of the company for free?

Essentially, yes.

But the company is only 100 % of a pie.

That equity has to come from somewhere.

It comes straight from the founders.

They get massively diluted.

It's a brutal, brutal mechanism designed to punish founders for losing value and to make sure the VCs maintain their ownership percentage, even when things are going badly.

It just really highlights that this capital isn't just fuel for the business.

It's also a leash.

And the text mentions staged financing as another one of those leashes.

Yeah, you don't get all the money at once.

You get just enough to hit the next milestone.

It keeps management on a very short leash.

If they don't hit their targets, the money stops.

It forces discipline.

So let's fast forward.

Let's say Marvin survives this whole gauntlet.

The gargle blaster is a hit.

Revenue is climbing.

Now they face the biggest decision of their corporate lives.

The exit.

Phase two.

The initial public offering.

The IPO.

The moment the company graduates from the private club and steps into the public square.

But the text asks a really interesting question here.

We just assume every company wants to go public.

But why?

Being public sounds like a huge pain.

You've got the SEC breathing down your neck.

Sarbanes -Oxley regulations.

Angry shareholders every quarter.

Why not just stay private?

The survey data in the chapter is fascinating.

You'd think the number one reason to go public is we need to raise cash for operations.

Yeah, that's what I would have guessed.

We need money to build more factories.

But that's actually lower on the list.

The number one reason that CFOs give is to create a currency for acquisitions.

Unpack that for me.

If Marvin, as a private company, wants to buy a competitor,

it's hard.

They can't easily pay with their own stock because,

well, who knows what it's worth.

Right.

There's no market price.

But if they're public and their stock is trading at, say, $100 a share on the NASDAQ, they can just print new shares and use those shares to buy other companies.

It effectively lets them mint their own money.

That's a huge incentive.

And I guess reason number two is so the founders and VCs can finally cash out.

Well, yes,

you establish a market value.

It gives them liquidity.

And remember, those VCs are on a ticking clock.

Their funds only last about 10 years.

They have to sell and return money to their investors.

The IPO is their big exit ramp.

So Marvin hires the financial midwives, the underwriters.

In the book, it's a firm called Klein -Merrick, and they kick off the road schnapp.

This is the sales pitch.

Management applies to New York, London, Tokyo, pitching the company to the big institutional investors,

pension funds, mutual funds.

They're trying to figure out how much demand there is.

This whole process is called book building.

This part confused me a little bit.

They're building a book of orders, but the tech says these aren't actually legally binding contracts.

No, they're not.

An investor might say, yeah, I'll take 100 ,000 shares if the price is around $80.

It's just an indication of interest.

So what's to stop them from just lying or backing out at the last minute?

Reputation.

Yeah.

It's a repeated game.

If a fund manager says they'll buy and then they flake, the underwriter is going to remember that.

They'll get blacklisted from the next hot IPO.

So the book is pretty solid, even if it's not legally binding.

OK.

So they build the book.

Demand is through the roof.

The financial models say the stock is worth maybe $75.

They decide to price it at 80.

And then the opening bell rings.

And the stock immediately opens at $105.

The pop.

The headlines all call this a huge success.

Marvin soars 30 percent.

But the text argues this is actually a failure or at least a major inefficiency.

Think about it from the company's perspective, from the founder's perspective.

Marvin sold the stock to the underwriters for $80 a share.

The market was clearly willing to pay $105, that $25 difference per share.

That money didn't go to Marvin to build factories.

It went straight into the pockets of the investors who got the IPO allocation.

That is money left on the table.

The text uses the Airbnb example from 2020.

They left something like three billion dollars on the table.

If I sold my house for half a million dollars and the next day the new owner flipped it for a million, I would be furious.

Why aren't founders suing their bankers for pricing it too low?

There are a couple of reasons.

First is what you could call the wealth effect.

Even though they left money on the table, the founders still own a massive chunk of stock.

When they see the price jump to 105, they just feel incredibly rich.

They're too busy popping champagne to look at the math.

Basically.

But the second, much more important reason is something called the winner's curse.

This is, I think, one of the most profound ideas in economics and it's almost always misunderstood.

We should really spend a minute here.

Okay, let's do it.

The text uses an option analogy to explain this.

Right.

Imagine I'm auctioning off a big jar of coins.

You don't know exactly how much money is inside.

I don't know.

Everybody in the room has to guess.

If you win that auction with a bid of a hundred dollars, what does that tell you?

It tells me I bid more than anyone else in the room.

Exactly.

Which implies that everyone else, some of whom are probably smarter than you, thought the jar was worth less than a hundred dollars.

By definition, you are the most optimistic And in a world of uncertainty, the most optimistic person is usually wrong.

You probably overpaid.

That's the winner's curse.

Okay, I get the jar.

How does this apply to stocks?

In the IPO market, you basically have two types of investors.

You've got the smart money, the hedge funds that do incredible amounts of research, and you've got the uninformed investors, people just chasing the hype.

The smart money can figure out which IPOs are lemons and which ones are peaches.

So if an IPO is a lemon, what does the smart money do?

They stay away.

They don't bid.

Right.

So as an uninformed investor, if you bid on that lemon...

I get all the shares I ask for because nobody else wants them.

You get a full allocation of a bad investment, you lose big.

Ouch.

Okay.

But what if it's the next Google?

A real peach.

The smart money knows this.

They flood the order book.

The deal is massively oversubscribed.

So you ask for a thousand shares, but because everyone wants them, the underwriter has to ration the shares.

You might only get 50.

Ah, I see the trap.

So on the bad investments, I lose a ton of money because I get a full load.

But on the good investments, I only win a tiny bit because I can't get enough shares.

Precisely.

If you average it all out and if IPOs were priced fairly, the uninformed investor would consistently lose money over time because of this adverse selection.

You'd fill your portfolio of lemons and only get a taste of the peaches.

So the game is rigged against the little guy.

It would be, unless there's a discount.

In order to keep the uninformed investors willing to play the game at all, the underwriters have to underprice the shares on average.

That pop isn't a mistake.

It's a required risk premium.

It's basically a bribe to keep uninformed capital in the market.

That creates such a weird dynamic.

The system literally requires this payout to keep the victims from leaving the game.

It's a very, very delicate balance.

And while we're on IPO mechanics, we have to mention the green shoe.

The over allotment option.

Yes.

This is a risk management tool for the underwriter.

When they go to sell the IPO,

they actually sell more shares than the company officially issued, usually about 15 % more.

So they're actually short the stock from day one.

Exactly.

They are technically short.

Now watch what happens.

Scenario one.

The stock price drops after the IPO, which is embarrassing for everyone.

The underwriter then goes into the market and buys back those shares to cover their short position.

Which creates buying pressure and helps prop up the price.

It stabilizes the fall.

But scenario two.

The stock price rises.

It pops.

The last thing they want to do is buy back expensive shares in the market.

So instead, they exercise their green shoe option, which lets them buy the extra shares they need directly from the company at the original lower IPO price.

So it's a no -lose situation for them.

It's a safety net.

It lets them support a weak stock without taking on unlimited risk if the stock is strong.

Okay, so that's the traditional IPO.

But lately, we've seen some other ways to do it.

The text talks about these alternative paths.

We've got SPACs, direct listings, and auctions.

The monopoly of the big investment banks is starting to crack a little.

Let's do a quick lightning round on these.

First, the SPACs, the Special Purpose Acquisition I know Virgin Galactic did this.

A SPAC is a blank check company.

I go public with no actual business, just a big pile of cash.

I tell investors, trust me, I'm going to go find a great private company to buy.

It's faster than a traditional IPO, but the incentives can be really misaligned.

The sponsor often gets huge fees, even if the deal they find is mediocre.

Right.

Then there's the direct listing.

Spotify is the famous example.

The message of a direct listing is basically, we don't need your money.

Spotify just wanted a way for their early employees and investors to sell their shares.

So they skipped the underwriters, skipped the roadshow, skipped raising new capital.

They just opened the doors and let the stock trade.

Cheaper, but you don't get any new cash.

Exactly.

And finally, the auction.

Google did this way back in 2004.

This seems like it should be the most logical way to solve that winner's curse problem.

Just let the market bid.

So why doesn't everyone do it?

Well, the banks hate it because they lose control and fees.

But the text points out something really interesting about uniform price auctions.

That's where everyone pays the same price, the price of the lowest winning bid.

Yes.

And counterintuitively, that method actually raises more money for the company than an auction where everyone pays what they bid.

Why would that be?

It completely removes the fear of the winner's curse.

If I know I'm not going to be the one sucker who pays the highest price, but I'm in to get the same price as all the other winners, I feel comfortable bidding much more aggressively.

Ah, that makes sense.

The U .S.

Treasury actually uses this method to sell bonds for that exact reason.

So Marvin Enterprises is now public.

Ticker MRVN.

They survived the IPO.

But the life cycle of financing isn't over.

Now we're in adulthood.

We're talking seasoned offerings.

Public companies, they have a persistent financial deficit.

They always need to feed the beast.

And here we find this really useful tool called Shelf Registration, or Rule 415.

Think of this like getting a pre -approved line of credit from the SEC.

Before this rule, every single time a company wanted to sell more stock or bonds, they had to go through this whole nightmare of paperwork.

Shelf Registration lets a big established company file one single, massive document that says, hey, we might sell up to, say, 200 million dollars of securities over the next three years.

And they just put that approval on the shelf.

Exactly.

Then, when the market conditions are just right, maybe interest rates dip for a few hours on a Tuesday, they can take a chunk of those securities off the shelf and sell them instantly.

It gives them incredible flexibility.

But when they do decide to sell that stock, we run into a puzzle.

The text points out this huge difference between how it's done in the U .S.

versus, say, Europe or Asia.

Yes, the big battle between the rights issue and the general cash offer.

Okay, explain the difference.

In Europe, it's very common that if a company needs more cash, they have to go to their existing shareholders first.

They offer them a right.

They'll say, you own one percent of the company, here is the right to buy one percent of all the new shares we're issuing and we'll sell them to you at a steep discount.

That seems pretty fair.

It protects me from having my ownership stake diluted.

It is extremely fair.

And mathematically, the shareholder doesn't lose.

If you use the right, you get cheap stock.

If you don't want to invest more money, you can just sell that right to someone else on the open market for cash.

Your wealth is protected.

But U .S.

companies almost never do this.

They use general cash offers.

They just sell a block of stock to the public, usually through an underwriter, paying them big fees.

Why would they pick the more expensive, less fair option?

The text calls this a genuine, unresolved puzzle in corporate finance.

The best theory we have is that U .S.

managers just value speed and certainty above all else.

An underwriter can say, I'll guarantee the deal and buy the whole thing today.

A rights issue can take weeks to organize.

U .S.

managers might just be impatient.

Impatient.

Or maybe they're worried about something else.

This brings us to phase five and honestly, the most psychological part of the whole chapter.

Market reaction.

This is the part of the job that keeps CFOs awake at night.

The data shows a very, very clear pattern.

In the U .S., when a public company announces, We are going to sell more stock.

It's share price drops.

Almost instantly.

And your first thought might be, well, that's just supply and demand.

More shares on the market means each one is worth a little less.

Yeah, that's the Econ 101 answer.

But it's wrong.

Because the size of the price drop doesn't really correlate with the size of the stock issue.

You can announce a tiny offering and the price still tanks.

So it's not about supply.

It's about asymmetric information.

Let's walk through the game theory here.

This is the manager's dilemma.

OK, and imagine you are the CEO of Marvin Enterprises.

You know more about the true state of the company than I do as an outside investor.

Now, if you secretly know that your company is about to strike gold, that your stock is fundamentally undervalued, would you sell new shares to me?

No way.

I'd be selling a dollar for 80 cents.

I'd borrow money or I'd just wait for the good news to come out.

Exactly.

Now flip it.

What if you secretly know the company is in trouble or you just think your stock price has gotten ridiculously overvalued by the market?

Then I would rush to sell as much stock as I possibly could before everyone else figures it out.

Get that cheap cash while I can.

And the market knows this.

The market knows that you know this.

So the moment you announce a plan to sell more stock, what do you think investors conclude?

They conclude that I must be in the second scenario.

They think, aha, the CEO thinks the stock is expensive.

They're basically confessing that the price is too high.

The announcement itself is a negative signal and the price drops immediately to correct for that new bad information.

The chapter mentions this brilliant study by Cornett and Taronian on banks that basically proves this point.

This is one of my favorite pieces of financial detective work.

They looked at a bunch of banks that issued new stock.

Some of them issued stock because they wanted to.

Those were voluntary issues.

But others issued stock because regulators forced them to raise more capital.

Those were involuntary issues.

That's a perfect natural experiment, a control group.

It's perfect.

In the involuntary case, the confession logic doesn't apply.

The CEO isn't selling because they think the stock is high.

They're selling because the government has a gun to their head.

And the result?

For the banks that were forced to issue stock,

the price did not drop.

For the banks that chose to issue stock, the price dropped significantly.

It's definitive proof that the market isn't reacting to the new supply of shares.

It's reacting to the signal for management.

That is so clear.

And it explains the pecking order theory that's mentioned.

Right.

Because issuing equity sends such a bad signal, I think my stock is overvalued, it becomes the absolute last resort for a company.

So the pecking order is?

Number one, you use your own internal cash, your retained earnings,

that sends no signal at all.

Number two, you issue debt.

Bondholders are generally harder to fool than stockholders, so the negative signal is much weaker.

And only when you've exhausted those options, when you're desperate, do you issue new equity.

So we've covered the whole public market journey, but there is this massive shadow world we have to mention before we wrap up.

Private placements.

The backstage of finance.

Not every big deal happens on the New York Stock Exchange.

Right.

Sometimes Marvin just wants to sell, say, $10 million in bonds directly to a single life insurance company.

They just draft the papers, hand them over, get the cash.

No SEC registration, no prospectus.

That's a private placement.

It's much cheaper and faster.

But historically, it had one huge problem.

Illiquidity.

If that insurance company suddenly needed its cash back, they couldn't easily sell those bonds to someone else because they weren't registered public securities.

They were stuck.

Enter rule 144A.

The game changer.

The SEC basically created a special club.

They said, look, you huge institutions, you qualified institutional buyers, you guys are professionals.

You don't need us to hold your hand.

Rule 144A allows these big players to trade these private placement securities freely amongst themselves.

It turned a stagnant pond into a flowing river of capital.

Exactly.

It made the private market so deep and so liquid that today, many companies delay their IPOs for years and years because they can get all the cash they need through rule

144A and private equity.

Which brings us perfectly to our provocative thought to end on.

The text notes that the number of public corporations in the U .S.

has plummeted.

It's been cut almost in half since 1996.

We're seeing what some people call the de -equitization of the economy.

You have these so -called unicorns, startups worth billions of dollars, that are staying private for a decade or more.

Think about SpaceX or Stripe.

They grow into giants in the dark, funded entirely by VCs and these private placements.

And by the time they finally do go public, a lot of the hyper growth phase is already over.

The 10 ,000 % returns have already happened.

So here's the question for you to think about.

Are we moving back towards a kind of feudal system of finance?

If the best, most explosive growth years of the next Apple or the next Google happened before the IPO, does that mean the average investor is being locked out of the biggest wealth creation opportunities?

Is the public corporation, which was really the engine of the 20th century middle class, is it becoming a dinosaur?

It's a trend that really challenges the whole idea of the democratization of capitalism.

Something to mull over.

Well that wraps up our deep dive into the life cycle of corporate financing, from the garage to the VC pitch, all the way to ringing the bell.

And remember to always watch the signals.

A huge thank you to the last minute lecture team.

We'll see you on the next deep dive.