Primary and secondary equity markets: issuing shares and why trading matters

How does a company raise equity in the primary market?

By selling shares to investors. The primary equity market is where an issuer lists and sells a new equity security to raise ownership capital, or where existing private stakes become publicly traded shares. The secondary equity market is where those listed shares trade afterwards.

Issuance usually moves ownership from private hands to public ones, rather than the other way round. Typical occasions:

• An early-stage firm outgrows founder and venture capital money and wants public investors.
• A company splits a division off as a new listed company, called a spin-off .
• A firm that private owners took off the market and restructured comes back to the public market.
• A government sells all or part of a state-owned company to the public, called a privatization .

Shares can be sold in a public offering , which is open to all investors, or in a private placement , which is sold only to a selected investor or group of investors.

Corporate Finance covers why companies go public (see public vs private companies). Here we look at how the shares are sold and what happens next.

Which routes lead from private to public?

Four routes lead into the public market: an initial public offering (IPO), a special purpose acquisition company (SPAC), a direct listing or a back door listing. Once listed, a company can sell more shares in a follow-on offering.

Primary equity marketshares sold to the public for the first time, or more of them

• Initial public offering (IPO) Memorize underwritten; prospectus and book building
• Special purpose acquisition company (SPAC) Memorize listed shell with cash in trust; must buy a private firm in about two years
• Direct listing Memorize existing shares, no underwriter, no new money
• Back door listing Use it private firm buys a listed one
• Follow-on offering Memorize
  • Primary follow-on new shares: dilutive
  • Secondary follow-on existing holders sell: not dilutive

An initial public offering (IPO) is the first time a private company sells shares to the public. The company usually hires investment banks for underwriting : the banks manage the sale of the new shares and find the buyers. The process runs in three stages.

1. About six months before the issue date, the issuer and its advisers present the planned listing and timetable to the market authorities, and present the company to equity analysts and prospective investors.
2. About three months before, a confidential draft prospectus is filed with the authorities, analysts publish research and the issuer meets investors.
3. On the issue date the authorities approve the prospectus and the issuer publishes it. An initial price range is set and book building begins.

The equity prospectus (also called the offering memorandum) describes the business model, the main industry and business risks, audited financial statements, the number of shares, the expected price range, the timetable and the use of proceeds.

book building collects investors’ orders and the prices they would pay, to set the offer price and decide who receives shares. Equity book building takes far longer than a bond’s, which is often done on the issue day, because investors must learn the business before they will name a price.

A special purpose acquisition company (SPAC) , also called a blank check company, is a shell that raises cash in its own IPO and puts the net proceeds in a trust account. It has a fixed window, typically two years, to buy a private company that its shareholders approve. That purchase is the de-SPAC transaction . At the deadline the SPAC must complete a deal, extend the deadline, or dissolve and return the cash to investors.

A direct listing puts a company’s existing shares on an exchange with no underwriter and no new shares, and the market sets the opening price. It suits large private companies that investors already know, and it avoids IPO underpricing (next section). Because no shares are created, it raises no new money for the company.

In a back door listing a private company acquires a listed company in order to use its existing listing.

Exam tip A SPAC buys a private company. In a back door listing, a private company buys a listed one.

Why do IPO shares jump on the first day?

Because IPOs are, on average, priced below where the shares close on their first trading day. IPO underpricing is that first-day rise measured from the offer price.

$$U = \dfrac{P_{close,1} - P_{offer}}{P_{offer}}$$

Why does it happen? The underwriter earns more from a higher price, but gains more from handing underpriced shares to favored institutional clients found during book building. Those clients keep asking for allocations and accept the bank’s brokerage fees in return, especially in “hot” IPOs. The issuer’s managers accept it because the first-day jump raises the value of their own shares, while the lost proceeds are a cost to the firm. That is a principal-agent problem : shareholders are the principals, managers the agents (see stakeholder conflicts).

Underpricing is an average, not a rule. Some IPOs fall on the first day, which means they were overpriced.

Exam tip Underpricing compares the offer price with the first-day close. It is not a discount to intrinsic value, which no one can observe, and it says nothing about long-run returns.

Go deeper Why underwriters underprice IPOs

A higher offer price lifts the underwriter’s fee a little. Placing underpriced shares with preferred institutional clients is worth more, because those clients are found during book building and they come back for every new issue in the hope of an attractive first-day return. The same banks run full-service brokerages that charge fees and commissions, and clients accept those charges more willingly when they receive preferential access to IPO allocations in return. A bank that always pushed for the highest price would cool that demand.

The issuer’s managers hold shares themselves, so they see the first-day jump as a gain in their own wealth, and they weigh it above the proceeds the company did not raise. Over longer horizons, newly listed companies have often lagged the market, so a first-day gain is no promise of later ones.

Follow-on offerings: when do they dilute you?

A seasoned equity offering , or follow-on offering, sells more shares of a company that is already listed. If the company issues new shares, it is a dilutive (primary) follow-on offering : each existing share’s claim on earnings and assets shrinks. If existing owners sell shares they already hold, it is a non-dilutive (secondary) follow-on offering : no new shares, so no dilution.

A follow-on still needs a prospectus, but it moves faster than an IPO because investors already know the company. Companies issue new shares to fund investment or repay debt. Founders and early investors sell existing shares to diversify.

$$\text{Stake after} = \dfrac{\text{Shares held}}{\text{Shares outstanding} + \text{New shares}}$$

Exam tip Follow the cash. If it goes to the company, new shares were created and existing holders are diluted. If it goes to existing owners, nothing is diluted.

Sort a set of deals by who receives the money, then name the route to a listing.

What does the secondary market do?

It lets investors buy and sell existing shares at any time, and the prices it produces are used by investors, the company and everyone who deals with it. The company receives nothing from these trades.

Secondary equity marketexisting shares trade between investors

• Liquidity Know the idea trade readily in rising and falling markets
• Price discovery Memorize observed prices give returns and a valuation reference
• Data for risk and return Know the idea price histories, comparison with peers and an index
• Feedback to management Know the idea plans judged by the share price
• Pay in shares Know the idea restricted stock units (RSUs) and options
• Health signal for stakeholders Know the idea suppliers, customers, employees, policymakers

• Liquidity. Investors can trade readily in falling markets as much as in rising ones. Primary issuance, by contrast, is busiest when prices are rising.
• Price discovery. Observed prices measure returns and give analysts a reference point for valuation. This is price discovery .
• Data. Price histories let investors measure returns, volatility and correlation, build portfolios, and compare a share with peers of similar size or sector and with a broad index.
• Feedback to management. Plans such as a restructuring are judged by the expected share price gain. A sharply rising price makes a follow-on offering more likely. A depressed one makes buybacks more likely than dividends (see dividends, splits and repurchases).
• Pay. Share-based compensation pays staff in shares. A common form is restricted stock units (RSUs) : shares granted to employees that cannot be sold until a vesting period, possibly several years, ends. Paying in shares aligns incentives and saves cash. New shares used this way dilute holders. Paying with shares the company bought back earlier dilutes less.
• A health signal. Suppliers, customers, competitors, employees and policymakers all read the share price. A supplier deciding whether to extend 90 days of credit to a retailer will look at the retailer’s share price: a 60% fall in a year says more, faster, than the last annual report.

Prices can swing far from what a company is worth, which is why analysts form their own view of value (see introduction to equity valuation).