Make Money In Stocks

Most people own stock. We hear the term “IPO” in the financial news all the time. But the process of creating a public stock is often a mystery — even to companies that are contemplating a public offering. Let’s pull back the curtain and look at the process of what goes on at an investment bank as it executes an initial public offering.

There comes a certain time in the life of a company when the owners or managers feel it’s time to “go public.” There can be many reasons to go public. The owners may feel they have built a lot of value into the company and they may want to liquidate some of that value — that is, sell some of their ownership for cash.

Management may feel like the company is poised for substantial growth that will need additional capital, so going public would enable them to sell shares to raise cash for growth. In any case, once a company thinks it is ready to go public, it starts to talk to investment banks, and the beauty contest begins.

The Beauty Contest

A beauty contest is financial jargon for the courtship process that takes place as a company selects an investment bank to perform a transaction such as an initial public offering. During this process, each bank prepares pitches that demonstrate each bank’s expertise.

A pitch will usually include information on how many deals a bank has done in the company’s industry. It will also talk about the current market for selling securities within the company’s industry. The bank will also go into a preliminary analysis of the valuation of the company.

Once the parade of banks has made their case to the company, one firm is usually chosen as the lead manager and other firms may be chosen as co-managers depending on the size and scope of the offering. For smaller deals, there may be just a single sole manager for the deal, while larger offerings may have as many as six co-managers.

Due Diligence

Once the investment banks are chosen for the initial public offering, due diligence begins. An organizational meeting is held at company headquarters that usually consists of company management (CEO, CFO), the company’s attorneys, the company’s accountants, the lead manager, the co-manager and the attorneys representing the managers.

Due diligence gives the underwriting managers an opportunity to kick the tires of the company and analyze it in as much detail as they can. They usually go through a due diligence checklist to make sure that they cover all relevant issues to the offering.

Due diligence usually includes a tour of the company, a discussion of any legal issues including potential litigation, questions about how the company operates and what its plans are for future growth. Once the banks have collected enough information, they begin drafting the prospectus.

The Prospectus

A company that seeks to go public must have an S-1 registration statement, or prospectus. The prospectus is the legal document used to market the offering to investors. All the parties involved in the initial organizational meeting will have a hand in drafting the prospectus.

A prospectus will go through dozens and dozens of drafts as lawyers, bankers and accountants scour over figures and legal wording. The drafting of the prospectus can take anywhere from five to ten weeks to complete.

The S-1 is then filed with the SEC and a preliminary prospectus or red herring is printed for marketing to potential investors. A red herring is so named because it has a disclaimer printed in red that the SEC has not yet approved the offering. The preliminary prospectus is also printed without an offering price as the offering price will be determined after the syndicate has built a book for the offering.

The Roadshow

The roadshow is a term used to describe the marketing period of an initial public offering. During this period, the lead manager puts together a presentation for the management of the company as they travel to major financial centers meeting with investors.

The lead manager also prepares a sales memo which contains key points for the syndicate to use as it pitches the offering to potential investors. The syndicate is the network of investment banks and their sales force of brokers that will sell the offering to the public.

The syndicate will then use the red herring and the sales memo as they contact institutional investors and set up roadshow meetings. During the roadshow, the syndicate department builds the book for the offering. The book is a list of potential investors that includes how much stock they would like to purchase and at what price they are willing to buy it. The information compiled in the book is what is used to price the offering.

Pricing and Trading

Once the final price of the offering is determined, the final draft of the prospectus is printed in preparation for the initial trading day. On trading day, shares are sold by each investment bank in the syndicate to investors. Each bank earns a fee — often around 7% — for each share that it sells and the net proceeds of the sale go to the company.

Shares then immediately begin trading publicly as investors sell their shares to new investors — and a stock is born. By the end of the day, the market for the security will yield a closing price, which could be higher or lower than the price paid by the initial purchasers of the stock (the offering price).

With publicly traded stock the company can now offer its shareholder liquidity and has a new avenue for raising money. Stock can also be used as a type of currency for acquiring other companies. Of course, being a company also comes with added responsibilities such as filing 10K and 10Q statements with the SEC.

Going public can be both nerve-wracking and exciting at the same time. To blow off steam and celebrate the occasion, the company and bankers involved in the transaction will often throw a closing dinner as the company begins its new public life.

“Deficit spending is simply a scheme for the ‘hidden’ confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.” – Alan Greenspan

Think that $20 bill in your pocket is money? Think again… it isn’t! Real money has three very distinct attributes:
* It must be fungible
* It must be divisible
* It must be a store of wealth

Lets look at these attributes one at a time.

To be “fungible” an asset must be exchangeable for another of equal value. The best example of a fungible asset is gold. My 1 oz gold bar is worth exactly the same as your 1 oz gold bar. The same goes for silver bullion bars. Why not use diamonds or some other gem stone? Simple – diamonds are a product of nature, and come in many different qualities. Diamonds have different colors, flaws, clarity, etc…. An ounce of gold, on the other hand, is minted to a specific weight and purity.

Divisibility is another important aspect of money. True money must be divisible so that you can make small purchases. Through out history, silver coins have fulfilled this role. While gems have value, it is not practical to use them for daily business activities. You can’t buy a loaf of bread and expect the seller to make change for a diamond.

Last – true money must be a store of wealth. The dollar in your pocket has lost 97% of its purchasing power since 1913, the year the Federal Reserve took over our banking system. Here is a frightening fact: The current rate of real inflation is about 6% a year. If you have 100k in the bank right now, it will only be worth 53k 10 years from now. Clearly, the dollar is not a store of wealth.

How did paper money lose it’s ability to be a store of wealth?

Prior to 1971, our currency was backed by gold. In theory, one could go to the bank and exchange paper money for gold or silver. (Private citizens lost that right in 1933. After that time, only foreign creditors could exchange paper for gold). In order to preserve the nations gold hoard, President Nixon closed the gold window. Now, paper money was not backed by anything at all… this paved the way for inflation through reckless money printing. Since it was no longer exchangeable for gold, the government could print as much money as it needed. The flood of new money in the market place drove up prices. Homes, cars, and everything else became more expensive.

The dollar in your pocket no longer money – it is fiat currency. Fiat is a Latin term that means “by decree”. That bit of colored paper only has purchasing power because the government decrees it. The longer you hold it, the less buying power it will have.

Now lets consider the purchasing power of gold. Soon after Nixon closed the gold window, the price of gold averaged $42.02 per ounce. To buy a brand new 1976 Cadillac Eldorado (retail price $7,546) would have cost you 179.58 ounces of gold. Years later, in 2006, a similar car would cost $77,295. The price of gold averaged $443.60 at that time. For the same 179.58 ounces of gold, you could buy an XLR and still have $2,367 left over to buy 739 gallons of gas!
Lets look at this another way. Rich Uncle has 2 nephews. In 1976 he spends $420 to buy 10 ounces of gold for one of his nephews. For the other boy, he places $420 in an envelope. He spent the same amount of money on both boys. Now, in September 2010, the price of gold is hovering around $1,250 an ounce. One boy has an inheritance worth about $12,500. The other boy has $420. Which would you rather have?

While it is true that the price of gold and silver has daily price fluctuations, it still the best store of value on the planet. Do not loose your wealth to mounting inflation – choose the hard assets that have stood the test of time.