316 PART 2 Important Financial Concepts
initial public offering (IPO)
The first public sale of a firm’s
stock.
prospectus
A portion of a security registra-
tion statement that describes the
key aspects of the issue, the
issuer, and its management and
financial position.
red herring
A preliminary prospectus made
available to prospective
investors during the waiting
period between the registration
statement’s filing with the SEC
and its approval.
factors related to the founders; the business structure, stage of development, and
outlook; and other market and timing issues. The specific financial terms will, of
course, depend on the value of the enterprise, the amount of funding, and the per-
ceived risk. To control the VC’s risk, various covenants are included in the agree-
ment, and the actual funding may be pegged to the achievement of measurable
milestones. The VC will negotiate numerous other provisions into the contract,
both to ensure the firm’s success and to control its risk exposure. The contract
will have an explicit exit strategy for the VC that may be tied both to measurable
milestones and to time.
The amount of equity to which the VC is entitled will, of course, depend on
the value of the firm, the terms of the contract, the exit terms, and the minimum
compound rate of return required by the VC on its investment. Although each
VC investment is unique and no standard contract exists, the transaction will be
structured to provide the VC with a high rate of return that is consistent with the
typically high risk of such transactions. The exit strategy of most VC investments
is to take the firm public through an initial public offering.Going Public
When a firm wishes to sell its stock in the primary market, it has three alterna-
tives. It can make (1) a public offering,in which it offers its shares for sale to the
general public; (2) a rights offering,in which new shares are sold to existing
stockholders; or (3) a private placement,in which the firm sells new securities
directly to an investor or group of investors. Here we focus on public offerings,
particularly theinitial public offering (IPO),which is the first public sale of a
firm’s stock. IPOs are typically made by small, rapidly growing companies that
either require additional capital to continue expanding or have met a milestone
for going public that was established in a contract signed earlier in order to
obtain VC funding.
To go public, the firm must first obtain the approval of its current sharehold-
ers, the investors who own its privately issued stock. Next, the company’s audi-
tors and lawyers must certify that all documents for the company are legitimate.
The company then finds an investment bank willing tounderwritethe offering.
This underwriter is responsible for promoting the stock and facilitating the sale of
the company’s IPO shares. The underwriter often brings in other investment bank-
ing firms as participants. We’ll discuss the role of the investment banker in more
detail in the next section.
The company files a registration statement with the SEC. One portion of the
registration statement is called the prospectus.It describes the key aspects of the
issue, the issuer, and its management and financial position. During the waiting
period between the statement’s filing and its approval, prospective investors can
receive a preliminary prospectus. This preliminary version is called a red herring,
because a notice printed in red on the front cover indicates the tentative nature of
the offer. The cover of the preliminary prospectus describing the 2002 stock issue
of Ribapharm, Inc. is shown in Figure 7.1. Note the red herring printed vertically
on its left edge.
After the SEC approves the registration statement, the investment community
can begin analyzing the company’s prospects. However, from the time it files until
at least one month after the IPO is complete, the company must observe aquiet
period,during which there are restrictions on what company officials may say