Seasoned equity offering

When a public firm (i.e., a firm whose shares are already listed on a stock exchange) sells shares to the public, this is known as a seasoned equity offering, or an SEO. This is contrast to an initial public offering (IPO) whereby a private firm (i.e., an unlisted firm) transforms into a public firm by selling shares to the public for the first time. In fact, the first SEO that follows after an IPO is often termed as a follow-on offering.

To give you a practical example, Facebook became a public firm in May 2012 through its initial public offering. About 1.5 years later, in December 2013, it conducted a seasoned equity offering by selling 70 million shares at a price of $55.05. About 60% of these shares were offered by existing shareholders, and the remaining 40% were newly issued shares (a.k.a., primary shares).

In this post, I’ll explain why firms conduct SEOs and discuss the different types of SEOs. I’ll also elaborate on the process, including the pricing of shares offered and the market’s reaction to SEOs.

Why do companies conduct SEOs?

Firms can conduct seasoned equity offerings to raise additional capital for their business. This additional capital can be used to:

invest in the firm’s growth opportunities,
meet working capital requirements,
acquire other businesses,
reduce debt, and so on.

Another common motivation is that SEOs can help founders and early investors (e.g., angel investors, venture capital funds, etc.) sell some (or sometimes all) of their holdings, especially during the first few years following the firm’s IPO. In this case, most or even all of the shares offered as part of the SEO are secondary shares (i.e., existing shares held by current shareholders) rather than primary shares (i.e., new shares). For that reason, such SEOs can be referred to as secondary offerings. They enable a route of successful exit for the investors mentioned above, who would refrain from selling a large fraction of their holdings during the IPO, in order not to send a bad signal to the market.

Types of SEOs: public offering, rights offering, and private placement

There are different mechanisms for conducting seasoned equity offerings. A common mechanism used is a public offering whereby the shares issued are offered to all investors, so that anyone (think of “general public”) can buy the shares. Public offerings help firms tap in to a large pool of investors. They allow firms to expand their investor base by bringing in new shareholders.

In contrast, in rights offerings (or rights issues), the existing shareholders are given the right to purchase the shares sold as part of the SEO. While public offerings are dilutive for existing shareholders, rights offerings protect existing shareholders who exercise their rights from dilution. And, the rights are normally transferable in the sense that if an existing shareholder isn’t interested in participating in the issue, they can sell their rights in the market. Rights issues are particularly popular in the UK market.

Finally, firms can conduct SEOs through a private placement. In this case, the shares are directly sold to a select group of investors (typically institutional ones such as mutual funds or pension funds) rather than to the general public. An advantage of private placements is that there are fewer regulatory requirements (because the general public isn’t involved and the buyers are sophisticated investors) and the process is much faster as a result.

Figure 1

The process

The process of a seasoned equity offering is similar to that of an initial public offering. Typically, issuing firms hire investment banks to act as underwriters of the issue. In particular, one or more investment banks are given the mandate to act as lead underwriters, and they’re responsible from managing the process. If the issuer was happy with the services of investment banks who managed their IPO, they’d likely hire them to manage their SEO as well. Otherwise, they’d switch to other investment banks.

Like in an IPO, once the lead underwriters are selected, they form an underwriting syndicate and perform due diligence. They are also responsible from preparing the required regulatory documents. Most notably, in a public offering, underwriters (together with input from issuer’s management teams) prepare a prospectus for the issue. This is a key document that contains all the relevant information about the firm and the issue, and it is the document that regulators carefully examine. It is similar in nature to an IPO prospectus.

As discussed in more detailed in the next section, pricing an SEO is much easier than pricing an IPO as the issuer’s shares are already traded in the market and a market price is available. Once the regulatory approval is obtained and the shares are priced, underwriters can begin to distribute the shares.

Pricing and market reaction

When firms go public, pricing the issue is a challenging process as the firm has no trading history at that point. The same can’t be said when they issue shares in a seasoned equity offering as not only a market price is available but also there is a lot more information about the firm available at that point.

This makes the pricing of an SEO a lot more straightforward than pricing an IPO. Nonetheless, the price isn’t necessarily set equal to the market price. It is often set at a discount for the following reasons. First, it increases investor demand as it makes the issue more attractive. Second, it serves as a cushion against uncertainty, particularly in terms of future declines in the stock price. This makes the investment less risky for participants. Finally, from the perspective of existing shareholders participating in the issue, the discount can be interpreted as compensation for dilution as well.

Then, the task of underwriters and issuers is to find the optimal level of the discount. A paper by Mola and Loughran (full reference at the end) document that the offer price is on average set at a discount of 3% relative to the previous day’s closing price.

How does the market react to SEOs? The answer primarily depends on the market’s belief about the intrinsic value of the issuer’s shares. To give a practical example, say a firm issues shares at $10 in its IPO. Then, in the months that follow the issue, the price steadily rises to $14, at which point the firm decides to conduct a follow-on offering. Now, if the market believes that the issuer is timing the market by offering overpriced shares, it’d react negatively to the issue. In particular, we’d expect the issuer’s price to go down on the SEO announcement date. On the other hand, if the market believes $14 reflects intrinsic value, no such reaction would be observed.

Academic evidence (see e.g., the study by Akhigbe and Whyte – full reference at the end) suggests that the market reaction to SEO announcement is negative, on average. This is supportive of the market timing hypothesis: Issuers try to seize a window of opportunity to sell overpriced equity and the market reacts negatively on the day of announcement as a result. Of course, this doesn’t mean that all SEOs are motivated by market timing, but it seems at least some of them are.

Video summary

Author Bio

Dr. Ufuk Güçbilmez is a senior lecturer (associate professor) in finance at the University of Glasgow Adam Smith Business School. He has previously held positions at the University of Bath School of Management and the University of Edinburgh Business School. He holds a Ph.D. in Finance from the Lancaster University Management School.

His broad areas of research are corporate finance and behavioral finance. His recent publications include:

Nonstandard Errors

Bidding styles of institutional investors in IPO auctions

What is next?

If you’ve enjoyed this post, you might find the following one useful as well:

Book building