investment banking representative qualification

Learning Guide

Investment Banking Representative Qualification

SerieS 79 Top-off

v10

Series 79 Top Off On-Demand Learning Guide

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How to Use This Learning Guide As the instructor presents the material through the On-Demand lecture, use this Learning Guide to take notes, answer questions, and complete activities. Once the On-Demand program is complete, this Learning Guide can be used as an ongoing resource.

About the Series 79 Exam

SECTIONS CHAPTERS # OF QUESTIONS

Collection, Analysis, and Evaluation of Data 8, 9, and 10 37

Underwriting/New Financing Transactions, Types of Offerings, and Registration of Securities 1, 2, 3, and 4 20

Mergers and Acquisitions, Tender Offers, and Financial Restructuring Transactions 5, 6, and 7 18

Total 75

© Copyright 2021. All Rights Reserved. v10 The following presentation is owned by Securities Training Corporation and is protected by the United States Copyright Law and applicable international, federal, state, and local laws and treaties. The presentation is made available to you for your personal, non-commercial use as a study tool to assist you in preparing for the related examination and no other purpose. ALL OTHER RIGHTS ARE EXPRESSLY RESERVED. Any other use by you, including but not limited to, the reproduction, distribution, transmission or sharing of all or any portion of the presentation, without the prior written permission of Securities Training Corporation in each instance, is strictly prohibited.

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85 MULTIPLE-CHOICE QUESTIONS

75 PLUS 10 EXPERIMENTAL

QUESTIONS

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TWO AND A HALF HOURS

(150 MINUTES) ALLOTTED

3 MINIMUM

REQUIRED PASSING SCORE IS 73% (BASED ON 75 QUESTIONS)

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Chapter 1 – Industry Terminology and Data Collection

Issuers and Securities Types of Issuers Types of Securities

Issuers are legal entities that raise capital by issuing securities. These include: Corporations U.S. Treasury and government agencies State and local governments Banks Foreign governments

Equity – used by corporations • Represents ownership • Common and Preferred stock

Debt (i.e., notes and bonds) • Represent an issuer’s promise to pay

Hybrid or Convertible Securities Derivatives

• Rights • Warrants

The Primary Market

Needs capital Hires underwriter Public v. Private

Issuance

Facilitates distribution Assumes liability that varies

with offering type Signs Underwriting

Agreement with issuer IPO VERSUS FOLLOW-ON


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Trading Markets and Regulation SECONDARY MARKET

Trading markets that facilitate the exchange of existing financial instruments among investors

E.g., NYSE and Nasdaq

THIRD MARKET Listed securities traded OTC

REGULATION

Securities Exchange Commission (SEC) SROs, such as the Financial Industry Regulatory Authority (FINRA)

Securities Act of 1933 Securities Exchange Act of 1934

Business Formation C CORPORATION S CORPORATION

Limited liability for owners Limited liability for owners

Unlimited number of shareholders No more than 100 shareholders (married couple considered as one shareholder) Trust may own shares

Profits subject to double taxation (taxed at both the corporate and shareholder level)

Like partnerships, avoids federal tax by passing through income and loss to shareholder based on percentage of ownership (no double taxation) Provides a deduction of up to 20% of the

pass-through amount

May have multiple classes of stock Must be a domestic corporation with only one class of stock

Question Which of these statements are TRUE with regards to industry terminology? Circle all that apply.

I. The secondary market facilitates the exchange of existing financial instruments among investors.

II. S Corporations may have an unlimited number of shareholders.

III. Trading markets are regulated by FINRA and the Securities Exchange Act of 1934.

IV. The underwriter in a primary market assumes liability that varies with the offering type.


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Real Estate Investment Trust (REIT) WHAT IS A REIT? A REIT invests in real estate-related activities

A REIT must have at least 75% of its total assets invested in real estate and cash

GROSS INCOME TESTS

Two Gross Income Tests: 1. At least 75% must be realized from real estate, through rents, or mortgage

interest 2. At least 95% of its gross income from such real estate sources listed above,

dividends or interest, and gains from the sale or other disposition of stock or securities from any source

TAXATION

At least 90% of its income must be distributed Investors are permitted to deduct 20% of the dividend income received, with

the remainder taxable at the investor’s ordinary income rate Cannot pass through losses

OWNERSHIP TEST

A REIT must meet the following ownership test: There must be at least 100 separate shareholders Five or fewer individuals may not own more than 50% of its common stock

during the last half of its taxable year

SEC 34 Forms Reporting company requirements:

A company must comply with the Act of 1934 and file forms with the SEC if any one of three conditions exist:

1. It issues securities by filing an SEC registration statement 2. Its security is listed on a national securities exchange 3. Its total assets exceed $10 million and it has 2,000 shareholders or 500 who are not accredited

SEC Reporting Companies • File Form 10-K (annual) • Form 10-Q (quarterly) reports

‒ Three filed annually


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Timing of 10-Q and 10-K LARGE ACCELERATED FILER ACCELERATED FILER NON-ACCELERATED FILER

Has filed one annual report (Form 10-K)

Has been subject to SEC reporting requirements for least 12 months

Public float of $700 million or more • File Form 10-K within

60 days and Form 10-Q within 40 days

Same as large accelerated filer, but: Public float of at least $75

million, but less than $700 million • File Form 10-K within


Not defined, but based on large accelerated filer and accelerated filer

Public float is less than $75 million, or

Has not filed one annual report (10-K) • File Form 10-K within


For 10-Ks, the day period begins at the end of the fiscal year;

however, for 10-Qs, it’s the end of the fiscal quarter.

Form 8-K A company files a Form 8-K for any material event that may affect its financial condition, such as: Agreement termination Bankruptcy Completion/disposition of an asset Delisting notice Unregistered sale of its equities Change of certifying accountant Change in company control Resignation/election of a director Regulation FD disclosures

Exhibits may be included, such as a press release that contains the latest quarterly financial statement.


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Insider Reporting and Restrictions Officers, directors, owners of more than 10% of the voting securities

REQUIRED FILINGS

Form 3 – Notification filed with the SEC within 10 calendar days of achieving insider status

Form 4 – Notification filed with the SEC for any changes in position within two business days

Form 5 – Annual filing covering certain transactions, such as gifts

PROHIBITIONS Prohibitions regarding trading the underlying security: Short-swing profits – those earned on stock held less than six months Short selling

Schedules 13D, 13G, and 13F Any person who acquires more than 5% of an issuer’s equity must file SCHEDULE 13D within 10 CALENDAR DAYS with the: Issuer SEC Exchange on which the security is traded

1. FILING REQUIREMENTS 2. SOURCE OF INFORMATION

The person required to file a 13D must provide detailed information, such as: Identity and background of the filer (may be a

group), source and amount of funds used for the purchase (existing cash or borrowed funds), amount and percentage of securities owned, contracts or relationships with respect to issuer’s securities, and exhibits (merger or tender offer agreement)

Most important is the “purpose of the transaction” – whether for acquisition, hostile takeover, or because it’s undervalued

A 13D is NOT filed if an issuer acquires more than 5% of its own securities in a stock repurchase program (10b-18)

If a number of separate investors form a group to acquire more than 5% of an issuer’s equity, a 13D must be filed

A 13D is an excellent source of information to determine an issuer’s largest shareholders

This may assist an M&A banker who represents the acquirer in regards to how a target may be approached

For material changes (e.g., the purchase or sale of 1% of the shares), an amended Schedule 13D must be filed

3. SCHEDULE 13G 4. SCHEDULE 13F

An alternative to filing 13D by institutional investors (e.g., investment companies) that have no intention of controlling or influencing the issuer

Quarterly filings for institutional investment managers (e.g., investment companies and hedge funds) that exercise investment discretion over at least $100 million in equities

Includes information about the equity securities owned by the filer

Must be filed regardless of whether the filer is registered with the SEC


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Proxy Statements

ANNUAL PROXY STATEMENTS

An issuer must provide this form to its shareholders prior to its annual meeting The statement includes detailed information concerning proposed executive compensation and ownership percentages Information on change of control payments to senior executives must

be disclosed An issuer is required to provide an annual proxy statement at least 20 calendar days prior to the meeting date An exception is granted if the issuer sends shareholders a notice of

internet availability at least 40 days prior to the meeting date

PRELIMINARY PROXY STATEMENTS

A preliminary proxy statement must be filed with the SEC at least 10 days prior to the date that the definitive proxy is sent to shareholders. (preliminary proxy is not sent to shareholders) The definitive proxy is filed with the SEC on the date it’s sent to the shareholders. In the following circumstances, the SEC doesn’t require a company to

file a preliminary proxy statement: • If the matter being voted on simply relates to the election of

directors, the election or approval of the company’s accountants, or a proposal that was put forth by shareholders of the company’s stock under SEC Rule 14a-8 (the rule that addresses when a company must include a shareholder proposal in its proxy)

Sarbanes-Oxley Act (SARBOX) Disclosure and corporate governance rules for publicly traded companies Rules make senior management more directly accountable for the company’s internal control system

and the financial information released to the public Who’s specifically responsible for certifying annual financial reports?

Principal Executive and Principal Financial Officers (i.e., CEOs and CFOs)

• They’re stating that the reports are not misleading based on their knowledge and don’t omit material information

No personal loans to officers and directors from company Section 404 requires SEC reporting companies and their external auditor to test the companies’

internal controls


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Audit Committee Rules 1 2 3

According to SARBOX, each member of the audit committee must be a member of the issuer’s BOD and be independent

According to Reg. S-K, an issuer must disclose that it: Has at least one audit

committee financial expert serving on its audit committee (expert’s name must be disclosed), or

Doesn’t have an audit committee financial expert serving on its audit committee

According to the listing requirements of the NYSE and Nasdaq, an issuer must have at least one person on the audit committee who meets the definition of a financial expert

Activity Match each description to the appropriate term.

PRINCIPAL EXECUTIVE AND PRINCIPAL FINANCIAL OFFICER

Has a public float of at least $75 million, but less than $700 million

LARGE ACCELERATED FILER

Must be filed for any even that may affect its financial condition such as agreement termination, bankruptcy, completion/ disposition of an asset, or a delisting notice

ANNUAL PROXY STATEMENT Includes detailed information concerning

proposed executive compensation and ownership percentages

ACCELERATED FILER Specifically responsible for certifying annual

reports

PRELIMINARY PROXY STATEMENT

An alternative to filing Schedule 13D by institutional investors that have no intention of controlling or influencing the issuer

FORM 8-K Must be filed with the SEC at least 10 days

prior to the date that the definitive proxy is sent to shareholders

SEC REPORTING COMPANIES

Has a public float of $700 million or more

SCHEDULE 13G Must file annual Form 10-K and quarterly

Form 10-Q reports (three filed annually)


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Chapter 2 – Public Offerings

Financing Alternatives Venture Capital

Private Equity

Private Placement (debt or equity)

Public Offering

Private Investment in Public Equity (PIPE) For PIPE offerings: Existing public company conducts a private placement Company may be limited in the manner in which to raise capital Once announced, value of issuer’s common stock usually declines Issuers are typically required to file resale registration statements

Registration Rights Piggyback Registration Rights Demand Registration Rights

These give investors the ability to register and sell their securities when the issuer conducts a public offering. Large investors, such as PE investors and

venture capital firms, may negotiate to have this provision, since they will be able to sell a certain amount of their restricted securities without being required to comply with the volume limitations of Rule 144.

Essentially, piggyback registration rights allow holders to sell their shares whenever the issuer files a registration statement.

These require an issuer to file a registration statement that covers a potential sale under certain conditions.

Demand registration rights require the issuer to file a registration statement.


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Securities Act of 1933

SCOPE

The Securities Act of 1933 regulates the underwriting and issuance process Scope of the law: Provide full and fair disclosure; prevent fraud in new issue sales Prospectus must include an SEC no approval clause; SEC doesn’t

judge investment merit (it reviews completeness) Requires securities to be registered unless exempt

COMMUNICATION

The permitted type and method of communicating with investors is different for an IPO versus an offering by an existing public company. IPO – equity market price is not yet known and company is generally a

non-reporting issuer Follow-on offering of equity or debt – price and company are already

established

SEC REGISTRATION FORMS

Form S-1 Registration form used for most initial public offerings and for issuers

that are not eligible for S-3 An F-1 is issued for an IPO of a foreign private issuer

Form S-3 (also referred to as a short-form registration) The minimum requirements for an issuer to utilize an S-3 filing includes:

• $75 million of public float in voting and non-voting common equity • Having filed reports under the Act of 1934 for a minimum of 12

months An F-3 may be used by foreign public issuers


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Securities Registration Timeline (IPO) PRE-FILING PERIOD No communication with the public; however, a safe harbor from gun jumping exists if the

communication made by the issuer is more than 30 days prior to filing and does not reference an offering

FILE REGISTRATION STATEMENT Begins 20 calendar day cooling-off period (issuer may be filing Form S-1 or F-1) Amendment triggers an automatic 20-day period (delayed registration) No sales and no money accepted Issuer distributes Preliminary Prospectus (Red Herring)

• Omits final price and effective date • Used to obtain indications of interest

“Blue Sky” provisions Issuer registers its securities in each state in which sales will occur B/Ds and their RRs must register in any state in which the securities are being sold to residents of

the state

BRING DOWN DUE DILIGENCE MEETING Final meeting to ensure that no changes have occurred since the last meeting Request for an accelerated effective date

EFFECTIVE DATE DETERMINED BY THE SEC Indications of interest are confirmed at the offering price Investors are now allowed to purchase shares from the syndicate at the POP Final prospectus must be delivered to all purchasers

SECONDARY MARKET TRADING BEGINS If an issuer decides to list on an exchange, a broker-dealer is not allowed to execute a transaction

away from that exchange until the exchange reports the first transaction

AFTER-MARKET PROSPECTUS DELIVERY RULE No requirement for a listed, follow-on offering 25 days for a listed, IPO 40 days for a non-listed, follow-on offering 90 days for a non-listed, IPO

(ACCESS equals DELIVERY)

PRE-FILING PERIOD FILING DATE

20-DAY COOLING-

OFF PERIOD

DUE DILIGENCE MEETING

EFFECTIVE DATE

AFTER-MARKET TRADING

AFTER-MARKET

PROSPECTUS DELIVERY

For an exchange-listed, follow-on offering, there’s no requirement under the After-market Prospectus Delivery Rule.


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IPO Order of Events

Issuer selects

underwriter

Registration statement filed with

SEC (red herring)

Non-binding indications of interest

Roadshow

Request accelerated

effective date

Bring down due

diligence meeting,

pricing, and underwriting agreement

Lock-up Agreements A lock-up agreement determines the amount of time that pre-IPO holders (e.g., management, venture capitalists, and other insiders) must wait to sell their shares after an IPO is trading in the after-market

The agreement may provide a comfort level for investors who are concerned that holders of pre-IPO shares may sell or flip their shares as soon as the IPO begins trading.

Prospectus Information Any communication, written or broadcast, that offers a security for sale

STATUTORY PRELIMINARY PROSPECTUS (RED HERRING) FREE WRITING PROSPECTUS (FWP)

Part of a registration statement that’s used before the effective date

Omits the offering price, underwriting and dealer discounts, and proceeds to be received by issuer

Once final offering price is set, a final prospectus is filed

Any written or graphic document that’s used to offer the securities, but doesn’t meet the standards of a statutory prospectus

Must include a legend which recommends that investors read the statutory prospectus

Examples include offering term sheets, e-mails, press releases, and marketing materials


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Categories of Existing Issuers

Well-Known Seasoned

Issuer (WKSI)

Eligible to file Form F-3 or S-3 for primary offerings, has a $75 million public float (market value that excludes shares held by affiliates), and has not failed to pay any preferred dividend or bond payment AND, within 60 days of determining eligibility, has either: $700 million common equity public float OR $1 billion in aggregate debt issuances in prior three years

Seasoned Issuer Eligible to use Form F-3 or S-3, but doesn’t meet the other requirements of a WKSI; public float less than $700 MM, but greater than $75 MM

Unseasoned Issuer A reporting company, but not eligible to use Form F-3 or S-3

Non-Reporting Issuer Pursuing an IPO

Ineligible Issuer

May not use a FWP Ineligible issuers include a blank check or shell company, an issuer

offering penny stocks, LP not offering its securities on a firm commitment basis, issuer that has filed for bankruptcy, issuer that was convicted of a felony or misdemeanor involving securities law violations in the past three years, and an issuer that is not current with its required SEC reports

Shelf Registration Allows the issuer to quickly access the markets to raise capital over a three-year period; however, the issuer must be eligible to file Form F-3 or S-3

A WKSI is permitted to file an immediately effective shelf; an S-3 Automatic Shelf Registration (ASR)

The issuer may omit certain unknown information, such as: The amount and offer price of the securities being sold Whether the offering is a primary or secondary Description of the securities (type or class of securities must be provided)

A seasoned issuer may use a shelf, but will be subject to SEC staff review

If WKSI status is lost after the ASR is filed, the offering may continue until the filing of the next Form 10-K

At-the-Market Offerings Rather than conducting a traditional offering of a fixed number of shares at a fixed price, securities offered at-the-market are sold directly into the secondary market through a designated broker-dealer at prevailing market prices Issuers may use a shelf registration to initiate an at-the-market offering Only issuers that register using Form F-3 or S-3 may engage in this type of offering Allows an issuer to act quickly and have more flexibility, with the company benefitting from the

potential stock price increase


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Communication by WKSI A WKSI is permitted to use a FWP prior to the filing of a registration statement for a specific issue. Below is the process a WKSI must adhere to under a shelf registration, including the use of a free

writing prospectus.

1 2 3 4

Issuer files an S-3 (ASR) listing the

types(s) of securities that it

may want to offer over the next three years

Each time the issuer offers

securities, it will file a preliminary prospectus

Each time the issuer offers

securities, it will file a final prospectus supplement with the SEC (for the

specific securities being issued)

If the company issues a press

release announcing the offering or term sheets describing the offering, either

document is defined as a free

writing prospectus

Free Writing Prospectus Seasoned Issuers and other issuers may use a FWP after the filing date.

Unseasoned and Non-Reporting (also Eligible) Issuers may use a FWP after the filing date, but the FWP must be accompanied by a statutory prospectus.

Ineligible Issuers, such as penny stock, blank check, and shell companies, are not permitted to use an FWP.

A term sheet is a frequently used type of FWP: It includes a summary of the specific securities being offered Issuer may use one for each offering it has filed with the SEC It must include a legend to indicate how a prospectus may be obtained

Issuer Use of an FWP WELL-KNOWN SEASONED

ISSUER (WKSI)

SEASONED ISSUER

UNSEASONED ISSUER

NON-REPORTING ISSUER

INELIGIBLE ISSUER

FWP may be used before or after SEC filing (anytime)

FWP may be used after SEC filing

FWP may be used after SEC filing and statutory prospectus must either

precede or accompany the FWP

Not permitted to use an FWP


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Activity Read each statement and fill in the blanks.

1. Venture capital, private equity, private placement, and public offering are all examples of .

2. allow holders to sell their shares whenever the issuer files a registration statement.

3. The regulates the underwriting and issuance process.

4. The amount of time that pre-IPO holders must wait to sell their shares after an IPO is trading in the after-market is determined by the _______________________________.

5. A is any communication written or broadcast that offers a security for sale.

6. WKSI, Seasoned, Unseasoned, Non-reporting and Ineligible are all categories of .

Types of Offering Communication Written communication includes written, printed, broadcast (radio or TV), and graphic communication. Graphic communication refers to using electronic media, such as e-mail, CDs, text messages, and

internet websites

Oral communication includes both live and real-time. If live and retransmitted using graphic communication methods to a live audience, it is still defined as

oral communication

Advertising relating to new issues is generally not permitted.

Internal communications may not be distributed to customers.


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Gun-Jumping Gun-jumping is a violation of the Act of 1933 and occurs if

prohibited oral or written communications are used by an issuer of securities.

1. WAITING PERIOD 2. SAFE HARBORS 3. ALLOWABLE COMMUNICATION

The period between the filing date and the effective date is referred to as the waiting or cooling-off period In the case of an offering by

a WKSI, the period is short; however, in the case of an IPO, the period may be months

E.g., Between the filing of a registration statement and the effective date, an issuer uses some type of written communication that was not filed with the SEC

Safe Harbors that allow communication released by, or on behalf of, an issuer that are not considered gun jumping include: Factual Business Information Information about the

issuer, including its business or financial developments, its products and services, dividend notices, and information in SEC-filed reports

Forward-Looking Information Includes earnings forecasts,

plans relating to future products and services, statements about future economic performance, and information in SEC-filed reports

Non-reporting issuers can only use factual information

This provision refers to allowable communication during the cooling-off period that relates to a new issue.

Communication that’s not deemed to be a prospectus includes a simple advertisement (i.e., a tombstone ad) It may include the name of

the issuer and selling shareholders, the security and amount being offered, date of sale, a brief description, underwriter’s identity, contact information for the organization sending the material, information of the market on which the issuer is or will be listed, and a statement indicating that the securities are in registration, but not yet effective

No orders may be accepted until the effective date

Research Reports Prior to Effective Date RULE 137 RULE 138 RULE 139

B/D may publish research reports when not acting as a distribution participant

B/D may publish research reports when acting as an underwriter for another class of security If issuer’s common stock is

under registration, a participant may comment on the issuer’s non-convertible bonds or vice versa

If the issuer is a reporting company and other conditions are met (e.g., eligible to use S-3), a B/D may publish research reports when acting as an underwriter for the security Provided the underwriter is

continuing regular coverage (it may NOT be initiating coverage)


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Road Shows A road show is a presentation made by senior management of an issuer, usually just prior to an offering (typically an IPO).

It’s organized by the syndicate (underwriting) manager.

It’s held by investment bankers and includes prospective clients and brokers. There is a live version which is presented to a large audience, as well as one-on-one

presentations which are made to large institutions.

Electronic Road Shows An electronic road show allows investment bankers and issuers to reach a larger audience.

Electronic road shows may be live or recorded A live, electronic road show (via webcast) falls into the definition of oral communication A recorded road show falls into the definition of graphic (written) communication

A non-reporting issuer that offers common equity or convertibles must file the electronic road show with the SEC, unless it is a bona fide electronic road show that’s made available without restrictions.

Electronic road shows for follow-on equity offerings and non-convertible debt offerings do not require SEC filing.

Jumpstart Our Business Startups (JOBS) Act

The law was designed to make it easier for small businesses to raise capital and create jobs

Created the term Emerging Growth Companies (EGC)

EGCs are issuers whose gross revenues are less than 1.07 billion

(originally $1.0 billion; now adjusted for inflation)

Permits an EGC to make a confidential filing to the SEC

at least 21 days before it holds its first road show


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Question Which of these statements are TRUE? Circle all that apply.

I. Advertising relating to new issues is generally permitted.

II. Gun-jumping occurs if prohibited oral or written communications are used by an issuer of securities.

III. A road show is a presentation made by senior management of an issuer, usually just prior to an offering (typically an IPO).

IV. The JOBS Act makes it tougher for small business to raise capital and create jobs.

FINRA Corporate Finance Review

WHAT IS IT?

A committee that evaluates the fairness of underwriter’s compensation, but NOT the public offering price

The managing underwriter is responsible for filing the underwriting agreement for IPOs and Reg. A issues

Factors taken into consideration: Offering proceeds Amount of risk assumed by underwriters (firm commitment versus best

efforts, or IPO versus follow-on) Type of securities being offered

ACCORDING TO FINRA,

COMPENSATION INCLUDES

Underwriting spread or commission, reimbursement of expenses to the underwriter, underwriter’s counsel fee, finder’s fee, wholesaler’s fee, financial consulting or advisory fee, special incentive items

Equity securities (including derivatives) received for acting as a private placement agent or arranging loans for the issuer at the time of the public offering

Compensation expected to be received as a result of exercising or converting, within one year following the effective date of the offering, any warrant or convertible security

Fees for a qualified independent underwriter

ACCORDING TO FINRA,

COMPENSATION DOESN’T INCLUDE

Registration fees (including Blue-Sky fees) Accounting fees FINRA filing fees Prospectus printing costs Cash compensation for acting as a placement agent Providing a loan for M&A related services Non-convertible securities and derivatives acquired at a fair price in the

ordinary course of business and unrelated to the public offering (FINRA looks back 180 days)


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Prohibited Arrangements Any payment of compensation prior to public sale of securities The receipt of a security, warrant, or option that has a duration exceeding five years or has more

favorable terms than those that are offered to the public A termination (tail) fee that has a duration of more than two years from the date the underwriter firm’s

services are terminated

Lock-Up Restrictions on Securities Any securities acquired by an underwriter in connection with an offering are restricted for a period of six months following the effective date of registration.

Options or warrants acquired in connection with the offering may be exercised at any time, but the securities received on exercise are restricted for the remainder of the initial six-month period.


FINRA CORPORATE FINANCE REVIEW

Charged by an underwriter for financial advisory services in the event an offering is cancelled and the issuer subsequently uses a different underwriter

TERMINATION (TAIL) FEE

Required to file documents with FINRA

LOCK-UP RESTRICTION

Any securities acquired by an underwriter in connection with an offering are restricted for a period of six months following the effective date of registration

MANAGING UNDERWRITER Evaluates the fairness of underwriter’s

compensation, but NOT the public offering price

A termination (tail) fee is a fee charged by an underwriter for financial advisory services in the event an offering is cancelled and the issuer subsequently uses a different underwriter


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Public Offerings of Securities With Conflicts of Interest

WHEN DOES THIS OCCUR?

This involves a member firm conducting a public offering of its own securities or securities of an affiliate. An affiliate is defined as an entity that controls or is controlled by the

member (10% or more ownership) It also includes an offering in which at least 5% of the net offering

proceeds are intended to reduce or retire debt extended by the member

CONDITION #1

Along with disclosing any conflict of interest, FINRA requires the member to comply with either one of two conditions: CONDITION #1 The first condition has three stipulations:

a. Member primarily responsible for managing the offering may not have a conflict of interest, or

b. The securities being offered have a bona fide market, or c. The securities being offered are investment-grade

CONDITION #2

CONDITION #2 A qualified independent underwriter (QIU) must participate in the preparation of the offering documents A QIU must have served as a manager or co-manager in at least three

public offerings of a similar size and type during the three-year period preceding filing of the registration statement

• The name of the QIU and any conflicts of interest must be disclosed in the prospectus

In both cases, written client consent is required to place the securities in discretionary accounts


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Regulation S-K WHAT IS IT? Standard instructions when an issuer makes its various SEC filings that are not

related to financial statements

GUIDELINES Creates guidelines for presenting projections which are used in non-financial statements contained in registration statements

TIME FRAME Issuer is not limited to a specific time frame, but it may not be misleading

OBJECTIVE Objective is to increase investor understanding

DISCLOSURES Requires disclosures in other SEC filings, such as the description of the types of securities being offered, use of proceeds, compensation of company management, and detailed information required in Forms 8-K, 10-K, and proxies

EXAMPLE An example is disclosure in a proxy statement of the name of any director who attended less than 75% of the meetings

Regulation S-X Governs the

requirements for financial statements

under both the Act of 1933 and the Act of 1934

Provides rules for the form and content of

detailed financial statements, such as pro

forma financial information

An independent accountant prepares an

attestation report

“Stale financials” refers to not being able to use outdated financials in a registration statement 135 days for

IPO issuers 130 days for

accelerated filers

Communication-Related Liability False Registration Statement The parties that may be liable for untrue statements and material omissions from a registration

statement include: • Every person who signed the registration statement • Every director or partner of the issuer at the time of the filing • Every accountant, engineer, or appraiser named as having prepared or certified any part of the

registration statement • Every underwriter of the security


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Section 11 Defense Under Section 11, the parties that may be sued, other than the issuer, are exempt from liability if they can prove that they had no knowledge of the fraud and properly notified the Commission.

This includes an accountant or other professional who refused to sign or certify any of the documents used to prepare the registration statement.

SEC rules describe the appropriate procedures to use in determining what constitutes a reasonable investigation to avoid being sued (referred to as due diligence defense).

Communication-Related Liability Civil Liability for Salespersons Any person who offers or sells a security in violation of the registration provisions of the 1933 Act, and

did not exercise reasonable care regarding untrue statements, is liable for: • Investment amount

plus a reasonable amount of interest on the investment minus the income received from the investment

Regulation FD (Fair Disclosure) WHAT IS IT? INTENTIONAL

DISCLOSURE UNINTENTIONAL

DISCLOSURE

To protect retail investors, Reg. FD prohibits issuers from selectively disclosing material, non-public information to securities professionals and holders of its securities if it’s "reasonably foreseeable" that these persons may trade on the information Public disclosure may be

made by filing an 8-K with the SEC

If the disclosure was intentional, the company must simultaneously disclose the information to the public

If the disclosure was unintentional, the company must publicly disseminate the information promptly, which is defined as: Within 24 hours of release

OR By the opening of the next

trading day if the disclosure takes place during a weekend or holiday, whichever is later


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Recordkeeping Requirements All communication used by the firm, as well as all research reports and correspondence (including e-mail and instant messaging), must be kept on file for a minimum of three years.

SEC registration statements (Forms S-1 or S-3), prospectuses that include a red herring or preliminary prospectus, and other documents written by an issuer are not required to be kept on file by broker-dealers.


I. A conflict of interest involves a member firm conducting a public offering of its own securities or securities of an affiliate.

II. Regulation S-K includes rules for the form and content of financial statements such as pro forma financial information.

III. Regulation S-X creates guidelines for presenting projections used in non-financial statements contained in registration statements.

IV. Regulation FD indicates that issuers may not selectively disclose material, non-public information to securities professionals and holders of the issuer’s securities if it is "reasonably foreseeable" that these persons may trade on the information.


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Chapter 3 – Underwriting

The Primary Market ISSUER

Managing or

Lead Underwriter

Syndicate Members

Selling Group

Types of Underwriting TYPE COMMENTS ESCROW

ACCOUNT?

FIRM COMMITMENT Syndicate purchases entire issue and will absorb any securities remaining unsold: Syndicate is committing capital

STAND-BY Syndicate commits to purchasing any shares remaining after a rights offering

BEST EFFORTS

Syndicate attempts to sell what it can and doesn’t commit capital

If using all-or-none or mini-maxi, offering is cancelled if the contingency is not met: Client funds placed in bank escrow account Bank (escrow agent) will release funds promptly only

when offer is cancelled or contingency is met

Signs Underwriting Agreement with issuer

Signs Syndicate Agreement with manager

Signs Selling Agreement with manager


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Underwriting Concepts 1. NEW ISSUES 2. FINAL SETTLEMENT

Unless released by the manager, syndicate members must sell

new issues at the public offering price

Final settlement of a syndicate must occur within 90 days of syndicate closing

Anticipated delays are reported to FINRA immediately

3. GREEN SHOE CLAUSE (OVER-ALLOTMENT PROVISION) 4. MARKET-OUT CLAUSE

Stipulation in an underwriting agreement that allows for the expansion

of the offering by a maximum of 15%

Good for 30 days from effective date

Allows a firm commitment underwriter to be released from liability if events occur making the

sale of the issue difficult or impossible

New Issue Practices 1. JUMP BALL 2. FREE RETENTION

This process sets aside shares for institutional clients and allows

all members to compete for orders

The profit is allocated based on each member’s sales

The amount that an underwriter is allotted for placement to its own clients

Sales to the firm’s retail clients are often filled from this amount

3. OVERSUBSCRIPTION 4. UNDERWRITING SPREAD

Prior to going effective, if the managing underwriter(s) and issuer feel the offering will be oversubscribed, they may increase

both the shares offered and the offering price

For equity IPOs, many have an underwriting spread of 7%, but the maximum is based on the amount of risk assumed by the underwriter and is inversely related to dollar value of proceeds

(fair and reasonable)


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Underwriting Spread (Equity) Underwriter purchases from issuer at $19, and sells at the POP of $20

MANAGER’S FEE $.20

MEMBER’S/U/W FEE $.20

CONCESSION $.60 $1.00

SPREAD Administration Risk Selling

Example: 1,000 shares are sold to a customer at $20 per share

IF MANAGER SELLS IF MEMBER SELLS IF SELLING GROUP SELLS

Customer pays: $20,000 $20,000 $20,000

Issuer receives: $19,000 $19,000 $19,000

Manager: $1,000 $200 $200

Member: $0 $800 $200

Selling group: $0 $0 $600

Underwriting Spread (Debt) Bonds are issued at par value of $1,000. Every one point equals $10 or 100 basis points

Let’s assume the manager’s fee is 25 basis points point per bond, the syndicate’s compensation is 75 basis points per bond sold, and the selling group’s concession is 50 basis points per bond sold

If bonds are issued at par, what are proceeds to the issuer? (i.e. what’s the total UW spread?)

$1,000 – 100 BP or $10 U/W spread = $990 per bond How much of the spread is compensation for risk?

75 BP – 50 BP = 25 BP

SELLING SYNDICATE MEMBERS 75 BP OR $7.50

Manager’s Fee Underwriter’s Fee Concession


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Communication with Research Department

WRITTEN PROCEDURES

Firms must have written procedures designed to: Prohibit prepublication review, clearance, and approval of reports

by investment banking (IB) and restrict or prohibit trading by other persons responsible for preparation, content, and distribution

Restrict or limit the role of IB in research coverage decisions Prohibit IB from supervising research analysts, including

compensation

INFORMATION BARRIERS

Firms also must establish information barriers that are designed to ensure that RAs are insulated from the review, pressure, or oversight by persons engaged in investment banking services activities or other persons, including sales and trading personnel, who may be biased in their judgment or supervision No prepublication review of reports by IB

PROMISES

Firms must prohibit explicit or implicit promises of favorable research, a particular research rating or recommendation, or specific research content as inducement for the receipt of business or compensation IB cannot contact a research analyst and request or demand a

higher rating or price target

COMPENSATION Research analyst compensation must be reviewed and approved at least annually by a committee that: Reports to the member’s Board of Directors and Includes no members of the Investment Banking Department


1. Jump ball and free retention are examples of ________________________ practices.

2. A allows a firm commitment underwriter to be released from liability if events occur making the sale of the issue difficult or impossible

3. The is an over-allotment provision in an underwriting agreement that allows for the expansion of the offering by a maximum of 15%.

4. Research analysts compensation must be reviewed and approved by at least ________________ by a committee that reports to the member firm’s board of directors.

5. Firms must establish ______________________________________ in investment banking services activities or other persons, including sales and trading personnel, who might be biased in their judgment or supervision.


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I. In the primary market, the Managing or Lead Underwriter signs the Underwriting Agreement with the issuer.

II. In the primary market, the Syndicate Members sign the Syndicate Agreement with the manager.

III. In a Firm Commitment, the Syndicate attempts to sell what it can and does not commit capital.

IV. In a Best Effort, the Syndicate purchases the entire issue and will absorb any securities remaining unsold.

Soliciting Research analysts are prohibited from soliciting investment banking services (IB business) Investment banking service includes underwriting, M&A, venture capital, placement agent, and PIPES

Prohibition includes: Participating in pitch meetings with prospective investment banking clients Having communications with companies for the purpose of soliciting investment banking business

Investment Banking Services Transaction A research analyst is PROHIBITED from: A research analyst is PERMITTED to:

Attending any road show relating to an investment banking services transaction

Communicating with investors concerning an investment banking services transaction in the presence of investment banking or issuer management personnel (referred to as three-way communication)

Investment banking personnel may not direct a research analyst to engage in sales, marketing, or other communication with an investor concerning an investment banking services transaction

Discuss an investment banking services transaction with an investor or potential investor

Discuss an investment banking services transaction with internal personnel

The communication should be for the purpose of educating clients and internal personnel about the transaction. It must be fair and balanced Investment banking and company

management cannot be present

Communication between analysts and companies for the purpose of due diligence is NOT prohibited.


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IB Services Transaction Scenarios QUESTION 1 QUESTION 2 QUESTION 3

May a research analyst, who’s attending a

conference, discuss an investment banking services transaction with an investor

and either company management or an

employee of his firm’s Investment Banking

Department?

May a salesperson ask a research analyst to discuss

an investment banking services transaction with

an investor that just attended a road show?

If an investor contacts a research analyst concerning

an investment banking services transaction, may

the analyst comment?

ANSWER ANSWER ANSWER

No. Yes, but an IBR cannot. Yes, but comments must be fair and balanced.


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Quiet Periods

For an IPO: 10 calendar days

following the offering date for underwriters

No distinction made for managers/ co-managers

For a follow-on offering: Three calendar

days following the offering date for manager/co-manager; no restriction for other underwriters

Doesn’t apply to reports that are distributed under Rule 139 regarding actively traded securities (as defined by Reg. M)

A public appearance includes participation in a public speaking activity (e.g., an industry conference), radio, TV, and other electronic forums if the analyst: Makes a

recommendation Offers an opinion

concerning an equity security

A small group gathering (fewer than 15 separate investors) is NOT defined as a public appearance

The same quiet periods apply as research reports

There’s an exception to the prohibition on the manager and co-manager issuing reports or conducting public appearances during the quiet period Reports are

permitted due to significant news or events

However, an earnings release by a subject company is NOT considered a significant news event for the purposes of an exemption

The reports or appearances must be preapproved by legal or compliance personnel

Emerging Growth Company (EGC) Two exemptions for FINRA research rules: Research reports and public appearances are not subject to the quiet period Research analysts are not restricted from attending pitch meetings for IPOs of an EGC, but should still

not solicit investment banking business

Firms are restricted from publishing a research report and its research analysts

are prohibited from making a public appearance during the quiet period


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I. A research analyst is prohibited from attending any road show relating to an investment banking services transaction.

II. The Quiet Period for a follow-on offering is 10 calendar days following the offering date for underwriters.

III. EGC research reports and public appearances are exempt from the Quiet Period.

IV. The Quiet Period for an IPO is three calendar days following the offering date for the manager or co-manager.

Regulation M – Overview Reg. M was created to prohibit manipulative conduct by persons that have an interest in the outcome of an offering of securities

Rule 101 is concerned with bids and purchases by distribution participants which includes underwriters and selling group members

Rule 102 is concerned with bids and purchases by the issuer and selling shareholders

Rule 103 is concerned with passive market making

Rule 104 is concerned with stabilization and short covering

Rule 105 is concerned with short selling in connection with certain types of offerings

Regulation M Restricted Period The restricted period is the time during which the

trading restrictions of Reg M apply under Rules 101 and 102

RESTRICTED PERIOD FOR REGULAR OFFERINGS

Begins one business day prior to pricing ADTV of at least $100,000 and market value of public float at least $25MM

Begins five business days prior to pricing All other securities

Ends when the distribution is completed

In the case of a distribution regarding a merger, acquisition, or exchange offer, the restricted period begins on the day the proxy solicitation materials are first

disseminated to holders of the securities and ends at the completion of the distribution.


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Regulation M

RESTRICTIONS

During the restricted period: Distribution participants MAY bid for or purchase the security being offered,

but only if the security is: • Actively traded (ADTV of at least $1 million and market value of public

float at least $150 million) ‒ This exception for actively traded securities is not available for

the issuer and selling shareholders • Investment grade non-convertible or asset-backed debt

Additionally, distribution participants may: Execute unsolicited customer orders Solicit offers to purchase the securities being distributed

If distribution participants are prohibited from active market making, they are permitted to engage in passive market making.

PASSIVE MARKET MAKING

If the security is not actively traded, a distribution participant is prohibited from making a market in it during the restricted period.

Since this prohibition reduces liquidity, the SEC permits Passive Market Making.

During the restricted period, passive market making is permitted provided there is at least one independent market maker. A passive market maker (PSMM) may not bid higher than highest

independent bid However, if an independent MM lowers its bid and leaves the PSMM as the

highest bid, the PSMM may maintain its bid until: • It purchases the lesser of two times the minimum quote

size or reaches its daily purchase limit (DPL)

Daily Purchase Limit (DPL) A passive market maker’s DPL is the greater of: 30% of its ADTV in the stock, or 200 shares

Once the PSMM’s net purchases exceed its DPL, it must withdraw from passive market making for the remainder of the day.

However, a PSMM may exceed its DPL to execute any single order.


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Regulation M – Summary The length of the restricted period and permissible activities are based

on the liquidity of the security and the status of the bidder or buyer.

RESTRICTED PERIOD

Buyer Status Illiquid Stocks Moderately Liquid Stocks (ADTV of $100,000)

Actively Traded Stocks (ADTV of $1 million)

Distribution Participants

Five days (passive)

One day (passive) No restriction

Issuers and Selling Shareholders

Five days (no activity)

One day (no activity)

One day (no activity)

Regulation M and IPO Allocations Regulation M also applies to initial public offerings by preventing underwriters and B/Ds from influencing the price prior to the completion of the distribution

During the distribution period for an offering of securities (regardless of whether it’s oversubscribed), it’s a violation to allocate IPO shares based on placing prearranged purchase orders in the after-market at specified prices

Tie-in arrangement may inflate the after-market price of the IPO and is considered a manipulative act

During a distribution, firms may not ask clients for the price they would be willing to pay for the security in the after-market

Regulation M – Stabilizing Bids Permits the syndicate to purchase shares in the secondary market to prevent a price decline

Only form of price manipulation allowed by SEC

Stabilizing bid may not exceed the public offering price

Only one syndicate member may stabilize

Notification is required to the principal market on which the bid is to be entered

There’s no limit as to how long a stabilizing bid may remain open


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Penalty Bids and Syndicate Covering Transactions PENALTY BID Arrangement that permits the managing underwriter to reclaim selling concession from a syndicate

member

SYNDICATE COVERING TRANSACTION Syndicate short positions may arise from overallotments, in which syndicate members sell more than

the number of shares being offered If the stock is trading above the IPO price, the underwriter may exercise the Green Shoe Clause rather

than having losses in a rising market If the stock is trading below the IPO price, the underwriter may prefer to buy the shares in the open

market, rather than at the higher IPO price

Regulation M: Short Sales in Connection With an Offering

SHORT SALE RULE PURPOSE EXCEPTION

If a short sale is effected within the five-business-day period prior to the pricing of a new issue, shares of the new issue may not be purchased by the short seller

This rule is designed to minimize the possibility that the short seller is able to benefit from an impending issuance of shares at an anticipated price and then use those shares to cover the short position

Bona Fide Purchase Exception allows a person who was not aware of the offering, or who had changed her mind, to close out the short sale at least one business day prior to pricing and still purchase the offered securities

FINRA Rules and Regulation M For any Nasdaq or OTC equity security, the managing underwriter may request an Underwriting Activity Report (UAR): This report will identify whether the restricted period is one day or five days The managing underwriter:

• May use other sources • Must disclose if there will be a penalty bid or stabilizing bid


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FINRA New Issue Allocation and Distribution Rule

1 Prohibits a member firm or its employees from using its allocation of a new issue (book building) as a means to obtain extra or excessive compensation from its customers FINRA refers to this activity as quid pro quo or a kickback

2

A firm is permitted to allocate new issue shares to a customer based on the customer having separately retained the member for other services (prime brokerage)

However, the customer may not have paid excessive compensation in relation to those services

3

A firm is prohibited from allocating shares of a new issue to certain decision makers, such as executive officers and directors of former, current, or prospective customers. Restrictions apply to both public and non-public companies that may be considering

an investment banking relationship with the member firm This prohibited activity is referred to as spinning Exception for issuer directed allocations

• Must be in writing and IB cannot be involved in decision

4 FINRA rules also prohibit a member firm from accepting a market order for a new issue prior to the commencement of trading for that stock in the secondary market Limit orders are permitted to be accepted


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FINRA’s New Issue (Equity IPO) Rule Prohibits member firms from selling equity IPOs to accounts

in which a restricted person has a beneficial interest

RESTRICTED PERSONS

Restricted persons include: FINRA member firms and any member firm employees The immediate family members of member firm employees (parents,

siblings, spouse, children, or in-laws) if any of three conditions apply: 1. There’s material support or the sharing of a household 2. The purchase is made through the associated person’s firm 3. The associated person controls the allocation of shares

Finders and fiduciaries Portfolio managers purchasing for themselves Owners of a broker-dealer (10% or greater)

PRECONDITION OF SALE

Firms must have written verification as to eligibility of purchasers (updated annually)

Is client associated with a B/D? Is their immediate family associated with a B/D?

EXEMPT ACCOUNTS

Account in which the combined ownership of all restricted persons represents 10% or less (de minimis)

• For example, a restricted person has an interest in a hedge fund Issuer-directed sales, but only if:

• The associated person or a member of the associated person’s immediate family is an employee or director of the issuer

NYSE Listing Requirements 400 U.S. round-lot shareholders

1,100,000 outstanding shares

A total market value of $100 million for all public shares

A stock price of at least $4 at the time of listing

At least one of several alternative financial tests

Majority of BOD must be independent


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Nasdaq Listing Requirements The three listing tiers from most to least stringent are: Global Select (NGS) Global Market (NGM) Capital Market (NCM)

For all three, the Nasdaq listing requirements include a minimum number of publicly held shares, round lot shareholders, market makers, bid price, and stockholder equity.

Issuers also must satisfy corporate governance requirements.

Highest to lowest requirements: NGS NYSE NGM NCM

Transactions Related to Initial Public Offerings If an issuer conducts an IPO and decides to list on an exchange (NYSE or Nasdaq), a broker-dealer may not execute a transaction away from that exchange until the exchange reports the first transaction.


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Activity Match the description to the appropriate term.

REGULATION M

Permits the syndicate to purchase shares in the secondary market to prevent a price decline

SHORT SALE RULE

Prohibits a member firm or its employees from using its book building as a means to obtain extra or excessive compensation from its customers

UNDERWRITING ACTIVITY REPORT

Arrangement that permits the managing underwriter to reclaim selling concession from a syndicate member

STABILIZING BID

Created to prohibit manipulative conduct by persons that have an interest in the outcome of an offering of securities

NEW ISSUE (EQUITY IPO) RULE

Identifies whether the restricted period is one day or five days

NEW ISSUE ALLOCATION AND DISTRIBUTION RULE

Prohibits member firms from selling equity IPOs to accounts in which a restricted person has a beneficial interest

PENALTY BID

Minimizes the possibility that a short seller can benefit from an impending issuance of shares at an anticipated price and then use those shares to cover the short position


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Chapter 4 – Exempt Securities and Exempt Transactions

Exempt Securities The following securities are exempt from registration, but not from antifraud provisions: Securities issued by the U.S. government or agencies Securities issued by municipalities Securities issued by banks Securities issued by non-profit organizations Short-term corporate debt; maximum maturity of 270 days

Registration Exemptions Rule 147 and Rule 147A are exemptions from SEC registration

for securities sold on an intrastate basis (updated in 2017)

RULE 147 Rule 147 applies to in-state offers and to companies that are organized and have their principal residence in that state Eligible purchasers include preexisting resident corporations, partnerships,

and trusts

RULE 147A

Rule 147A permits the use of general solicitation and multi-state offers, but all sales are limited to in-state residents In addition, companies are able to be incorporated or organized outside of

the state as long as they have their principal place of business in that state • For example, if ABC is incorporated in New Jersey, but its principal

place of business is in New York, ABC will be allowed to sell securities to residents of New York

Eligible purchasers include preexisting resident corporations, partnerships, and trusts

“DOING BUSINESS” REQUIREMENTS

For both Rule 147 and 147A, the issuer must satisfy one of four “doing business” requirements:

1. At least 80% of its gross revenues are derived from the operation of a business that’s located in the state

2. At least 80% of its assets are located within the state 3. At least 80% of the net proceeds from the offering are intended to be used

by the issuer within the state 4. A majority of the issuer’s employees are based in the state or territory

(this fourth requirement was not included in the original Rule 147)

Resales to persons who reside outside of the state are restricted for a period of six months from the date of the sale by the issuer to the purchaser (formerly nine months)

ADRs, REITs, and mutual fund shares must be registered


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Regulation A – Small Issues Securities may be offered to the public

Similar to registered offerings; public solicitation is permitted; no resale restrictions

Issuer files Form 1-A as an offering statement with the SEC

Offering Circular is part of this filing and is used as a disclosure document and must accompany any sales literature

Prior to SEC filing, issuer may provide factual information to determine whether investors are interested – referred to as “testing the waters”

Registration Exemptions REGULATION A TIER 1 REGULATION A TIER 2

Maximum offering size $20 Million $75 Million

Time period 12 Months 12 Months

Maximum amount that may be sold by existing shareholders

$6 Million (30% max. of offering)

$22.5 Million (30% max. of offering)

Audited financial statements/ ongoing reporting? No Yes

Question Which of these statements are TRUE with regards to exemptions? Circle all that apply.

I. Securities issued by municipalities, banks, non-profit organizations, and the U.S. government are exempt from registration.

II. Corporate debt with a maturity of three months is exempt from the antifraud provision of the Securities Act of 1933.

III. Rule 147 permits the use of multi-state sales if the size of the offering does not exceed a specified amount.

IV. An Offering Circular is part of a small issue filing and is used as a disclosure document.


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Private Placements These offerings are exempt from SEC registration based on the target audience The issuers are usually privately held companies that are not SEC reporting companies (i.e., start-ups):

• More restricted than public offerings Offerings may be equity or debt and are primarily marketed to a limited number of sophisticated investors Broker-dealers that offer these securities are still required to conduct an investigation of the issuer

(due diligence) Below are some terms associated with private placements

PLACEMENT AGENT PLACEMENT AGENT AGREEMENT

ENGAGEMENT LETTER

PRIVATE PLACEMENT MEMORANDUM (PPM)

An investment banking firm that acts in an agency

capacity by agreeing to find institutional investors to purchase the securities

being offered

Terms and conditions between the issuer and

placement agent

Signed by issuer and banker to engage the

placement agent

Used as a disclosure document for investors, but is not filed with SEC

TEASER NON-DISCLOSURE AGREEMENT (NDA) TERM SHEET SUBSCRIPTION

AGREEMENT

Executive summary of the private placement

memorandum

Confidentiality document that’s signed by investors

who agree not to disclose confidential

information

Contains information regarding the securities

being offered

Sales contract for the securities being offered

through a private placement

Private Placement Regulations Section 4 of the Act of 1933 relates to exempt transactions and has two main exemptions—4(2) and 4(5).

SECTION 4(2)

Under Section 4(2), registration is NOT required for transactions that do not involve a public offering and include the following factors: A limited number of offerees (not purchasers); no form of general

solicitation or advertising is permitted To qualify, the purchasers must have enough knowledge and experience

in finance and business to understand and evaluate the risks and merits of the investment

Investors must have access to the same information that is normally provided in a prospectus and must agree to not resell or distribute the securities publicly

SECTION 4(5)

The Section 4(5) exemption, formerly 4(6), is referred to as the accredited investor exemption and must meet the following conditions: The amount of the offering may not exceed $5,000,000 No advertising or public solicitation may be used to offer the securities,

and the offering may be sold only to accredited investors No document delivery requirement applies, but antifraud provisions apply

This exemption is different than Regulation D, which allows for the participation of a limited number of non-accredited investors.


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Regulation D – Use of Form D RULE 504 RULE 506

Maximum of $10 million dollar amount Unlimited number of investors

Unlimited dollar amount Unlimited number of accredited investors and

a maximum of 35 non-accredited investors Sophistication test and purchaser

representatives for non-accredited investors

Accredited Investor Definition What is an accredited investor? Financial institutions (regardless of their assets) Pension plans, 501(c)(3) plans, ERISA accounts, and trusts with total assets in excess of $5 million Any executive officers, directors, or general partners of the issuer of the securities Individuals who meet one of the following two financial tests:

• $1 million net worth (exclusive of primary residence) OR • $200,000 annual income ($300,000 if joint) in each of the last two years

Any entities in which all of the equity owners are accredited investors

Regulation D – Private Placement WHAT IS IT? An offering which limits the number of non-accredited investors (no more than 35)

PURCHASER REPRESENTATIVE

The purchaser representative (no specific qualifications): Evaluates risk and merits for a non-accredited investor May not be an officer, director, or greater than a 10% owner, unless related

to purchaser Required under 506, but not 504

DISCLOSURE DOCUMENT (PPM)

Not required if all investors are accredited Required for ALL investors if non-accredited investors are included Includes use of proceeds, suitability standards, and financials Investors acknowledge that they are purchasing restricted securities


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Rule 506 GENERAL SOLICITATION BAD ACTORS

Regulation D generally prohibits an issuer, or the securities firm that represents an issuer, from using any form of general solicitation or general advertising to promote an offering However, the JOBS Act created Rule 506(c) which allows issuers, and the securities firms that assist these issuers, to raise an unlimited amount of capital through the private placement market and use general solicitation and general advertising if all of the purchasers are accredited investors The issuer also must take reasonable steps to verify that purchasers of the securities which are sold in any offering under 506(c) are accredited investors

Under Rule 506, the SEC prohibits an offering if the issuer or other participants (e.g., placement agents, certain shareholders, directors, and executive officers) are defined as Bad Actors The objective is to prohibit persons who have been convicted of securities fraud, or subject to administrative sanctions for securities fraud, from raising unlimited amounts of capital through the private placement market Look-back period is 10 years; however, for the

issuer and affiliated issuers, the look-back period is five years

E.g., if a director of an issuer was convicted of a felony within the last 10 years, that issuer is unable to raise funds in a 506 offering

Rule 144 Rule 144 permits the sale of restricted and control stock.

RESTRICTED STOCK Restricted (unregistered) stock is acquired through a private placement or as compensation by a senior executive of an issuer. Six-month holding period

CONTROL STOCK

Control (affiliated) stock is registered stock that is a part of an issuer’s public float and purchased in the open market by officers, directors, or greater than 10% shareholders of the issuer. No required minimum holding period

TO SELL RESTRICTED OR CONTROL STOCK

SEC must be notified at the time the sell order is placed by filing Form 144 Person then has 90 days to sell the specified securities

MAXIMUM AMOUNT THAT CAN BE SOLD

Greater of 1% of outstanding shares or the average weekly trading volume over the last four weeks

EXCEPTION TO NOTIFYING THE SEC

If selling no more than 5,000 shares that are worth no more than $50,000


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Rule 144A Provides an exemption if restricted securities are sold to Qualified Institutional Buyers (QIBs): QIB – Institution with at least $100 million under management 144A securities may be equity or debt securities and be offered by domestic or foreign issuers If securities of the same class are listed on an exchange, they’re ineligible for 144A exemption Used mostly for corporate debt Unlike Rule 144, after the sale, the securities are still restricted (unregistered)

Regulation S Provides a registration exemption to U.S. and foreign issuers that offer securities outside of the U.S. if: The offer or sale is an offshore transaction

• No offer may be directed to a U.S. person and the transaction must be effected through an overseas securities market − U.S. person defined as any natural person who’s a U.S. resident

Regulation S securities may be resold: Through a designated offshore securities market immediately OR In the U.S., non-convertible debt may be sold after 40 days, while equities may be sold after one year

(six months for reporting issuers)


PRIVATE PLACEMENTS

Permits the sale of restricted and control stock

RULE 144A Specifies exemptions under Section 4 of the Act

of 1933

ACCREDITED INVESTOR

Provides an exemption from registration to U.S. and foreign issuers that offer securities outside of the U.S. provided the offer or sale is an offshore transaction

RULE 144 Exempt from SEC registration based on the target

audience; issuers are usually privately held companies that are not SEC reporting companies

RULE 506 Includes financial institutions, pension plans,

501(c)(3) plans, ERISA accounts, and trusts with total assets in excess of $5 million

SECTIONS 4(2) and 4(5)

Prohibits an offering if the issuer or other participants are defined as Bad Actors

REGULATION S Provides an exemption if restricted securities are

sold to Qualified Institutional Buyers


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Chapter 5 – Mergers and Acquisitions

Two Types of Buyers – A Summary FINANCIAL BUYER STRATEGIC BUYER

Time Frame Shorter Longer

Typical Currency Cash/uses LBO analysis Stock and/or cash

Operating Synergies Less important Very important

Potential Targets Non-specific Industry specific

Private Equity Transactions PRIVATE EQUITY (PE) RECAPITALIZATION

MINIORITY RECAPITALIZATION

DIVIDEND RECAPITALIZATION

PE firm buys most, but not all, of the owner’s interest in the company

Owner has liquidity, but can still participate in the equity upside when the business is sold or taken public

PE firm will look to increase the business by increasing revenue, reducing expenses, and possibly by making other acquisitions

Company reorganizes its debt and equity mixture with a PE investor that owns less than 50% of the company

This generally provides liquidity to specific shareholders while preserving capital structure flexibility to facilitate future growth

PE firm that has already purchased a company takes on additional debt to pay itself (and possibly management) a cash dividend

The hope is that, after initially buying the company, its equity has risen and the buyer can tap into this excess by borrowing funds to pay the dividend


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Valuation COMPARABLE

COMPANIES ANALYSIS

Comparison of the subject company to other companies in

the same or similar sector

PRECEDENT TRANSACTIONS ANALYSIS

Comparison of the transactional value of an M&A transaction to

other transactions in the same or similar industry sector

DISCOUNTED CASH FLOW (DCF) ANALYSIS

Valuation is based on the net present value

(using WACC as the discount rate) of projected cash flow and

ending (terminal) value

Comparison of Cash or Stock Offer CASH OFFER STOCK OFFER

Known value for both buyer and seller

Unknown value for both buyer and seller

No dilution of buyer’s ownership structure

Dilution of buyer’s ownership structure

Immediate tax liability to seller No immediate tax liability to seller

May be impractical for large deals

May be impossible for private buyers

Often made at a discount to an all-stock deal

Often made at a premium to an all-cash deal

The process of valuing a publicly traded company is easier than a privately held company.


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Transactional Structure of an Asset Sale

ASSET SALE

Corporation is selling its assets rather than selling shares of stock (selling entity continues to exist)

Asset purchases are preferred by buyers • Buyer may “cherry pick” preferred assets and leave liabilities

behind • Buyer is able to exclude pre-acquisition liabilities • Buyer benefits by having a stepped-up (higher) tax basis on the

assets which may produce a lower taxable gain when the assets are sold in the future

Seller must pay tax on the difference between the cost basis of the assets and their sale price

STOCK SALE

Corporation’s shareholders are selling their shares (selling entity ceases to exist)

Shareholders, not the corporation, pay tax on the difference between cost basis and sale price

• Capital gain Stock sales are preferred by sellers

• Selling corporation is not required to pay tax on this type of transaction

• The buyer is purchasing all of the corporation’s assets; therefore, the seller will not have liability going forward

Section 338(h)(10) Election SECTION 338 (h)(10)

ELECTION Refers to a part of the tax code which allows a stock sale to be treated as an asset sale for tax purposes if certain conditions are met

BUYER The buyer benefits by being able to step-up (increase) the value of the target’s assets to their fair value, rather than using their book value (no tax is paid by purchasers to receive the benefit)

SELLER The seller will be required to pay tax on the difference between book value and fair value of the assets

NET OPERATING LOSSES

If the seller has net operating losses that were carried forward, it may offset those losses against its gain on the sale of the assets

PREMIUM In many cases, the seller demands a premium (higher) price to compensate for the tax it is required to pay on this transaction

ADVANTAGE This type of structure may be advantageous to both parties


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Role of Sell-Side Banker PERFORMS

DUE DILIGENCE CONDUCTS

EXTENSIVE ANALYSIS OTHER

Performs due diligence on the seller; identifies and assesses potential transactions Sale of entire company Divestitures (spin-offs,

split-offs) Stock sale versus asset

sale

Conducts extensive analyses of potential buyers to: Identify their strengths and

weaknesses, including their capacity to pay and the strength of their currency (cash or stock)

• Seller would prefer cash Assist in evaluating any

financing requirements, including stapled financing

• Prearranged financing package offered by an investment bank to potential bidders in an acquisition

Valuation is the key • Banker’s suggestion may

entail methods to increase revenue and/or reduce expenses to increase valuation (this would delay a liquidity event)

Determines whether the company should conduct an auction or whether one-on-one negotiation is preferable

Prepares a fairness opinion

Creates data room Addresses antitrust

concerns


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FINANCIAL BUYER A corporation’s shareholders sell their shares (selling entity ceases to exist) and the shareholders, not the corporation, pay tax on the difference between cost basis and sale price

STRATEGIC BUYER Part of the tax code which allows a stock sale to be treated as an asset sale for tax purposes if certain conditions are met

PRIVATE EQUITY TRANSACTIONS Includes Private Equity Recapitalization, Minority

Recapitalization and Dividend Recapitalization

STOCK SALE Has a shorter time frame and the typical currency is cash using a LOB Analysis

ASSET SALE Known value for both the buyer and seller, there is no dilution of the buyer’s ownership structure and there is an immediate tax liability to the seller

SECTION 338(H) ELECTION

Performs due diligence, conducts extensive analysis, and determines whether the company should conduct an auction or a one-on-one negotiation

SELL-SIDE BANKER Has a longer time frame and the typical currency is stock and/or cash

CASH OFFER The corporation sells its assets rather than selling shares of stock (selling entity continues to exist) and the seller must pay tax on the difference between the cost basis of the assets and their sale price

Cross-Border Due Diligence Foreign Corrupt Practices Act (FCPA) prohibits corrupt or improper payments to foreign government officials for the purpose of obtaining business Anti-bribery law which applies to U.S. companies and foreign companies that issue stock or trade as a

sponsored ADR in U.S. market When performing DD, it is important for an IBR to look for these prohibited situations. If discovered,

firm should notify DOJ and SEC.

Also check list maintained by the Treasury Department Office of Foreign Assets Control (OFAC list) Sanctions list includes companies from Cuba, Iran, North Korea, and Syria All transactions must be blocked and law enforcement notified within 10 business days if entity is on

the list


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Deal Structure SPINOFF SPLIT-OFF REVERSE MERGER

Receives new shares Each shareholder of the

parent retains her original shares, but is also given shares in the newly created entity

Requires an exchange of shares

A corporation is split into pieces

One group of shareholders will ultimately own shares solely in the original parent, while the other group will own shares solely in the split-off entity

A private company buys a public company with the acquirer’s shareholders swapping their shares for a majority stake in the publicly traded corporation

Role of Buy-Side Banker RESEARCH

Researches the target’s largest shareholders to determine how they should be approached Proxy statement, 10K, 13D and 13G fillings

DUE DILIGENCE

Facilitates the due diligence process Evaluates the leadership of the target company, including interviewing

management and performing background checks Performs due diligence from available sources other than the target

company, such as interviewing suppliers and accountants

RATIONALE

Evaluates the rationale for the acquisition and value of the business Analyzes target’s financial results, prospects, and potential synergies

with the buyer Produces preliminary stand-alone and pro forma valuation analysis and

accretion/dilution analysis

CONFIDENTIALITY Reviews the Confidential Information Memorandum (CIM) and Confidentiality Agreement that was prepared by the seller

RISK

Uncovers risk and impediments to the transaction such as: Unfunded liabilities Degree of off-balance sheet disclosures Shareholder rights plans Staggered boards

OTHER

Assesses the strategy, resources, and financial capacity of the buyer and assists in arrangement of financing alternatives

Helps coordinate the schedule for management presentations, data room access, and site visits with the buyer and the target

Assists the buyer with developing, finalizing, and reviewing its bid Prepares a fairness opinion Informs the buyer of any recent developments among other buyers and

competitors Evaluates potential market reaction announcements concerning a

merger/acquisition


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Auctions Sellers may choose to auction the business entirely or may select certain assets to be sold

Seller would choose banker in a “bake-off”

This process generates interest from multiple parties, allows for comparison of multiple bids, and can be limited or open

Auction may occur after one-on-one negotiations

Banker for acquirer may make its bid more attractive by increasing the price and/or shortening the time to close the deal

The Auction Process – Seller’s Perspective 1

ENGAGEMENT LETTER

2 DEVELOPMENT OF

CONTACT/PROSPECT LIST

3 CREATION OF THE

TEASER

4 CONFIDENTIALITY

AGREEMENTS

Defines the legal relationship between the investment banker and

seller in an M&A transaction

Targets firms that have natural synergies and

financial resources

A brief profile created to elicit interest; seller is

anonymous

NDAs are signed by all parties that wish to receive additional

information

5 CONFIDENTIAL INFORMATION

MEMORANDUM (CIM) CREATED

6 DISTRIBUTE THE

INITIAL BID PROCEDURES

LETTER

7 CREATION OF DATA

ROOM (CONTROLLED BY THE SELLER)

8 INDICATIONS OF INTEREST (IOI)

A CIM is a more detailed document

disclosing identity of seller and financial

specifics

Indicates deadlines for initial bids and other seller requirements

A data room is a secure confidential location

where all parties participating in the deal

can access DD information

(Non-binding) bids detailing the intended

purchase currency (e.g. cash, stock, or

combination) and a price range

9 CONDUCTING MANAGEMENT

PRESENTATIONS

10 LETTER OF INTENT (LOI); NON-BINDING

11 FINAL BID

ACCEPTANCE

12 SIGNING OF DEFINITIVE

AGREEMENTS

These presentations typically attempt to

provide a deal rationale, as well as address DD

concerns

Formal document containing a more

detailed description of the proposed

transaction (discussed next)

Winning bidder is selected and negotiates

terms of a definitive purchase agreement to

close the deal

Final price, proof of financing sources, and

other specific conditions agreed-to by the buyer and seller (discussed

later)


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Letter of Intent These documents, also referred to as term sheets or memorandums of understanding (MOUs), may contain: Anticipated pricing and agreed-upon reasons for price adjustments Proposed deal structure and currency to be used Defined time frame for due diligence Period of exclusivity, if any Potential break-up fees (payment that a target owes to an acquirer if the deal falls through) No-shop or go-shop provisions (may result in a higher price) Earn out provisions Employment contract issues Warranties as to the validity of financial statements Agreements regarding disclosure of any subsequent material events

Definitive Purchase or Asset Agreement One of the provisions included is an Indemnification Clause

Often requested by buyers as protection against a seller’s material breach of contract after a deal has closed

Examples include misrepresentation of financials and/or failure to disclose a material event, such as the loss of a major client prior to closing

It quantifies the amount of compensation that’s payable to the buyer if the officers and directors of the selling firm fail to meet their legal obligations

An indemnification cap limits the seller’s liability for breach of contract to a set amount of money based on the sale price

An indemnification basket sets a certain dollar amount of losses that must be experienced due to a breach of contract in order for the buyer to claim any compensation


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Fairness Opinion (FO)

WHAT IS IT?

Used at the conclusion of an M&A transaction; created by banker only to judge fairness of transaction price States that the price is reasonable (need not be the highest) Examines similar transactions Reviews the buyer’s and seller’s financial statements Reviews the financial projections Discloses any potential conflicts of interest Used mostly with publicly traded companies

Seller’s BOD requests a FO in most transactions (except tender offers) since a premium is often offered to shareholders In many situations, the buyer will also request an FO

“Based on and subject to the foregoing, we are of the opinion that, as of the date hereof, the Merger Consideration to be paid to holders of Company Common Stock, and the Merger, is fair to such holders from a financial point of view.”

FINRA REGULATIONS

The creator of a fairness opinion is required to disclose: Whether a financial advisor to any party in the transaction will receive compensation

contingent on the completion of the merger or takeover Whether the broker-dealer will receive any other significant payment contingent on the

completion of the transaction (Note: the amount of compensation is not required to be disclosed)

Whether any material relationship existed within the past two years between the broker-dealer and any party subject to the fairness opinion

ADDITIONAL DISCLOSURES

Whether any information obtained from the party that has requested the fairness opinion has been independently verified by the member firm

Whether the fairness opinion was approved by a fairness committee (committee must include members that are not on the deal team)

Whether the fairness opinion addresses the fairness of the compensation paid to corporate insiders relative to the compensation received by public shareholders

Note: A fairness opinion is not required, but is used in most transactions that require a shareholder vote The opinion doesn’t make a recommendation about the transaction and doesn’t address tax considerations


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Takeover Defenses Unwilling targets may employ the following defensive measures:

Shareholders’ rights (poison pill) plans Rights are only issued to existing shareholders

Staggered boards

Supermajority approvals

Golden parachutes Represents a payment that’s made to a senior officer of a company in the event of a takeover or a

change in control Excess golden parachute payments (payments greater than three times the individual’s average

annualized compensation as computed over the previous five years) result in: • The acquirer losing the tax deduction for the payments, and • The recipient possibly being subject to an excise tax of 20% on the excess payments


1. The researches the target’s largest shareholders to determine how they should be approached.

2. A is used in an M&A transaction. It is created by a banker to judge the fairness of the transaction price and states that the price is reasonable.

3. The Engagement Letter, development of a Prospect List, creation of the teaser, indications of interest and conducting management presentations are all steps in the .

4. Poison Pill Plans, Staggered Boards, and Supermajority Approvals are examples of .

5. The process for a publicly traded company is easier than a privately held company.

6. Misrepresentation of financials and/or failure to disclose a material event such as the loss of a major client prior to closing are examples of .


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Chapter 6 – Tender Offers and M&A Rules

Tender Offers WHAT IS IT? A tender offer is defined as a broad solicitation by an issuer or third party to

purchase securities for a limited period; typically at a premium

SCHEDULE TO Filed with SEC by any person (issuer or third party) that makes a tender

offer and subsequently becomes the owner of more than 5% of a company This is in addition to a 13D filing

SCHEDULE 14D-9 Filed by certain persons (e.g., the issuer and other owners of the company) and includes recommendations or solicitations that relate to the tender offer

PROCESS

This process involves going directly to shareholders: Tender offer

• In an acquisition, it would be for all the issuer’s shares • An issuer may offer to buy back its stock through a partial tender

A vote is not required May be made by the issuer or a third party Tender could also be an exchange offer

RULES

Shareholders must be notified no later than 10 business days from the date the tender is made

Management of the subject company must advise its shareholders of their bias toward the tender (for, against, or neutral) by no later than 10 business days from the date the tender offer is made

Tender offers must generally be held open for at least 20 business days If the person that makes the offer alters the terms of the offer, it must

remain open for at least 10 business days from the change In order to extend the offer, the buyer must make a public announcement

(e.g., a press release) no later than the earlier of 9:00 a.m. Eastern Time OR the opening of the exchange on the next business day after the scheduled expiration date of the offer

It’s fraudulent for the buyer to fail to promptly pay the consideration being offered or fail to return the securities tendered after the offer is terminated or withdrawn (“promptly” generally refers to no more than two business days from the conclusion of the offer)

OPEN MARKET PURCHASES

No open market purchases are allowed during the tender period. The purchase of the issuer’s non-convertible bonds is allowed if the tender

is for the equity (however, convertibles equate to equity) The dealer-manager (usually a B/D) is also subject to this rule, but limited

exceptions are made if: • Done on an agency basis • Done on a principal basis, provided the DM is not a market maker or

an affiliate, and information barriers exist


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Tendering Shares What may be tendered (long positions)? Shares that are owned outright Shares that are owned based on a convertible security Shares that are owned based on a right or warrant (DO NOT need to be exercised) Shares that are owned based on a call option (but ONLY if exercised) Net-Long Position

• An investor who owns 500 shares and is short 2 call options is net long 300 shares

Tenders – Prohibited Practices

SEC Rule 14e-3

No trading while in possession

of insider information

SEC Rule 14e-5

Short tendering of stock (i.e., tendering stock that

one doesn’t own) is prohibited

SEC Rule 14d-10

No preferential pricing; all shareholders must be offered the same price

regardless of their ownership position

Also referred to as the best price rule, but an exception is granted for changes

in compensation arrangements for executives of the company; however, the arrangements must be approved by the compensation committee of

the target which consists of independent board members

One-Step Versus Two-Step Mergers ONE-STEP MERGER TWO-STEP MERGER

In a one-step merger process, the target company obtains approval from its shareholders through a vote at a special meeting Generally requires a simple majority vote for

approval

In a two-step merger process, the acquirer offers to purchase the shares of the target for cash or proposes an exchange offer First step is a tender offer, if this is successful

(generally need 90% of shares tendered) Second step is a short-form merger

agreement that does not require shareholder vote of approval (this is referred to as a squeeze-out)

A two-step merger is quicker than the one-step merger in the time that it takes to complete the process

Each of these practices is prohibited.


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I. Open market purchases are allowed during the tender period.

II. SEC Rule 14d-10 dictates that all shareholders be offered the same price regardless of their ownership position.

III. In a one-step merger, the target company obtains approval from its shareholders through a vote at a special meeting.

IV. In a two-step merger process, the acquirer offers to purchase the shares of the target for cash or proposes an exchange offer.

Tender Offer by Issuers ISSUER SHARE

BUYBACK The issuer intends to purchase a specified number of its own shares through a tender offer

DUTCH AUCTION The tender may be conducted via a modified Dutch Auction in which shareholders select the price within a specified price range at which they’re willing to sell their shares

LOWEST PRICE The company will normally select the lowest price that will allow the purchase of the number of shares specified in the tender. All shareholders receive the same price.

PRO RATA SYSTEM If oversubscribed, a pro rata system should be used

ONE-TIME EVENT Used as a one-time event, in lieu of a company repurchasing its stock in the open market (buyback program)


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SEC Filings – Going Private

WHAT IS IT?

In a Going Private transaction, an issuer is buying back its own shares which causes the company to: Become delisted from an exchange or Cease to be an SEC reporting company (i.e., it falls below the SEC

reporting threshold of 300 shareholders)

PURPOSE The purpose may be to reduce regulatory costs

FILING REQUIREMENTS

Typically, the issuer must file: Schedule 13E-3 A fairness opinion A summary term sheet A copy of the proxy statement

TRANSACTION MAY INVOLVE

The transaction may involve a reverse stock split (reducing shares outstanding below the requirement for a reporting company) or an LBO

14A Proxy Statements 1. PROXY STATEMENT 2. DEFINITIVE PROXY

A proxy statement is used when a vote is required of shareholders

A definitive proxy goes to shareholders to provide them with sufficient information in order to make an informed decision

3. ANNUAL PROXY 4. SPECIAL PROXY

With an annual proxy: No preliminary proxy is required to be filed

with the SEC An issuer files a definitive proxy with the SEC

when it is provided to shareholders

With a special proxy (for M&A): A preliminary proxy must first be filed with the

SEC and, after review, the definitive proxy may be provided to shareholders


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Special Proxy A business combination (e.g., a proposed merger) requires the filing of a preliminary proxy at least 10 days prior to the definitive proxy being distributed to shareholders. It is not sent to shareholders

A definitive proxy statement must also be filed with the SEC by no later than the date it’s first distributed to shareholders.

Application concerning cash mergers: If a public company is buying a private company, no proxy is required to be filed If a public company is buying another public company, only the target is required to file a proxy


I. A Going Private transaction causes the issuer to become delisted from an exchange or cease to be an SEC reporting company.

II. In a tender offer by an issuer, the company will select the highest price and all shareholders receive the same price.

III. A proxy statement is used when a vote is required of shareholders.

IV. With a special proxy (for M&A), a preliminary proxy must first be filed with the SEC.

SEC Rules 135, 145, and 165 135 145 165

Provides a safe harbor for certain limited announcements regarding a proposed public offering or business combination

Applies to situations in which securities are being offered as a result of business combinations Prospectus required S-4 registration statement

(discussed next)

Any written communication after the public announcement, and until the filing of a registration statement and effective date, must be filed with the SEC These communications are

referred to as Form 425 filings Filed on date of first use,

could also part of an 8-K filing


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Form S-4 Registration Statement Required filing for securities to be issued in connection with a merger (filed by acquirer) Since target shareholders are required to vote on the proposed merger, a proxy statement is also

required to be issued • Issuers are permitted to incorporate most of the important details of the merger in S-4 filings • The form is a great source of information regarding the cash and/or stock that the shareholders

of the target company will receive from the acquirer • Usually contain a “fairness opinion" that provides valuation comparisons

Filing Requirements for Acquisitions IF USING STOCK

Acquirer files a Form S-4 Target files a proxy

IF USING CASH

Acquirer has no filing requirement Target files a proxy

FOR TENDER OFFERS

Acquirer directly solicits the target’s shareholders and files a Schedule TO

Proxy Statements – M&A Transaction Voting Shareholders often vote on a transaction via proxy May be issued in mergers, consolidations, and acquisitions Seller’s shareholders always vote (except for two-step merger process) Buyer’s shareholders may vote if the deal is dilutive (if greater than 20% additional shares are being

issued)

VOTING RIGHTS TARGET SHAREHOLDERS ACQUIRER SHAREHOLDERS

Stock Deal Yes Yes (unless issuance is minimal)

Cash Deal Yes No


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Hart-Scott-Rodino Act (HSR) A federal antitrust act that requires certain parties to file notice with the Federal Trade Commission (FTC) and the Antitrust Division of the Justice Department before a large deal is completed

The merger may not be completed until 30 days after the notice is filed (15 days if the transaction is all cash)

HSR also requires financial investors to file and comply with the 30-day waiting period, unless the purchase was for investment purposes only and without the intent to control the company


SEC RULE 135 Required filing for securities to be issued in

connection with a merger (filed by acquirer)

SEC RULE 145 Must be filed with the SEC no later than the

date it is first distributed to shareholders

SEC RULE 165 A federal antitrust act that relates to mergers

and acquisitions

FORM S-4 REGISTRATION

STATEMENT

Provides a safe harbor for certain limited announcements regarding a proposed public offering or business combination

M&A TRANSACTION VOTING

Any written communication after the public announcement, and until the filing of a registration statement and effective date, must be filed with the SEC

DEFINITIVE PROXY STATEMENT

May be issued in mergers, consolidations, and acquisitions and means shareholders often vote on a transaction via proxy

HSR ACT Applies to situations in which securities are

being offered as a result of business combinations


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Chapter 7 – Financial Structuring and Bankruptcy

Bond Indentures TRUST INDENTURE

ACT OF 1939 TRUSTEE INDENTURE

Applies to corporate debt only

Each bond has a trustee (bank) Appointed by issuer to

act in bondholders’ best interests

Written contract which contains two components:

1. Covenants (issuer pledges) • A violation of a covenant

triggers a default 2. Steps taken if an issuer defaults

• If an indenture contains a cross default clause, a default is triggered if any of the bonds issued by the same company default


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Chapter 11 Bankruptcy Bankruptcy occurs if an issuer (debtor) cannot make the payments owed to creditors

1

REORGANIZATION BANKRUPTCY For voluntary bankruptcy, the company files the petition For involuntary bankruptcy, the creditors file the petition Management and BOD continue to exist Goal is to sell assets in order to pay down liabilities Debtor-in-possession (DIP) status of company

2

PLAN APPROVAL Step One – the DIP files the reorganization plan within 120 days Step Two – the creditors and court must approve the plan

• Under bankruptcy code, an entire class of claims is considered to have accepted the plan if creditors holding at least two-thirds of the dollar amount of claims, and representing more than one-half of the total number of creditors in that class, agree to the plan

Step Three – the court confirms the plan

Note: The court may approve the plan if at least one class of impaired creditors (those not paid in full) approves and the plan is considered fair to all creditors; this is referred to as a cramdown

3

DIP Responsibility of the DIP: Secures DIP financing which may have priority over existing claims (superpriority status)

• In many cases, this financing is provided by existing creditors Operates and manages the business Handles a possible 363 sale (discussed later) Files motions with the court since significant decisions must be approved

The trustee monitors the DIP and appoints the creditors committee (and any other committee)

4

CREDITORS’ COMMITTEE In order to protect the interests of unsecured lenders during the reorganization, a creditors’ committee is appointed by the U.S. Trustee and ordinarily consists of the seven largest unsecured creditors

Role of the Creditors’ Committee: Participate in formulating the plan To review and advise the court on its position regarding motions or other legal actions that

have been filed To hire professionals who will investigate any lien that is filed by secured creditors To advise other unsecured creditors on whether to accept or reject the plan that has been filed


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Chapter 7 Bankruptcy Liquidation Bankruptcy Trustee files the plan Management and BOD cease to exist Trustee may operate the business while it’s being liquidated

• May appoint other professionals to assist in the liquidation Goal is to sell assets to pay off creditors and equity holders Secured creditors will have priority up to the value of their collateral; thereafter, they’re grouped with

the other unsecured creditors

Payment Priority for Unsecured Creditors

Common shareholders

Preferred shareholders

Other unsecured creditors (senior, then junior bondholders)

Employee back wages (but only to the extent of $10,000 for each individual or corporation, earned within 180 days before the date of the filing of the petition)

Unsecured claims under Section 502(f)

This subsection may occur in an involuntary case in which a claim arises in the ordinary course of business after the filing, but before the appointment of a trustee

Administrative expenses (DIP financing may have priority)

Current wages of employees, trustee, attorney, and accounting fees


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Bankruptcy Creditors Versus Shareholders Priority of payments is as follows:

Secured Debt

Unsecured Debt

Subordinated Debentures

Preferred Stock

Common Stock

Warrants

Recovering Funds CHAPTER 11 LIQUIDATION

Unsecured creditor is not required to file a proof of claim in order to recover funds unless: The debtor does not list the creditor in its schedule of liabilities, or The debtor lists the creditor on the schedule of liabilities, but qualifies the debt as disputed,

contingent, or liquidated

CHAPTER 7 LIQUIDATION Unsecured creditor or an equity security holder must file a proof of claim in a timely manner in order to recover any funds Claim must be filed by no later than 90 days after the first date set for the meeting of creditors

Section 363 Sales The sale of assets during a bankruptcy outside the normal course of business by a distressed seller Benefits include that assets may be sold free and clear of liens and encumbrances Debtor or trustee files with the court

Stalking Horse Bidder usually conducts the due diligence and provides the lead bid Sets a minimum price May receive overbid protection and break-up fees Will receive reasonable expense reimbursement


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1. The Trust Indenture Act of 1939 applies to debt only.

2. For voluntary bankruptcy, the files the petition. For involuntary bankruptcy, the file the petition.

3. To protect the interests of unsecured lenders during a reorganization, a is appointed by the U.S. Trustee and ordinarily consists of the seven largest unsecured creditors.

4. In the Trustee files the plan, Management and BOD cease to exist, and the Trustee may operate the business while it is being liquidated.

5. In Chapter 7 Liquidation, an unsecured creditor or an equity security holder must file a in a timely manner in order to recover any funds.

6. The sale of assets during a bankruptcy outside the normal course of business by a distressed seller is referred to as .

Activity Match each number to the appropriate payment priority.

1

Preferred Stock

2

Warrants

3

Common Stock

4

Secured Debt

5

Subordinated Debentures

6

Unsecured Debt


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Chapter 8 – Financial Analysis

Financial Statements INCOME

STATEMENT Financial results for a stated period

BALANCE SHEET As of the report date ‒ an entity’s assets, liabilities, and stockholders’ equity

STATEMENT OF CASH FLOWS

Shows cash inflows and outflow changes for a stated period Incorporates details of both the income statement and balance sheet

• The net income from the income statement is the first line of the cash flow statement

• The ending cash balance from the cash flow statements appears as cash in the current assets section of the balance sheet

Metrics used which require more than one component • Earnings before interest, taxes, depreciation, and amortization

(EBITDA) • EBIT from income statement plus D&A from cash flow statement

Income Statement REVENUE (SALES) – Cost of Goods Sold Gross Profit – Operating Expenses (SG&A, D&A) Operating Income ± Other Income or Expenses EBIT – Interest Taxable Income – Taxes Net Income – Preferred Stock Dividends Earnings Available to Common Stockholders – Common Stock Dividends Changes to Retained Earnings


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Net Operating Losses (NOLs) Net operating losses that a company has had in past years may be used to offset income This allows a company to use losses in the past to lower taxable income by either carrying back or

carrying forward these losses

Under previous IRS guidelines, an NOL may be carried back two years and carried forward for a period of 20 years

Effective January 1, 2018, NOLs are deductible only to the extent of 80% of the corporation’s income These losses can now be carried forward indefinitely, but can no longer be carried back

Income Statement Analysis

Operating Profit Margin = EBIT Sales or Revenue

Why would the operating margins be different if sales and net income are identical?

(Millions) Co. A Margin Co. B Margin

Revenue 100 100 COGS - 30 - 25 SG&A - 40 - 35 Operating Income (EBIT) 30 30% 40 40% Interest - 2 - 8 Taxable Income 28 32 Tax - 7 - 11 Net Income 21 21% 21 21%

Application Question A company’s revenue remains flat, but the operating expenses as a percentage of sales have declined. If the company’s net income declined 4.5%, which TWO of the following statements are TRUE? Circle all that apply. I. The company’s tax rate increased. II. The company’s tax rate decreased. III. The interest expense has increased. IV. The interest expense has decreased.


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Basic EPS Deduct preferred dividend to obtain earnings available Where applicable, shown as continuing operations and discontinued operations

Basic EPS = Earnings Available to Common Shareholders

Average Number of Shares of Common Stock Outstanding

Dilutive Application (Convertible Securities) A company has the following: EBIT = $250 million 21% tax rate 80 million outstanding shares $600 million of 5% convertible debentures

(the conversion price is $25)

Basic EPS EBIT $250 MM Less: Interest $30 MM ($600 MM x 5%) Taxable Income $220 MM Less: Taxes $46.2 MM ($220 MM x 21%) Net Income $173.8 MM

Basic EPS is $173.8/80 MM shares outstanding = $2.17

Basic EPS EBIT $250 MM Less: Interest (no interest deduction) Taxable Income $250 MM Less: Taxes $52.5 MM Net Income $197.5 MM $600 MM convertible debentures, convertible at $25 =

24 MM additional shares; total shares outstanding is now 104 MM

Fully diluted EPS is $197.5/104 MM shares outstanding = $1.90


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Application Question – Follow-On Offering A company has the following financial information: EBIT = $85 million with EBIT growth rate of 9% 21% tax rate 20 million outstanding shares $300 million of 7.5% debentures outstanding Cash dividends paid of $5 million

The company is planning a follow-on offering of 4 million shares, in which it will sell 2 million shares and selling shareholders will also sell 2 million shares. Using the growth rate given, what will the company’s EPS be after the offering? a. $1.90 b. $2.31 c. $2.77 d. $2.52

Balance Sheet CURRENT ASSETS CURRENT LIABILITIES Cash $500,000 Accounts Payable $500,000 Marketable Securities 80,000 Accrued Expenses 400,000 Accounts Receivable 90,000 Income Tax Payable 100,000 Inventories 800,000 Short-Term Debt 50,000 Other Current Assets 150,000 Total Current Assets $1,620,000 Total Current Liabilities $1,050,000

FIXED ASSETS LONG-TERM LIABILITIES Property, plant and equipment (PPE) 2,000,000 Long-Term Debt (Notes and Bonds) 480,000 Other Long-Term Liabilities 20,000 Total Liabilities $1,550,000

INTANGIBLES STOCKHOLDERS’ EQUITY Goodwill 400,000 Common Stock 10,000 Other intangibles 15,000 Additional Paid-in Capital 400,000 Retained Earnings 2,500,000 Treasury Stock at Cost (425,000) Total Shareholders’ Equity $2,485,000 Total Assets $4,035,000 Total Liab. And Sh. Equity $4,035,000


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Balance Sheet

CAPITAL SURPLUS

Additional paid-in capital may also be referred to as Capital Surplus or Capital in Excess of Par (difference between issue price and par value) Company prices its IPO at $14, underwriting expenses are $1.00 per

share, par value is $5.00 • Additional paid in capital is $8.00

MARKET CAPITALIZATION

Total number of common shares outstanding (including restricted shares) multiplied by the market value per share Outstanding Shares = issued shares less Treasury stock

PUBLIC FLOAT

Shares that are available for public trading (excludes restricted stock); used as a regulatory definition

Inventory First-In, First-Out

(FIFO) Oldest costs matched with first units sold Inventories reflect the cost of the latest purchases

Last-In, First-Out (LIFO)

Most recent costs matched with first units sold Inventories reflect the cost of the earliest purchases Assuming prices are rising Using FIFO will result is lower COGS, but higher net income, taxes, and

margins Using LIFO will result is higher COGS, but lower net income, taxes, and

margins

Switching Inventory Valuation Methods

What’s the financial effect of using each method if prices are rising? Switch from FIFO to LIFO: COGS increases, which results in:

• Lower EBIT and EBITDA Switch from LIFO to FIFO: COGS decreases, which results in:

• Higher EBIT and EBITDA • Revenue is $100MM, COGS is $60MM, D&A is $5MM

= EBITDA of $45MM ‒ Now switch from LIFO to FIFO and COGS declines to $55MM

• EBITDA rises to $50MM (100 – 55 + 5)


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Liquidity Ratios

Current Ratio = Current Assets $1,620,000 = 1.54

Current Liabilities $1,050,000

Quick Ratio = Cash + Cash Equivalents + Accounts Receivable

$500 + $80 + $90 = .64

Current Liabilities $1,050

Days Sales Outstanding =

Accounts Receivable

(Total Credit Sales ÷ 360 *) (* or the number of days in the period)

Capital Measurements Measurements of the financial leverage of a company Two potential methods: Book value (found on the balance sheet) or market value

• Debt is total interest-bearing debt

Debt-to-Total Capitalization Ratio =

Total Debt $480 + $50 = 17%

Total Capital $480 + $50 + $2,485

Debt-to-Equity Ratio = Total Debt $530

= 21% Total Shareholders’ Equity $2,485

Consolidation Consolidation is used if ownership interest exceeds 50% of company

Balance sheets and income statements are combined

This often creates goodwill (purchase price in excess of current fair market value) which is evaluated annually for impairment

Balance sheet indicates any non-controlling interest or NCI (formerly referred to as minority interest) in net earnings of the consolidated companies


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Goodwill and Other Intangible Assets Generally tangible assets such as machinery are depreciated and

intangible assets such as patents are amortized over their useful life.

Goodwill and other intangible assets with indefinite useful lives:

Intangible assets with finite useful lives (e.g., patents, trademarks, and intellectual property):

Will not be amortized Will be tested for impairment on at least

an annual basis • Comparing fair value of operating

unit to book value • If fair value is less, an impairment

loss is recognized

Will be amortized over useful life without any arbitrary ceiling

Are not part of goodwill

Book Value and Tangible Book Value Per Share Book Value per

Common Share = Common Stockholders’ Equity

Shares of Common Stock Outstanding

Book value includes intangible assets and goodwill

$2,485,000 = $2.48 per share

1,000,000 shares of CS outstanding

A more conservative number is tangible book value, which is equal to the total assets of the company minus liabilities and goodwill Patents and trademarks, which may be sold separately, are usually included when calculating tangible

book value $4,035,000 - $1,550,000 - $400,000 = $2,085,000 $2,085,000 ÷ 1,000,000 = $2.08


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Non-Recurring Events A company may have a one-time or non-recurring event in which earnings are affected: Sale of an asset or business Severance cost Change in the method of accounting used Litigation charges

What’s the effect of these events on the company’s financials?

Application Question RFQ Corporation reported net income of $30 million which included a one-time, pre-tax loss of $20 million from the sale of assets. The marginal tax rate is 25% and the effective tax rate is 20%. Assuming no substantial changes in the company’s operations for the next period, what is the forecast for the next period’s net income?

I. $15 million

II. $16 million

III. $45 million

IV. $46 million

Retained Earnings Calculate a company’s ending retained earnings if given the following: RE is $50 million at the end of 2017 Net income is $8 million at the end of 2017 In 2018, net income increased by 15% In 2018, the company paid a dividend of $2 million

Net income in 2018: 2018 RE increase is equal to net income less the 2018 dividend paid: 2018 ending RE is:

If the company had a loss and still paid a cash dividend, RE would decline.

$8 million x 1.15 = $9.2 million

$9.2 million – $2 million = $7.2 million

$50 million + $7.2 million = $57.2 million


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Statement of Cash Flows OPERATING ACTIVITIES

Net Income $ 2,500 Source of cash Depreciation 3,700 Non-cash charge; add back Reduction in deferred tax (4,000) Did not affect income; used cash Reduction in receivables 5,000 Clients have paid; source of cash Increase in inventory (3,000) Use of cash Accounts payable increase 6,000 Source of cash Net cash provided (used in) operating activities 10,200

INVESTING ACTIVITIES Increase in plant (9,000) Company used cash

Payment for business acquired (5,000) Funds used to purchase a related business

Net cash provided (used in) investing activities (14,000) FINANCING ACTIVITIES

Common stock issued 6,400 Sale of stock raises cash Debt retirement (5,000) Use of cash Dividends paid (2,200) Cash paid to shareholders

Net cash provided (used in) financing activities (800) Net increase (decrease) in cash (4,600)

The net result is a $4,600 reduction in cash position from the previous year’s balance sheet.

Statement of Cash Flows If an asset decreases = Source of cash

In an asset increases = Use of cash

If a liability decreases = Use of cash

If a liability increases = Source of cash

A SOURCE OF CASH INCREASES CASH FLOW

A USE OF CASH DECREASES CASH FLOW


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Activity: Recreating a Balance Sheet If given a cash flow statement from 2017 and a balance sheet from 2016, recreate the 2017 balance sheet

2017 CASH FLOW STATEMENT

Net Income $12,000

Accounts Receivable (3,000) Use

Inventories 4,000 Source

Accounts Payable 2,000 Source

Taxes Payable (2,500) Use

Cash 12,500

Variations in Accounting If a company uses a different method of accounting,

there may be a significant impact on financials (gray areas of accounting)

Capitalizing versus expensing costs

Operating lease versus capital lease

Operating lease is more aggressive as it does not appear on the balance sheet

Overvaluing assets or underestimating liabilities

Use of discount rates in calculating pension fund liabilities

The use of a high discount rate is aggressive, while use of a low discount rate is conservative

2016 BALANCE SHEET

Cash $ 45,000

Accounts Receivable 5,000

Inventories 46,000

Accounts Payable 6,000

Taxes Payable 4,000


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Application Question: Depreciation DEPRECIATION IS A SOURCE OF CASH ON THE CASH FLOW STATEMENT. If a firm uses accelerated depreciation for tax reporting and straight line for GAAP reporting to shareholders, what is the effect during the early years? Circle all that apply.

I. Creates lower earnings reported for tax purposes.

II. Creates higher earnings reported for tax purposes.

III. Increases deferred tax liability.

IV. Decreases deferred tax liability.

Deferred Taxes Deferred taxes may be an asset or liability If accounting income exceeds taxable income = DTL If accounting income is less than taxable income = DTA

EXAMPLE: If a company has three years’ worth of income of $9 million that it reports for tax purposes in one year, what’s the DTA?

Step 1: $9 million divided by three years = $3 million per year ($3 million of income should be included in year one)

Step 2: Add the deferred income of years two and three multiplied by the company’s marginal tax rate (assume 25%)

• 6 million x .25= $1.5 million, which is the company’s DTA

Be sure to use the MTR, not the statutory or effective tax rate


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Operating Leverage Operating Leverage

Defined as the measurement to which a firm or project relies on fixed rather than variable costs

Fixed Costs

Fixed costs remain constant regardless of the goods or services sold by a company and includes salaries and other compensation costs, rent, and equipment

Variable Costs

Variable costs are based on the level of goods and services produced and includes the materials and other related costs involved in producing the products or services sold by the company (direct manufacturing costs)

Majority of Costs

If the majority of costs for a company (or project) are fixed, then the costs will remain high relative to its declining sales

Profits Profits will increase by a large percentage if sales increase above the company’s breakeven point

Return on Capital There are a few different formulas for return on capital or return on invested capital (ROIC)

If given EBIT of $140 million, tax rate of 21%, and total capital of $570 million, use the following:

EBIT or Operating Income (1.00 – Tax Rate %) Total Capital (BV of Debt and Equity) $140 million x .79

= $110 million

= 19%

$570 million $570 million


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Leverage Measures Using EBITDA Earnings Before Interest, Taxes, Depreciation, and Amortization; Operating income (EBIT) plus D & A

Interest Coverage Ratio: EBITDA

Interest Expense

An indication of earnings to meet interest payment Some professionals use EBIT instead of EBITDA

Debt-to-EBITDA Ratio: Short- and Long-Term Debt

EBITDA

An indication of the company’s leverage How much additional debt may the company incur?

EBIT and EBITDA Margin Earnings before Interest, Taxes, Depreciation, and Amortization Permits comparisons of companies even though there are differences in the companies’ capital structures EBITDA Margin is based on the following:

Begin with EBIT: 48 Add depreciation and amortization: + 6 54

Divide by Sales of 250: 54÷ 250 = 21.6%

EBIT Margin: 48 ÷ 250 = 19%

IF A VALUATION TABLE HAS EBIT MARGIN HIGHER THAN EBITDA MARGIN, THERE MUST HAVE BEEN AN ERROR MADE WHEN THE TABLE WAS CREATED

EBITDAR – adding rent for companies that have leases (e.g., restaurants, retail stores, and airlines)


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Activity: EBIT and EBITDA Margin The following table was prepared by another investment banking analyst who transposed the numbers. Which of the following entries would be indicative of a transfer error?

YEAR END EQUITY VALUE

ENTERPRISE VALUE

LTM MARGINS NET DEBIT/ LTM EBITDA EBITDA EBIT

Co. A 31-Dec $15,995 $19,747 8.5% 11.0% 3.6x

Co. B 30-Jun $41,782 $35,515 18.2% 16.2% 0.0x

Co. C 31-Dec $11,996 $14,010 8.3% 6.4% 2.7x

Co. D 31-Mar $31,336 $42,540 13.7% 12.2% 4.9x

Co. E 30-Jun $24,074 $25,637 11.4% 11.2% 1.5x


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Chapter 9 – Valuation Analysis

Valuation – Two Approaches

Relative Valuation Values a company based on its price as compared to a financial metric

Price-to-earnings ratio Enterprise value-to-EBITDA

Discounted Cash Flow (DCF) Does not use comparisons; instead, the company or project is valued based

on the present value of expected cash flows

Price/Earnings (P/E) Ratio TRAILING P/E RATIO LEADING OR

FORWARD P/E RATIO NORMALIZED

P/E RATIO RELATIVE P/E

Based on the earnings of most recent 12-month period

Projected earnings for the upcoming period

Used if the company is cyclical

Calculated using an average of earnings over a period of time or earnings which are normalized by not including non-reoccurring or unusual events

Used in comparison to an index – if market multiple is 20 and a company’s P/E is 25, it has a relative P/E of 1.25

At what price should a company offer its shares to investors? What price should a buyer pay for a business or an asset? At what price should a seller agree to sell its business or an asset?

?


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P/E Ratio LITIGATION OR

ONE-TIME EVENT

Litigation or one-time event could alter P/E; current price $32 ÷ $2.00 EPS = 16 Share price declines to $24, P/E is now 12

PROJECTED GROWTH RATE OF THE COMPANY

OR INDUSTRY

Three companies in the same sector; P/Es are 19, 20, and 39 Higher P/E of third company could be due to higher projected

growth rate

CALCULATE P/E

Calculate P/E if given net income $100MM, shares outstanding 50MM, market cap $900MM, calculate P/E: NI/shares = EPS = $100 ÷ 50 = $2.00

Market cap ÷ shares = price ($900 ÷ 50 = $18.00) P/E is therefore $18 ÷ $2.00 or 9 (or Market cap ÷ NI = $900 ÷ $100 = 9)

Application Question Gosford Scientific currently has a P/E ratio of 34. The company normally trades at a premium of 150% to the S&P 500 Index. The historic range of Gosford’s P/E is from 20 to 35. If the S&P 500 Index has an average P/E of 18, which of the following descriptions best characterizes Gosford?

A. It appears to be underpriced.

B. It is a growth company with accelerated earnings.

C. It is in a mature, cyclical industry.

D. It is expected that the earnings of the company are decelerating.

Other Relevant Formulas

Earnings Yield is the inverse of the P/E ratio; a low P/E equals a high EY

EY = EPS P/E = $45 ÷ $5 = 9 and EY of $5 ÷ $45 = 11% Price P/E = $60 ÷ 2 = 30 and EY of $2 ÷ $60 = 3%

Dividend Yield = annual dividend ÷ market price

Quarterly dividend = $0.50, price = $48, $0.50 x 4 = $2 ÷ $48 = 4.2%

Dividend payout ratio = dividend ÷ EPS

Dividend = $2 ÷ EPS of $5 = Payout ratio of 40%


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Solving for the Valuation Metric If given quarterly dividend and dividend yield, find the stock price.

Price = Dividend = 4 x $0.30 = $1.20 = $30.00 Dividend Yield .04 .04

Now, if also given the dividend payout ratio, find the EPS.

EPS = Dividend = $1.20 = $3.00 Dividend Payout Ratio .40

Solving for the Valuation Metric XYZ has a dividend payout ratio of 24%, pays an annual dividend of $1.40, and has an earnings yield of 5.3%. Find the dividend yield.

Dividend Yield = Dividend Payout Ratio x Earnings Yield

Dividend Yield = 24% x 5.3%

Dividend Yield = 1.27%

Solving for the Dividend Yield If given the P/E ratio, the annual dividend, and both basic and fully diluted EPS, calculate the dividend yield:

P/E Ratio: 16 Primary EPS: $2.85 Fully Diluted EPS: $2.45 Annual Dividend: $1.20

Finding the stock price: P/E x EPS

Calculate stock price using fully diluted EPS:

16 x $2.45 = $39.20

$1.20 ÷ $39.50 = 3.06%


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P/E-to-Growth (PEG) Ratio Evaluates a company using a projection of its future performance

Valuation is based on growth potential

P/E-to-Growth Ratio (PEG) = P/E Ratio Annual Growth Rate Low number may indicate undervalued, high number may indicate a firm is overvalued

Industry average P/E is 12 and PEG is 1.33,

a company with a P/E of 17 has a growth rate of 15

PEG is 17 ÷ 15 or 1.13 than 1.33

Question: Target Price Using PEG QRM Corp. has a PEG of 1.24; its EPS is $.56 and is projected to be $.65 next year. What is the target price for QRM?

A. $12.90

B. $11.17

C. $11.11 D. $9.58

Application Question What’s the PEG for Company V? LTM NTM PROJECTED Stock Price Shares Sales EBITDA Net Inc. Sales EBITDA Net Inc. Co. V 66.50 13.30 $133 $106.4 $59.85 $159.60 $127.68 $71.82 Co. W 27.50 22.00 $96 $82 $39.0 $107.52 $91.84 $43.68 Co. X 12.50 40.00 $104 $78 $37.2 $118.56 $88.92 $42.41

(numbers in millions except share price)


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Price-to-Sales (Revenue) Ratio May be used for companies that have negative or inconsistent earnings This valuation metric may be used for start-ups or firms in financial difficulty Not influenced by different methods of accounting Sales or revenue is NOT as volatile as earnings

Enterprise Value (EV) The real tangible value of a company; EV includes the total capital structure, not just the equity

The formula is: Market capitalization of common and preferred stock + Long-term and short-term debt, capital leases, and

minority interest (NCI)

– Cash and cash equivalents

SIMPLY STATED: EV IS EQUAL TO THE MARKET CAP OR EQUITY VALUE + NET DEBT

EV Calculation XAM

SHARES OUTSTANDING 4,500,000

MARKET PRICE X $28.46

MARKET CAPITALIZATION = $128,070,000

DEBT OUTSTANDING + $4,800,000

CASH AND EQUIVALENTS - $12,060,000

ENTERPRISE VALUE = $120,810,000


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Calculating the Equity Value Per Share If the previous example had given the enterprise value, total debt, cash, and the number of common shares outstanding, calculate the equity value per share:

XAM EV: $120,810,000 + Cash: $12,060,000 - Total debt: $4,800,000 $128,070,000

The equity value per share is $28.46 ($128,070,000 ÷ 4,500,000)

Calculating Enterprise Value If given the P/E ratio and estimate of net income, the equity value is able to be calculated P/E of 9.5 and net income of $200 million equals an equity value of $1.9 billion

If net debt is added, enterprise value is able to be calculated

If given the equity value, cash and equivalents, and debt/equity ratio, the company’s enterprise value may be calculated Equity value is $884.45 million, debt/equity ratio is 80%; therefore, the value of the debt is $707.56

million ($884.45 million x .8), while cash is $133 million EV = $884.45 million + $707.56 million – $133 million = $1,459.01 million

Enterprise Value (EV)-to-EBITDA This is a frequently used metric for corporate profitability that neutralizes the differences in the capital structure

Used to evaluate the overall value of the company, rather than the equity value of the company

EBITDA is used as a measure of cash flow

Solving for changes in EV/EBITDA EV is $100MM, EBITDA is $10MM, multiple is 10

A company changes from LIFO to FIFO causing EBITDA ↑ 12, causing EV/EBITDA ↓ to 8.33 (100/12)


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Activity: Enterprise Value (EV)-to-EBITDA Calculate the EV/EBITDA Ratio for Company X

LTM Stock Price Shares Debt/Equity Ratio Cash Sales EBITDA Net Inc.

Co. V 66.50 13.30 0.8:1 $133 $133 $106.4 $59.85

Co.W 27.50 22.00 0.4:1 $242 $96 $82 $39.0

Co. X 12.50 40.00 0.5:1 $150 $104 $78 $37.2

(numbers in millions except share price)

Question: Analyzing Enterprise Value-to-EBITDA Two companies (one U.S. and one foreign) are in the same industry, have similar operating margins, enterprise values, net income, and P/E ratios. Why would the foreign company have a higher EV/EBITDA?

A. Higher dividends paid by the U.S. company.

B. A declining U.S. dollar.

C. Higher U.S. taxes.

D. Higher foreign taxes.

EV-to-Sales (Revenue) Enterprise Value

Sales or Revenue

Used to evaluate companies with very low profit margins, including start-ups with no history of earnings

Evaluates a company’s use of capital to generate sales

Expressed as a multiple


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Present Value

Net Present Value (NPV)

Calculation which compares the projected amount earned from a project to its cost (a certain discount rate is used in calculating the PV of costs and revenue) Invest $5 million today and receive a cumulative return over five years,

which is discounted using the required rate of return If PV > $5 million = Positive NPV If PV < $5 million = Negative NPV

Internal Rate of Return (IRR)

The discount rate used when calculating the PV of the cash flows Also referred to as the discount rate which matches PV of outflows to PV of

inflows

Discounted Cash Flow (DCF) DCF may be used to calculate either the value of an entire firm (enterprise value) or the equity value of a firm

There are five steps:

Cost of Capital The opportunity cost of the funds employed as a result of a business decision

Components: Debt Preferred stock Common stock

The methods commonly used to value the cost of equity are the Capital Asset Pricing Model (CAPM) and the Dividend Growth Model

Both are used to evaluate investments and projects

Step 1:

Requires an estimate of the discount rate used to apply to the cash flows for calculating the present value • Cost of equity is

used if the cash flow is FCFE

• WACC is used if the cash flow is FCFF

Step 2:

Cash flows are estimated for a given period

Step 3:

An ending or terminal value is estimated

Step 4:

Using the discount rate, enterprise value is calculated

Step 5:

Subtract the net debt from the EV to calculate the implied equity value


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Cost of Equity (CAPM)

WHERE: Ri = Rate of return; cost of equity capital for company i Rf = Risk-free rate of return (a Treasury rate) Rm = Rate of return on the market as a whole (S&P 500) β = Beta; measure of the co-movement of a firm’s returns with those of the overall market

The difference between the return of the market and the risk-free rate is referred to as the risk premium or excess market return

Question: CAPM GPD Corporation has a beta of 1.6. If the expected return on the S&P 500 is 9% and the Treasury rate is 2.8%, what is GPD’s equity cost of capital?

A. 9.9%

B. 12.7%

C. 17.2%

D. 21.6%

Levered and Unlevered Beta Unlevered Beta

Formula Unlevered beta = levered beta / (1 + [(1 – tax rate) x (debt/equity)])

Levered Beta Formula Levered beta = unlevered beta x (1 + [(1 – tax rate) x (debt/equity)])

Example

To calculate the levered beta if the unleveraged beta is 1.3, the debt/equity ratio is 35%, and the tax rate is 21%, the formula is applied as follows: The levered beta = 1.3 x (1 + [(1 – 21%) x (35%)]) The levered beta = 1.3 x [1 + (.79 x .35)] The levered beta = 1.3 x [1 + (.276)] The levered beta = 1.3 x 1.276 = 1.659

Ri = R

f + β (R

m – R

f)


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Dividend Growth Model

Dividend Growth Model

The cost of equity may be calculated using the following formula: In the formula: k* = the required rate of return (cost of equity) D1 = the dividend to be paid at the end of the year P0 = the current market price g = the growth rate per year

Example

Model Company V has: Current earnings = $4.60 Current dividend = $1.15 Current market price = $40 Projected growth rate per year = 4%

D1 = $1.15 x (1 + .04) = $1.20

Application Question Normax Corp. has a pre-tax cost of debt of 8% and is in the 20% tax bracket. The risk-free rate of return is 3% and the expected rate of return for the market is 9%. The company has a beta of 1.4 and a debt-to-equity ratio of 30%. What’s the WACC* for Normax?

A. 7.94%

B. 9.90%

C. 10.25%

D. 10.62% * WACC = Wtd. Avg. Cost of Debt + Wtd. Avg. Cost of Equity

k* = D1 + g P0

k* = $1.20 = 3.0% + 4.0% = 7.0% $40.00


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Estimating Cash Flows Cash flow from operations less capital expenditures Operating expenses include investments in inventories and fixed capital Free cash flow ignores cash flow from non-operational investments

FORMULAS FOR FREE CASH FLOW:

FREE CASH FLOW TO THE FIRM FREE CASH FLOW TO EQUITY EBIT x (1 – Tax Rate) Net Income

+ Depreciation and Amortization + Depreciation and Amortization – Capital Expenditures – Capital Expenditures

+ Decrease (– Increase) to Wrk. Cap. + Decrease (– Increase) to Wrk. Cap.

Present Value of Free Cash Flow WHAT IS IT?

Free cash flow for the firm (FCFF) evaluates the present value of future cash flows to the firm

HOW IS IT CALCULATED?

Cash flow is discounted using the firm’s weighted average cost of capital (WACC)

PV =

t = n

Σ t = 1

FCFFt (1 + WACC)t

WHAT HAPPENS IF EITHER VARIABLE IS CHANGED?

Cash flows will cause an valuation, whereas an in the WACC will cause a in valuation


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Terminal Value In a DCF analysis, the sum of the present value of the estimated future free cash flows for a

limited number of years are added to the present value of an estimated terminal or ending value

Terminal Value may be estimated by using either one of two different methods:

Exit Multiple Method

Terminal Multiple – a relative valuation based on a multiple (e.g., EV/EBITDA) for similar companies or similar transactions

Terminal Value = EBITDAn x Exit Multiple (sector average)

Perpetuity Growth Method

The terminal year FCFF is treated as a perpetuity growing at an assumed rate

Terminal Value = FCFFn x (1 + g)

r – g r = required rate of return g = growth rate (perpetual)

DCF Used to Calculate Firm or Enterprise Value

EV = ∑ FCFFt

+ TV

(1 + WACC)t (1 + WACC)n

WHERE: EV = Enterprise Value (Value of the Firm) t = Period n = Number of Periods TV = Terminal Value WACC = Discount Rate


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Using DCF to Calculate the Implied Equity Value To determine the implied equity value of a company, cash is added to the total present value (enterprise value) and debt is subtracted. Implied equity value of the company is divided by the number of shares of common stock outstanding to determine the implied value per share.

Assume the following (in millions): Present value of cash flows = $520 Present value of the terminal value = $3,600 Net debt (total debt less cash) = $360 Shares outstanding = 110

Enterprise Value: $520 + $3,600 = $4,120 Implied Equity Value: $4,120 – $360 = $3,760 Implied Equity Value Per Share: $3,760 ÷ 110 = $34.18

Dividend Discount Model Value of a firm’s equity (P) equals the present value of all future dividends paid by the firm to its equity holders

P0 = d1 + d2 + (1 + r) (1 + r)2

P0 = n

Σ t = 1

dt (1 + r)t

WHERE: P0 = Value of the stock today d1, d2, … dn = Expected dividends (cash flows) r = Discount rate (required rate of return)


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Gordon Growth Model Used to find the implied or intrinsic value of stock if certain variables are given and assumptions are made P0 = d1 / (k – g) Where: P0 = present price d1 = the dividend in the next period (if given only the current dividend, use the following formula) d1 = D0 x (1 + g) D0 is $1.20 and growth rate is 5%; therefore, d1 = $1.20 x (1.0 + 5%) = d1 = $1.26 k = the equity cost of capital (assume 11%) g = the growth rate (this example assumes 5%; but if not given, use the following formula) g = b x ROE

In the formula: g = the dividend growth rate b = the earnings retention rate (the complement of the dividend payout ratio) ROE = the return on equity

Using the model and the information given, the intrinsic value is $21.00 $1.26 / (.11-.05) = $21.00

Sum of the Parts Analysis Business is divided into segments

Different valuation metrics may be used for each segment

Business segments may be assigned different growth rates

Segment incomes may be projected into the future

Future value is discounted to the present using a required rate or return if using DCF

Activity #11 Match each description to the appropriate term.

PRICE / BOOK VALUE

Companies with negative earnings

PRICE / FUNDS FROM OPERATIONS

Companies with high P/E ratios

NORMALIZED, RELATIVE P/E

Basic (Heavy) industry companies

EV / EBITDA

Financial services companies

EV / SALES

Cyclical companies

PEG RATIO

REITs


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Chapter 10 – M&A Valuation

Accretion/Dilution Analysis Acquisitions may use cash, stock, or a combination

In an all stock transaction, an exchange ratio describes the percentage of one share that’s exchanged for another

Exchange Ratio: ABC is trading at $56 and it’s considering offering a 20% premium for XYZ which is currently trading at $30 per share. XYZ has 11.6 million outstanding shares. Offer value is $36.00 ($30 x 1.20).

Exchange Ratio: .64 ($36 ÷ $56)

Additional shares issued: 11.6 million x .64 = 7.42 million

Is the transaction accretive or dilutive to the acquirer’s earnings?

Accretion/Dilution Analysis

Offer price of the Target Company Market Price of the Acquirer

Net Income of the two companies* Total Number of shares of the acquirer**

* May include synergies realized when firms are combined

** Includes the additional shares issued to fund the transaction

ABC has net income of $15 million, while XYZ has net income of $6 million.

If ABC had 12 million shares outstanding before the acquisition and will issue 7.42 million additional shares to fund the acquisition, what is the effect on ABC’s earnings?

? ABC’s EPS before the acquisition:

$15 million ÷ 12 million = $1.25

Total net income after acquisition: $15 million + $6 million = $21 million

Total shares outstanding following the acquisition: 12 million + 7.42 million = 19.42 million

ABC’s EPS after the acquisition: $21 million ÷ 19. 42 million = $1.08

The result of the transaction is a $.17 dilutive effect ($1.25 - $1.08)


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Accretion/Dilution Analysis If the previous example was instead 20% cash and 80% stock, is it accretive or dilutive?

When calculating the EPS of the combined company, remember to consider the additional interest expense on the debt added to finance the acquisition.

New exchange rate is .512 (.80 x .64), new shares issued is 5.94 (11.6 x .512), new total shares outstanding is 12 million + 5.94 million = 17.94 million

Offer value is $417.6MM (11.6 MM shares x $36.00); 20% or $83.52MM needs to be financed.

If the tax rate is 21% and financing cost is 7%, the adjustment to the combined company's net income is found by determining the after-tax cost of interest expense and subtracting it from the net income.

The after-tax cost of interest is calculated by multiplying the interest expense by the complement of the tax rate 83.52MM x 7% x .79 = 4.62MM. The net income of the combined company is $16.38MM ($21 MM – $4.62MM).

ABC’s old EPS is $1.25. The combined company’s EPS is $.91 ($16.38MM ÷ 17.94 million). The deal is 27% dilutive ($1.25 – $.91 = $.34 and $.34 ÷ 1.25 = 27%).

Comparable Companies Analysis Comparable companies analysis or trading comps

are sometimes referred to as multiples analysis

Compares target to peer group valuation

Uses financial metrics such as price/earnings ratio, price/book ratio, or EV/EBITDA

This methodology is useful when there is a large universe of publicly traded companies that are similar to the target

If similar companies are not available (niche business), companies with a business unit that is similar to the target may be used


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Application 1 – DETERMINE A

VALUATION METRIC 2 – DETERMINE A RANGE

BASED ON SECTOR 3 – ESTIMATE EBITDA

Determine a valuation metric: EV/EBITDA

Determine a range for this metric based on the sector:

7x to 9x EBITDA Estimate EBITDA: $500MM

4 – CALCULATE IMPLIED ENTERPRISE VALUE

5 – CALCULATE IMPLIED EQUITY VALUE

6 – CALCULATE IMPLIED EQUITY PER SHARE

Use this estimate to calculate the implied enterprise value

range: The range is $3.5 billion to $4.5 billion

To calculate the implied equity value, subtract the net debt of $800 million:

$3.5B – $800MM = $2.7B and $4.5B – $800MM = $3.7B

Assuming 100 million shares outstanding, calculate the

implied equity value per share: The range is $27.00 to $37.00

In the fairness opinion, it is expected that the price offered

to the target’s shareholders would be in the high range

Precedent Transaction Analysis Precedent transaction comparable analysis is also referred to as transaction comps

Compares the pricing of recent deals involving similar enterprises

Examines S-4s, proxies, and Schedule TOs

This methodology is useful in an industry undergoing recent consolidation

Mergers of equals analysis may also be used even if the companies are in a different sector


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Precedent Transaction Analysis: Questions to Consider Was the purchaser a strategic or financial buyer?

What were the market conditions? Difficult to compare a recent technology merger to the dot.com bubble of 1999-2000

Was the contest friendly or hostile?

What currency was used, cash or stock?

Was the sector going through any major changes? Banking consolidations in 2009-2010

Effects of Employee Stock Options In calculating EV of a potential target, the shares outstanding may need to be recalculated since in-the-money employee stock options would be exercised. Current price is $22.00 and the offer price is $25.00.

Current outstanding shares: 9,000,000 Number of options: 500,000 at a strike price of $22.00 400,000 at a strike price of $30.00 Offered stock price: $25.00 per share

Exercised options would generate proceeds $11,000,000 (500,000 x $22.00)

The company may repurchase 440,000 shares from the market ($11,000,000 ÷ $25.00)

Difference between number of shares repurchased and number of shares granted through options exercise, equals 60,000 shares (500,000 – 440,000)

Additional shares would be issued from the company’s treasury stock account, bringing the number of shares outstanding to 9,060,000 (9,000,000 previously outstanding + 60,000 shares from treasury stock)


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What Price to Offer the Target? Sector analysis shows that the target price for TR Industries should be 11 times EBITDA

EBITDA $780 million CASH: $350 million DEBT: $950 million OUTSTANDING SHARES: 240 million CURRENT STOCK PRICE: $27.20

WHAT SHOULD BE THE TARGET PRICE BASED ON THE EBITDA MULTIPLE?

EV based on the transaction multiple is $8.58 billion ($780 million x 11)

Equity value = $7.98 billion ($8.58 billion – $600 million)

$7.98 billion ÷ 240 million shares = $33.25 offer price (also known as the implied equity price per share)

What is the Premium of the Implied Offer Price? TR Industries: The current stock price of TR Industries is $27.40 The acquisition offer price based on 11 times EBITDA is $33.25 The amount of the premium is $5.85 ($33.25 – $27.40) The premium divided by the current market price is 21.3% ($5.85 ÷ $27.40)

Some projections may be based on a comparison of the 30 or 60-day moving average of the stock price in lieu of the current price

Calculating the Implied Equity Value Given P/E range of 15 to 20 and N.I. of $37MM, and an 8% growth rate:

$37MM × 1.08 = $40MM

15 × $40MM = $600MM

20 × $40MM = $800MM

Therefore, the implied equity value is between $600 and $800MM.

In a merger valuation, a premium may be offered; however, if valuing an IPO, pricing may be at a discount.


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Calculating the Adjusted EBITDA Multiple

Current EBITDA is $29 million and a company will pay 8.5 times to acquire the company (total EV = $246.5 million)

If the company is able to realize $4 million of synergies, what is the adjusted EBITDA multiple?

$246.50 million ÷ ($29 million + $4 million) = 7.47

The adjusted EBITDA multiple is 7.47

Merger Analysis and Implied Value of Acquirer’s Shares

Exchange ratio is $7 ÷ $35.16 = .1991

The number of shares is fixed, but the dollar value of the deal may change if FW’s price fluctuates.

Is .1991 shares of FW worth $7.00? Calculate adjusted P/E:

FW estimated EPS = $2.35 and the industry average P/E range is 13.5x to 15.5x

$2.35 × 13.5 = $31.73 and $2.35 × 15.5 = $36.43

Multiply these prices by the exchange ratio:

$31.73 × .1991 = $6.32 and $36.43 × .1991 = $7.25

Adjusted EBITDA may be used as a valuation metric in a potential acquisition since the buyer may

realize synergies due to the M&A transaction

WACH is trading at $3.91 and FW is trading at $35.16. FW offers to buy WACH for $7.00.


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Merger Analysis and Implied Value of Acquirer’s Shares FW tangible book value is $10.31 and the industry average multiple range is 2.5x to 3.0x

Is .1991 shares of FW worth $7.00? Calculate adjusted tangible book value:

$10.31 × 2.5 = $25.78 and $10.31 × 3.0 = $30.93

Multiply this price by the exchange ratio:

$25.78 × .1991 = $5.13 and $30.93 × .1991 = $6.16

Estimated Earnings Per Share:

$2.35 13.5x - 15.5x $31.73 - 36.43 $6.32 - 7.25

Tangible Book Value per Share:

$10.31 2.5x - 3.0x $25.78 - 30.93 $5.13 - 6.16

LBO Analysis

WHAT IS IT?

It’s a valuation technique that’s especially useful to financial sponsors or buyers, such as private equity funds Goal is to purchase a business using debt and some equity, to improve the

profitability of the company, to pay down the debt in order to increase the equity value (time horizon usually 3 to 7 years)

Free cash flow analysis may also be used to calculate the amount of new or additional borrowing that a company may incur and the after-tax cost of debt is used as the discount rate

EBITDA may be used as a measure of cash flow; a high offer value equates to a lower return

A company with high level of free cash flow has the capacity to issue additional debt

EV/EBITDA is not used a metric in LBO analysis

EXAMPLE

Current EBITDA is $50MM, purchase company at 8x or EV of $400MM, using 70% debt/30% equity

Improve EBITDA over a five-year period by 20% to $60MM and repay a portion of the debt (assume debt has been reduced from $280MM to $220MM)

Exit after five years at the same EBITDA multiple: 8x new EBITDA $60MM or $480MM, repay debt of $220MM, equity has increased to $260MM

Increase equity from $120MM ($400MM x .30) to $260MM


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Leveraged Buyout Analysis What is the debt-to-EBITDA ratio after the completion of the following transaction?

EBITDA: $750 million

Transaction purchase price is 11.5 times EBITDA

Equity Contribution: 20%

Transaction value is $8.625 billion with 80% being financed, which equals $6.900 billion

If there is no existing debt, the debt-to-EBITDA ratio is 9.2 ($6.900 billion ÷ $750 million = 9.2)

Calculating Goodwill After Transaction Completion

(IN MILLIONS) Total Assets $1,800

Total Liabilities $700

Existing Goodwill $250

Intangibles $180

Shares Outstanding 25

Current Stock Price $74

Offer Price $85

Net tangible assets equal $670 million:

$1.8 billion – ($700 million + $250 million + $180 million)

The offer value is $2.125 billion (25 million × $85)

The goodwill created equals $1.455 billion ($2.125 billion – $670 million)

The amount of Goodwill is often based on the fair market value of assets, not the book value (referred to as a write-up).

Example: A company’s balance sheet shows net tangible assets valued at $5 million (book value or BV).

The company is acquired for a total purchase price of $35 million.

At closing, the fair market value (FV) of the assets is determined to be $15 million ($10 million write-up).

Goodwill amount is $20 million ($35MM – $5 MM – $10 MM)

A write-up will create less goodwill, or less than expected.

NOTE:

Intangibles may be recorded on acquirer’s BS rather than creating goodwill (patents and trademarks)


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Exchange-Rate Risk Strong U.S. Dollar Weak U.S. Dollar

A strong U.S. dollar will make foreign companies more attractive takeover targets for U.S.-based buyers

In a strong-dollar environment, U.S. companies will be less attractive takeover candidates, since foreign buyers will have less buying power

A weak U.S. dollar (correlated with strengthening foreign currencies) will make U.S. companies more attractive takeover targets for foreign buyers

In a weak-dollar environment, foreign companies will be less attractive takeover candidates since U.S. buyers will have less buying power

Risk After the Deal is Announced If the target is a foreign company, a risk to the buyer is the increasing value of the target’s currency, making the acquisition more expensive E.g., A U.S. company offers £9.8 billion for a British company. If the pound is trading at 1.66, the cost

is $16.27 billion. If the pound rises to 1.72, the cost would be $16.86 billion.

If an offer consists of stock (or a portion in stock), exchange-rate risk exists. If the target company’s currency increases (the acquirer’s currency decreases), the stock portion of the acquisition will decline.

In addition to exchange-rate risk, there is also the risk that the acquirer’s stock price may decline.

Weakness in the U.S. dollar, along with a drop in the acquirer’s stock price, may cause the value of a bid to fall.

Question: International M&A Which of the following statements BEST describes the effect of a weakening U.S. dollar on the M&A business?

A. A weaker dollar makes U.S. companies less attractive takeover targets.

B. A weaker dollar makes U.S. companies more attractive takeover targets.

C. Foreign companies become more attractive takeover targets.

D. A weaker dollar has no effect on the M&A business.

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