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Chapter 23

Investment Banks, Securities Brokers and Dealers,and Venture Capital Firms

Investment Banks

Background

Underwriting Stocks and Bonds

Following the Financial News: New Securities Issues

Equity Sales

Mergers and AcquisitionsSecurities Brokers and Dealers

Brokerage Services

Mini-Case: Using the Limit-Order Book

Securities Dealers

Regulation of Securities Firms

Relationship Between Securities Firms and Commercial Banks

Venture Capital Firms

Description of the Industry

Venture Capitalists Reduce Asymmetric Information

Origins of Venture Capital

Structure of Venture Capital FirmsThe Life of a Deal

E-Finance: Venture Capitalists Lose Focus with Internet Companies

TTTT Overview and Teaching Tips

This chapter covers securities firms which are firms that buy and sell bonds and stock. This chapter alsocovers organized exchanges, securities brokers, and dealers. The Securities and Exchange Commissionregulates the information that prospective investors receive. When investment bankers underwrite a stock or bond issue, the firm purchases the whole issue and resells it in the market. Giving advice, filingdocuments, and marketing issues are some of the services provided in underwriting. Investment bankers

also deal with mergers and acquisitions and private placements, which is an alternative method of sellingsecurities.

Securities brokers and dealers trade within the secondary market and link buyers to sellers. Dealersactually buy and sell the stocks or bonds, while brokers do not take ownership of them. Brokers offerseveral services to their customers, including securities orders, margin credit, and other servicestraditionally offered by commercial banks like ATMs and debit cards. There are two different types of securities orders, a market order or a limit order. Both are concerned with the price at which one will buyor sell a security. Full-service brokers provide advice on investments and do research for their customers.There is a large fee for this type of service. On the other hand, discount brokers simply place orders whenrequested. Firms are prohibited from trading on insider information because it is against SEC regulations.

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Chapter 23 Investment Banks, Securities Brokers and Dealers, and Venture Capital Firms 159

This chapter concludes by discussing the role of venture capital firms in funding start up firms. The use of venture capital financing peaked in the early 2000s. The chapter traces the usual progression of a venturecapital deal.

TTTT Answers to End-of-Chapter Questions

1. Regulators felt that investment banking was riskier and had led to bank failures during the GreatDepression.

2. The Glass Steagall Act.

3. When an offering is underwritten, the investment banker purchases the issue at a pre-specified price.In a best-efforts issue, the investment bankers does not take ownership.

4. Investment bankers offer advice, help with filing documents, and assistance with marketing the issue.

5. No, an SEC review simply determines if the proper documents have been filed.

6. By forming a syndicate the risk of the issue is spread among many different firms and more brokerswill be attempting to sell the securities.

7. It is better to be fully subscribed because oversubscription indicates that the investment bankerspriced the security too low.

8. The investment banker and the firm may not be able to agree on a price or the issue may be too smallfor the investment banker to want to invest the time and effort needed to arrive at price.

9. In a hostile takeover, the target firm does not want control to pass to the acquiring firm, and so itsmanagement makes every effort to prevent the takeover from happening. In a merger, both sides

work together to expedite the union of the firms.

10. They make a market by standing ready to buy or sell securities.

11. A market order has the broker buy or sell the security at the current market price. A limit order sets amaximum price for buying the security and a minimum price for selling the security.

12. Yes, selling the security short.

13. Banks object because legislation prevents banks from entering the brokerage business but does notprevent brokers from entering the banking business.

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TTTT Quantitative Problems

Amazon.com1issued an initial public offering in May of 1997. Prior to its IPO, the following

information on shares outstanding was listed in the final prospectus:

Percentage of SharesOutstanding

Name and Address

Number Of SharesBeneficially

OwnedPrior to

Offering

After

Offering

9,885,000 47.5% 41.4%Jeffrey P. Bezosc/o Amazon.com, Inc.1516 Second Avenue, 4th FloorSeattle, WA 98101

3,401,376 16.4 14.3L. John DoerrKleiner Perkins Caufield & Byers4 Embarcadero Center, Suite 3520San Francisco, CA 94111

Tom A. Alberg 195,000 * *Scott D. Cook 75,000 * *Patricia Q. Stonesifer 75,000 * *All directors and executive officers as

a group (14 persons)15,688,925 72.5 63.5

Total shares outstanding 20,858,702 100.0 —

In the IPO, the firm issued 3,000,000 news shares. The initial price was $18.00 per share withinvestment bankers retaining $1.26 as fees. The final first-day closing price was $23.50.

1. What were the total proceeds from this offering? What part was retained by Amazon? What part bythe investment bankers? What percent of the offering is this?

Solution: Total proceeds = 3,000,000 × $18.00 = $54,000,000To Amazon = 3,000,000 × $16.74 = $50,220,000

To the IB = 3,000,000 × $1.26 = $3,780,000, or 7% of the offer price.

2. Mr. Doerr of Kleiner Perkins Caufield & Byers owned a significant number of shares. What was themarket value of these shares at the end of the first day of trading?

Solution: Market value = 3,401,376 × $23.50 = $79.93 million.

3. What was the market value of Amazon.com following its first day as a publicly-held company?

Solution: Market cap = (20,858,702 + 3,000,000) × $23.50 = $560.68 million

4. Refer back to the IPO of Ebay presented in the problems for Chapter 11. What were the fees for Ebayas a percent of funds raised? Does a pattern emerge?

Solution: For Ebay, the offering price was also $18.00, with $1.26 retained by the investmentbankers. Or 7% of the offering price.

1Information summarized from http://www.sec.gov/Archives/edgar/data/1018724/0000891020-97-000868.txt

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Chapter 23 Investment Banks, Securities Brokers and Dealers, and Venture Capital Firms 161

5. To verify this further, examine the IPO for Blue Nile, Inc. It can be found on the SEC’s site at:

http://www.sec.gov/Archives/edgar/data/1091171/000089161804001024/v97093b4e424b4.htm

What was the offering price? What percent was retained by the underwriter?

Solution: The offering price can be viewed on the top of the first page. It was $20.50, with $1.435

retained by the underwriter. This represents a fee of 1.435/20.50 = 7%.

6. For Blue Nile, Inc., what are the expected proceeds to the company? Is this certain? Whatassumptions are you making? How would you verify this?

Solution: The expected proceeds are 3,740,000 × ($20.50 − $1.435) = $71,303,100. The assumptionis that this IPO is a firm commitment offering. If the offering is a best-effort, the proceedsare not certain. This can be checked in the prospectus. Indeed, in the prospectus, it states,“On March 9, 2004, the Company’s Board of Directors passed the following resolutions:

• To authorize the officers of the Company to undertake a firm commitmentunderwritten public offering of shares of the Company’s common stock

• etc.”

7. You want to buy 100 shares of a stock currently trading at $50 per share. Your brokerage firm allowsmargin sales with a 50% opening margin and a maintenance margin of 25%. What does this mean? If you close your position with the shares at $53.50, what is your return?

Solution: The value of the shares you want to purchase is 100 × $50 = $5,000. With a 50% openingmargin, you can give your broker $2,500, and your broker will lend you the rest.

A 25% maintenance margin means your equity position cannot fall below 25%. Thequestion is how low the price can fall before you must deposit additional funds. To findthis, solve for the price X as follows:

100 2500

100

X

X

−= 0.25, or X = $33.33. If the price falls below $33.33, a margin call

will occur.

If you close your position at a price $53.50, the value if 100 × $53.50 = $5,350, or a gain

of $350. Since this only required $2,500 from you, the percentage gain is 350/2500 = 14%.

8. The limit order book for a security is:

Unfilled Limit Orders

Buy Orders Sell Orders 25.12 100 25.36 30025.20 500 25.38 20025.23 200 25.41 200

The specialist receives the following, in order:

(1) Market order to sell 300 shares

(2) Limit order to buy 100 shares at 25.38

(3) Limit order to buy 500 shares at 25.30

How, if at all, are these orders filled? What does the limit order book look like after these orders?

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162 Part 6 The Financial Institutions Industry

Solution: (1) is fulfilled with 200 shares @ 25.23 and 100 shares @ 25.20(2) is fulfilled with 100 shares @ 25.36(3) is not filled, and goes into the book After these, the book looks like:

Unfilled Limit OrdersBuy Orders Sell Orders 25.12 100 25.36 20025.20 400 25.38 20025.30 500 25.41 200

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