Issuing costs

What Are Issuing Costs?

Issuing costs, also known as flotation costs, are the total expenses incurred by a company when it sells new securities—such as stocks or bonds—to the public. These costs fall under the broad category of corporate finance, representing the expenditures necessary to bring new financial instruments to the capital markets. Issuing costs reduce the net proceeds a company receives from an offering, directly impacting the amount of capital effectively raised. These expenses can be substantial, especially for large public offerings like an Initial Public Offering (IPO). They encompass a variety of fees and administrative charges, from legal and accounting expenses to underwriting commissions.

History and Origin

The concept of issuing costs is as old as the organized securities markets themselves, evolving with the complexity of capital raising. Historically, companies seeking to raise capital directly approached investors or relied on small networks of financiers. As markets became more sophisticated, particularly with the rise of industrialization, the role of financial intermediaries grew. Early forms of investment banks began to facilitate these offerings, charging fees for their services.

A significant shift in the regulation and transparency surrounding securities issuance occurred in the United States in the aftermath of the 1929 stock market crash and the Great Depression. The Banking Act of 1933, commonly known as the Glass-Steagall Act, was a landmark piece of legislation that, among other things, separated commercial banking from investment banking. This act was designed to restore public confidence in the financial system by preventing speculative excesses and promoting greater transparency in securities offerings. This regulatory environment formalized the process of issuing securities and, by extension, the costs associated with it, ensuring that expenses were clearly defined and disclosed.

##⁵ Key Takeaways

• Issuing costs are the total expenses incurred by a company when it sells new securities to the public.
• They include a range of direct and indirect expenses, such as underwriting fees, legal and accounting fees, printing costs, and regulatory filing fees.
• These costs reduce the net capital a company raises from a security offering, impacting the effective cost of capital.
• Issuing costs are a significant consideration in a company's decision to pursue equity financing or debt financing.
• The magnitude of issuing costs can vary based on the type of security, the size of the offering, market conditions, and the complexity of the issuer.

Formula and Calculation

Issuing costs do not typically follow a single, simple formula but rather represent the sum of various components. Conceptually, the total issuing costs can be expressed as:

Where:

• Underwriting Fees: Compensation paid to the investment bank or syndicate for their services, often expressed as a percentage of the gross proceeds. This is typically the largest component.
• Legal Fees: Costs associated with legal counsel for drafting the prospectus and other required documentation, ensuring compliance with securities laws.
• Accounting Fees: Expenses for auditing financial statements, preparing pro forma financial information, and other accounting-related services necessary for the offering.
• Printing & Administrative Costs: Costs for printing prospectuses, marketing materials, and other administrative expenses related to the offering.
• Regulatory Fees: Fees paid to regulatory bodies like the Securities and Exchange Commission (SEC) and stock exchanges for registering the securities and listing them.
• Other Expenses: Miscellaneous costs such as roadshow expenses, transfer agent fees, and public relations.

Interpreting the Issuing Costs

Interpreting issuing costs involves understanding their impact on the capital raised and the overall financial health of the issuing entity. These costs directly reduce the actual funds available to the company. For example, if a company raises $100 million in a public offering but incurs $7 million in issuing costs, its net proceeds are only $93 million. This means the company effectively pays $7 million to raise $93 million, making the cost of capital higher than it might initially appear based on the gross amount.

High issuing costs can diminish the attractiveness of a public offering, especially for smaller companies or those raising modest amounts of capital. Analyzing issuing costs against the backdrop of the company's existing balance sheet and future funding needs is crucial. Companies often perform a thorough due diligence process to estimate and manage these expenses effectively.

Hypothetical Example

Imagine "GreenTech Innovations," a private company, decides to go public through an Initial Public Offering (IPO) to raise $200 million for expansion. They engage an investment bank to manage the offering.

Here’s a breakdown of their hypothetical issuing costs:

1. Underwriting Fees: The investment bank charges a 6% underwriting fee.
   • 0.06 × $200,000,000 = $12,000,000
2. Legal Fees: For preparing the registration statement, reviewing contracts, and ensuring compliance.
   • $1,500,000
3. Accounting Fees: For auditing historical financial statements and preparing pro forma data.
   • $1,000,000
4. Printing and Administrative Costs: For the prospectus, marketing materials, and roadshow expenses.
   • $500,000
5. Regulatory Filing Fees: Fees paid to the SEC and the exchange where the shares will be listed.
   • $100,000 (Based on the total offering amount as per SEC fee rates)

To⁴tal Issuing Costs:
$12,000,000 (Underwriting) + $1,500,000 (Legal) + $1,000,000 (Accounting) + $500,000 (Printing) + $100,000 (Regulatory) = $15,100,000

Net Proceeds to GreenTech Innovations:
$200,000,000 (Gross Proceeds) - $15,100,000 (Issuing Costs) = $184,900,000

In this example, while GreenTech aimed to raise $200 million, the actual capital it received after covering issuing costs was $184.9 million. This highlights how issuing costs directly reduce the capital available for the company's intended investments.

Practical Applications

Issuing costs are a critical consideration in several areas of finance and business:

• Capital Raising Decisions: Companies weigh issuing costs when deciding whether to raise capital through public offerings, private placements, or alternative financing methods. The significant expense of going public often influences smaller companies to remain private longer or seek venture capital.
• Underwriting Negotiations: The level of underwriting fees is a key negotiation point between the issuing company and the investment banks. These fees are typically the largest component of issuing costs.
• Regulatory Compliance: Companies must meticulously track and disclose issuing costs in their registration statements with regulatory bodies like the SEC. The SEC requires companies to report specific filing fees, which vary based on the type of security and offering amount.
• ³Valuation and Shareholder Dilution: High issuing costs can lead to greater dilution for existing shareholders, as a larger portion of the capital raised is consumed by expenses rather than directly funding the business.
• Mergers and Acquisitions (M&A): Issuing costs can arise in M&A transactions that involve issuing new shares to finance the acquisition, impacting the overall cost of the deal.
• Government and Municipal Finance: Governments and municipalities also incur issuing costs when floating bonds to fund public projects, which affects the net amount they receive for infrastructure or other initiatives.

The entire process of an IPO, which generates many of these costs, involves multiple steps, from selecting an investment bank to regulatory filings and the eventual launch and trading of shares.

Li²mitations and Criticisms

While issuing costs are an unavoidable part of raising capital through public markets, they are subject to several limitations and criticisms:

• High Proportional Costs for Smaller Offerings: Issuing costs can represent a disproportionately higher percentage of gross proceeds for smaller offerings compared to larger ones. This is because certain fixed costs, like legal and accounting fees, do not scale down linearly with the size of the offering.
• Lack of Transparency in Pricing: Critics sometimes argue that the underwriting fees, particularly the standard 7% "spread" seen in many U.S. IPOs, can be excessively high and may not always reflect competitive market pricing or the actual work involved, especially for highly sought-after companies. The Organisation for Economic Co-operation and Development (OECD) has called for a review of IPO underwriting fees, suggesting they may be "akin to tacit collusion" and work against long-term productive investment.
• ¹Impact on Shareholder Value: High issuing costs reduce the net capital available to the company, potentially leading to greater dilution for existing shareholders if more shares need to be issued to achieve the desired funding level after expenses.
• Underpricing Concerns: While not a direct "cost" in the traditional sense, IPO underpricing (where shares are sold below their true market value on the first day of trading) can be seen as an indirect cost to the issuing company, as it leaves money on the table for initial investors rather than being captured by the company. Some academic research delves into the reasons behind and implications of IPO underpricing.
• Incentive Misalignment: There can be perceived misalignments of incentives between the issuing company and the underwriters, particularly regarding pricing and allocation, which can indirectly affect the net benefit to the issuer.

Issuing Costs vs. Underwriting Fees

While often used interchangeably by the lay public, "issuing costs" and "underwriting fees" are distinct financial terms:

In essence, underwriting fees are a major part of issuing costs. Issuing costs provide a holistic view of the financial burden of a public offering, while underwriting fees specify the portion paid to the financial intermediaries who guarantee the sale of the securities.

FAQs

What types of expenses are included in issuing costs?

Issuing costs include direct expenses like underwriting commissions, legal fees, accounting fees, printing costs for the prospectus, and regulatory filing fees. They can also include other administrative and marketing expenses like those for a roadshow.

Why are issuing costs important for a company?

Issuing costs are crucial because they directly reduce the net amount of capital a company receives from a securities offering. Understanding these costs helps a company assess the true cost of raising capital and make informed decisions about its financing strategy.

Do issuing costs apply only to stocks, or also to bonds?

No, issuing costs apply to any new security offering, whether it's equity (stocks), debt (bonds), or other financial instruments. The specific components and their magnitude might vary based on the type of security.

How do companies minimize issuing costs?

Companies can try to minimize issuing costs by negotiating lower underwriting fees, optimizing legal and accounting processes to reduce professional fees, and exploring alternative capital-raising methods like direct listings if appropriate. The size and demand for the offering can also influence the negotiating power for lower fees.

Are issuing costs disclosed to investors?

Yes, companies are typically required by regulatory bodies, such as the Securities and Exchange Commission (SEC), to disclose issuing costs in their registration statements and prospectuses. This ensures transparency for potential investors.