Floatation

What is “Floatation”?

When the directors or owners of a company decide to float their company on the stock market  (for example on NYSE or FTSE 100) through issue of stocks, it involves issuing shares or selling a certain percentage (for example, 20%) of the company’s stocks to investors – the general investing public and/or institutional investors. This is known as Floatation. Usually, such stocks can be purchased on a stock market (more specifically in the primary market). New stock is often issued as part of a company’s floatation.

Floatation is often termed as a company “Going Public” or ‘Listing’ as it is the process of shifting a company from being privately held into being a publicly listed and held company. Floatation requires a company to adhere to legal and regulatory standards of the specific market – always required of a public limited company. It creates an opportunity for private company owners to allow new investors to facilitate further company growth. Importantly it also creates a more liquid environment to trade the stock both for the existing owners (if they want to sell part of their stake) and new potential investors.

Floatation Explained

There are various ways of floating new stocks of a company such as an IPO (initial public offering), private or stock market placement, rights issue, and bought out deals.

IPO: In an initial float or an Initial Public Offering (IPO), the company issues a certain percentage (for example, 20%) of its equity (i.e. of the company in the form of stocks) to the public or investors in the primary market. It is traded later in the secondary market. Given that this is the most expensive method of floatation, it is larger companies who usually take up this route to raise substantial amounts of capital and desire a broader base of shareholders.

Private Placement: Under private placement or stock market placement of new stocks, the same are issued to or placed to a small group of investors, usually institutional investors (such as mutual funds and insurance companies among others, or even high net worth individuals). This method of floatation is relatively low cost, less time consuming and the company has greater hold over the number of new shareholders.

Rights Issue: A publicly listed company can choose to go in for a rights issue when it wants to increase its subscribed capital. Here the company allocates more stocks to existing shareholders of the company.

Bought Out Deal: In a ‘Bought Out’ deal, the underwriter, usually an investment banker, purchases the entire stock offering (for example 50 million stocks) from the company that issues the same. Here, while the financing risk is eliminated for the issuing company, the price offered to them by the underwriter for the entire stock offering is usually a discounted price (for example, US per share, as against the expected market value per share of US).

This is not surprising, as there is a risk that the underwriter may not be able to resell the stocks at a higher price in the future. The company may resort to such deals, as there is no surety that all the stocks that they issue will be purchased by investors (via the stock markets or in private placements).

Advantages of Floatation

Floatation has the advantage that a company gains access to new and large amounts of capital or external finance from across a spectrum of the investment community, in order to expand its business and create a market for its stocks. Otherwise, the company might have to rely on either its retained earnings or debt (which could be expensive) to expand or finance new projects.

Floatation generally improves a company’s debt to equity ratio. It may also enable the company to borrow on more favorable terms from conventional sources (for example, banks).

A carefully prepared or planned pre-float preparation by a company has been widely found to be a key determinant of success vis-a-vis floating and listing its stocks on a stock market.

Some of the key factors that may influence the percentage of a company’s stocks to be floated or offered to investors are: how much money does the company want to raise from the market, what is the valuation of their business, and does the company want to repay any outstanding bank debt or pay off existing holders of their stocks, which might include venture capitalists.

Floatation Costs

When a company issues new securities, it incurs certain costs such as underwriting, audit, registration, and legal expenses among others. Such costs are termed as ‘floatation costs’, which are expressed as a percentage of the issue price of a stock. These costs typically range between 2% to 8% for issuing common stocks.

Below is a workout of floatation costs of common stocks issued by Company A. Assume that  Company A issued common stock in order to raise capital of US$100  million. The issue price per stock is US$20. Furthermore, we assume that this company will pay a dividend of US$3 per stock next year (i.e. year two 2) and the floatation cost to stock issue prices is 5%. Moreover, we expect a dividend growth rate of 14% in year 3.

How do we calculate the floating cost? It is equal to the cost of new equity minus the cost of existing equity. When a company issues new stocks, the issuance increases its cost of equity. This has to be calculated first, in order to calculate floatation costs.

Cost of New Equity = D/P (1-F) + M

D = Dividend in Year 2

F = Floatation Cost to Stock Issue Price

P = Issue Price per Stock

M = Dividend Growth Rate (Expected) in Year 3

If we assume no floatation costs (i.e. F= 0%), then we get the cost of existing equity.

Please refer to the workout below: