Organizations raise capital by selling securities to investors in the primary market. Many different transaction types can occur in this market, but one feature is always true: the proceeds go to the issuer.
A simple way to identify the market is to follow the money:
There are four roles to be aware of when discussing the primary market: issuers, underwriters, investors, and the SEC.
From a small start-up company to the federal government, issuers come in many forms. Issuers raise capital when a need is identified. That need might include expanding a business, hiring a large number of employees, or funding deficit spending (as governments do). Real-world examples of issuers include:
Issuers often need help selling securities. In most cases, they don’t have the network or infrastructure to reach enough investors on their own. Also, selling new issues involves detailed rules and responsibilities.
Underwriters are hired by issuers to manage the marketing and sale of securities to the public. Investment banking (also called underwriting) can be a large business. For example, Facebook’s underwriters made over $100 million during their IPO in 2012. Underwriters can provide general advice, help structure the offering, and sell the securities. Real-world examples of underwriters include:
The underwriter on an IPO is usually not the only firm involved. When an issuer hires an underwriter, it typically hires a lead underwriter, who then forms a group called a syndicate. A syndicate is usually made up of multiple financial firms that help the lead underwriter sell the offering.
Securities sold in the primary market are sold to investors. Investors can be individuals, financial institutions, or government entities. Regulations around new issues are designed to protect investors from fraud and manipulation by issuers and underwriters.
When a new issue is sold, it will typically be regulated by the SEC. Unless an exemption applies, new issues must be registered with the SEC. Registration involves substantial paperwork and fees. The purpose is to ensure the issuer and underwriter provide enough information for the public to make an informed investment decision. This process is covered later in the chapter.
When a security is offered in the primary market, underwriters take on one of two underwriting commitments: firm or best efforts. An underwriting commitment describes the underwriter’s liability for unsold securities.
Firm underwriting commitments make the underwriter liable for any unsold shares. In a firm commitment, the investment bank buys the securities from the issuer and then sells them to investors. Offerings can involve thousands of bonds or millions of shares of stock. If demand is weak, the underwriter may sell only part of the issue and must keep the unsold securities.
A firm underwriting is also known as a principal or dealer transaction. A principal (dealer) transaction occurs when a customer buys a security from a firm’s inventory. In a firm commitment underwriting, the investment bank owns the securities it is selling, so the securities are part of its inventory. The firm profits if it buys at a lower price and sells at a higher (marked-up) price.
A standby underwriting is a type of firm commitment that involves a rights offering. In a rights offering, an issuer gives existing shareholders the right to buy newly issued shares. Not all shareholders will exercise their rights, which can leave unsold shares. Before the rights offering begins, the issuer typically hires an underwriter to “stand by.” After the rights offering ends, the underwriter buys any unsold shares from the issuer on a firm basis and then resells them to its customers.
A best efforts underwriting commitment means the investment bank agrees to use its best efforts to sell the securities, but any unsold units or shares are returned to the issuer. Best efforts underwritings are less risky for underwriters, so the underwriting fees are typically lower (less risk, less potential return).
A best efforts underwriting is also known as an agency transaction. An agency transaction occurs when a firm acts as a middleman, connecting buyers and sellers rather than selling from its own inventory. In a best efforts underwriting, the investment bank connects the issuer with the investing public.
There are a few variations of best efforts underwriting commitments. A mini-max underwriting sets both a minimum and a maximum number of shares to be sold. For example, an issuer might offer 1 million shares but require that at least 750,000 be sold for the offering to proceed. If the minimum can’t be sold, the offering is canceled and investors receive their money back.
Also, there’s an all or none underwriting commitment. The underwriter must sell all of the securities for the offering to proceed. If an issuer offers 1 million shares, all 1 million must be sold. Otherwise, the offering is canceled and investors receive their money back.
As you can see, public offerings can use several commitment styles. Choosing the commitment is a key part of the agreement between the issuer and the underwriting syndicate. Some agreements include market-out clauses, which allow the syndicate to withdraw due to unforeseen market events. If an unexpected event occurs (for example, the Great Recession or the COVID-19 pandemic), demand for the security could drop sharply, making the offering much harder to sell. Market-out clauses are especially important in firm commitment offerings because the syndicate is taking on more risk.
The commitment type also affects compensation. In general, more risk means more potential return. Underwriters in firm commitment offerings are typically paid more than underwriters in best efforts offerings because firm commitments can leave the underwriter holding unsold securities.
Primary market offerings can take several forms, but the Series 6 exam focuses mainly on two: IPOs and APOs.
An initial public offering (IPO) occurs when an issuer sells a security to the public for the first time. IPOs of common stock from large companies are widely covered in the financial media. For example, Uber’s IPO in 2019 received significant attention and raised $8.1 billion for the company. Uber had previously sold securities through private placements, but the IPO was the first time its shares were offered to the general investing public.
Issuers can also raise capital through additional public offerings (APOs), sometimes called follow-on offerings. When a corporation is formed (incorporated), it authorizes a certain number of shares that may be sold to investors. Typically, only a portion of those authorized shares are sold in private placements and in the IPO. This leaves the issuer the option to raise more capital later by selling additional shares. If a company already has stock outstanding and decides to sell more shares to the public, that sale is an APO.
In each case, primary market transactions create proceeds for the issuer. IPOs, APOs, and private placements are common forms of primary market sales. In the next section, we’ll look more closely at the IPO process.
Sometimes shares are offered to the public, but the proceeds do not go to the issuer. These are secondary offerings, and they often involve large shareholders (commonly company executives) selling a significant number of shares. For example, Mark Zuckerberg (CEO of Meta/Facebook) sold $2.3 billion of stock he owned in a 2013 registered offering. The $2.3 billion in proceeds went to Zuckerberg, not Facebook. Secondary transaction proceeds do not go to the issuer.
In that same transaction, Facebook also sold $1.6 billion of its own stock alongside Zuckerberg’s shares, bringing the total sold to $3.9 billion. This is a combination offering, sometimes called a split offering. Combination offerings include both:
In the Facebook example, Zuckerberg sold $2.3 billion and the company sold $1.6 billion, for a total $3.9 billion combination offering.
Sign up for free to take 16 quiz questions on this topic