An adjustment of the situation becomes a matter of bargaining between the promoters who are advancing $500,000 and the bankers who are advancing $3,000,000 for the enter prise. Assume that the promoters want the same possibility of later separating their in terest in the corporation into more specula tive and less speculative parts. They cannot take part bonds and part stock for the funds they supply to the corporation, because the bankers insist that the bonds must have an equity back of them of a full $500,000. The bankers consent, however, to giving the pro moters a claim that will come in ahead of the speculative interest the bankers want as part of their return for the funds they supply. Let us suppose as a result of the bargaining that the promoters and the bankers come to an agreement on this plan as satisfying their various requirements.
In return for the $3,500,000 of funds sup plied for its purposes the corporation will issue: $3,500,000 5 per cent bonds; 1,000,000 7 per cent preferred stock; 4,500,000 common stock.
Of these securities the bankers, in return for supplying $3,000,000 of cash, will get: $3,500,000 5 per cent bonds; 3,500,000 common stock.
In return for supplying $500,000 in cash the promoters will get: $1,000,000 7 per cent preferred stock; 1,000,000 common stock.
That is, the bankers, in return for funds, for every $100 supplied, get: $116.66 par value 5 per cent bonds; 116.66 par value of stock.
The promoters, in return for funds, for every $100 supplied, get: $200 par value 7 per cent preferred stock; 200 par value common stock.
As a matter of fact, the way the parties will view the transaction is that the bankers get 5 per cent 25-year bonds at 85.71, and with the bonds get a bonus of 100 per cent of com mon stock, and that the promoters get pre ferred stock at 50, with a bonus of 100 per cent of common.
Assume now that the corporation gets to a point where it can earn 10 per cent on the cash invested. Its earnings will then amount to: Net $350,000 Interest . . 175,000 Available for preferred . . 175,000 Required for preferred . . 70,000 Available for . . 105,500 or only a little over 2 per cent on the com mon, hardly sufficient out of which to pay a dividend.
If the business is of the type not subject to large declines in gross, now that the corpora tion is earning 60 per cent above interest charges the bankers may begin to market the bonds. Suppose they are able to get an aver age of 95.71 for the bonds. They have made in the transaction, 10 points gross, or 12 per cent on the funds involved, and have besides a possibility of further profit in the common stock they hold. In order that this may not be thought an enormously profitable trans action for the bankers, it is only fair to say here that it has perhaps cost them between four and five points to sell the bonds.
The promoters are getting 14 per cent on their cash invested, and have their further possibility of profit in the stock they hold. Presumably they cannot yet on this showing of earnings dispose of their preferred stock advantageously.
Assume now that the affairs of the corpora tion continue to prosper till it can earn 15 per cent on the funds invested. Earnings increase
to: Net $525,000 Interest and preferred dividends require 245,000 Available for common . . $280,000 or a little in excess of 6.2 per cent. Probably the directors of the corporation will not de clare a 5 per cent dividend on this showing. To do so would leave little available for emer gencies, or to build up the property against future recessions in business. So far, too, we have said nothing about a sinking-fund to amortize the bonds. Earnings available for dividends have, however, given the common stock a substantial value. The directors may declare a dividend at the rate of 4 per cent, and so enable the holders to make, if they wish, a market for the security.
We have assumed that this is a new enter prise, and at the time of the negotiations be tween the promoters and the bankers had yet to go through the construction process. It would be at least two years before the project got on an earning basis, or, say, two and a half to three years before the bankers could begin to place the bonds with the investing public on the basis of assured earning power. The bankers do not want to tie up so large an amount of funds for so long a time. Hav ing assumed the responsibility for supplying $3,000,000 of funds, they may now proceed to get the amount underwritten. That is, they will find people who will advance the money till the corporation can show established earn ing power, when they may either place their securities with the general lot for the bankers to offer for sale, or may withdraw them from the general mass and keep them for personal investment. Terms of these underwriting agreements vary a great deal, and we shall not attempt to go into them. The amounts taken by each underwriter or member of the underwriting syndicate, as it is called, may also vary widely, both within one syndicate and between one syndicate and another. In the case of some underwritings a compara tively few members may form the entire syn dicate; it may comprise only other bankers who are taking participations. The members of other underwriting syndicates may be pri vate capitalists widely scattered, and some of rather small resources, so that many parti cipations may amount to as little as $5000. It seems to be the tendency to scatter the under writing more broadly, and make the amount required for participation smaller and smaller. Often now, in fact, the idea of a syndicate with the original bankers subsequently mak ing a general market issue to investors is hardly even pretended, and the so-called un derwriting amounts really to the issue of the securities. So far as that gives the people who are supplying the money a larger proportion of earnings it seems desirable. The danger lies in the possibility of people, not familiar enough with financial matters to discriminate between a speculation and an investment, supplying funds at this point when they can not afford to assume the amount of risk neces sarily accompanying the transaction.