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How primary and secondary markets work
This article appeared in the June 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
They're both vital parts of the 'sharemarket', but play very different roles.
By Owen Richards, author
In a discussion with friends recently, someone complained that share prices should be fixed and not "all over the place", and suggested there should be no need for sharemarkets or share trading because neither speculators nor the market served any real purpose. I asked, "But what about the primary market?". His response was a blank stare and I realised the question meant nothing to him.
I wondered how many other people do not realise the term "sharemarket" is a catch-all phrase to denote both the primary market and the secondary market, and that these are distinct terms. The primary market refers to where shares are created, are sold by the issuing company to investors, and are listed for the first time on an exchange, such as ASX, and become available for buying and selling.
The secondary market is the one we all know, where existing shares are bought and sold by investors, traders and speculators alike. The defining characteristic of the secondary market is that investors buy and sell among themselves. They trade previously issued securities without any involvement by the issuing companies. For example, if you buy or sell BHP Billiton shares, the company itself is in no way involved with the transaction.
It is in the primary market that firms sell (float) new shares to the public for the first time. For most purposes, the primary market is synonymous with an initial public offering (IPO), which occurs when a private company first sells shares to the general public and is listed on an exchange.
Listing, therefore, is the process of taking a privately owned organisation and making the transition to a publicly owned entity whose shares can be traded on a sharemarket. Small companies looking to grow will often use an IPO as a way to generate the necessary capital. Although further expansion is a benefit to the company, there are both advantages and disadvantages that arise when a company goes public.
Benefits of capital raisings
The financial benefit in the form of raising capital is the most distinct advantage, especially when sufficient funds cannot be raised elsewhere by, say, borrowing. Another advantage is an increased public awareness of the company. An IPO usually makes the company's products known to a new group of potential customers and this may lead to an increase in its market share. An IPO also may be used by founding individuals as an exit strategy. Many venture capitalists have used IPOs to cash in on successful companies they have helped start.
Even with the benefits of an IPO, public companies often face many new challenges. One of the more important changes is the need for continuous disclosure for investors, in accordance with ASX Listing Rules. Public companies are regulated by the Australian Securities and Investments Commission (ASIC) regarding periodic financial reporting, which may be difficult for newer public companies. More importantly, especially for smaller companies, the cost of complying with regulatory requirements can be relatively high. Some additional costs include financial reporting documents, audit fees and investor relations.
Time and money
The listing process can be relatively lengthy and costly. The time its takes to list a company on ASX will depend upon the complexity and scale of the capital raising. From initial discussions to completion, the listing can be expected to take a median period of around six months, although this might range from three months to two years. Listing takes a lot of effort and time and can be demanding on company management. There still has to be time to manage the usual affairs of the company, and this should be a factor in setting the timetable for listing.
The financial costs might include the appointment of specialists: underwriters, lawyers, accountants and advisers. The underwriting and broking fees can range from about 2 per cent to 7 per cent of the amount raised. Other fees such as legal, accounting, advisers, registry, ASX and printing can have a median price of around $500,000, depending on the size, the business and the extent of any restructuring work required. Larger floats can involve costs of $1 million and more.
It is probably not surprising that entities looking to access the capital markets to fund new products or services, or to provide liquidity for shareholders, might look for alternatives to an IPO to secure a listing on ASX. These could be through either a "backdoor listing" or a "reverse takeover". The first requirement for a backdoor listing is to identify a suitable listing vehicle, preferably a listed company. The new product can then be sold into the listed vehicle (either by an asset or share sale) in return for cash or equity in the listed vehicle, or a combination of the two.
Where additional funds are required for effective commercialisation of the new product, the listed vehicle may conduct a capital raising, either at the time the listing is effected or later. If the nature of the product being moved into the listed vehicle means a change of business activities for the company, ASX will probably require a prospectus-style disclosure to be made in obtaining the consent of existing shareholders to the company's new direction. The process of effecting a backdoor listing can take between two and four months. The interests of all stakeholders need to be taken into account and due diligence will be likely on both the listed vehicle and the new product. The documentation for the transaction is also more complex than for an IPO.
A reverse takeover is similar (and the terms are sometimes used interchangeably) but there are differences. The reverse takeover is an acquisition by a public firm of all the shares, assets and business operations of a private firm. The public firm pays for this by issuing a large number of new shares with voting rights to the owners of the private firm. The issued shares may be supplemented with cash or options.
Although it appears that the public firm is the acquirer and the private firm the target, at the end of the process it is the private firm owners who obtain effective control of the combined public-private entity (a reverse takeover). The private firm's business and assets are now the dominant focus of the merged and publicly listed entity, because the public firm is essentially a corporate shell with no business operations.
The reverse takeover is a popular way private firms can achieve a listing through the corporate shell of publicly listed companies. The major distinction between this and a "normal" takeover is in the rights of control of the combined entity. The market sees a major corporate restructure, which typically involves a name change, new business activities, and new a board of directors and management.
The reverse takeover was a popular mechanism for getting a public listing in the dot.com boom. Technology-based companies were able to achieve listed status relatively quickly and cheaply through shell companies, especially mining companies. Some of these companies, in turn, provided the vehicles for new mining companies when the minerals boom came about. There is little doubt that any boom times lead eventually to the availability of shell companies, and can form the basis of a private company seeking access to more capital and a wider exposure to investors, on a share exchange.
About the author
Owen Richards has been a trader for several years and is a contributor to local and overseas trading magazines. He has written this article on behalf of the Australian Investors Association, an independent, non-profit organisation aimed at helping its members become more successful long-term investors.
The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.
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