Initial Public Offering (IPO)
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An initial public offering (IPO) is the first time a company sells its stocks to the public.
Main advantages of selling shares to the public:
o Greater liquidity. Private equity investors are able to diversify their holdings as
they can now sell the company’s stock through a public stock market.
o Better access to capital. A firm is usually able to raise much more funding after
becoming a public company.
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Main disadvantages of selling shares to the public:
o Dispersed equity holdings. With more equity owners, investors lose their ability
to influence management.
o Compliance is costly and time-consuming. Public companies need to adhere to
strict compliance from organizations such as the Securities and Exchange
Commission (SEC), the securities exchanges (NYSE and NASDAQ), and
Congress (through legislation). This compliance can be burdensome.
Type of Offering
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After a company has chosen to go public, the managers of the company will hire an
underwriter. An underwriter is an investment banking firm that oversees the offering and
creates its structure.
Two main types of offerings:
o Primary offerings. There are new shares sold to raise new capital.
o Secondary offerings. These are existing shares which are sold by current
shareholders, thus closing their position in the company.
When issuing an IPO, the company and underwriter must decide on the best mechanism
to sell shares:
o Best efforts. The underwriter does not guarantee all shares will be sold: the shares
will simply be sold at the best possible price. These types of deals usually have an
all-or-none clause which stipulates that the deal will be cancelled if any shares
remain unsold. Note that the best-efforts mechanism is usually used in smaller
IPOs.
o Firm commitment. This is the most common approach. The underwriter
guarantees that all shares will be sold at the offer price. The underwriter purchases
the shares at a discount and then attempts to resell them at the offer price. If the
shares sell for less, the underwriter must cover the loss.
o Auction IPOs. In this type of IPO, shares are sold through an auction system and
are sold directly to the public. Investors place bids, and the resulting share price is
the highest price such that the number of bids at or above that price equals the
number of shares offered. All winning bidders pay the same price.
EXAMPLE
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Silveroar is issuing 700,00 shares of stocks in an auction IPO. Here are the results of the
bidding for a share of Silveroar
Determine the offer price of the shares.
SOLUTION
First, calculate the cumulative number of shares at or above any given price:
Silveroar issues a total of 700,000 shares. So, the winning auction price would be $9.00 per
share. However, the cumulative demand at this price (755,000) is higher than the number of
shares offered (700,000). So, only bidders who bid higher than $9.00 per share would receive
their full bid at the winning price of $9.00 per share. The bidders who bid exactly $9.00 per share
will be awarded the remaining shares on a prorated basis.
Mechanics of an IPO
Underwriters and Syndicates
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A group of underwriters typically manage an IPO, with the lead underwriter handling
most of the process. The smaller underwriters, called a syndicate, receive advice from the
lead underwriter.
Underwriters are important because they:
o Market the IPO
o Assist in required filings
o Actively participate in determining the offer price
o Ensure the stock’s liquidity after the IPO
SEC filings
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Companies must file a registration statement, which provides a company financial and
other important information to the investors.
The registration statement has 2 parts:
1. Preliminary prospectus/red herring, which contains all the required information
needed by potential investors in the stock. This goes out earlier to outside investors
before the stock is offered.
2. Final prospectus, which includes details of the IPO such as the quantity of shares
available and the offer price
Valuation
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In an IPO, a fair valuation of the company is performed by the underwriter.
The valuation of a company is often done through:
o Estimating the present value of future cash flows, or
o Estimating the value of comparable companies.
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With an initial price estimate, a road show takes place, where underwriters and the
company’s senior management market the offering to the underwriter’s largest clients
(e.g., mutual funds, pension funds, and other institutional investors) and attempt to survey
the market about their opinion on the valuation range.
The customers will inform the underwriters of their interest by suggesting how many
shares they want to buy. The underwriters undergo a process called book writing where
they adjust the share price to customer demand so that the IPO is most likely to succeed.
Although these commitments are non-binding, they are typically honored to maintain
future business relationships.
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Pricing the deal and managing risk
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The company will pay the IPO underwriters an underwriting spread, which is a
percentage of the issue price. For example, if the issue price is $10.00 and the
underwriting spread is 5%, the underwriters will buy each share from the company at a
5% discount, i.e., $9.50, and sell the share at $10.00 to their customers.
When underwriters provide a firm commitment, they often unintentionally underprice the
IPO. This increases the probability all the shares will be sold at the offer price, which
reduces the risk of loss for the underwriter.
After the IPO, underwriters can protect themselves more against losses by using the overallotment allocation or greenshoe provision. This gives the underwriters the option to
issue a limited amount of additional shares at the IPO offer price. This means the
underwriter can market more shares than is listed in the prospectus
o If the issue is a success and the price rises above the IPO offer price, the
underwriters will exercise the greenshoe provision so they have all the needed
shares to deliver.
o If the issue is not a success and the price falls below the IPO offer price, the
underwriters will not exercise and the greenshoe provision. Instead, they will buy
shares in the open market at the reduced price which can be used to deliver shares
to the over-allotment sold.
Upon completion of the IPO, the lead underwriter will typically make a market for the
stock, increasing its liquidity in the secondary market, and then assign an analyst to the
stock.
Note that in most IPOs, pre-existing shareholders cannot sell their shares for 180 days
after the IPO, which is referred to as “180-day-lockup.”
EXAMPLE
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To estimate a company’s value, Silveroar’s investment bankers use data they have
collected on comparable companies that have recently gone public:
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Silveroar had earnings of $16 million and revenues of $350 million during the most
recent fiscal year.
Assume that Silveroar will have 10,000,000 outstanding shares after the IPO
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Estimate the IPO price for Silveroar using the price/earnings ratio and the price/revenues
ratio.
SOLUTION
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Using the price/earnings ratio, calculate the total market value of Silveroar’s stock as:
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 = 21.0 × $16 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = $336 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
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Silveroar is expected to have 10 million outstanding shares after the IPO. So, the price
per share under the price/earnings ratio is:
$336 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
= $33.60
10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
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Using the price/revenues ratio, calculate the total market value of Silveroar’s stock as:
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 = 1.0 × $350 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = $350 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
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Thus, the price per share under the price/revenues ratio is:
$350 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
= $35.00
10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
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Based on these estimates, the underwriters will probably set an initial price range
between $33.60 to $35.00 per share for the road show.
 Over-allotment. Underwriters given 10% over-allotment for 100,000 shares. This means
they are able to sell 110,000 shares in total, 10,000 being a short sale.
o If price goes up (issue is a success), the underwriters are able to sell all 110,000
shares and then exercise the option to buy additional 10,000 shares from the issuer
to cover their short sale position. The profit comes from the underwriter being
able to buy the 10,000 additional shares at the initial offering price, when they are
already worth more.
o If price goes down (issue fails), the market price will be less than the offer price.
Therefore, the underwriters can cover their short position by buying the shares
from the market. In this case, they still sold high and bought low, because they
sold at the offer price, and bought at the lower market price.
IPO Puzzles
Financial economists are puzzled that:
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The average IPO seems to be priced too low
New issues appear cyclical
The transaction costs of an IPO are high
Long-run performance after an IPO is poor on average
Underpricing
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Underwriters tend to underprice an IPO to reduce their risk. This also biases the first-day
return to be very positive. For IPOs between 1960 and 2015, the average return on the
first day of trading is 17%. This reflects a significant amount of underpricing if the price
at the end of the first day is considered as the price that underwriters should set.
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The two parties that benefit the most from this underpricing are:
1. Underwriters. They are able to minimize their risk of not selling all issued shares at
the IPO offer price.
2. Investors who buy stock directly from underwriters. They are able to gain
tremendous returns on first-day underpricing. If the average one-day return is 17%,
they could theoretically earn (1.17)365 − 1 = 7.7 × 1024 per year. However, this
return is not realistic.
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The investors that suffer the most from underpricing are the pre-IPO shareholders of the
issue firm. They are selling their stock at a significantly lower price than in the
aftermarket. Hence, financial economists are puzzled that pre-IPO shareholders allow
underpricing.
EXAMPLE
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You have the opportunity to purchase an IPO from a large investment bank. The bank
requires you to purchase 4,000 shares for every IPO deal.
You will get all the shares if the shares are available. If not, your allocation of shares is
rationed in proportion to the oversubscription.
It is known that the IPO deal will be oversubscribed 16 to 1 (for 16 orders, only 1 order
can be filled) 80% of the time.
When the shares are oversubscribed, the price tends to increase by 20% on the first day.
When the shares are not oversubscribed, the price tends to decline by 5% on the first day.
Assuming the offer price is $20, calculate your expected average return as an investor.
SOLUTION
In order to calculate your average return, you will need to consider two scenarios:
1. When the IPO is oversubscribed.
2. When the IPO is not oversubscribed.
When the IPO is oversubscribed:
You will only get 4,000/16 = 250 shares due to high demand.
Your profit for the first day is:
𝑃𝑟𝑜𝑓𝑖𝑡 = $20 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 × 250 𝑠ℎ𝑎𝑟𝑒𝑠 × 20% 𝑟𝑒𝑡𝑢𝑟𝑛
= $1,000
When the IPO is not oversubscribed:
You will get all 4,000 shares due to low demand.
Your profit for the first day is:
𝑃𝑟𝑜𝑓𝑖𝑡 = $20 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 × 4,000 𝑠ℎ𝑎𝑟𝑒𝑠 × −5% 𝑟𝑒𝑡𝑢𝑟𝑛
= −$4,000
Thus, the expected profit is:
𝐸[𝑃𝑟𝑜𝑓𝑖𝑡] = $1,000(80%) + [−$4,000(20%)]
=0
 So, on average, you will only break even. This is an example of the winner’s curse,
where you “win” a high allocation of the less successful IPOs. Therefore, underpricing
does not guarantee investors will earn a profit.
Cyclicality
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IPOs follow a cyclical pattern in terms of volume and number of issues. This is not
surprising as we would expect a greater need for capital in times of growth and lesser
need for capital during low periods of economic activity. However, since the magnitude
of the swings in each cycle varies, it appears that the number of IPOs is not solely driven
by the demand for capital. This cyclicality remains a mystery to financial economists.
Cost of an IPO
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Compared to the cost of other security issues, such as bonds, convertible bonds, etc., the
cost of an IPO is typically much higher. In addition, the fees for IPOs do not seem to be
sensitive to the difference in issue sizes. For example, an issue size of $80 million could
have the same underwriting spread as an issue size of $20 million. In addition, financial
economists are unclear as to why underwriters charging slightly lower fees tend to have a
larger market share than underwriters charging much lower fees.
Long-Run Underperformance
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In the subsequent 3-5 years after their IPOs, newly listed firms appear to underperform.
Financial economists have yet to find an explanation for why IPOs generally follow this
trend.