Project sponsors are likely to be overoptimistic.
The project sponsor, or underwriter will want any offering to be successful do it is in their
interest to be optimistic about a prospective initial public offering (IPO).
At the outset, a firm will choose its underwriters after a beauty parade, so sponsors will
inevitably be trying to be optimistic and give the best impression of what price they can
achieve for the firm from the start.
Once an underwriter has been chosen, assuming they have a Firm Commitment, the
investment bank agrees to underwrite the issue. The process involves the underwriter
purchasing all the shares from the firm and reselling them to the public – so it is in the
sponsor’s interest to be as optimistic as possible! The sponsor receives payment via an
underwriting spread (the difference between the price they buy and sell it at). This spread is
typically around 7% for US underwriters.
The IPO process as underwriters may be as follows:
1. The firm chooses a lead underwriter
2. The underwriters ensure that the firm satisfies all regulatory requirements, such as
legal documents, filing reports, fees, financial data etc.
3. The underwriters work with the company to come up with a price range offers a
reasonable valuation for the company. This is calculated by estimating the future cash
flows and calculating the NPV.
4. The underwriter contacts prospective buyers of stock, such as fund managers and
insurance companies and doing road shows.
5. During these meetings the underwriter assesses overall interest from the market and
finalises the price at which the shares will be sold.
a. The underwriter wants to get this bit right. Too high a price will leave the firm
with unsold stock, too low a price will mean revenue has been sacrified.
Bearing in mind that if the underwriter does not sell all the stock they are on the hook and are
likely to have to sell the rest of the stock at a loss, it is therefore in the interests of the sponsor
to be as optimistic as possible – and that results in them being overoptimistic.