Going Public
Initial Public Offerings (IPOs)
Agenda
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The Going Public Process
The methods of going public
Benefits/Costs
The Economics of IPOs: Underpricing
The IPO Process
• Time 0: The firm decides to go public.
• Time 1: The firm chooses an underwriter (an
investment bank). The underwriter will advice
the firm on the type of security to issue, help with
the pricing, the marketing, and the registration of
the shares on an organized exchange.
• Time 2: The firm starts trading on the exchange.
Methods of Going Public
• Firm Commitment
– The company hires an underwriter with whom it makes a
preliminary prospectus and the underwriter then solicits
indications of interest from potential investors.
– The preliminary prospectus gives a price range of the issue but
not the final price. If the SEC approves the issue then the final
pricing meeting takes place and within a couple of hours (at most
a day) prior to when the underwriter distributes the issue.
– The investment banker receives the offer price P from investors.
The underwriter is not allowed to increase the price, only to
decrease it.
– In all cases (even if it cannot sell the issue) the underwriter pays
P(1-c) to the company, where c is the commission spread.
Firm Commitment as an Option
• The issuing company buys a put option
from the underwriter.
• The company (the underwriter) gives a call
option to investors.
• The issuing company's put option
becomes real only in the final pricing
meeting.
Underwriter Profits
• Commission from the spread between the issue
price (P) investors pay and the amount paid to
the firm, P(1-C).
• Over-Allotment Option or “Green Shoe”
provision.
– Option granted to an underwriter for a period of 15 to
45 days (usually 30) after the issue date to purchase
additional shares.
• Typically, up to 15% of the shares being sold.
• This is a call option issued by the firm to the
investment bank.
Best Efforts
• The investment bank only markets the issue.
The prospectus states an offer price (P), the
minimum number of shares that must be sold for
the issue to go through (Qmin) and the greatest
number of shares that will be sold (Qmax)
– If Qmin is not reached in 90 days (this can vary) the
investors get their money back from an escrow
account.
– Once again the company gives a call option to
investors.
General Facts
• The majority of IPOs take place via firm
Commitment offers.
• Only 35% of IPOs are Best Effort and they
account for only 13% of the total money raised.
– This implies that best effort IPOs are generally from
small firms.
– One rationale is that otherwise the investment banker
would force the company to go public at very low
price. In the best efforts issue the company can
choose the price itself.
IPOs in the U.K.
(Three Primary Methods)
• Placing
– This method is almost identical with the firm
commitment.
– The underwriter and the issuing company determine
the issue price on the impact day.
– The underwriter then quickly (during the same day)
distributes the shares according to the interest shown
by institutional investors.
– Exactly as in the firm commitment method the general
public is totally excluded from the investor set.
– Placing is becoming the main method in the UK
probably due to the fact that eliminates all risk to the
underwriters.
U.K. Method #2
• Fixed-price Offer for sale
– The issuing company and the investment bank decide
on the price well in advance of the selling period.
– A prospectus is printed and the investment bank
advertises the issue to general public (and to
institutions).
– From the option point of view this method give rise to
same options as the firm commitment method. Now
the both options just have longer maturity.
U.K. Method #3
• Auction-rate Offer for sale
– No underwriting is needed as the market
decides the correct price.
• Losing popularity in the UK.
• But remains popular in Denmark, France and the
Netherlands.
Going Public Costs and Benefits
• Benefits
– Better access to the capital markets.
• The company cannot anymore find financing: it is too levered
for new debt financing and the owners are unwilling/unable to
invest more. At the same time the company sees promising
investment opportunities.
• Seasoned equity offerings
• Acquisitions paid for with its own now liquid shares.
– Liquidity and diversification for the firm, its managers,
and more generally the company’s insiders.
– Monitoring role of the stock market.
– Signaling (i.e. for credit purposes)
IPO Costs
• The total costs of going public are a big
percentage of the possible issue proceeds (on
average, from 15 % to 30%). The costs can be
divided into four parts:
– Direct costs.
• These include the underwriter commission (3% to 8%), legal
fees, auditor fees, printing fees, advertising costs,…
• Direct costs are on average 11% of the money raised (as
usual being mostly fixed, they range form 6% for larger firms
to 17%(!) for smaller firms)
– Disclosure and market competitors.
– Management time.
– Underpricing. (Coming right up!)
IPO Underpricing
• Underpricing is defined as the difference in
price between the closing price on the first
day of trading and the offer price.
• In the US:
– Firm commitment contract: about 15%;
– Best effort contracts: about 48%.
• Similar results appear in many European
countries.
IPO International Underpricing
Country
Underpricing
Data Years
UK
8.6%
1985-88
France
4.2%
1983-86
Netherlands
5.1%
1982-87
Switzerland
35.8%
1983-89
Germany
21.5%
1977-87
Spain
22.3%
1986-90
Finland
9.5%
1984-89
Why are Issues Underpriced?
• Typical excuses offered:
– Agency costs explanation.
– Information-based explanations.
– Underwriter support.
Underwrites’ Incentives and Agency
Costs: Baron (1982)
• Underwriters have the expertise to value a firm and have
access to a portfolio of investors. This is why firms willing
to go public should hire investment banks.
• But, underwriter is really a middleman between the firm
and investors.
– Whose agent is the underwriter?
– Should they think about maximize the net proceeds of the IPO
for the firm, or giving a good deal to their (probably) long-term
customers?
– A lower price will make investment bankers’ life easier.
• Discounts reduce marketing efforts and the probability of ending up
with an unsuccessful offer.
Evidence on Agency Costs
• Muscarella – Vetsuypens (1989).
• Examine the average underpricing of 38 Investment
banks. These are IPO’s of an investment bank’s stock.
• The explanation put forth by Baron would suggest that
because of the firm is the underwriter agency costs
should be absent and therefore, there would be no
reason to underprice.
• Explanation partially rejected by the data.
– Average underpricing is 7%.
– Grows to 13% for those investment banks that were also the
main underwriters of the syndicate!
More Agency Evidence
• There is a relation between underpricing
and market share.
• Beatty and Ritter (1986) found that
underwriters that underpriced the most,
lost market share in the IPO market.
– For the 25 out of 49 investment banks in their
study that underpriced the shares of their
clients most, the market share went down
from 46.5% to 24.5%.
Information Based Explanations
• Signaling hypothesis: Welch (1989) and Chemmanur
(1989).
• Managers have better information and wish to maximize
the net proceeds of the IPO and of the SEO.
• A low priced IPO is used to signal the company’s quality.
The message managers are sending is very close to that
sent to those managers who discount a new product:
– “Today, you buy my product because it is cheap. Tomorrow,
however, you will buy my product because you liked it.”
– Firms of lower quality cannot afford to send this signal and
investors are thus more forgiving of bad news in the future if the
IPO was significantly underpriced.
Signaling the Empirical Evidence
• The empirical evidence is not in line with the
empirical implications stemming from this theory
(the better the firm’s quality, the greater the
underpricing).
– Firms that underprice do not have a higher probability
of returning to the market.
– Levis (1995), for the U.K. market, found that firms that
underpriced more also experienced a higher
probability of default.
• This is opposite to the relationship between firm quality and
underpricing that a signaling model would call for.
The winner’s curse: Rock (1986)
• Example:
• Suppose firms can be either Good or Bad each with
probability one half.
• The value of a Good firm is 100 and the value of a Bad
firm is 50.
• The firm does not have a real informational advantage
and would like to price its shares on average at 75.
• Outsiders can be divided in a small percentage of
Informed and a vast majority of Uninformed.
– Informed investors know the firm’s quality.
– Uninformed investors do not know the firm’s true value.
However, they will always bid for its shares if they believe that
they will not make an expected loss.
Implied Bidding Patterns
Informed
Uninformed
P≥V
Do not bid.
Bid.
P<V
Bid
Bid
Implications
• Uninformed investors will 100% of the shares in
an overpriced offer since they are the only
bidders.
• Uninformed investors receive just a fraction of
the underpriced offers as they must compete
with the informed investors.
• Uninformed investors realize that:
– When they are allocated more shares, they will get a
bad deal (winner’s curse).
– When they are allocated fewer shares it is because
the deal is good.
Getting the Uninformed to Bid
• Does it really make sense that uninformed investors
always bid?
– No. They must expect to at least break even.
• Uninformed investors will only bid if the offer price is
below 75 as they expect to get:
– Large allotments of $50 offers.
– Small allotments of $100 offers.
• If the price is set to $75, the uninformed will not
participate.
• On average IPOs will be underpriced.
• Underpricing can be seen as a way to attract uninformed
investors.
Any Chance this Theory is Right?
• Model requires that for some reason the
informed investors cannot afford to purchase
100% of the issue.
• For most institutional investors (presumably the
informed) new issues are small investments.
– So just who is it that must be attracted?
• Spanish data:
– Both over and underpriced issues tend to be
oversubscribed.
– When institutional investors do not bid on an issue it
still tends to be underpriced. Under the model these
issues should be overpriced.
Underwriter Support Explanations
• Initial returns are calculated from the
transactions during the first trading day.
• Underwriters typically support the IPO stock at
95% to 100% of its offering price level.
– In the US this stabilization is legal so long as it is not
performed above the issue price.
• There exists evidence supporting this hypothesis
as the median underpricing is much smaller than
the average underpricing.
Underpricing: Solutions?
• Auction
– Problem: will investors to gather the necessary information?
– France: underpricing is much lower for those firms that use
auction methods to go public!
• Unit IPOs
– The company sells units of securities instead of shares.
– IPO evidence relies on the fact that only stocks are issued at the
IPO stage. Perhaps stocks are not the best way to go public.
• Puttable Common Stocks: a combination of stocks and Put options.
• The put options can be seen as a “money-back warranty” that
enable investors to sell back the stock to the firm if the stock does
not perform.