• The majority of firms in the US are sole proprietorships and partnerships
• But this group accounts only for 15% of total
US sales
• These firms are typically small
– Limited access to capital
– Undiversified position for owner
• What firms should raise equity capital and what are the alternatives?

• Family and friends…
• Angel investors
– Wealthy industry experts
– Acquaintances of the entrepreneur
– Receive equity stake in the firm
– May have influence on decisions

• Venture capital
– Limited partnerships
– Experienced general partners
– Bring capital and expertise to the firm – active investors
• What do they do?
– Charge 20% of upside or more and 2% annual fee
– Important capital providers
• Pension funds and institutional investors
• Corporate investors (why?)

120
100
80
60
40
20
3.7
4.2
7.6
11.5
14.8
21.2
0
54.4
106.2
40.7
21.2
18.4
Source: Brealey, Myers, Allen Principals of Corporate finance, McGraw-Hill, 9 th edition

• Outside investors
– Private firms will typically issue preferred stock
• This is different than the preferred stock issued by mature firms
• It gives the owner an option to convert it into common stock on some future date – “convertible preferred stock”
• The exit strategy
– How do investors eventually unwind their position?

• The firm sells its shares to the public
• The procedure:
– The firm approaches an investment bank
(underwriter) to issue the shares for a fee of around
7%
– The underwriter offers the shares at the issue price to investors
– The issue price is determined by the underwriter firm’s valuation of the young firm (this is part of the
“road-show”)
– Potential investors subscribe to purchase shares at the offer price. When an IPO is over subscribed shares are sold randomly. Allocation is not guaranteed!

Young Firm
Issue price fees
Investment bank underwriter
Issue price shares
Investors

• Why IPO?
• Diversification
• Need for capital
• Control?
• Regulation?
• “Under pricing” phenomenon
• Issue price appears to be too low on average

• On average the closing price in first day is higher than the issue price around the world
Canada
Netherlands
Spain
France
Australia
Hing Kong
UK
USA
Italy
Germany
Japan
Singapore
Sweden
Taiwan
Mexico
Switzerland
India
Greece
Korea
Brazil
China
0 20 40 60 return (percent)
80
257 %
100
Source: Brealey,
Myers, Allen
Principals of
Corporate finance,
McGraw-Hill,
9 th edition

• With such average daily(!) Returns isn’t investing in IPO’s a very good investment strategy?
• High returns to investors at the expense of whom?
• Reasons for under pricing….
– Cyclicality (Risk)?
– Markets over-price IPO’s
• Long-run underperformance

There is a chance you subscribe but you are not allocated shares since the IPO was over subscribed
There is a chance that if you are allocated shares that you are paying too much for the shares

Example:
• Suppose that the startup SmartPhone developed a new device that supports super-fast internet and data service.
The success of its innovation depends on the demand for its newly developed hardware. In the best case scenario the value of SmartPhone next year will be $300 million – this will happen with probability one half. Alternatively, its value will be $150 million. The founder of SmartPhone wishes to sell 75% of her equity ownership – 0.75 million shares are offered for sale (the founder will keep .25 million shares to herself). As an investor you can only subscribe to buy 10 shares. Suppose that 150,000 investors are expected to subscribe to purchase 10 shares each.

• Example:
– How much would an investor be willing to offer for 10 shares of SmartPhone?
– What is the probability that you receive an allocation of 10 shares of SmartPhone if the offer price is $225 per share?

• Example:
– What are the revenues for the issuing firm if the offer price is $2250 per share?
.
– What is the NPV of participating in the IPO for investors?

• Example:
– Now suppose that 50,000 investors are better informed than the other 100,000 investors.
– You are among the informed!!!
– In particular suppose you already know the demand for
SmartPhone’s product at the time of the IPO.
– How much would you be willing to pay for 10 shares of
SmartPhone?
.

• Example:
– Now lets ask again….for the uniformed investors….is it a good investment to subscribe for the IPO at the issue price of $2250 per share?
.

• Example:
– At what price should the IPO shares be issued if they are to sell completely to the public?

• Example:
– What are the revenues for the issuing firm under the issuing price?
.
– What is the NPV of participating in the IPO for informed and uninformed investors?

The bidder that binds the highest has a higher valuation than all other bidders and might be wrong in his valuation…especially when others are better informed

– Asymmetric information between investors leads to lower IPO prices
– Informed investors participate only when the IPO is underpriced
– Uninformed investors always participate but do not lose money on average
– The issuing firm looses money when some investors are better informed than others