• Financing new ideas
• Venture capital
• Initial Public Offering
• Why issue equity publicly
• IPO process
• Underpricing puzzle
• Long-run performance of IPOs
• Other IPO/Divestiture methods
1

• Personal savings
• Bank, but not likely to work
• Government but a very limited resources
• Large industrial companies
• Venture Capital Funds
– Mostly organized as private partnerships
– Need to prepare a business plan for funding
– They invest in stages to control risk
– They require board representation and get shares
2

• http://www.ventureeconomics.com/
• http://www.nvca.org/
Fund Type
Early/Seed VC
Balanced VC
Later Stage VC
All Venture
Small Buyouts
Med Buyouts
Large Buyouts
Mega Buyouts
All Buyouts
Mezzanine
All Private Equity
NASDAQ
S & P 500
Venture Economics' US Private Equity Performance Index (PEPI)
Investment Horizon Performance through 06/30/2004
1 Yr 3 Y 5 Yr 10 Yr
-2.00
11.90
18.70
-18.30
-8.00
-7.00
25.70
13.20
4.60
39.80
21.40
16.80
7.40
14.70
14.20
19.30
26.30
23.70
13.70
18.80
26.20
17.10
-12.20
-1.20
-0.60
4.20
2.40
2.20
1.40
-2.00
-1.90
-2.30
14.40
1.00
4.10
4.10
2.90
3.10
5.20
5.70
-5.30
-3.60
26.70
8.70
10.20
10.50
7.30
8.50
7.40
12.90
11.20
9.90
20 Yr
19.10
13.60
13.80
15.60
27.20
17.80
14.20
9.10
12.70
9.50
13.70
13.20
13.50
3
Source: Thomson Venture Economics/National Venture Capital Association

• If idea is successful then more money can be raised through an IPO
• IPO also allows venture capital to exit the investment
Historical IPO Activity
700
600
500
400
300
200
100
0
Years 4

• Demand-side explanation suggests that start-up firms with good projects cannot get private funding and they use IPO for raising capital - internet firms during 95-98
• Supply-side explanation suggests that during some time periods investors and institutions that invest in IPOs have excess funds to invest
5

• A time period with a lot of IPOs is called “hot issue period”
• If a hot issue period is driven by supply-side then it may be advantageous for a new firm to go public
• If a hot issue period is driven by demand for funds then a new firm may be better off delaying to go public - competition for funds
6

Advantages
1. Access to capital markets
2. Improved liquidity for shareholders
3. Allowing original owners to diversify
4. Monitoring by external capital markets
5. Information provided by capital markets
6. Enhanced credibility with stakeholders
Disadvantages
1. Expensive
2. Costs of dealing with shareholders
3. Allowing competitiors gain information
4. Public pressure
7

• Underwriter Selection
• Registration
• Marketing and Book Building
• Pricing
• After Market Activities
8

• Factors to consider:
– Investment banker’s general reputation and expertise
– Quality of its research coverage
– Investment bank’s distribution expertise - individual or institutional
– Prior banking relationships
• The most common underwriting arrangement is the “firm commitment”
• In this case the underwriter purchases all issued securities and then resells them to the public - price differential is called the “gross spread”
9

• The lead manager plays the major role in the
IPO - scheduling, pricing, distribution of new issue, and assembling a group of underwriters to sell shares to the public
• The syndicate members are paid a portion of the gross spread for their participation - 60% of the gross spread
• The lead underwriter receives a fee for its efforts that is typically 20% of the gross spread
10

• Letter of intent
– The letter of intent protects the underwriter against expenses if the offer is withdrawn
– The letter of intent obligates the company to reimburse the underwriter
– It also specify the gross spread
– In most cases, the gross spread is 7% of the proceeds
– It also includes clauses on:
• Underwriter’s firm commitment
• Cooperation by the company
• Releasing of all available relevant information
• Commitment by the private firm to grant 15% overallotment option to the underwriter
– Letter of intent is in effect until Underwriting Agreement is signed at pricing of the issue
11

• The Securities Act of 1933 (Section 5) requires a registration statement to be filed with the SEC
• The registration statement consists of two parts
– The prospectus to be given to every purchaser of the securities
– “Part II” which contains information that need not be furnished to the public but is made available for public inspection by the SEC
• The registration statement allows public to obtain information about the issue
• The underwriter has a “due diligence” requirement to verify the information
• The Securities Act also makes it illegal to offer or sell securities to the public without registration
• The SEC has no authority to block a public offering based on the quality of the securities involved. It can require the issuer to provide all material facts
• The registration statement has to be signed by directors and principal officers of the issuer, the underwriters, accountants, appraisers and other experts registration statement may sue these signatories

• Once it is filed the registration statement is transformed into the preliminary prospectus or “Red
Herring”
• The preliminary prospectus is used to market the issue
• The SEC has 20 days to declare the issue effective
• At that point the red herring becomes a prospectus
• The company and the underwriter promote the IPO through the “road show”
• Road shows provide important monitoring for the underwriter on investor demand
13

• During the road shows the underwriter receives orders from individual and institutional investors - book building
– Retail investors typically submit a “market order” in which only the quantity desired is stated
– Institutions typically submit limit orders where the quantity demanded is subject to a maximum price
– Retail orders are received earlier than institutional orders since institutions prefer to wait to a later stage of the process before submitting their orders
– Institutions submit an order with a commitment to purchase more shares in the open market if their order is fulfilled
14

• Once the registration statement is approved by the
SEC then two most important items have to be determined:
– offer price
– the number of shares to be sold
• Book building at this stage is very important to gauge the investor demand
• Some suggest that an IPO may be successful if it is three times oversubscribed
15

• Ritter (1991) on IPO pricing suggests that IPOs are “under-priced” – meaning that you can make money buy buying stocks from an underwriter and selling them in the market once public trading starts
• Flipping – dumping of shares as soon as trading starts – is discouraged by the underwriters, but it is not easy to control
16

Percentage average first-day returns
120
100
80
60
40
20
0
-20
-40
1960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000
Year
17

80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
IPO Underpricing
Years
18

$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$0
Aggregate Money Left on the Table, millions
Years
19

• If an issue is too low then the issuing firm’s owners will not like bearing the additional cost of going public
• If an issue is priced too high then the underwriter is stuck with shares plus a bad reputation
• The underwriter is to balance between the tow extreme
– Underpricing allows the underwriter to sell shares of the firm easily
– It reduces the possibility of lawsuits 20

• Assume that average investor is not informed well on the quality of an issue
• The uninformed investor faces a “winner’s curse” that is if you bid in an auction and you end up with the item you most likely over bid
• Underwriters know that most average investors cannot distinguish between good and bad issues and to keep uninformed investors interested they underprice
• Otherwise uninformed investors would not play the game for long reducing the demand for the issue - bad for the underwriter
21

• Stabilization activities by the underwriter:
– These involve trading by the underwriter to support the stock by buying shares if order imbalances arise
– This price support can be done only at or below the offering price
– The standard prohibitions against price manipulation do not apply to the underwriter during this period
• The final stage of the IPO begins 25 calendar days after the IPO when the so called “quiet period” ends
• During the “quiet period” investors rely on prospectus
• After the “quiet period” underwriters can comment on the valuation and provide earnings estimates on the new company
22

Year
1988
1989
1990
1991
1992
1993
1994
1995
1980
1981
1982
1983
1984
1985
1986
1987
1996
1997
1998
1999
2000
Average 3-year Buy-and-Hold Return
Market Size and Book-to-
IPOs Adjusted Market Adjusted
88.20%
12.80%
32.20%
15.40%
27.70%
7.60%
18.60%
-1.80%
55.70%
51.10%
12.20%
31.50%
34.80%
44.90%
74.10%
24.80%
25.60%
67.70%
27.10%
-46.20%
-64.70%
35.50%
-26.20%
-36.50%
-38.70%
-51.30%
-39.50%
-20.40%
-18.90%
8.30%
16.80%
-34.10%
-1.70%
-2.30%
-7.80%
-8.30%
-62.30%
-57.00%
6.80%
9.10%
-32.90%
-36.40%
8.60%
41.00%
12.20%
-74.20%
-42.60%
17.10%
-7.40%
-48.70%
2.50%
3.00%
7.30%
14.30%
4.50%
51.30%
32.50%
-32.40%
5.80%
-19.40%
-23.90%
1.00%
-14.10%
Periods
1980-1989
1990-1994
1995-1998
1999-2000
Average 3-year Buy-and-Hold Return
Market Size and Book-to-
IPOs
20.80%
Adjusted
-24.70%
Market Adjusted
6.90%
44.70%
36.00%
-53.80%
-7.20%
-32.30%
-34.30%
-12.70%
11.60%
-61.20%
23

Average 3-year Buy-and-Hold Return
Market Size and Book-to-
IPOs Adjusted Market Adjusted
Correlation with # of
IPOS
Correlation with First Day
Return
-0.21
-0.67
-0.34
-0.18
-0.18
-0.64
24

• Spin-off: a company gives the shares of a subsidiary to its own shareholders
• Shareholders can then sell their shares in the market
• Shareholders are not subject to taxes if 80% of the subsidiary stock is distributed
• Miles and Rosenfeld (1983) find an abnormal return of +3.34% to parent firms over days (0,
+1) around the announcement
25

• Eliminate negative synergies
• Increases focus
• Improves managerial compensation contract design
• Reduces the possibility of unprofitable business lines being supported by profitable ones
26

• Sell-off: a parent firm sells the assets of a subsidiary to another firm
• Signaling effect is different depending on why assets are sold
– If firm is refocusing its investments then it may be good news
– If assets are sold to raise cash to pay down debt then it may be bad news
• Capital gains tax would be paid
• Rosenfeld (1984) finds an abnormal return of +2.21% over days (0,+1)
27

• Carve-out: shares of a subsidiary are sold to general public through an IPO
• The parent usually maintains the control
– Funds that are made available for the subsidiary can be invested for positive NPV projects
– Reduced asymmetric information improves the value of subsidiary
– Improved managerial compensation
• Allen and McConnel (1998) find an abnormal return of +1.9% over days (-1,+1), but if the parent indicates special dividend payment or debt reduction with the proceeds then abnormal return is +6.63%
• In other cases the abnormal returns is close to zero
28

• Muscarella and Vetsuypens, 1989, A simple test of Baron’s Model of IPO Underpricing,
Journal of Financial Economics 24, 125-135.
• SSRN-Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and
Allocations" (February 2002). Yale ICF Working Paper No. 02-01. http://ssrn.com/abstract=296393
•
JSTOR-Why Do Companies Go Public? An Empirical Analysis, Marco Pagano; Fabio
Panetta; Luigi Zingales, The Journal of Finance, Vol. 53, No. 1. (Feb., 1998), pp. 27-64.
• URL: http://links.jstor.org/sici?sici=0022-
1082%28199802%2953%3A1%3C27%3AWDCGPA%3E2.0.CO%3B2-Z
• JSTOR-Equity Carve-Outs and Managerial Discretion, Jeffrey W. Allen; John J.
McConnell, The Journal of Finance, Vol. 53, No. 1. (Feb., 1998), pp. 163-186.
•
URL: http://links.jstor.org/sici?sici=0022-
1082%28199802%2953%3A1%3C163%3AECAMD%3E2.0.CO%3B2-W
29

•
JSTOR-Additional Evidence on the Relation Between Divestiture Announcements and
Shareholder Wealth, James D. Rosenfeld,The Journal of Finance, Vol. 39, No. 5. (Dec.,
1984), pp. 1437-1448.
•
URL: http://links.jstor.org/sici?sici=0022-
1082%28198412%2939%3A5%3C1437%3AAEOTRB%3E2.0.CO%3B2-1
•
JSTOR-The Effect of Voluntary Spin-off Announcements on Shareholder Wealth, James
A. Miles; James D. Rosenfeld, The Journal of Finance, Vol. 38, No. 5. (Dec., 1983), pp.
1597-1606.
•
URL: http://links.jstor.org/sici?sici=0022-
1082%28198312%2938%3A5%3C1597%3ATEOVSA%3E2.0.CO%3B2-0
•
JSTOR-The Long-Run Performance of Initial Public Offerings, Jay R. Ritter, The Journal of Finance, Vol. 46, No. 1. (Mar., 1991), pp. 3-27.
• URL: http://links.jstor.org/sici?sici=0022-
1082%28199103%2946%3A1%3C3%3ATLPOIP%3E2.0.CO%3B2-9
30