Initial Public Offerings

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Initial Public Offerings
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The firms choices to raise equity financing

• The firms choices of equity financing depend on
  its size, its life cycle stage, and its growth
  prospects
• The firms choices include
• Venture capital/Private equity
• Private issue of securities (sale to fewer than
  35 investors)
• Public issue of securities
• The first public issue of equity is called an
  Initial Public Offering (IPO)
• New issues of equity for firms that have
  previously issued equity are called Seasoned
  Equity Offerings (SEO)

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• There are two types of public equity issues
• A general cash offer is the issue of securities
  offered for sale to investors
• A rights offer is a public issue of equity where
  securities are first offered to existing
  stockholders
• Rights offers are common in other countries, but
  not in the US, especially in recent years

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Why do private firms decide to go public?

• Private firms that have experienced growth and
  have established a position in their market will
  then consider making the transition to a public
  firm through an IPO
• Any firm must weight the benefits and costs of
  going public before deciding to proceed with an
  IPO
• Often times, the decision is forced by a lack of
  other financing choices or pressure from venture
  capitalists who desire to liquidate their
  investments

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Benefits and costs of going public

• Benefits of going public
• Firm has access to a larger supply of capital
• Firms owners can obtain a market value for their
  share of ownership
• Firms owners can share risks with other
  investors
• Diversification among public investors may also
  result in lower cost of capital for the firm
• Some firms may decide to raise equity in order to
  reduce their amount of debt

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• Costs of going public
• Loss of control for current owners
• Public firms are subject to more disclosure
  requirements
• Information on the firms financial health and
  business strategy becomes publicly available
• The firm must face the direct and indirect costs
  of issuing equity
• The firm must face the cost of underpricing in
  IPOs

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Types of IPOs

• A large firm going public to raise funds to use
  in acquisitions and compensation (e.g., UPS,
  Goldman Sachs)
• A spin-off from an already publicly-traded firm
  (e.g., Agilent from HP, Lucent from ATT, Palm
  from 3-Com, Kraft from Philip Morris)
• A young firm seeking funds to expand (e.g.,
  Netscape, Pets.com)

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Recent IPO trends

• About 400-500 non-financial U.S. firms have gone
  public each year from 1994-2000, but only 83 in
  2001, 70 in 2002, and 68 in 2003
• Numbers have been rising 216 in 2004, 194 in
  2005
• All time Biggest U.S. IPOs
• ATT Wireless Group 10.6 B 4/00
• Kraft Foods 8.7 B 6/01
• UPS 5.5 B 11/99
• Highest first-day price increases
• VA Linux Systems 698 12/99
• theglobe.com 606 11/98

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Best and worst IPO performers in last 12 months
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The IPO process Main participants and their
interests

• The main participants in the IPO process are
• The issuing firm (the firm that goes public)
• The IPO underwriters
• The IPO marketer
• The regulatory agency (SEC)
• Participants are faced with risks and there may
  also be conflicts of interest among them
• Before we discuss these issues, we examine the
  steps of the IPO process

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Steps in the IPO process

• The firm selects the underwriter, typically an
  established investment bank, that will provide
  several services related to the IPO process
• The underwriter will
• Provide financial and procedural advice
• Assist with the regulatory procedures of the IPO
• Time the offer to occur under favorable market
  conditions
• Price the firms shares
• Either purchase the entire equity issue or act as
  a broker to sell the issue to the public
• Provide aftermarket price support in early
  secondary market trading

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• The main underwriter may choose to share the
  risks of the IPO process by forming a group with
  other underwriters called a syndicate
• The issuing firm has two choices of selling its
  shares
• In a firm commitment underwriting, the issuer
  sells the entire stock to the underwriter who
  then attempts to sell it to the public
• In a best efforts underwriting, the underwriter
  makes no promise about the price, but instead
  promises to make the best effort to sell the
  equity at the best agreed upon price

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• Underwriters are paid for their services through
  the underwriter or gross spread, which is the
  difference between the price that the underwriter
  pays for the shares and the price that these are
  offered to investors
• Underwriters may also have the option to purchase
  additional shares from the issuing firm if the
  IPO is oversubscribed, which is called the green
  shoe provision (or overallotment option)

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Underwriting activity in 2001(Global debt and
equity issues bn)
Source WSJ
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• A registration statement is filed with the SEC
  that gives info on the proposed offering, firm
  history, financials, existing business, and
  future plans
• During the period that the SEC examines the
  registration statement (20 days), the firm can
  distribute a preliminary prospectus, called red
  herring
• The firm conducts a road show to talk to
  potential investors and size up demand for the
  issue called building the book

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• A major part of the IPO process is the valuation
  of the issuing firms shares
• One approach is to do a DCF valuation, but
  typically the underwriter will perform a
  multiples valuation
• Identify a peer group of publicly traded firms
• Use multiples (P/E ratio, market-to-book ratio,
  etc.) to obtain a range of valuations

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Risks and conflicts of interest among IPO
participants

• The issuing firm and the underwriter are faced
  with risks during the IPO process and they also
  may have conflicting interests
• The issuer would like to raise as much capital as
  possible at the lowest cost to the current owners
  and thus would benefit by selling the shares at a
  higher price
• The issuer must weigh the benefits of a high IPO
  price against the potential cost of a cold
  reception by investors

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• The underwriter plays the role of the
  intermediary between the issuer and the investors
  who would buy the new shares
• The underwriter also absorbs the risk of selling
  the new shares by purchasing them from the issuer
  and selling them to the public
• Given its intermediary role, the underwriter is
  faced with the difficult task of pleasing both
  the issuer and investors
• Therefore, an important part of the IPO process
  is that the underwriter collects and processes
  information about the issuer and values the
  issuers shares

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The underpricing of IPOs

• The issuer in the IPO is faced with a tradeoff
• If the offering price is too high, investors may
  not purchase the offer and the IPO will not be
  successful
• If the offering price is too low, the firms
  existing owners will incur a loss given that they
  sell their shares at a price below their true
  value
• Evidence shows that on the first day of trading
  of new stocks, the stocks price rises
  significantly above the issue price
• This implies that there is considerable
  underpricing in IPOs

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• Evidence on underpricing of IPOs shows that the
  average underspricing in the US market was
• 21.2 in the 1960s
• 9 in the 1970s
• 6.9 in the 1980s
• 20.9 in the 1990s
• There also exist cycles in both the degree of
  underpricing and the number of IPOs, and new
  offerings tend to follow periods of significant
  underpricing by roughly 6 months

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IPO underpricing around the world
Source Jay Ritters web page
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Possible explanations of IPO underpricing

• Possible explanations of IPO underpricing are the
  following
• The underwriter wants to please investors and
  would like to avoid any risk from being sued
  because of evidence of overpricing
• Winners curse Under-pricing compensates
  uninformed investors for potential losses due to
  asymmetric information
• Underwriters want to be sure offering is fully
  subscribed (sufficient demand for shares) and
  that clients are pleased quid pro quos