Initial Public Offerings

1
Initial Public Offerings

• Private and Public companies
• Private (privately held) companies have fewer
  shareholders and their shares are NOT freely
  traded
• Public (publicly held) companies have their
  shares traded publicly on a stock exchange
  without restrictions, they have large number of
  shareholders
• Private companies are usually smaller (but think
  of IKEA, Mittal Steel (Ispat International) until
  1997)
• Public companies are subject to much stricter
  rules and regulations (e.g. disclosure, financial
  reporting), must have a board of directors
• IPO is the first sale of stock by a company to
  the public.

2
A bit on the mechanics of IPO

• 3 players
• Issuer
• Investment Bank (Underwriter)
• Investors
• Issuer supply audited financial statements and
  prepare a prospectus (details of the company)
• Investment Bank conducts a due diligence
  investigation and helps to price and place the
  offer
• Road Show presentation of securities to
  potential buyers (mainly institutional investors)

3
Reasons for Going Public(see Röell (1996))

• New Finance
• Direct. Funds raised at IPO
• Indirect. Helps to raise funds in the future
• Reduction in leverage (mitigates debt overhang
  and other problems of debt). But why not private
  placement? ??
• Increase in liquidity of stock and
  diversification.
• Liquidity is valuable per se, but in addition it
  helps to raise funds in the future (more precise
  information about a firms value helps to attract
  finance)
• Increased competition among suppliers of finance

4
Reasons for Going Public (cont-d)

• Greater dispersion of ownership mitigates the
  problem of overmonitoring of managers by
  shareholders (will be discussed in detail at the
  end)
• Enhanced company image and publicity
• Visibility of the company and its products
• Motivating management and employees
• E.g. through conditioning compensation on the
  stock price (stock-based compensation)
• Cashing in
• Exploiting mispricing
• Timing issues to take advantage of swings in
  investor sentiment
• Other benefits (unexpected side effects)
• Closer working relationships with professional
  advisers (esp. brokers)
• Formulation of a clearly defined strategy for
  growth
• Improved management and organizational and
  financial structure

5
Costs of Going Public

• Direct costs (underwriting, auditing and legal
  fees, effort)
• Cost of information disclosure
• Underpricing
• Cost of constraining business decisions
• Tax implications
• Greater transparency of accounts may lead to more
  taxes paid
• Danger of loss of control

6
Underpricing at IPO

• Widely documented phenomenon offering price is
  typically lower than the market price of the
  shares right after the IPO
• Ritter and Welch (2002), US data (but the same
  seems to be true for other countries too)
• In the sample of 6,249 IPOs from 1980 to 2001 the
  average first-day return is 18.8 percent.
• About 70 percent of the IPOs end the first day of
  trading at a closing price greater than the offer
  price and about 16 percent have a first-day
  return of zero.

7
Some Theories of Underpricing

• Theories based on asymmetric information
• Issuer is better informed than investors
  signaling by underpricing as a response to the
  lemons problem
• Good firms separate themselves from bad ones by
  offering underpriced stock
• Some investors are more informed than others and
  the issuer (e.g. about market demand for shares)
• Winners curse uninformed investors are afraid
  to buy unless the price is sufficiently low. If
  they buy, but informed investors dont, that
  means that they lose money and they do not share
  the losses with informed investors, because
  informed investors DONT buy exactly when the
  issue is overpriced.At the same time, the gains
  in case the issue is underpriced are shared with
  informed investors

8
Some Theories of Underpricing (cont-d)

• Underwriter is more informed than the issuer
• To exert better effort, he needs to be
  compensated for using his superior information by
  allowing to offer the issue at easier conditions,
  i.e. at lower price.
• Informational cascades
• An investor is looking at whether other investors
  are buying the shares. If there are sufficiently
  many others buying, he concludes that the stock
  is worth buying. If the initial price is too
  high, the firm risks that nobody will start
  buying the shares, hence no cascade will start
• Some other theories
• Avoiding legal liabilities (more relevant for the
  US).
• Drops in prices may trigger lawsuits. So its
  better to have a lower price from the start.
• Achieving greater liquidity through greater
  ownership dispersion

9
Decision to Go Public

• The decision to go public should be based on the
  comparison of the mentioned benefits and costs
  (direct and indirect) of doing an IPO
• Many models focusing on specific costs and
  benefits.
• In Corporate Finance II we will discuss Zingales
  (1995). In the presence of a prospective
  acquirer, going public first maximizes aggregate
  proceeds from selling a company.
• Today we will discuss Pagano and Röell (1998)

10
Key References

• Ritter (1998), Initial Public Offerings,
  bear.cba.ufl.edu/ritter/rittipo1.pdf
• Röell (1996), The Decision to Go Public An
  Overview, European Economic Review 40, pp.
  1071-1081
• Ritter and Welch (2002), A Review of IPO
  Activity, Pricing, and Allocations, Journal of
  Finance, August 2002, pp. 1795-1828
• Pagano and Röell (1998), The Choice of Stock
  Ownership Structure Agency Costs, Monitoring,
  and The Decision to Go Public, The Quarterly
  Journal of Economics, February 1998, pp. 187-225.