Why Do Firms Go Public Welch and Ritter 2002

1
Why Do Firms Go Public? Welch and Ritter (2002)

• Desire to raise capital for a growing firm.
• Create liquidity for founders and other
  shareholders.
• Questions
• Why are IPOs the best way to raise capital?
• Why are these reasons stronger in some times than
  others?
• Welch and Ritter (2002) Table 1

2
Why Do Firms Go Public? Welch and Ritter (2002)

• Life Cycle Theories
• Zingales (1995) For a potential acquiror, public
  targets are easier to spot than private targets.
  Entrepreneurs can facilitate the acquisition of
  their company for a higher value after the IPO.
• Black and Gilson (1998) In VC-backed companies,
  entrepreneurs often regain control of the company
  from the VC.

3
Why Do Firms Go Public? Welch and Ritter (2002)

• Life Cycle Theories
• Chemmanur and Fulghieri (1999)
• To allow for greater dispersion of ownership.
  Pre-IPO angel investors and VCs hold
  undiversified portfolios (hence, bear systematic
  and unsystematic risk) and, therefore, are not
  willing to pay as high a price as diversified
  public-market investors.
• Fixed costs of going public.
• Early in its lifecycle a firm will be private. As
  it grows and faces profitable investment
  opportunities, the costs of going public are
  worth incurring.
• Public trading can itself add value to the firm
  as it inspires confidence from investors,
  customers, suppliers, and employees.
• IPO capital allows for first-mover
  advantages.(1998-99 IPOs)

4
Why Do Firms Go Public? Welch and Ritter (2002)

• Market-Timing Theories
• Lucas and McDonald (1990) Asymmetric information
  model firms postpone (seasoned) equity issue if
  they know they are currently undervalued. If
  there are common misvaluations, aggregate issue
  volume will increase following bull markets.
• Schultz (2000) Markets provide valuable
  information to entrepreneurs. Higher prices
  signal higher growth opportunities.
• Welch and Ritter (2002) propose a semi-rational
  theory without asymmetric information to explain
  increased IPO volume following bull markets
  Entrepreneurs sense of value derives more from
  their operations perspective and underlying
  business fundamentals than from public markets.

5
IPO Underpricing Welch and Ritter (2002)

• http//www.hoovers.com
• IPO Central
• Table 1
• Average First-day Return
• 1980-1989 7.4
• 1990-1994 11.2
• 1995-1998 18.1
• 1999-2000 65.0
• 14.0
• Expected return on a U.S. stock on any given day
• 12 / 240 trading days
• 0.05
• Why are IPOs underpriced?

6
IPO Underpricing Welch and Ritter (2002)

• Why are IPOs underpriced?
• Theories Based on Asymmetric Information
• I.A. Issuer is more informed than investor
• High-quality issuers deliberately underprice
  their shares to signal their high quality. With
  some patience, these issuers can recoup their
  upfront sacrifice post-IPO through future issuing
  activity or analyst coverage. (Question Why is
  IPO underpricing a more efficient signal than,
  say, charitable donations or advertising?)

High Quality Issuer
Share Price
Low Quality Issuer
Months
Offer Day
7
IPO Underpricing Welch and Ritter (2002)

• Why are IPOs underpriced?
• Theories Based on Asymmetric Information
• I.A. Issuer is more informed than investor
• High-quality issuers deliberately underprice
  their shares to signal their high quality. With
  some patience, these issuers can recoup their
  upfront sacrifice post-IPO through future issuing
  activity or analyst coverage. (Question Why is
  IPO underpricing a more efficient signal than,
  say, charitable donations or advertising?)
• Evidence Welch (1989) provides some support.
  Jegadeesh, Weinstein, and Welch (1993) A high
  return on the IPO date and the two subsequent
  months implies that the issuer has underestimated
  the quality of their projects hence, the issuer
  will need additional funds in the future to grow.
  Jegadeesh, Weinstein, and Welch (1993) find that
  the return in the two subsequent months is more
  strongly (compared to IPO date return) related to
  the probability and timing of subsequent seasoned
  equity offerings.

8

• Why are IPOs underpriced?
• Theories Based on Asymmetric Information
• I.B. Investors are more informed than issuer
• Rock (1986), Beatty Ritter (1986), Beatty,
  Riffe and Thompson (2000)
•  
• The theory (story) While most IPOs are
  underpriced, a few are overpriced. Hence, an
  investor submitting a purchase order cannot be
  certain about the offerings value once it starts
  trading.
• Testable implication Greater the uncertainty
  about the true value of the IPO, greater the
  underpricing.
•  
• Shares to be issued 100.
• True price 10.
•  
• Assume (1) Informed investors do not have
  sufficient wealth to purchase all shares of all
  firms wishing to go public.
• (2) If demand gt 100 shares, pro-rata
  distribution.

9

• Why are IPOs underpriced?
• Theories Based on Asymmetric Information
• I.B. Investors are more informed than issuer
• Offer Price Informed Uninformed
•  
• 12 (overpriced)
• Shares demanded 0 100
• Shares supplied 0 100
• Gain / Loss 0 (10-12)100 -200
•  
• 8 (underpriced)
• Shares demanded 100 100
• Shares supplied 50 50
• Gain / Loss (10-8)50 (10-8)50
• 100 100

10

• Why are IPOs underpriced?
• Theories Based on Asymmetric Information
• I.B. Investors are more informed than issuer
• Correct Pricing, on average.
•  
• 4 offerings 2 underpriced, 2 overpriced.
• Gain/Loss to informed 2(100) 2(0) 200
• Gain/Loss to uninformed 2(100) 2(-200)
  -200
•  
• Hence, uninformed will not participate in the IPO
  market.
•  
•  
• Underpricing, on average.
•  
• 4 offerings 3 underpriced, 1 overpriced.
• Gain/Loss to informed 3(100) 1(0) 300

11

• Why are IPOs underpriced?
• Theories Based on Asymmetric Information
• I.B. Investors are more informed than issuer
• Fly in the ointment If informed are making
  abnormal profits then over time they should have
  sufficient wealth to purchase all shares of all
  firms wishing to go public.
• Perhaps a different set of investors are the
  informed investors for different IPOs depending
  on the industry of the IPO.
•  
• Empirical evidence is consistent with the above
  model Beatty, Riffe and Thompson (2000) find
  that IPOs for which there is greater uncertainty
  about their value are underpriced more.
  Additionally, underwriters that underprice too
  much or too little lose their market share.

12

• Why are IPOs underpriced?
• Theories Based on Asymmetric Information
• I.B. Investors are more informed than issuer
• Book-Building Theory/Story
• In the preliminary IPO prospectus underwriters
  note the range for the future offer price.
  Underwriters then canvass potential investors
  regarding their demand for the IPO shares.
  Underwriters seem reluctant to fully adjust their
  pricing upward to keep IPO underpricing constant.
  When underwriters revise the share price upward
  from the original range, underpricing tends to be
  higher. Perhaps this extra underpricing is
  necessary to induce investors to reveal their
  high demand for the IPO shares.
• Table 3
• Mean first-day return when offer price is below
  range 3.3
• Mean first-day return when offer price is within
  range 12.0
• Mean first-day return when offer price is above
  range 52.7

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Why are IPOs underpriced? II. Theories Based on
Symmetric Information Tinic (1988) and Hughes
and Thakor (1992) argue that issuers underprice
to reduce their legal liability. But Drake and
Vetsuypens (1993) find that underpricing did not
protect firms from being sued. Boehmer
and Fishe (2001) note that trading volume in the
aftermarket is higher, greater the underpricing.
But How does the issuing firm benefit from
underpricing unless the increased liquidity is
persistent?
Share Price
Lawsuit less likely
Lawsuit more likely
Months
14
Why are IPOs underpriced? III. Theories Focusing
on Allocation of Shares If IPOs are underpriced
on average, then the opportunity to purchase them
at the offering price would be quite attractive.
Table 1 1999-2000 65 return on the first
day! Underwriters have the opportunity to
allocate such underpriced shares to their
preferred customers. How does one become a
preferred customer? Provide underwriter with
economic benefits (other business). Provide
underwriter with political benefits.
15
Selling Out to Public Firms vs.
IPOsPoulsen-Stegemoller (2006)

• Determinants of the Choice between Selling Out to
  Public Firms vs. IPOs
• A. Growth and the Need for Capital
• IPO Private firm raises public capital and
  allocates it to projects the managers deem most
  worthy.
• Sellout Capital allocated by managers of
  acquiring company. Sellout firm has to compete
  with other divisions of the acquiring company for
  new capital.
• Companies with greater growth potential more
  likely to go public through an IPO.

16
Selling Out to Public Firms vs.
IPOsPoulsen-Stegemoller (2006)

• Determinants of the Choice between Selling Out to
  Public Firms vs. IPOs
• A. Growth and the Need for Capital
• Companies with greater growth potential more
  likely to go public through an IPO.
• Proxies for growth
• Increase in assets, capital expenditures,
  revenues over the past year.
• Capital expenditure / Assets,
• RD / Assets,
• Market value of assets / Book value of assets.
• (Market Book Growth Opportunities.
• Market / Book 1 Growth Opportunities.)

17
Selling Out to Public Firms vs.
IPOsPoulsen-Stegemoller (2006)

• Determinants of the Choice between Selling Out to
  Public Firms vs. IPOs
• A. Growth and the Need for Capital
• Companies with greater growth potential more
  likely to go public through an IPO.
• Myers (1984) Underinvestment Problem With risky
  debt outstanding, shareholders will sometimes
  pass up positive NPV projects.
• Companies that have
• lots of growth opportunities,
• have some debt, and
• cash constrained
• are more likely to do an IPO to gain access to
  equity capital.

18
Selling Out to Public Firms vs.
IPOsPoulsen-Stegemoller (2006)

• Determinants of the Choice between Selling Out to
  Public Firms vs. IPOs
• B. Asymmetric Information
• IPOs offered by investment bankers to mostly
  mutual/pension funds.
• Investment bankers and mutual/pension fund
  managers may not be able to value the assets of a
  private company as well as
• Another company in the same industry.
• Additionally, firm-specific information may
  retain its value only when it is not accessible
  to outside competitors.

19
Selling Out to Public Firms vs.
IPOsPoulsen-Stegemoller (2006)

• Determinants of the Choice between Selling Out to
  Public Firms vs. IPOs
• B. Asymmetric Information
• Investment bankers and mutual/pension fund
  managers may not be able to value the assets of a
  private company as well as
• Another company in the same industry.
• What type of companies may be more difficult to
  value?
• More intangible assets.
• Less developed.
• Smaller.
• Less profitable.
• No VC backing.