IPO :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION IPO


IPO :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION IPO Why issue public equity? Costs & Benefits of IPOs Why is there Underpricing? Hot Issues Markets


Why issue Public Equity? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why issue Public Equity? Lower cost of capital for the firm A “wealth constraint” prevents current owner-managers from financing a project Provide liquidity for current stockholders Shift monitoring costs from private lenders to external agency ( for ex. the Securities and Exchange Commission (S.E.C.) in USA) Firm can learn from the information contained in stock price movements Entrepreneurs regain control from venture capitalists when shares are distributes Signals stability and dependability to customers and suppliers


Why issue Public Equity? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why issue Public Equity? Lower the cost of capital for the firm One of the main lessons from portfolio theory is that risk reduction due to diversification lowers the risk (and required return) for stocks This won’t work is owner-manager has a large undiversified stake in the firm Amihud-Mendelson argument about lowering the cost of capital for the firm by reducing trading costs (increasing liquidity)


Why issue Public Equity? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why issue Public Equity? A “wealth constraint” (or lack of diversification) prevents current owner-managers from financing a project with NPV>0


Why issue Public Equity? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why issue Public Equity? Provide liquidity for current stockholders But if this were the only reason, the firm could register the securities and allow stockholders to sell some stock through a secondary offering with a primary offering: more cash comes to the company Shift monitoring costs from private lenders to an external agency (for ex: the S.E.C. ) If the costs of registration, filing, etc. are below the benefits?


Why issue Public Equity? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why issue Public Equity? By creating a public market for the stock, the firm can learn from the information contained in stock price movements (useful for incentive compensation for employees, feedback on management decisions, etc.) Creating a secondary trading market in the stock allows owner-managers to sell their stock in the future if they want consumption, liquidity, or diversification Usually have to wait from 6 month to 2 years after IPO – Rule 144 in USA but it depends on countries


Costs of Initial Public Offering(IPO) :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Initial Public Offering(IPO) Disclosure of propietary information May be helpful to competitors, other contracting parties Cost of reporting/filing with the institutional agency (S.E.C. for example) Largely fixed


Costs of an IPO :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of an IPO Costs of corporate control Outside stockholders can impose costs on managers if they feel that the firm is not being managed in the stockholders’ interests, even if they only represent a minority position e.g. Hugh Hefner, the majority stockholder of Playboy, was sued for having too many private benefits by outside minority shareholders


Costs of an IPO :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of an IPO Underpricing Ibboston (1975, JFE) found average abnormal returns in the first month after the IPO (starting at the IPO price) of 11.4% He also found that the beta for IPO stocks falls from about 2.0 in the first month after the IPO to a little over 1.0 five yeas after the IPO Beta:A measurement of the movement of the price of a particular stock compared with the movement of the market as a whole during the same period. Ritter (1984, JBus) found average underpricing of 18.8% in first month after issue (5000 offerings 1960-82)


Direct and Indirect costs of IPOs :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Direct and Indirect costs of IPOs


Step 1: selecting an underwriter :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Step 1: selecting an underwriter Criteria: Reputation of the analyst covering the firm Performance of past IPOs Not a criteria: fees! (7% of capital raised) Hi-tech IPOs are often underwritten by a consortium Technology specialist plus large underwriter, “bulge bracket”


Step 2: Tasks of the underwriter :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Step 2: Tasks of the underwriter Due Diligence (investigate value of firms) Determine the offering size Prepare the marketing material Prepare regulatory filings (S-1) together with the legal representation of the firm


Step 3: Marketing the Offering :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Step 3: Marketing the Offering “Red Herring”: Circulate a preliminary prospectus to potential investors Road-Show Book-building: Collect information about the demand from potential investors to set the price and size of the offering “Firm commitment offerings”: Investment bank commits to sell the shares at the set price


Step 4: The Offering :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Step 4: The Offering The underwriter buys the shares from the company at a fixed price and immediately sells it to investors at the IPO price “Green Shoe” option: Clause in the underwriter agreement specifying that in case of exceptional public demand the issuer will authorize additional shares for distribution by the underwriter at the offering price (usual is over-allotment option of 15%)


Step 5: Aftermarket activities :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Step 5: Aftermarket activities Short covering Underwriter shorts the stock prior to the IPO. If the share price rises after the IPO, underwriter uses over-allotment option to cover the short; if the price falls, it buys stocks in the market “Pure” stabilization bids Underwriter posts bid in the open market not exceeding the offer price Penalty bids Revoke selling concession if shares are “flipped”


Flipping and spinning :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Flipping and spinning Flipping: Investors that are allocated share in the IPO sell these at the first day of trading at a significant profit A way for investment banks to reward their institutional clients? Spinning: Underwriters offer shares in hot IPOs to executives in companies, whose business the bank is looking to attract


Empirical regularities :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Empirical regularities First-day underpricing Long-run under-performance IPO markets are very cyclical “Hot issue markets”


First day under-pricing :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION First day under-pricing On average the stock price jumps on the first day of trading From 1990 to 1998 companies left over $27 billion on the table The median firm has modest first day return, but a few firms have several hundreds percent This pattern is found in most developed capital markets


Average first-day returns of IPOs :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Average first-day returns of IPOs


First-day returns of IPOs (1990-1998) :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION First-day returns of IPOs (1990-1998)


Averatge first-day returns :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Averatge first-day returns


Money left on the table :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Money left on the table


Ibbotson (JFE, 1975):Abnormal returns to IPOs :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Ibbotson (JFE, 1975):Abnormal returns to IPOs Risk is high for early months of seasoning Falls to average levels after 4-5 years Abnormal returns are large in first month Much smaller (maybe negative?) after that


Why is there underpricing? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why is there underpricing? Compensation for underwriters Compensation for investors Selection bias Litigation insurance Marketing expense (for products and/or stocks) Hot Issues Markets


Why is there underpricing?1. Compensation for underwriters :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why is there underpricing?1. Compensation for underwriters Underwriters with “firm commitment” contracts: Guarantee a minimum price and number of shares sold to the issuing firm Underwriter bears risk that the IPO will not sell out at the offering price Underwriters feel an obligation to act as a market-maker for the stock after the IPO Don’t wait to be in the position of holding inventory of the stock if the price falls after the IPO.


Compensation for underwriters :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Compensation for underwriters Frequently told story: Underwriters provide som unmeasurable service to IPO firm (e.g. cheap consulting) Get underpricing in return


Why is there underpricing?2.Compensation for investors :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why is there underpricing?2.Compensation for investors Underwriters claim it is important to cultivate investors so that subsequent securities offerings will be successful i.e. “leave something on the table” so that buyers of the IPO will have an incentive to gamble on this unknown prospect


Why is there underpricing?3. Selection bias :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why is there underpricing?3. Selection bias Excess returns are mismeasured “favoured” customers get more of the best deals


Why is there underpricing?4. Litigation insurance :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why is there underpricing?4. Litigation insurance Both the underwriter and the firm face liability if the stock price drops after the IPO Entrepreneurial law firms representing the class of IPO purchasers are highly likely to file suit claiming a failure to disclose some types of bad news in the IPO prospectus In essence, the IPO also contains a put option give to the purchasers of the stock: the firm has to buy back the shares if they fall too much Underpricing reduces the cost of the put option


Why is there underpricing?4. Litigation insurance :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why is there underpricing?4. Litigation insurance Tinic (J Fin, 1988) studies underpricing before and after the 1933 Securities Act 33 Act created federal filing requirements Standardizes liability of underwriters and the issuing firms Lowered the costs of subsequent litigation Finds that underpricing is lower pre-1933 Consistent witht the litigation insurance argument Lowry and Shu (JFE 2002) find that firms more likely to be sued underprice more


Why is there underpricing?5. Marketing Expense :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why is there underpricing?5. Marketing Expense If an IPO is “hot” (big initial return & lots of after-market trading), it tends to get a lot of attention i the popular press It creates “awareness” advertising Front page “ads” on the WSJ are very expensive (they don’t sell them at any price) Bob Merton says that the long term demand for the company’s stock increases as more potential investors become aware of the stock This lowers their cost of learning Leads to a long term higher price for the stock But, it’s hard to imagine that this effect is permantents, i.e. is price permanently lower without underpricing at IPO?


Why is there underpricing?5. Marketing Expense :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why is there underpricing?5. Marketing Expense Demers and Lewellen (JFE, 2003) argue that after-market publicity also affects demand for the firm’s product/services They measure “hits” to web pages of internet stocks before and after IPOs Find that there is a significant increase in web traffic following a “successful” IPO i.e. when the initial return is high (underpricing)


Hot Issues MarketsIs Underpricing a Bubble? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Hot Issues MarketsIs Underpricing a Bubble? Jay Ritter looked at the “hot issue” market of 1980: Underpricing was greater if It is a startup company vs. one with past operating results (e.g. Indian Bingo) The after-market standard deviation is higher There was lots of underpricing in “penny stocks” in Denver in 1980 Inexperienced underwriters were underpricing


Hot Issues Markets :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Hot Issues Markets Ritter also found lots of variation in underpricing over time (“hot issues” markets) See his figs. 1&2 showing percent average initial returns and number of offerings per month It looks like underpricing leads issues, then when underpricing disappears, after a few months the new issues markets dry up (no more new issues)


IPOs with downward revisions have less under-pricing :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION IPOs with downward revisions have less under-pricing


IPOs with upward revisions have more under-pricing :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION IPOs with upward revisions have more under-pricing


Quiet Period :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Quiet Period During the first 25 days after the IPO the firm and its underwriters have to remain silent about the firm’s financial prospects Prevent insiders from “hyping up” the price After 25 days underwriters release their (usually favourable) reports about the firm On average stock price rises at the end of the quiet period


Lock-up Period :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Lock-up Period Underwriters require that initial pre-IPO shareholders do not sell their stock for a predetermined period (usually 180 days) Keep incentives aligned Prevent pressure on stock prices, if demand curves are downward sloping Stock price drops significantly after the expiration of the lock-up period


Long-run underperformance :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Long-run underperformance IPOs under-perform the market in the 5 years after the IPO Reasons: “Clientele effects”: Only optimistic investors buy into an IPO, but beliefs converge when more information is released about the firm “Window of opportunity”: Valuations of IPOs is subject to fads so issues try to go public in “hot markets”


Long-run under-performance :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Long-run under-performance


Long-run performance of VC-backed IPOs :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Long-run performance of VC-backed IPOs VC-backed IPOs show much less under-performance than non-VC-backed IPOs Relative to their industry benchmarks VC-backed IPOs have no under-performance VC are better able to time industry cycles? Most of the under-performance in the aggregate is driven by the smaller offerings


VC-backed IPOs :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION VC-backed IPOs


“Hot Issue” Markets :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION “Hot Issue” Markets High average initial IPO returns lead to higher volume in the IPO market Reasons Cycles in the quality and risk composition of firms that go public Correlation in the fund inflow of large money managers, but this cannot explain under-pricing “Animal spirits”


Number of IPOs from 1996 to 1999 :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Number of IPOs from 1996 to 1999


IPO Volume from 1996 to 1999 :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION IPO Volume from 1996 to 1999


IPOs Lower the Cost of Capital for the Firm :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION IPOs Lower the Cost of Capital for the Firm Risk reduction Increase Liquidity


Cost of Capital for Private Firm: Risk Reduction :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Cost of Capital for Private Firm: Risk Reduction Assume: Equity is held by entrepreneur Entrepreneur’s portfolio is not diversified Then the risk of returns to private equity is the variance of returns, not the beta, because the “residual risk” σ2(ei) cant’ be diversified away σ2(Ri)= βi2 σ2(Rm)+ σ2(ei)