On May 18, 2012, in a long-awaited initial public offering (IPO), social network Facebook went

public at a price of $38 per share. The stock price opened trading at $42.05 before quickly falling
back to $38. To the surprise of many, the stock closed at $38.23, barely unchanged from its IPO
price. Over the next few trading days, investors turned antisocial and unfriended the stock, sending
it tumbling to $32 per share. In contrast, when Twitter went public on November 7, 2013, at a price
of $26, investors went #crazy. The stock quickly jumped to a high of $50.09, before closing the first
day at $44.90. Then, on April 17, 2014, Chinese

social media platform Weibo went public at a price of $17. The stock price jumped to $20.24 at the
end of the day, a 19.1 percent increase.

Businesses large and small have one thing in common: They need long-term capital. This chapter
describes how they get it. We pay particular attention to what is prob- ably the most important
stage in a companys financial life cyclethe IPO. Such offerings are the process by which
companies convert from being privately owned to publicly owned. For many people, starting a
company, growing it, and taking it public is the ultimate entrepreneurial dream.

Thischapterexamineshowfirmsaccesscapitalintherealworld.Thefinancing
methodisgenerallytiedtothefirmslifecycle.Startupfirmsareoftenfinancedvia
venturecapital.Asfirmsgrow,theymaywanttogopublic.Afirmsfirstpublic
offeringiscalledanIPO,whichstandsforinitialpublicoffering.Laterofferingsare
calledSEOsforseasonedequityofferings.Thischapterfollowsthelifecycleofthe
firm,coveringventurecapital,IPOs,andSEOs.Debtfinancingisdiscussedtoward
theendofthechapter.

20.1EarlyStageFinancingandVentureCapital
Oneday,youandafriendhaveagreatideaforanewcomputersoftwareproductthat
willhelpuserscommunicateusingthenextgenerationmeganet.Filledwith
entrepreneurialzeal,youchristentheproductMegacommandsetaboutbringingitto
market.

Workingnightsandweekends,youareabletocreateaprototypeofyourproduct.It
doesntactuallywork,butatleastyoucanshowitaroundtoillustrateyouridea.To
actuallydeveloptheproduct,youneedtohireprogrammers,buycomputers,rent
officespace,andsoon.Unfortunately,becauseyouarebothMBAstudents,your
combinedassetsarenotsufficienttofundapizzaparty,muchlessastartupcompany.
YouneedwhatisoftenreferredtoasOPMotherpeoplesmoney.

Yourfirstthoughtmightbetoapproachabankforaloan.Youwouldprobably
discover,however,thatbanksaregenerallynotinterestedinmakingloanstostartup
companieswithnoassets(otherthananidea)runbyfledglingentrepreneurswithno
trackrecord.Insteadyousearchforothersourcesofcapital.

Onegroupofpotentialinvestorsgoesbythenameofangelinvestors,orjustangels.
Theymayjustbefriendsandfamily,withlittleknowledgeofyourproductsindustry
andlittleexperiencebackingstartupcompanies.However,someangelsaremore
 knowledgeableindividualsorgroupsofindividualswhohaveinvestedinanumberof
previousventures.

VENTURECAPITAL
Alternatively,youmightseekfundsintheventurecapital(VC)market.Whilethe
termventurecapitaldoesnothaveaprecisedefinition,itgenerallyreferstofinancing
fornew,oftenhighriskventures.Venturecapitalistssharesomecommon
characteristics,ofwhichthree1areparticularlyimportant:

1. VCsarefinancialintermediariesthatraisefundsfromoutsideinvestors.VCfirmsare
typicallyorganizedaslimitedpartnerships.Aswithanylimitedpartnership,limited
partnersinvestwiththegeneralpartner,whomakestheinvestmentdecisions.The
limitedpartnersarefrequentlyinstitutionalinvestors,suchaspensionplans,
endowments,andcorporations.Wealthyindividualsandfamiliesareoftenlimited
partnersaswell.ThischaracteristicseparatesVCsfromangels,sinceangelstypically
investjusttheirownmoney.Inaddition,corporationssometimessetupinternal
venturecapitaldivisionstofundfledglingfirms.However,MetrickandYasudapoint
outthat,sincethesedivisionsinvestthefundsoftheircorporateparent,ratherthanthe
fundsofothers,theyarenotinspiteoftheirnameventurecapitalists.

2. VCsplayanactiveroleinoverseeing,advising,andmonitoringthecompaniesinwhichthey
invest.Forexample,membersofventurecapitalfirmsfrequentlyjointheboardof
directors.TheprincipalsinVCfirmsaregenerallyquiteexperiencedinbusiness.By
contrast,whileentrepreneursatthehelmofstartupcompaniesmaybebright,
creative,andknowledgeableabouttheirproducts,theyoftenlackmuchbusiness
experience.

3. VCsgenerallydonotwanttoowntheinvestmentforever.Rather,VCslookforanexit
strategy,suchastakingtheinvestmentpublic(atopicwediscussinthenextsection)
orsellingittoanothercompany.Corporateventurecapitaldoesnotsharethis
characteristic,sincecorporationsarefrequentlycontenttohavetheinvestmentstayon
thebooksoftheinternalVCdivisionindefinitely.Thislastcharacteristicisquite
importantindeterminingthenatureoftypicalVC

investments.Afirmmustbeacertainsizetoeithergopublicorbeeasilysold.Since
theinvestmentisgenerallysmallinitially,itmustpossessgreatgrowthpotential;
manybusinessesdonot.Forexample,imagineanindividualwhowantstoopena
gourmetrestaurant.Iftheownerisatruefoodiewithnodesiretoexpandbeyond
onelocation,itisunlikelytherestaurantwilleverbecomelargeenoughtogopublic.
Bycontrast,firmsinhightechfieldsoftenhavesignificantgrowthpotentialandmany
VCfirmsspecializeinthisarea.Figure20.1showsVCinvestmentsbyindustry.As
canbeseen,alargepercentageoftheseinvestmentsareinhightechfields.

HowoftendoVCinvestmentshavesuccessfulexits?Whiledataonexitsaredifficult
 tocomeby,Figure20.2showsoutcomesformorethan11,000companiesfundedin
the1990s.Ascanbeseen,nearly50percent(514%133%)wentpublicorwere
acquired.However,theInternetbubblereacheditspeakinearly2000,sotheperiod
coveredinthetablemayhavebeenanunusualone.

STAGESOFFINANCING
Bothpractitionersandscholarsfrequentlyspeakofstagesinventurecapitalfinancing.
Wellknownclassificationsforthesestagesare2:

1.Seedmoneystage:Asmallamountoffinancingneededtoproveaconceptor
developaproduct.Marketingisnotincludedinthisstage.

2.Startup:Financingforfirmsthatstartedwithinthepastyear.Fundsarelikelyto
payformarketingandproductdevelopmentexpenditures.

4. Firstroundfinancing:Additionalmoneytobeginsalesandmanufacturingaftera
firmhasspentitsstartupfunds.

5. Secondroundfinancing:Fundsearmarkedforworkingcapitalforafirmthatiscur
rentlysellingitsproductbutstilllosingmoney.

6. Thirdroundfinancing:Financingforacompanythatisatleastbreakingevenandis
contemplatinganexpansion.Thisisalsoknownasmezzaninefinancing.

7. Fourthroundfinancing:Moneyprovidedforfirmsthatarelikelytogopublicwithin
halfayear.Thisroundisalsoknownasbridgefinancing.

Althoughthesecategoriesmayseemvaguetothereader,wehavefoundthattheterms
arewellacceptedwithintheindustry.Forexample,theventurecapitalfirmslistedin
PrattsGuidetoPrivateEquityandVentureCapitalSources3indicatewhichofthese
stagestheyareinterestedinfinancing.

Figure20.3showsventurecapitalinvestmentsbycompanystage.Theauthorsofthis
figureuseaslightlydifferentclassificationscheme.SeedandEarlyStagecorrespond
tothefirsttwostagesabove.LaterStageroughlycorrespondstoStages3and4above
andExpansionroughlycorrespondstoStages5and6above.Ascanbeseen,venture
capitalistsinvestlittleattheSeedstage.

SOMEVENTURECAPITALREALITIES
Althoughthereisalargeventurecapitalmarket,thetruthisthataccesstoventure
capitalisverylimited.Venturecapitalcompaniesreceivehugenumbersofunsolicited
proposals,thevastmajorityofwhichendupunreadinthecircularfile.Venture
capitalistsrelyheavilyoninformalnetworksoflawyers,accountants,bankers,and
otherventurecapitaliststohelpidentifypotentialinvestments.Asaresult,personal
contactsareimportantingainingaccesstotheventurecapitalmarket;itisverymuch
anintroductionmarket.

Anothersimplefactaboutventurecapitalisthatitisquiteexpensive.Inatypicaldeal,
theventurecapitalistwilldemand(andget)40percentormoreoftheequityinthe
company.Venturecapitalistsfrequentlyholdvotingpreferredstock,givingthem
variousprioritiesintheeventthecompanyissoldorliquidated.Theventurecapitalist
willtypicallydemand(andget)severalseatsonthecompanysboardofdirectors
andmayevenappointoneormoremembersofseniormanagement.

VENTURECAPITALINVESTMENTSAND
ECONOMICCONDITIONS
Venturecapitalinvestmentsarestronglyinfluencedbyeconomicconditions.Figure
20.4showscapitalcommitmentstoU.S.venturecapitalfirmsovertheperiodfrom
1985to2013.Commitmentswereessentiallyflatfrom1985to1993butroserapidly
duringtherestofthe1990s,reachingtheirpeakin2000beforefallingprecipitously.
Toalargeextent,thispatternmirroredtheInternetbubble,withpricesofhightech
stocksincreasingrapidlyinthelate1990s,beforefallingevenmorerapidlyin2000
and2001.Thisrelationshipbetweenventurecapitalactivityandeconomicconditions
continuedinlateryears.Commitmentsroseduringthebullmarketyearsbetween
2003and2006,beforedroppingfrom2007to2010intandemwiththemorerecent
economiccrisis.

20.2ThePublicIssue
Iffirmswishtoattractalargesetofinvestors,theywillissuepublicsecurities.There
arealotofregulationsforpublicissues,withperhapsthemostimportantestablished
inthe1930s.TheSecuritiesActof1933regulatesnewinterstatesecuritiesissuesand
theSecuritiesExchangeActof1934regulatessecuritiesthatarealreadyoutstanding.
TheSecuritiesandExchangeCommission(SEC)administersbothacts.

Thebasicstepsforissuingsecuritiesare:

1. Inanyissueofsecuritiestothepublic,managementmustfirstobtainapproval
fromtheboardofdirectors.
2. ThefirmmustpreparearegistrationstatementandfileitwiththeSEC.This
statementcontainsagreatdealoffinancialinformation,includingafinancial
history,detailsoftheexistingbusiness,proposedfinancing,andplansforthe
future.Itcaneasilyrunto50ormorepages.Thedocumentisrequiredforall
 publicissuesofsecuritieswithtwoprincipalexceptions:a.Loansthatmature
withinninemonths.b.Issuesthatinvolvelessthan$5million.
3. Thesecondexceptionisknownasthesmallissuesexemption.Issuesofless
than$5millionaregovernedbyRegulationA,forwhichonlyabriefoffering
statementratherthanthefullregistrationstatementisneeded.
4. TheSECstudiestheregistrationstatementduringawaitingperiod.Duringthis
time,thefirmmaydistributecopiesofapreliminaryprospectus.The
preliminaryprospectusiscalledaredherringbecauseboldredlettersare
printedonthecover.Aprospectuscontainsmuchoftheinformationputinto
theregistrationstatement,anditisgiventopotentialinvestorsbythefirm.The
companycannotsellthesecuritiesduringthewaitingperiod.However,oral
offerscanbemade.
5. Aregistrationstatementwillbecomeeffectiveonthe20thdayafteritsfiling
unlesstheSECsendsaletterofcommentsuggestingchanges.Afterthe
changesaremade,the20daywaitingperiodstartsanew.
6. Theregistrationstatementdoesnotinitiallycontainthepriceofthenewissue.
Ontheeffectivedateoftheregistrationstatement,apriceisdeterminedanda
fullfledgedsellingeffortgetsunderway.Afinalprospectusmustaccompany
thedeliveryofsecuritiesorconfirmationofsale,whichevercomesfirst.
7. Tombstoneadvertisementsareusedduringandafterthewaitingperiod.An
exampleisreproducedinFigure20.5.
8. Thetombstonecontainsthenameoftheissuer(theWorldWrestling
Federation,nowknownasWorldWrestlingEntertainment).Itprovidessome
informationabouttheissue,andliststheinvestmentbanks(theunderwriters)
involvedwithsellingtheissue.Theroleoftheinvestmentbanksinselling
securitiesisdiscussedmorefullyinthefollowingpages.
9. Theinvestmentbanksonthetombstonearedividedintogroupscalledbrackets
basedontheirparticipationintheissue,andthenamesofthebanksarelisted
alphabeticallywithineachbracket.Thebracketsareoftenviewedasakindof
peckingorder.Ingeneral,thehigherthebracket,thegreateristhe
underwritersprestige.Inrecentyears,theuseofprintedtombstoneshas
declined,inpartasacostsavingmeasure.

Crowdfunding
OnApril5,2012,theJOBSActwassignedintolaw.Aprovisionofthisact
allowedcompaniestoraisemoneythroughcrowdfunding,whichisthepractice
ofraisingsmallamountsofcapitalfromalargenumberofpeople,typicallyvia
theInternet.CrowdfundingwasfirstusedtounderwritetheU.S.tourofBritish
rockbandMarillion,buttheJOBSActallowscompaniestosellequityby
crowdfunding.Specifically,theJOBSActallowsacompanytoissueupto$1
millioninsecuritiesina12monthperiod,andinvestorsarepermittedtoinvest
upto$100,000incrowdfundingissuesper12months.Althoughcrowdfunding
hasbeenpassedintolaw,theSECmuststillsettherulesandregulationsfor
 thesenewexchanges.

20.3AlternativeIssueMethods
Whenacompanydecidestoissueanewsecurity,itcansellitasapublicissue
oraprivateissue.Ifitisapublicissue,thefirmisrequiredtoregistertheissue
withtheSEC.Iftheissueissoldtofewerthan35investors,itcanbetreatedas
aprivateissue.Aregistrationstatementisnotrequiredinthiscase. 4

Public
Traditional Companynegotiatesanagreementwithaninvestm
Firmcommitmentcashoffer
shares.Aspecifiednumberofsharesareboughtby
negotiatedcash
offer

Companyhasinvestmentbankerssellasmanyoft
Besteffortscashoffer
price.Thereisnoguaranteeconcerninghowmuc

Companyhasinvestmentbankersauctionsharesto
Dutchauctioncashoffer
givennumberofsharestobesold.

Privileged
Directrightsoffer Companyoffersthenewstockdirectlytoitsexisti
subscription

Likethedirectrightsoffer,thiscontainsaprivileg
Standbyrightsoffer
shareholders.Thenetproceedsareguaranteedbyt

Nontraditional Qualifyingcompaniescanauthorizealltheshares
Shelfcashoffer
cashoffer themwhenneeded.

Companycanelecttoawardtheunderwritingcont
Competitivefirmcashoffer
negotiation.

Securitiesaresolddirectlytothepurchaser,who,a
Private Directplacement
thesecuritiesforatleasttwoyears.

Therearetwokindsofpublicissues:thegeneralcashofferandtherightsoffer.Cash
offersaresoldtoallinterestedinvestors,andrightsoffersaresoldtoexisting
shareholders.Equityissoldbyboththecashofferandtherightsoffer,thoughalmost
alldebtissoldbycashoffer.

Acompanysfirstpublicequityissueisreferredtoasaninitialpublicoffering(IPO)
oranunseasonedequityoffering.Allinitialpublicofferingsarecashoffersbecause,
ifthefirmsexistingshareholderswantedtobuytheshares,thefirmwouldnotneed
tosellthempublicly.Aseasonedequityoffering(SEO)referstoanewissuewhere
thecompanyssecuritieshavebeenpreviouslyissued.Aseasonedequityofferingof
commonstockmaybemadebyeitheracashofferorarightsoffer.

ThesemethodsofissuingnewsecuritiesareshowninTable20.1anddiscussedinthe
nextfewsections.

20.4TheCashOffer
Asjustmentioned,stockissoldtointerestedinvestorsinacashoffer.Ifthecash
offerisapublicone,investmentbanksareusuallyinvolved.Investmentbanksare
financialintermediariesthatperformawidevarietyofservices.Inadditiontoaiding
inthesaleofsecurities,theymayfacilitatemergersandothercorporate
reorganizationsandactasbrokerstobothindividualandinstitutionalclients.You
maywellhaveheardoflargeWallStreetinvestmentbankinghousessuchasGoldman
SachsandMorganStanley.

Forcorporateissuers,investmentbankersperformservicessuchasthefollowing:
Formulatingthemethodusedtoissuethesecurities.Pricingthenewsecurities.Selling
thenewsecurities.

Therearethreebasicmethodsofissuingsecuritiesforcash:

1.Firmcommitment:Underthismethod,theinvestmentbank(oragroupofinvest
mentbanks)buysthesecuritiesforlessthantheofferingpriceandacceptstheriskof
notbeingabletosellthem.Becausethisfunctioninvolvesrisk,wesaythatthe
investmentbankerunderwritesthesecuritiesinafirmcommitment.Inotherwords,
whenparticipatinginafirmcommitmentoffering,theinvestmentbankeractsasan
underwriter.(Becausefirmcommitmentsaresoprevalent,wewilluseinvestment
bankerandunderwriterinterchangeablyinthischapter.)

Tominimizetheriskshere,anumberofinvestmentbanksmayformanunderwriting
group(syndicate)tosharetheriskandtohelpselltheissue.Insuchagroup,oneor
moremanagersarrangeorcomanagethedeal.Themanagerisdesignatedasthelead
managerorprincipalmanager,withresponsibilityforallaspectsoftheissue.The
otherinvestmentbankersinthesyndicateserveprimarilytoselltheissuetotheir
clients.

Thedifferencebetweentheunderwritersbuyingpriceandtheofferingpriceiscalled
thegrossspreadorunderwritingdiscount.Itisthebasiccompensationreceivedby
theunderwriter.Sometimestheunderwriterwillgetnoncashcompensationinthe
formofwarrantsorstockinadditiontothespread.

Firmcommitmentunderwritingisreallyjustapurchasesalearrangement,andthe
syndicatesfeeisthespread.Theissuerreceivesthefullamountoftheproceedsless
thespread,andalltheriskistransferredtotheunderwriter.Iftheunderwritercannot
sellalloftheissueattheagreeduponofferingprice,itmayneedtolowerthepriceon
theunsoldshares.However,becausetheofferingpriceusuallyisnotsetuntilthe
underwritershaveinvestigatedhowreceptivethemarketistotheissue,thisriskis
usuallyminimal.Thisisparticularlytruewithseasonednewissuesbecausetheprice
ofthenewissuecanbebasedonpriortradesinthesecurity.

Sincetheofferingpriceisusuallysetjustbeforesellingbegins,theissuerdoesnt
knowpreciselywhatitsnetproceedswillbeuntilthattime.Todeterminetheoffering
price,theunderwriterwillmeetwithpotentialbuyers,typicallylargeinstitutional
buyerssuchasmutualfunds.Often,theunderwriterandcompanymanagementwill
dopresentationsinmultiplecities,pitchingthestockinwhatisknownasaroadshow.
Potentialbuyersprovideinformationaboutthepricetheywouldbewillingtopayand
thenumberofsharestheywouldpurchaseataparticularprice.Thisprocessof
solicitinginformationaboutbuyersandthepricesandquantitiestheywoulddemand
isknownasbookbuilding.Aswewillsee,despitethebookbuildingprocess,
underwritersfrequentlygetthepricewrong,orsoitseems.

2.Bestefforts:Theunderwriterbearsriskwithafirmcommitmentbecauseitbuysthe
entireissue.Conversely,thesyndicateavoidsthisriskunderabesteffortsoffering
becauseitdoesnotpurchasetheshares.Instead,itmerelyactsasanagent,receiving
acommissionforeachsharesold.Thesyndicateislegallyboundtouseits

besteffortstosellthesecuritiesattheagreeduponofferingprice.Beyondthis,the
underwriterdoesnotguaranteeanyparticularamountofmoneytotheissuer.This
formofunderwritinghasbecomerelativelyrare.

3.Dutchauctionunderwriting:WithDutchauctionunderwriting,theunderwriter
doesnotsetafixedpriceforthesharestobesold.Instead,theunderwriterconducts
anauctioninwhichinvestorsbidforshares.Theofferpriceisdeterminedfromthe
submittedbids.ADutchauctionisalsoknownbythemoredescriptivenameuni
formpriceauction.ThisapproachisrelativelynewintheIPOmarketandhasnot
beenwidelyusedthere,butisverycommoninthebondmarkets.Forexample,itis
thesolewaythattheU.S.Treasurysellsitsnotes,bonds,andbillstothepublic.

TounderstandaDutchoruniformpriceauction,considerasimpleexample.Suppose
theRialCompanywantstosell400sharestothepublic.Thecompanyreceivesfive
bidsasfollows:

Thus,bidderAiswillingtobuy100sharesat$16each,bidderBiswillingtobuy100
sharesat$14,andsoon.TheRialCompanyexaminesthebidstodeterminethe
highestpricethatwillresultinall400sharesbeingsold.Forexample,at$14,AandB
wouldbuyonly200shares,sothatpriceistoohigh.Workingourwaydown,all400
shareswontbesolduntilwehitapriceof$12,so$12willbetheofferpriceinthe
IPO.BiddersAthroughDwillreceiveshares,whilebidderEwillnot.

Therearetwoadditionalimportantpointsinourexample.First,allthewinning
bidderswillpay$12evenbiddersAandB,whoactuallybidahigherprice.Thefact
thatallsuccessfulbidderspaythesamepriceisthereasonforthenameuniform
priceauction.Theideainsuchanauctionistoencouragebidderstobidaggressively
byprovidingsomeprotectionagainstsubmittingahighbid.

Second,noticethatatthe$12offerprice,thereareactuallybidsfor500shares,which
exceedsthe400sharesRialwantstosell.Thus,therehastobesomesortof
allocation.Howthisisdonevariesabit;butintheIPOmarkettheapproachhasbeen
tosimplycomputetheratioofsharesofferedtosharesbidattheofferpriceorbetter,
which,inourexample,is400/5005.8,andallocatebiddersthatpercentageoftheir
bids.Inotherwords,biddersAthroughDwouldeachreceive80percentoftheshares
theybidatapriceof$12pershare.

Theperiodafteranewissueisinitiallysoldtothepubliciscalledtheaftermarket.
Duringthisperiod,themembersoftheunderwritingsyndicategenerallydonotsell
sharesofthenewissueforlessthantheofferprice.

Inmostofferings,theprincipalunderwriterispermittedtobuysharesifthemarket
pricefallsbelowtheofferingprice.Thepurposeistosupportthemarketandstabilize
thepricefromtemporarydownwardpressure.Iftheissueremainsunsoldafteratime
(e.g.,30days),membersmayleavethegroupandselltheirsharesatwhateverprice
themarketwillallow.

ManyunderwritingcontractscontainaGreenShoeprovision,whichgivesthemem
bersoftheunderwritinggrouptheoptiontopurchaseadditionalsharesattheoffering
price.5ThestatedreasonfortheGreenShoeoptionistocoverexcessdemandand
oversubscription.GreenShoeoptionsusuallylastforabout30daysandinvolve15
percentof

thenewlyissuedshares.TheGreenShoeoptionisabenefittotheunderwriting
syndicateandacosttotheissuer.Ifthemarketpriceofthenewissuegoesabovethe
offeringpricewithin30days,theunderwriterscanbuysharesfromtheissuerand
immediatelyresellthesharestothepublic.

Almostallunderwritingagreementscontainlockups.Sucharrangementsspecifyhow
longinsidersmustwaitafteranIPObeforetheycansellsomeoftheirstock.
Typically,lockupperiodsaresetat180days.Thus,insidersmustmaintaina
significanteconomicinterestinthecompanyforsixmonthsfollowingtheIPO.
Lockupsarealsoimportantbecauseitisnotunusualforthenumberoflockedup
insidersharestoexceedthenumberofsharesheldbythepublic.Thus,whenthe
lockupperiodends,insidersmaysellalargenumberofshares,therebydepressing
shareprice.

Beginningwellbeforeanofferingandextendingfor40calendardaysfollowingan
IPO,theSECrequiresthatafirmanditsmanagingunderwritersobserveaquiet
period.Thismeansthatallcommunicationwiththepublicmustbelimitedto
ordinaryannouncementsandotherpurelyfactualmatters.TheSECslogicisthatall
relevantinformationshouldbecontainedintheprospectus.Animportantresultofthis
requirementisthattheunderwritersanalystsareprohibitedfrommaking
recommendationstoinvestors.Assoonasthequietperiodends,however,the
managingunderwriterstypicallypublishresearchreports,usuallyaccompaniedbya
favorablebuyrecommendation.

FirmsthatdontstayquietcanhavetheirIPOsdelayed.Forexample,justbefore
GooglesIPO,aninterviewwithcofoundersSergeyBrinandLarryPageappearedin
Playboy.TheinterviewalmostcausedapostponementoftheIPO,butGooglewas
abletoamenditsprospectusintime.However,inMay2004,Salesforce.comsIPO
wasdelayedbecauseaninterviewwithCEOMarcBenioffappearedinTheNewYork
Times.Salesforce.comfinallywentpublictwomonthslater.

INVESTMENTBANKS
Investmentbanksareattheheartofnewsecurityissues.Theyprovideadvice,market
thesecurities(afterinvestigatingthemarketsreceptivenesstotheissue),and
underwritetheproceeds.Theyaccepttheriskthatthemarketpricemayfallbetween
thedatetheofferingpriceissetandthetimetheissueissold.

Aninvestmentbankerssuccessdependsonreputation.Agoodreputationcanhelp
investmentbankersretaincustomersandattractnewones.Inotherwords,financial
economistsarguethateachinvestmentbankhasareservoirofreputationcapital.
Onemeasureofthisreputationcapitalisthepeckingorderamonginvestmentbanks
which,aswementionedearlier,evenextendstothebracketsofthetombstoneadin
Figure20.5.MBAstudentsareawareofthisorderbecausetheyknowthatacceptinga
jobwithatoptierfirmisuniversallyregardedasmoreprestigiousthanacceptinga
jobwithalowertierfirm.

Investmentbanksputgreatimportanceintheirrelativerankingsandviewdownward
movementintheirplacementwithmuchdistaste.Thisjockeyingforpositionmay
seemasunimportantasthecurryingofroyalfavorinthecourtofLouisXVI.
However,inanyindustrywherereputationissoimportant,thefirmsintheindustry
mustguardtheirswithgreatvigilance.

Afirmcanofferitssecuritiestotheunderwriteroneitheracompetitiveora
negotiatedbasis.Inacompetitiveoffer,theissuingfirmsellsitssecuritiestothe
underwriterwiththehighestbid.Inanegotiatedoffer,theissuingfirmworkswith
oneunderwriter.Becausethefirmgenerallydoesnotnegotiatewithmany
underwritersconcurrently,negotiateddealsmaysufferfromlackofcompetition.

Whereascompetitivebiddingoccursfrequentlyinotherareasofcommerce,itmay
surpriseyouthatnegotiateddealsininvestmentbankingoccurwithallbutthelargest
issuingfirms.Investmentbankerspointoutthattheymustexpendmuchtimeand
effortlearningabouttheissuerbeforesettinganissuepriceandafeeschedule.Except
inthecaseoflargeissues,underwriterscouldnot,itisargued,committhistime
withoutthenearcertaintyofreceivingthecontract.

Studiesgenerallyshowthatissuingcostsarehigherinnegotiateddealsthanin
competitiveones.However,manyfinancialeconomistspointoutthattheunder
writergainsagreatdealofinformationabouttheissuingfirmthroughnegotiation
informationlikelytoincreasetheprobabilityofasuccessfuloffering.

THEOFFERINGPRICE
Determiningthecorrectofferingpriceisthemostdifficulttasktheleadinvestment
bankfacesinaninitialpublicoffering.Theissuingfirmfacesapotentialcostifthe
offeringpriceissettoohighortoolow.Iftheissueispricedtoohigh,itmaybe
unsuccessfulandhavetobewithdrawn.Iftheissueispricedbelowthetruemarket
price,theissuersexistingshareholderswillexperienceanopportunityloss.The
processofdeterminingthebestofferpriceiscalledbookbuilding.Inbookbuilding,
potentialinvestorscommittobuyingacertainnumberofsharesatvariousprices.

Underpricingisfairlycommon.Forexample,Ritterexamined12,373firmsthatwent
publicbetween1960and2014intheUnitedStates.HefoundthattheaverageIPO
roseinprice16.9percentinthefirstdayoftradingfollowingissuance(seeTable
20.2).Thesefiguresarenotannualized!

Underpricingobviouslyhelpsnewshareholdersearnahigherreturnonthesharesthey
buy.However,theexistingshareholdersoftheissuingfirmarenothelpedby
underpricing.Tothem,itisanindirectcostofissuingnewsecurities.Forexample,
considerChineseonlineretailerAlibabasIPOinSeptember2014.Thestockwas
pricedat$68intheIPOandrosetoafirstdayhighof$99.70,beforeclosingat
$93.89,againofabout38.1percent.Basedonthesenumbers,Alibabawas
underpricedbyabout$25.89pershare.BecauseAlibabasold320.1millionshares,the
companymissedoutonanadditional$8.3billion(5$25.893320.1million),arecord
amountleftonthetable.Thepreviousrecordof$5.1billionwasheldbyVisa,setin
its2008IPO.
UNDERPRICING:APOSSIBLEEXPLANATION
Thereareseveralpossibleexplanationsforunderpricing,butsofarthereisno
agreementamongscholarsastowhichexplanationiscorrect.Wenowprovidetwo
wellknownexplanationsforunderpricing.Thefirstexplanationbeginswiththe
observationthatwhenthepriceofanewissueistoolow,theissueisoften
oversubscribed.Thismeansinvestorswillnotbeabletobuyallofthesharesthey
want,andtheunderwriterswillallocatethesharesamonginvestors.Theaverage
investorwillfinditdifficulttogetsharesinanoversubscribedofferingbecausethere
willnotbeenoughsharestogoaround.Althoughinitialpublicofferingshavepositive
initialreturnsonaverage,asignificantfractionofthemhavepricedrops.Thus,an
investorsubmittinganorderforallnewissuesmaybeallocatedmoresharesinissues
thatgodowninpricethaninissuesthatgoupinprice.

Considerthistaleoftwoinvestors.Ms.Smartsknowspreciselywhatcompaniesare
worthwhentheirsharesareoffered.Mr.Averageknowsonlythatpricesusuallyrise
inthefirstmonthaftertheIPO.Armedwiththisinformation,Mr.Averagedecidesto
buy1,000sharesofeveryIPO.DoesMr.Averageactuallyearnanabnormallyhigh
averagereturnacrossallinitialofferings?

Theanswerisno,andatleastonereasonisMs.Smarts.Forexample,becauseMs.
SmartsknowsthatcompanyXYZisunderpriced,sheinvestsallhermoneyinitsIPO.
Whentheissueisoversubscribed,theunderwritersmustallocatethesharesbetween
Ms.SmartsandMr.Average.IftheydothisonaproratabasisandifMs.Smartshas
bidfor,say,twiceasmanysharesasMr.Average,shewillgettwosharesforeach
oneMr.Averagereceives.Thenetresultisthatwhenanissueisunderpriced,Mr.
Averagecannotbuyasmuchofitashewants.

Ms.SmartsalsoknowsthatcompanyABCisoverpriced.Inthiscase,sheavoidsits
IPOaltogether,andMr.Averageendsupwithafull1,000shares.Tosummarize,Mr.
Averagereceivesfewershareswhenmoreknowledgeableinvestorsswarmtobuyan
underpricedissue,buthegetsallhewantswhenthesmartmoneyavoidstheissue.

Thisiscalledthewinnerscurse,anditisonepossiblereasonwhyIPOshavesucha
largeaveragereturn.Whentheaverageinvestorwinsandgetshisallocation,itis
becausethosewhoknewbetteravoidedtheissue.Tocounteractthewinnerscurse
andattracttheaverageinvestor,underwritersunderpriceissues.6

Perhapsasimplerexplanationforunderpricingisrisk.AlthoughIPOsonaverage
havepositiveinitialreturns,asignificantfractionexperiencepricedrops.Apricedrop
wouldcausetheunderwriteralossonhisownholdings.Inaddition,theunderwriter
risksbeingsuedbyangrycustomersforsellingoverpricedsecurities.Underpricing
mitigatesbothproblems.