Reputation, IPO Decisions and IPO Mispricing

Yu-Fen Chen*
Department of Business Administration
Da-Yeh University
112, Shanjiao Rd.,
Dacun, Changhua 51591
Taiwan, R.O.C.
yfchen@mail.dyu.edu.tw

Su-Jane Chiang
Department of Business Administration
Fu Jen Catholic University
510 Chung Cheng Rd.,
Hsinchuang, Taipei County 24205
Taiwan, R.O.C
badm2053@mails.fju.edu.tw

Victor W. Liu
Department of Business Management
National Sun Yat-Sen University
70, Lienhai Rd.,
Kaohsiung, 80424,
Taiwan, R.O.C.
vwliu@mail.nsysu.edu.tw

* Corresponding Author. Address: 112, Shanjiao Rd., Dacun, Changhua, 515 Taiwan
Tel.: 886-4-8511888 ext. 3018, Fax: 886-4-8511382, E-mail: yfchen@mail.dyu.edu.tw

1
 Reputation, IPO Decisions and IPO Mispricing
Abstract

Many rigorous studies on IPO activities have been performed in the literature,

yet few have discussed af

ir
m’sr
eput
ati
one
ffe
cts
. This paper performs a reputation

model to analyze a f
ir
m’sr
eput
ati
one
ffe
ctsonI
PO a
cti
vit
ies
,es
pec
ial
lyont
he

decision to go public and IPO pricing. We find that when the firm owns private

information of its management quality, the f

ir
m’sr
eput
ati
onhence affects its decision

to go public. By listing equities publicly, good management quality firms with a

good past anticipate enhancing their reputations and those with a poor past anticipate

building up good names. They are respectively regarded as reputation-enhancing

and reputation-building effects. On the other hand, good reputation firms with bad

management quality anticipate maintaining their reputations by going public and this

is regarded as the reputation-maintaining effect.

But, in this paper, we also find that firms of good management quality

over-invest in building up their reputations and those of bad management quality take

advantage of their reputations to go public. Both result in firms’over-going public

and IPO mispricing; firms of good quality underprice their equities and firms of bad

one overprice their IPOs. This constitutes an alternative interpretation on IPOs’

long-run underperformance and the sharp decline of the survival rate.

Keywords: reputation, going-public decision, over-going public, IPO mispricing

2
1. Introduction

What kind of firm chooses to go public? Why do firm owners share their

golden pot with the public since the firm makes money for its own self? Does

reputation affect firms’decisions to go public? How does the reputation effect work

on IPO activities? Such questions are widely asked by potential and current

shareholders. Theoretic analyses on the decisions to go public focus on the

information cost that affects a firm’

s financing sources (e.g. Chemmanur and

Fulghieri, 1999), but the information content that drives a firm to go public, such as

the firm’
s reputation, is less discussed.

In this paper we initiate a reputation model to answer these questions and

conclude that from the perspective of the firm’

s reputation, the motive for a firm to go

public is to enhance its reputation, to build a good name, or to maintain a good history.

We also find that some firms take advantage of their reputation to go public in

anticipation of increasing their value. Hence, a firm with either good management

quality or a good reputation will choose to go public. Our findings that a firm’
s

reputation does affect its decision to go public are supported by some recent

investigative research studies (e.g. Rydqvist and Hogholm, 1995; Pagano et al., 1998;

Chemmanur and Paeglis, 2005 and Brau and Fawcett, 2006, etc.). Furthermore, in

our model the reputation effects help to explain the empirical phenomena of IPO

mispricing and long-run underperformance.

Reputation models have been applied to predict a variety of managerial decisions

(e.g. Kreps and Wilson, 1982; Milgrom and Roberts, 1982; Tedelis, 1999 and Cabral,

2000, etc.), but to our best knowledge, this article is the first reputation model on IPO

activities. To identify the reputation effects on IPOs, we assume a firm needs funds

for a new project. The firm chooses between going public to generate funds needed

or not. The firm’

s value is determined by the firm’
s management quality, which is

3
private information to the public. Investors assess their beliefs on management

quality as being good through three steps: (1) their observations of the firm’
s past

performance, (2) the firm’

s going public decision, and (3) their expectations of the

firm’
s future performance. Once the new information arrives, the investors update

their beliefs. This dynamic formulation meets the features of reputations, which

establish links between past behavior and expectations of future behavior (Mailath

and Samuelson, 2006).

The equilibria of this model constitute some main findings. First, firms with

good management quality as well as good reputations choose to go public. This

result is intuitive since for a firm with good management quality as well as a good

reputation, going public signals good quality and amplifies the already good

reputation. The quality and reputation of a firm’

s top management can have a

certifying effect on firm value (Chemmanur and Paeglis, 2005). What interests us

more is that those suffering bad reputations also choose to go public as long as they

possess good management quality. On the flip side of the coin, those having bad

management quality also choose to go public if they have owned good names.

Why does a firm suffering a bad reputation choose to go public? Our model

proves that going public is regarded as a reputation-building activity and it does

increase the publicity, reputation, and value of the going public firm (Maksimovic and

Pichler, 2001). Draho (2004) stated that an IPO is valuable, because it directly

improves the reputation. An investigative research by Brau and Fawcett (2006) also

found that high-tech firms view an IPO more as a strategic reputation-enhancing

move than as a financing decision. Hence, for younger firms with few records to be

tracked, building up the firm’

s reputation and attracting analysts’attention motivate

them to go public.

Why does a firm with bad management quality choose to go public, too? We

4
find that firms take advantage of good reputations to go public as they are the

so-called golden geese. Going public is regarded as a reputation-maintaining

strategy, and thus firms time their IPOs in good times in anticipation of maintaining

their good names. This is consistent with some empirical studies. Ritter (1984)

showed that entrepreneurs time their decisions to go public. Loughran et al. (1984)

found that IPOs tend to cluster during periods in which investors place relatively high

values on the cash flows of the firms that go public. On the other side, the survey by

Brau and Fawcett (2006) showed that a strong history of earnings (good reputation)

serves as a signal that the firm going public is a good firm. We thus conclude that

the other attempt for a firm with bad management quality to go public is to be

grouped with good firms.

How does our model predict IPO mispricing? Most studies in the literature

related with IPO underpricing take the first-day market price as the “
fair value”of the

issuing firm and identify IPO mispricing by differentiating between the offering price

and the first-day market price. This measurement presumes that the capital market is

efficient. Extended from Purnanandam and Swaminathan’

s viewpoint (2004), the

market might not be efficient and investors tend to be optimistic or overconfident on

the first trading day of IPOs. Thus, we identify the magnitude of IPO mispricing by

comparing the offering price with the firm’

s intrinsic value, instead of the first-day

market price. The firm’

s intrinsic value is measured as there being no asymmetric

information of a firm’
s type. Comparing the intrinsic value for a going public firm

with that for a non-going public firm, we find that firms give up their first best

strategy and choose to go public instead. It follows that the good firms over-invest

in building up their reputations and underprice their equities to go public, while bad

firms take advantage of past good names and overprice their equities to go public.

Both result in a phenomenon of over-going public.

5
 The prediction of IPO underpricing by good firms is consistent with that of

Welch (1989), but there are three different features of our model. Except for the

identification of IPO mispricing, we propose that good management quality firms

underprice their IPOs to certify they are good so that going public feed-backs the

reputation value to their remaining equities. In Welch’

s model, high-quality firms

underprice their IPOs in order to obtain a higher price at a seasoned offering. Our

model finds that bad management quality firms overprice their IPOs. In Welch’
s

model, a high imitation cost may induce low-quality firms to reveal their quality

voluntarily. This is a distinctive feature which differs a lot from the predictions of

most theoretical models, ending with the conclusion that the average IPO is

undervalued at the offer price. The prediction of IPO overpricing is most supported

by some recent empirical studies (e.g. Purnanandam and Swaminathan, 2004).

What about the so-called golden goose firm that is no longer so golden? Welch

(1999) showed that almost half the firms that go public are de-listed within five years

after their IPO. It seems that, for some theoretical models that stress the signaling

role of going public (e.g. Leland and Pyle, 1977), they are unable to give a reason to

the phenomenon of IPO delisting. The phenomenon of over-going public indicates

that some firms that have bad management quality also list their shares publicly, while

they are not as lucky as before to complete their projects successfully. Under such a

circumstance, reputation - serving as a spurious signal of a good firm - plays a

negative role in IPO activities. It also gives an alternative reason to the long-run

underperformance and the declining survival rate of some IPO firms.

Many established studies in the literature have been generated on initial public

offerings, because IPO activities such as the going-public decision, process, and

performance, etc. are all important not only from the firm’
s viewpoint, but also from

that of the market. Empirical studies focusing on some interesting IPO phenomena

6
include the first-day returns anomaly, underpricing, t
he“
hot-issue”market, and the

long-term underperformance, etc. (Loughran et al., 1994; Teoh et al., 1998; Loughran

and Ritter, 2001, 2002; Ritter and Welch, 2002), while a few take the issuer’
s

reputation into consideration. This paper interprets the IPO phenomena, such as the

going public decisions, the timing of going public, the IPO mispricing, the long-run

under-performance, and the decline of the survival rate, from the viewpoint of a firm’
s

reputation.

The rest of our paper is organized as follows. Section 2 develops the model.

Section 3 forms the equilibrium and characterizes the results. Section 4 proposes the

main information effects and explains the reputation effects on IPO activities.

Section 5 states the phenomenon of over-going public, IPO mispricing, and long-run

underperformance. We conclude this paper in section 6. All proofs are in the

attached appendix.

2. The Model

We consider an economy with three dates, indexed by T=0, 1, and 2 as shown in

Figure 1. The firm is established at the beginning of the first period (time 0 or T=0).

After one period of operation (time 1 or T=1), the firm decides to participate in a new

project and needs funding for this investment. In this paper we analyze the firm’
s

reputation effects on the decision to go public. Thus, the manager’

s choice is to

generate the funds needed through the public markets or not, regardless of some other

alternative financing tools. If the manager chooses to generate the funds from the

public, then the firm needs to go public and sell a proportion of shares to outside

investors, which is regarded as an initial public offering (IPO). A manager’

s choice

is denoted as d {C , N } , where C refers to going public and N refers to not going

public.

7
2.1 Management Quality

The new project continues for one period and the outcome is realized at time 2.

If it is a successful investment, then the firm’

s value will accumulate to 1. A failed

investment will cause the firm to face ruin. The firm’

s value after the execution of

the new project depends on the management quality of the firm as being either good

(a type-G firm) or bad (a type-B firm). Management quality is private information

and outside investors cannot identify the firm’

s type. It is assumed that a firm’
s

management quality will sustain the same level across periods. Furthermore, we

assume that the project executed by a good firm will be successful with probability

, whereas that executed by a bad firm will be successful with probability 1 .

Thus, we have:

P ( S G ) P ( F B ) 

P ( F G ) P( S B ) 1  . (1)

The distribution of  is publicly known, while only a firm’

s manager observes it.

It is assumed that  1 / 2 .

2.2 Firm’
s Reputation

The firm’
s performance within the first period is observable, which forms an

inference as to the management’

s quality. It is believed that a good management

quality firm is more likely to have a successful historical performance and hence carry

with it a successful name. Thus, higher performance is “

good news’regarding a

firm’
s quality (Milgrom, 1981).

s performance within the first period as 1 {S , F } .

We denote a firm’

Consequently, 1 becomes a sufficient indicator for the firm’

s reputation level. We

refer to 1 as the firm’

s initial reputation status. After observing the firm’
s past

8
performance, outside investors believe that the firm is type-G with a probability of p.

Thus, the firm’

s expected value is:

v( p) P( S ) 
1 P( F ) 
0
P( S G ) 
P(G ) P( S B) 
P( B) (2)
p (1 )(1 p).

2.3 IPO Decision

At time 1, a firm’
s manager decides whether to go public in order to generate the

funds needed for the new project. Assume that the primary goal of the management

is to maximize the firm’

s expected value perceived by outside investors. The firm’
s

d
going public decision again updates investors’beliefs of the firm’
s type. Here, p 1

at time 1 refers to a posterior that the firm is type-G, given d {C , N } and

1 {S , F } . If the firm chooses not to go public, taking pN1 as investors’

posterior that the firm is type-G, then the firm’

s expected value will be

NVt 1 t {G, B}, 1 {S , F } , where:

NVt 1 v( p N1 )

(3)
p N1 (1 )(1 p N1 ).

If the firm goes public, then it sells a proportion of equity to the public. We

assume here that the proportion sold is , which does not vary with the firm’
s type.

Moreover, since a firm’

s type remains uncertain to the underwriter that takes charge in

the IPO, the floatation cost related to the IPO is assumed to be an exogenous K over

both types of firms. The expected values for a going-public firm, Vt t {G, B}

and {1 , 2 } , include the expected value the new shareholders are willing to pay

for the IPO shares as well as that of the remaining equities after the IPO. Taking

C
p 1
as investors’posterior that the firm is type-G, a firm’
s expected value from those

9
IPO shares equals  C
v( p  1
) K 1 {S , F } , where:

C
v( p  1
) p
C
1
(1 )(1 p 
C
1
). (4)

The expected value of the remaining equities depends on another of the

C
investors’posterior, p12
1 {S , F } and 2 {S , F } . Since going public

s private information, 2 refers to investors’

means revealing much more of the firm’

prediction of a firm’
s reputation after observing the firm going public as either bearing

a successful name (S) or a failed name (F). Take 1 S and 2 F as an

example. This implies that investors observe a firm’

s successful performance in the

first period and perceive that the project will hurt the firm’
s name in the future. Thus,

the expected value of the remaining equities is (1 )vt ( p

C
12
) , where:

C
vt ( p 12
)   C
v( p  1S
) (1 )  C
v( p 1F
), if t=G

 C
v( p  1F
) (1 )  C
v( p 1S
), if t=B, (5)

and the expected value for a type-G firm and a type-B firm is as follows, respectively.

VG  C
v( p  1
) (1 )  C
vG ( p  12
) K (6)

VB  C
v( p 1
) (1 )  C
v B ( p 12
) K . (7)

t
The probability of a firm going public equals g  . The subscript t refers to the

s type, where  refers to the firm’

firm’ s reputation observed by outside investors.

The firm’ ’beliefs associated with

s expected value is also a function of the investors
t
the firm’
s type and reputation. Hence, g  is increasing in the firm’
s expected

value. We further assume that for a firm with a successful business history, investors

are more likely to perceive it as a type-G firm - that is, p Sd p Fd d {C , N } .

Finally, it is assumed that 0 , p, K 1 .

10
3. Equilibria of the Going-Public Decision

The equilibrium concept we use is that of the Bayesian equilibrium defined as

below.

Definition: A Bayesian equilibrium is a set of conditional going public probabilities,

t
g t 
G, B, 
1 , 2 , and a set of investors
’be
lie
f d
s, p  ,

d 
C , N , 
1 , 2 ; where (i) t
g maximizes a f
ir
m’s
d
expected value and (ii) p  s
ati
sfi
esBa
ye’
srul
e.

The model constructed in the previous section has multiple Bayesian equilibria,

which are consistent with any kind of beliefs. These equilibria are sets of mixed

strategies containing pure strategies, where degenerate probability distributions are

included (Fudenberg and Tirole, 1992). We will now discuss the features of these

equilibria.

Lemma 1 For each historical performance 1 {S , F } , there exists a pooling

equilibrium where both types of firms choose not to go public - that is,
t
g 0t .

Proof: See the Appendix

Lemma 1 is a common result in signaling games. If we make investors’beliefs

unfavorable to one of the financing strategies such as going public in Lemma 1, then
t
we make going public a zero-probability event and form a pure strategy, g  0t .

Here, a firm going public is associated with the belief of having bad quality, and thus

this makes “
not going public”an equilibrium. We define an equilibrium with a

zero-probability event as a degenerate equilibrium. In this paper we are not going to

11
focus on the degenerate equilibrium. 1 Lemma 2 eliminates the existence of a

separating equilibrium.

Lemma 2 There exists no equilibrium such that one type of firms chooses to
t
go public, while the other does not - that is, g  1 and g 
t'
0 .

Proof: See the Appendix

Lemma 2 eliminates the existence of a separating equilibrium and implies that no

matter what type the firm is, the probability for a firm to go public is increasing in .

This supports the existence of the equilibrium with mixed strategies. We define an

equilibrium which excludes pure strategies as a non-degenerate equilibrium.

Proposition 1 There exists a unique non-degenerate equilibrium where both type-G

t
and type-B firms choose to go public - that is, g  0t , .

Proof: See the Appendix

Proposition 1 confirms a non-degenerate equilibrium, where for any level of firm

management quality and reputation, the probability to go public is positive.

Moreover, we propose that the propensity to go public is increasing in management

quality and in a firm’

s reputation.

1
The degenerate pooling equilibrium is due to the assumption of the investor’
s homogeneous belief

regarding a firm’ C
s type, such as p  1
0 in Lemma 1. We avoid discussing the homogeneous

belief case since it hardly happens in the real world.

12
Proposition 2 For any status of a firm’
s reputation, the propensity to go public for

a type-G firm is higher than that for a type-B firm. For any

possible type of firm, the propensity to go public for a high

reputation firm is also greater than that for a low reputation firm -

G
that is, g  g B 0 and g St g Ft 0t .

Proof: See the Appendix

We again do not focus on the pure strategy (defined as the degenerate

equilibrium) where both types of firms choose to go public.2 The remaining mixed
G
strategies, g  1 and g 
B
(0,1), imply that the propensity for a type-G firm to

go public is higher than that for a type-B firm. Moreover, the other mixed strategies,

g St 1 and g Ft (0,1)t , indicate that the propensity to go public for a good

reputation firm is higher than that for a bad reputation firm. Combined with these

two sets of semi-pooling equilibria, Table 2 shows a probability matrix, which is the

joint point probability of going public decision as a function of a firm’

s management

quality and its reputation.

4. Main Reputation Effects and Empirical Evidence

According to the two semi-pooling equilibria in Proposition 2, we define two

reputation effects on IPO activities. G

The first, the equilibrium g  1, supports

the reputation-enhancing and reputation-building effects here, implying that going

public is regarded as a reputation-enhancing or a reputation-building activity. Thus,

the firm possessing good management quality as well as a good reputation chooses to

2
The reasoning for footnote 1 applies here.

13
go public to enhance its reputation value. The firm with good management quality,

but suffering a bad reputation, now chooses to go public in order to build up its

reputation. The second g St 1t supports a reputation-maintaining effect. It

implies that going public maintains a firm’

s reputation. Thus, a firm with a good

reputation chooses to go public so as to maintain its reputation status, even though it

is poorly operated now. We also find some empirical phenomena in accordance with

the two reputation effects.

4.1 Reputation-Enhancing and Reputation-Building Effects

G
The result in Proposition 2, g  1 and g 
B
(0,1) , gives an answer to the

question: what kind of firm goes public? Firms with good management quality

choose to go public, even though some suffer bad reputations. However, why would

the good firms share their golden pot with others? We prove in this paper that due to

asymmetric information, good firms go public so as not to be regarded as bad ones.

On the other hand, good firms believe that going public conveys good news of their

prospects and enhances their reputations. In fact, no matter how good-quality firms

performed in the past, they believe that they will succeed in their new projects and

their underpriced new equities will revert to the intrinsic value. Thus, those good

firms with a good past go public so as to enhance their reputations and those with a

poor past go public to build their reputations. Reputations feed-back to the returns of

the new issues as well as the remaining equities. These are regarded as the

reputation-enhancing and reputation-building effects.

The reputation model we formalize here offers good predictions on the results

from the investigative and empirical research. In an overview of the decision to go

public, Roell (1996) summarized that a public listing could be regarded as a

14
marketing device and enhances a company’
s image and publicity. This publicity

induces outside investors to learn more about the firm and leads to a run-up in the

share price on the first trading day (Chemmanur, 1993). Maksimovic and Pichler

(2001) stated that public trading can add value to the firm as it inspires more faith in

the firm from other investors, customers, creditors, and suppliers. An academic

survey conducted by Brau and Fawcett (2006) found that high-tech firms view an IPO

more as a strategic reputation-enhancing move than as a financing decision.

Chemmanur and Paeglis (2005) directly examined the relationship between the

quality and reputation of a firm’

s management and its post-IPO operation performance.

The result shows that firms with higher management quality have stronger post-IPO

performance.

4.2 Reputation-Maintaining Effect

The other result in Proposition 2 gives the other answer to the question of which

firm chooses to go public. The equilibrium of g St 1 and g Ft (0,1)t implies

that a firm with a good reputation chooses to go public. We further find that some

firms take advantage of their good names to go public no matter whether they are well

or poorly operated. Hence, going public is regarded as a reputation-maintaining

mechanism. Reputations directly add value to the new issues as well as the

remaining equities. We regard this as the reputation-maintaining effect.

Some financial indicators, such as a history of strong earnings, higher cash flows,

and the firm’

s market value, etc., serve as signals of a good reputation. The

prediction of the reputation-maintaining effect is consistent with some empirical

evidence. Empirical studies have suggested that IPO firms are either older or larger

with a track record (e.g. Panago et al., 1998; Chemmanur and Fulghieri, 1999, etc.) or

15
young, but with higher cash flows (e.g. Schultz, 2003; Benninga et al., 2005, etc.).

Chemmanur and Fulghieri (1999) found that public firms are older and larger. Only

firms with entrepreneurs who have accumulated a significant track record for

successful performance find it optimal to go public.

A study of the determinants of IPOs in Italy has indicated that the likelihood of

an IPO increases in firm size and the industry’

s market-to-book ratio (Panago et al.,

1998). Firms that grow faster and are more profitable before an IPO also tend to go

public. Hence, due to a lack of enforcement of minority property rights, Italian firms

need a long track record in order to capture investors’trust before going public.

The reputation-maintaining effect can be applied to explain an IPO’

s timing.

Ritter (1984) showed that entrepreneurs time their decisions to go public.

Furthermore, IPOs tend to cluster during periods in which investors place relatively

high values on the cash flows of firms that went public (Loughran et al., 1994).

Benninga et al. (2005) proved that IPOs come in waves. Entrepreneurs choose to go

public when the “

public”cash flow valuation of their firm is relatively high. If the

market expects a low valuation of the cash flows, then firms generally remain private.

Thus, high values on the cash flows of the firms as well as high growth before the IPO

motivate them to list their shares publicly since going public adds value to the firm’
s

equity.

5. Over-Going Public, IPO Mispricing, and Long-Run Underperformance

5.1 Over-Going Public and IPO Mispricing

Purnanandam and Swaminathan (2004) proposed that if security prices are not

efficient in the short run, then the IPO “

fair value”is not identical to the first-day

market price, but presumably to some notion of the long-run fair value. Extended

from this thought, we propose that the long-run fair value is the intrinsic value of the

16
firm’
s equities as all private information is revealed. (In our model, the firm’
s type

will be realized as long as the project is completed.) Hence, in comparison with the

firm’
s intrinsic value, we find that good management quality firms underprice their

IPOs, but bad ones overprice their IPOs. In such a circumstance, IPOs are not

necessarily underpriced. Next, in Corollaries 1 and 2, we are going to demonstrate

how IPOs are mispriced due to the existence of asymmetric information.

Corollary 1 G
From the proof of Proposition 2, the equilibrium g  1 pushes good

firms to underprice their IPOs and forms a situation of over-going

public.

If one considers the case when there is no information asymmetry between the

firm and outside investors, then the investors could fully identify a firm’
s management

quality. In the case where  equals approximately one, the intrinsic value of a sure

good firm going public, VG , is  K ,3 while that for a non-going public firm,

NVG1 , is .4 The first-best decision for the good firm should be to not go public.

However, why does the good firm choose to go public even though it is not the

first-best decision? We prove that asymmetric information does exist, which pushes

the good firm to go public so that the firm is not regarded as a bad one. This is

regarded as a phenomenon of over-going public.

We further compare the expected value of a good firm’

s IPOs with the intrinsic

value of a good firm’

s equities. The expected value of a good firm’
s IPOs is

3
Calculated from equation (6) as
C
p 1 .

4
Calculated from equation (3) as pN1 1 .

17
expressed as p
C
1
(1 )(1 p
C
1
) K and the intrinsic value of its equities is

 K . Except under the circumstance of symmetric information where p

C
1
1 ,

the good firm underprices its equities to go public.

This corollary is similar with the prediction from Welch’

s model (1989). In that

model, the asymmetric information also originates from the unverified management

quality, but there are three different features of our model. First, we identify how

IPOs are mispriced at the offering price relative to their “

intrinsic value”
. Second,

we propose that good management quality firms underprice their IPOs to certify they

are good so that going public feeds-back the reputation value to their remaining

equities. In Welch’
s model, high-quality firms underprice at their IPOs in order to

obtain a higher price at a seasoned offering. Third, we are going to propose in

Corollary 2 that bad management quality firms overprice at their IPOs. In Welch’
s

model, a high imitation cost may induce low-quality firms to reveal their quality

voluntarily. This is a distinctive feature which differs a lot from the predictions of

most theoretical models, ending with the conclusion that the average IPO is

undervalued at the offer price. Next, we present a detailed analysis on it.

The other result from Proposition 2 concludes that firms with a good reputation

will choose to go public, no matter whether they are good or bad. Hence, a poor

management quality firm chooses to go public as long as it has a good name. This

raises another question here: what about a golden goose that is not golden any more?

We propose that a low quality firm may take advantage of its good name to go public,

while unfortunately it fails in its new project.

Corollary 2 From the proof of Proposition 2, the equilibrium g SB 1 prompts bad

firms to overprice their IPOs and forms a situation of over-going

public.

18
 Also due to the existence of asymmetric information, investors are unable to

identify the quality of a firm. In the case where  equals approximately one, the

intrinsic value of a sure bad firm going public, VB , is 1  K ,5 while that for a

non-going public firm, NVB1 , is 1 .6 The first-best decision for the bad firm

should be to not go public. However, why does the bad firm choose to go public

even though it is not the first-best decision? We prove that asymmetric information

does exist, and that the bad firm takes the chance to mimic the good firm’
s strategy of

going public so that the real type of bad firm is not revealed. Again, this is also

regarded as a phenomenon of over-going public.

We also compare the expected value of a bad firm’

s IPO with the intrinsic value

of a bad firm’
s equities. The expected value of a bad firm’
s IPO is expressed as

p
C
1
(1 )(1 p
C
1
) K and the intrinsic value of its equities is 1  K .

C
Except under the circumstance of symmetric information where p 1
0 , the bad

firm takes the chance to overprice its equities.

As we identify the magnitude of IPO mispricing by comparing the offering price

with the firm’

s intrinsic value, instead of the first-day market price, this theoretical

model consequently offers a different perspective on IPO mispricing and further

supports the empirical evidence of IPO overpricing (Purnanandam and Swaminathan,

2004). ’overconfidence about

Behavioral theorists also have suggested that investors

private information could cause an initial overvaluation on securities (Daniel,

Hirshleifer, and Subrahmanyam, 1998). We propose that investors’overconfidence

may originate from the firm’

s good reputation. When observing the firm’
s past

5
Calculated from equation (7) as
C
p 0 .

6
Calculated from equation (3) as pN1 0 .

19
success, investors tend to be optimistic about the firm’
s prospects and there is no

doubt that bad firms will take advantage of their good names to overprice their IPOs.

5.2 IPO Long-Run Underperformance

Following from the analysis of Corollary 2, the phenomenon of over-going

public as well as IPO overpricing offers an alternative perspective to interpret the IPO

long-run underperformance and the sharp decline in survival rates found in some

empirical studies (e.g. Ritter, 1991; Teoh et al., 1998; Fama and French, 2004 and

Purnanandam and Swaminathan, 2004, etc.)

First, this model proposes that bad firms overprice their new equities to go public,

but firms’types will be realized after the project is completed. At that time, the

overpriced equities will revert to their intrinsic value, and long-run underperformance

emerges. As stated in Purnanandam and Swaminathan’

s study (2004), IPOs are

overvalued at the offer price, tend to run up in the after market, and follow up

ultimately with long-run reversals.

Second, firms with good reputations are more likely to go public. Bad firms

which take advantage of their good names to go public are more likely to face

long-run underperformance. Schultz (2003) offered an explanation for the

phenomenon that more IPOs follow successful IPOs. When the followers carry a

large fraction of the sample and also underperform in the market, then the average

returns of all the IPOs tend to be low. Shefrin (2002) summarized his study from the

viewpoint of behavioral finance. He suggested that firms are more likely to issue

new shares when they face a window of opportunity and that their stocks are

overvalued. The investors at the same time expect a continuation and bet on trends.

They overweight the recent past when making long-term projections and thus suffer

from long-term underperformance. Teoh et al. (1998) attributed the long-run

20
underperformance to the deliberate manipulation of the IPO firm’
s reputation by

adopting discretionary accounting accrual adjustments that raise reported earnings

relative to actual cash flows before IPO.

Third, the activity for the bad firm going public also ends up with a sharp rise in

the de-listing rate. According to Fama and French (2004), the ten-year de-listing

rates for new listings rose from 26% for 1973-1979 to 44.2% for 1980-1991. They

suggested that the sharp decline in survival rates is due to a decline in the cost of

equity that allows firms of poorer quality as well as firms with distinct future payoffs

to go public.

The reputation model concludes a similar implication regarding the long-run

underperformance and the sharp decline of IPOs’survival rates. This model implies

that as long as the bad-quality firm is able to obtain a good name before going public,

then no matter by luck or through deliberate manipulation, it takes advantage of its

good name to go public so as to be perceived as a good-quality firm. Under such a

circumstance, reputation plays a negative role in IPO activity.

6. Conclusion

Which firm chooses to go public? Why do firm owners share their golden pot

with the public since the firm makes money for its own self? Such questions are

widely asked by the researchers as well as the practitioners. The reputation model in

this paper answers these questions from the perspective of a firm’

s reputation.

The results show that firms that possess good management quality or have a

good reputation choose to go public. Firms go public in anticipation of enhancing,

maintaining, or building up their reputations. Thus, reputation does affect a firm’

s

decision to go public. For a given level of a firm’

s reputation, good management

quality firms are more likely to go public than bad management quality ones. Going

21
public further enhances a firm’
s reputation as well as its value, which is known as the

reputation-enhancing effect. For a given level of management quality, high

reputation firms are more likely to go public than low reputation ones. Reputation

drives a firm to go public, which is known as the reputation-maintaining effect.

In this paper we find that due to the existence of asymmetric information, firms

give up their first-best strategy and choose to go public instead. It follows that good

firms may over-invest in their reputations and underprice their equities to go public,

while bad firms take advantage of their past good names and overprice their equities

to go public. Both result in a phenomenon of over-going public. This prediction

differs a lot from that of most theoretical models, ending with the conclusion that the

average IPO is undervalued at the offer price.

We extend our analysis based on Purnanandam and Swaminathan’

s viewpoint

(2004), indicating that if the first-day market price is driven by investors’sentiments,

then this price does not resemble the intrinsic value of the issuing firm. The firm’
s

intrinsic value is determined when the firm’

s type is revealed and asymmetric

information does not exist any more. Thus, we identify the magnitude of IPO

mispricing by comparing the offering price with the firm’

s intrinsic value, instead of???

the first-day market price. Consequently, good firms underprice at their IPOs and

bad firms overprice at their IPOs. The phenomena of firms’over-going public and

IPO mispricing also contribute to the interpretations of the IPO long-run

underperformance, the sharp rise in the de-listing rate, and the sharp decline of IPOs’

survival rates.

22
Figure 1. Time Line of the Economy

T=0 T=1 T=2

Firm established, either Firm needs funds for Outcome of new
as type-G or type-B. new investment. project realized.

Firm decides whether to go

public or remain private.

Investors update their beliefs

of the firm being good after observing
the firm’
s past performance and the
going public decision.

23
Table 1. Notation of the Model
t Fi
rm’
sty
pede
pending on the quality of a firm’
s management.

(G, B) (Good or Bad).

 Firm’
s performance set as a signal of a firm’
s reputation, either as

( 1 , 2 ) success or failure, {S,F}. 1 : firm’

s performance in the first period.

2 : firm’
s performance in the second period.

 Probability that a type-G firm will succeed.

 P
S G P
F B
.

d Decision of a firm going public.

(C,N) (Going or Not going public).

p The probability to be a type-G firm.

d
p Posterior that the firm is type-G, given the f
ir
m’sfinancing decision

d C , N  a
nd f
ir
m’s reputation



1 , 2 
, 1 {S , F }, 2 {S , F }
.
t
g Probability that a firm will go public at time 1, given t 
G, Band


S, F .

 Proportion of the stocks being sold in an IPO activity.

K Floatation cost of IPO.

24
Table 2. Probability Matrix of Going Public as a Function of a
Firm’
s Quality and Its Reputation

Reputation
S F
Type

G 1 ≧ ( 0,1]

≦
B ( 0,1] ＞ (0,1)

25
Appendix
Proof of Lemma 1

Suppose that, by observing a firm going public, investors believe the firm to be

type-B. C
Therefore, p 1
0 . It follows that from (3), NVt 1  and from (6)

and (7), VG VB 1  K . By the assumption of  1 / 2 , no matter what type

the firm is, no firm will choose to go public.

Q.E.D.

Proof of Lemma 2
B
In Lemma 1 the assumptions, g  0 and g 
G
0 , form a pooling equilibrium
t
g 0 . B
Considering the other assumptions, g  0 and g 
G
0 , it follows that

from (3), NVt 1 1 , and from (6) and (7), VG VB  K . Thus, no matter

what type the firm is, the probability to go public is increasing in  - that is, a

C
type-B firm is likely to go public, which contradicts the assumption of p 1
1 .

Q.E.D.

Proof of Proposition 1 and Proposition 2

The proofs in Lemma 1 and Lemma 2 imply that, in a non-degenerate

t
equilibrium, g  0t ,  . The marginal benefit from going public is strictly

greater for a type-G firm than that for a type-B firm as shown below.

MB (VG NVG1 ) (VB NVB1 )

[ C
v( p 1
) (1 )  C
vG ( p 12
) K v( pN1 )]
(8)
[ C
v( p  1
) (1 )  C
v B ( p 12
) K v( pN1 )]
(1 )(2 1)( p 
C
1S
p 
C
1F
) 0

26
From the inequality above, the signaling game results in three equilibria.

(1) VG NVG1 0 and VB NVB1 0 . B

These two inequalities cause g  to be

t
zero, which contradicts the fact that g  0t , .

(2) VG NVG1 0 and VB NVB1 0 . These inequalities support a separating

equilibrium whereby the type-G firm goes public and the type-B firm does not.

Lemma 2 eliminates this equilibrium.

(3) VG NVG1 0 and VB NVB1 0 . For the type-G firm, the inequality,

VG NVG1 0 , implies g 

G
1. 7 For the type-B firm, the inequality,

VB NVB1 0 , implies either VB NVB1 0 or VB NVB1 0 . Either

B
g 1 or g 
B
(0,1) will be true. G
Thus, g  g B 0, which confirms

the equilibrium.

The same reasoning in Proposition 1 applies well to prove Proposition 2.

MB t (VSt NVSt ) (VFt NVFt )

[
v( p SC ) (1 ) 
v( p SC2 ) K v( p N1 )] (10)
[
v( p FC ) (1 ) 
v( p FC2 ) K v( p N1 )] 0

Equation (10) also implies that VSt NV St 0 , and thus g St 1t . At the

same time, VFt NV Ft 0 such that g Ft 1 or g Ft (0,1) . Thus, g St g Ft 0t ,

which confirms the equilibrium.

Q.E.D.

7
For a rational manager whose objective is to maximize a firm’
s expected value, she will choose the
decision which has a higher expected value. Here, V NV 0 implies that for a type-G firm,
G G

the expected value of a going public firm will be larger than that of a not going public firm. Thus, the
type-G firm chooses to go public and hence
G
g 1.

27
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