Initial Public Offerings (IPOs)

Financing new ideas

Venture capital
Initial Public Offering
Why issue equity publicly
IPO process
Underpricing puzzle
Long-run performance of IPOs
Other IPO/Divestiture methods
1

Financing New Ideas

Personal savings
Bank, but not likely to work
Government but a very limited resources
Large industrial companies
Venture Capital Funds

Mostly organized as private partnerships

Need to prepare a business plan for funding
They invest in stages to control risk
They require board representation and get shares
2

How Successful is Venture Funds

http://www.ventureeconomics.com/
http://www.nvca.org/
Venture Economics' US Private Equity Performance Index (PEPI)
Investment Horizon Performance through 06/30/2004
Fund Type
1 Yr
3Y
5 Yr
10 Yr
Early/Seed VC
-2.00
-18.30
25.70
39.80
Balanced VC
11.90
-8.00
13.20
21.40
Later Stage VC
18.70
-7.00
4.60
16.80
All Venture
7.40
-12.20
14.40
26.70
Small Buyouts
14.70
-1.20
1.00
8.70
Med Buyouts
14.20
-0.60
4.10
10.20
Large Buyouts
19.30
4.20
4.10
10.50
Mega Buyouts
26.30
2.40
2.90
7.30
All Buyouts
23.70
2.20
3.10
8.50
Mezzanine
13.70
1.40
5.20
7.40
All Private Equity
18.80
-2.00
5.70
12.90
NASDAQ
26.20
-1.90
-5.30
11.20
S & P 500
17.10
-2.30
-3.60
9.90
Source: Thomson Venture Economics/National Venture Capital Association

20 Yr
19.10
13.60
13.80
15.60
27.20
17.80
14.20
9.10
12.70
9.50
13.70
13.20
13.50

Years

If idea is successful then more money can be raised

through an IPO
IPO also allows venture capital to exit the investment
Historical IPO Activity

700

600

500

400

300

200

100

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and
Allocations" (February 2002). Yale ICF Working Paper No. 02-01.
http://ssrn.com/abstract=296393

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

Number of IPOs

IPO Activity

Why IPO Activity is Cyclical

Demand-side explanation suggests that
start-up firms with good projects cannot get
private funding and they use IPO for raising
capital - internet firms during 95-98
Supply-side explanation suggests that
during some time periods investors and
institutions that invest in IPOs have excess
funds to invest
5

Why IPO Activity is Cyclical

A time period with a lot of IPOs is called hot
issue period
If a hot issue period is driven by supply-side
then it may be advantageous for a new firm to
go public
If a hot issue period is driven by demand for
funds then a new firm may be better off
delaying to go public - competition for funds
6

Why Issue Equity Publicly

1.
2.
3.
4.
5.
6.

Advantages
Access to capital markets
Improved liquidity for shareholders
Allowing original owners to diversify
Monitoring by external capital markets
Information provided by capital markets
Enhanced credibility with stakeholders

Disadvantages
1.
2.
3.
4.

Expensive
Costs of dealing with shareholders
Allowing competitiors gain information
Public pressure

IPO Process

Underwriter Selection
Registration
Marketing and Book Building
Pricing
After Market Activities

Underwriter Selection
Factors to consider:

Investment bankers general reputation and expertise

Quality of its research coverage
Investment banks distribution expertise - individual or institutional
Prior banking relationships

The most common underwriting arrangement is the firm

commitment
In this case the underwriter purchases all issued securities and
then resells them to the public - price differential is called the
gross spread

Lead Underwriter
The lead manager plays the major role in the
IPO - scheduling, pricing, distribution of new
issue, and assembling a group of underwriters to
sell shares to the public
The syndicate members are paid a portion of the
gross spread for their participation - 60% of the
gross spread
The lead underwriter receives a fee for its
efforts that is typically 20% of the gross spread
10

Underwriter
Letter of intent
The letter of intent protects the underwriter against expenses if the offer is
withdrawn
The letter of intent obligates the company to reimburse the underwriter
It also specify the gross spread
In most cases, the gross spread is 7% of the proceeds
It also includes clauses on:

Underwriters firm commitment

Cooperation by the company
Releasing of all available relevant information
Commitment by the private firm to grant 15% overallotment option to the
underwriter

Letter of intent is in effect until Underwriting Agreement is signed at pricing

of the issue

11

Registration
The Securities Act of 1933 (Section 5) requires a registration statement to be filed with
the SEC
The registration statement consists of two parts
The prospectus to be given to every purchaser of the securities
Part II which contains information that need not be furnished to the public but is made
available for public inspection by the SEC

The registration statement allows public to obtain information about the issue
The underwriter has a due diligence requirement to verify the information
The Securities Act also makes it illegal to offer or sell securities to the public without
registration
The SEC has no authority to block a public offering based on the quality of the
securities involved. It can require the issuer to provide all material facts
The registration statement has to be signed by directors and principal officers of the
issuer, the underwriters, accountants, appraisers and other experts
Investors who maintain losses as a result of misstatements or omissions in the
12
registration statement may sue these signatories

Marketing
Once it is filed the registration statement is
transformed into the preliminary prospectus or Red
Herring
The preliminary prospectus is used to market the issue
The SEC has 20 days to declare the issue effective
At that point the red herring becomes a prospectus
The company and the underwriter promote the IPO
through the road show
Road shows provide important monitoring for the
underwriter on investor demand
13

Marketing
During the road shows the underwriter receives orders
from individual and institutional investors - book
building
Retail investors typically submit a market order in which
only the quantity desired is stated
Institutions typically submit limit orders where the quantity
demanded is subject to a maximum price
Retail orders are received earlier than institutional orders since
institutions prefer to wait to a later stage of the process before
submitting their orders
Institutions submit an order with a commitment to purchase
more shares in the open market if their order is fulfilled
14

Pricing
Once the registration statement is approved by the
SEC then two most important items have to be
determined:
offer price
the number of shares to be sold

Book building at this stage is very important to

gauge the investor demand
Some suggest that an IPO may be successful if it
is three times oversubscribed
15

Pricing
Ritter (1991) on IPO pricing suggests that IPOs
are under-priced meaning that you can make
money buy buying stocks from an underwriter
and selling them in the market once public
trading starts
Flipping dumping of shares as soon as trading
starts is discouraged by the underwriters, but it
is not easy to control
16

IPO Underpricing
Percentage average
first-day returns
120
100
80
60
40
20
0
-20

Year

-40

1960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000

17

0.00%

IPO Underpricing

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and
Allocations" (February 2002). Yale ICF Working Paper No. 02-01.
http://ssrn.com/abstract=296393

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

Underpricing %

IPO Underpricing

Years

18

2001

2000

1999

1998

1997

1996

1995

1994

1993

Aggregate Money Left on the Table, millions

$40,000

$35,000

$30,000

$25,000

$20,000

$15,000

$10,000

$5,000

$0
Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and
Allocations" (February 2002). Yale ICF Working Paper No. 02-01.
http://ssrn.com/abstract=296393

Years
1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

Millions

IPO Underpricing

19

Why IPOs are Underpriced

If an issue is too low then the issuing firms owners
will not like bearing the additional cost of going
public
If an issue is priced too high then the underwriter is
stuck with shares plus a bad reputation
The underwriter is to balance between the tow
extreme
Underpricing allows the underwriter to sell shares of the
firm easily
It reduces the possibility of lawsuits
20

Underpricing and Average Investor

Assume that average investor is not informed well on the
quality of an issue
The uninformed investor faces a winners curse that is if
you bid in an auction and you end up with the item you
most likely over bid
Underwriters know that most average investors cannot
distinguish between good and bad issues and to keep
uninformed investors interested they underprice
Otherwise uninformed investors would not play the game
for long reducing the demand for the issue - bad for the
underwriter
21

After Market
Stabilization activities by the underwriter:
These involve trading by the underwriter to support the stock by buying
shares if order imbalances arise
This price support can be done only at or below the offering price
The standard prohibitions against price manipulation do not apply to the
underwriter during this period

The final stage of the IPO begins 25 calendar days after the IPO
when the so called quiet period ends
During the quiet period investors rely on prospectus
After the quiet period underwriters can comment on the
valuation and provide earnings estimates on the new company
22

Long-Run IPO Performance

Year
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000

Average 3-year Buy-and-Hold Return

Market
Size and Book-toIPOs
Adjusted
Market Adjusted
88.20%
35.50%
17.10%
12.80%
-26.20%
-7.40%
32.20%
-36.50%
-48.70%
15.40%
-38.70%
2.50%
27.70%
-51.30%
3.00%
7.60%
-39.50%
7.30%
18.60%
-20.40%
14.30%
-1.80%
-18.90%
4.50%
55.70%
8.30%
51.30%
51.10%
16.80%
32.50%
12.20%
-34.10%
-32.40%
31.50%
-1.70%
5.80%
34.80%
-2.30%
-19.40%
44.90%
-7.80%
-23.90%
74.10%
-8.30%
1.00%
24.80%
-62.30%
-14.10%
25.60%
-57.00%
8.60%
67.70%
6.80%
41.00%
27.10%
9.10%
12.20%
-46.20%
-32.90%
-74.20%
-64.70%
-36.40%
-42.60%

Periods
1980-1989
1990-1994
1995-1998
1999-2000

Average 3-year Buy-and-Hold Return

Market
Size and Book-toIPOs
Adjusted
Market Adjusted
20.80%
-24.70%
6.90%
44.70%
-7.20%
-12.70%
36.00%
-32.30%
11.60%
-53.80%
-34.30%
-61.20%

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity,
Pricing and Allocations" (February 2002). Yale ICF Working Paper
No. 02-01. http://ssrn.com/abstract=296393

23

LR IPO Performance and Hot

Issue Periods
Average 3-year Buy-and-Hold Return
Market
Size and Book-toIPOs
Adjusted
Market Adjusted
Correlation
with # of
IPOS
Correlation
with First Day
Return

-0.21

-0.34

-0.18

-0.67

-0.18

-0.64

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity,
Pricing and Allocations" (February 2002). Yale ICF Working Paper
No. 02-01. http://ssrn.com/abstract=296393

24

Other Divestiture Methods

Spin-off: a company gives the shares of a
subsidiary to its own shareholders
Shareholders can then sell their shares in the
market
Shareholders are not subject to taxes if 80% of
the subsidiary stock is distributed
Miles and Rosenfeld (1983) find an abnormal
return of +3.34% to parent firms over days (0,
+1) around the announcement
25

Why Spin-off?
Eliminate negative synergies
Increases focus
Improves managerial compensation contract
design
Reduces the possibility of unprofitable business
lines being supported by profitable ones

26

Other Divestiture Methods

Sell-off: a parent firm sells the assets of a subsidiary to
another firm
Signaling effect is different depending on why assets
are sold
If firm is refocusing its investments then it may be good
news
If assets are sold to raise cash to pay down debt then it may
be bad news

Capital gains tax would be paid

Rosenfeld (1984) finds an abnormal return of +2.21%
over days (0,+1)
27

Other Divestiture Methods

Carve-out: shares of a subsidiary are sold to general public
through an IPO
The parent usually maintains the control
Funds that are made available for the subsidiary can be invested for
positive NPV projects
Reduced asymmetric information improves the value of subsidiary
Improved managerial compensation

Allen and McConnel (1998) find an abnormal return of +1.9%

over days (-1,+1), but if the parent indicates special dividend
payment or debt reduction with the proceeds then abnormal
return is +6.63%
In other cases the abnormal returns is close to zero
28

Additional Articles

Muscarella and Vetsuypens, 1989, A simple test of Barons Model of IPO Underpricing,
Journal of Financial Economics 24, 125-135.

SSRN-Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and
Allocations" (February 2002). Yale ICF Working Paper No. 02-01.
http://ssrn.com/abstract=296393

JSTOR-Why Do Companies Go Public? An Empirical Analysis, Marco Pagano; Fabio

Panetta; Luigi Zingales, The Journal of Finance, Vol. 53, No. 1. (Feb., 1998), pp. 27-64.
URL: http://links.jstor.org/sici?sici
=0022-1082%28199802%2953%3A1%3C27%3AWDCGPA%3E2.0.CO%3B2-Z

JSTOR-Equity Carve-Outs and Managerial Discretion, Jeffrey W. Allen; John J.

McConnell, The Journal of Finance, Vol. 53, No. 1. (Feb., 1998), pp. 163-186.
URL: http://links.jstor.org/sici?sici
=0022-1082%28199802%2953%3A1%3C163%3AECAMD%3E2.0.CO%3B2-W

29

Additional Articles

JSTOR-Additional Evidence on the Relation Between Divestiture Announcements and

Shareholder Wealth, James D. Rosenfeld,The Journal of Finance, Vol. 39, No. 5. (Dec.,
1984), pp. 1437-1448.
URL: http://links.jstor.org/sici?sici
=0022-1082%28198412%2939%3A5%3C1437%3AAEOTRB%3E2.0.CO%3B2-1
JSTOR-The Effect of Voluntary Spin-off Announcements on Shareholder Wealth, James
A. Miles; James D. Rosenfeld, The Journal of Finance, Vol. 38, No. 5. (Dec., 1983), pp.
1597-1606.
URL: http://links.jstor.org/sici?sici=00221082%28198312%2938%3A5%3C1597%3ATEOVSA%3E2.0.CO%3B2-0
JSTOR-The Long-Run Performance of Initial Public Offerings, Jay R. Ritter, The Journal
of Finance, Vol. 46, No. 1. (Mar., 1991), pp. 3-27.
URL: http://links.jstor.org/sici?sici=00221082%28199103%2946%3A1%3C3%3ATLPOIP%3E2.0.CO%3B2-9

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