Introduction to Finance: Initial Public Offering (IPO)

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Introduction to Finance Initial Public Offering
(IPO)
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Why Go Public?

• Is going pubic simply a stage in the life cycle
  of the firm?
• It is a choice. A choice in financing.
• Positive effects must be balanced against the
  negative effects.
• Negative effects adverse selection problem,
  large expenses, loss of confidentiality
• Positive effects alternative financing
  possibilities, increased bargaining power with
  banks

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Underwriter (Syndicate)

• Syndicate group of investment banks. Managing
  bank (leading bank) organizes the syndicate.
• Firm commitment syndicate (underwriters) commit
  to buying shares and selling. Shares bought at
  less than the offering price but the investment
  bank accepts the risk of not being able to sell
  the shares. The syndicate reduces the spreads the
  risk across banks.

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Cont.

• Green Shoe provision Members of the underwriting
  group have the option to purchase additional
  shares at the offering price.
• Book Building Recent IPOs in Japan take this
  approach. Estimate investor demand (taking into
  account all facts and circumstances).

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Positive Effects

• If future investments expected to increase
  public offerings make funds available.
• Firms with relatively large debt positions could
  use the proceeds from the offering to reduce
  debt exposure.
• Better access to capital markets. Bargaining
  power with banks could increase.
• (current) Shareholders gain liquidity. Equity
  based compensation schemes become possible.

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Cont.

• Monitoring and information provided by the
  market.
• Enhance firms credibility.

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Negative Effects

• In the event of an IPO, a small firm could face
  information asymmetry. Investors not familiar
  with the firm.
• Loss of confidentiality For example, firms with
  RD projects which they do not wish to disclose
  to the public for competitive reasons.
• Costs of dealing with shareholders costs of
  operating a publicly traded firm (PR dept.,
  audits, etc.)

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Cont.

• Direct costs of IPO registration, underwriting
  fees, etc. (total direct cost amount to
  approximately 10 of amount raised).
• Indirect Cost - underpricing problem.

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Empirical Evidence

• Hiraki and Hebner (1993) document a 32 initial
  return on average for IPOs during 1981-91.
• Isobe, Ito, Kairys (1998) look at long-run
  performance of IPOs and find less evidence of
  deliberate underpricing. Their results appear
  somewhat consistent with an over-reaction
  hypothesis. However, they conclude that
  instituional features in price setting (using
  comparables) could be an important factor.

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Understanding Underpricing

• 1) Underwriter incentives Avoid risk of not
  being able to sell shares.
• 2) Sequencing of issues. If the first issue is
  underpriced then investors make a gain. They
  might be more likely to subscribe to a firms
  secondary offering because of their experience in
  the IPO (primary offering).

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Cont.

• 3) Underpricing induces the average investor to
  buy. Informed investors are assumed to know the
  true value of the share. Thus informed investors
  will only purchase those valued shares which are
  underpriced. The average investor, on the
  other hand, will purchase across the board since
  they do not know which shares are truly
  underpriced.

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Cont.

• However, the average investor will lose money (on
  average). Realizing they do not have the same
  information as the informed investor, the average
  investor may choose not to enter the market.
  Hence, to induce these average investors into the
  market, the IPOs are underpriced.

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Netscape

• The choice of going public need of substantial
  funds for RD over next several years.
• Saturated private funding
• Angel wealthy individuals who invest in the
  business. Jim Clark (4.1 million)
• Venture capital funds Kleiner, Perkins,
  Caufield, Byers (5 million)
• Bank Loans?