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 Economi
Investment
Fund Type 1 Yr
Early/Seed VC -2.00
Balanced VC 11.90
Later Stage VC 18.70 3
 Number of IPOs

0
100
200
300
400
500
600
700
1980
1981
1982
1983
through an IPO

1984
1985
1986
1987
1988
1989
1990

Years
1991
1992
Historical IPO Activity

1993
1994
1995
IPO Activity

1996
1997
1998
1999
2000
2001
• If idea is successful then more money can be raised

• IPO also allows venture capital to exit the investment

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and
4

Allocations" (February 2002). Yale ICF Working Paper No. 02-01.

http://ssrn.com/abstract=296393
 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
Advantages
1. Access to capital markets
2. Improved liquidity for share
3. Allowing original owners to
4. Monitoring by external capi
5. Information provided by cap 7
 IPO Process
• Underwriter Selection
• Registration
• Marketing and Book Building
• Pricing
• After Market Activities

8
 Underwriter Selection
• Factors to consider:
– Investment banker’s general reputation and expertise
– Quality of its research coverage
– Investment bank’s 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”

9
 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:
• Underwriter’s 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
-40 Year
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
 Underpricing %

0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
1980
1981

1982
1983
1984

1985
1986

1987
1988
1989

1990

Years
1991
IPO Underpricing

1992
1993
1994
1995
1996
IPO Underpricing

1997
1998
1999

2000
2001
18

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
 Millions

$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
$35,000
$40,000
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Years
1991
1992
1993
Aggregate Money Left on the Table, millions

1994
1995
1996
IPO Underpricing

1997
1998
1999
2000
2001
19

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
 Why IPOs are Underpriced
• If an issue is too low then the issuing firm’s 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 “winner’s 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
Average 3-year Buy-
Market
Year IPOs Adjusted
1980 Periods 35.50%I
88.20%
1981 1980-1989 -26.20%
12.80% 20
1982 1990-1994 -36.50%
32.20% 44
Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO

1995-1998 -38.70%
36
Activity, Pricing and Allocations" (February 2002). Yale ICF

1983 15.40%
Working Paper No. 02-01. http://ssrn.com/abstract=296393

1984 1999-2000 -51.30%

27.70% -53 23
 LR IPO Performance and Hot
Issue Periods

IP
Correlation
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 Baron’s 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
=0022-1082%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
=0022-1082%28199103%2946%3A1%3C3%3ATLPOIP%3E2.0.CO%3B2-9 30