THE ROLE OF THE UNDERWRITER AND LEAVING MONEY ON THE TABLE By: The Cos The Google IPO

is considered an exotic offering as it seemed to have defied traditional theories and models. It had for, example, seemingly casted away the lauded role of the underwriters and mimicked Warren Buffets disdain of leaving money on the table by opting for the Dutch auction rather than the traditional book building. But did Google actually discard the academics view on underpricing and the underwriters role or was the Google IPO an actual application of the best of all theories combined?

Underpricing in IPOs is a puzzling phenomenon such that, to date, it remains a debatable subject and is not universally understood, much less accepted. Numerous theories and models have been advanced to explain and rationalize underpricing. Academics variably argue that underpricing is the consequence of the existence of the investors uncertainty as to the trading price after the offering and the probability of a winners curse;1 it is necessary to reduce the effects of asymmetric information and adverse selection, and consequently, to increase optimal allocation of shares; it is an effective form of signalling to the market; and, is useful as an insurance against legal liability. It is argued that the existence of winners curse is a rationale for IPO underpricing considering that if the new shares are priced at their expected value, informed investors crowd out the others when good issues are offered and they withdraw from the market when bad issues are offered. The offering firm must, therefore, price the shares at a discount in order to guarantee that the uninformed investors purchase the issue.2 In other words, as uninformed investors receive only small allocations in good IPOs (because everyone bids for them) and get large allocations in bad IPOs (because informed investors dont compete for these), underwriters and issuers deliberately underprice IPOs in order to reduce this adverse selection and prevent the uninformed investors from systematically making losses. Also, as underpricing creates excess demand for the issue, the underwriters and issuers can decide on quantity rationing.3 Further, there are those who maintain that underpricing is a consequence of ex-ante uncertainty both on the part of the issuer and the investors. The investor is not sure whether the issues price will increase or decline in the aftermarket, i.e., if he will lose or gain, hence, the investors will demand that more money be left on the table, via underpricing. The issuers, on the other hand, cannot make a commitment by themselves that the offering price is below the expected price once it starts trading. Underpricing is also seen as a mechanism whereby firms with favourable private information signal their firm quality to the market and thereby increase the price received on subsequent offerings. This is so considering that as exogenous factors will likely reveal true firm quality, it is costly for low quality firms to execute underpricing.4 Meanwhile, there are those who consider underpricing as viable insurance against legal liability. According to this view, underpricing is done by issuers and underwriters to prevent legal liabilities under federal securities laws for material misstatements in the offering prospectus or registration statement because large positive initial returns reduce the probability of a lawsuit, the conditional probability of an adverse judgment if a lawsuit is filed, and the amount of damages in the event of an adverse judgment. 5 Similarly, underpricing is considered necessary for underwriters to maintain their reputation in the
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If one is allocated the number of shares, one can expect that the initial return will be less than the average initial return. Faced with this winners curse, a representative investor will only submit purchase orders if, on average, initial public offerings are underpriced. (Beatty, Randolph P.; Ritter, Jay R. Investment Banking, Reputation, and the Underpricing of Initial Public Offerings. Journal of Financial Economics, Vol. 15, 1986, p. 213-232) Rock, Kevin, Why New Issues Are Underpriced, Journal of Financial Economics, Vol. 15, 1986, p. 187-212. Also, Levis, Mario. The Winner's Curse Problem, Interest Costs and the Underpricing of Initial Public Offerings. The Economic Journal, Vol. 100. Iss. 399, March 1990, pp. 76-89. Thus, there are those who posit that underpricing is relevant to achieve fairness in the market. Others, however, maintain that it is necessary more for purposes of ensuring returns both for the firms and the investors. Allen, Franklin; Faulhaber, Gerald R. Signaling by Underpricing in the IPO Market. Journal of Financial Economics, Vol. 23, 1989, p. 303-323.

market, as a falling share price will reduce the investors confidence not only on the issuer but also the underwriter. Indeed, underwriters and the shares price in IPOs are entwined and the theories explaining underpricing further highlight the role played by underwriters during IPOs. In fact, Beatty who proposed the theory of ex-ante uncertainty as an explanation of underpricing explicitly asserted that underwriters are the key to finding the underpricing equilibrium, as any investment banker who cheats on the underpricing equilibrium by persistently underpricing either by too little or by too much.6 Similarly, underwriters are considered indispensable for: the production of information necessary to align the expectations of the issuing firm and the investors; the performance aftermarket services; and the provision of coverage of the issuers shares by top-ranked analysts. 7 Furthermore, underwriters stabilize prices and create price support by repurchasing shares in the aftermarket if the IPO is performing poorly.8 More importantly, underwriters lend credibility to the issuer and the securities to be issued.9 Hence, some assert that an issuing firm must hire an investment banker (underwriter) to take the firm public.10 In fact, it has been proposed that the bigger the underwriter syndicate is, the better.11

In Googles case, the actual underpricing of 15.3% left nearly $350 million on the table.12 Note: The theories assume that the issuing firm and the underwriter are also uninformed as to the issues true value in the aftermarket. Thus, have little value when the firms or the underwriters can closely approximate their shares value. Also, the utility of underpricing is greater for issues with greater price uncertainty.

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Drake, Philip D. and Vetsuypens, Michael R. IPO Underpricing and Insurance Against Liability. Financial Management Association International. 1993. See also, Hughes, Patricia J.; Thakor, Anjan V. Litigation Risk, Intermediation, and the Underpricing of Initial Public Offerings Review of Financial Studies, Vol. 5, Iss. 4, 1992, S. 709-742; Lowry, Michelle; Shu, Susan Litigation risk and IPO-Underpricing. Journal of Financial Economics, 2002. Beatty, supra. Corwin, Shane A. and Schultz, Paul H., The Role of IPO Underwriting Syndicates: Pricing, Information Production, and Underwriter Competition (March 2003). AFA 2004 San Diego Meetings. Available at http://papers.ssrn.com/sol3/papers.cfm? abstract_id=389723 . Lewellen, Katharina, Risk, Reputation and the Price Support of IPOs (December 2003).MIT Sloan Working Paper No. 4453-03. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=479925. Anand, Anita and Johnson, Lewis. Are Underwriters Essential? Empirical Evidence on Non Book-Built Offerings. NYU Journal of Law and Business. Vol. 3, No. 1, Fall 206. Beatty,supra. Corwin, supra. Berg, Joyce E., Neumann , George R. and Rietz, Thomas A., Searching for Google's Value: Using Prediction Markets to Forecast Market Capitalization Prior to an Initial Public Offering (August 2008). Available at SSRN: http://ssrn.com/abstract=887562.