Why Do Firms Go Public?

Welch and Ritter (2002)

•Desire to raise capital for a growing firm.

•Create liquidity for founders and other shareholders.

Questions
•Why are IPOs the best way to raise capital?
•Why are these reasons stronger in some times than others?
Welch and Ritter (2002): Table 1
 Why Do Firms Go Public? Welch and Ritter (2002)

Life Cycle Theories

•Zingales (1995): For a potential acquiror, public targets are
easier to spot than private targets. Entrepreneurs can
facilitate the acquisition of their company for a higher value
after the IPO.
•Black and Gilson (1998): In VC-backed companies,
entrepreneurs often regain control of the company from the
VC.
 Why Do Firms Go Public? Welch and Ritter (2002)
Life Cycle Theories
•Chemmanur and Fulghieri (1999):
•To allow for greater dispersion of ownership. Pre-IPO
angel investors and VCs hold undiversified portfolios
(hence, bear systematic and unsystematic risk) and,
therefore, are not willing to pay as high a price as
diversified public-market investors.
•Fixed costs of going public.
•Early in its lifecycle a firm will be private. As it grows
and faces profitable investment opportunities, the costs
of going public are worth incurring.
•Public trading can itself add value to the firm as it
inspires confidence from investors, customers, suppliers,
and employees.
•IPO capital allows for first-mover advantages.(1998-99
IPOs)
 Why Do Firms Go Public? Welch and Ritter (2002)
Market-Timing Theories

•Lucas and McDonald (1990): Asymmetric information

model: firms postpone (seasoned) equity issue if they know
they are currently undervalued. If there are common
misvaluations, aggregate issue volume will increase
following bull markets.
•Schultz (2000): Markets provide valuable information to
entrepreneurs. Higher prices signal higher growth
opportunities.
•Welch and Ritter (2002) propose a semi-rational theory
without asymmetric information to explain increased IPO
volume following bull markets: Entrepreneur’s sense of
value derives more from their operations perspective and
underlying business fundamentals than from public markets.
 IPO Underpricing: Welch and Ritter (2002)

• http://www.hoovers.com
IPO Central

• Table 1
Average First-day Return
1980-1989 7.4%
1990-1994 11.2%
1995-1998 18.1%
1999-2000 65.0%
2001 14.0%

Expected return on a U.S. stock on any given day

=12% / 240 trading days
= 0.05%

Why are IPOs underpriced?

 IPO Underpricing: Welch and Ritter (2002)
Why are IPOs underpriced?

I. Theories Based on Asymmetric Information

I.A. Issuer is more informed than investor:

High-quality issuers deliberately underprice their shares to signal their
high quality. With some patience, these issuers can recoup their
upfront sacrifice post-IPO through future issuing activity or analyst
coverage. (Question: Why is IPO underpricing a more efficient signal
than, say, charitable donations or advertising?)

High Quality Issuer

Share
Price

Low Quality Issuer

Months
Offer Day
 IPO Underpricing: Welch and Ritter (2002)
Why are IPOs underpriced?

I. Theories Based on Asymmetric Information

I.A. Issuer is more informed than investor:

High-quality issuers deliberately underprice their shares to signal
their high quality. With some patience, these issuers can
recoup their upfront sacrifice post-IPO through future issuing
activity or analyst coverage. (Question: Why is IPO underpricing a
more efficient signal than, say, charitable donations or advertising?)
Evidence: Welch (1989) provides some support. Jegadeesh, Weinstein,
and Welch (1993): A high return on the IPO date and the two
subsequent months implies that the issuer has underestimated the
quality of their projects; hence, the issuer will need additional funds in
the future to grow. Jegadeesh, Weinstein, and Welch (1993) find that
the return in the two subsequent months is more strongly (compared
to IPO date return) related to the probability and timing of subsequent
seasoned equity offerings.
Why are IPOs underpriced?

I. Theories Based on Asymmetric Information

I.B. Investors are more informed than issuer:

Rock (1986), Beatty & Ritter (1986), Beatty, Riffe and Thompson (2000)
 
The theory (story): While most IPOs are underpriced, a few are overpriced.
Hence, an investor submitting a purchase order cannot be certain about
the offering’s value once it starts trading.
Testable implication: Greater the uncertainty about the true value of the IPO,
greater the underpricing.
 
Shares to be issued = 100.
True price = $10.
 
Assume: (1) Informed investors do not have sufficient wealth to purchase all
shares of all firms wishing to go public.
(2) If demand > 100 shares, pro-rata distribution.
Why are IPOs underpriced?

I. Theories Based on Asymmetric Information

I.B. Investors are more informed than issuer:

Offer Price Informed Uninformed

 
$12 (overpriced)
Shares demanded 0 100
Shares supplied 0 100
Gain / Loss 0 (10-12)*100= -$200
 

$8 (underpriced)
Shares demanded 100 100
Shares supplied 50 50
Gain / Loss (10-8)*50= (10-8)*50=
$100 $100
Why are IPOs underpriced?

I. Theories Based on Asymmetric Information

I.B. Investors are more informed than issuer:

Correct Pricing, on average.
 
4 offerings: 2 underpriced, 2 overpriced.
Gain/Loss to informed = 2($100) + 2($0) = $200
Gain/Loss to uninformed = 2($100) + 2(-$200) = -$200
 
Hence, uninformed will not participate in the IPO market.
 
 
Underpricing, on average.
 
4 offerings: 3 underpriced, 1 overpriced.
Gain/Loss to informed = 3($100) + 1($0) = $300
Gain/Loss to uninformed = 3($100) + 1(-$200) = $100

Now, uninformed expect positive profits and, hence, will participate in the IPO market.
Why are IPOs underpriced?

I. Theories Based on Asymmetric Information

I.B. Investors are more informed than issuer:

Fly in the ointment: If informed are making abnormal profits then over
time they should have sufficient wealth to purchase all shares of all
firms wishing to go public.
Perhaps a different set of investors are the informed investors for
different IPOs depending on the industry of the IPO.
 
Empirical evidence is consistent with the above model: Beatty, Riffe
and Thompson (2000) find that IPOs for which there is greater
uncertainty about their value are underpriced more. Additionally,
underwriters that underprice too much or too little lose their market
share.
Why are IPOs underpriced?

I. Theories Based on Asymmetric Information

I.B. Investors are more informed than issuer:

Book-Building Theory/Story
In the preliminary IPO prospectus underwriters note the range for the
future offer price. Underwriters then canvass potential investors
regarding their demand for the IPO shares. Underwriters seem
reluctant to fully adjust their pricing upward to keep IPO
underpricing constant. When underwriters revise the share price
upward from the original range, underpricing tends to be higher.
Perhaps this extra underpricing is necessary to induce investors to
reveal their high demand for the IPO shares.
Table 3:
Mean first-day return when offer price is below range: 3.3%
Mean first-day return when offer price is within range: 12.0%
Mean first-day return when offer price is above range: 52.7%
Why are IPOs underpriced?

II. Theories Based on Symmetric Information

Tinic (1988) and Hughes and Thakor (1992) argue that issuers
underprice to reduce their legal liability. But Drake and Vetsuypens
(1993) find that underpricing did not protect firms from being sued.

Share
Price Lawsuit less likely

Lawsuit more likely

Months

Boehmer and Fishe (2001) note that trading volume in the aftermarket
is higher, greater the underpricing. But… How does the issuing firm
benefit from underpricing unless the increased liquidity is
persistent?
Why are IPOs underpriced?

III. Theories Focusing on Allocation of Shares

If IPOs are underpriced on average, then the opportunity to purchase

them at the offering price would be quite attractive.
Table 1: 1999-2000: 65% return on the first day!

Underwriters have the opportunity to allocate such underpriced shares

to their “preferred customers.”

How does one become a “preferred customer?”

Provide underwriter with economic benefits (other business).
Provide underwriter with political benefits.
 Selling Out to Public Firms vs. IPOs
Poulsen-Stegemoller (2006)

Determinants of the Choice between Selling Out to Public

Firms vs. IPOs
A. Growth and the Need for Capital

– IPO: Private firm raises public capital and allocates it to projects

the managers deem most worthy.
– Sellout: Capital allocated by managers of acquiring company.
Sellout firm has to compete with other divisions of the acquiring
company for new capital.
Companies with greater growth potential more likely to go
public through an IPO.
 Selling Out to Public Firms vs. IPOs
Poulsen-Stegemoller (2006)

Determinants of the Choice between Selling Out to Public Firms

vs. IPOs
A. Growth and the Need for Capital

Companies with greater growth potential more likely to go public

through an IPO.
Proxies for growth:
– Increase in assets, capital expenditures, revenues over the past year.
– Capital expenditure / Assets,
– R&D / Assets,
– Market value of assets / Book value of assets.
(Market = Book + Growth Opportunities.
Market / Book = 1+ Growth Opportunities.)
 Selling Out to Public Firms vs. IPOs
Poulsen-Stegemoller (2006)

Determinants of the Choice between Selling Out to Public

Firms vs. IPOs
A. Growth and the Need for Capital

Companies with greater growth potential more likely to go

public through an IPO.
Myers (1984) Underinvestment Problem: With risky debt outstanding,
shareholders will sometimes pass up positive NPV projects.
Companies that have
– lots of growth opportunities,
– have some debt, and
– cash constrained
are more likely to do an IPO to gain access to equity capital.
 Selling Out to Public Firms vs. IPOs
Poulsen-Stegemoller (2006)

Determinants of the Choice between Selling Out to Public

Firms vs. IPOs
B. Asymmetric Information

IPOs offered by investment bankers to mostly mutual/pension funds.

Investment bankers and mutual/pension fund managers may not be

able to value the assets of a private company as well as
Another company in the same industry.

Additionally, firm-specific information may retain its value only when it

is not accessible to outside competitors.
 Selling Out to Public Firms vs. IPOs
Poulsen-Stegemoller (2006)

Determinants of the Choice between Selling Out to Public Firms

vs. IPOs
B. Asymmetric Information

Investment bankers and mutual/pension fund managers may not be able to

value the assets of a private company as well as
Another company in the same industry.

What type of companies may be more difficult to value?

– More intangible assets.
– Less developed.
– Smaller.
– Less profitable.
– No VC backing.