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The Cost of Going Public: Why IPOs Are Typically Underpriced

by Lena Booth

Executive Summary
• The underpricing of initial public offerings (IPOs) is an indirect cost of going public that is borne by
the issuing firm. Its magnitude varies across IPOs with different issue characteristics, allocation
mechanisms, underwriter reputations, and general financial market conditions.
• Commonly used share allocation methods in IPOs are auction, fixed price, and book-building. Book-
building is the most popular method, and it allows smaller, less known companies to go public.
• IPOs are underpriced to signal issue quality, mitigate adverse selection problems, reward investors
for truthfully revealing information, lessen underwriters’ potential legal liabilities, allow underwriters to
curry favor with their clients, promote ownership dispersion for liquidity and control, and attract media
• Issuing firms can attempt to reduce underpricing by engaging reputable underwriters and auditors,
having frequent disclosures, waiting until they possess desirable characteristics, and/or using the
auction method if they are of high quality.

When firms go public, they incur direct and indirect costs associated with the initial public offering (IPO)
process. Direct costs are fairly predictable—they include registration, underwriting, and attorney and auditing
fees. The indirect cost, commonly known as IPO underpricing, is one of the most perplexing puzzles in
finance. It is observed in almost every financial market in the world and across all procedures of share
allocation. IPOs are, on average, underpriced by 18–20% in the United States. During the hot issue period,
underpricing was much higher, as many of the IPO firms did not have strong financials or growth potential
and simply rode the wave to go public. In countries where regulations and restrictions are imposed in the IPO
market, underpricing is higher as well.

What Is IPO Underpricing?
Underpricing refers to the price run up of the IPO on the first day of trading. It is also known as the initial
return or first-day return of the IPO.
Underpricing = (First-day closing price – Offer price) ÷ Offer price × 100%
The first-day closing price represents what the investors are willing to pay for the firm’s shares. If the offer
price is lower than the first-day closing price, the IPO is said to be underpriced and money is left on the
table for new investors. Since existing shareholders settle for a lower offer price/proceeds than what they
could have got, money left on the table represents the wealth transfer from existing shareholders to new
Money left on the table = (First-day closing price – Offer price) × Number of shares
On average, the amount of money left on the table is about twice the amount of direct underwriting fees, and
for many IPO firms it can equal several years of operating profit.
Although most IPOs are underpriced, the level of underpricing varies across IPOs with different issue
characteristics, allocation mechanisms, underwriter reputation, and general financial market conditions.
For example, the level of underpricing is reduced for larger IPOs, those underwritten by prestigious
investment banks, firms with a longer operating history or more experienced insiders on the board, and
those which intend to use the proceeds to repay debt. On the other hand, technology firms, firms backed by
venture capital, firms with negative earnings prior to the IPO, or firms that went public during a bull market
experience greater underpricing.

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In the book-building method. and investors place orders for shares at this price. the book-building method might be the only option that will allow them to go public. This is done to prevent investors from placing very high bids to ensure that they are allocated shares. The offer price that will allow the firm to sell all its shares is determined after bids are submitted. Some studies suggest that investment banks underprice IPOs to protect their reputation. on a pro rata basis. Investment bankers also benefit from underpricing because it allows them to curry favor with their clients in exchange for their loyalty and continued business. In a uniform price auction. In the less common discriminatory price auction. The underwriter then uses this information to determine the final offer price. Since uninformed investors tend to get a higher allocation of overpriced shares. or the book- building method to go public. they will stop participating in IPOs if issues are not. Underpricing also helps to overcome adverse selection problems.qfinance. Under this method the underwriter has complete discretion on the allocation of new shares. In the book-building framework. thus. all the investors receiving shares will pay the same market clearing price. the underwriter promotes the IPO by disseminating information about the issuing firm via road shows. If issuing firms want to have a more dispersed ownership. there is also an explanation that predicts an inverse relationship between these two variables. investors face higher aftermarket trading costs associated with asymmetric information. Theories based on information asymmetry suggest that high-quality issuers deliberately underprice their IPOs to signal their quality to outside investors. investment bankers reduce their legal liability by lowering the chance of price declines. In the auction method. and also helps existing owners to retain control of their firms. so that unrealistic bids (bids well over the clearing price) can be eliminated. For these firms. A maximum price is usually chosen as well. However. they demand a higher level of underpricing to compensate them for the liquidity risk. underpriced. they need to underprice their IPOs so that more investors will be induced to produce information about the issue and subsequently buy the shares. gaining popularity around the world. on average. This problem is especially common for smaller. They purposely leave money on the table to reward investors who truthfully reveal their information about the issue and threaten access to future deals for those that do not. It is therefore not surprising to see the book-building method. There is also evidence that greater underpricing leads to more aftermarket trading volume. which require substantial information production and dissemination by the underwriters. and hence incorporates the demand for the shares. the theory of partial adjustment suggests that investment banks only partially adjust IPO offer prices upward when they receive positive information about the value of the issue. These explanations predict a positive relationship between underpricing and aftermarket liquidity. investors submit their desired price and quantity bids. hoping that it will be too costly for low-quality issuers to mimic. In a fixed-price offer. to all the investors who placed bids between these two prices.Share Allocation in IPOs IPO underpricing happens regardless of whether issuers use the auction. Why Are IPOs Underpriced? IPO underpricing continues to be a global phenomenon despite a vast amount of research that attempts to explain it. The Cost of Going Public: Why IPOs Are Typically Underpriced 2 of 5 www. the issuer and the underwriter jointly determine the offer price. which increases the revenue of investment bankers when they subsequently become the market-makers for these IPO firms. When aftermarket trading for an IPO is expected to be thin. There are explanations of underpricing that are based on information production and ownership dispersion which will benefit the issuing firms. shares are either allocated through lottery or on a pro rata basis. less known companies. Shares are then allocated. When new issues are priced lower than they should be. Dispersed ownership increases liquidity and aftermarket trading. Of the three allocation mechanisms. These explanations do not make it clear why issuing firms approve underpricing as it only benefits the investment banks. investors pay the prices they bid for. the fixed-price. They gather indications of interest by soliciting from potential investors their desired prices and quantities for the issue. evidence has shown that IPOs under the auction method show the lowest average underpricing. However. a method that is used predominantly in the United States. If the issue is oversubscribed. firms that choose the auction method sometimes fail to go public because bids for their shares are .

Making It Happen Although underpricing may be inevitable due to certain risk and liquidity constraints. Google grew rapidly in the internet space. They also wanted their shares to be within reach for any investors. With a core business in selling search-based advertising.34. insiders are so contented with their new-found wealth that they do not mind leaving some money on the table for new investors. underpricing creates excitement that could help create sustainable interest in the firm’s shares. unlike book-built IPOs. Here are some suggestions: The Cost of Going Public: Why IPOs Are Typically Underpriced 3 of 5 www. an auction would provide a fair process for all investors and help to determine the share price that reflected a fair market valuation of Google. Google successfully went public on August 19. thus keeping demand strong until they are ready to sell. and the number of shares offered was reduced after it became apparent that the IPO wasn’t as popular as expected. According to its filing. However. Research shows that an extra dollar left on the table reduces other marketing expenditure by about the same amount. To them. a deviation from the book-building method that is primarily used in the United States. Higher underpricing also attracts more analyst coverage post IPO. selling 19. many industry watchers felt that Google did not fare well in its IPO because it chose the auction method.9 million of revenue and US$106. Some attributed the low demand to lack of participation by institutional investors. Conclusion Underpricing comes at the expense of the original owners and venture capitalists of the issuing firm. They believed that auction mitigates problems associated with unreasonable speculation. Morgan Stanley and Credit Suisse First Boston. became a household name. filed for an IPO in April 2004.05% and US$300. Google generated US$961.qfinance. The first-day closing price was US$100. especially those that went public during the bubble period of 1999–2000.6 million shares. Additionally. these insiders typically do not strongly oppose or even attempt to avoid it. yet had to reduce its filing price range due to insufficient demand at the higher price range that was originally proposed. at US$85 per share. and had a record of positive earnings. Founded in 1998 by Sergey Brin and Larry Page. Case Study The Google IPO Google. there are ways in which issuing firms can reduce it if they want to. Others claimed that Google was sabotaged by investment bankers. after the lockup period expires. Google managed to go public using the auction method because it waited six years until it was well established. That range was later revised to US$85–95. 2004. because they generally do not sell their shares until about six months later. by 2004 Google had shown impressive sales growth and handsome profit margins. which can result in boom–bust cycles that may hurt investors in the long run. Hugely underpriced IPOs tend to receive a disproportionate amount of media attention and publicity. According to Brin and Page.5 million of net profit in 2003. helped to decide on a preliminary price range of US$108 to US$135 a share. It had been profitable since 2001. due mainly to its superior search technology. The underpricing of 18% was about average compared to other US IPOs but low relative to other internet IPOs.It has also been argued that underpricing is a substitute for marketing expenditure. However. It started as a hot IPO.7 million left on the table. which are available only to those who have special relationships with the underwriters. resulting in an underpricing of 18. Could Google have got a higher offer price and larger issue proceeds if it had used the book-building method? It is a question we cannot answer but which will leave us wondering for a long time. The lead underwriters of the Google IPO. Underpricing is simply viewed as an inevitable cost of going public. Google decided to use the auction method to go public. the world’s most widely used search . who prevented their clients from bidding because it had chosen a method that offered them little benefit.

iporesources. provided that the quiet period rule is not Womack. • might want to go public that way.1111/1540-6261. • Issuer characteristics: IPO underpricing is lower with certain issuing firm .doi.00478 Websites: • IPO data—Jay R. and hence lower the information production costs incurred by investors. price stabilization and post-IPO analyst coverage provided by investment banks—book-building may be a better choice. Franç See Also Best Practice • Acquiring a Secondary price stabilization and post-IPO analyst coverage provided by investment banks—book-building may be a better Online at: dx. the auction method works only if the issuing firm is a superior quality firm that has high investor awareness. they are likely to reduce the level of underpricing. From a partial adjustment perspective. Frequent disclosures reduce asymmetric information. • Use the auction method if feasible: As noted above. However.qfinance. Jay R..1093/rfs/ • Engage reputable underwriters and auditors: Prestigious underwriters use their reputation capital to certify the value of the firm and reduce investor uncertainty about the value of the issue. Reputable auditors are better able to certify the accuracy of the financials and reduce uncertainty as well.1. 2nd ed.” Journal of Finance 57:4 (August 2002): 1795–1828. and that consequently lowers the level of underpricing. pricing. “Auctions vs. Also. They do not have to pre-commit a large underpricing for each issue and thus are expected to underprice less. However. if the issuing firm is concerned more about factors other than underpricing—for example. Ritter’s page of IPO links: bear. If issuing firms can wait until they are larger in size. and Kent L. book-building and the control of underpricing in hot IPO markets. Going Public: The Theory and Evidence on How Companies Raise Equity Finance. 2001.31 • Ritter. many explanations of underpricing were derived from the book-building framework. and allocations. and Alexander Ljungqvist. To reduce underpricing. if the issuing firm is concerned more about factors other than underpricing—for example. Underpricing can also be reduced if there are more experienced insiders sitting on the board of the issuing firm. Oxford: Oxford University Press. and Ivo Welch. the auction method works only if the issuing firm is a superior quality firm that has high investor awareness. issuers in IPO markets in which the auction mechanism is available might want to go public that way. • Frequent disclosure: Issuing firms can also reduce underpricing by voluntarily and frequently disclosing information about themselves in the press. Also. “A review of IPO activity. have a longer operating history. Tim. Articles: • Derrien. More Info Book: • Jenkinson. Online at: dx. and possess a record of positive earnings before going public.” Review of Financial Studies 16:1 (Spring 2003): 31–61.htm • IPOresources. or Cross-Listing • IPOs in Emerging Markets • Price Discovery in IPOs Checklists • Conflicting Interests: The Agency Issue • Merchant Banks: Their Structure and Function • Raising Capital by Issuing Shares • Stock Markets: Their Structure and Function The Cost of Going Public: Why IPOs Are Typically Underpriced 4 of 5 www. prestigious underwriters are expected to have more future deals to compensate investors.

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