INITIAL PUBLIC OFFERING (IPO)

1. Market and developments

There are clear windows of opportuniy that open and close for IPO issuers. After
crasches (1987, 2002, 2011) almost all pending IPO deals were cancelled.
IPO activity differs in time and internationally.
The literature does not have a full model that can explain:

At what stage of a firms lifecycle it is optimal to go public: Private firms

seem to face both life-cycle considerations and market-timing
considerations in the decision when to go public. Market-condition
considerations can be viewed as time-varying relative costs of debt versus
equity and private versus public funding costs.
why the volume of IPOs varies dramatically across time and across
countries. The flow of companies coming to the market should depend on
factors that determine the trade-off between the costs and benefits of a
stock market listing. The flow of companies coming to the market should
depend on factors that determine the trade-off between the costs and
benefits of a stock market listing. Major ingredients: demand for outside
equity capital and the markets willingness to supply such capital.

2. Advantages and disadvantages of going public

The capital availability is related to a variety of parameters, e.g.

General economic climate

General stock market condition
Technology cycle
Firm life cycle
Frequency and size of all IPOs in the financial cycle
Industry market condition
Frequency and size of industry IPOs in the financial cycle

2.1 Advantages of going public

New capital: almost all companies go public primarily because they need money for new
projects (or the reduction of leverage) all other reasons are of secondary importance
Future capital: once public, firms can easily go back to the public markets to raise
additional cash
Typically, about a third of all IPO issuers return to the public market within 5 years to
issue a "seasoned equity offering (US data)
Those that do return raise about three times as much capital in their seasoned
equity offerings as they raised in their IPO (US data)

Cashing out: although it is a bad signal to investors when an entrepreneur sells her own
shares, it still might make sense for some to cash out some of their wealth.
Mergers and acquisitions: many private firms do not attract potential acquirers -being
public makes it easier for other companies to notice and evaluate potential synergies and
vice versa pay with your shares for acquisitions
Image: public firms tend to have higher profiles than private firms (important in industries
where success requires customers and suppliers to make long-term commitments)
Employee compensation: having a public share price makes it easy for firms to give
employees a formal stake in the company.

2.2 Disadvantages
Profit-sharing: if the firm is sitting on a gold-mine, future gold has to be shared with
outsiders; after the typical IPO, about 40% of the company remains with insiders, but this can
vary from 1% to 88%, with 20% to 60% being comfortably normal.
Loss of confidentiality: going public could destroy the business if the company has to
disclose its technology or profitability to its competitors.
Reporting and fiduciary responsibilities: public companies must continuously file reports
with regulators and the exchange they are listed on costs money and discloses information
to competitors
Loss of control: outsiders could take control and even fire the entrepreneur; there are
certain anti-takeover measures, but what investor wants to pay a high price for a company in
which poor management cannot be replaced?
IPO expenses: a typical (smaller) firm may spend about 15-25% of the money raised on
direct expenses (detailed in a later section.); even more resources are spent indirectly
(management time, disruption of business)
Stronger agency problems: new shareholders have more different motives than former
owner/managers
Legal liability: IPO participants in the coalition are jointly and severally liable for each
others' actions i.e., they are sometimes sued for various omissions in the IPO prospectus,
especially when the public market valuation fall below the IPO offering price (especially in the
US)

2.3 Cost of going and being public

Cost components:

Under the objective of wealth maximization stockholders should design the IPO in a
way that the firms cost of capital is minimized
The after-IPO cost of capital has three components:
-The investors required return on equity
-The cost of being public: continuous expenses, such as listing fees, disclosure costs
and the flotation cost caused by future seasoned equity offerings
-The cost of going public: this is an up-front cost caused by the IPO of the company
(i.e. underwriting fees and non-underwriting fees). More formally, we define:

Assume free cash flows to equity to be a perpetuity, then it follows:

The difference between the cost of equity (ke) and the cost of being public (, gamma,
fIPO) is in the order of one to two magnitudes
Hence, managing keis the core issue of any IPO
Note that by simplifying, the inverse of ke can be interpreted as an earnings multiplier,
i.e. the price-earnings-ratio (PER). There is no clear evidence that PERs may
systematically differ among different stock exchanges. Since 1994 the average PER
for German stocks was 16.0 and for UK stocks 16.7.
Underwriting.
Listing fees tend to be lower at FWB than at LSE. However, the impact of this
difference on the cost of capital is negligible, even though listing fees are a perpetuity
(less than 1 Bp.). Costs associated with disclosure requirements may not be
completely negligible. However, there are no numbers available for this cost tem.
Underpricing: According to Ritter (EFM 2003) average underpricing in UK over the
period 1959 to 2001 was 17.4% (3122 observations). On a more recent database,
Oxera(2006, p. 21) estimates underpricing at LSE to be 10.4% (397 observations).
Average underpricing in Germany over the period 1983 to 2006 was 30.6% (716
observations); value weighted underpricing is 21.8%. Since 2002 underpricing in
Germany has averaged 6.9% (66 observations)

3. Reasons for going Public. Clustering of IPO

activity in time
Changes in IPO activity occur, whenever the costs and benefits of IPOs change. That could
be triggered by:
1.

External reasons for clustering of IPO activity in time

Need of projects to be funded by IPOs:
IPO activity varies with the availability of investment opportunities and hence
the business cycle, since funding needs should be greatest when there are
many projects to finance
Reduction of costs should lead to more IPOs:
Publicity and compliance requirements (information required in the IPO
prospectus)
Relaxation of listing rules (minimum float requirements, restrictions on nonvoting shares)

Reduction in commission fees to investment banks and listing fees to stock

exchanges (well, semi-external)
2.

3.

Reasons external to the firm but internal to the stock market

Favorable stock markets will lead to more IPOs:
If the original owners care about dilution of control, they will tend to take their
firms public during periods of high stock market valuations, since, for a given
funding need, a higher offer price implies less dilution thus, IPO volume
should be related to the stock market climate
Reasons internal to the firm -firm and product market characteristics that
might explain why IPOs cluster in industries
Situation: entrepreneur needs to obtain external financing to undertake a
positive net present value project
Assumption: asymmetric information entrepreneur does know best about
projects; outsiders can gain information about the projects at a certain cost.

Choice of entrepreneur:
1.
2.

IPO: required capital is generated by selling shares to a large number of small

investors
Stay private: much of the external financing is provided by one large investor or a
small group of large investors (venture capitalists)

Consequences:

Small equity holders in public firms are much better diversified than those in
private firms. Large investors in private firms have considerably more
bargaining power against the entrepreneur than small investors in a public
firm
In public firms a much larger group of investors must be convinced about the
quality of the firms projects (and the firmsmanagement). In equilibrium, any
such costs expended by outsiders in evaluating the firms projects will be
borne by the firm in form of a lower share price
When a firm goes public, the common price at which the equity is sold is
publicly observable by all outside investors the total costs involved in the
outsiders evaluation of the firms projects will be reduced somewhat: many
unsophisticated investors being able to free ride.
Venture capital financing minimizes the information production costs since the
large investor contributes the entire capital after evaluating the firm only once.
However, the venture capitalist is little diversified and has power against the
entrepreneurwill demand a greater rate of return than investors in public
companies. Investors in public companies have no bargaining power (since
the equity is priced in a competitive market) but information production is
duplicated by at least a couple of investors, and consequently a larger
aggregate information production cost is borne by the firm!

Solution of trade-off: depends on the magnitude of outsiders information production costs:

Firms with longer track records have lower costs of information acquisition for
the public!

Firms go public only when a sufficient amount of information about them has
accumulated in the public domain (so that the costs to outsiders of assessing
true firm value becomes sufficiently small).
Younger and more opaque firms, which entail a greater information acquisition
choose venture capitalist financing.

IPOs will be clustered in time in industries (think solar energy; internet):

Firms which go public later in time are able to free ride on the costly
information generated by those in the industry which have gone public ahead
of them
Important also: the price chosen in an IPO is in itself informative to outside
investors (more on that later on)
The pipeline of IPOs (IPOs registered with the financial authority, e.g. the
SEC) can also have an effect on IPO clustering. Firms appear to wait out
difficult markets (e.g. height of the recent financial crisis in 2008) and then go
to the market, once the environment improved. In addition, the standard
deviation of previous IPO returns has a significant negative effect on new
issuances(Boeh& Dunbar, 2014). This is consistent with issuers rationally
avoiding IPO markets when pricing efficiency is low.

Also works the other way round: IPO candidates learn from success or failure of first IPO

Outcomes of pioneers IPOs reflect participating investors private information

on common valuation factors. This makes the pricing of subsequent issues
relatively easier and attracts more firms to the IPO market
High offer price realizations for pioneers IPOs better reflect investors private
information and trigger a larger number of subsequent IPOs than low offer
price realizations do.
Empirical evidence suggests that venture capital backed IPOs have positive
information spill-overs in the form of higher valuation for rival companies in the
same industry. Venture capital backed IPOs therefore signal superior
information to the market relative to non-venture backed IPOs (Cotei& Farhat,
2013)

Some additional reasons for firms to Go Public:

Shareholders need an exit channel. Especially financial investors (e.g.

venture capitalists and private equity) use IPOs as an exit channel for their
high quality portfolio companies
Increase the likelihood of mergers or acquisitions
Use own stocks as a currency for future M&A deals
Heighten the public visibility and analyst coverage
Facilitate the use of shares or equity-linked incentives for employees.

When owners wish to exit their firm, they have a choice of selling the firm privately or taking
the firm public first and then selling it. The amount of money owners are able to receive
depends on their relative bargaining power vis--vis potential investors: companies that have
the option to go public but sell privately are able to sell at $1.11 for every dollar they expect to
raise in an IPO, whereas firms who do not have this option only receive $0.54. However,
owners conducting a two-stage sale of the company (i.e. taking the company public before
selling it) received $1.54 for every dollar they expect to raise in an IPO.

4. Why firms go public empirical studies

The main factor affecting the probability of an IPO is the market-to-book ratio at which firms
in the same industry trade. This might reflect a higher investment need in sectors with high
growth opportunities (and correspondingly high market-to-bookratios) or the entrepreneurs
attempt to time the market, i.e. the use of favorable market conditions i.e. to take
advantage of overly optimistic investors
Second most important determinant is the size of the company: larger companies are more
likely to go public.
Surprisingly, companies experience a reduction in the cost of bank credit after the IPO. after
IPO firms borrow from more banks and reduce concentration of their borrowing. This is
possible due to the improved public information and/or stronger bargaining position vis--vis
banks now that capital markets are available.
Other findings:

Shareholders most often board members, keep tight control over the firm's assets
even after flotation (i.e., going public)
Founders continue to hold a significant stake of voting equity and keep up to be
strongly represented in the firm's management and supervisory board. They even
consolidate control as the relative size of their blockholdingin comparison with the
other blockholders stakes increases
Founders sell shares, but venture capitalists sell even more.
Firms with projects that are cheaper for outsiders to evaluate, and operating in
industries characterized by less information asymmetry are more likely to go public

5. Mechanics of going public

In going public, an issuing firm will typically sell 20-40% of its stock to the public. The issuer
(i.e. the firm) will hire investment bankers to assist in pricing the offering and marketing the
stock. In cooperation with outside counsel, the investment banker will also conduct a due
diligence investigation of the firm, write the prospectus, and file the necessary documents
with the supervisory authorities.
For young companies, most or all of the shares being sold are typically newly-issued
(primary shares), with the proceeds going to the company. With older companies going
public, it is common that many of the shares being sold come from existing stockholders
(secondary shares).
Main steps when going public:
1.
2.
3.
4.
5.
6.

Decision to go public.
Beauty Contest and IPO Pitches
Selection of Underwriter(s).
Definition of the IPO structure. Estimation of investors and decisions about discounts.
Preparation of documents & filings, company valuation and analysis
Roadshow and Bookbuilding

7.

8.
9.

Order Taking, Price setting. Most companies prefer an offer price of between $10.00
and $20.00 per share, firms frequently conduct a stock split to get into the target
price range
Allotment
Price Support

6. Leaving money on the table Underpricing

Underpricing: Difference between the offering price and the market price at the end of the
first day or within a few weeks of the offering date.

Some hypotheses and observations have been brought forward to explain underpricing:

Assymetric information
Winners curse hypotheses
Market feedback hypothesis
Signalling hypothesis

6.1 Assymetric information

6.2 Winners curse hypothesis (between investors)

To explain the underpricing of IPOs Rock (1986) developed a model on asymmetric
information. His arguments are based on twogroups of market participants:
1.
2.

Informed investors: they know the true value of the company they buy underpriced
stocks only
Uninformed investors: they do not know the true value of the company

What happens in case of a.

A good offering (i.e. high quality firm)?

Investors that are well informed are more likely to attempt to buy shares when an
issue is underpriced .
The not-so-well informed investors will be allocated only a fraction of the most
desirable new issues.
Rationing of uninformed investors as their bids compete with the bids of informed
investors.
As both types of investors bid for shares, we observe an unexpectedly strong
demand.
Does it lead to underpricing? No, but if some investors are at an informational
disadvantage relative to others, some investors will be worse off.

A bad offering (i.e. low quality firm)?

Uniformed investors receive a full allocation according to their bid. Their average
return is lower than their expected return. Winners Curse. Underpricing
compensates this Winners curse of uninformed investors. There is empirical
evidence that small investors (presumably less well-informed) get a lesser
percentage of all shares when the underpricing is high.

6.3 Market feedback hypothesis (between investors and

underwriter)
Pricing of IPOs needs information not only about the firm but also from the market, i.e.
(potential) investors. Institutional investors whose nonbindingbids or indications of interest
provide the foundation for establishing the issuers offer price.Problem: Investors have no
incentive to reveal positive information before the shares are sold.
By keeping information to themselves until after the offering, investors can expect to benefit:
they would pay a low initial price for the stock and then could sell it at a higher price in the
post-offering market. Without compensation (in the form of large allocations of underpriced
shares), institutions would have little incentive to bid aggressively, knowing that doing so
would only drive up the offer price.
In order to induce regular investors to truthfully reveal their valuations, investment bankers
compensate investors through underpricing. IPO prices are set low to provide to compensate
investors for revealing positive information. Although this practice diminishes the issuers
proceeds from the offering ex post, expected proceeds are maximized. On net, discretion
appears to be a good thing: it allows issuers to set more informed prices and thus minimize
the wealth loss of going public.
How do you get investors to reveal their valuations?

Find a good mechanism in IPO allocation: An investor has less incentive to bid
low for an issue she values high if doing so jeopardizes her allocation.
Bookbuilding:Allocations of shares in IPO depends on the bid price in the
allocation process.
Offer price depends on the bid prices in the allocation process.

Problem: The profit per capital invested declines.

In order to induce truthful revelation for a given IPO, the investment banker must
underprice issues for which favorable information is revealed by more than those for
which unfavorable information is revealed! That is: According to the Market Feedback
Hypothesis, IPOs for which the offer price is revised upwards will be more
underpriced than those for which the offer price is revised downwards

6.4 Signalling hypothesis

Is it profitable for a low quality firm to imitate high quality firms by leaving money on the
table? No, as low quality firms cannot recoup the initial loss and only high quality firms can
be expected to recoup this loss. So, leaving money on the table is a relatively inefficient way
to signal.
Undervalued firms leave a good impression to investors and can ask for higher prices at
laters SEOs.

6.5 Conclusions

Overall only moderate underpricingof European property IPOs

Degree of uncertainty before IPO only marginally affects IPO returns
Firm age as significant explanatory factor
Does Europes national diversity have significant impact on the amount of money left
on the table? IPOs that were underwritten by a local investment bank showed on
average higher underpricing.

6.6 Additional empirical evidence

There is evidence that certain factors appear to influence underpricing, regardless of the
research focus (Butler et al., 2014). The most important ones (at least for the US) appear to
be:

Firm sales
Offer price revision
News stories
Total liabilities to Assets ratio
Investment bank market share
Shares retained to shares offered
Industry market value to sales ratio
Average underpricing in previous 30 days
Prior 30 day industry returns
Prior 30 day standard deviation of industry returns

The role of the underwriter in underpricing:

There is also evidence that social ties between the investment bank and the firm prior
to the IPO (e.g. friendship, personal relationships between respective executives and
directors) play an important role for the ultimate outcome of an IPO (Cooney et al.,
2015).
An investment bank is more likely to be included in the underwriting syndicate if social
ties exist between the firm and the bank prior to the IPO.
The outcomes of such ties suggest a quid pro quo arrangement between the firm and
the bank. The investment bank benefits by receiving higher compensation, a more
senior role in the IPO, and greater share allocation (see also the
bookbuildingprocess).
The IPO firm experiences higher net wealth gains for its pre-IPO shareholders.

The role of venture capital in underpricing:

Venture capital backed IPOs with high R&D spending experience lower underpricing
than non-venture capital backed IPOs
Venture capital seems to be reducing information asymmetries and therefore provide
a positive signallingeffect and suggesting that the company has a higher quality.

The role of regulation in underpricing:

The Sarbanes-Oxley Act of 2002 lead to a reduction in underpricing of shares.

But: The costs for IPOs also increased significantly, largely due to increased
accounting and legal fees that incur due to higher transparency requirements.

The role of institutional and legal environment in underpricing:

Underpricing appears higher in countries with stronger protection of outside investors.

However, underpricing is reduced when there is stronger law enforcement and higher
level of accounting transparency and/or availability of accounting data, as this likely
reduces the value of private benefits of control.
State-owned enterprises (SOEs) have higher underpricing than private firms.
However, a better institutional environment reduces IPO underpricing, particularly for
private firms and less so for SOEs.

7. Analyst research
Distribution of research reports represents important part of investor communication ahead of
an IPO. Underwriting banks provide institutional investors with their analysts analyses of the
issuers net assets, financial position and results of operations (ca. 2 weeks prior to the offer

period). The intention is to enable investors to form an opinion on the issuers strength, value
and prospects. Time and practice in discussion due to potential conflicts of interest.
Besides, there is Information asymmetry over other investors Selective Disclosure of
additional/other information to the prospectus to selected institutional investors.
(Facebookcase!) Research reports associated with an IPO may evoke liability risks.
Distribution of written pre-deal reports by underwriting banks is thus not permittedin the US.
In practice, analysts present their analysis in oral form.

7.1 Market practice (voluntary seld-regulation)

Steps:

Intention-to-float-announcement (IPO intention)

Distribution of research reports, investor education
Blackout Period: no further research for ca. 14 days
Publication of the prospectus start of the offer period (ca. 2 weeks).
ca. 4 weeks risk of downturn in market environment!

Theoretically also risk of prospectus liability claims, based on an allegedly incomplete

research report (only a threat if issuer adopts the analysis and/or confirms the analysts
valuation).
Recent reform efforts in the United States:

Investor education by analysts in oral form (precondition: confidentiality declaration)

Intention-to-float-announcement
Waiver of Blackout Period or reduction to 7 days
Immediate publication of prospectus, start offer period, distribution of research reports

These reforms have the advantage of faster implementation of the public offering, lowered
placement risk, risk of prospectus liability claims controllable. A potential disadvantage: IPO
plans become public too early.

8. Allocating shares in IPOs

8.1 Fixed price
A fixed-price offer has the offer price set prior to requests for shares being submitted.
Time line
1. Valuation by investment bank.
2. Offer price published.
3. Subscription period.
4. Pro rata allocation to subscribers (in case of that demand is higher than supply).
5. Mostly: placement risk is taken by the investment bank (it is = underwriting the
risk).

If there is excess demand, shares are typically rationed on a pro rata or lottery basis.
However, frequently requests for large numbers of shares are cut back more than requests
for more moderate numbers of shares.
If there is discrimination in the allocation of shares, it is normally done solely on the basis of
order size.
There is no way for the underwriter to reward investors who provide information.
In most countries, fixed-price offers have been the predominant form of allocation until the
1990s. In many countries, with a fixed-price offer investors must submit the money to
purchase the requested shares, without knowing whether they will receive many shares.
In general, the longer the time that elapses between the time a fixed offer price is set and
trading begins, the higher is the average first-day return. Partly this is because the longer the
time until completion, the higher the probability that market conditions will deteriorate and
that the offering will fail. To reduce the probability of a failed offering, a lower offer price is set.
Conditional on the offer succeeding, the expected underpricing is relatively low.

8.1.1 Firm commitment vs. Best efforts

In the US, firms issuing stock use either a firm commitment or best efforts contracts.
With a firm commitment contract, a preliminary prospectus is issued containing a preliminary
offer price range. After the issuing firm and its investment banker have conducted a
marketing campaign and acquired information about investors willingness to purchase the
issue, a final offering price is set. The investment banker must sell all of the shares in the
issue at a price no higher than the offering price once it has been set.
With a best efforts contract, the issuing firm and its investment banker agree on an offer price
as well as a minimum and maximum number of shares to be sold. A "selling period" then
commences, during which the investment banker makes its "best efforts" to sell the shares to
investors. If the minimum number of shares is not sold at the offer price within a specified
period of time, usually 90 days, the offer is withdrawn and all of the investors' money is
refunded from an escrow account, with the issuing firm receiving no money.
Best efforts offerings are used almost exclusively by smaller, morespeculativeissuers.
Essentially all IPOs raising more than $10 million use firm commitmentcontracts.

8.2 Auctions
The most common is the Dutch auction. A market-clearing or slightly below market
clearing price is set after bids are submitted. Since there is little if any excess demand at
the offer price, in general shares are allocated to all successful bidders. The number of
shares is usually fixed before the auction starts. Sometimes, there is a minimum or maximum
price published before the auction.
Dutch auctions had lower underpricing than regular auctions. However, the OLS analysis
indicated that factors other than the Dutch auction process account for this lower
underpricing. The evidence much rather suggests that institutional rationing is the motive for
underpricing, a result that possibly extends to all auction process, not just Dutch ones.
The French IPO market gives issuers and their underwriters a choice of mechanisms:

Offre prix ferme(OPF) a fixed-price offer.

Offre Prix Minimal (OPM) an auction procedure (formerly called miseen vente),
and placement garanti(PG) similar to US bookbuilding.
1. Minimum price is chosen (ca. 2 weeks before the IPO).
2. Investors submit price and quantity of bids.
3. IPO price and upper limit are chosen.
4. Non-discretionary pro rata allocation to investors with bids between IPO price
and upper limit
- The offer price is a common price that every selected investor will pay
for his or her shares.
- All bids greater than the maximum price are eliminated.
Although there is no written rule, it appears that the maximum price is chosen
(negotiated between issuer, underwriterand SBF Socit des Bourses Franaises)
sothat unrealistic bids are eliminated. Bids that are considered unrealistic are the
ones that are well overtheclearingprice. This rule is aimed at preventing investors
from placing bids at very high prices to make sure they will obtain shares. Coherent
with goal of the procedure: Investors place bids that reveal their true valuation of the
IPO firm.

8.3 Bookbuilding
Main differences to previous procedures are in the underwriters role in all stages of the IPO:

During the road show (not that common with other procedures) underwriters market
the offering to potential investors.
The underwriter has much more price-setting power than in other procedures.
Underwriters allocate shares in a discretionary manner.

Steps:
1.

The firm is presented to institutional investors in the marketing phase (road

show) and the issuing firm and the underwriter set a price range.

2.

Sometimes, the price is set only after the first marketing, thesocalleddecoupled process.

3.

Investors transmit nonbinding indications of interest to the underwriter.

4.
After the bookbuildingperiod, at the end of which the offers become
binding,the issuing firm and the underwriter set theofferprice.
5.

The underwriter and the issuing firm allocate the shares.

The Pre-marekting phase involves:

Preparation of research reports and equity story

Underwriters talk informally to investors
Price indication from first feedback of investors
Initial price range set

There are three types of bids:

Strike bidsbid for a specified number of shares or amount regardless of the offer
price.
Limit bidsspecified maximum price.
Step bidsa demand schedule as a step function (i.e. a combinationoflimitbids).

After collecting the bids, the underwriter aggregates them into a demand curve and chooses
the issue price. The issue price is usually below market-clearing.
The actual allocating decision depends on quality of institutions and distribution objectives of
the issuer.

Timing of order, price and a rating of the investor are important criteria in the allocation
process.
Bookbuildingis the primary IPO method in the US. But for decades bookbuildinghas
generated controversy because it allows shares to be preferentially allocated. Investors
complain that they are shut out of the allocation process, calling for changes that will give
everyone a fair chance.
With the book building method, the offering price is set below the expected aftermarket value
of the issue. Those investors who regularly contribute to the price discovery process are
rewarded through larger allocations this procedure necessarily gives the underwriter
discretion overstock allocation. The main complaint about book building appears to come
from the fact that, at least in some cases, this discretion has been abused. However, this
does not justify eliminating all discretion by mandating simple, rigid rules for both allocations
and pricing, as in a standardauction.
Although we observe that auctions lead to less underpricing than bookbuilding, there many
reasons for bookbuilding:

A key characteristic of IPOs is that the shares are difficult (and therefore costly) to
evaluate there are no independent analyst reports to read and no market prices to
observe. Corporate insiders have a clear, absolute advantage in terms of their
knowledge of current assets and past performance, but valuation requires more than
just this
A second key aspect of IPOs is that the number of potential entrants to the auction is
extremely large, relative to the number of bidders that the auction can profitably
accommodate. Each potential entrant has many investment alternatives and is not
compelled to participate in, or to evaluate, any one particularoffering.
First, the underwriter has substantial control over information acquisition through
bookbuilding. But little or no control in the auction itself. This control can be used to

maximize expected proceeds from the currento ffering or to induce investors to more
carefully evaluate the issue, resulting in a more accurate aftermarket price.
Another advantage of coordinating entry to the IPO process is that there is less
uncertainty about the number of bidders. The expected number of shares sold is
higher
because
undersubscriptionis
less
likely
when
the
number
ofparticipantsiscoordinated. With bookbuilding, the underwriter recruits investors it
cannot force investors to like the issue, but it can promise them a reasonable
allocation at a sufficiently low price to cover their time and effort, guaranteeing that a
number of investors will at least considertheoffering.
Investors have many alternatives, and evaluating a new stock requires more effort
than simply sticking with their currentportfolio. In order to guarantee that a stock
develops a following and does not get overlooked (i.e. does not become a so-called
orphan stock), the issuer somehow needs to compensate investors for their time and
effort evaluating the new security. Bookbuildingcan perform this role. Uniform price or
discriminatory auctions, on the other hand, cannot guarantee a return to investors.
When it is costly to gather information relevant to valuing a new issue, investors who
do so must be rewarded -standard auctions do not guarantee this.

9. Price stabilization and green shoe

In the Facebook IPO you'll see that the price basically bottomed out at $38, but never went
below $38, which is where the price support kicked in. With new buyers of the stock trying to
sell, the underwriters posted massive buy limit-orders, known as "price support" in the jargon
(or more politically correctly "price stabilization"). This is part of the underwriting service, in
which, in exchange for their fee, the underwriters pledge to try to keep the price at or above
the initial offer price.
You might be thinking that the underwriters just got the short end of the stick here -they've
had to buy huge amounts of the stock at $38, knowing full well that the stock is likely to go
down further on Monday when the market opens again. But you'd be wrong. At the end of the
Friday, it is unlikely that the underwriters are actually holding any Facebookstock. The way
the underwriters do this is to use two tricks:

Green shoe option

The underwriter is allowed to sell shares that it doesn't own -it can create a naked
short position -so in effect, 15% of the shares sold to the public don't actually exist.

The flexibility of being able to take a naked short position combined with the Green shoe
option ensures that the underwriter can provide aggressive price support without actually
having to end up owning a ton of stock.
The lead underwriter and the rest of the syndicate members distribute the stock to their
customers. In most cases, the managing underwriter overallotsthe issue. Thereby creating a
short position by accepting more orders than there are shares to be sold. The overallotment
option (the green shoe) grants an option to the underwriter to purchase from the issuing
company, within 30 days, an additional 15% of the shares sold in the IPO at the offer price
(15% limit in the US and in Germany).

9.1 Price support

Underwriters accumulate large inventories of cold IPOs on the first day of trading: If a stock
opens the first day at the offer price, on average market makers purchase 6% of shares
offered before they allow the bid to drop. Corresponding number is 2.1% for IPOs that open
below the offer price, and only 0.4% for stocks that open above the offer price. Only very little
evidence that stock prices decline after stabilization is withdrawn stabilization might raise
the equilibrium price (supply of shares is reduced).
Aftermarket activities are price-influencing activities that affect both issuers and investors. Tje
basic forms are:

Underwriters post a stabilizing bid to purchase shares at a price not exceeding the
offer price this postpones a pricedrop (pure stabilization).
Underwriters initially sell shares in excess of the original amount offered, thereby
taking a short position prior to theoffering. This short position can be covered by
exercising the overallotment option and / or by short covering in the aftermarket.

In offerings where weak demand is anticipated, underwriter frequently take a naked short
position by allocating more than 115 percent of the stated size of the offering (after market
short covering). Naked short position for price stabilization is not allowed in Germany.
Aftermarket short covering allows underwriters to absorb shares flipped in the first few days
of trading otherwise flipping would put downward pressure on the stock price. In weak
offerings the underwriters must have a large enough short position to absorb the selling
pressure from flipping, else the stock price falls. If the short position is not large enough and
flipping is excessive, they are not able to provide effective price support unless they take a
long position and hold inventory ofthestock.
Underwriters may penalize members of the selling group whose customers quickly flip
shares in the aftermarket by taking away their selling concession (penalty bid). Penalty bids
are used selectively and tend to be assessed only for weak offerings. Purpose of penalty bids
is to control the flipping i.e. reselling of shares that have been received in an initial
allocation in the immediate aftermarket. On average, the volume of shares traded on the first
trading day of an offering is 60 to 70 percent of the stated number of shares offered.
When there is strong demand, underwriters are happy to see flipping (and the commissions
the trading generates). When demand is weak, selling pressure due to flipping requires that
the underwriter either stabilize the price or see it decline below the offer price. If the
distribution of firms customers, who bought at the initial offer price, sell their shares in the
first few days, then penalty bids may be assessed on the distributing firm. Assessment of
penalty bids results in forfeiture of the selling concession received for the distribution of
shares that are repurchased by the lead manager in the secondary market because of
flipping.
Pure stabilization is never done. Aftermarket short covering is the principal form of
stabilization (almost no disclosure requirements). Underwriters cannot predict completely
which offerings will trade above or below the offer price: the short position must be taken ex
ante, before trading starts sometimes short covering has to be done even for IPOs that go
up in price. On average, short covering is not expensive for underwriters and amounts to a
small proportion of the gross spread they receive.

Stabilization could be regarded as a put option given to institutional investors as a reward for
revealing private information during the offer period.
The put option might also compensate uninformed investors for the winners curse: since
uninformed investors are more likely to end up with overpriced IPOs, they value the put
option more than informed investors.
Stabilization like underpricing helps compensating uninformed investors for adverse
selection costs.
Price support also allows underwriters to disguise overpriced offerings from investors by
temporarily inflating the stockprice.

9.2 Green shoe

The overallotment option (the green shoe) grants an option to the underwriter to purchase
from the issuing company, within 30 days, an additional 15% of the shares sold in the IPO at
the offer price.
With this option, an underwriter can (and virtually always does) sell 115% percent of the
firms shares at the offering. The motivation for this option is to provide buying support for the
shares without exposing the underwriter to excessive risk. If the offering is strong and the
price goes up, the underwriter covers its short position by exercising the green shoe option at
the
offering
price
and
receives
an
additional
gross
margin
on
the
proceedsfromtheoverallottedshares.

If the offering is weak and the price goes down, the underwriter does not exercise the option,
and instead buys back all or part of the extra 15 percent of shares in the market, thereby
supporting the stock price. The overallotment option thus provides the underwriter with
buying power in the aftermarket, enabling it to support the price of the newly traded security.
The underwriter has a maximum of 30 days to exercise all or part of the option and to
stabilize prices.

10. Costs of IPOs

Direct costs of IPOs for the issuing firm are substantial, reaching an average of 7% of the
IPO volume in the US. In other countries, this spread is roughly 3.5% on average, that is
about half of the costs of US IPOs. Once an issuer chooses a book manager and comanagers, the lead manager invites other underwriters into the underwriting syndicate.
Typically, the syndicate is split into several brackets depending on the number of syndicate
members there are.

Historically, syndicates existed partly for regulatory capital requirementsandrisk-sharing

purposes and partly to facilitate the distribution of an issue. This was particularly relevant
when the lead underwriter did not have a significant retail or institutional distribution network,
and had limited capital. Underwriters such as Merrill Lynch, Deutsche Bank or Citigroup, with
their large institutional and retail distribution networks, do not need other investment bankers
to assist in distributin ga given issue. And with their large capital bases, risk sharing would
seem to be important only for the very largest issues. Today, in a typical IPO, the vast
majority of revenue and profits goes to the book manager.
Fees are typically structured as follows:

20% management fee to the lead manager (Costs: due diligence, prospectus, pricing,
organisation of syndicate, roadshow)
20% underwriting fee (Pacement risk, price stabilization)
60% selling concession (A syndicate member would receive the selling commission
for each share whose sale is credited to that member).

Note that there is not necessary a relation between the number of shares underwritten and
the selling credits earned normally, the vast majority of the shares sold will be credited to
the book manager.
All syndicate members would receive the underwriting fee of 20%, minus underwriting and
stabilization expenses, for each share underwritten. The managing underwriters would
receive 20% management fee on every share sold by any member, with the split between the
lead and co-managing underwriters usually tilted in the lead managers favor. The book
manager receives at least a proportionate share of the management fee revenue, the vast
majority of the selling concession revenue, and part of the net underwriting fee revenue. This
last item is typically a small number, and may even be negative if stabilization expenses are
high.

10.1 The seven percent solution

It is accepted that there are fixed costs associated with issuing securities, leading to
economies of scale in the costs of issuing debt, equity, and hybrid securities. For initial public
offerings of moderate size, however, no economies of scale are evident when one examines
the commissions paid to investment bankers, also known as the gross spreads or
underwriting discounts in the US.
Reasons:

Explicit collusion: Not likely, too many people involved.

Implicit collusion: With IPOs, it is quite plausible that underwriters fear that quoting a
lower spread will set off a price war that will drive gross spreads down on future
deals. After all, many of the individuals in the business that we have talked to state
that they do not want to charge a lower spread because they dont want to turn it into
a commodity business.
IPO market has low concentration and is characterized by ease of entry. 7% not
abnormally profitable.
Competition on other features of IPOs, such as reputation, placementservice,
underpricing.

10.2 Investor communication and disclosure

Being public consumes considerable resources to comply with disclosure requirements:

Management time.
Collecting, analyzing and processing of information.
Complying with legal and regulatory requirements.
Disseminating information and educating investors.

In imperfect capital markets, communication can be an effective means to mitigate

information asymmetry and thus increase market value.
The DVFA and PwC suggest that analyst presentations as an executive summary of a
companys financial communication. Analyst presentations are predominantly business
updates of a firm to the financial community (i.e. analysts, investors, investors advisers).
They provide condensed information (in line with annual reporting) to an educated and
informed audience.

11. Lock up
Typically, upon a firm going public, the owners tend to sell roughly 15-20% of the company.
As part of the IPO process, the remaining 80-85% of the shareholders are almost always
subject to a lock-up period, usually (but not always) 180 days, in which they have agreed not
to sell any of their shares. Upon completion of this period, these shareholders are then free
to sell their existing shares.
Lock-ups are not a legal requirement but a standard arrangement for the underwriters to
insist upon the shares of the pre-issue shareholders to be restricted from sale for a certain
period o ftime.This period, the so-called lock up period, is one way of aligning the incentives
of the current owners and new owners, at least during the initial phase for the company of
being public.
The majority of lock-up periods last 180 days, or approximately 6 months. In Germanys
Neuer Markt a six-month lock-up period has been required by Deutsche Brse.
Reasons for lock ups:

They reassure the market that key employees will continue to apply themselves for at
least a few months.
They provide a credible signal that insiders are not attempting to cash out in advance
of imminent bad news.
They may aid the underwriters price support efforts by temporarily constraining the
supply of shares.

Most of the existing shareholders are free to sell the shares after thelock-upperiod. These
shareholders often have strong reason to sell after the end of the lock up period:

In general, these shares represent significant fractions of their wealth, subjecting

them to significant asset risk.
From a diversification point of view, it is natural that after the lock-up period there is
significant selling pressure on these stocks.
Therefore, rationally, markets should incorporate the economic impact (if any) of
either price pressure or permanent shocks tosharesupply.

In other words, the price impact should be built into the IPO traded price long before
the end of the lock-up period.

From an expectationalpoint of view, there should be no impact on the stock prices of these
firms. However:

On the lock-up expiration (defined as day 0/-1), there is a 1.15% average drop in the
price.
Extending this period an additional three days surrounding the end of the lock-up
period (i.e., day -4 to 0), the drop increases to 2.03% for the price of stocks that have
gone through IPOs.

Given the permanence of the stock price drop, arbitrageurs, or even just existing
shareholders, should have an incredible incentive to sell the shares prior to the run down.
Problems in shorting these shares:

Trading costs
Difficulty of shorting newly-public stocks, and short-term capital gains faced by the
original shareholders (which are taxed)

Abnormal returns around the unlock day are driven largely by firms backed with venture
capital. More often than most investors, venture capitalists tend to exit the firm as soon as
possible.

12. Long run performance

In measuring long-run performance, one can focus either on raw (absolute) performance, or
performance relative to a benchmark(abnormal returns).
Differences between industries are significant. Especially, technology, media and
telecommunication firms seem to be a bad choice for investors. Such investments may result
in about 50% opportunity costs in three years after IPO.
The Choice of underwriter is crucial. Firms choosing top-10 underwriters are significantly
underpriced by 9.1% and perform after three years moderately negative (-11.3%).
Companies choosing underwriters with less reputation are much less underpriced (0.6%), but
perform poorer in the long run with average three year returns of -22.1%.
The size of a company seems to have a large impact on aftermarket performance. While
small firms in terms of market capitalization are overpriced by 0.4%, large firms are
underpriced by 6.2%. After three years, small firms underperform the market significantly by
-27.6%, whereas large firms perform moderately weak (-11.0%).
How to explain this:

The lowest returns are on the very smallest IPOs. These stocks are most likely to be
taken public by underwriterswithregulatoryproblems. Also, these IPOs are least likely
to be backed by venture capitalists. Moreover, there is little or no institutional investor
interest in these stocks.

In order to measure long-run performance, usual benchmarks are:

The market index

Some sub-market index (such as TecDax)
Similar firms (same size) very similar firms (same size & same book-to-market-ratio)
this is called firms of the same style This is also the best approach!

There IPO characteristics of firms that eventually become index firms differ from those
companies who fail to do so. The following characteristics increase the likelihood of a
company to be eventually included in an index (in this case the S&P500):

High-reputation of underwriter(s)
Larger firm size
Higher ROA
High-tech industry company
Venture capital backing
Highly underpriced IPOs have lower inclusion odds

Overall, the results indicate that higher quality firms, which showed less asymmetric
information problems around there IPO, are more likely to eventually become an index
member.

SEASONED EQUITY OFFERINGS

1. Definition, reasons and types
When a firm, which is already publicly traded, sells additional stock, the new shares are
perfect substitutes for the existing ones. For these transactions, the academic literature tends
to use the term seasoned equity offering (SEO), in contrasted to unseasoned equity offering,
an IPO.
Reasons for selling seasoned equity:

Raise cash for profitable projects with a positive net present value.
Management thinks the stock is overvalued.
Firm has too much leverage, so firm wants to retire some of its debt.
Corporate controlmotivations:
selling stock to a diffuse group of outsiders will weaken the control of outside
stockholders.
selling stock to a single large blockholderwill create a new 'monitor' for
management (or a friendly 'white knight' to shelter management from unfriendly
raiders).

Results of an SEO:

The number of shares outstanding rises.

Cash goes into the firm.
Public floatrises.
Number of shareholders rises.

There is evidence that the liquidity of a stock increases after an SEO. One of the reasons for
this increase in liquidity is analyst coverage. A better analyst coverage usually leads to
increased liquidity in the stock and companies should therefore promote analyst coverage.

1.1 Capital increase

Capital increases can be distinguished:

By the means of the increase:

- Capital increase in return for cash:
Usual case new shares (young shares) are issued against cash. In general,
shareholders have the right to buy these new shares to prevent dilution of
their shares (in Germany and most EU states; generally not the case in the
US). This is called rights offering.
- Capital increase in return for stock (Sacheinlagen):
New shares are issued against other goods (mostly: other firms).
- Capital increase from the companys reserves:
Reserves are turned into capital
No cash flows to the firm
New shares are distributed to existing shareholders for free
(Gratisaktien)
Share price decreases accordingly
By the formal procedure
- Orderly capital increase
- Authorized capital increase:
Since capital increases need the support of the shareholders, they are quite
inflexible. The shareholder meeting can decide to authorize capital increases in
advance (in Germany: maximum five years in advance; maximum 50% of the
existing capital).
- Conditional (or contingent) capital increase:
Similar to the above, but capital increases are triggered by exercise of warrants
and/or convertible bonds.

All capital increases need a 75% majority of at the general shareholder meetings.

2. Rights
Example:

Suppose that at date t a firm issues a 'right' to buy one share of stock for each share
currently held.
At an exercise price of $X per share, on or before date T.
This right can be sold to other investors and exercised by them.
At the date the stock goes 'ex-rights' (i.e. the stockholders on date t-1receive the
right, and holders on date tdo not),
S(t-1) = S(t) + C(t)
Where S(t) and C(t) are the value of the stock and the righton datet, respectively.

There is an special procedure: Opration blanche: An investor sells s certain amount of his
rights and uses the proceeds to purchase his remaining rights issues. In this case the
investor does not need invest any additional funds. However, the ownership decreases.

Rights issues are not common in the US.

3. Cycles and underpricing

3.1 Cycles
Fims only conduct SEOs when the market conditions are good.
Using monthly number of SEOs as a measure of SEO volume, there is significant variation in
the monthly SEO volume, but smaller than that in monthly IPO volume; also cycles tend to be
shorter.
It appears that in certain time periods private firms simply cannot go public by issuing equity
-however, seasoned firms issued equity in every month in the thirty years from 1973 to 2002

3.2 Underpricing
The magnitude of SEO underpricing has been relatively small historically, it increased
dramatically during the 1990s. SEO underpricing averaged 1.15% for offers from 1980 to
1989, increased to 2.92% for offers from 1990 to 1998, and reached as high as 3.72% in
1996. While this level of underpricing is much smaller than that observed for IPOs, it
represents a substantial cost to issuing firms.
Consistent with evidence from the IPO literature, SEO underpricing is positively related to the
level of uncertainty aboutfirm value.
Compensation is required because informed investors will participate only in good issues,
leaving uninformed investors with a disproportionate share of bad issues (winners curse)
There is only little evidence of a reliable relation between SEO underpricing and proxies for
asymmetric information such as firm size and bid-ask spread. Therefore, while price
uncertainty plays a significant role in SEO pricing, asymmetric information effects have little
impact on offer pricing for seasoned firms.
Even in the absence of asymmetric information, the time lag between offer pricing and
distribution may lead to a significant relation between uncertainty and underpricing.
One could view a seasoned offer as a permanent shift in the supply of existing shares: if the
aggregate demand curve for the firms shares is downward sloping, this increase in supply
will result in a permanent decrease in stock price.

SEC rule10b-21: Adopted on August 25, 1988, prohibits investors from covering a short
position with stock purchased in a new offering if the short position was established between
the filing date and the distribution date.

4. Underperformance
Firms that do an SEO underperform.
For both IPOs and SEOs, 44% more money must be invested in issuers than in non-issuers
of the same size to achieve the same wealth level five years later.
For firms conducting SEOs, the average return is 11% per year; compared to 15% for their
matching firms an underperformance of 4% per year.

The new issue puzzle is explained by a failure of the matched-firm technique to provide a
proper control for risk. It appears that as equity issuers lower leverage, their exposures to
unexpected inflation and default risks also decrease relative to the matched firms. In addition
SEOs significantly increase stock turnover, which is often interpreted as a measure of
liquidity, while the matched firms experience no change in stock turnover. Therefore, stocks
of SEO issuers could require lower liquidity premiums in the post-offering period.
During the post-offering period, issuer stocks are on average less risky and therefore require
lower expected returns than stocks of matched firms. The definition of abnormal performance
that uses matched firms as a performance benchmark by itself gives rise to the
newissuespuzzle. Expansion options and assets in place prior to equity issuance could be
thought of as real options this composition is levered and risky. If capital investment is
financed by equity, then risk must decrease because investment in effect extinguishes the
risky growth options.
Also, equity issuers invest much more than matching non-issuers with similar size and bookto-market ratios.

5. Announcement returns Investors reactions

Capital market participants react to security issue announcements by revaluing the issuer's
stock price.
The average two-day announcement-induced abnormal stock return to SEOs on the
NYSE/Amex is -2 to -3%, a value reduction equal to approximately 20% of the proceeds of
the averageissue.
This revaluation depends in part on the market's perception of the issuing firm's objectives
and in part on the nature of the information asymmetry between investors and the firm
concerning the true value of its securities.
The most popular explanation among academics for this negative announcement effect is
that of the Myers and Majluf(1984) adverse selection model (pecking order theory). Myers
and Majlufassume that management wants to maximize the wealth of its existing
shareholders in the long-run. At any point in time, however, the current market price may be
too high or too low relative to managements private information about the value of assets in
place. If management thinks that the current market price is too low, the firm will not issue
undervalued stock, for doing so dilutes the fractional ownership of existing shareholders. If
management thinks that the current stock price is too high, however, the firm will issue equity
if debt financing is not an option. Rational investors, knowing this decision rule, therefore
interpret an equity issue announcement as conveying managements opinion that the stock is
overvalued, and the stock pricefalls.
If the market interprets the equity issue as implying that a new positive net present value
project will be undertaken, the announcement effect could be positive.
If the market is concerned that the equity issue means that management will squander the
funds on empire building, then the announcement effect could be interpreted as causally
linked to the equity issue, in which case external equity is in fact very expensive. The
rationale is that the additional equity resources are relaxing a constraint on managements

tendency to engage in empire-building, or growth for the sake of growth. In other words,
agency problems between shareholders and managersareintensified.
Key theories on SEO-underperformance:
1. Capital structure: issuing equity changes the capital structure and (mostly) leads to a
lower valuation due to increased capital costs (Akhigbe/Harikumar, 1996).
2. Asymmetric information (Myers/Majluf, 1986, Miller/Rock, 1985):
Signalling: Managers issue equity when its value is relatively high, favouring
existing shareholders at the expense of new investors. The latter anticipate this
behaviour and react accordingly.
Signalling/Pecking order: Managers prefer using internal resources over debt and
debt over equity capital to make investments. Using equity is a signal to investors
about the (in)ability of management to generate other resources and thus about
the future prospects of the company.
3. Demand effects/asymmetric information: issuing equity increases the supply of share
capital of a given firm. Assuming a fixed demand for those shares, issuing equity
should result in a decrease in price (Chaplinsky/Ramchand, 2000).
Example of luxury industry:

Asymmetric information in the luxury industry lead to highly negative abnormal

returns at SEO announcement.
Performance of luxury operations likely to be very difficult to predict (collections,
designs). Issuing equity constitutes a highly negative signal.
Volume and market phase also represent a key driver of negative performance.

6. PIPES
PIPE= Private Investment in Public Equity (sometimes Private Investment Public
Enterprises). It means that capital comes from a selected private source without an
investment offer for the public at large.
It is a quicker alternative to traditional methods like SEOs.The closing of a PIPE transaction
does not depend upon the Security Exchange Commission (SEC) review process.
It is an alternative instrument to raise equity capital. PIPE volume increased over time. As an
OTC transaction, various terms can be agreed upon.
The issuers are, usually, small and risky firms. The investors are hedge funds normally.
Stock market reactions, on average, are positive in the short-run and negative in the longrun.
Benefits t the issuer:

Time efficient
Confidentiality
Reduce undervaluation
Last resort: Sophisticated investors are experienced, willing, and capable of taking
risk and may be the only investors left for troubling companies.
Small issues possible
Strategic investing: various terms can be negotiated, e.g. board representation.

Deep insights in the firm: Investors can directly communicate with the issuer and
perform due diligence on their own.

In general, the capital market reactions:

Short-run performance: on average the market reaction around the announcement of

a PIPE is positive.
Long-run performance: on average, the long-run market performance is negative.

PIPEs provide a supplement to the traditional SEO market. PIPEs as an alternative to SEOs
in raising equity capital are preferred:

If firms have weak operating performance and show characteristics of information

asymmetry (=have no other alternatives to raise capital)
If firms are likely to be undervalued (=signalling good quality to the market).
If PIPE conditions allow for cheaper financing than current SEO terms.