Initial Public Offerings IPOs Financing new ideas Venture

Initial Public Offerings (IPOs) • • Financing new ideas Venture capital Initial Public Offering Why issue equity publicly IPO process Underpricing puzzle Long-run performance of IPOs Other IPO/Divestiture methods 1

Financing New Ideas • • • Personal savings Bank, but not likely to work Government but a very limited resources Large industrial companies Venture Capital Funds – Mostly organized as private partnerships – Need to prepare a business plan for funding – They invest in stages to control risk – They require board representation and get shares 2

How Successful is Venture Funds • http: //www. ventureeconomics. com/ • http: //www. nvca. org/ 3

• If idea is successful then more money can be raised through an IPO • IPO also allows venture capital to exit the investment Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02 -01. http: //ssrn. com/abstract=296393 IPO Activity 4

Why IPO Activity is Cyclical • Demand-side explanation suggests that start -up firms with good projects cannot get private funding and they use IPO for raising capital - internet firms during 95 -98 • Supply-side explanation suggests that during some time periods investors and institutions that invest in IPOs have excess funds to invest 5

Why IPO Activity is Cyclical • A time period with a lot of IPOs is called “hot issue period” • If a hot issue period is driven by supply-side then it may be advantageous for a new firm to go public • If a hot issue period is driven by demand for funds then a new firm may be better off delaying to go public - competition for funds 6

Why Issue Equity Publicly 7

IPO Process • • • Underwriter Selection Registration Marketing and Book Building Pricing After Market Activities 8

Underwriter Selection • Factors to consider: – – Investment banker’s general reputation and expertise Quality of its research coverage Investment bank’s distribution expertise - individual or institutional Prior banking relationships • The most common underwriting arrangement is the “firm commitment” • In this case the underwriter purchases all issued securities and then resells them to the public - price differential is called the “gross spread” 9

Lead Underwriter • The lead manager plays the major role in the IPO - scheduling, pricing, distribution of new issue, and assembling a group of underwriters to sell shares to the public • The syndicate members are paid a portion of the gross spread for their participation - 60% of the gross spread • The lead underwriter receives a fee for its efforts that is typically 20% of the gross spread 10

Underwriter • Letter of intent – The letter of intent protects the underwriter against expenses if the offer is withdrawn – The letter of intent obligates the company to reimburse the underwriter – It also specify the gross spread – In most cases, the gross spread is 7% of the proceeds – It also includes clauses on: • • Underwriter’s firm commitment Cooperation by the company Releasing of all available relevant information Commitment by the private firm to grant 15% overallotment option to the underwriter – Letter of intent is in effect until Underwriting Agreement is signed at pricing of the issue 11

Registration • The Securities Act of 1933 (Section 5) requires a registration statement to be filed with the SEC • The registration statement consists of two parts – The prospectus to be given to every purchaser of the securities – “Part II” which contains information that need not be furnished to the public but is made available for public inspection by the SEC • The registration statement allows public to obtain information about the issue • The underwriter has a “due diligence” requirement to verify the information • The Securities Act also makes it illegal to offer or sell securities to the public without registration • The SEC has no authority to block a public offering based on the quality of the securities involved. It can require the issuer to provide all material facts • The registration statement has to be signed by directors and principal officers of the issuer, the underwriters, accountants, appraisers and other experts 12 • Investors who maintain losses as a result of misstatements or omissions in the registration statement may sue these signatories

Marketing • Once it is filed the registration statement is transformed into the preliminary prospectus or “Red Herring” • The preliminary prospectus is used to market the issue • The SEC has 20 days to declare the issue effective • At that point the red herring becomes a prospectus • The company and the underwriter promote the IPO through the “road show” • Road shows provide important monitoring for the underwriter on investor demand 13

Marketing • During the road shows the underwriter receives orders from individual and institutional investors - book building – Retail investors typically submit a “market order” in which only the quantity desired is stated – Institutions typically submit limit orders where the quantity demanded is subject to a maximum price – Retail orders are received earlier than institutional orders since institutions prefer to wait to a later stage of the process before submitting their orders – Institutions submit an order with a commitment to purchase more shares in the open market if their order is fulfilled 14

Pricing • Once the registration statement is approved by the SEC then two most important items have to be determined: – offer price – the number of shares to be sold • Book building at this stage is very important to gauge the investor demand • Some suggest that an IPO may be successful if it is three times oversubscribed 15

Pricing • Ritter (1991) on IPO pricing suggests that IPOs are “under-priced” – meaning that you can make money buying stocks from an underwriter and selling them in the market once public trading starts • Flipping – dumping of shares as soon as trading starts – is discouraged by the underwriters, but it is not easy to control 16

IPO Underpricing 17

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02 -01. http: //ssrn. com/abstract=296393 IPO Underpricing 18

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02 -01. http: //ssrn. com/abstract=296393 IPO Underpricing 19

Why IPOs are Underpriced • If an issue is too low then the issuing firm’s owners will not like bearing the additional cost of going public • If an issue is priced too high then the underwriter is stuck with shares plus a bad reputation • The underwriter is to balance between the tow extreme – Underpricing allows the underwriter to sell shares of the firm easily 20 – It reduces the possibility of lawsuits

Underpricing and Average Investor • Assume that average investor is not informed well on the quality of an issue • The uninformed investor faces a “winner’s curse” that is if you bid in an auction and you end up with the item you most likely over bid • Underwriters know that most average investors cannot distinguish between good and bad issues and to keep uninformed investors interested they underprice • Otherwise uninformed investors would not play the game for long reducing the demand for the issue - bad for the underwriter 21

After Market • Stabilization activities by the underwriter: – These involve trading by the underwriter to support the stock by buying shares if order imbalances arise – This price support can be done only at or below the offering price – The standard prohibitions against price manipulation do not apply to the underwriter during this period • The final stage of the IPO begins 25 calendar days after the IPO when the so called “quiet period” ends • During the “quiet period” investors rely on prospectus • After the “quiet period” underwriters can comment on the valuation and provide earnings estimates on the new company 22

Long-Run IPO Performance Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02 -01. http: //ssrn. com/abstract=296393 23

LR IPO Performance and Hot Issue Periods Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02 -01. http: //ssrn. com/abstract=296393 24

Other Divestiture Methods • Spin-off: a company gives the shares of a subsidiary to its own shareholders • Shareholders can then sell their shares in the market • Shareholders are not subject to taxes if 80% of the subsidiary stock is distributed • Miles and Rosenfeld (1983) find an abnormal return of +3. 34% to parent firms over days (0, +1) around the announcement 25

Why Spin-off? • Eliminate negative synergies • Increases focus • Improves managerial compensation contract design • Reduces the possibility of unprofitable business lines being supported by profitable ones 26

Other Divestiture Methods • Sell-off: a parent firm sells the assets of a subsidiary to another firm • Signaling effect is different depending on why assets are sold – If firm is refocusing its investments then it may be good news – If assets are sold to raise cash to pay down debt then it may be bad news • Capital gains tax would be paid • Rosenfeld (1984) finds an abnormal return of +2. 21% over days (0, +1) 27

Other Divestiture Methods • Carve-out: shares of a subsidiary are sold to general public through an IPO • The parent usually maintains the control – Funds that are made available for the subsidiary can be invested for positive NPV projects – Reduced asymmetric information improves the value of subsidiary – Improved managerial compensation • Allen and Mc. Connel (1998) find an abnormal return of +1. 9% over days (-1, +1), but if the parent indicates special dividend payment or debt reduction with the proceeds then abnormal return is +6. 63% • In other cases the abnormal returns is close to zero 28

Additional Articles • Muscarella and Vetsuypens, 1989, A simple test of Baron’s Model of IPO Underpricing, Journal of Financial Economics 24, 125 -135. • SSRN-Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02 -01. http: //ssrn. com/abstract=296393 • JSTOR-Why Do Companies Go Public? An Empirical Analysis, Marco Pagano; Fabio Panetta; Luigi Zingales, The Journal of Finance, Vol. 53, No. 1. (Feb. , 1998), pp. 27 -64. URL: http: //links. jstor. org/sici? sici=00221082%28199802%2953%3 A 1%3 C 27%3 AWDCGPA%3 E 2. 0. CO%3 B 2 -Z • • • JSTOR-Equity Carve-Outs and Managerial Discretion, Jeffrey W. Allen; John J. Mc. Connell, The Journal of Finance, Vol. 53, No. 1. (Feb. , 1998), pp. 163 -186. URL: http: //links. jstor. org/sici? sici=00221082%28199802%2953%3 A 1%3 C 163%3 AECAMD%3 E 2. 0. CO%3 B 2 -W 29

Additional Articles • • • JSTOR-Additional Evidence on the Relation Between Divestiture Announcements and Shareholder Wealth, James D. Rosenfeld, The Journal of Finance, Vol. 39, No. 5. (Dec. , 1984), pp. 1437 -1448. URL: http: //links. jstor. org/sici? sici=00221082%28198412%2939%3 A 5%3 C 1437%3 AAEOTRB%3 E 2. 0. CO%3 B 2 -1 JSTOR-The Effect of Voluntary Spin-off Announcements on Shareholder Wealth, James A. Miles; James D. Rosenfeld, The Journal of Finance, Vol. 38, No. 5. (Dec. , 1983), pp. 1597 -1606. URL: http: //links. jstor. org/sici? sici=00221082%28198312%2938%3 A 5%3 C 1597%3 ATEOVSA%3 E 2. 0. CO%3 B 2 -0 JSTOR-The Long-Run Performance of Initial Public Offerings, Jay R. Ritter, The Journal of Finance, Vol. 46, No. 1. (Mar. , 1991), pp. 3 -27. URL: http: //links. jstor. org/sici? sici=00221082%28199103%2946%3 A 1%3 C 3%3 ATLPOIP%3 E 2. 0. CO%3 B 2 -9 30