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Introduction to Finance: Initial Public Offering (IPO)

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Title: Introduction to Finance: Initial Public Offering (IPO)


1
Introduction to Finance Initial Public Offering
(IPO)
2
Why Go Public?
  • Is going pubic simply a stage in the life cycle
    of the firm?
  • It is a choice. A choice in financing.
  • Positive effects must be balanced against the
    negative effects.
  • Negative effects adverse selection problem,
    large expenses, loss of confidentiality
  • Positive effects alternative financing
    possibilities, increased bargaining power with
    banks

3
Underwriter (Syndicate)
  • Syndicate group of investment banks. Managing
    bank (leading bank) organizes the syndicate.
  • Firm commitment syndicate (underwriters) commit
    to buying shares and selling. Shares bought at
    less than the offering price but the investment
    bank accepts the risk of not being able to sell
    the shares. The syndicate reduces the spreads the
    risk across banks.

4
Cont.
  • Green Shoe provision Members of the underwriting
    group have the option to purchase additional
    shares at the offering price.
  • Book Building Recent IPOs in Japan take this
    approach. Estimate investor demand (taking into
    account all facts and circumstances).

5
Positive Effects
  • If future investments expected to increase
    public offerings make funds available.
  • Firms with relatively large debt positions could
    use the proceeds from the offering to reduce
    debt exposure.
  • Better access to capital markets. Bargaining
    power with banks could increase.
  • (current) Shareholders gain liquidity. Equity
    based compensation schemes become possible.

6
Cont.
  • Monitoring and information provided by the
    market.
  • Enhance firms credibility.

7
Negative Effects
  • In the event of an IPO, a small firm could face
    information asymmetry. Investors not familiar
    with the firm.
  • Loss of confidentiality For example, firms with
    RD projects which they do not wish to disclose
    to the public for competitive reasons.
  • Costs of dealing with shareholders costs of
    operating a publicly traded firm (PR dept.,
    audits, etc.)

8
Cont.
  • Direct costs of IPO registration, underwriting
    fees, etc. (total direct cost amount to
    approximately 10 of amount raised).
  • Indirect Cost - underpricing problem.

9
Empirical Evidence
  • Hiraki and Hebner (1993) document a 32 initial
    return on average for IPOs during 1981-91.
  • Isobe, Ito, Kairys (1998) look at long-run
    performance of IPOs and find less evidence of
    deliberate underpricing. Their results appear
    somewhat consistent with an over-reaction
    hypothesis. However, they conclude that
    instituional features in price setting (using
    comparables) could be an important factor.

10
Understanding Underpricing
  • 1) Underwriter incentives Avoid risk of not
    being able to sell shares.
  • 2) Sequencing of issues. If the first issue is
    underpriced then investors make a gain. They
    might be more likely to subscribe to a firms
    secondary offering because of their experience in
    the IPO (primary offering).

11
Cont.
  • 3) Underpricing induces the average investor to
    buy. Informed investors are assumed to know the
    true value of the share. Thus informed investors
    will only purchase those valued shares which are
    underpriced. The average investor, on the
    other hand, will purchase across the board since
    they do not know which shares are truly
    underpriced.

12
Cont.
  • However, the average investor will lose money (on
    average). Realizing they do not have the same
    information as the informed investor, the average
    investor may choose not to enter the market.
    Hence, to induce these average investors into the
    market, the IPOs are underpriced.

13
Netscape
  • The choice of going public need of substantial
    funds for RD over next several years.
  • Saturated private funding
  • Angel wealthy individuals who invest in the
    business. Jim Clark (4.1 million)
  • Venture capital funds Kleiner, Perkins,
    Caufield, Byers (5 million)
  • Bank Loans?
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