1. 1 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

2. 2 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

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

4. 4 IPO Activity 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

5. 5 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

6. 6 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

7. 7 Why Issue Equity Publicly

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

9. 9 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”

10. 10 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

11. 11 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

12. 12 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 Investors who maintain losses as a result of misstatements or omissions in the registration statement may sue these signatories

13. 13 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

14. 14 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

15. 15 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

16. 16 Pricing Ritter (1991) on IPO pricing suggests that IPOs are “under-priced” – meaning that you can make money buy 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

17. 17 IPO Underpricing

18. 18 IPO Underpricing 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

19. 19 IPO Underpricing 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

20. 20 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 –It reduces the possibility of lawsuits

21. 21 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

22. 22 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

23. 23 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

24. 24 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

25. 25 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

26. 26 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

27. 27 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)

28. 28 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 McConnel (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

29. 29 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 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=0022- 1082%28199802%2953%3A1%3C27%3AWDCGPA%3E2.0.CO%3B2-Zhttp://links.jstor.org/sici?sici=0022- 1082%28199802%2953%3A1%3C27%3AWDCGPA%3E2.0.CO%3B2-Z JSTOR-Equity Carve-Outs and Managerial Discretion, Jeffrey W. Allen; John J. McConnell, The Journal of Finance, Vol. 53, No. 1. (Feb., 1998), pp. 163-186. URL: http://links.jstor.org/sici?sici=0022- 1082%28199802%2953%3A1%3C163%3AECAMD%3E2.0.CO%3B2-Whttp://links.jstor.org/sici?sici=0022- 1082%28199802%2953%3A1%3C163%3AECAMD%3E2.0.CO%3B2-W

30. 30 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=0022- 1082%28198412%2939%3A5%3C1437%3AAEOTRB%3E2.0.CO%3B2-1http://links.jstor.org/sici?sici=0022- 1082%28198412%2939%3A5%3C1437%3AAEOTRB%3E2.0.CO%3B2-1 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=0022- 1082%28198312%2938%3A5%3C1597%3ATEOVSA%3E2.0.CO%3B2-0http://links.jstor.org/sici?sici=0022- 1082%28198312%2938%3A5%3C1597%3ATEOVSA%3E2.0.CO%3B2-0 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=0022- 1082%28199103%2946%3A1%3C3%3ATLPOIP%3E2.0.CO%3B2-9http://links.jstor.org/sici?sici=0022- 1082%28199103%2946%3A1%3C3%3ATLPOIP%3E2.0.CO%3B2-9