ipo and seos

8/18/2019 IPO and SEOs

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INITIAL PUBLIC OFFERING (IPO)

1. Market and developent!

There are clear „windows of opportuniy“ that open and close for IPO issuers. Aftercrasches (1987 !""! !"11# al$ost all pendin% IPO deals were cancelled.

IPO acti&ity di'ers in ti$e and internationally.

The literature does not ha&e a full $odel that can eplain)

• At what sta%e of a *r$+s lifecycle it is opti$al to %o pu,lic) Pri&ate *r$s

see$ to face ,oth life-cycle considerations and $aret-ti$in%

considerations in the decision when to %o pu,lic. /aret-condition

considerations can ,e &iewed as ti$e-&aryin% relati&e costs of de,t &ersus

e0uity and pri&ate &ersus pu,lic fundin% costs.

• why the &olu$e of IPOs &aries dra$atically across ti$e and acrosscountries. The ow of co$panies co$in% to the $aret should depend on

factors that deter$ine the trade-o' ,etween the costs and ,ene*ts of a

stoc $aret listin%. The ow of co$panies co$in% to the $aret should

depend on factors that deter$ine the trade-o' ,etween the costs and

,ene*ts of a stoc $aret listin%. /a2or in%redients) de$and for outside

e0uity capital and the $aret+s willin%ness to supply such capital.

". Advanta#e! and d$!advanta#e! o% #o$n# p&'l$

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 I!s in the financial cycle• Industry market condition• Frequency and size of industry I!s in the financial cycle

".1 Advanta#e! o% #o$n# p&'l$

•Ne ap$tal* almost all companies go public primarily because they need money for ne"pro#ects $or the reduction of leverage% &all other reasons are of secondary importance

•F&t&re ap$tal* once public, firms can easily go back to the public markets to raise

additional cash

&Typically, about a third of all I! issuers return to the public market "ithin ' years to

issue a (seasoned equity offering) $*+ data%

&Those that do return raise about three times as much capital in their seasoned

equity offerings as they raised in their I! $*+ data%


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•Ca!+$n# o&t* although it is a bad signal to investors "hen an entrepreneur sells her o"n

shares, it still might make sense for some to cash out some of their "ealth.

•Mer#er! and a,&$!$t$on!* 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

•Ia#e* public firms tend to have higher profiles than private firms $important in industries

"here success requires customers and suppliers to make longterm commitments%

•Eplo-ee open!at$on* having a public share price makes it easy for firms to give

employees a formal stake in the company.

"." $!advanta#e!

•Pro%$t/!+ar$n#* if the firm is sitting on a goldmine, future gold has to be shared "ith

outsiders- after the typical I!, about /0 of the company remains "ith insiders, but this can

vary from 10 to 220, "ith 3/0 to 4/0 being comfortably normal.

•Lo!! o% on%$dent$al$t-* going public could destroy the business if the company has to

disclose its technology or profitability to its competitors.

•Report$n# and %$d&$ar- re!pon!$'$l$t$e!* public companies must continuously file reports

"ith regulators and the e5change they are listed on &costs money and discloses information

to competitors

•Lo!! o% ontrol* outsiders could take control and even fire the entrepreneur- there are

certain antitakeover measures, but "hat investor "ants to pay a high price for a company in

"hich poor management cannot be replaced6

•IPO e0pen!e!* a typical $smaller% firm may spend about 1'3'0 of the money raised on

direct e5penses $detailed in a later section.%- even more resources are spent indirectly

$management time, disruption of business%

•tron#er a#en- pro'le!* ne" shareholders have more different motives than former

o"ner7managers

•Le#al l$a'$l$t-* I! participants in the coalition are #ointly and severally liable for each

others8 actions &i.e., they are sometimes sued for various omissions in the I! prospectus,

especially "hen the public market valuation fall belo" the I! offering price $especially in the

*+%

".2 Co!t o% #o$n# and 'e$n# p&'l$


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9ost components:

• *nder the ob#ective of "ealth ma5imization stockholders should design the I! in a

"ay that the firm;s cost of capital is minimized• The afterI! cost of capital has three components:

The investors required return on equity

The cost of being public: continuous e5penses, such as listing fees, disclosure costsand the flotation cost caused by future seasoned equity offerings

The cost of going public: this is an upfront cost caused by the I! of the company

$i.e. under"riting fees and nonunder"riting fees%.


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• The difference bet"een the cost of equity $ke% and the cost of being public $>, gamma,

fI!% is in the order of one to t"o magnitudes• ?ence, managing keis the core issue of any I!• @ote that by simplifying, the inverse of ke can be interpreted as an earnings multiplier,

i.e. the priceearningsratio $AB%. There is no clear evidence that ABs may

systematically differ among different stock e5changes. +ince 1CC the average AB

for German stocks "as 14./ and for *D stocks 14.E.• *nder"riting.• isting fees tend to be lo"er at FH than at +A. ?o"ever, the impact of this

difference on the cost of capital is negligible, even though listing fees are a perpetuity

$less than 1 Hp.%. 9osts associated "ith disclosure requirements may not be

completely negligible. ?o"ever, there are no numbers available for this cost tem.• *nderpricing: =ccording to Bitter $AF< 3//J% average underpricing in *D over the

period 1C'C to 3//1 "as 1E.0 $J;133 observations%. !n a more recent database,

!5era$3//4, p. 31% estimates underpricing at +A to be 1/.0 $JCE observations%.

=verage underpricing in Germany over the period 1C2J to 3//4 "as J/.40 $E14

observations%- value "eighted underpricing is 31.20. +ince 3//3 underpricing in

Germany has averaged 4.C0 $44 observations%

2. Rea!on! %or #o$n# P&'l$. Cl&!ter$n# o% IPO

at$v$t- $n t$e

9hanges in I! activity occur, "henever the costs and benefits of I!s change. That could

be triggered by:

1. E0ternal rea!on! %or l&!ter$n# o% IPO at$v$t- $n t$e• @eed of pro#ects to be funded by I!s:• I! activity varies "ith the availability of investment opportunities and hence

the business cycle, since funding needs should be greatest "hen there are

many pro#ects to finance• Beduction of costs should lead to more I!s:

&ublicity and compliance requirements $information required in the I!

prospectus%

&Bela5ation of listing rules $minimum float requirements, restrictions on non

voting shares%


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&Beduction in commission fees to investment banks and listing fees to stock

e5changes $"ell, )semie5ternalK%

3. Rea!on! e0ternal to t+e %$r '&t $nternal to t+e !tok arket• Favorable stock markets "ill lead to more I!s:• If the original o"ners care about dilution of control, they "ill 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, I! volume

should be related to the stock market climateJ. Rea!on! $nternal to t+e %$r /%$r and prod&t arket +arater$!t$! t+at

$#+t e0pla$n +- IPO! l&!ter $n $nd&!tr$e!• $t&at$on* entrepreneur needs to obtain e5ternal financing to undertake a

positive net present value pro#ect• A!!&pt$on* asymmetric information &entrepreneur does kno" best about

pro#ects- outsiders can gain information about the pro#ects at a certain cost.

9hoice of entrepreneur:

1. I!: required capital is generated by selling shares to a large number of small

investors3. +tay private: much of the e5ternal financing is provided by one large investor or a

small group of large investors $venture capitalists%

9onsequences:

• +mall equity holders in public firms are much better diversified than those in

private firms. arge investors in private firms have considerably more

bargaining po"er 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 firm;s pro#ects $and the firm;smanagement%. In equilibrium, any

such costs e5pended by outsiders in evaluating the firm;s pro#ects "ill be

borne by the firm in form of a lo"er share price• hen a firm goes public, the common price at "hich the equity is sold is

publicly observable by all outside investors &the total costs involved in the

outsider;s evaluation of the firm;s pro#ects "ill be reduced some"hat: many

unsophisticated investors being able to free ride.• Lenture capital financing minimizes the information production costs since the

large investor contributes the entire capital after evaluating the firm only once.

?o"ever, the venture capitalist is little diversified and has po"er against theentrepreneur&"ill demand a greater rate of return than investors in public

companies. Investors in public companies have no bargaining po"er $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 firmM

+olution of tradeoff: depends on the magnitude of outsider;s information production costs:

• Firms "ith longer track records have lo"er costs of information acquisition for

the publicM


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• Firms go public only "hen 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%.• Nounger and more opaque firms, "hich entail a greater information acquisition

choose venture capitalist financing.

I!s "ill be clustered in time in industries $think solar energy- internet%:

• Firms "hich go public later in time are able to free ride on the costly

information generated by those in the industry "hich have gone public ahead

of them• Important also: the price chosen in an I! is in itself informative to outside

investors $more on that later on%• The pipeline of I!s $I!s registered "ith the financial authority, e.g. the

+A9% can also have an effect on I! clustering. Firms appear to )"ait outK

difficult markets $e.g. height of the recent financial crisis in 3//2% and then go

to the market, once the environment improved. In addition, the standard

deviation of previous I! returns has a significant negative effect on ne"

issuances$HoehO Punbar, 3/1%. This is consistent "ith issuers rationally

avoiding I! markets "hen pricing efficiency is lo".

=lso "orks the other "ay round: I! candidates learn from success or failure of first I!

• !utcomes of pioneers; I!s reflect participating investors; private information

on common valuation factors. This makes the pricing of subsequent issues

relatively easier and attracts more firms to the I! market• ?igh offer price realizations for pioneers; I!s better reflect investors; private

information and trigger a larger number of subsequent I!s than lo" offer

price realizations do.• Ampirical evidence suggests that venture capital backed I!s have positive

information spillovers in the form of higher valuation for rival companies in the

same industry. Lenture capital backed I!s therefore signal superior

information to the market relative to nonventure backed I!s $9oteiO Farhat,

3/1J%

+ome additional reasons for firms to Go ublic:

• +hareholders need an )e5it channelK. Aspecially financial investors $e.g.

venture capitalists and private equity% use I!s as an e5it channel for their

high quality portfolio companies• Increase the likelihood of mergers or acquisitions• *se o"n stocks as a currency for future


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3. 4+- %$r! #o p&'l$ 5 ep$r$al !t&d$e!

The main factor affecting the probability of an I! is the markettobook ratio at "hich firms

in the same industry trade. This might reflect a higher investment need in sectors "ith high

gro"th opportunities $and correspondingly high markettobookratios% or the entrepreneurs;

attempt to )time the marketK, i.e. the use of favorable market conditions &i.e. to take

advantage of overly optimistic investorsS

+econd most important determinant is the size of the company: larger companies are more

likely to go public.

+urprisingly, companies e5perience a reduction in the cost of bank credit after the I!. after

I! firms borro" from more banks and reduce concentration of their borro"ing. This is

possible due to the improved public information and7or stronger bargaining position visQvis

banks no" that capital markets are available.

!ther findings:• +hareholders most often board members, keep tight control over the firm8s 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 firm8s management and supervisory board. They even

consolidate control as the relative size of their blockholding&in comparison "ith the

other blockholders stakes &increases• Founders sell shares, but venture capitalists sell even more.• Firms "ith pro#ects that are cheaper for outsiders to evaluate, and operating in

industries characterized by less information asymmetry are more likely to go public

6. Me+an$! o% #o$n# p&'l$

In going public, an issuing firm "ill typically sell 3//0 of its stock to the public. The issuer

$i.e. the firm% "ill hire investment bankers to assist in pricing the offering and marketing the

stock. In cooperation "ith outside counsel, the investment banker "ill also conduct a )due

diligenceK investigation of the firm, "rite the prospectus, and file the necessary documents

"ith the supervisory authorities.

For young companies, most or all of the shares being sold are typically ne"lyissued

$primary shares%, "ith the proceeds going to the company. ith older companies goingpublic, it is common that many of the shares being sold come from e5isting stockholders

$secondary shares%.


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E. !rder Taking, rice setting.


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• = good offering $i.e. high quality firm%6

&Investors that are "ell informed are more likely to attempt to buy shares "hen an

issue is underpriced .

The notso"ell informed investors "ill be allocated only a fraction of the most

desirable ne" issues.

Bationing of uninformed investors as their bids compete "ith the bids of informed

investors.

=s both types of investors bid for shares, "e observe an une5pectedly strong

demand.

Poes it lead to underpricing6 @o, but if some investors are at an informational

disadvantage relative to others, some investors "ill be "orse off.

• = bad offering $i.e. lo" quality firm%6

&*niformed investors receive a full allocation according to their bid. Their averagereturn is lo"er than their e5pected return. inners 9urse. *nderpricing

compensates this inner;s curse of uninformed investors. There is empirical

evidence that small investors $presumably less "ellinformed% get a lesser

percentage of all shares "hen the underpricing is high.

7.2 Market %eed'ak +-pot+e!$! ('eteen $nve!tor! and

&nderr$ter)

ricing of I!s needs information not only about the firm but also from )the marketK, i.e.

$potential% investors. Institutional investors "hose nonbindingbids or indications of interest;provide the foundation for establishing the issuer;s offer price.roblem: Investors have no

incentive to reveal positive information before the shares are sold.

Hy keeping information to themselves until after the offering, investors can e5pect to benefit:

they "ould pay a lo" initial price for the stock and then could sell it at a higher price in the

postoffering market. ithout compensation; $in the form of large allocations of underpriced

shares%, institutions "ould have little incentive to bid aggressively, kno"ing that doing so

"ould only drive up the offer price.

In order to induce regular investors to truthfully reveal their valuations, investment bankers

compensate investors through underpricing. I! prices are set lo" to provide to compensateinvestors for revealing positive information. =lthough this practice diminishes the issuerUs

proceeds from the offering e5 post, e5pected proceeds are ma5imized. !n net, discretion

appears to be a good thing: it allo"s issuers to set more informed prices and thus minimize

the "ealth loss of going public.

?o" do you get investors to reveal their valuations6

• Find a good mechanism in I! allocation: =n investor has less incentive to bid

lo" for an issue she values high if doing so #eopardizes her allocation.• Hookbuilding:=llocations of shares in I! depends on the bid price in the

allocation process.• !ffer price depends on the bid prices in the allocation process.


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roblem: The profit per capital invested declines.

•In order to induce truthful revelation for a given I!, the investment banker must

underprice issues for "hich favorable information is revealed by more than those for

"hich unfavorable information is revealedM That is: =ccording to the


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• Firm sales• !ffer price revision• @e"s stories• Total liabilities to =ssets ratio• Investment bank market share• +hares retained to shares offered• Industry market value to sales ratio• =verage underpricing in previous J/ days• rior J/ day industry returns• rior J/ day standard deviation of industry returns

The role of the under"riter in underpricing:

• There is also evidence that social ties bet"een the investment bank and the firm prior

to the I! $e.g. friendship, personal relationships bet"een respective e5ecutives and

directors% play an important role for the ultimate outcome of an I! $9ooney et al.,

3/1'%.

• =n investment bank is more likely to be included in the under"riting syndicate if socialties e5ist bet"een the firm and the bank prior to the I!.• The outcomes of such ties suggest a quid pro quo arrangement bet"een the firm and

the bank. The investment bank benefits by receiving higher compensation, a more

senior role in the I!, and greater share allocation $see also the

bookbuildingprocess%.• The I! firm e5periences higher net "ealth gains for its preI! shareholders.

The role of venture capital in underpricing:

• Lenture capital backed I!s "ith high BOP spending e5perience lo"er underpricing

than nonventure capital backed I!s

• Lenture capital seems to be reducing information asymmetries and therefore providea positive signallingeffect and suggesting that the company has a higher quality.

The role of regulation in underpricing:

• The +arbanes!5ley =ct of 3//3 lead to a reduction in underpricing of shares.• Hut: The costs for I!s 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:

• *nderpricing appears higher in countries "ith stronger protection of outside investors.

?o"ever, underpricing is reduced "hen there is stronger la" enforcement and higher level of accounting transparency and7or availability of accounting data, as this likely

reduces the value of private benefits of control.• +tateo"ned enterprises $+!As% have higher underpricing than private firms.

?o"ever, a better institutional environment reduces I! underpricing, particularly for

private firms and less so for +!As.

9. Anal-!t re!ear+

Pistribution of research reports represents important part of investor communication ahead of

an I!. *nder"riting banks provide institutional investors "ith their analysts; analyses of the

issuer;s net assets, financial position and results of operations $ca. 3 "eeks prior to the offer


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period%. The intention is to enable investors to form an opinion on the issuer;s strength, value

and prospects. Time and practice in discussion due to potential conflicts of interest.

Hesides, there is Information asymmetry over other investors )+elective PisclosureK of

additional7other information to the prospectus to selected institutional investors.

$FacebookcaseM% Besearch reports associated "ith an I! may evoke liability risks.Pistribution of "ritten predeal reports by under"riting banks is thus not permittedin the *+.

In practice, analysts present their analysis in oral form.

9.1 Market prat$e (vol&ntar- !eld/re#&lat$on)

+teps:

• Intentiontofloatannouncement $I! intention%• Pistribution of research reports, investor education• )Hlackout eriodK: no further research for ca. 1 days• ublication of the prospectus start of the offer period $ca. 3 "eeks%.

ca. "eeks risk of do"nturn in market environmentM

Theoretically also risk of pro!pet&! l$a'$l$t- la$!, based on an allegedly )incompleteK

research report $only a threat if issuer adopts the analysis and7or confirms the analyst;s

valuation%.

Becent reform efforts in the *nited +tates:

• Investor education by analysts in oral form $precondition: confidentiality declaration%• Intentiontofloatannouncement• aiver of )Hlackout eriodK or reduction to E days• Immediate publication of prospectus, start offer period, distribution of research reports

These reforms have the advantage of faster implementation of the public offering, lo"ered

placement risk, risk of prospectus liability claims controllable. = potential disadvantage: I!

plans become public too early.

:. Alloat$n# !+are! $n IPO!

:.1 F$0ed pr$e

= fi5edprice offer has the offer price set prior to requests for shares being submitted.

Time line

1. Laluation by investment bank.

3. !ffer price published.

J. +ubscription period.

. ro rata allocation to subscribers $in case of that demand is higher than supply%.

'.


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If there is e5cess demand, shares are typically rationed on a pro rata or lottery basis.

?o"ever, 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 "ay for the under"riter to re"ard investors "ho provide information.

In most countries, fi5edprice offers have been the predominant form of allocation until the

1CC/s. In many countries, "ith a fi5edprice offer investors must submit the money to

purchase the requested shares, "ithout kno"ing "hether they "ill receive many shares.

In general, the longer the time that elapses bet"een the time a fi5ed offer price is set and

trading begins, the higher is the average firstday return. artly this is because the longer the

time until completion, the higher the probability that market conditions "ill deteriorate and

that the offering "ill fail. To reduce the probability of a failed offering, a lo"er offer price is set.

9onditional on the offer succeeding, the e5pected underpricing is relatively lo".

:.1.1 F$r o$tent v!. Be!t e%%ort!

In the *+, firms issuing stock use either a Wfirm commitment) or Wbest efforts) contracts.

ith a firm commitment contract, a preliminary prospectus is issued containing a preliminary

offer price range. =fter the issuing firm and its investment banker have conducted a

marketing campaign and acquired information about investors; "illingness 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.

ith a best efforts contract, the issuing firm and its investment banker agree on an offer price

as "ell as a minimum and ma5imum number of shares to be sold. = (selling period( then

commences, during "hich 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 "ithin a specified

period of time, usually C/ days, the offer is "ithdra"n and all of the investors8 money is

refunded from an escro" account, "ith the issuing firm receiving no money.

Hest efforts offerings are used almost e5clusively by smaller, morespeculativeissuers.

Assentially all I!s raising more than R1/ million use firm commitmentcontracts.

:." A&t$on!The most common is the )Putch auctionK. = marketclearing &or slightly belo" market

clearing &price is set after bids are submitted. +ince there is little if any e5cess demand at

the offer price, in general shares are allocated to all successful bidders. The number of

shares is usually fi5ed before the auction starts. +ometimes, there is a minimum or ma5imum

price published before the auction.

Putch auctions had lo"er underpricing than )regularK auctions. ?o"ever, the !+ analysis

indicated that factors other than the Putch auction process account for this lo"er

underpricing. The evidence much rather suggests that institutional rationing is the motive for

underpricing, a result that possibly e5tends to all auction process, not #ust Putch ones.The French I! market gives issuers and their under"riters a choice of mechanisms:


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• !ffre Q pri5 ferme$!F% &a fi5edprice offer.• !ffre Q ri5


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The remarekting phase involves:

• reparation of research reports and )equity storyK• *nder"riters talk informally to investors• rice indication from first feedback of investors• Initial price range set

There are three types of bids:

• )+trike bidsK&bid for a specified number of shares or amount regardless of the offer

price.• )imit bidsK&specified ma5imum price.• )+tep bidsK&a demand schedule as a step function $i.e. a combinationoflimitbids%.

=fter collecting the bids, the under"riter aggregates them into a demand curve and chooses

the issue price. The issue price is usually belo" marketclearing.

The actual allocating decision depends on quality of institutions and distribution ob#ectives of

the issuer.


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Timing of order, price and a )ratingK of the investor are important criteria in the allocation

process.

Hookbuildingis the primary I! method in the *+. Hut for decades bookbuildinghas

generated controversy because it allo"s shares to be preferentially allocated. Investors

complain that they are shut out of the allocation process, calling for changes that "ill give

everyone a fair chance.

ith the book building method, the offering price is set belo" the e5pected aftermarket value

of the issue. Those investors "ho regularly contribute to the price discovery process are

re"arded through larger allocations &this procedure necessarily gives the under"riter

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. ?o"ever, this

does not #ustify eliminating all discretion by mandating simple, rigid rules for both allocations

and pricing, as in a standardauction.

=lthough "e observe that auctions lead to less underpricing than bookbuilding, there many

reasons for bookbuilding:

• = key characteristic of I!s 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. 9orporate insiders have a clear, absolute advantage in terms of their

kno"ledge of current assets and past performance, but valuation requires more than

#ust this• = second key aspect of I!s is that the number of potential entrants to the auction is

e5tremely large, relative to the number of bidders that the auction can profitably

accommodate. Aach potential entrant has many investment alternatives and is not

compelled to participate in, or to evaluate, any one particularoffering.• First, the under"riter has substantial control over information acquisition through

bookbuilding. Hut little or no control in the auction itself. This control can be used to


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ma5imize e5pected proceeds from the currento ffering or to induce investors to more

carefully evaluate the issue, resulting in a more accurate aftermarket price.• =nother advantage of coordinating entry to the I! process is that there is less

uncertainty about the number of bidders. The e5pected number of shares sold is

higher because undersubscriptionis less likely "hen the number

ofparticipantsiscoordinated. ith bookbuilding, the under"riter recruits investors &itcannot force investors to like the issue, but it can promise them a reasonable

allocation at a sufficiently lo" price to cover their time and effort, guaranteeing that a

number of investors "ill at least considertheoffering.• Investors have many alternatives, and evaluating a ne" stock requires more effort

than simply sticking "ith their currentportfolio. In order to guarantee that a stock

develops a follo"ing and does not get overlooked $i.e. does not become a socalled

orphan stock%, the issuer someho" needs to compensate investors for their time and

effort evaluating the ne" security. Hookbuildingcan perform this role. *niform price or

discriminatory auctions, on the other hand, cannot guarantee a return to investors.• hen it is costly to gather information relevant to valuing a ne" issue, investors "ho

do so must be re"arded standard auctions do not guarantee this.

;. Pr$e !ta'$l$


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;.1 Pr$e !&pport

*nder"riters accumulate large inventories of )coldK I!s on the first day of trading: If a stock

opens the first day at the offer price, on average market makers purchase 40 of shares

offered before they allo" the bid to drop. 9orresponding number is 3.10 for I!s that open

belo" the offer price, and only /.0 for stocks that open above the offer price. !nly very littleevidence that stock prices decline after stabilization is "ithdra"n &stabilization might raise

the equilibrium price $supply of shares is reduced%.

=ftermarket activities are priceinfluencing activities that affect both issuers and investors. T#e

basic forms are:

• *nder"riters post a stabilizing bid to purchase shares at a price not e5ceeding the

offer price &this postpones a pricedrop $)pureK stabilization%.• *nder"riters initially sell shares in e5cess of the original amount offered, thereby

taking a short position prior to theoffering. This short position can be covered by

e5ercising the overallotment option and 7 or by short covering in the aftermarket.

In offerings "here "eak demand is anticipated, under"riter frequently take a naked short

position by allocating more than 11' percent of the stated size of the offering $)after market

short coveringK%. @aked short position for price stabilization is not allo"ed in Germany.

=ftermarket short covering allo"s under"riters to absorb shares flipped in the first fe" days

of trading &other"ise flipping "ould put do"n"ard pressure on the stock price. In "eak

offerings the under"riters 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 e5cessive, they are not able to provide effective price support unless they take a

long position and hold inventory ofthestock.*nder"riters may penalize members of the selling group "hose customers quickly )flipK

shares in the aftermarket by taking a"ay their selling concession $)penalty bidK%. enalty bids

are used selectively and tend to be assessed only for "eak offerings. urpose of penalty bids

is to control the )flippingK &i.e. reselling of shares that have been received in an initial

allocation in the immediate aftermarket. !n average, the volume of shares traded on the first

trading day of an offering is 4/ to E/ percent of the stated number of shares offered.

hen there is strong demand, under"riters are happy to see flipping $and the commissions

the trading generates%. hen demand is "eak, selling pressure due to flipping requires that

the under"riter either stabilize the price or see it decline belo" the offer price. If the

distribution of firm;s customers, "ho bought at the initial offer price, sell their shares in the

first fe" days, then penalty bids may be assessed on the distributing firm. =ssessment 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.

)ure stabilizationK is never done. =ftermarket short covering is the principal form of

stabilization $almost no disclosure requirements%. *nder"riters cannot predict completely

"hich offerings "ill trade above or belo" the offer price: the short position must be taken e5

ante, before trading starts &sometimes short covering has to be done even for I!s that go

up in price. !n average, short covering is not e5pensive for under"riters and amounts to asmall proportion of the gross spread they receive.


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+tabilization could be regarded as a put option given to institutional investors as a re"ard for

revealing private information during the offer period.

The put option might also compensate uninformed investors for the )"inner;s curseK: since

uninformed investors are more likely to end up "ith overpriced I!s, they value the put

option more than informed investors.+tabilization &like underpricing &helps compensating uninformed investors for adverse

selection costs.

rice support also allo"s under"riters to disguise overpriced offerings from investors by

temporarily inflating the stockprice.

;." Green !+oe

The overallotment option $the )green shoeK% grants an option to the under"riter to purchasefrom the issuing company, "ithin J/ days, an additional 1'0 of the shares sold in the I! at

the offer price.

ith this option, an under"riter can $and virtually al"ays does% sell 11'0 percent of the

firm;s shares at the offering. The motivation for this option is to provide buying support for the

shares "ithout e5posing the under"riter to e5cessive risk. If the offering is strong and the

price goes up, the under"riter covers its short position by e5ercising the green shoe option at

the offering price and receives an additional gross margin on the

proceedsfromtheoverallottedshares.


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If the offering is "eak and the price goes do"n, the under"riter does not e5ercise the option,

and instead buys back all or part of the e5tra 1' percent of shares in the market, thereby

supporting the stock price. The overallotment option thus provides the under"riter "ith

buying po"er in the aftermarket, enabling it to support the price of the ne"ly traded security.

The under"riter has a ma5imum of J/ days to e5ercise all or part of the option and to

stabilize prices.

1=. Co!t! o% IPO!

Pirect costs of I!s for the issuing firm are substantial, reaching an average of E0 of the

I! volume in the *+. In other countries, this spread is roughly J.'0 on average, that is

about half of the costs of *+ I!s. !nce an issuer chooses a book manager and co

managers, the lead manager invites other under"riters into the under"riting syndicate.

Typically, the syndicate is split into several brackets depending on the number of syndicatemembers there are.


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?istorically, syndicates e5isted partly for regulatory capital requirementsandrisksharing

purposes and partly to facilitate the distribution of an issue. This "as particularly relevant

"hen the lead under"riter did not have a significant retail or institutional distribution net"ork,

and had limited capital. *nder"riters such as


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Heing public consumes considerable resources to comply "ith disclosure requirements:

•


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• In other "ords, the price impact should be built into the I! traded price long before

the end of the lockup period.

From an e5pectationalpoint of vie", there should be no impact on the stock prices of these

firms. ?o"ever:

• !n the lockup e5piration $defined as day /71%, there is a 1.1'0 average drop in theprice.

• A5tending this period an additional three days surrounding the end of the lockup

period $i.e., day to /%, the drop increases to 3./J0 for the price of stocks that have

gone through I!s.

Given the permanence of the stock price drop, arbitrageurs, or even #ust e5isting

shareholders, should have an incredible incentive to sell the shares prior to the run do"n.

roblems in shorting these shares:

• Trading costs

• Pifficulty of shorting ne"lypublic stocks, and shortterm capital gains faced by theoriginal shareholders $"hich are ta5ed%

=bnormal returns around the )unlock dayK are driven largely by firms backed "ith venture

capital.


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• The market inde5• +ome submarket inde5 $such as )TecPa5K%• +imilar firms $same size% &very similar firms $same size O same booktomarketratio%

&this is called firms of the same )styleK This is also the best approachM

There I! characteristics of firms that eventually become inde5 firms differ from those

companies "ho fail to do so. The follo"ing characteristics increase the likelihood of a

company to be eventually included in an inde5 $in this case the +O'//%:

• ?ighreputation of under"riter$s%• arger firm size• ?igher B!=• ?ightech industry company• Lenture capital backing• ?ighly underpriced I!s have lo"er inclusion odds

!verall, the results indicate that higher quality firms, "hich sho"ed less asymmetric

information problems around there I!, are more likely to eventually become an inde5member.

EAONE E>UIT? OFFERING

1. e%$n$t$on@ rea!on! and t-pe!hen a firm, "hich is already publicly traded, sells additional stock, the ne" shares are

perfect substitutes for the e5isting ones. For these transactions, the academic literature tends

to use the term seasoned equity offering $+A!%, in contrasted to unseasoned equity offering,

an I!.

Beasons for selling seasoned equity:

• Baise cash for profitable pro#ects "ith a positive net present value.•


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There is evidence that the liquidity of a stock increases after an +A!. !ne of the reasons for

this increase in liquidity is analyst coverage. = better analyst coverage usually leads to

increased liquidity in the stock and companies should therefore promote analyst coverage.

1.1 Cap$tal $nrea!e

9apital increases can be distinguished:

• Hy the means of the increase: 9apital increase in return for cash:

*sual case &ne" shares $)young sharesK% are issued against cash. In general,

shareholders have the right to buy these ne" shares to prevent dilution of

their shares $in Germany and most A* states- generally not the case in the

*+%. This is called )rights offeringK. 9apital increase in return for stock $)+acheinlagenK%:

@e" shares are issued against other goods $mostly: other firms%. 9apital increase from the company;s reserves:

Beserves are turned into capital @o cash flo"s to the firm

@e" shares are distributed to e5isting shareholders for free

$)GratisaktienK% +hare price decreases accordingly

• Hy the formal procedure !rderly capital increase =uthorized capital increase:

+ince capital increases need the support of the shareholders, they are quite

infle5ible. The shareholder meeting can decide to authorize capital increases in

advance $in Germany: ma5imum five years in advance- ma5imum '/0 of the

e5isting capital%. 9onditional $or contingent% capital increase:

+imilar to the above, but capital increases are triggered by e5ercise of "arrants

and7or convertible bonds.

=ll capital increases need a E'0 ma#ority of at the general shareholder meetings.

". R$#+t!

A5ample:• +uppose that at date t a firm issues a 8right8 to buy one share of stock for each share

currently held.• =t an e5ercise price of R[ per share, on or before date T.• This right can be sold to other investors and e5ercised by them.• =t the date the stock goes 8e5rights8 $i.e. the stockholders on date t1receive the

right, and holders on date tdo not%,• +$t1% V +$t% \ 9$t%• here +$t% and 9$t% are the value of the stock and the righton datet, respectively.

There is an special procedure: !pXration blanche: =n investor sells s certain amount of his

rights and uses the proceeds to purchase his remaining rights issues. In this case theinvestor does not need invest any additional funds. ?o"ever, the o"nership decreases.


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Bights issues are not common in the *+.

2. C-le! and &nderpr$$n#

2.1 C-le!

Fims only conduct +A!s "hen the market conditions are good.

*sing monthly number of +A!s as a measure of +A! volume, there is significant variation in

the monthly +A! volume, but smaller than that in monthly I! volume- also cycles tend to be

shorter.

It appears that in certain time periods private firms simply cannot go public by issuing equity

ho"ever, seasoned firms issued equity in every month in the thirty years from 1CEJ to 3//3

2." Underpr$$n#The magnitude of +A! underpricing has been relatively small historically, it increased

dramatically during the 1CC/s. +A! underpricing averaged 1.1'0 for offers from 1C2/ to

1C2C, increased to 3.C30 for offers from 1CC/ to 1CC2, and reached as high as J.E30 in

1CC4. hile this level of underpricing is much smaller than that observed for I!s, it

represents a substantial cost to issuing firms.

9onsistent "ith evidence from the I! literature, +A! underpricing is positively related to the

level of uncertainty aboutfirm value.

9ompensation is required because informed investors "ill participate only in good issues,leaving uninformed investors "ith a disproportionate share of bad issues $"inner;s curse%

There is only little evidence of a reliable relation bet"een +A! underpricing and pro5ies for

asymmetric information such as firm size and bidask spread. Therefore, "hile price

uncertainty plays a significant role in +A! pricing, asymmetric information effects have little

impact on offer pricing for seasoned firms.

Aven in the absence of asymmetric information, the time lag bet"een offer pricing and

distribution may lead to a significant relation bet"een uncertainty and underpricing.

!ne could vie" a seasoned offer as a permanent shift in the supply of e5isting shares: if the

aggregate demand curve for the firm;s shares is do"n"ard sloping, this increase in supply"ill result in a permanent decrease in stock price.


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+A9 rule1/b31: =dopted on =ugust 3', 1C22, prohibits investors from covering a short

position "ith stock purchased in a ne" offering if the short position "as established bet"eenthe filing date and the distribution date.

3. Underper%orane

Firms that do an +A! underperform.

For both I!s and +A!s, 0 more money must be invested in issuers than in nonissuers

of the same size to achieve the same "ealth level five years later.

For firms conducting +A!s, the average return is 110 per year- compared to 1'0 for their

matching firms &an underperformance of 0 per year.


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The )ne" issue puzzleK is e5plained by a failure of the matchedfirm technique to provide a

proper control for risk. It appears that as equity issuers lo"er leverage, their e5posures to

une5pected inflation and default risks also decrease relative to the matched firms. In addition

+A!s significantly increase stock turnover, "hich is often interpreted as a measure of

liquidity, "hile the matched firms e5perience no change in stock turnover. Therefore, stocks

of +A! issuers could require lo"er liquidity premiums in the postoffering period.

Puring the postoffering period, issuer stocks are on average less risky and therefore require

lo"er e5pected 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

)ne"issuespuzzleK. A5pansion 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 e5tinguishes the

risky gro"th options.

=lso, equity issuers invest much more than matching nonissuers "ith similar size and book

tomarket ratios.

6. Anno&neent ret&rn! 5 Inve!tor8! reat$on!

9apital market participants react to security issue announcements by revaluing the issuer8s

stock price.

The average t"oday announcementinduced abnormal stock return to +A!s on the

@N+A7=me5 is 3 to J0, a value reduction equal to appro5imately 3/0 of the proceeds of

the averageissue.

This revaluation depends in part on the market8s perception of the issuing firm8s ob#ectives

and in part on the nature of the information asymmetry bet"een investors and the firm

concerning the true value of its securities.

The most popular e5planation among academics for this negative announcement effect is

that of the


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tendency to engage in )empirebuildingK, or gro"th for the sake of gro"th. In other "ords,

agency problems bet"een shareholders and managersareintensified.

Dey theories on +A!underperformance:

1. 9apital structure: issuing equity changes the capital structure and $mostly% leads to a

lo"er valuation due to increased capital costs $=khigbe7?arikumar, 1CC4%.3. =symmetric information $


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• Peep insights in the firm: Investors can directly communicate "ith the issuer and

perform due diligence on their o"n.

In general, the capital market reactions:

• +hortrun performance: on average the market reaction around the announcement of

a IA is positive.• ongrun performance: on average, the longrun market performance is negative.

IAs provide a supplement to the traditional +A! market. IAs as an alternative to +A!s

in raising equity capital are preferred:

• If firms have "eak operating performance and sho" characteristics of information

asymmetry $Vhave no other alternatives to raise capital%• If firms are likely to be undervalued $Vsignalling good quality to the market%.• If IA conditions allo" for cheaper financing than current +A! terms.

ipo and seos

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