1

Initial Public Offering (I.P.O)

1. Introduction

In an initial public offering (IPO), an entrepreneurial firm offers a portion of its shares to

the public or potential investors to meet its financing needs.

Certo, Daily, Dalton, (2001) suggests that: ‘an IPO represents an important transition

point in a firm’s development, since the firm moves from being privately held towards

being publicly held’. In the so-called “financing hierarchy” formulated in pecking-order

theory, the IPO appears to be a firm’s financing source after internal financing and debt

(Myers, 1984).

An underwriting fee paid to the underwriters as compensation is a direct cost of initial

public offerings (IPOs). Underwriters need to examine a new issue company, and

should ensure the fairness of the offer price and set a fair offer price to maintain their

reputational capital (Booth and Smith, 1986).

Consequently the underwriters of Pet.Com Company having accessed the company’s

present financial position and found it very weak, it would be unethical and would also

perhaps hurt their reputation in future if the stick on having a high stock price $24 per

share instead of that of $18 per share. For the I.P.O, it would be indeed prudent to

have a low stock price given its poor trading performance for the last three years and

being no evidence of it making significant profits in the future.

www.investor.gov/news-alerts/investor-bulletins/investor-bulletin-investing-ipo website

say in essence that:

“It is important to understand that the offering price is determined by a mix of

market conditions, analysis and negotiation. Competing interests affect the

2

determination of the offering price. From the perspective of the company offering

its shares in the IPO, the higher the offering price, the more capital the company

can raise. The underwriters also have an interest in a high price not only to meet

the company’s objectives, but also because their compensation is typically a

percentage of the offering price”

Therefore from the scenario we can see why the underwriters want a high stock price,

this is certainly because they will be paid a percentage of the offering price thereby

translating into a high return as underscored by one of its members.

From the above calculation we indeed see that the issuing costs exceed the annual

revenue and the reason why the shares will be issued at a low stock price.

Number of shares Fraction

Shareholders 1,500,000 2/3

Company 750,000 1/3

Total 2,250,000 1

Number of shares

Cost per

share Total

Share of

Company

Share of

Shareholders

Spread cost 1,250,000 1.25 1,562,500 520,833 1,041,667

Issue Costs 1,300,000 433,333.33 866,666.67

Total Cost 2,862,500 954,167 1,908,333

Total annual revenue 3,400,000

Profit on issue 537,500

3

Suzuki (2008:98) emphasizes that:

“Since a manager with a high proportion of equity ownership has the incentive to

secure more financing through exaggerating corporate value to the underwriter,

underwriters incur greater expenses in examining such companies”

Thus, it’s evident that the shareholders of the company own two-thirds of the total

shares while the company owns the remaining one-third of the shares. The

shareholders will no doubt be asking for a high stock price of $24 and not $18.

On the other hand as the underwriters will have to undertake extra work to re-assess

the valuation of the company in general, it will only be natural for them to want a high

return in compensation and that’s why some of its members want a high stock price and

a high return consequently.

www.investor.gov/news-alerts/investor-bulletins/investor-bulletin-investing-ipo website

further highlights that:

“At the same time, the underwriters are responsible for selling the IPO and will

want a price that is attractive to the client-investors to whom they will be selling.

Underpricing an IPO creates a discount for the initial investors, increases the

demand for the IPO and helps the underwriters sell all of the available shares.

Underpricing may also affect how much, if at all, the stock’s price rises on its first

trading day. If there is a large increase, or “bump,” from the offering price during

the initial trading, the underwriter’s client-investors may be satisfied because the

value of their investment will have increased. However, the company may be

4

unsatisfied in that case, as it might have been able to sell its shares at a higher

initial offering price and thereby raise more capital”.

In respect to the notion that the initial day’s return on an IPO should be considered part

of the issue costs, I feel that the financial manager views are fundamentally flawed and

that the underwriters are correct in that these are separate issues. However, I further

wish to inform the financial manager on what the additional issuing costs could be

incurred by the underwriters after the day of issue of the I.P.O.

In order to attach a fair offer price, they need to clarify the information within which the

company is hidden. Underwriters incur considerable expense in such an examination

(certification costs). As a result, IPO firms have to pay more for prestigious

underwriters because they will spend more on certification to protect their reputation.

Such a tendency is also revealed in the underwriter fee at the time of seasoned equity

offerings (SEOs) (Drucker and Puri, 2005).

Furthermore, underwriters monitor the post-issue operations of a newly issued

company (Easterbrook, 1984). The costs of this monitoring affect underwriter

compensation in SEOs (Hansen and Torregrosa, 1992a). Moreover, the costs of

certification and monitoring are influenced by the ownership structure of the IPO

firms.

Jensen and Meckling (1976) opine that:

“Issuers with higher levels of managerial ownership incur lower agency costs.

Such issuers achieve better performance by taking action that gives higher

priority to its profits than to a manager’s private benefits, and they will reduce the

5

need for investment bank monitoring. Therefore, underwriters may charge lower

fees for issuers with a high level of managerial ownership”

However, Pet.Com company seems a small company with three shareholders and a

financial manager thus the issue of principal-agency will not be that serious hence the

underwriters could charge them much lower issuing fees.

Hansen and Torregrosa (1992b) argue that:

“underwriters play a monitoring role in reducing agency costs and in improving

corporate performance within SEOs. As agency problems become aggravated,

issuers require investment bank monitoring. Consequently, underwriters charge a

higher underwriter spread for issuers with serious agency problems to cover

monitoring costs”.

It is possible that the underwriters of Pet.Com will have to monitor the company

situation to see if it turns into to be a profitable venture given that customers and

investors could pump the required cash to revamp its operations.

Jain and Kini (1999) argue that ‘the certification role of the underwriter ends at the time

of the IPO, while the monitoring function begins during the post-IPO period’.

It is possible that certification and monitoring costs paid by underwriters become so

high that the asymmetric information problems between issuers and underwriters

become serious. To avert this problem probably Pet.Com Company would need to be

charged more issuing fees by the underwriters.

6

The danger of overpricing is also an important consideration. If a stock is offered to the

public at a higher price than the market will pay, the underwriters may have trouble

meeting their commitments to sell shares. Even if they sell all of the issued shares, the

stock may fall in value on the first day of trading. If so, the stock may lose its

marketability and hence even more of its value. This could result in losses for investors,

many of whom being the most favored clients of the underwriters. Thus, the underwriter

should attempt to determine an appropriate price that is neither too high nor too low for

the Pet.Com Company.

IPO underpricing, which refers to stock returns experienced during the initial trading day

in the secondary market, reduces the capital received by an IPO firm through the IPO

process (Lin and Chuang, 2011).

Rock (1986) suggests that:

“Underpricing occurs because of information asymmetry between issuers and

potential investors; hence a discount price is offered to attract investors. He

further argues that this information asymmetry leads to the so-called “winner’s

curse”, since informed investors will compete for “good” issues, leaving

uninformed investors exposed to higher probability of obtaining “bad” issues”.

Beatty and Ritter (1986) indicate that ‘a higher level of underpricing belongs to firms that

have more uncertainties’. ‘As such, IPO firms that are subject to more asymmetric

information will need a greater degree of underpricing’ (Johnston and Madura, 2009)

7

In the case of Pet.Com company it has been racking up sizeable losses for the last

three years implying that it faces uncertainties concerning its future profitability therefore

a low stock price would be appropriate.

Chen and Strange, (2004), however, explain that Rock’s adverse-selection model face

challenges due to unclear division between uninformed investors, as well as the

pervasiveness of oversubscription in IPOs across markets.

Perhaps the Pet.Com company after-all will not get affected by the distinction between

who are the uninformed and informed investors therefore they will be better off charging

a high stock price, in fact from the scenario its regarded by investors as one of the

hottest new e-commerce businesses and the news of the company going public

generated a lot of considerable excitement.

Leland and Pyle, (1977) using the signaling theory postulates that:

“Due to information asymmetry existing between the issuer and the potential

investors firms send signals to demonstrate their superior quality. Equity

retention by original shareholders can be regarded as a good signal of firm value

to potential investors, because principal-agent conflicts that may arise when the

ownership of a firm is dispersed can be minimized”.

In the case of Pet.Com Company it’s evident that the existing shareholders were selling

part of their holding, therefore sending signals to the new investors that the company

may be experiencing uncertainties like liquidity or profitability and hence will only be

willing to pay a low stock price. Therefore I would advise the financial manager that

principal-agent conflicts arising would make the company less attractive to the new

investors and they will only be willing to pay a low stock price.

8

Allen and Faulhaber (1998) further extend the work of Leland and Pyle and propose

that:

“Firms tend to underprice their shares in IPOs as a signal of superior quality to

potential investors. Through a discount of its offer price in an IPO, an issuer

indicates that its financial position is sound and losses incurred from underpricing

can be recovered”.

It would be unwise for Pet.Com Company to underprice their I.P.O in anticipation that

the losses incurred will be recouped in future. The company has made sizeable losses

for the last three years and there is nothing extra-ordinary to infer that it will make profits

in the near future as categorically the company does not have a sound financial

position.

Garfinkel (1993), furthermore contend that:

“High-quality IPO firms generally have favorable private information regarding

their prospects, which may be revealed in the future. To communicate their high

quality to potential investors, they may perform certain strategies, including

setting a low offer price”.

Once again, it will be naïve for the financial manager to believe that their company

Pet.Com would move drastically from a company making sizeable losses to one that

makes sizeable profits. Therefore in the same vein the company should capitalize on

their business being one of the hottest businesses and insist on a issuing a high stock

price for the I.P.O

9

Stoughton and Zechner (1998) in contrast suggest that managers may choose to

allocate a high proportion of shares to a single investor to encourage better monitoring,

thereby enhancing firm value. A low price may be offered to attract potential large

investors.

Therefore if Pet.Com strategy would be to control the potential monitoring of the firm

then to avoid a new large shareholding that enables effective monitoring on the firm, the

financial manager would be better off to have a low stock price that allows over

subscription, so that the share allocation can be rationed and discriminated.

A high stock price would enable a new shareholding to buy all the shares and effectively

monitor and control Pet.Com making the three previous shareholders irrelevant when it

comes to making key decisions in the company and this may jeopardize their status that

they currently enjoy in the company

Other signals used by I.P.O firms to convey information on their high quality include the

reputation of the external auditor (Titman and Trueman, 1986) or the reputation of the

investment banker (Carter, Dark, Singh, 1998)

Therefore if Pet.Com underwriters are a high reputable firm then its member comments

‘that underwriters want to see a high return and high stock price’ would be appropriate

that is to ask for a high stock price as new investors would have confidence with them

and would be willing to splash their money on the I.P.O despite the high stock price.

Regarding the concern whether the issue price would matter for Pet.com company, if

they had not planned to sell, here I feel that the financial manager is misinformed and

lacking some information which is elaborated further in the following website.

10

www.investor.gov/news-alerts/investor-bulletins/investor-bulletin-investing-ipo website

states that

“All of the foregoing factor into the determination of the offering price. Whether

you have an opportunity to participate directly in an IPO or are buying shares in

the open market, it is important to realize that the offering price reflects a

negotiated estimate as to the value of the company. The offering price may bear

little relationship to the trading price of the securities, and it is not uncommon for

the closing price of the shares shortly after the IPO to be well above or below the

offering price”

“In addition, purchasing shares in the market immediately following an IPO

can be risky. Underwriters can support the trading price of the new issue

in its first few days of trading with certain trading activities, including

purchasing shares of the company. This is often done to keep the trading

price from falling too far below the offering price. Once this support ends,

the stock price may decline significantly below the offering price”

The above information from the website indicates that the issue price is not

affected by Pet.Com company decision to sell because the offering price only

reflects a negotiated estimate as to the value of the company determined

primarily by the underwriters and various market forces at that point in time.

11

Conclusions

Jones and Swaleheen (2008) reckon that:

“Given that underwriters are compensated based on a percentage of the

proceeds they raise for the issuer, it would seem that the underwriter would want

to underprice the issue as little as possible (i.e. rise as much proceeds as

possible). However, firms that are able to secure a more reputable underwriter

are more likely to be in greater demand at the time of their I.P.O and are thus

more likely to have higher initial returns”

Firstly, following the above line of argument the underwriters who are responsible for

the roadshow have indicated that a low price stock would be appropriate for the I.P.O as

they pointed out that indications from investors were not the same as firm orders, they

further argue that it was more important to have a successful issue than to have a group

of disgruntled shareholders. Thus have a suggested the low stock price of $18 and not

$24. That why they too will be pleased as they will raise as much proceeds as possible

perhaps through oversubscriptions involving many shareholders.

Secondly and to sum up, it appears that the Pet.com company underwriters are not a

reputable firm and that’s why they are not insisting on a higher stock price. I feel that if

they were truly a highly reputable firm they should ask for a higher stock price but on the

other hand perhaps they are a reputable firm who know that Pet.com company has

made size-able losses in the last three years and is likely to continue making losses and

hence they are playing it safe be asking for low stock price while at the same time

protecting their reputation.

12

References:

Journals

1. Allen, F. and Faulhaber, G.R. (1989), “Signaling by underpricing in the IPO market”,

Journal of Financial Economics, Vol. 23 No. 2, pp. 303-23.

2. Beatty, R.P. and Ritter, J.R. (1986), “Investment banking, reputation, and the

underpricing of initial public offerings”, Journal of Financial Economics, Vol. 15 Nos

1/2, pp.

3. Booth, J. and Smith, R. (1986), “Capital raising, underwriting, and the certification

hypothesis”, Journal of Financial Economics, Vol. 15 Nos 1-2, pp. 261-81.

4. Carter, R.B., Dark, F.H. and Singh, A.K. (1998), “Underwriter reputation, initial

returns, and long-run performance of IPO stocks”, The Journal of Finance, Vol. 53

No. 1, pp. 285-311.

5. Certo, S.T., Daily, C.M. and Dalton, D.R. (2001), “Signaling firm value through board

structure: an investigation of initial public offerings”, Entrepreneurship Theory &

Practice, Vol. 26, pp. 33-50. (J)

6. Easterbrook, F. (1984), “Two agency-cost explanations of dividends”, American

Economic Review, Vol. 74 No. 4, pp. 650-9.

7. Hansen, R. and Torregrosa, P. (1992a), “Underwriter compensation and corporate

monitoring”, Journal of Finance, Vol. 47 No. 4, pp. 1537-55.

8. Hansen, R. and Torregrosa, P. (1992b), “Underwriter compensation and corporate

monitoring”, Journal of Finance, Vol. 47 No. 4, pp. 1537-55.

13

9. Jain, B. and Kini, O. (1999), “On investment banker monitoring in the new issues

market”, Journal of Banking and Finance, Vol. 23 No. 1, pp. 49-84.

10. Jensen, M. and Meckling, W. (1976), “Theory of the firm: managerial behavior,

agency costs and ownership structure”, Journal of Financial Economics, Vol. 3 No.

4, pp. 305-60.

11. Garfinkel, J.A. (1993), “IPO underpricing, insider selling and subsequent equity

offerings: is underpricing a signal of quality?”, Financial Management, Vol. 22 No. 1,

pp. 74-83.

12. Myers, R. (1984), “The capital structure puzzle”, The Journal of Finance, Vol. 39 No.

3, pp. 575-92

13. Lin, C.P. and Chuang, C.M. (2011), “Principal-principal conflicts and IPO pricing in

an emerging economy”, Corporate Governance: An International Review, Vol. 19

No. 6, pp. 585-600.

14. Johnston, J. and Madura, J. (2009), “The pricing of IPOs post-Sarbanes-Oxley”, The

Financial Review, Vol. 44 No. 2, pp. 291-310.

15. Rock, K. (1986), “Why new issues are underpriced”, Journal of Financial Economics,

Vol. 15 Nos 1/2, pp. 187-212.

16. Suzuki, K (2008), “Ownership Structure and underwriter spread”: Evidence from

Japanese I.P.O firms, International Journal of Managerial Finance, Vol No. 2, 2008

pp.96-111

17. Titman, S. and Trueman, B. (1986), “Information quality and the valuation of new

issues”, Journal of Accounting and Economics, Vol. 8 No. 2, pp. 159-72.

14

18. Jones, T and Swaleheen, M (2010), “Endogenous examination of underwriter

reputation and IPO returns”, International Journal of Managerial Finance: Vol.36, No.

4, 2010 pp.284-293

Internet Articles

19. http://www.investor.gov/news-alerts/investor-bulletins/investor-bulletin-investing-ipo

website accessed on the 28th, November 2013

Paper

20. Chen, J. and Strange, R. (2004), The Effect of Ownership Structure on the

Underpricing of Initial Public Offerings: Evidence from Chinese Stock Markets,

working paper, King’s College London, London, April. (Paper)