Initial Public Offerings

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Presentation transcript:

Initial Public Offerings MFIN 403 Financial Markets and Institutions

What is an “Equity” claim? Equity is simply an ownership claim in a company. It provides the holder cash flow rights (e.g., rights to receive dividends) and control rights (e.g., voting rights). Types of equity: Common stock Preferred stock Limited partnership interest

Equity markets: A preliminary view Primary markets Transaction between the issuer and investors. Examples: Going public (conducting an initial public offering (IPO), privatizations Secondary markets Transaction between investors typically in stock exchanges. Examples: Seasoned (or follow-on) equity offerings (SEOs)

Why do companies go public? To finance investment projects. To take advantage of mispricing (i.e., overvaluation) in equity markets. To provide an exit strategy for VC investors. To allow entrepreneurs regain control from VCs. To allow entrepreneurs convert paper wealth to cash (especially when the value of the firm comes from the value of growth options). To allow entrepreneurs diversify their wealth.

The IPO process The decision to go public Finding an underwriter Why do firms need an underwriter? How do firms choose an underwriter? Registration for public offering Road show Setting the offer price Completion of IPO and first day trading

Conflicts of interest between the firm and the underwriter(s) Underwriters have the right to allocate the shares. This creates an incentive on behalf of the underwriters to “low ball” the offer price and favor existing and potential future clients. Spinning Flipping

How to value IPO firms? Difficult! Uncertainty about future earnings, since most IPO firms are young and some have negative earnings. Comparable firm valuations P/E ratio, enterprise value-to-sales, enterprise value-to-operating cash flows etc. Need to take into account “public float” if demand curve for stocks is not flat.

Stylized Facts about IPOs Short-run underpricing (first-day return>0) Cycles in the number of IPOs and the average first-day returns Long-run underperformance of IPO firms