#20 Initial Public Offerings May 6, 2015 FIN 680 Richard Oluoha - Greg Werthman - Kapil Jain - Aaron Cyr - Jen-Chiang La

INTRODUCTION ●Privately held firm or successful venture capital project raises capital and achieves greater liquidity by going public ●Risks are faced by each of the three major parties involved: issuer, investment banker, an investor ●The pricing of initial public offering (IPO) is difficult because there are no prior market price and the firm has little or no operating history o Price too low:  The issuer does not get the full advantage of its ability to raise capital o Price too High:  Investor gets inferior return and might reject offering

DECISION TO SELL/UNDERWRITER SELECTION Decision to Sell ●Decision to sell Company and receive as much as possible in return ●Price depends on overall market conditions, the specifics of the company, and the policies of the investment banker Underwriter Selection ●Selection of an underwriter or syndicate of underwriters o Prestigious underwriter provide favorable signal to the market o Underwriters may refuse more speculative issues in order to remain prestigious

METHODS Alternative Methods of Sell ●Decision between “best efforts” or “firm commitment” o Best efforts - issuer and underwriter negotiate an offering price  The underwriter uses its best efforts to raise all of the desired capital at the negotiated price, usually receiving a percentage of the capital raised as its fee  Reduces the risks faced by the underwriter and leaves much of the risk with the issuer o Firm commitment - underwriter guarantees that the agreed upon amount of capital will be raised  The underwriter buys all of the stock issued at the agreed on price and is then responsible for selling it all  The underwrite takes on much of the risk

SECURITIES ACT OF 1933 Securities Exchange Commission Act of 1933 ●Parties comply with the Securities Act of 1933 o Designed to disclose information to potential investors, giving investors the right to sue if there is misleading information or material omission of facts o Restrictions are stricter for S-1 offerings (greater than $7.5 million gross proceeds than for S-18 offerings (less than $7.5 million) o The smallest offerings (less than $1.5 million in gross proceeds) are eligible for a Regulation A offering, which means fewer requirements

SEC REGULATION SEC Regulation ●After investigating the issuing company, the underwriter files necessary information (financial statement, type of business, etc.) in the preliminary prospectus ●There is a period of at least 20 days in which the SEC reviews the submitted material o During this period (cooling off period) the underwriter surveys the market by sending information to prospective investors about their willingness to purchase shares at some price  Underwriter uses information gained to set offering price

SETTING THE PRICE Setting the price ●Price too low: o Issuer does not realize full potential to raise capital o Reputation of underwriter is under the line when future firms choose underwriter o Excessive dilution of ownership ●Price too high: o Firm commitment underwriter has a financial loss because it has to lower the price to sell the entire issue o Best efforts underwriter will have to withdraw the issue and the issue raises no capital and the underwriter receives no commission

EFFECTS OF INVESTOR UNCERTAINTY ON UNDERPRICING Results in Summary 1.Initial public offerings are significantly underpriced 2.The more established the issuer, the lower the amount of underpricing 3.Hot and cold performances come in waves, which is predictable 4.Cold issue markets have average initial returns that are not necessarily positive 5.The new of new offerings also comes in waves of heavy and light activity which are highly serially correlated 6.Underpricing appears to lead the number of new offerings by roughly six to twelve months

UNDERPRICING IN VARIOUS MARKETS Underpricing occurs due to asymmetric information between investors. Some reasons for the underpricing are: 1.Regulations require an underwriter to underprice an issue 2.Collusion occurs between underwriters to take advantage of novice investors and benefit experienced investors 3.Underpriced issues make investors feel good about buying future issues from the underwriter at low prices 4.The underwriter’s spread does not cover the total risk in a firm commitment 5.Side payments used from investors to the underwriters and then the issuer used to compensate for underpricing 6.Issuer sees underpricing as a way to avoid lawsuits These 6 items are not totally valid on their own and they create doubt

POLICY IMPLICATIONS ●The IPO market shows deviations from efficient markets ●Investors should buy underpriced IPOs during a “hot market” o Buy early when stocks are the most underpriced ●Only “insiders” should buy into IPO’s because they’re the only ones who will make a profit ●IPOs that have gains can be predicted by comparing the initial price listed in the prospectus and the final offering price o A lower final price leads to a negative return o A higher final price leads to a positive return ●Issuers should focus on large, “hot” markets and use both a firm commitment and a strong underwriter ●Issuers should be as transparent as possible. The lower the amount of uncertainty, the less underpricing necessary to gain investors