Executive Stock Options and Ipo Underpricing

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Executive Stock Options and IPO Underpricing

Michelle Lowry• Smeal College of Business Penn State University E-mail: mlowry@psu.edu Phone: (814) 865-1483

Kevin J. Murphy Marshall School of Business University of Southern California E-mail: kjmurphy@usc.edu Phone: (213) 740-6553

July 31, 2006 Abstract In about one-third of US IPOs between 1996 and 2000, executives received stock options with an exercise price set equal to the IPO offer price (rather than a price determined by the market). Among firms with such “IPO options”, 58 percent of top executives receive a net gain from underpricing, meaning the gain from IPO options exceeds the loss from the dilution of their pre-IPO shareholdings. If executives can influence the IPO offer price, we expect a positive relation between these IPO options and underpricing. Alternatively, executives may be able to influence the timing and terms of their stock options, and this would similarly predict a positive relation between IPO options and underpricing. However, we fail to find any evidence of such a relation. Our results run counter to the emerging literature claiming that managers blatantly take self-serving actions to improve their personal welfare at shareholder expense. ____________________________________________________________

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We would like to thank Laura Field, David Haushalter, Karin Lee, Ajai Singh, John Wald, and especially Jay Ritter for comments on this paper. We also thank Alexander Ljungqvist for providing data, and Laura Barrante, Eric Fricke, Douglas Gardner, and Lauren Roane for research assistance.

Corresponding author: Smeal College of Business, Penn State University, University Park, PA 16802. Fax: 814-865-3362. •

Executive Stock Options and IPO Underpricing

Abstract In about one-third of US IPOs between 1996 and 2000, executives received stock options with an exercise price set equal to the IPO offer price (rather than a price determined by the market). Among firms with such “IPO options”, 58 percent of top executives receive a net gain from underpricing, meaning the gain from IPO options exceeds the loss from the dilution of their pre-IPO shareholdings. If executives can influence the IPO offer price, we expect a positive relation between these IPO options and underpricing. Alternatively, executives may be able to influence the timing and terms of their stock options, and this would similarly predict a positive relation between IPO options and underpricing. However, we fail to find any evidence of such a relation. Our results run counter to the emerging literature claiming that managers blatantly take self-serving actions to improve their personal welfare at shareholder expense.

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Executive Stock Options and IPO Underpricing
1. Introduction More than two thousand U.S. firms went public through initial public offerings (IPOs) between 1996 and 2000, generating average first-day returns of 35 percent over this five-year period. Many explorations of IPO underpricing have focused on who gains and who loses from pricing the IPO significantly less than the closing market price on the first trading day.1 Gainers include initial IPO investors (such as institutions and invited participants in “family and friends” programs), while losers include pre-IPO shareholders who either sell shares in the offering significantly below their market value or suffer substantial dilution on the shares they continue to hold. Indeed, between 1996 and 1998, the average IPO left $15 million “on the table,” meaning the average company would have raised $15 million more if it had been able to sell its shares at the first after-market closing price, rather than at the offer price. In 1999 and 2000, average money left on the table increased to almost $80 million. The purpose of this paper is to examine another set of winners from IPO underpricing: executives receiving stock options on the IPO date with an exercise price set equal to the offer...
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