The Process of an Initial Public Offering (Ipo). the Underpricing Problem.
1. Introduction
All companies need to raise capital at one time or another, first of all to start-up their business, and then to finance new projects and expand operations. Most of them start out by raising money from private sources, with no liquid market existing if the investors wish to sell their stock. A lot of new ventures rely initially on these internal funds, which come mostly from relatives and friends; some other firms, instead, receive help from the so-called “angel investors”. Furthermore, in some countries as Italy, debt (bank loans) is the main form of financing. Indeed, even after the start-up, there are many successful entrepreneurs (e.g. IKEA, Domino’s Pizza and Levi Strauss) who continue to operate successfully as private, unlisted companies.
Anyway, if a company prospered, it would need additional equitiy capital. To raise it, a firm usually “go public”; it means that it starts selling a portion of itself to a large number of diversified investors. What occurs in this case is named IPO (Initial Public Offering): a security is sold to the general public for the first time, and thanks to this, usually, a liquid market will develop.
The process is long and subject to strict rules and regulations. My purpose is that of going through the main steps of it, analysing pros and cons of IPOs and providing explanations for their apparent “underpricing”. I will mainly concentrate on the U.S. model, but being aware that other systems, like the European ones, might be slightly different.
2. The IPO process
An IPO works thanks to a process known as “underwriting”.
Even if in theory is possible for a company to sell shares on its own (from the mid-1990s, a growing number of small companies have followed the way of direct public offerings – DPOs), realistically, an investment bank is required. So, the first task for a firm is that of hiring an underwriter, with the role of middleman between the company and the investing public. Some of the most famous
All companies need to raise capital at one time or another, first of all to start-up their business, and then to finance new projects and expand operations. Most of them start out by raising money from private sources, with no liquid market existing if the investors wish to sell their stock. A lot of new ventures rely initially on these internal funds, which come mostly from relatives and friends; some other firms, instead, receive help from the so-called “angel investors”. Furthermore, in some countries as Italy, debt (bank loans) is the main form of financing. Indeed, even after the start-up, there are many successful entrepreneurs (e.g. IKEA, Domino’s Pizza and Levi Strauss) who continue to operate successfully as private, unlisted companies.
Anyway, if a company prospered, it would need additional equitiy capital. To raise it, a firm usually “go public”; it means that it starts selling a portion of itself to a large number of diversified investors. What occurs in this case is named IPO (Initial Public Offering): a security is sold to the general public for the first time, and thanks to this, usually, a liquid market will develop.
The process is long and subject to strict rules and regulations. My purpose is that of going through the main steps of it, analysing pros and cons of IPOs and providing explanations for their apparent “underpricing”. I will mainly concentrate on the U.S. model, but being aware that other systems, like the European ones, might be slightly different.
2. The IPO process
An IPO works thanks to a process known as “underwriting”.
Even if in theory is possible for a company to sell shares on its own (from the mid-1990s, a growing number of small companies have followed the way of direct public offerings – DPOs), realistically, an investment bank is required. So, the first task for a firm is that of hiring an underwriter, with the role of middleman between the company and the investing public. Some of the most famous
References: • BREALEY, R.A., MYERS, S.C. and ALLEN, F. (2005) Principals of corporate finance 8th ed. New York: McGraw-Hill/Irwin • BUCKLE, M • LOUGHRAN, T. AND RITTER, J.R. (2002) Why don’t issuers get upset about leaving money on the table in IPOs? The Review of Financial Studies, 15 (2), pp. 413-438 • LOUGHRAN, T • KARLIS, P.L. (2000) IPO underpricing. The Park Place Economist, VIII, pp. 81-89 • MUCCICHINI, M.R • RITTER, J.R. (1987) The costs of going public. Journal of Financial Economics, 19, pp. 269-281 • RITTER, J.R • RITTER, J.R. AND BEATTY, R.P. (1986) Investment banking, reputation, and the underpricing of initial public offerings. Journal of Financial Economics, 15, pp. 213-232 • RITTER, J.R • ROSS, S.A., WESTERFIELD, R.W. and JAFFE J. (1996) Corporate finance 4th ed• Chicago: Irwin