Week 5: Initial Public Offerings (IPOs) Flashcards
What is an Initial Public Offering (IPO)?
First sale of company’s shares to public on stock mkt listing (floatation).
What are the benefits of firms going public?
1) ABILITY TO RAISE CAPITAL –> companies who go public can access larger pool of capital from wide range of investors e.g. institutional investors, retail investors, index funds.
2) ACHIEVE LIQUIDITY TO DIVERSIFY INVESTORS –> shares become tradable on public stock exchange, providing highly liquid market for existing investors & employees to buy & sell shares/stock options to earn return on investment –> public mkts offer investors opportunity to diversify their portfolios by investing in wide range of companies across diff industries & sectors to spread their risk & reduce exposure to any single investment –> public mkts typically more liquid than private markets, where selling shares can be more complex & time-consuming (although some private funding rounds may offer opps. for employees to sell shares).
3) STOCK CAN BE USED FOR M&A ACTIVITY –> IPO process typically raises substantial capital in form of cash for company to use in acquisitions but stock can also be used as form of payment/currency to target company’s shareholders (instead of paying cash) –> particularly advantageous if company’s stock perceived as overvalued, as company can conserve its cash reserves while still pursuing growth opportunities –> publicly traded companies often have better access to debt financing at favorable interest rates compared to private companies due to being subject to greater scrutiny & disclosure requirements, which can enhance their creditworthiness to lenders, decreasing cost of capital –> increased transparency about acquiring firm’s true value can reduce uncertainty for potential acquisition targets, making it easier to negotiate deals & facilitate M&A activity.
4) SIGNALS STABILITY TO CUSTOMERS & SUPPLIERS –> enhanced visibility & prestige associated w firm going public may attract new customers & suppliers who perceive company as successful, w high-quality products or credible enough to pay its obligations –> going public also reduces info asymmetries due to firm being subject to stringent regulatory requirements e.g. financial reporting and disclosure obligations –> customers & suppliers are more confident in firm’s true financial health & valuation.
What are the costs of firms going pubic?
1) IPO CREATES SUBSTANTIAL FEES –> e.g. legal, accounting, investment banking fees are ~10
% of funds raised in offering, shared by IPO underwriters.
2) Greater degree of disclosure & scrutiny e.g. in U.S. compliance w Sarbanes Oxley Act –> i.e. conducting regular audits & ensuring accurate & timely financial disclosures –> requires substantial resources, e.g. hiring additional staff, investing in technology and infrastructure etc. which may -vely impact profitability (esp. of smaller companies) –> risk of non-compliance e.g. financial penalties, reputational damage & legal liabilities.
What is the process of a firm going public?
1) Select underwriter –> mix of institutional investors e.g. mutual funds, hedge funds, & some individual investors.
2) Tasks of underwriter –> due diligence (assess firm’s financial performance/risks) + determine offering size (no. of shares & offering price) based on firm’s valuation & mkt conditions + prep marketing materials & regulatory filings w firm’s legal rep for securities regulators e.g. SEC in USA.
3) Marketing of offering –> circulates preliminary prospectus to potential investors + delivers ‘road-show’ i.e. presentations to pitch IPO to potential investors + ‘book-building’ to collect info about potential investor demand to determine final share price & allocation + ‘firm commitment offerings’ where investment bank commits to sell shares at set price regardless of investor demand.
4) Offering –> on day of IPO, underwriter purchases shares from company at fixed price agreed upon during book-building process –> immediately sells shares to investors at IPO price, generating proceeds for company –> may be ‘green-shoe’ option clause in underwriter agreement specifying that in case of exceptional public demand, issuing firm authorises underwriter to distribute additional shares at offering price (typical over-allotment option of ~15 %).
What is underpricing in the context of IPOs?
When offering price of shares to public is set below their mkt value on first day of trading –> investors purchasing shares at IPO price can immediately realise a profit when shares begin trading on ‘hot-issue’ secondary mkt as newly issued shares tend to experience significant price increases on first day of trading due to favorable mkt conditions, investor sentiment, or presence of high-growth/ innovative companies going public –> however mkt may eventually correct & there may be lower returns for investors hold onto shares beyond initial trading period –> IPO mkts are cyclical.
What explains underpricing in the context of IPOs?
Higher average initial IPO returns leads to higher IPO mkt volume as result of increased demand for newly issued shares –> firms incentivised to go public in ‘hot-issue’ mkt:
1) Cycles in quality & risk composition of firms –> clusters of firms in industries w significant tech innovation choosing to go public may signal strong growth prospects & having innovative business models, making them more attractive investment opportunities –> investors compete to gain allocations of shares contributing to higher IPO demand & underpricing.
2) Asymmetric info between managers & investors –> managers of issuing firm may possess better info about company’s prospects & value than general investing public –> may intentionally underprice IPO to attract +ve attention from investors, which can benefit company’s long-term growth & profitability –> may issue IPO as precursor to a larger seasoned equity issue to test investor appetite & mkt conditions before raising additional capital in future.
3) Winner’s Curse –> asymmetric info between investors –> informed investors have more info about share’s value than uninformed investors –> in competitive IPO mkts, investors may engage in aggressive bidding to secure allocations of shares however uninformed investors may fear that they will only be allotted shares in bad IPOs, leading them to discount their bids –> receive higher allocation of shares in IPOs w low or no underpricing –> underpricing occurs as shares allocated to highest bidders i.e. informed investors, who may have overestimated IPO value & put in orders when shares underpriced –> underwriters want to broaden attractiveness of IPO issues, so underprice shares to induce uninformed investors to buy & make gains however these investors systematically lose money.
4) Asymmetric info between investors & underwriters –> e.g. during book-building process investors have incentive to appear pessimistic about issuing firms’ prospects to negotiate a lower offering price or secure larger allocation of shares at discounted price such that they can sell shares at higher price when floated on public stock exchange & earn higher profits –> however can lead to missed opportunities for issuer to raise additional capital & result in lower initial proceeds from offering.
5) Mkt power of underwriters –> underwriters have control over order book & allocation of shares in IPO –> may underprice offering to ensure its success & maintain relationships w institutional investors who can potentially buy them at lower price during IPO & sell them at higher price shortly after trading begins on secondary market, capturing price diff as profit –> underwriters prioritise their own interests & those of their clients over max. issuing firm’s value –> e.g. Royal Mail’s October 2013 underpriced IPO; Airbnb IPO.
Why might IPO issuers not mind underpricing?
1) Believe reasons their underwriters present to them –> to keep investor interest high & maintain +ve relationships w underwriters & institutional investors.
2) Minimise risk & ensure success –> issuers are typically risk-averse & prioritise success of their IPO –> while underpricing may result in leaving money on table, it can also help mitigate risk of failed offering –> can also attract sufficient investor demand & +ve market perception for their company –> however significant underpricing may lead to missed opportunities for issuer to raise additional capital.
3) Issuers also benefit financially from IPO through sale of shares –> may be less concerned about leaving money on table in short term, especially if anticipating future opportunities to capture value through share price appreciation or subsequent offerings.
Why might underpricing be to the detriment of IPO issuers?
Offering price set below the level that would max initial proceeds for issuer –> missed opportunities for issuer to raise additional capital.
What is meant by dual-class share structure?
When company issues 2 classes of shares –> one class w superior voting rights (typically held by insiders, founders, or management) & another class w inferior or no voting rights (usually held by public shareholders).
What are the benefits & costs of a dual-class share structure?
BENEFITS:
1) ENHANCED CONTROL–> w dual-class shares, founders & key stakeholders can retain greater control over corporate decision-making compared to other shareholders –> allows them to maintain focus on long-term growth w/out being swayed by short-term market pressures, performance targets or shareholder activism.
2) PROTECTION AGAINST TAKEOVER THREATS –> dual-class structures can act as defense mechanism against hostile takeovers due to superior voting rights of founder or controlling shareholders, allowing management to resist takeover attempts that may not be in best interest of the company or its long-term shareholders.
COSTS:
1) AGENCY CONFLICTS BETWEEN MANAGERS & SHAREHOLDERS –> dual-class structures give insiders e.g. managers disproportionate voting rights relative to their cash flow rights –> allows insiders to maintain control over corporate decision-making while bearing smaller proportion of financial consequences of their decisions –> insiders may prioritise their own private benefits over those of outside shareholders e.g. by misusing corporate cash reserves for personal gain, engaging in excessive remuneration practices, pursuing value-destroying acquisitions, or making poor capital expenditure decisions –> can decrease shareholder returns & investor confidence in company’s management –> lower contribution of capital expenditures to shareholder value due to inefficient cash reserve allocation –> may hinder firm’s ability to invest in growth opportunities & create long-term value for shareholders.
Explain the relationship between the prices of shares in a dual-class structure and those in a single-class structure?
Ordinary shares in dual-class structure tend to trade at discount relative to single-class structure due to inferior voting rights compared to most powerful shareholders so shareholders may be concerned about having less influence over corporate decision-making –> however in bull markets e.g. innovative tech mkts this discount may reduce or disappear if investors perceive opportunity to invest in firm w good long-term growth prospects due to increased investor confidence –> higher firm valuations & enhanced access to capital –> hence in less innovative mkts/mkts w lower trading activity investors may be more cautious to overlook governance implications of investing in companies w dual-class structures, particularly if discount is significant.
