This page is hosted by Ivo Welch, a professor of Finance at Yale.


IPO - The Initial Public Offerings (IPO) Resource Page
October 1996, Updated January 1999, January 2000
/ipopage.html


Ivo Welch Professor of Finance
mailto:ivo _ welch @brown.edu Yale
http://welch.econ.brown.edu
See /iporefs/ for a bibliography of work on IPOs.
© Ivo Welch, 1996. This document is for the free use of all interested parties. However, this document must not be distributed, except in its entirety. Computer printouts are permitted, but further copies of printouts are not. Computer WWW references/links are expressly permitted. This site is listed at www.yahoo.com. The author is not liable for any false or misleading information in this WWW page.

Table of Contents

  1. Introduction
  2. Should The Company Go Public?
    1. Advantages
    2. Disadvantages
    3. Suitability
    4. Preparation
    5. Alternative Sources of Capital
  3. Is the Time Right To Do an IPO?
  4. What Advisors Should The Firm Hire?
    1. Consultants
    2. Auditors
    3. Lawyers
    4. Underwriters
    5. Printers
    6. Program/Bibliography: Find an appropriate advisor.
  5. What Should the Offer Price be?
    1. Company Valuation
    2. The Road-Show
    3. Program/Bibliography: Find an appropriate P/E ratio.
  6. How Does The Market React to IPO's?
    1. The Short-Run IPO Underpricing
    2. The Long-Run IPO Underperformance
  7. Other Noteworthy Aspects
  8. Appendix 1: Bibliography and Research Resources
  9. Appendix 2: Purpose of this page

Introduction

This WWW page provides information on initial public offerings (IPO's). It is a first draft. To read more about the philosophy guiding this page, please read Appendix 2.

Should The Company Go Public?

Advantages

New Capital
Almost all companies go public primarily because they need money. All other reasons are of secondary importance. The typical (firm-commitment) IPO raises $20-40M, but offerings of $100M are not unusual either. This can vary widely by industry. Some basic facts about the IPO market can be found in Table 1.
Future Capital
Once public, firms can easily go back to the public markets to raise more cash. Typically, about a third of all IPO issuers return to the public market within 5 years to issue a "seasoned equity offering" (the term secondary is used to denote shares sold by insiders rather than by firms). Those that do return raise about three times as much capital in their seasoned equity offerings as they raised in their IPO.
Cashing Out
Although it is a bad signal to investors when an entrepreneur sells his own shares (indicating that [s]he is jumping ship), it still makes sense for many entrepreneurs to cash out some of their wealth to diversify or just to enjoy life.
Mergers and Acquisition
Many private firms just do not appear on the "radar screen" of potential acquirors. Being public makes it easier for other companies to notice and evaluate the firm for potential synergies.
Image
Public firms tend to have higher profiles than private firms. This is important in industries where success requires customers and suppliers to make long-term commitments. For example, software requires training and no manager wants to buy software from a firm that may not be around for future upgrades, improvements, bug fixes, etc. Indeed, the suppliers' and customers' perception of company success is a self-fulfilling prophesy.

But public firms also tend to be larger to begin with, and this may explain why public firms on average have a better image. For example, although Gateway is private, there is no question that it will be around for a while. Going public would not aid increase its sales. The important question is if going public improves the firm's stakeholders' perception of success.

Employee Compensation
Having a public share price makes it easy for firms to give employees a formal stake in the company.

Disadvantages

Profit-sharing
If the firm is sitting on a gold-mine, future gold has to be shared with outsiders. But if the price is right, this is worth it. After the typical IPO, about 40% of the company remains with insiders, but this can varies from 1% to 88%, with 20% to 60% being comfortably normal.
Loss of Confidentiality
A major reason why firms may not receive the right price is that firms are unable to convince investors that there is a gold in the mine. For example, it could destroy the business if the company were to disclose its technology of profitability to its competitors.
Reporting and Fiduciary Responsibilities
Public companies must continuously file reports with the SEC and the exchange they list on. They must comply with certain state securities laws ("blue sky"), NASD and exchange guidelines. It costs money and discloses information to competitors.
Loss of Control
Outsiders often could take control and even fire the entrepreneur. Now, there are effective anti-takeover measures, but what investor wants to pay a high price for a company in which poor management could not be replaced?
IPO Expenses
An IPO is a costly undertaking. A typical firm may spend about 15-25% of the money raised on direct expenses (detailed in a later section.). Even more resources are spent indirectly (management time, disruption of business).
Immediate Cash-out Usually Not Permitted
Typically, IPO entrepreneurs face various restrictions that do not permit them to cash out for many months after the IPO.
Legal Liability
All IPO participants in the coalition are jointly and severally liable for each others' actions. In practice, this mean that they were routinely sued for various omissions in the IPO prospectus when the public market valuation fell below the IPO offering price. Congress recently passed (overriding a presidential veto!) The Private Securities Litigation Reform Act of 1995. The Act protects disclosure of firm projections, and (to the best of my knowledge) forced the suing shareholder to have a substantial participation in the firm. (This prevents "professional class action plaintiffs.") Although nothing can eliminate law suits, the Act reduces the likelihood of successful suits and thus influences settlement terms.

Suitability


Characteristics of 1990-1996 IPO Offerings/Firms
(By Industry, Excl. ADRs.).
Issue Sizes Firm Revenues Net Income
All Firms All Firms All Firms
Small Firms Small Firms Small Firms
West-Coast Firms West-Coast Firms West-Coast Firms
Recent IPOs (post-1994) Recent IPOs (post-1994) Recent IPOs (post-1994)

Define The Need for Money
Companies that do not know what to do with the money are lousy investments. Consequently, their shares are not easy to sell. If there is a specific need for capital, it needs to be documented!

Preparation

Before a company can sell itself to outside investors, it must put it affairs in order and present an appropriate face to investors. This cannot be done in a month or two: it needs long-standing planning. Here are some of the most important aspects:
Credible Management and Board of Directors
Marc Andreessen of Netscape is a terrific technology expert, but without a credible investor/manager like Jim Barksdale as CEO and president, he would not have had a prayer to raise IPO funds. A good product alone does not make a good company. It's all about marketing and sales, not about technology. Investors want to see investment returns, not gadgets.
Credible Advisors
Like credible management, credible experts (underwriters, auditors, lawyers) are necessary to assure investors that their money is well-spent. In addition, credible, neutral advisors to evaluate the relationship between the firm and the experts help.
Record Keeping
Companies need to require audited financial statements for the last three years before they can go public. (This is an SEC rule, but even if it were not, investors would be reluctant to invest in companies failing to supply this information.) These need to be provided separately for each significant (>20%) unconsolidated subsidiary. If it is expensive and time-consuming to produce audited financial statements annually, think about how much more expensive it would be if they had to be produced three years later! Important: the firm is legally liable for the information it provides. Any existing, operating company planning to go public in a few years should begin to produce financial statements in accordance with GAAP. It will pay off!
Clear up Property Rights and Contractual Agreements
Ambiguous relationships between the company and insiders (managers, entrepreneurs) or outsiders (suppliers, customers) raise a red flag. If the entrepreneur has other businesses, what is the relation between them? Are investors assured that profits created by the firm/entrepreneur will go to their company?
Public Relations
IPO firms have two sets of customers: those buying products and those buying shares. Sometimes the two are the same. For example, in preparation of its upcoming IPO, Deutsche Telekom heavily advertised on TV to both its customers and potential share buyers. It is important for entrepreneurs to talk not only to their customers, but also to the investment community.
Business Plan
A good business plan is a selling tool to both advisors (ranging from VCs to investment bankers to other clients) and outside investors. Most of the information in the business plan is of immediate relevance to the IPO prospectus. Having a good business plan significantly shortens the time required to produce an IPO prospectus.
Earnings Management
Earnings should show a systematic up-trend. Earnings can be legally managed--Accounting Principles Board Opinion 20 allows IPOs to restate their financials to look good for an IPO. It makes no sense to accelerate earnings recognitions two years before an offering and "pay for" it in lower earnings in the recently reported earnings read by investors just before the offering. GAAP permits firms to take reasonable accruals, to recognize earnings either before or after the physical cash has come in. A firm that does not manage its earnings appropriately is throwing the entrepreneur's money away!

Alternative Sources of Capital

Venture Capital (VC)
About ??% of IPO issuers are financed by VCs before they go public. This varies by industry; it can be as high as ??% for firms in such industry as biotech. In general, VCs finance companies that are smaller and at an earlier stage than IPO firms. They prefer high-risk high-return investments. (The typical VC fund offered a return of ??% in the ??- ?? period. Most VCs "cheat" [legally] when they state their returns. This is a long topic in itself) But VCs also take an active interest in the firm's management: on the plus side, this provides the firm with additional management expertise, industry expertise, and financing expertise. Many of the best hi-tech companies would have long since ceased to exist without venture capital. On the minus side, VCs are expensive. They take a large chunk of the firm, and often acquire "control," which permits them to fire management or sell the firm altogether. (Details on venture capital and private funding can be obtained from Josh Lerner's WWW page at http://www.people.hbs.edu/jlerner/vcpe.html.)
Private Placements and Limited Offerings
If the firm or its financial advisor have access to interested high net worth individuals and the publicity of an IPO is not important, this is an excellent alternative. Unlike Venture Capitalists (VCs), private investors typically play a smaller role in the management the company. This can be good or bad, depending on the firm.
Bank and Finance Companies
This works better than IPO's for stable, profitable, non-growth firms that can provide collateral. (An important, sometimes overlooked source of financing can be collateralization of receivables.)
Leases
This avoids initial outlays (a sale-leaseback can often be used when the property is already owned). Further, small growth companies often do not have the profits to get immediate use of tax depreciation allowances. Leasing firms can use these tax advantages and will pass on this benefit through lower lease rates directly back to the firm (provided there is enough competition among leasing firms).
Government Loans (Small Business Loans)
Thanks to Bill Clinton, the federal Small Business Administration (SBA) is experiencing a renaissance. If the firm or its advisors have the stomach (experience) for government redtape and the appropriate connections, this is a great way to get some tax dollars back. More information can be found at http://www.sec.gov/smbus1.htm.
Unregistered Public Offerings (Regulation A) and Intra-state Offerings
These are special forms of IPO's. Requirements are less formal. My advice: try to avoid them. They often are not worth the effort. If you must, more information about the specific regulations can be found at http://www.sec.gov/smbus/qasbsec.htm.
Funds from Partners
The firm's suppliers and customers know the firm's potential better than unaffiliated investors, and may be amenable to become investors. Because they have better information than outside investors, they should be willing to provide the firm with funds on better terms. They also have something to loose: the firm's business. (Trade credit is a less direct form of investment by partners, more similar to a debt than an equity investment.)

Is the Time Right To Do an IPO?

There are clear "windows of opportunity" that open and close for IPO issuers. For example, immediately after the 1987 crash, almost all pending IPO deals were cancelled. Most of what determines suitability are There is a 3-6 months lead time between starting the IPO process and going public. So, the firm needs to forecast the market conditions 3-6 months later. Luckily, for such short-run purposes, stock returns behave almost as if they follow a random walk. So, it is not a bad guess to make decisions about going public based on current stock market conditions. So, how are market conditions right now?
Current Market Conditions
To be filled in.

What Advisors Should The Firm Hire?

Consultants

It is important for entrepreneurs to hire someone independently who understands IPO's, preferably someone who understands IPO's in the same industry. Auditors, lawyers, and underwriters all have interests conflicting with the entrepreneur's interests. The auditors want to make sure they do not get sued and bill as many hours as possible. The lawyers want to never state anything in writing for which they can later be held liable, and also be paid as many hours as possible. The underwriters want to do "the deal" under conditions as favorable to them as possible, including pricing the offering low so as to minimize their necessary selling effort. When negotiating with the underwriter, it is imperative that the firm runs the numbers itself first!

This is not to say that experts are typically dishonest. Indeed, entrepreneurs need to build up mutual trust with their advisors to succeed. But at the same time, they should protect their own interests. An independent consultant can guide the appropriate selection, compensation, and behavior of other experts. The consultant should not be recommended by other experts: it is the consultant's job to advise the firm how to work with the other experts. A cozy relationship between advisor and other experts can bias the consultants' decision-making process. (Remember: after the IPO, the consultant will get little new business from the entrepreneur--but [s]he can get a lot of business from other IPO experts!)

It is astonishing how rarely independent advisors on relationships with IPO experts are retained by entrepreneurs, and how frequently independent advisors on relationships with IPO experts are retained by lawyers in law suits between firms and their former advisors lateron.

Auditors

Auditors are highly concentrated. The top 6 auditors (Ernst and Young, Arthur Anderson, Coopers and Lybrand, Deloitte and Touche, KPMG, Price Waterhouse) control about 90% of the IPO market (by dollar volume and roughly in the quoted order). So, the choice is easy: choose one of the Big-6. It helps getting the appropriate credibility with investors.

The cost of auditors' services in the typical IPO ranges from $1K to $2M, with most firms paying between $100K and $300K. (Mean/Median/Stddev. were about $170K/$130K/$175K in 1990-dollars for 960 issuers in the 1992-1994 period.) Clearly, auditor cost varies mostly by firm size and age: more complex and older operations require more auditing. Offerings below $10M typically pay $50-100K, offerings above $100M typically pay $300-400K.

Lawyers

Lawyers are basically advisors. They typically are not liable/responsible. Their role is to make sure that documents conform to legal standards, and that participants are properly indemnified. Although there are a few law firms that are expert for IPO's (and in a particular field), there are many more reasonable choices for legal services than for auditing services. Worth mentioning are Skadden Arps, and Wilson-Sonsini (computer industry expertise), but there are many other reasonable choices.

The cost of legal services in the typical IPO ranges from $5K to $2.5M, with most firms paying between $150K and $400K. (Mean/Median/Stddev. were about $255K/$202K/$175K in 1990-dollars for 960 issuers in the 1992-1994 period.) Offerings below $10M in size typically pay $100-200K, offerings above $100M typically pay $500K-700K.

Underwriters

The most important choice is the underwriter. The underwriter is the principal player in the IPO, providing the firm with

Reputation
Because the underwriter is legally liable and because the underwriter has ongoing dealings with the customers to whom he sells shares, the underwriter puts his reputation on the line.
Finding Investors
The underwriter first puts together a syndicate of other underwriters to distribute firm shares. The syndicate finds investors willing to put their money into the company. This has serious implications: Will the new investors be institutional or private? Is the company widely held or are shares concentrated with just a few investors? Will there be a lot of trading in the company in the aftermarket, or will there by long-term investors?
Experience
The underwriter knows the details of the process better than any other participant--unlike other participants, issuing shares is one of their primary business functions. Underwriters are the ones to provide proper guidance.
Aftermarket Support
For 30 days after the offering, a good underwriter provides price stabilization. This protects investors and makes the offering more attractive. It is important for the firm to have a clear understanding with the underwriter exactly how much support he/she plans to provide.
Future Services
The underwriter often provides post-IPO analyst coverage and market-making services. Most successful IPO's return to the market to do a seasoned equity offering. A good relationship with an underwriter can save time and money in future offerings.
Pre-Offering Sales
The underwriter will conduct road-shows with the company's management, distribute the preliminary prospectus, and talk to potential investors about appropriate pricing. Some part of the value potential shareholders attach to shares is directly generated by the marketing of the underwriters itself.

The services of good underwriters do not come cheap, however. Most IPO's pay a flat 7% of the offering size to the underwriter, plus they grant an overallotment ("green shoe") option, and on occasion pay significant legal expenses on top. (The entrepreneur should make sure to negotiate a cap.) Underwriters may request the right of first refusal to do future public offerings, but it is advisable for issuers either not to agree or to limit this right to 2-3 years. Also, underwriters prefer lower prices: lower prices make selling shares a lot easier, and allow the underwriter to reward his/her best customers by giving them share allotments. In a sense, pricing that is too low is an expense that an entrepreneur should factor into the costs of underwriting.

It is a good idea to solicit presentations from several investment banks. Professional underwriters understand that this is common business sense.

A (non-binding) price range is usually indicated in the preliminary prospectus, but the actual price is decided on the day before the IPO. Similarly, the scale of the offering (the number of shares) is decided on the first day. Entrepreneurs should not sell too many shares (for IPO's are unusually expensive to conduct), but selling too few shares may limit the market liquidity and reduce the appeal to investors. It is of paramount importance that investors know the worth of their shares and the appropriate issuing size when negotiating with the underwriter for the appropriate price!

Virtually all reputable IPO's in the United States are done via firm-commitment offerings, in which the underwriter guarantees that the shares will be sold. Both investors and reputable firms should stay away from best-efforts offerings, in which the underwriter is only an agent on behalf of the firm. This is not because the contract is intrinsically bad; instead, it is because no other reputable firms and underwriters seem to use it.

Among the 960 issues in the 1992-1994 period, the lowest underwriter compensation was 4% of the offering, the highest about 12%--but almost all offerings were between 5% and 9%. Offerings raising less than $10M paid about 7-9%, offerings raising more than $100M paid about 5.5-6.2%. The top underwriters were Goldman Sachs Merill Lynch, and Morgan Stanley, all of whom specialized in large size IPO's.

Printers

Choosing the right printer used to be of importance in the past. But with printing costs down and advanced printing technology inhouse in most firms, this is no longer an important choice.

Tables: Find an appropriate advisor.

/experts.html contains expert (underwriter/lawyer/auditor) compensation and ratings up until the end of 1994.
Appropriate Underwriters
To be filled in.

What Should the Offer Price be?

Company Valuation

This should be of paramount concern to issuers: how much to charge for giving away a part of the firm. There are basically three methods that should be used:
  1. Net Present Value.
  2. Earnings/Price or Cash-Flow Ratios.
  3. Various Other Ratio Analysis.

It is important [1] to adjust appropriately for the effects of leverage, and [2] not to ignore the value of strategic options (sometimes called real options; these include such items as potential future spin-offs, timing abilities, etc).

"Typical" P/E ratios are difficult to come by. They need to be tailored appropriately to each offering. Note that earnings can be negative, and thus it makes no sense to average P/E ratios. They need to be "adjusted" appropriately. Here are some suitable values:


Earnings Price (E/P) ratios for 1990-1996 IPOs
(By Industry, Excl. ADRs.)
All Firms
Small-Firms
West-Coast Firms
Recent IPOs

The Road-Show

The road show allows firms to raise interest in the company and thus the price. It allows the firm and its underwriters to gather information from potential purchasers.

Program/Bibliography: Find an appropriate P/E ratio.

How Does The Market React to IPO's?

The Short-Run IPO Underpricing

One of the big puzzles in finance is why the typical IPO underpricing (that is, the return from the offering price to the price when the market starts trading) is about 10%. Think about it: where else can an investor systematically make 10% in one day on average?
First-Day IPO Stock Returns (Underpricing)
(By Industry, Excl. ADRs, post-1990)
All Firms
Small-Firms
West-Coast Firms
Recent IPOs

The academic consensus is that there are a number of reasons why issuers leave so much money on the table:
The Winner's Curse
If you are an investor who is asking for an allocation of 1,000 shares, and there are two IPO's. One is overpriced, the other is underpriced by 20%. Do you get out even? Probably not. When the offering is overpriced, few other people will have asked for shares and you typically get all 1,000 shares. When the offering is underpriced, half the world will have asked for shares, and you typically get shares only rarely. (It gets even worse when underwriters give the "good shares" only to their friends, and you are not one of them.) For the sake of argument, assume you get shares only half the time. Then, your expected return on these two offerings would be
50%*(+20%) + 100%*(-20%) = -10%
Consequently, an investor who participates in an offering that is just fairly priced is likely to make a negative return and thus would not wish to participate. To get investors to participate at all, issuers must set a lower price for the IPO. It will look as if the average IPO left money on the table, but the typical investor cannot profit from this money. (This is not the case in the reasons described below, where investors are presumed to get a bargain.)
A Good Taste In Investors' Mouths
Issuers like to donate some money to investors. They will want to come back to investors later for more funds, and those investors will remember if they got a good or a raw deal at the IPO.
Pre-Selling
Underpricing is necessary to solicit information from investors about potential interest. Why would investors tell underwriters that they like an offering, unless they knew that if they told the underwriters that they liked it, the underwriter would give them more shares for a better price.
Marketing
If one important investor defects, maybe all investors will follow. (This is sometimes called a "herd mentality.") To make sure the important first investor does not defect, it is better to play it safe, and leave too much money on the table.
Legal Liability
(This is no longer as important, because the recent ??? Act has significantly reduced issuers' legal liability.) Investors tended to sue when shares where ex-post overpriced, because IPO's were subject to unusually strong liability. Being 10% underpriced reduced the probability that IPO prices would soon drop below the offering price.
Agency
This reason concentrates on the conflict between investors and underwriters. Because underwriters prefer to work less, especially when the price is high which makes selling painful, it is best to make selling a little easier for them and underprice the offering.
Placement
The issuer cares more about who to place shares with than what the price is. By giving shares at a bargain price, the issuer can pick and choose.

The Long-Run IPO Underperformance

In the long-run, IPO shares have significantly underperformed to the tune of 30-50% below comparable companies over 3-5 years. This does not detract from the IPO underpricing puzzle--after all, a first-day investor can sell soon after the IPO and realize the immediate IPO underpricing.


Long Run IPO Stock Return Performance
By Return Window By Industry
All Firms All Firms
Small Firms Small Firms
West-Coast Firms West-Coast Firms
Recent IPO Firms (post-1994) Recent IPO Firms (post-1994)

This long-run underperformance of issuers (and it also applies to seasoned equity issues) is one of the major puzzles of finance today. Why would anyone be willing to hold shares in companies that are risky and that can systematically barely beat the rate on safe treasury bonds? Ultimately, the answer is related to irrational investor behavior. The two most prominent explanations of this long-run underperformance are that firm managers are smarter than the market and are thus good at timing--with some managers issuing only because conditions are not right, not because they need the money--and that firm managers (legally) manipulate earnings, so as to look as best they can at the time of the offering. Investors may be disappointed lateron, but it is too late--they have already invested their funds. Again, within limits, this can be done legally (within appropriate limits, of course), and it is indeed common among issuers.

If you are an investor who wants to invest for the long haul, avoid portfolios of firms having recently conducted an equity offering. At least, do some research to determine if the firm had unusually high accruals, i.e., made its earnings look better than they actually were.

Other Noteworthy Aspects

These are best to be gathered from experts that do IPO's day-in day-out. Here are a few random notes:

Appendix 1: Bibliography and Research Resources

Appendix 2: Purpose of this page

The purpose of this resource page is to provide a basic summary of the principal issues facing IPO market participants and researchers. This synopsis is supposed to be accessible to novices and to be a reference to experts.

Business information can be loosely classified into three forms: institutional, academic and case-oriented. Good information (and hopefully this page eventually) draws on all three forms. Sometimes, the academic and case-oriented approach are (mistakenly) perceived to be conflicting. But each have their unique strengths. The advantage of the academic approach is that it draws its insights primarily from the analysis of many firms. Such insights tend to be more "universal"--how else can one know if a particular case was an unusual one-time experience? Further, typically being based on publicly accessible data, academic studies are reproducible/checkable by third parties--how else can one know that an expert's account is appropriate and objective? Which expert should one believe in? The advantage of case-oriented studies is their access to more detail, that is often lost in the need to analyze thousands of firms. Further, case-studies provide an invaluable aid to explain and understand the real-world nature of the problem at hand.

This WWW page favors the academic approach. It emphasizes empirical regularities that I consider to be reproducible, robust, and universal. I had to exercise some judgment, but it is are based on a decade of research experience in the IPO area. Another caveat is that some information provided here has not been published. Other information would be unsuitable for publication, because it is educated speculation. I will attempt to indicate this to the reader. At the same time, to preserve readability, this synopsis does not attempt to systematically cite/give credit where credit is due. A bibliography of relevant IPO publications is linked to this page, as is a bibliography of experts and resources to IPO market participants.

Most of what follows is based on U.S. IPO's, excluding such special cases as REITs, bond or closed-end funds, or equity carve-outs (see the bibliography for some basic references). The role of venture-capital and private funding, a large topic in itself, is not covered in the detail it deserves, but a separate bibliography is included. I would like to point the interested reader at http://www.people.hbs.edu/jlerner/vcpe.html.