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Initial Public Offerings (IPOs) repre- has raised several issues. For example,
sent a common way by which emerging initial returns exceeding 200 percent for
firms finance their growth. This is espe- IPOs of companies such as Boston
cially taie when the resources required Chicken and Netscape have sparked con-
for such growth can neither be provided siderable interest in IPO pricing. Such ex-
by the entrepreneurs nor secured traordinarily high returns to investors im-
through debt financing due to increased mediately after the IPO seem to suggest
costs and risks associated with higher lev- that in a number of cases IPOs are priced
els of debt. The active market for initial at a significant premium over their book
public offerings (IPOs) in recent years value. This leads to the obvious ques-
tions, "Why do some IPOs command a
high premium over book price while
y Dr. Rasheed is currently professor of management at the other do not? What factors are responsi-
University of Texas at Arlington. His research interests are in
the areas of corporate strategy, strategy decision processes, ble?" These questions have important im-
corporate restructuring, and initial public offerings. plications from the perspective of the is-
Dr. Datta is currently associate professor of business and suer who has a self-interest in maximiz-
y School of Business Research fellow at the University of Kan-
sas. His research interests include corporate diversification, ing the share price.
mergers and acquisitions, strategic decision processes, and top This study addresses the issue of IPO
management characteristics.
^ Dr. Chinta is currently senior project manager at Senco
pricing and investigates the factors that
Products, Inc. with functional responsibilities in strategic influence the price premiums in initial
planning and new business development. He has eight years of public offerings. Because industry condi-
.^experience in the venture capital industry. tions are likely to influence IPO pricing
*The authors thank three anonymous reviewers for their
valuable suggestions. They also wish to thank Nandini and price premiums, we control for in-
Rajagopalan, Anthony Daboub, and Li Chin Ho for their valu- dustry effects. We focus on IPOs in a sin-
able comments. A previous version of this article was present- gle industry the medical diagnostics
ed at the National Academy of Management Meetings, Dallas,
and devices industry. This industiy has
7
Texas, 1994.
OCTOBER 1997 11
been characterized by significant change over, the company may be able to moti-
and a relatively large number of IPOs, vate and retain high-quality management
This article is stmctured as follows. In by initiating stock-compensation plans
the next section, we discuss issues related (Lauer and Zeune 1987),
to IPO motivations, pricing, and price Besides these benefits to the firm, a
premiums. We also discuss the factors public offering also provides benefits to
likely to infiuence price premiums and the individual owners. First, it provides
identify the specific hypotheses exam- the owners a more liquid investment.
ined in this study. In the next section, we Second, it aids in the estate planning of
discuss the research methodology, the firm's principals (Steck 1984), Third, it
including sample identification and selec- is a way to answer the dream of becom-
tion, measures, and the analytic tech- ing wealthy. The story of Bill Gates be-
nique adopted. In the final section, we coming a billionaire overnight as a result
present the results, discuss the implica- of Microsoft's IPO is the stuff of legend
tions, and suggest possible directions for (Uttal 1986), In addition, going public
future research. also feeds the desire to become the CEO
of a publicly-traded corporation (Young
Theoretical Overview and and Zaima 1988), At the very least, going
Research Hypotheses public provides a means for entrepre-
IPOs: Motivations, Pricing, and Price neurs to harvest and venture capitalists tC)
Premiums exit from their investments (Timmons
What motivates the decision to go 1985),
public? The literature suggests several Overall, an IPO can be viewed as an
factors, A public offering provides a firm event shaped by the motivations, deci-
the resources required to pursue aggres- sions, and actions of three sets of players:
sive growth strategies. Since an IPO in- the issuer, the underwriter(s), and the in-
creases the amount of equity, it also ena- vestors. They are guided by different and,
bles the firm to borrow more. An initial often confiicting, sets of objectives at the
public offering gives the firm an excellent time of an IPO, For example, issuers like
opportunity to restructure its balance to maximize the offering price per share
sheet. Once the shares are publicly trad- to enhance their returns. In contrast, in-
ed, the firm can acquire new busine,sses vestors would like the lowest offering
by issuing new stock to the sellers Qames price, so that they can earn above-market
1989), A public issue also brings greater returns when they subscribe to the issue.
name recognition to the company. More- Underwriters, on the other hand, seek to
Table 1
Pricing of IPOs: Players and Motivations
Issuer Underwriter Investor
High price (+) Maximize wealth (+) Maximize income (-) Lower returns
(-) Under subscription (-) Under subscription
(-) Investor alienation
(-) Obligation to meet
underwriting commitments
Low price (-) Ownership transfer (+) Insurance against (+) High returns
at below market legal liability
prices (-) Low commission
income
(+) Low Risk
OCTOBER 1997 13
ial perspective, however, there are certain only information readily available to all
limitations associated with this stream of three players (issuer, investor, and under-
research. First, the owners or the under- writer) at the time of an IPO is the book
writers can only find out whether the is- value of the shares as stated in the audit-
sue was under- or over-priced after a ed financial statements of a company. By
market price is established through the focusing on price premium (issue price
trading of securities. In addition, the ex- over book value) instead of issue price
tent of under- or over-pricing can vaiy relative to subsequent market price, this
substantially based on the time period in study emphasizes the entrepreneur's de-
which prices are examined. There is cision making on the basis of available in-
strong evidence that IPO shares trade at formation, rather than any post-facto
significantly higher prices in the days im- analysis of why the IPO was underpriced.
mediately after the issue date. However, When going public, issuers typically
this result does not hold up if prices over expect to get from investors a price per
a longer time period are examined (Eysell share that is significantly higher tlian the
and Kummer 1993). Ritter (1991) found book value of the stock. Therefore, it is
that the widely documented phenome- not the absolute price at which a share is
non of underpricing is essentially very issued to the public that is important to
short-nin in nature. If longer time frames us, but, rather, the premium that investors
are used, IPOs stocks actually underper- are willing to pay over and above the
form those of comparable firms in the book value of that share. There is consid-
market. Second, recent empirical re- erable variability in the extent of the pre-
search indicates that the high prices mium. Some IPOs are made at prices
prevailing immediately after the issue which are several times the book value of
date may not necessarily be the result of the shares, while others are made at
underpricing. Aggarwal and Rivoli (1990) prices close to book value. This study
found that this phenomenon may be focuses on the factors which help explain
more a result of overvaluation or fads in this variability.
the after market, since prices declined
substantially in the subsequent period. While the use of book values in the
Even when high prices may not be attrib- IPO pricing literature is new (prior
utable to market fads, they may be the research having almost exclusively
result of deliberate underwriter price sup- focused on underpricing), there have
port. As this support is withdrawn, prices been several investigations of the rela-
begin to decline (Ruud 1993). Additional tionship between the book value and the
evidence of overpricing in the early mar- market value of firms in the finance and
ket is provided by Schultz and Zaman accounting literatures. For example, Ro-
(1994). Third, it has been argued that the senberg, Reid, and Lanstein (1985) report
initial return (IR) measure widely used in that an investment strategy based on buy-
past literature is ovedy simplistic, as it ing stocks with a high ratio of book value
overestimates the initial returns available to stock price produces positive abnor-
to the investor and the costs of underpric- mal returns. In addition, Fama and
ing to the issuer (McGuinness 1993). French (1992) report that book-to-market
equity is a powerful predictor of stock
Alternatively, to determine whether a returns. Moreover, authors such as Ohl-
particular issue is under- or over-priced, son (1995) and Feltham and Ohlson
one may look at the pricing decision (1995) have also used book value as an
strictly in terms of discounted cash flow important aspect of their theoretical mod-
analysis (Zent 1990). However, this ap- els of firm value. Given the increasing at-
proach is often unrealistic, because it is tention paid to book value in firm valua-
impossible to determine the future in- tion in both tlie theoretical and empirical
come streams of companies which do not literatures, the use of book value of
have a long earnings history or even shares would seem appropriate to the
commercialized products or services. The study of IPOs as well.
OCTOBER 1997 15
writers are in a sense certifying the un- high number of uses of proceeds can ac-
tested management of a young firm, tually generate uncertainty among poten-
because of their obligation to "due dili- tial investors, A long list of intended uses
gence." The prestige of the underwriter re- leaves the investor unsure about the
duces uncertainty for investors and elicits future direction of a firm and the appro-
a higher price relative to the book value of priateness of the multiple uses of the IPO
stocks. Thus, we hypothesize that; proceeds, Beatty and Ritter (1986), for
Ii2: Tbere will be a positive relationsbip example, used the number of uses of pro-
between underwriter reputation and ceeds disclosed in the prospectus as a
tbe price premium at the time of the measure of uncertainty. They found a
IPO. positive relationship between the num-
Stage of development. In this context, a ber of proceeds listed and the degree of
company's stage of development is based underpricing. It can also be assumed that
on whether the firm's products have been the higher the number of the uses of pro-
commercially introduced into the market ceeds, the higher will be the investors'
or not. In many IPOs, the products are cost in investigating the potential returns
not commercially produced. At times, from them. Consequently, investors will
they are not even in a developmental be less willing to pay a substantial premi-
stage. From the perspective of potential um for issues with multiple uses. There-
investors, the prospects of a company fore, the gap between the IPO price and
whose products have been commercially the book value will be smaller. This leads
introduced are more easily assessed than to the fourth hypothesis,
those of a company whose products are H^: Tbere will be a negative relationsbip
still under development. Generally between tbe number of uses of pro-
speaking, the longer a firm has been in ceeds and tbe premium tbat a firm is
existence, the more likely it is to have a able to cbarge in an IPO.
record of sales. Longevity in a firm, in Stock retained by management. Al-
turn, reduces information asymmetries though IPOs are a means by which insid-
between insiders and potential investors ers can haivest their investment in the
(Muscarella and Vetsuypens 1989; Young company, the percentage of ownership
and Zaima 1988), When market evalua- retained by them sends a powerful signal
tion of the products is absent, the investor to potential investors. If the management
is forced to rely on information provided and other insiders retain a significant
by the issuer and the undei-writer. The stake, they communicate a positive out-
risks associated with IPOs of firms whose look on the future of the firm. The reten-
products have not been tested in the mar- tion of stock by management as a positive
ketplace are obviously higher. Conse- signal has been demonstrated both theo-
quently, such firms are likely to com- retically and empirically. Grinblatt and
mand a lower price premium. The inves- Hwang (1989), for example, propose a
tors expect to pay a lower price for as- signaling model in which the fraction of
suming greater risks. Therefore, we can the new issue retained by the issuer con-
hypothesize that: veys to investors the intrinsic value of the
H^: Firms ivitb a sales bistory ivill be able firm and the variance of its cash flows.
Gale and Stiglitz (1989) have also demon-
to cbarge bigber premiums tban firms strated theoretically that the sale of equi-
in tbe development stage. ty in an IPO by insiders is an impoitant
Number of uses of proceeds. In addi- piece of information. In an empirical
tion to risk factors, IPO prospectuses pro- study, McBain and Krause (1989) showed
vide information about the number of that the offering price in an IPO is rela-
uses of proceeds from the IPO, It can be tively high when it appears that the insid-
argued that such information reduces ers are not "bailing out" as the company
both the uncertainty and the information goes public. Similarly, Eysell and Kum-
gathering costs for the investor. However, mer (1993) have shown empirically that
the reverse is more likely to be truea
OCTOBER 1997 17
prospectus. In many of the prospectuses, viously discussed, sometimes they are
these are listed in a numbered sequence, not even in a developmental stage.
minimizing counting problems,' Finally,
the dependent variable, IPO price premi- Data Analysis
um (PRIPREM) was computed as follows: Given a continuous dependent vari-
PIUPREM = (Offering price - Net tangible able (PRIPREM), OLS multiple regression
book value per share after offering) / Of- analysis was used to examine Hy-
fering price. The measure tells us what potheses 1-5, The following model was
utilized:
fraction of the offering price represents
PRIPREM = (So + IS] (UNDREP) + 13
the premium over book value. The data
(DEBEQ) + 1S3(NOUOP)
used to calcLilate this measure were taken
from the prospectuses. Stage of develop- 4 5
ment (STADEV) was treated as a categor- where,
ical variable with a value of "0" for com- PRIPREM = Price premium paid by the
panies in the developmental (pre-sales) investors in an IPO
stage and "1" for companies that have UNDREP = Reputation of the under-
commenced sales,^ As is often the case in writer
NOUOP = Number of uses of pro-
IPOs, the products are not commercially
ceeds stated in the pros-
produced at the time of the IPO, As pre- pectus
Table 2
Means, Standard Deviations, and Intercorrelations
of Study Variables
(n = 57)
Variable Mean S.D. 1 i 2 3 4
1, Price premium 0,7 0,09
2, Number of uses 4,49 1,6 0,32' -
of proceeds
3, Leverage 0,21 1,94 -0,24* 0,13
4, Reduction in ownership 15,84 10,69 -0,27' 0,31* 0,31
5, State of development 0,57 0,50 -0,09 -0,07 0,13 0,11
6, Undei-writer reputation 0,33 0,47 -0,05 / -0,16 -0,03 -0,21 0,16
" p < ,001
" p < ,01
' p < .05
' In those cases where the number of uses of proceeds were not numbered, they were counted by
the authors. To avoid errors resulting from subjectivity in counting, two of the three authors did the
counting independently, and the results were compared, tn the three cases where the results differed,
the authors arrived at the final number through discussion and clarification,
^ Ideally, we should have included the sales figure itself, because from the point of view of an
investor, a firm with sales of $10 million is very different from one with sales of only $500,000,
However, the use of the sales figure would have resulted in a very skewed sample given the number
of firms with no sales at all.
^ Tolerance values were cohiputed for the independent variables in the OLS regressions.
Tolerance is defined as | l-/?i^| >vhere//f,-^ i^ the proportion of an independent variable's variance
explained by the regression model's Other mdependent variables. Although the correlation matrix
indicates a moderate degree of intercorrelation among the predictor variables, tolerance values were
uniformly high (greater than 0.80) suggesting that multicollinearity was not a problem in this study.
OCTOBER 1997
firm's stage of development would be fidence in the stock, A signal of greater
positively related to the size of ttie price commitment from the current owners
premium, and that leverage, the number (those most familiar with the firm) is a
of uses of funds, and the extent of man- valuable source of information for in-
agement's reduction in stock tiotdings vestors. Quite likely, investors expect
would be negatively related to the premi- greater appreciation of shares when in-
um. The parameter estimate associated siders retain a significant stake in the firm
with leverage (DEBEQ) was significant at and investors are therefore willing to pay
the 0,001 level and negative in sign, pro- a higher premium during the IPO, as indi-
viding strong support to Hypothesis 1, In cated by our results.
addition, the reduction in stoctc owner- However, contrary to expectations,
ship by existing management following IPOs that listed a greater number of "uses
the IPO was, as expected, negatively of proceeds" tended to command higher
associated and statistically significant price premiums, A possible explanation
(p < ,05) with IPO price premiums. for this unexpected finding is that, al-
Finally, although the parameter estimate though a high number of uses of pro-
associated with number of uses of pro- ceeds increases investors' cost of evalua-
ceeds was significant at the 0,01 level, it tion, the amount of detail provided by
was in the direction opposite to that hy- these uses serves to enhance confidence
pothesized. Two of the other hypothe- in the firm and in the IPO, This higher
sized relationships were not significant level of confidence may lead investors to
(that is, Hypotheses 2 and 3 were not pay higher premiums for the IPO, These
supported). In other words, the firm's results seem to indicate that, for the in-
stage of development and the lead under- vestor, the costs associated with evaluat-
writer's reputation did not have a signifi- ing the alternate uses of the funds are ex-
cant impact on the price premiums asso- ceeded by the value of the information.
ciated with IPOs in the sample. Surprisingly, our results do not indi-
cate a statistically significant relationship
Study Implications between underwriter reputation and
Our results indicate that the leverage price premium. While there are compell-
of the firm, the retention of equity by ing theoretical arguments supporting
management, and number of uses of pro- such a relationship, no empirical evi-
ceeds are all significantly related to the dence was found in our study. One pos-
price premium. As hypothesized, higher sible explanation for these results might
levels of debt raise questions regarding a be the often-observed tendency among
firm's ability to meet its interest payment "reputable" underwriters to underprice
obligations in the post-IPO periocl. The IPOs to avoid potential damage to their
resulting uncertainty reduces its ability to reputation arising from "overpricing," A
command premiums. These findings sug-
gest that it is very important for the issuer high initial price can reduce post-IPO
to reduce, to the extent possible, the returns to investors and can thus trigger
component of debt in the capital struc- damaging litigation. As Drake and Vet-
ture, A lower debt component reduces suypens (1993) argue, the possibility of
the investors' uncertainty about the firms' lawsuit and adverse judgement often
ability to service the debt and become a causes underwriters to underprice their
viable and profitable entity. In addition, offerings.
lower debt and higher owner's equity sig- Directions for Future Research
nal to potential investors greater commit- Our exploratory study, based on 57
ment and involvement on the part of the IPOs in the medical diagnostics and de-
current owners. The relationship be- vices industry, provides interesting in-
tween leverage and price premium was, sights on factors influencing price premi-
therefore, as expected. Similarly, the re- ums. However, its limitations must be
tention of significant stock by manage- considered in interpreting the results. An
ment increases a potential investor's con- important limitation of the study relates to
OCTOBER 1997 21
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