The Cost of Going Public: Why IPOs Are Typically Underpriced

by Lena Booth

Executive Summary
The underpricing of initial public offerings (IPOs) is an indirect cost of going public that is borne by
the issuing firm. Its magnitude varies across IPOs with different issue characteristics, allocation
mechanisms, underwriter reputations, and general financial market conditions.
Commonly used share allocation methods in IPOs are auction, fixed price, and book-building. Book-
building is the most popular method, and it allows smaller, less known companies to go public.
IPOs are underpriced to signal issue quality, mitigate adverse selection problems, reward investors
for truthfully revealing information, lessen underwriters potential legal liabilities, allow underwriters to
curry favor with their clients, promote ownership dispersion for liquidity and control, and attract media
attention/publicity.
Issuing firms can attempt to reduce underpricing by engaging reputable underwriters and auditors,
having frequent disclosures, waiting until they possess desirable characteristics, and/or using the
auction method if they are of high quality.

Introduction
When firms go public, they incur direct and indirect costs associated with the initial public offering (IPO)
process. Direct costs are fairly predictablethey include registration, underwriting, and attorney and auditing
fees. The indirect cost, commonly known as IPO underpricing, is one of the most perplexing puzzles in
finance. It is observed in almost every financial market in the world and across all procedures of share
allocation. IPOs are, on average, underpriced by 1820% in the United States. During the hot issue period,
underpricing was much higher, as many of the IPO firms did not have strong financials or growth potential
and simply rode the wave to go public. In countries where regulations and restrictions are imposed in the IPO
market, underpricing is higher as well.

What Is IPO Underpricing?

Underpricing refers to the price run up of the IPO on the first day of trading. It is also known as the initial
return or first-day return of the IPO.
Underpricing = (First-day closing price Offer price) Offer price 100%
The first-day closing price represents what the investors are willing to pay for the firms shares. If the offer
price is lower than the first-day closing price, the IPO is said to be underpriced and money is left on the
table for new investors. Since existing shareholders settle for a lower offer price/proceeds than what they
could have got, money left on the table represents the wealth transfer from existing shareholders to new
shareholders.
Money left on the table = (First-day closing price Offer price) Number of shares
On average, the amount of money left on the table is about twice the amount of direct underwriting fees, and
for many IPO firms it can equal several years of operating profit.
Although most IPOs are underpriced, the level of underpricing varies across IPOs with different issue
characteristics, allocation mechanisms, underwriter reputation, and general financial market conditions.
For example, the level of underpricing is reduced for larger IPOs, those underwritten by prestigious
investment banks, firms with a longer operating history or more experienced insiders on the board, and
those which intend to use the proceeds to repay debt. On the other hand, technology firms, firms backed by
venture capital, firms with negative earnings prior to the IPO, or firms that went public during a bull market
experience greater underpricing.

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Share Allocation in IPOs
IPO underpricing happens regardless of whether issuers use the auction, the fixed-price, or the book-
building method to go public. In the auction method, investors submit their desired price and quantity bids.
The offer price that will allow the firm to sell all its shares is determined after bids are submitted, and hence
incorporates the demand for the shares. A maximum price is usually chosen as well, so that unrealistic bids
(bids well over the clearing price) can be eliminated. This is done to prevent investors from placing very
high bids to ensure that they are allocated shares. Shares are then allocated, on a pro rata basis, to all the
investors who placed bids between these two prices. In a uniform price auction, all the investors receiving
shares will pay the same market clearing price. In the less common discriminatory price auction, investors
pay the prices they bid for.
In a fixed-price offer, the issuer and the underwriter jointly determine the offer price, and investors place
orders for shares at this price. If the issue is oversubscribed, shares are either allocated through lottery or on
a pro rata basis.
In the book-building method, the underwriter promotes the IPO by disseminating information about the
issuing firm via road shows. They gather indications of interest by soliciting from potential investors their
desired prices and quantities for the issue. The underwriter then uses this information to determine the final
offer price. Under this method the underwriter has complete discretion on the allocation of new shares.
Of the three allocation mechanisms, evidence has shown that IPOs under the auction method show the
lowest average underpricing. However, firms that choose the auction method sometimes fail to go public
because bids for their shares are insufficient. This problem is especially common for smaller, less known
companies, which require substantial information production and dissemination by the underwriters. For
these firms, the book-building method might be the only option that will allow them to go public. It is therefore
not surprising to see the book-building method, a method that is used predominantly in the United States,
gaining popularity around the world.

Why Are IPOs Underpriced?

IPO underpricing continues to be a global phenomenon despite a vast amount of research that attempts to
explain it. Theories based on information asymmetry suggest that high-quality issuers deliberately underprice
their IPOs to signal their quality to outside investors, hoping that it will be too costly for low-quality issuers to
mimic. Underpricing also helps to overcome adverse selection problems. Since uninformed investors tend to
get a higher allocation of overpriced shares, they will stop participating in IPOs if issues are not, on average,
underpriced. In the book-building framework, the theory of partial adjustment suggests that investment banks
only partially adjust IPO offer prices upward when they receive positive information about the value of the
issue. They purposely leave money on the table to reward investors who truthfully reveal their information
about the issue and threaten access to future deals for those that do not.
Some studies suggest that investment banks underprice IPOs to protect their reputation. When new issues
are priced lower than they should be, investment bankers reduce their legal liability by lowering the chance
of price declines. There is also evidence that greater underpricing leads to more aftermarket trading volume,
which increases the revenue of investment bankers when they subsequently become the market-makers for
these IPO firms. Investment bankers also benefit from underpricing because it allows them to curry favor with
their clients in exchange for their loyalty and continued business. These explanations do not make it clear
why issuing firms approve underpricing as it only benefits the investment banks.
There are explanations of underpricing that are based on information production and ownership dispersion
which will benefit the issuing firms. If issuing firms want to have a more dispersed ownership, they need
to underprice their IPOs so that more investors will be induced to produce information about the issue and
subsequently buy the shares. Dispersed ownership increases liquidity and aftermarket trading, and also
helps existing owners to retain control of their firms. These explanations predict a positive relationship
between underpricing and aftermarket liquidity. However, there is also an explanation that predicts an
inverse relationship between these two variables. When aftermarket trading for an IPO is expected to be thin,
investors face higher aftermarket trading costs associated with asymmetric information; thus, they demand a
higher level of underpricing to compensate them for the liquidity risk.

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It has also been argued that underpricing is a substitute for marketing expenditure. Hugely underpriced IPOs
tend to receive a disproportionate amount of media attention and publicity. Research shows that an extra
dollar left on the table reduces other marketing expenditure by about the same amount. Higher underpricing
also attracts more analyst coverage post IPO.

Case Study

The Google IPO

Google, the worlds most widely used search engine, filed for an IPO in April 2004. Founded in 1998 by
Sergey Brin and Larry Page, Google grew rapidly in the internet space, due mainly to its superior search
technology. With a core business in selling search-based advertising, by 2004 Google had shown impressive
sales growth and handsome profit margins. According to its filing, Google generated US$961.9 million of
revenue and US$106.5 million of net profit in 2003. It had been profitable since 2001.
Google decided to use the auction method to go public, a deviation from the book-building method that is
primarily used in the United States. According to Brin and Page, an auction would provide a fair process
for all investors and help to determine the share price that reflected a fair market valuation of Google. They
believed that auction mitigates problems associated with unreasonable speculation, which can result in
boombust cycles that may hurt investors in the long run. They also wanted their shares to be within reach
for any investors, unlike book-built IPOs, which are available only to those who have special relationships
with the underwriters. The lead underwriters of the Google IPO, Morgan Stanley and Credit Suisse First
Boston, helped to decide on a preliminary price range of US$108 to US$135 a share. That range was later
revised to US$8595, and the number of shares offered was reduced after it became apparent that the IPO
wasnt as popular as expected.
Google successfully went public on August 19, 2004, at US$85 per share, selling 19.6 million shares. The
first-day closing price was US$100.34, resulting in an underpricing of 18.05% and US$300.7 million left on
the table. The underpricing of 18% was about average compared to other US IPOs but low relative to other
internet IPOs, especially those that went public during the bubble period of 19992000. Google managed
to go public using the auction method because it waited six years until it was well established, became a
household name, and had a record of positive earnings.
However, many industry watchers felt that Google did not fare well in its IPO because it chose the auction
method. It started as a hot IPO, yet had to reduce its filing price range due to insufficient demand at the
higher price range that was originally proposed. Some attributed the low demand to lack of participation by
institutional investors. Others claimed that Google was sabotaged by investment bankers, who prevented
their clients from bidding because it had chosen a method that offered them little benefit. Could Google have
got a higher offer price and larger issue proceeds if it had used the book-building method? It is a question we
cannot answer but which will leave us wondering for a long time.

Conclusion
Underpricing comes at the expense of the original owners and venture capitalists of the issuing firm.
However, these insiders typically do not strongly oppose or even attempt to avoid it, because they generally
do not sell their shares until about six months later, after the lockup period expires. To them, underpricing
creates excitement that could help create sustainable interest in the firms shares, thus keeping demand
strong until they are ready to sell. Additionally, insiders are so contented with their new-found wealth that
they do not mind leaving some money on the table for new investors. Underpricing is simply viewed as an
inevitable cost of going public.

Making It Happen
Although underpricing may be inevitable due to certain risk and liquidity constraints, there are ways in which
issuing firms can reduce it if they want to. Here are some suggestions:

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 Engage reputable underwriters and auditors: Prestigious underwriters use their reputation capital
to certify the value of the firm and reduce investor uncertainty about the value of the issue, and that
consequently lowers the level of underpricing. Reputable auditors are better able to certify the accuracy
of the financials and reduce uncertainty as well. From a partial adjustment perspective, prestigious
underwriters are expected to have more future deals to compensate investors. They do not have to
pre-commit a large underpricing for each issue and thus are expected to underprice less.
Frequent disclosure: Issuing firms can also reduce underpricing by voluntarily and frequently disclosing
information about themselves in the press, provided that the quiet period rule is not violated. Frequent
disclosures reduce asymmetric information, and hence lower the information production costs incurred
by investors.
Issuer characteristics: IPO underpricing is lower with certain issuing firm characteristics. If issuing firms
can wait until they are larger in size, have a longer operating history, and possess a record of positive
earnings before going public, they are likely to reduce the level of underpricing. Underpricing can also
be reduced if there are more experienced insiders sitting on the board of the issuing firm.
Use the auction method if feasible: As noted above, many explanations of underpricing were derived
from the book-building framework. To reduce underpricing, issuers in IPO markets in which the auction
mechanism is available might want to go public that way. However, the auction method works only if
the issuing firm is a superior quality firm that has high investor awareness. Also, if the issuing firm is
concerned more about factors other than underpricingfor example, price stabilization and post-IPO
analyst coverage provided by investment banksbook-building may be a better choice.
might want to go public that way. However, the auction method works only if the issuing firm is a
superior quality firm that has high investor awareness. Also, if the issuing firm is concerned more
about factors other than underpricingfor example, price stabilization and post-IPO analyst coverage
provided by investment banksbook-building may be a better choice.

More Info
Book:
Jenkinson, Tim, and Alexander Ljungqvist. Going Public: The Theory and Evidence on How
Companies Raise Equity Finance. 2nd ed. Oxford: Oxford University Press, 2001.

Articles:
Derrien, Franois, and Kent L. Womack. Auctions vs. book-building and the control of underpricing
in hot IPO markets. Review of Financial Studies 16:1 (Spring 2003): 3161. Online at:
dx.doi.org/10.1093/rfs/16.1.31
Ritter, Jay R., and Ivo Welch. A review of IPO activity, pricing, and allocations. Journal of Finance
57:4 (August 2002): 17951828. Online at: dx.doi.org/10.1111/1540-6261.00478

Websites:
IPO dataJay R. Ritters page of IPO links: bear.cba.ufl.edu/ritter/ipodata.htm
IPOresources.org: www.iporesources.org

See Also
Best Practice
Acquiring a Secondary Listing, or Cross-Listing
IPOs in Emerging Markets
Price Discovery in IPOs
Checklists
Conflicting Interests: The Agency Issue
Merchant Banks: Their Structure and Function
Raising Capital by Issuing Shares
Stock Markets: Their Structure and Function

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 Understanding Capital Markets, Structure and Function
Industry Profile
Banking and Financial Services

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