378 A. Ljungqvist
- Introduction
Going public marks an important watershed in the life of a young company. It provides
access to public equity capital and so may lower the cost of funding the company’s
operations and investments. It also provides a venue for trading the company’s shares,
enabling its existing shareholders to diversify their investments and to crystallize their
capital gains from backing the company—an important consideration for venture cap-
italists. The act of going public itself shines a spotlight on the company, and the at-
tendant publicity may bring indirect benefits, such as attracting a different caliber of
manager. At the same time, the company acquires new obligations in the form of trans-
parency and disclosure requirements, and becomes accountable to a larger group of
relatively anonymous shareholders who will tend to vote with their feet (by selling the
shares) rather than assist the company’s decision-makers in the way a venture capitalist
might.
Most companies that go public do so via an initial public offering of shares to in-
vestors. IPOs have interested financial economists for many decades. Early writers,
notablyLogue (1973)andIbbotson (1975), documented that when companies go pub-
lic, the shares they sell tend to be underpriced, in that the share price jumps substantially
on the first day of trading. Since the 1960s, this ‘underpricing discount’ has averaged
around 19% in the United States, suggesting that firms leave considerable amounts of
money on the table. Underpricing has tended to fluctuate a great deal, averaging 21%
in the 1960s, 12% in the 1970s, 16% in the 1980s, 21% in the 1990s, and 40% in the
four years since 2000 (reflecting mostly the tail-end of the late 1990s internet boom).^2
Clearly, underpricing is costly to a firm’s owners: shares sold for personal account are
sold at too low a price, while the value of shares retained after the IPO is diluted. In
dollar terms, IPO firms appear to leave many billions ‘on the table’ every year in the
U.S. IPO market alone.
This remarkable empirical regularity inspired a large theoretical literature in the
1980s and 1990s trying to rationalize why IPOs are underpriced. The resulting theo-
retical models in turn have been confronted with the data over the past fifteen years
or so. This chapter will outline the main theories of IPO underpricing and discuss the
empirical evidence.
Theories of underpricing can be grouped under four broad headings: asymmetric
information, institutional reasons, control considerations, and behavioral approaches.
The best established of these are the asymmetric information based models. The key
parties to an IPO transaction are the issuing firm, the bank underwriting and market-
ing the deal, and investors. Asymmetric information models assume that one of these
parties knows more than the others.Baron (1982)assumes that the bank is better in-
formed about demand conditions than the issuer, leading to a principal-agent problem
(^2) Underpricing averages are based on data available on Jay Ritter’s website (http://bear.cba.ufl.edu/ritter/
ipodata.htm).