3.7The Decision to Issue Shares Publicly

Many economists believe that the relatively liquid equity markets and the active new

issues market provide a competitive advantage to young firms in the United States.

Without access to good capital markets, many entrepreneurs and venture capitalists

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78	Part IFinancial Markets and Financial Instruments

EXHIBIT3.4

Numberof Offerings, Average Initial Return, and Gross Proceedsof Initial Public Offerings in 1960=1999

			Gross Proceeds,
Year	Number of Offerings	Average Initial Return,%	$ Millions

1960–69	2,661	21.2	7,988
1970–79	1,640	9	6,868
1980–89	4,759	15.3	80,946
1990–99	5,316	20.6	353,923
Total	14,376	17.4	449,725

Source:Professor Jay Ritter’s University of Florida Web page http://bear.cba.ufl.edu/ritter.

would find it difficult or impossible to cash out or diversify their holdings. That in

turn would make starting a firm more expensive and reduce the rate at which firms

are created.

As an example, investors plowed $10 billion into U.S. start-up firms in 1993 as

opposed to about $4 billion in Europe, even though the economies of Europe and the

United States are about the same size.¹¹

This means that about 3 percent of European

investments went into start-ups as opposed to 14 percent in the United States. Part of

the reason for the much larger share of U.S. investment in start-up companies is the

ease with which U.S. firms can go public and initial investors can take their money out

of the firm.

The initial public offering (IPO) market for common stock in the United States is

both large and active. During the 1990s more than 4,000 U.S. firms went public, rais-

ing more than $300 billion in the process. Exhibit 3.4 shows the annual number of

firms going public and the total annual proceeds raised by those firms. The IPO mar-

ket is extremely cyclical: In 1974, only 9 firms went public, compared with more than

900 in 1986 and several thousand per year in the late 1990s. Some of the reasons for

this cyclical behavior are discussed below.

Demand- and Supply-Side Explanations for IPO Cycles

There are both demand-side and supply-side explanations for the cyclical nature of the

IPO market. On the demand side, there are periods when an especially large number of

new firms, which are unlikely to obtain private funding at attractive terms, have invest-

ment projects that need to be funded. The Internet start-ups from 1995–1998 are good

examples. On the supply side, there might be periods when investors and institutions that

traditionally invest in IPOs have a lot of money to invest. This could happen, for exam-

ple, if a large inflow of money went into mutual funds that invest in small stocks.¹²

Afirm considering going public would be interested in knowing whetherhot issue

periods—periods during which large numbers of firms are going public_are driven by

a large demand for public funds by firms that need financing or, alternatively, by a large

¹¹The Economist,Nov. 12, 1994. Statistics in the late 1990s are contaminated by privatizations of

large government-held companies in Europe. These do not qualify as start-ups, and no IPO-related data

has yet distinguished these two segments of the IPO market.

¹²See

Choe, Masulis, and Nanda (1993) for a discussion and evidence on demand-side effects. Loughran

and Ritter (1995) discuss and provide evidence of supply-side explanations of the hot issue market.

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Chapter 3

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79

supply of public funds that need to be invested. If the hot issue periods are demand driven,

entrepreneurs may wish to avoid going public during that time because the competition

for funds would suggest that the firm might get a better price by waiting. However, the

supply-side explanation would suggest the opposite: IPOs are observed frequently in some

years and not in others because entrepreneurs are able to time their initial public offer-

ings to correspond with the greater supply of available funding and thereby get better

deals in the hot issue periods. Loughran and Ritter’s empirical study (1995) suggested

that the post-issue stock returns of firms that go public in hot issue periods are quite low,

which supports the supply-side explanation. What this means is that entrepreneurs may

benefit by timing their IPOs so that they come out in hot issue periods. From an investor’s

perspective, however, this would not be a good time to buy IPOs.

Result 3.2

IPOs are observed frequently in some years and not in other years. The available evidencesuggests that the hot issue periods are characterized by a large supply of available capital.Given this interpretation, firms are better off going public during a hot issue period.

The Benefits of Going Public

Although most large U.S. firms are publicly held, there are important exceptions.

Cargill, a multibillion dollar grain dealer in Minneapolis, and Koch Industries, a major

energy firm in Kansas, are privately owned firms. Large firms like these that were pri-

vately owned since inception have always existed. However, during the 1980s, a num-

ber of large publicly traded firms were transformed into private companies. Most of

these firms, such as Safeway and RJR Nabisco, subsequently went public again.

Firms go public for a number of reasons. First, firms may be able to obtain capi-

tal at more attractive terms from the public markets. For example, emerging Internet

firms may have found public markets to be a cheaper source of financing because of

investor enthusiasm for their products. However, a number of firms that go public issue

very few shares in their initial public offering and do not really need the capital that

is raised. This was the case when Microsoft went public.¹³

Microsoft stated that one reason it went public was to provide liquidity through the

public markets to the firm’s managers and other insiders who were previously com-

pensated with shares and who might otherwise be locked into an illiquid investment.

Similarly, the stock of a publicly traded firm may be considered a more attractive form

of compensation than the stock of a private firm, making it easier for the public firm

to attract the best employees. Being public means that the original owners, investors,

and old and new managers can cash out of the firm and diversify their portfolios.

An additional advantage to being public is that stock prices in the public markets

provide a valuable source of information for managers of the firm. Every day, investors

buy and sell shares, thereby rendering their judgments about the firm’s prospects.

Although the market isn’t infallible, it can be a useful reality check. For example, a

manager would probably think twice about expanding the firm’s core business after its

stock price fell. Afalling stock price indicates that a number of investors and analysts

have unfavorable information about a firm’s prospects, which would tend to imply that

an expansion would not be warranted.

Finally, some managers believe that going public is good publicity. Listing the

firm’s stock on a national exchange may bring name recognition and increase the

firm’s credibility with its customers, employees, and suppliers. In some businesses,

¹³For

a discussion of Microsoft’s initial public offering (IPO), see Uttal (1986).

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80Part IFinancial Markets and Financial Instruments

this kind of credibility matters very little. However, the reputation effect of having a

public company with a buoyant stock price was probably very important for many of

the emerging Internet companies in the late 1990s.

The Costs of Going Public

It costs a lot of money to go public. An obvious cost is hiring an investment banker,

attorneys, and accountants, but by far the largest expense is the underwriting fee. As

Exhibit 1.7 in Chapter 1 shows, the total direct costs associated with taking a firm pub-

lic are about 11 percent of the amount of money raised.

While direct costs may be large, there exists an additional and equally important

cost of going public. The price at which the investment banker sells the issue to the

original investors is generally 10 to 15 percent below the price at which the stock trades

in the secondary market shortly thereafter. Regardless of the reason for the observed

underpricing of new issues, firms should add the typical 10 to 15 percent underpricing

to their cost of going public. Taking all of these costs into account, the total cost of

going public could exceed 25 percent of the amount raised in the initial public offer-

ing. However, firms often raise very little in the initial public offering, so the cost as

a fraction of the firm’s total value is generally considerably smaller.

Once a firm is public, it faces other costs that private firms do not bear. Public

firms are required to provide proxy statements and quarterly and annual reports. They

also must hold shareholder meetings and communicate with institutional shareholders

and financial analysts. Because a public firm’s communication with its shareholders

must be relatively open (even more so since the SEC’s Regulation FD changed public

disclosure rules in 2000), any information provided to shareholders also will be avail-

able to competitors, which may put the firm at a competitive disadvantage.

Because a public corporation is more visible than a private company, it may be

pressured to do things in ways that it would not otherwise do. For example, Jensen and

Murphy (1990) advanced the idea that the required revelation of managerial compen-

sation by public companies constrains them from paying their executives too much. In

addition, shareholders may put pressure on managers to make “socially responsible”

investment choices they might not otherwise consider. Examples include shareholder

pressure to pull investments out of South Africa before the abandonment of apartheid

or pressure to avoid using nuclear energy.

Result 3.3 summarizes the discussion in the last two subsections.

Result 3.3The advantages and disadvantages of going public are as follows:

Advantages

•Better access to capital markets.

•Shareholders gain liquidity.

•Original owners can diversify.

•Monitoring and information are provided by external capital markets.

•Enhances the firm’s credibility with customers, employees, and suppliers.

Disadvantages

•Expensive.

•Costs of dealing with shareholders.

•Information revealed to competitors.

•Public pressure.

In general, a firm should go public when the benefits of doing so exceed the costs.

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The Process of Going Public

Taking a company public is a lengthy process that usually requires several months.

The Registration Statement.Once the firm chooses an underwriter, it begins assem-

bling the data required for the registration statement. This includes the audited financial

statements and a complete description of the firm’s business: products, prospects, and

possible risks (for example, reliance on major customers or contracts and dependence

on key personnel). The underwriters are legally responsible for ensuring that the regis-

tration statement discloses all material information about the firm. Material informa-

tionis information that, if omitted, would significantly alter the value of the firm.

Marketing the Issue.The underwriter is also responsible for forming the underwrit-

ing syndicate, marketing the stock, and allocating shares among syndicate members.

Marketing the stock may involve “road shows” in which the firm’s management and

the underwriter explain and try to sell the IPO to institutional investors. These presen-

tations not only enable investors to get a feel for management, but also, and equally

important, they enable the underwriter to form an estimate of the demand for an issue.

Although “expressions of interest” from potential buyers are nonbinding, they influ-

ence the offer price, number of shares, and allocations to particular investors.

Pricing the Issue.Once the SEC approves the registration statement, the process of

going public can move into its final stage of pricing the issue, determining the num-

ber of shares to be sold, and distributing the shares to investors. In many cases, the

IPO is oversubscribed. An oversubscribed offeringmeans that investors want to buy

more shares than the underwriter plans to sell. For example, when Netscape went pub-

lic, the underwriters had five million shares to sell. However, the issue was substan-

tially oversubscribed and the underwriters probably could have sold many times that

number of shares at the offering price. In oversubscribed offerings, U.S. underwriters

have discretion to allocate the shares as they see fit. Individual investors who are not

regular buyers of IPOs are unlikely to be allocated shares in oversubscribed offers. As

we will discuss below, in many countries outside the United States, the underwriter is

required to allocate some shares to all investors who request them.

Book Building vs. Fixed-Price Method.The preceding description of the way in

which investment bankers price and market a new issue is called the book-building

process. The important thing to note about a book-building process is that it allows the

investment banker to gauge the demand for the issue and, as a result, to price the issue

more accurately. This book-building process is used for all but the smallest U.S. IPOs

and has become increasingly popular for foreign IPOs that are marketed internationally.

Until recently, most non-U.S. IPOs were sold with the fixed-price method. For

example, fixed-price offerings in the United Kingdom advertise the number of shares

and the offer price by prospectus 14 days before accepting applications from interested

investors. The important distinction between the fixed-price and book-building meth-

ods is that with the former method the investment bank is less able to gauge investor

demand. In addition, investors in fixed-price offerings are generally allocated shares in

oversubscribed offerings using some fixed formula. For example, if a company offers

one million shares to investors, and investors, in the aggregate, request two million

shares, then each investor may receive only half what he or she requested. In other

words, shares may be allocated on what is called a pro rata basis. There are, however,

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82Part IFinancial Markets and Financial Instruments

frequent deviations from these pro rata allocations. For example, in some cases under-

writers can discriminate in favor of small investors, giving them a larger proportion of

the shares they request. In contrast to the book-building method, where the underwriter

has considerable discretion, in fixed-price offerings, investment banks generally have

little leeway in how to allocate the shares of new issues.

During the 1990s book-building’s popularity increased throughout the world, par-

ticularly in Europe and South America, where governments typically do not limit the

choices of issuers. In Asia, where regulations tend to be more restrictive, the shift to

book building has not been as rapid. In many countries the underwriter uses a hybrid

method_a book-building method for allocating the shares to institutions and a fixed-

price method for allocating shares to individual investors. There has also been a small

number of IPOs that are sold through auctions on the Internet.¹⁴