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offering the United States, firms have to meet several requirements. First, they have to
file a registration statement and prospectus with the SEC, providing information about
the firm™s financial history, its forecasts for the future and how it plans for the funds it
raises from the initial public offering. The prospectus provides information about the
riskiness and prospects of the firm for prospective investors in its stock. The SEC reviews
this information and either approves the registration or sends out a deficiency


recommendations, on the other, can cause the stock price to drop. This is especially true for small,
unknown firms.



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memorandum asking for more information. While the registration is being reviewed, the
firm may not sell any securities, though it can issue a preliminary prospectus, titled a red
herring, for informational purposes only. Once the registration has been approved by the
SEC, the firm can place a tombstone advertisement in newspapers and other
publications.
Step 5: Allocate stock to those who apply to buy it at offering price: If the demand for the
stock exceeds the supply (which will happen if the offering price is set too low), you will
have to ration the stock. If the supply exceeds the demand, the investment banker will
have to fulfill the underwriting guarantee and buy the remaining stock at the offering
price.
On the offering date ““ the first date the shares can be traded ““ the market price
is determined by demand and supply. If the offering price has been set too high, as is
sometimes the case, the investment bankers will have to discount the offering to sell it
and make up the difference to the issuer, because of the underwriting agreement. If the
offering price is set too low, as is often the case, the traded price on the offering date will
be much higher than the market price, thus enriching those who were allocated shares in
the initial public offering.


The Costs of Going Public
There are three costs associated with an initial public offering. First, the firm must
consider the legal and administrative cost of making a new issue, including the cost of
preparing registration statements and filing fees. Second, the firm should examine the
underwriting commission ““ the gross spread between the offering price and what the
firm receives per share, which goes to cover the underwriting, management, and selling
fees on the issue. This commission can be substantial and decreases as the size of the
issue increases. Figure 7.6 summarizes the average issuance and underwriting costs for
issues of different sizes, reported by Ritter (1998).




11 One study of initial public offerings between 1979 and 1982 found that 29% of firms terminated their
initial public offerings at this stage in the process.

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Figure7.6: Issuance Costs by Size of Issue

16.00%


14.00%


12.00%


10.00%
Costs (%)




Underwriting Commission
8.00%
Issuance Expenses

6.00%


4.00%


2.00%


0.00%
<1.99 2.00 -4.99 5.00 - 9.99 10.00 - 20.00 - 50.00 - 100.00 -
19.99 49.99 99.99 500.00
Size of Issue (in millions)



Source: Ritter
The third cost is any underpricing on the issue, which provides a windfall to the investors
who get the stock at the offering price and sell it at the much higher market price. Thus,
for Netscape, whose offering price was $29 and whose stock opened at $50, the
difference of $21 per share on the shares offered, is an implicit cost to the issuing firm.
While precise estimates vary from year to year, the average initial public offering seems
to be underpriced by 10-15%. Ibbotson, Sindelar, and Ritter (1993), in a study of the
determinants of underpricing, estimate its extent as a function of the size of the issue.
Figure 7.7 summarizes the underpricing as a percent of the price by size of issue.




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Figure 7.7: Underpricing as percent of Price - By Issue Size

30.00%



25.00%



20.00%
Underpricing (%)




15.00%



10.00%



5.00%



0.00%
< 1.9 2 - 3.99 4 - 5.99 6 - 9.99 10 - 120
Size of Issue


Source: Ibbotson, Sindelar and Ritter
Private firms tend to pick investment bankers based upon reputation and
expertise, rather than price. A good reputation provides the credibility and the comfort
level needed for investors to buy the stock of the firm; expertise applies not only to the
pricing of the issue and the process of going public but also to other financing decisions
that might be made in the aftermath of a public issue. The investment banking agreement
is then negotiated, rather than opened up for competition.




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Illustration 7.2: The Initial Public Offering for United Parcel Service

On July 21, 1999, United Parcel Service, the world™s largest private package
company, announced plans to sell its shares to the public. The company, which was
wholly owned by its managers and employees, announced that it was going public in
order to raise capital to make acquisitions in the future. UPS reported revenues of $ 24.8
billion and net income of $ 1.7 billion in 1998 and at that time employed about 330,000
people.
UPS followed the initial announcement by filing a prospectus with the SEC on the
same day, announcing its intention of creating two classes of shares. Class A shares, with
10 votes per share, would be held by the existing owners of UPS, and class B shares,
having one vote per share, would be offered to the public.
The firm chose Morgan Stanley as its lead investment banker, and Morgan
Stanley put together a syndicate that included Goldman Sachs and Merrill Lynch as
senior co-managers. Other co-managers included Credit Suisse, Salomon Smith Barney
and Warburg Dillon Read. On October 20, 1999, UPS filed a statement with the SEC
(called an S-1 registration statement) announcing that it planned to issue 109.4 million
shares (about 10% of the 1.1 billion outstanding shares) at a price range12 of $ 36 to $ 42,
and that the initial public offering would occur sometime in early November.
Based upon the strong demand from institutional investors, gauged in the process
of building the book, the investment banking syndicate increased the offering price to $
50 per share on November 8, 1999, and set the offering date at November 10, 1999. At
that time, it was the largest initial public offering ever by a U.S. company.
On November 10, 1999, the stock went public. The stock price jumped to $
70.1325 from the offering price of $ 50. At the end of the trading day, UPS shares were
trading at $ 67.25. Based upon this price and the total number of shares outstanding, the
market value of UPS was assessed at $ 80.9 billion.



12 The process by which this price range was set was not made public. We would assume that it was
partially based upon how the market was pricing two other publicly traded rivals “ Fed Ex and Airborne
Freight.

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7.9. ˜: The Cost of Underrpricing
Assume that the market is correct in its assessment of UPS value and that the investment
bankers underpriced the issue. How much did the underpricing cost the owners of UPS?
a. About $ 22 billion
b. About $ 50 billion
c. About $ 2.2 billion
d. None of the above


In Practice: The Underpricing of IPOs
Investment bankers generally underprice initial public offerings and are fairly
open about the fact that they do. This gives rise to two questions. First, why don™t the
offering firms express more outrage about the value left on the table by the underpricing?
Second, can investors take advantage of the underpricing by subscribing to dozens of
initial public offerings? There are simple answers to both questions.
It is true that an underpriced initial public offering results in less proceeds going
to the issuing firms. However, the loss of wealth is a function of how much of the equity
of the firm is offered in the initial offering. If, as in the UPS offering, only 10% of the
stock is being offered, we can see why many issuing firms go along with the
underpricing. The favorable publicity associated with a strong opening day of trading
may act as promotion for subsequent offerings that the firm plans to make in future
months or even years.
It is not easy constructing an investment strategy that takes advantage of the IPO
mispricing. If an investor applies for shares in a number of offerings, she is likely to get
all the shares she requests in the offerings that are over priced and only a fraction of the
shares she requests in the offerings that are underpriced (where there will be rationing
because of excess demand). The resulting portfolio will be overweighted in overpriced
public offerings and underweighted with the underpriced offerings, and the returns will
not match up to those reported in IPO studies.




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The Choices for a Publicly Traded Firm

Once a firm is publicly traded, it can raise new financing by issuing more
common stock, equity options or corporate bonds. Additional equity offerings made by
firms that are already publicly traded are called seasoned equity issues. In making stock
and bond offerings, a publicly traded firm has several choices. It can sell these securities
with underwritten general subscriptions, through stocks and bonds are offered to the
public at an offering price guaranteed by the investment banker. It can also privately
place both bonds and stocks with institutional investors, or issue stocks and bonds
directly to investors, without any middlemen.

General Subscriptions

In a general subscription, the issue is open to any member of the general public
to subscribe. In that sense, it is very similar to an initial public offering, though there are
some basic differences:
Underwriting Agreement: The underwriting agreement of an initial public offering

almost always involves a firm guarantee and is generally negotiated with the
investment banker, while the underwriting agreements for seasoned issues take on a
wider variety of forms. First, there is the potential for competitive bids to arise on
seasoned issues, since investment bankers have the information13 to promise a fixed
price. There is evidence that competitive bids reduce the spread, though even
seasoned firms continue to prefer negotiated offerings. Second, seasoned issues also
offer a wider range of underwriting guarantees; some issues are backed up by a best
efforts guarantee, which does not guarantee a fixed price; other issues come with
stand-by guarantees, where the investment banker provides back-up support, in case
the actual price falls below the offering price. The payoff from relaxing the guarantee
comes as lower underwriting commissions.
Pricing of Issue: The issuer of an initial public offering has to estimate the value of

the firm and then the per-share value before pricing the issue, while the pricing of a



13 The information takes two forms. The first are the filings that every publicly traded firm has to make
with the SEC. The other, and more important, is the current stock price.

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