INITIAL PUBLIC OFFERINGS (IPOs) & STOCK VALUATION

1. INITIAL PUBLIC OFFERINGS (IPOs)&STOCK VALUATION

2. Introduction • The modern U.S. corporation was born in a courtoom in Washington, D.C., on February 2, 1819. On that day the U.S. Supreme Court established the legal precedent that the property of a corporation, like that of a person, is private and entitled to protection under the U.S. Constitution. • The Four Types of Firms • Sole Proprietorship • Partnership • Limited Liability Company • Corporation

3. The Four Types of Firms Sole Proprietorship Business is owned and run by one person Typically has few, if any, employees Advantages Easy to create Disadvantages Unlimited personal liability Limited life

4. The Four Types of Firms Partnership Similar to a sole proprietorship, but with more than one owner All partners are personally liable for all of the firm’s debts. A lender can require any partner to repay all of the firm’s outstanding debts. The partnership ends with the death or withdrawal of any single partner.

5. The Four Types of Firms Partnership Limited Partnership has two types of owners. General Partners Have the same rights and liability as partners in a “regular” partnership Typically run the firm on a day-to-day basis Limited Partners Have limited liability and cannot lose more than their initial investment Have no management authority and cannot legally be involved in the managerial decision making for the business

6. The Four Types of Firms (cont'd) Limited Liability Company (LLC) All owners have limited liability but they can also run the business. Relatively new business form in the U.S.

7. The Four Types of Firms Corporation A legal entity separate from its owners Has many of the legal powers individuals have such as the ability to enter into contracts, own assets, and borrow money The corporation is solely responsible for its own obligations. Its owners are not liable for any obligation the corporation enters into. Corporations must be legally formed. The corporation files a charter with the state it wishes to incorporate in.

8. The Four Types of Firms Corporation Ownership Represented by shares of stock Owner of stock is called Shareholder Stockhoder Equity Holder Sum of all ownership value is called equity. There is no limit to the number of shareholders, and thus the amount of funds a company can raise by selling stock. Owner is entitled to dividend payments.

9. The Four Types of Firms • Because most corporations have many owners, each owner owns only a small fraction of the corporation. • The entire ownership stake of a corporation is divided into shares known as stock. • The collection of all the outstanding shares of a corporation is known as the equity of the corporation. • An owner of a share of stock in the corporation is known as a shareholder, stockholder, or equity holder and is entitled to dividend payments, that is, payments made at the discretion of the corporation to its equity holders. .

10. Types of U.S. Firms Source: www.bizstats.com

11. Corporations: Ownership vs Control It is often not feasible for the owners of a corporation to have direct control of the firm because there are sometimes many owners In a corporation, direct control and ownership are often separate. Rather than the owners, the board of directors and chief executive officer possess direct control of the corporation. The shareholders of a corporation exercise their control by electing a board of directors, a group of people who have the ultimate decision-making authority in the corporation. In most corporations, each share of stock gives a shareholder one vote in the election of the board of directors, so investors with the most shares have the most influence. The board of directors makes rules on how the corporation should be run (including how the top managers in the corporation are compensated), sets policy, and monitors the performance of the company.

12. Corporations: Ownership vs Control • The board of directors delegates most decisions that involve day-to-day running of the corporation to its management. • The chief executive officer (CEO) is charged with running the corporation by instituting the rules and policies set by the board of directors. • The separation of powers within corporations between the board of directors and the CEO is not always distinct. • In fact, it is not uncommon for the CEO also to be the chairman of the board of directors. • The most senior financial manager is the chief financial officer (CFO), who often reports directly to the CEO.

13. Organizational Chart of a Typical Corporation

14. Corporations: Ownership vs Control Goal of the Firm Shareholders will agree that they are better off if management makes decisions that maximizes the value of their shares.

15. The Stock Market The stock market provides liquidity to shareholders. Liquidity The ability to easily sell an asset for close to the price you can currently buy it for Public Company Stock is traded by the public on a stock exchange. Private Company Stock may be traded privately.

16. The Stock Market Primary Markets When a corporation itself issues new shares of stock and sells them to investors, they do so on the primary market. Secondary Markets After the initial transaction in the primary market, the shares continue to trade in a secondary market between investors.

17. The Stock Market • In bank-based systems (as in Germany and Japan) banks play a leading role in mobilizing savings, allocating capital, overseeing the investment decisions of corporate managers, and providing risk management vehicles. • In market-based systems (as in England and the United States) securities markets share center stage with banks in getting society's savings to firms, exerting corporate control, and easing risk management. • “For over a century, economists and policy makers have debated the relative merits of bank-based versus market-based financial systems. Recent research, however, argues that classifying countries as bank-based or market is not a very fruitful way to distinguish financial systems (“Bank-Based or Market-Based Financial Systems: Which is Better?”, 2012, Ross Levine, Carlson School of Management, University of Minnesota)

18. The Stock Market • Since the 19th century, many economists have argued that bank-based systems are better at mobilizing savings, identifying good investments, and exerting sound corporate control, particularly during the early stages of economic development and in weak institutional environments. • Proponents of the bank-based view also stress that liquid markets create a myopic investor climate [Bhide, 1993]; also, banks form long-run relationships with firms. • However, powerful banks can stymie innovation by extracting informational rents and protecting established firms with close bank-firm ties from competition (Hellwig, 1991; Rajan, 1992). • Others, emphasize the advantages of markets in allocating capital, providing risk management tools, and mitigating the problems associated with excessively powerful banks. • On the other hand, well-developed markets quickly reveal information in public markets, which reduces the incentives for individual investors to acquire information [Stiglitz, 1985].

19. The Stock Market Largest Stock Markets New York Stock Exchange (NYSE) Market Makers/Specialists Each stock has only one market maker NASDAQ Does not meet in a physical location May have many market makers for a single stock Bid Price versus Ask Price Bid-Ask Spread Transaction cost

20. Worldwide Stock Markets Ranked by Two Common Measures Source: www.world-exchanges.org

21. Εισηγμένες Επιχειρήσεις, ΝΥ

22. GOING PUBLIC Initial Public Offerings (IPOs)

23. Raising Capital • Bank Loans • Issuing Bonds • Issuing Stocks • Retained Earnings • For example, with bonds the rate may often be less compared to a bank loan, but the firm must make coupon payments even when it has no profits. • With stocks the cash generated does not have to be repaid, however, new stock issuance dilutes ownership, may affect management, and profits are shared with more stockholders.

24. Why firms go public? • Myers and Majluf (1984) and Myers (1984), based on information asymmetry and possible mis-pricings argue that there is a pecking order of financing: → internal funds → loans → external funding

25. Why firms go public? • Many theories • Firms decide to go public when external funds minimize the cost of capital, and thus, they maximize the value of the firm (Scott (1976), Modigliani and Miller (1963)). • Others argue that through IPOs internal investors may get their capital back i.e. cash out, (Zingales (1995), Mello and Parsons (2000)). • Ang and Brau (2003) show that internal investors find an opportunity to sell their shares in the IPO with a profit • Black and Gilson (1998) argue that through IPOs Venture Capitals take their profits

26. Why firms go public? • Through IPOs Mergers and Acquisitions (M&As) are possible (Zingales (1995)). • For example, an IPO may be the first step of an acquisition: a publically traded stock may be used as “currency” for an M&A (e.g. stock for stock merges) and assist significantly in the valuation.

27. Why firms go public? • An IPO may be a strategic move, e.g. to broaden the shareholder base of the firm (Chemmanur and Fulghieri (1999)). • An IPO may give an advantage to the firm against competitors (that are not public firms), increase its reputation and publicity about the firm (Maksimovic and Pichler (2001)). • Finally, Bradley, Jordan, and Ritter (2003) also show that analyst reports and suggestions are positively biased after and IPO.

28. Why IPOs come in waves? • Management wants to take advantage of the positive sentiment in bull (up) markets in order to sell the stock in attractive valuations • (Ritter and Welch (2002), Ritter (1991), Loughran and Ritter (1995)). • Lowery and Schwert (2002) argue that the IPO first day abnormal returns drive other firms to go public

29. Why IPOs come in waves? • Choe, Masulis, and Nanda (1993) argue that many firms will proceed with an IPO when other good firms do • Choe, Masulis, and Nanda (1993) and Lowery (2002) argue that firms will do an IPO when they reach a certain point in the life-cycle of the sector and need external capital to continue growing

32. Table 2 • CFOs feel that it is very important to proceed with an IPO in order to create currency (stocks) for future Mergers and Acquisitions (M&As) (mean = 3.56; % agreeing = 59) • This holds for all samples, i.e. firms that did a successful IPO, firms that did not do an IPO finally (withdrawn), and firms that did not even tried(not tried) • Only one other reason (to create a market price for their firm) is supported by answers. • Note that to establish a market price is the first step for M&As

34. Table 3 • Timing is the single most important reason for CFOsto proceed with an IPO (mean = 4.21; % agreeing = 83). • This finding is important for all sub-samples • Other important factors are the conditions in the industry (3.87; % agreeing = 70) and the need for capital to support growth (3.82; % agreeing = 66). • The IPO underpricing are relatively not important

35. The role of the Underwriter • It has been observed that firms often change underwriter between the IPO and a subsequent capital raising (Krigman et al. (2001)). • Why? See Table 4 • The findings suggest that CFOsbelieve that the ability of the underwriter to provide sophisticated know-how and advice is the most important reason • overall reputation (mean = 4.39, % agreeing = 91) • quality of research (4.25, 83%) • industry expertise (4.24, 88%)

37. IPO underpricing • A global phenomenon • The pricing of an initial public offering (IPO) below its market value. • When the offer price is lower than the price of the first trade, the stock is considered to be underpriced. • A stock is usually only underpriced temporarily because the laws of supply and demand will eventually drive it toward its intrinsic value. • IPOs have historically had very large initial first day gains compared to the performance of the rest of the market.

38. IPO underpricing • Underpricing: shares traded publicly for the first time substantially jump in price on the first trading day. • This implies that investors are willing to pay higher prices for shares when trading begins than investors paid for their share allocation from the investment bank that accompanied the prospective IPO. • Since a large amount of money is left on the table when oweners sell their shares too low underpricing is costly to firm owners (Ljungqvist (2006)).

39. Do differences in institutional and legal environments explain cross-country variations in IPO underpricing? C Hopp, A Dreher - Applied Economics, 2013

40. Differences between European & American IPO market, Jay Ritter, European Financial Management, 2003, Vol. 9(4)

41. Differences between European & American IPO market, Jay Ritter, European Financial Management, 2003, Vol. 9(4)

42. A Review of IPO Activity, Pricing, and Allocations, Jay R Ritter, Ivo Welch The Journal of Finance, 2003, Vol. 579(4)

43. Theories of underpricing • Differences between the IPO offering price and the first day closing price occur too often and are, on average, too large to be explained away by error in auditing practices (for a review see also P. Karlis, The Park Place Economist / vol. VIII, p. 81-89, see next slides). • If this were the case, then an auditing firm or investment bank would also error on the side of overpricing the stock. • Any price movement upwards from the IPO price (minus floatation fees) is precious money left on the table by the issuing firm that will be needed someday. • Ideally, stock prices should match the per share present value of the discounted future earnings of the company, theoretically paid out as dividends.

46. Theories of underpricing • IPO underpricing cannot be explained by asset-pricing risk premia, systematic risk, liquidity risk (Ritter & Welsh, 2002, pp. 1802-1803) • Attempts to explain: • Asymmetric information theories • Symmetric information theories • Theories focusing on the allocation of shares

47. Theories of IPO Underpricing • Adverse Selection Theory (Rock, 1986) • There are two different investor groups, informed and uninformed; the informed investors know the true value of the stock and uninformed investors invest randomly without any knowledge of the company. • Rock assumes that the investment bank has perfect knowledge of the issuing firm’s real value and the issuing firm must rely on the investment bank’s audit for this information. • Since the supply of a company’s common stock is held constant, the price fluctuates by changes in the demand for the stock. Here, demand is separated into two categories: informed investor demandand uninformed investor demand.

48. Theories of underpricing • Adverse Selection Theory (Rock, 1986) • If companies had IPO prices that reflected their true value then, by the law of large numbers, the uninformed investors would either break even or lose money because the informed investors would only invest in the “good” IPOs, crowding out the uninformed investors, and be the only ones turning profits. • Thus, uninformed investors would choose not to participate in the IPO market, thereby cutting the demand for stock in IPOs. • This drop in demand for IPOs would leave less promising issuing firms with undersubscribed IPOs. • To compensate for this, companies intentionally underprice IPOs as a rational behavior in order to induce the uninformed investors to participate in the market and thereby raising the demand for the issues.

49. Theories of underpricing • Principal-Agent Theory (Baron, 1982) • Baron & Holmstrom (1980) and Baron (1982) argue that the underwriters use their superior knowledge and underprice (asymmetric information) in an attempt to reduce their cost of promoting the issue and attract buy-side clients. • Assumption: the issuing firm does not know its own true value and must rely on the auditing of outside companies and the investment bank to report accurate information. • The issuing firm and investment bank agree to an IPO contract based on the report that the investment bank gives the issuing firm concerning its value.

50. Theories of underpricing • Principal-Agent Theory (Baron, 1982) • The price of the IPO must be low enough to induce the investment bank, to act in the issuing firm’s best interest. • That is, the issuing firm leaves some money on the table for the investment bank in order to insure that they (the agent) disclose all information about the firm and act in the firm’s best interest.