From Private to Publicly Traded Firm: The Initial Public Offering

            A private firm is restricted in its access to external financing, both for debt and equity. In our earlier discussion of equity choices, we pointed out the hard bargain venture capitalists extract for investing equity in a private business. As firms become larger and their capital needs increase, some of them decide to become publicly traded and to raise capital by issuing shares of their equity to financial markets.

Staying Private versus Going Public

            When a private firm becomes publicly traded, the primary benefit is increased access to financial markets and to capital for projects. This access to new capital is a significant gain for high growth businesses, with large and lucrative investment opportunities. A secondary benefit is that the owners of the private firm are able to cash in on their success by attaching a market value to their holdings. Thus, owners can become very wealthy individuals overnight. To illustrate, in a well publicized stock offering, Netscape, a company servicing the Internet, was valued at $2.1 billion on the day it went public. Jim Clark, the CEO and co-founder of the firm, who owned about 25% of the outstanding shares in the firm, found his stake valued at $565 million, while Marc Andreesen, the then 24-year old programmer who co-founded the firm, found his million shares to be worth $58.25 million.

            These benefits have to be weighed against the potential costs of being publicly traded. The most significant of these costs is the loss of control that may ensue from being a publicly traded firm. As firms get larger and the owners are tempted to sell some of their holdings over time, the owner誷 share of the outstanding shares will generally decline. If the stockholders in the firm come to believe that the owner誷 association with the firm is hurting rather than helping it, they may decide to put pressure for the owner誷 removal. In the case of Apple Computers, for instance, the two founders, Steve Jobs and Steve Wozniak, were eventually removed from management positions, largely as a consequence of stockholder disapproval with their actions. In an ironic twist, Steve Jobs returned as Apple誷 CEO in 1998 and engineered a turn around in its fortunes.

            Other costs associated with being a publicly traded firm are the information disclosure requirements and the legal requirements[1]. A private firm experiencing challenging market conditions (declining sales, higher costs) may be able to hide its problems from competitors, whereas a publicly traded firm has no choice but to reveal the information. Yet another cost is that the firm has to spend a significant portion of its time on investor relations, a process in which equity research analysts following the firm are cultivated[2] and provided with information about the firm誷 prospects.

            Finally, firms may not be able to go public if they do not meet the minimum listing requirements for the exchange on which they want to be traded. The listing requirements vary across exchanges, with the New York Stock Exchange imposing the strictest requirements [pre-tax income of at least $ 2.5 million, tangible assets of at least $ 18 million and 2000 or more stockholders]. Most small firms, therefore, choose to get listed on the NASDAQ, which has far fewer restrictions on listing. While some of these firms move on to the NYSE as they become larger, firms like Intel and Microsoft have chosen to stay on the NASDAQ.

            Overall, the net tradeoff to going public will generally be positive for firms with large growth opportunities and funding needs. It will be smaller for firms that have smaller growth opportunities, substantial internal cash flows, and owners who value the complete control they have over the firm.

Choosing an Investment Banker

            Once the decision to go public has been made, a firm generally cannot approach financial markets on its own. This is so because it is largely unknown to investors and does not have the expertise to go public without help. Therefore, a firm has to pick intermediaries to facilitate the transaction. These intermediaries are usually investment bankers, who provide several services. First, they help the firm meet the requirements of the Securities and Exchange Commission (SEC) in preparing and filing the necessary registration statements needed for the public offering. Second, they provide the credibility a small and unknown private firm may need to induce investors to buy its stock. Third, they provide their advice on the valuation of the company and the pricing of the new issue. Fourth, they absorb some of the risk in the issue by guaranteeing an offer price on the issue; this guarantee is called an underwriting guarantee. Finally, they help sell the issue by assembling a group called an underwriting syndicate, who try to place the stock with its clients. The underwriting syndicate is organized by one investment bank, called the lead investment bank.

            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 行 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 17.9 summarizes the average issuance and underwriting costs for issues of different sizes, reported by Ritter (1998).

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 17.10 summarizes the underpricing as a percent of the price by size of issue.

Source: Ibbotson, Sindelar and Ritter

            If the only task for the issuing company were to find the investment banker who could deliver the lowest combined cost, including both underwriting commission and underpricing costs, the whole process could be opened up to auction and the investment banker that promised to deliver the highest net proceeds to the firm would be chosen. There are several problems with this ideal scenario, however. First, the proceeds from the issue, based upon the offering price, may not be delivered, and the investment bank may not have the capital to back up its guarantee. Second, a bungled initial public offering 行 one whose offering price is set too high 行 can create lasting damage to the issuing firm誷 reputation and affect its ability to make future issues. Third, the investment banker of choice may not have the specialized expertise[3], say in biotechnology or software development, to provide the advice needed to help the issuing company decide on the particulars of the issue. Fourth, given that this is a private firm, no investment banker may be willing to estimate an offering price without receiving more information from the firm. Finally, the presumption that there will be a large number of investment bankers contending for the issue may not hold true. A number of private firms have to seek out and convince an investment banker to take them public and do not have the luxury of choosing between multiple bidders.

            Given these problems, 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.

Valuing the Company and Setting Issue Details

            Once the firm chooses an investment banker to take it public, the next step is to estimate a value for the firm. This valuation is generally done by the lead investment bank, with substantial information provided by the issuing firm. The value is sometimes estimated using discounted cash flow models, similar to those described in chapter 5. More often, though, the value is estimated by using a multiple, like a price earnings ratio, and by looking at the pricing of comparable firms that are already publicly traded. Whichever approach is used, the absence of substantial historical information, in conjunction with the fact that these are small companies with high growth prospects, makes the estimation of value an uncertain one at best.

            The other decision the firm has to make relates to the size of the initial issue and the use of the proceeds. In most cases, only a portion of the firm誷 stock is offered at the initial public offering; this reduces the risk on the under pricing and enables the owners to test the market before they try to sell more stock. In most cases, the firm uses the proceeds from the initial stock issue to finance new investments.

            The next step in this process is to set the value per share for the issuer. To do so, the equity in the firm is divided by the number of shares, which is determined by the price range the issuer would like to have on the issue. If the equity in the firm is valued at $ 50 million, for example, the number of shares would be set at 5 million to get a target price range of $10, or at 1 million shares to get a target price range of $ 50 per share.

            The final step in this process is to set the offering price per share. Most investment banks set the offering price below the estimated value per share for two reasons. First, it reduces the bank誷 risk exposure, since it ensures that the shares will be bought by investors at the offering price. (If the offering price is set too high and the investment bank is unable to sell all of the shares being offered, it has to use its own funds to buy the shares at the offering price.) Second, investors and investment banks view it as a good sign if the stock increases in price in the immediate aftermath of the issue. For the clients of the investment banker who get the shares at the offering price, there is an immediate payoff; for the issuing company, the ground has been prepared for future issues.

In setting the offering price, investment bankers have the advantage of first checking investor demand. This process, which is called building the book, involves polling institutional investors prior to pricing an offering, to gauge the extent of the demand for an issue. It is also at this stage in the process that the investment banker and issuing firm will present information to prospective investors in a series of presentations called road shows. In this process, if the demand seems very strong, the offering price will be increased; in contrast, if the demand seems weak, the offering price will be lowered. In some cases, a firm will withdraw[4] an initial public offering at this stage, if investors are not enthusiastic about it.

SEC Requirements

            In order to make a public 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誷 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 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. This ad contains details of the issue, the name of the lead investment banker, and the names of other investment bankers involved in the issue. The order in which the investment bankers are listed is significant. At the top is the lead investment banker and the co-managers of the issue, followed by the major bracket investment bankers. The categorization is based both upon reputation and national focus. Then comes the mezzanine bracket, which includes smaller investment banks that operate nationally, and at the bottom are the regional investment bankers involved with the issue. Figure 17.11 shows a typical tombstone advertisement for an initial public offering.

Figure 17.11: Tombstone Advertisement


The Issue

            Once the offering price has been set and the tombstone advertisement published, the die is cast. If the offering price has indeed been set below the true value, the demand will exceed the offering, and the investment banker will have to choose a rationing mechanism to allocate the shares. On the offering date 行 the first date the shares can be traded 行 there will generally be a spurt in the market price. 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.

In Practice 17.1: The Initial Public Offering for United Parcel Service

            On July 21, 1999, United Parcel Service, the world誷 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 outstanding shares) at a price range[5] 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 oustanding, the market value of UPS was assessed at $ 80.9 billion.


[1] The costs are two fold. One is the cost of producing and publicising the information itself. The other is the loss of control over how much and when to reveal information about the firm to others.

[2] This may sound like an odd term, but it is accurate. Buy recommendations from equity research analysts following the firm provoke investor interest and can have a significant impact on the stock price; sell recommendations, on the other, can cause the stock price to drop. This is especially true for small, unknown firms.

[3] Hambrecht and Quist, for instance, is an investment bank that is viewed as a specialist on initial public offerings of technology firms.

[4] 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.

[5] 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.